To Our Clients and Friends of Parthenon LLC
The S&P 500 started the year at 1257.64. The S&P 500 finished the year at 1257.60. If you followed the markets with more than just a passing interest in 2011, you would be forgiven for initially doubting those facts. After such a violent ride, with so many twists, turns, starts, and stops, it would be understandable to be incredulous that the rider was deposited right back at the starting line. The S&P 500, with dividends, finished with a slight gain of 2.09%. We have never experienced a year with such violent market movement and ultimately so little change. While the equity market was turbulent and went nowhere, bond yields did what they apparently will always do – dropped from new low to new low. The ten year Treasury bond yield fell from 3.29% to 1.88% over the year. We have written the term “historic lows’ so many times over the past three years it risks losing any meaning and impact. Maybe history has become irrelevant in the bond market. Nevertheless, we remain skeptical that bond prices can remain at such lofty heights, and bond yields at such stunning lows, indefinitely.
For much of the year, all equity prices seemed to move in tandem as the correlation in stocks was extraordinarily high. Many days, every market sector moved in sync as investors were in thrall to worldwide economic and political uncertainty. Europe news dominated the markets while the “Euro” became a “four-letter word” to stock investors around the world. Investors sold stocks on concern that our economic well-being was hanging by a European thread one day, only to buy enthusiastically the next over excitement that the domestic economy was recovering, and thus stocks were too cheap. The alternating currents of fear and exuberance created the enormous volatility. Though overshadowed by the macroeconomic and political developments, corporate profits overall grew at a solid pace. We were pleased with the earnings growth of most of our businesses, though we expect growth to moderate unless the economy accelerates. The U.S. economy, though far from strong, did display some tentative signs of a sustainable, though fragile, recovery. Our outlook for stocks has not changed significantly. We continue to expect long-term (five to ten year) returns to be somewhat below historic averages. Though we believe equity valuations are attractive, that valuation positive must be balanced against our expectation for slower than average economic growth.
Stocks – Why Bother?
Market pundits who shun stocks and urge investors to run, not walk, from the equity markets have a plethora of seemingly compelling ammunition to fortify their argument. While we may not agree with that stance, we can understand the allure of the argument. Broad equity markets have done little over the past dozen years. Equity investors have endured two brutal bear markets. Even the most staid, boring investments – high quality government bonds – have produced superior returns over the past decade with less risk, and much less daily volatility and angst. The decline in overall equity valuations (price to earnings ratios) has been relentless since the market peak in 2000. The economic outlook is fraught with danger. Politicians here, and in Europe, seem both unable and unwilling to deal with the economic and fiscal problems.
Nevertheless, we think the scales are weighted in favor of stock ownership for the long-term investor. The past decade, with its near zero return, was not unique in stock market history. Consider that the market was lower in 1982 than the peak reached 14 years earlier in 1968. This is, unfortunately, what markets sometimes do. Long-term investment returns are not symmetrical. Many pundits were no less vociferous in their disdain for equities in the early 1980s after that long period of stock investment pain. And, they were right for a time, until the beginning of one of the great stock bull markets of all time in 1982.
Consider this “thought experiment”: Pretend that you wish to maximize your returns and can own only one asset class for the next decade. Also, you must make that choice now and cannot alter it (though you can buy, and sell, within that asset class.) Of course, we would never recommend this “strategy.” Economic conditions, and most importantly asset valuations, will change over time. Plus, different asset classes provide different, and necessary, benefits including short-term stability and a current and reliable income stream. Consequently, as part of the thought process, assume you have no current income needs and no need for the money for the entire ten years. What would you own? Perhaps long term bonds? If so, you would be buying near the lowest yields (highest prices) in history. High quality bonds held to maturity for the next ten years would provide returns of only 2%-3%. Maybe cash is the best option. That is the default choice for many investors today, with a current yield of zero. When we perform this thought experiment, we always come back to one asset class, stocks, and one group within that class, high quality domestic equities. One can put together a diversified portfolio of stocks with dividend yields of 2%-4% that equal or exceed the yields on bonds. In addition, many high quality companies may pay little or no cash dividends, but generate “stealth dividends” through share repurchase using excess free cash flow. Dividends and/or share repurchases combined with very modest earnings growth of 3%-5% per year provides a total return of 5% -9% annually.
The Big Caveat.
While we believe that the combination of expected returns and long-term risk is favorable, our enthusiasm for stocks is tempered by a caveat. There is a big pachyderm in the investment room – government and consumer debt both here at home and in Europe. We are under no illusion about the challenge that presents, and the years it will take to deal with it. That unfortunate fact cannot be ignored when cheerleading for stock ownership. To account for that, we apply, as we have for the past four years, a “debt overhang discount” to our valuation analysis. However, even with that discount, high quality domestic stocks look relatively attractive. In addition, we structure our portfolios, where appropriate and necessary, with other asset classes that provide stability and cushion. Be forewarned, we expect volatility to remain high. There will be days that will test the mettle of any stockholder, no matter how committed and faithful. Our long-term positive outlook for equities is not predicated on a near term cessation of volatility. Stock price swings, or daily market “price quotational volatility” rarely equate to actual “valuation volatility,” or a change in the real fundamental long-term value of a business.
Finally, a thought about “uncertainty” – no word is used more in describing the current market environment. Uncertainty is high, we are told, and that is reason enough to stay on the sidelines. One day the all clear will sound and then we can dive in with less risk and greater returns. Maybe, but we
recall that at the market peak in 2000, uncertainty was nowhere to be found, while certainty was in great supply. A lack of fear creates only the illusion of certainty, not certainty itself. Do not forget that all investing is probability. A characteristic of probability is uncertainty. Hence, all investing is uncertain. Even a decision to hold that least volatile of assets, cash, is an investment decision with risk – the risk of loss of value through inflation. We accept uncertainty as inevitable and work within that framework through conservative valuations, high quality securities, and appropriate portfolio asset blends.