To Our Clients and Friends of Parthenon LLC
2010 Market Indices Results:
Standard & Poor’s 500 15.1%
Dow Jones Industrial Average 14.1%
The broad equity markets moved solidly higher in 2010, propelled by a combination of strong corporate earnings growth and improving investor sentiment. The markets’ strength occurred within a global economic environment that did not seem particularly conducive to above average investment returns. Though the domestic economy grew, overall growth in Gross Domestic Product (GDP) over the past two years has been much slower than the historical average following a major recession. Private sector unemployment has stubbornly remained near 10%, and job growth has yet to accelerate significantly. In addition, financial Armageddon seemed imminent in Europe on more than one occasion last year as the continent seemed to experience a near national default every month. The stock market’s upward climb was hardly placid and tranquil as the market suffered a stunning and stomach churning one day “crash” in May and was down for the year until the final four months. Yet, with all that, returns for the broad market were well above the long-term averages. The strong corporate earnings rebound helped push the financial crisis and market panic from the forefront and lured investors back into stocks. In addition, and not unimportantly, bond yields remained very low as the Federal Reserve continued to hold short term rates at record low levels. The ten year Treasury bond yield ended the year at 3.30%, down from 3.84% at the start. Such extremely low yields make stocks more attractive, and bonds less relatively attractive, as investment alternatives.
The strong stock markets of the past two years eliminated most of the stock market decline experienced in the financial crisis of 2008 and equity valuations are less attractive generally, though some sectors still appear modestly undervalued. While the results for any one year may be significantly above average as in 2009 and 2010, we think returns for the market for the next decade are likely to be much closer to average, and, we suspect, somewhat below average given current valuation levels. Near term conditions are positive for equities as corporate earnings strengthen, the economy accelerates, and the Federal Reserve stimulates. But longer term, we suspect that debt deleveraging by developed countries and individuals will continue to act as a damper on overall economic growth. Also, many states aided by the flood of Federal stimulus money over the past two years were able to kick the fiscal “can” down the road, but the end of the road has arrived and the belt tightening has begun.
For a brief period in the depths of the financial crisis (which did not seem so brief while living through it), everything was cheap. The valuation homogeneity is gone now and equity valuations are more stratified. While the market broadly looks reasonable, a closer look reveals some pockets of burgeoning valuation excesses and perhaps some pockets of undervaluation as well. In particular, we have observed some signs of speculative excitement in the stock prices of high quality mid-cap companies. In addition, some lower quality companies, currently enjoying a cyclical growth rebound, are being priced as if their normal cyclicality will never return. We are wary of that premise. One group whose stocks have not bounced back as much is large multinational companies. Many look attractively priced and we think some are, but they are not without challenges. Most large multinationals’ stocks underperformed in 2010, as they have for most of the past five years. Valuations on many are as low as they have been at any time over the past 25 years, with the exception of the market sell-off induced by the financial crisis. Also, dividend yields are attractive, with yields of 2% to 4% not uncommon. Nevertheless, in developed economies, they confront the growth inhibiting burden of size, competitive challenges, input cost inflation, and limited pricing flexibility. However, many of these businesses have significant exposure to international markets, including high growth emerging economies, and significant economies of scale throughout all their markets and enjoy strong cash-rich balance sheets. We suspect the total return, including dividends and stock price appreciation, from a collection of high quality large companies will be quite satisfactory over the long term. We own some and continue to research others that may offer a good balance of return with acceptable risk.
A Perspective on Municipal Bonds
The normally quiet world of municipal bond investing has not been so sedate over the past year and more tumult may be coming. We offer some thoughts and perspective.
Numerous technical factors, as well as concern over credit quality, have led to a significant decline in municipal bond prices and a rise in yields over the last couple of months. More than a quarter of all new municipal issuance in 2010 was part of the federal government subsidized Build America Bonds (BABs) program. This program allowed municipalities to issue taxable bonds to finance capital projects with the federal government picking up the tab for 35% of the interest costs. This program, while designed to stimulate economic activity, also opened up a new market for a significant amount of municipal issuance. The BABs program, in a surprise to many, was not extended into calendar year 2011 resulting in municipalities once again depending solely on their traditional tax free market for funding. In another negative for the municipal market the lower tax rates scheduled to expire at year end were extended for two years. While none of us like paying taxes, higher tax rates are a positive for municipal bond prices as their relative tax free return becomes all the more valuable. The most publicized negative was the concern over credit quality, particularly after analyst Meredith Whitney’s prediction on “60 Minutes” of 50-100 sizable municipal defaults in 2011 totaling hundreds of billions of dollars, a prediction quickly dismissed by many high profile experts including Federal Reserve Chairman Ben Bernanke and PIMCO bond manager Bill Gross.
With the lingering impact from the worst recession in decades, a decrease in federal support and underfunded pension plans there are certainly valid reasons for credit quality concern. However, some perspective is necessary. There are about 50,000 municipal issuers with over two million outstanding issues. According to a Bank of America Merrill Lynch report, confirmed by other sources, there were five municipal bankruptcy filings in 2010 down from ten in 2009. Most defaults are due to problems with individual projects and not the fiscal health of local governments. The Center on Budget and Policy Priorities reported that between 1970 and 2009 only four defaults were from cities or counties. While municipal bankruptcy filings were rare there were more than 11,000 Chapter 11 corporate bankruptcy filings in 2010 alone. S & P reported that the municipal default rate in 2010 was less than one-tenth of one percent. Historically, the worst speculative grade component of municipal bonds has had a lower default rate than the rate for average rated corporate debt. However, we do not today and have never had any interest in lower quality municipal bonds.
We have been and will continue to be buyers of high quality municipal bonds. The recent events have created attractive opportunities seldom seen in these securities. While one may argue about the absolute attractiveness of bonds in general given current interest rate levels, high quality municipal bonds are exceptionally attractive as compared to taxable alternatives. They can be purchased at this time at higher absolute yields than Treasury bonds and in some cases at about the same yield as high quality corporate bonds. For individuals in a high tax bracket the after tax advantage is extraordinary.
While the opportunities are outstanding, this is a complex market and we are very selective in the securities that we purchase. We recognize that many municipalities, including most states, need to address structural imbalances that have built up over many years. Thus, we insist on a strong underlying credit and prefer bonds for basic necessities like schools, highways, and major water and sewer projects. We like bonds backed by entities with taxing authority, particularly with state or federal support. As a general rule we avoid issuers such as hospitals, airports, and sports stadiums, particularly if the projects are dependent on an unpredictable revenue stream. While insurance may be a positive, in most cases the bonds we buy are of equal or better credit quality than the insurer and thus we see little value added. We believe that the most significant risks fall among smaller issuers with less financial flexibility, while the best deterrent to municipal default is a large backer of the issue with a major taxing authority and a fear of losing their ability to access the market in the future. In summary, risks have increased, but there are great opportunities to improve after tax income in a prudent and safe manner.
