To Our Clients and Friends of Parthenon LLC
After beginning the year with a strong first quarter performance, the stock market finished the first half down following a very weak second quarter. For the year through June, the S & P 500, with dividends, was down 6.65%. Investors grew concerned in the second quarter about European national debt fears and as global economic data began to deteriorate. The economic data shows that private employment growth has not accelerated, retail sales have cooled, and manufacturing and industrial production, while still strong, are displaying nascent signs of weakening. While an economic deceleration from the robust growth following the severe recession is not surprising or terribly disconcerting long term, it has created more near term uncertainty. Although the economy and the capital markets are healing, the healing process is going to be erratic and likely to encounter numerous temporary setbacks. Climbing out of the economic abyss we descended into is likely to be a slow, and at times, fitful process. The damage was simply too great, and the hurdles too high, to expect an immediate, dramatic, and smooth recovery. However, corporate profits have rebounded solidly and equity valuations are not unattractive for long term investors, as we will discuss further.
Bonds and Yields
The continuing flight of investment capital to the perceived safe haven of Treasury bonds has driven bond yields down to levels hardly imagined or contemplated only a few years ago. At the end of the second quarter, the two- year Treasury bond was 0.61%, the five- year was 1.78%, and the ten- year was 2.93%. Let those numbers sink in a minute. Municipal and high quality corporate bond yields have tracked the treasury yield decline, though not as dramatically. Perhaps, in a world of permanent zero inflation, one would argue that treasury yields are reasonable and not far out of line with historic real returns. However, the era of zero inflation will not last indefinitely. In many investment portfolios, bonds serve several very necessary purposes, including generating current income and providing portfolio stability. In response to the low yields, we have not and will not reduce our quality standards and increase risk in search of greater returns, which would be at odds with the twin objectives of reliable income and safety. We will look diligently for the best after-tax returns consistent with our quality standards in municipal and corporate bonds. We continue to monitor carefully our average bond portfolio maturities to reduce the risk to bond valuations should rates rise and we are using cash positions prudently and selectively. We have been able to exploit some pockets of inefficiency in the municipal bond market to buy some relatively attractive, high quality municipal bonds in the secondary market over the past year. Our modest relative purchase requirements (in the size positions we seek) are a definitive competitive advantage in the municipal market. In addition, some new municipal issues have recently been priced at attractive yields. Also, we have purchased some very attractive corporate bonds over the past 18 months and we continue to search for more, but the compelling opportunities have diminished.
We recall few times in our careers in which we have seen such uniformity of opinion on the intermediate- and long- term outlooks for the economy and the market. With only a few exceptions, the public outlooks from strategists, economists, and market prognosticators range from moribund to dismal for the next decade. The narrow range of opinions and forecasts reminds us of what one Hollywood actress once dismissively said of a younger rival’s performance: “She exhibited the full range of emotions from A to B.” We will spare you a complete rundown of the reasons for the dour outlooks as we suspect most could recite them with ease. For many prognosticators it is not a question of whether the economic glass is half full or half empty, instead they imply there is not even a glass.
Our natural contrarian tendencies instinctively cause us to rear up and challenge such a consensus. While we have no desire to be blind, nor bland, cheerleaders for the economy or the stock market, we are not convinced that equity returns are destined for the dustbin indefinitely. We are mindful of the challenges and headwinds that the economies of most developed countries face as they attempt to deal with the burden of the public and private debts accumulated over the past several decades. But, history shows that nations can adjust, alter political and economic policies, and allow private sector ingenuity to flourish again. At home, our economy has overcome daunting obstacles in the past and we still have a deep reservoir of valuable assets and financial and intellectual capital to draw on.
In financial matters, a strong consensus provides reason enough to consider the alternative. Examples abound of the “consensus” being wrong, often extraordinarily so. Consider that the tech “bubble” was a sure thing. Only three years ago, oil spiked to $150 a barrel and was definitely on its way to $200 and beyond. Nevertheless, arguing against the current consensus is a challenge. We have commented on our agreement that the recession was not an ordinary downturn, and the recovery is likely to differ from the norm as well. The market and the economy “reset” at a lower level and the likelihood of an extended period of excess growth as a “catch up” is low. We believe that equity market returns following the 2008 decline are more likely to be average than excessive, unlike periods following previous deep downturns which were followed by long periods of above-average returns. Our outlook for positive equity returns over the next five to ten years is bolstered by the historically inexpensive current valuations of many strong businesses, as we discuss below.
Back to the Future
In 1998, the S & P 500 Index shot past 1,000 amid celebration, exuberance, and great hope for the future. The composite earnings (all index companies weighted) for the index in 1998 was $44/share and the composite dividend was $16. That placed the price to earnings ratio at 23 and the dividend yield at 1.6%. The index, twelve long and volatile years later, is again hovering around 1,000. However, now the mood is distinctly different as investors are consumed with concern and fear, not joy. The composite earnings estimate for 2010 is approximately $77/share and the estimated total dividend is $23. The price to earnings ratio for the index is now under 13 with a dividend yield approximately 2.3%. By comparison, the average index valuation for the past 60 years is 15 times earnings. Interestingly, even in the depths of the earnings recession in 2009, total index earnings were $60/share, 36% above the level in 1998.
Looking beyond the overall market to individual stocks, we can find (and we own) numerous high quality companies selling for 11 to 13 times earnings with dividend yields of 2.5% to 4.0%. These companies have very strong balance sheets, above-average returns on capital, market leadership, and significant free cash flow. Yet, few investors are interested in these companies, while a dozen years ago they were the belles of the ball. We think the indifference is as much a product of the frustrating equity results over the past decade as it is a rational analysis of the prospects for stocks over the coming decade. What are those prospects? Consider an extremely well capitalized company which is currently valued at 12 times earnings with a 3.0% dividend yield, and has had a long-term earnings growth rate of 9% to 10% annually. Assume that earnings only grow 5% annually over the next decade. Is it so irrational to think that the valuation, now near historic lows, will be at least that high at the end? We think not. The total return, under extremely conservative assumptions, would be 8.5%. So, even with very modest growth and valuation expectations the total return of this stock would approach the historical long term market averages.
We cannot be certain that these cheap stocks will not remain cheap nor that earnings, particularly in the short- term, might not stumble again. Earnings growth is certain to be erratic and will undoubtedly falter at times. However, the probabilities, in our opinion, are distinctively in favor of the buyer over the long- term at current prices. Though shunned now, if these stocks and the market overall rises, we can be pretty sure they will be more popular at higher prices. Stocks are one of the few items for sale daily that elicit more interest at higher prices. Let us know the next time you see a store advertise its wares with the pitch “Great deals available, hurry in, prices up 25%.” Surprisingly, that pitch usually works for stocks. While we do not see a near- term end to the extreme volatility and schizophrenia of the market, we believe the final destination will make the trip worthwhile for equity investors even though the ride may be jarring at times.