To Our Clients and Friends of Parthenon LLC
After a nearly flat first quarter, the stock market moved solidly higher in the second quarter. The S&P 500 was up, with dividends, 6.24% and is up 6.99%, with dividends, through mid-year. Bond prices fell and yields rose with the ten-year Treasury bond yield rising to 5.03% after starting the year at 4.70%. The ten-year Treasury yield briefly broke through 5.25% for the first time in over five years as investors grew less convinced that overall inflation will remain low enough to allow the Federal Reserve to lower rates. The increase in bond yields contributed to an ultimately modest, but at times aggressive, drop in the stock market from its all-time highs. There is a growing concern that global liquidity, with all its attendant benefits, will diminish. However, even after the increase, long-term, high-quality bond yields remain historically low. We stated at the beginning of the year our belief that equities were priced at a level likely to generate returns close to the underlying growth in business values. We continue to feel that way, although returns for the broad market were modestly above that level for the first half. The economy slowed significantly in the first quarter with growth in Gross Domestic Product of only 0.7%. Economic growth is expected to be higher for the second-quarter and job growth remains reasonably robust. Overall inflation readings, excluding energy and food, have remained subdued. However, excluding energy and food costs understates the toil that inflation is taking on the consumer. Both costs inputs remain wildcards in attempting to forecast consumer spending and, hence, growth in GDP over the next year.
The Beginning of the End (of Easy Money)?
A measure of fear returned to the stock market, if only briefly, in the second quarter. The fear centered on both a potential threat to the private equity buyout boom, and worsening sub-prime mortgage defaults. The common underlying theme is risk tolerance. Will lenders, and investors, demand greater expected returns for their forbearance? In the sub-prime mortgage arena, the answer is already in, and the answer is resoundingly negative. Lenders are tightening loan terms and covenants, and regulators are tightening their grip and oversight of the sub-prime market. The answer in the private equity arena is more uncertain. We read recently that more than 150 private equity funds have over $1 billion each, with many of those well in excess of that. Combined with the multiplying effect of leverage (debt), that has created an enormous pool of capital to buy public companies, often at substantial premiums to their public market prices. The captains of the private equity funds may be brilliant, charismatic and hard charging, but make no mistake about it, leverage makes the math work. The math is elementary, and the cheaper the debt the higher the buyout price that can, and will, be paid for public companies. The price of that leverage is pegged to the overall level of interest rates, and perhaps more importantly, to the spread between low-risk and high-risk debt. And that spread, compared to historical standards, has been very narrow. The lenders have been quite generous and kind. They are true believers and have been rewarded for that faith thus far. Nevertheless, many of the biggest deals, at the highest prices, are relatively young. As they season, it could prove a little like the man who fell from a tall building. As he passed each floor, he could be heard saying “so far, so good.” The deals continue to be announced (if the funds have money they will spend it), and are unlikely to slow down dramatically until, and if, conditions create significantly more risk aversion among the suppliers of capital.
Berkshire and Blackstone – Yin and Yang.
Along the same theme of risk and debt, we think it makes for an interesting comparison to ponder the differences between the venerable long-time paragon of business accumulation, Berkshire
Hathaway, and the newcomer, The Blackstone Group, the reigning king of private equity and recent issuer of stock to the public. Their respective business styles could not be more different. Neither could the market’s recent attitude toward each. The market’s excitement for the pending and subsequent offering of Blackstone contrasts mightily with the recent indifference toward Berkshire. We are not comparing the relative investment merits of the two. We profess only modest knowledge of the newcomer. Blackstone has grown assets much faster than Berkshire over the past several years, as have other private equity firms, and may prove to be a solid investment from the offering price. We do have a fairly in-depth knowledge of Berkshire, and we believe it will be a sound investment at current prices. Blackstone’s lifeblood is debt and the willingness of lenders to extend credit at attractive (to the borrower) prices. A decrease in lenders tolerance of risk would dramatically alter the value proposition in Blackstone, which depends so heavily on the kindness of friends. Berkshire eschews debt and risk with a passion and maintains a balance sheet whose strength is unequaled in corporate America. Berkshire’s economic advantages include that unparalleled financial strength, myriad businesses with superior economic characteristics, expertise in capital allocation, and a reputation as a good “home” for superior private businesses. Blackstone has its strengths, for sure, though they may be less enduring and more prone to competitive pressures. As the competition for good deals intensifies, the 20% or better annual returns of Blackstone and other private equity firms becomes much more problematic. There is only so much low hanging fruit. We do not have a strong opinion on the near-term outlook for the industry, but as more private equity firms rush to go public, we would be reluctant to be enthusiastic buyers from such eager and knowledgeable inside sellers.
The Price of Consistency?
We have always bemoaned our “sins of omission.” We define that as not buying, for some reason, a promising business that we have studied and believe we understand, that ultimately moves much higher. These “sins of omission” can be quite frustrating and painful. In contrast, we have never been particularly troubled that we may not have fully participated in the popularity of a particular sector. We create our portfolios from the “bottom-up” company by company, not from the “top-down” by sector or industry. Consequently, we often have limited exposure in our portfolios to certain sectors if we feel there are few companies within a sector with the business characteristics, and risk profile, we prefer – we like to play a strong “defense”. Also, we may be unable to find stocks within a sector selling at the valuations we demand. This philosophical characteristic has not generally been, over the past two decades, a large hindrance other than for fairly brief periods. But, our limited exposure to the energy and basic materials sectors has been a substantial and sustained headwind for the past several years. This has caused us to reflect and examine carefully our methodology. Is this simply the cost of philosophical consistency, a cost worth enduring for superior long-term performance? And, has our insistence on a strong “defense” come at the expense of a high-quality “offense”? To quote Emerson, “A foolish consistency is the hobgoblin of little minds.” Delineating wise, as opposed to foolish, consistency is the challenge and a challenge we are confronting. We will continue to insist on the same quality and valuation parameters in our portfolios, and continue to search all industries for businesses that have the enduring advantages we desire.
