To Our Clients and Friends of Parthenon LLC
We always begin our year-end letters with a brief review of the relevant investment statistics for the year. We will continue that tradition, although we recognize that few investors need the specifics to appreciate the extraordinary events in the capital markets. In 2008, the investment news became the headline news. The facts are stunning. The broad market endured its worst calendar year since 1937. The S & P 500 index fell, including dividends, 37%. As brutal as the U.S. market was, there was virtually no place to hide in any asset. International markets fell even more, as an index of global stocks, excluding the U.S., fell 45.2%. Many emerging markets fell over 50%. Commodities, the popular alternative asset class over the past several years, collapsed, with oil down 50%. Many high quality corporate bonds fell as the spread between the yield on high-quality corporate bonds and Treasury bonds reached unprecedented levels. Even many high-quality municipal bonds dropped in value. There was a flight from all risk assets, regardless of quality.
Nothing exemplified the fear more than the yield investors were willing to accept to own short-term Treasury bills. The yield fell briefly below 0%, meaning investors were willing to pay to own government securities. Stock market volatility was unprecedented. From mid-September through year-end, the Dow Jones Index finished up or down over 5% eighteen times. According to one study we saw referenced, this exceeded the total number of such moves from the previous 50 years combined. As economic conditions deteriorate worldwide, governments are mounting unprecedented efforts to combat the decline through spending, tax cuts, and liquidity interventions. We believe the efforts will ultimately succeed. However, halting and reversing the decline will not be without costs and risks, including higher inflation and higher taxes.
Compelling Valuations/Dismal Economics.
We recognize that, as investors, there are many things we cannot know, and we accept and work with that uncertainty. However, we are quite confident of some things. We know that global economic conditions are the most difficult since at least the early 1980s, and perhaps since the end of World War II, and those conditions will continue to be challenging for much of 2009, at least. Also, we feel strongly that stock valuations are the most attractive in over 25 years. The latter condition is a direct result of the former. The most attractive investment opportunities are always at periods of extreme economic distress. Finally, we know it is never, ever, psychologically easy to buy at, or near, the bottom of a painful bear market. Although we understand the allure of waiting for comfort, that invariably means waiting for higher stock prices. Of course, some wary investors may feel that wading into the equity arena now makes them feel like the ancient Roman gladiators who, as they were marched into the arena heard the chant, “those who about to die, we salute you.” The primary comfort is the bargain price. While it is necessary at times like this to look over the valley of uncertainty, it is extremely difficult when the valley resembles an abyss, as it does today.
We are very mindful and wary of the daunting challenges nearly all businesses face. We wrote in our letter last year of adding an “X” factor to our analysis to provide an additional layer of protection beyond our usual. We did, and avoided many of the worst of the investment debacles, although we did not anticipate the extraordinary impact the financial meltdown would have on the demand for nearly all products and services. As we analyze companies that we own or may buy, we continue to err on the side of caution. As an example, we forecast lower earnings or little growth in 2009 for every company we study. We also view 2009 estimates not as “depressed,” and therefore subject to an above trend-line bounce, but as a new baseline from which to grow, and then with only a modest economic tailwind in 2010. Nevertheless, we are finding strong companies with excellent balance sheets that are attractive under these very conservative assumptions. One result of the market’s equal opportunity decline is that valuations within, and across, industries have been “flattened.” Quality is on sale, which has created opportunities to own and buy the most structurally advantaged companies at little premium to both their inferior competitors and to the market. We are concentrating our study on those businesses with the strength to survive the challenges and prosper when the massive headwinds abate, and working to avoid or eliminate businesses with underlying structural problems that will be further exposed as the economy weakens.
Historically, the best times to buy have occurred when there is seemingly no compelling reason to do so, when no reason for optimism exists, and when few believe that stocks will ever again provide a positive return. Is this an “inflection” point? We cannot say for sure, and believe no one can. We know our companies are priced at valuations not seen in more than a generation. Is that enough? We think so, and, although we do not know if 2009 will be a year of recovery, we believe returns will be above historical averages from current levels over the next 5 to7 years. Our valuation thoughts on stocks are echoed in our evaluation of high quality corporate and municipal bonds. It is neither prudent nor necessary to be bold and daring, but now is a time to be carefully opportunistic.
The New Bubble?
The investment history of the past decade can be written as a history of bubbles. The technology stock bubble inflated in the late 90s, and burst in 2000. The housing bubble burst in 2007, and the commodity bubble burst in 2008. We think we see a new bubble forming – the cash bubble. Previous bubbles were created by rampant, unbridled enthusiasm that overwhelmed rational investment analysis. The genesis of the new bubble is overwhelming fear. The demand for safety is fueling a massive move into cash and cash equivalents, including short-term U.S. Treasury bills. This is an understandable, and even rational, response to the pain of the past year. But, we question whether it is a wise decision to position significant long-term assets in an investment yielding less than zero after inflation. Though it may appear to be, we know it is not without risk, including the risk of inflation eroding the value of the cash hoard. The desire to avoid more downside and then nimbly dance back into the market before the next move up is alluring but more hopeful than probable. Although we have no idea when, we suspect that this bubble, like the others, will burst. However, the popping of the cash bubble may prove a positive for long-term assets, particularly high-quality equities.
Prepare Instead of Predict.
We are amused at what passes for the latest indispensable and sage investment advice. To wit – do not put assets needed in the near-term in the stock market. Though wise, the advice is hardly new to us. We suspect many now preaching and practicing this mantra were quite comfortable otherwise when the stock market was more benign. Putting short-term assets in the stock market means predicting short-term market moves. Predicting short-term asset moves can create the hubris that leads to a confidence to maintain risky portfolio blends. After all, if you “know” stocks are going up, why not make the most of it? We have always felt it is more productive and less risky to prepare than predict. We prefer to assess every portfolio’s near term cash and
income needs, and an investor’s ability to withstand short-term market volatility, and then position our portfolios accordingly. When a portfolio is able to weather several years of market weakness, should that happen, an investor is free to pursue long-term growth with the balance of the assets. From current valuations, we think that pursuit will prove fruitful and fulfilling.