To Our Clients and Friends of Parthenon LLC
2009 Market Indices Results:
Standard & Poor’s 500 26.5%
Dow Jones Industrial Average 22.7%
As the above results illustrate, the past year was pleasant for equity investors and provided some salve to the wounds inflicted by the bear market. But if you feel the decade just ended was challenging, you are right. It was, by most measures, the worst decade for equity investors since the Great Depression. The S&P 500, with dividends, fell 9.1% over the past ten years. While the end of a calendar quarter does not line up neatly with a change in economic conditions or challenges, it does encourage retrospective thoughts. In that spirit, let us take a brief look back further beyond the past decade, which we think is interesting and instructive.
Imagine an individual, a knowledgeable and active investor, who on December 31, 1989, leaves his investment portfolio in the care of a trusted advisor. He then retreats to a distant monastery to live a quiet life of contemplation and thought, completely removed from the modern media and worldly intrusions. He remains blissfully unaware of the outside world. He returns today and visits his advisor to see the status of his portfolio. The advisor informs him that he has matched the return of the S&P 500, or 8.2% per year for 20 years which, as the knowledgeable individual recalls, is pretty much in-line with the results of the previous 100 years of market history.
Our intrepid would-be monk, upon hearing the news, says, “Ah, not an extraordinary period I see, I clearly did not miss much excitement.” The 20 year returns were the consequence of one of the worst investment decades for U.S. stocks following one of the best. For those who have lived, and invested, through both decades, it has been anything but unexciting. But as extraordinary as the times were, or seemed, the results produced were quite ordinary. Ultimately, equity results will follow economic progress and corporate earnings growth. Time may not heal all investment wounds, but it does smooth them. The 1990s began with stock valuations near historic averages and ended with stocks dramatically overvalued, which resulted in outsized gains. The 2000s then began with stocks overvalued and ended with stocks fairly valued, thus creating very weak results. While we do not know at what level overall equity valuations will end this decade, we believe they begin at reasonable valuations – a much better and more promising starting point than the past decade.
Our more immediate outlook for the equity markets can be summed up succinctly: we see a battle of opposing forces. We think corporate earnings are going to be solid for at least the next several quarters and perhaps beyond due to expense controls and cost cuts, lean inventories, international growth, easy comparisons to prior year earnings, government stimulus spending, and modest domestic revenue growth. Also, we believe stocks generally, and particularly high-quality, financially strong companies, are reasonably priced on normalized earnings. However, the economy is likely to face continuing challenges and headwinds which may hinder corporate earnings growth – stubbornly high unemployment, higher taxes, diminished home equity values, and eventually, a pullback in government stimulus spending. Our outlook reminds us of the comments from President Truman, who said he wished for an economist who was one-handed because his advisors would always respond “on the one hand… and on the other…” We will continue to emphasize high-quality equities, which we believe are relatively attractive and, mindful of the economic headwinds we see on the horizon, risk erring on the side of caution in our expectations for intermediate term earnings growth.
The financial crisis also created some compelling values in the fixed income market, in particular in high-quality corporate bonds and municipal bonds. Where appropriate, we took advantage of those values to add to our holdings. The opportunities in those securities are fewer now since the prices of high quality bonds have rallied as the economy has stabilized. We anticipate rising rates if economic conditions continue to improve. We are being cautious but opportunistic with our bond purchases, with an emphasis on short and intermediate maturities.
A Puzzle or a Mystery
An article we recently read on intelligence gathering and national security was intriguing. The core thesis centered on the importance of defining and differentiating between an analytical puzzle and a mystery, and the implications for intelligence gathering and analysis. The implications for investing are equally intriguing. A puzzle is an analytical challenge with a definitive answer. If the right information is available the answer can be found. Examples of national security puzzles would include the true status of Iran’s nuclear capabilities and the size of China’s military budget as a percent of GDP. We only need to discover the right photograph or talk to the right person to ascertain the answer. Generally, the more data available, the more likely the answer will be found. A mystery, however, cannot be answered definitively. Examples might include the consequences if the U.S. military pulls out of Afghanistan and the consequences should Israel attack Iran. More data may not improve our chances of understanding the mystery and too much data may make an analysis more challenging. What may be needed is often less focus on raw data, and more emphasis on judgment and analysis and an understanding and appreciation of the uncertainty. How does this relate to investing? An investor is faced with many unknowns, and must determine which can be answered definitively through research and analysis and which can only be estimated with some degree of probability. The difference may seem trivial and even obvious, but it is often neither. We think it is imperative for an investor to appreciate the difference and adjust the analysis, and use the data and conclusions accordingly. We continue to endeavor to solve the investment “puzzles,” and define the parameters and possibilities inherent in the “mysteries.”
Defense Wins Championships
The undersigned are all college football fans and the axiom that offense puts fans in the seats, but defense wins championships, is an old one. But, though it is old and some say dated, the axiom still has more than a hint of validity. Consider that the two teams that competed for the BCS national championship were numbers two and three in total team defense. And, the number one team in total defense finished the season undefeated and played in a major bowl. None of those three teams were in the top four in total offense. We feel in equity investing, defense wins championships also, if one defines championships as solid, low risk returns over the long-term. The past decade provided ample opportunity to test that theory. While our absolute returns were much better in the 90’s, and much more fun to achieve, we are not displeased with our relative returns for the past decade.
We attempt to play good investment “defense” by concentrating on high quality businesses and striving to pay only prices for stocks below a reasonable, conservative estimate of intrinsic value. We do not try to play defense by timing the market. We do not leave the playing field and attempt to jump back in the game when conditions are perfect. We think it is simply not possible to consistently time an exit and re-entry. However, we will have variations in the cash balances in our equity “bundle” due to a lack of, or abundance of, compelling opportunities. Playing good defense may produce times of relative underperformance during some periods of great exuberance in equity markets as we avoid the hottest stocks or sectors and accumulate more cash due to a dearth of compelling opportunities, but it does not preclude strong absolute and relative results over longer periods as we saw during the halcyon days of the 90s. While we expect equities to generate positive total returns over the next decade, good defense will still produce long-term benefits.