To Our Clients and Friends of Parthenon LLC
Although 2007 was a year of growing market volatility and economic angst, the returns for the broad market were only moderately below the long-term average. Hidden behind the broad numbers were some extremely wide divergences in business and stock performance across industries and companies. The S&P 500, with dividends, finished the year up 5.49%. Bond yields dropped as the economic outlook diminished. The 10-year Treasury bond yield declined from 4.70% to 4.02% and has continued to drop since the beginning of the year. The Federal Reserve cut rates three times during the year for a total of 1.00% to stimulate the economy, and cut again 0.75% as we prepared this report, with more reductions widely anticipated.
Rarely has one word so dominated the financial and investment landscape as “mortgage” did in 2007. More importantly, rarely has it been more appropriate. The preoccupation with the spreading economic fallout and financial damage from the mortgage meltdown has continued into 2008. The consequences of the housing slowdown and rising delinquencies have been swift, and hugely negative, for companies directly in the maelstrom. Over 100 mortgage companies have filed for bankruptcy. Many more diversified financial institutions have suffered severe damage. Few financial firms have totally sidestepped the storm.
The stock market, while not cheap, does not appear expensive by historical standards, assuming only a modest and brief profit recession. However, a severe downturn would have greater consequences for earnings and valuations. The stock market began to anticipate a recession in the fall and economists, investors, and politicians, have now reached a consensus that a recession, possibly a serious one, is all but inevitable. We do not know if one will occur, nor how bad it will be if it does. We have listened to the companies we own, and to many more that we follow. Some are already experiencing a downturn while others, as late as mid-January, still did not feel the economy was going to fall into a recession. Much like the parable of the blind men touching the elephant and describing what they have touched, where you “touch” the economy may determine your outlook. “Touch” housing and you find a momentous downturn, but the story is quite different at manufacturers with a sizable export businesses. A weak dollar may cause numerous ills, but it also has improved the competitiveness of U.S. exporters.
As we search for opportunities, more stocks are moving into our value range. Nevertheless, we have not been aggressive net buyers of stocks. Our concern is that we may not be in “normal” times, and we are working to understand the possible implications for business profitability. Numerous questions abound. What earning power was illusory and what is sustainable? The building supply retailers, for example, were boosted for years by residential real estate transactions, house price appreciation, and home equity loans. What is the real run rate of earnings for this group? Are historical valuation models relevant for those sectors of the market most directly in the line of fire if, in fact, this is no ordinary consumer downturn? We are asking those questions for businesses we own, and many more that we follow. The housing downturn and its impact on the actual and perceived wealth of consumers may be unprecedented, particularly so when combined with the burden of higher energy costs. We think it may be rational, and prudent, to include an “X factor” of some magnitude when estimating earning power for some sectors and determining a price that constitutes a compelling opportunity. However, too high an “X” factor may leave an investor on the sidelines too long. All downturns end and it takes great hubris to predict the direction of such an enormously complex organism as the global economy and correctly time the eventual upturn.
Cautious but Opportunistic
It is only through serendipity that an investor can expect to buy an asset at the precise bottom (or sell at the top). We cannot predict the ultimate bottom of the market, nor of any particular stock we are contemplating purchasing. If history is a reliable guide, one thing seems probable – the stock market will bottom before the economy does. That knowledge is of some, but limited, value since the timing and depth of any economic downturn cannot be predicted with much certainty. The analysis hinges on deciding if a slowdown is already “in” the stock price. Has the price dropped enough to discount a period of general economic weakness, and provide a good return when the economy again moves forward?
Among the sectors that may yield abundant opportunities are cyclical companies with strong balance sheets. It may prove fruitful as the economy slows to venture into cyclically exposed but financially strong companies. Obviously, all companies directly or peripherally involved in housing have been marked down dramatically in valuation. We are moving with extreme caution here, as their earning power is being revealed to have dropped commensurately. It is always necessary to look over the “valley” to the next upturn. One of the most difficult things about investing is that the stocks to own and buy are often the ones that have recently been the most painful for the current owners. The downtrodden of today are often the victors of tomorrow.
As domestic equities falter, there are few investment siren songs that sound as appealing now as the call to invest in emerging markets. We believe, where appropriate given risk parameters, income needs, and other portfolio characteristics, exposure to these markets may present a compelling long-term opportunity. However, it is far from assured that the probable strong growth of the emerging economies will produce strong investment returns, particularly in the intermediate term given the recent exuberance of their respective markets. Economic growth and greater earning power does not always correlate with good investment results. Consider an example closer to home. At the peak in March of 2000, the market value of Cisco Systems was approximately $580 billion, making it briefly one of the two most valuable public companies in the world. Cisco earned $3.9 billion that year. Current consensus expectations call for Cisco to earn over $8 billion in 2008. That progress is actually understated since stock option costs were not expensed in 2000, somewhat inflating reported earnings for that year. Given that progress, and good long-term prospects, the market value might be expected to have increased. But, the market value at the end of 2007 was only $160 billion, a decline of over 70%. The valuation on higher earnings has declined from 150 times earnings to 22 over the past 8 years. We “cheated” a little with this illustration by using the “poster child” of the tech bubble and we have no reason to believe that the valuation of the emerging markets has entered the extremely overvalued level, although some investors we respect have cautioned that they are. Nor do we predict they will “pop” with the ferocity and magnitude that the tech bubble did. Nevertheless, price bubbles can, and occasionally do, develop anywhere that assets are bought and sold, including the countries with the most promising growth prospects.
Our investment approach remains the same through expansions and recessions, and it has served us particularly well in the most difficult markets over the past two decades. Though unsettling, weak markets are times of increasing opportunities for the long-term investor.