To Our Clients and Friends of Parthenon LLC
Our topics in this letter will be, as always, financial. That narrow focus, though appropriate for this forum, seems inadequate to address the year just ended and the one beginning. Our subject is finance but our thoughts are also on the well-being of our clients and friends. We hope for continued health and safety for all over the next difficult months as the vaccine rollout progresses, and ultimately leads to the end of the pandemic and a return to more normal conditions.
After that preamble, it is remarkable to note that 2020 was a very strong year for domestic stocks. Though the pandemic has been arguably the most negatively impactful global event since World War II, stocks more than took it in stride. We will discuss this incongruency in much more detail later. The S&P 500 total return was 18.4%. The ten-year Treasury bond yield ended the year at 0.92%, after beginning 2020 at 1.92%.
The downturn that accompanied the pandemic was not a classic financially induced one (manufacturing inventory excesses, speculative fevers, financial and banking problems, etc.), but instead the direct result of measures taken to control the spread of the virus. As much of the economy was intentionally shut down, creating massive dislocations, the country experienced the largest decline in Gross Domestic Product (GDP) and the highest unemployment levels since the Great Depression (albeit briefly). The downturn was accompanied by large government stimulus actions, both fiscal (direct cash payments, enhanced unemployment benefits, forgivable business loans, and other measures) and monetary as the Federal Reserve took actions to lower rates across the credit spectrum. Those measures worked well to maintain consumer spending and stem job losses. They also provided a huge boost to the stock market, propelling one of the largest 50-day rallies in market history. Improbably, considering the GDP collapse, total household income for 2020 dropped only marginally in total, and the consumer savings rate climbed. The impact on households has been very uneven, as many service workers lost significant income, while workers that kept full-time employment often enjoyed increased net income (including direct and indirect government aid).
It remains to be seen if any long-term economic price will be paid for this spending binge, which has driven federal government debt levels to heights not reached since WW II. We say that not to register political or philosophical disagreement with the programs. They have bridged the gap between the pandemic chasm of 2020 and it is hoped, the economic rebound expected to come in 2021. However, as investors with a value bias, we are wary of the market exuberance the stimulus has engendered. Stocks, in our opinion, entered the year at modestly above-average valuations, justified in large part by very low rates, and also a generally strong economy and solid earnings growth. Stocks exited 2020 at valuations only slightly below historic highs by most valuation parameters. We always have an attitude of cautious opportunism. As the market has elevated, we remain opportunistic but our caution is growing.
We have little doubt that better times are likely ahead in 2021 for overall health, living conditions, and the economy. Our caution has grown because the stock market has celebrated the good times already, and that meaningfully limits the probable long-term returns.
Does this equation make sense: a global pandemic plus the largest decline in GDP since the 1930s plus massive unemployment equals an 18.4% total return in stocks? Is that equation irrational? Or logical? It would seem wildly irrational if viewed narrowly and with little context. It becomes more logical in the context of extremely low interest rates, government stimulus, and the implicit and explicit promises of more of both to come.
It is difficult to overstate the direct and derivative impacts of interest rates on stock prices:
Rates and the immediate economic impact – Lower rates are an immediate stimulus for business investment and consumer and business spending. Lower rates decrease business costs and consumer living expenses by decreasing corporate borrowing costs, lowering consumers’ mortgage rates and improving refinancing options. Low rates make business projects and investments more financially viable.
Rates and stock valuations – This is the most consequential piece of the rate/stock price relationship. The value of a business (and therefore the rational price of the public stock of the business) is largely the current value of all future cash flows available to owners. Those future expected cash flows become significantly more valuable in a very low interest rate environment. A dollar expected to be earned in the future has much greater value today if interest rates are 1% instead of 4%. When we were young analysts, and bonds had yields well above 1%, we would often use an inversion of the 10-year Treasury bond rate to create essentially a bond “price to earnings” ratio to compare to stocks. This was useful to calibrate a rational price to earnings (p/e) ratio for stocks. A 7% bond p/e is 14.3 (1 divided by .07), while a 5% bond has a p/e of 20. Consequently, an investor can justify a higher p/e for a stock when bond yields are lower (all other things being equal.) With the 10-year bond at 1.9%, as it was at the beginning of the year, the p/e is 53. At year end, with the yield at .92%, it is over 100 – the sky is the limit for stock valuations. While most investors understand the analytical irrationality of using that comparison to its full extent, it still provides a very strong propellant for stock prices.
Rates and required returns – Treasury bill rates are often referred to as the “risk-free” rate. That means investors buying those instruments feel certain they will get that return (there is no perceived default/business risk.) The return required for all other assets must be higher than this risk-free rate to compensate for the greater risk. That difference is the “risk premium”. Assuming a stock risk premium of 4%-5% (approximately the historic range), the required return for stocks in a world with a “risk-free” return of only 1.0% or less would be only about 5% annually. By comparison, the stock market’s long-term return has been about 9%. For investors that accept that rationale, it justifies a lower expected long-term return, and hence higher current valuations for stocks.
Few alternatives – Nowhere else to go. Lower rates bring down the return requirement for nearly all assets. If investors view stocks as having higher probable returns than the alternatives, stocks can still look attractive in comparison to the paltry returns offered by other options. There is no superior place to go. If comfortable with the risk, we would of course choose a 5% return over a 1% return. The danger is in underestimating, or ignoring, the greater risk of the higher return alternative.
Although stock prices long-term will reflect the underlying value of the businesses, ascertaining exactly why stock prices go up in any discrete period (much less predicting it in advance) is guesswork. Nonetheless, low rates and the promise of low rates as far as the economic “eye” can see was, we believe, much of the wind in the market’s sails in 2020.
Permanent or Temporary?
The rapid changes in societal and lifestyle practices due to the pandemic have been stunning and unprecedented. While any “predictions” we would make are only a little more than informed guesses it is a worthwhile thought exercise to contemplate which changes may be permanent, and others temporary. It is important to us because the changes may impact many of the businesses we own and/or study. We have always been very dubious of predictions of permanent and massive changes in human behavior due to short-term discrete events. One esteemed epidemiologist stated early in the pandemic that he hoped this would be the end of the handshake greeting (epidemiologists do not like germs.) We will take the other side of that bet – we have thousands of years of human habit and behavior on our side. Nevertheless, while many behavioral changes and business and personal practices will prove temporal, life is unlikely to look exactly the same for years.
Business Travel. One of the changes we suspect is permanent will be a meaningful reduction in business travel. The success of virtual meetings, and the cost savings gained from not sending employees around the globe if the same outcome can be achieved with a video gathering, are too financially enticing for businesses to forgo. This will have significant implications for airlines, hotels, convention centers, rental car companies, and many other businesses that depend heavily on the business traveler.
Personal Travel. We foresee a much more rapid return to historic normality here. People love to travel, vacation, and explore, and eventually personal travel will, we think, begin to look much the same as before. That said, some changes seem likely, such as more vacation stays in houses and cabins instead of hotel rooms. Also, the boom in sales of recreational vehicles, boats, and other outdoor gear (all socially-distanced approved) may alter travel and vacation habits for some time.
Work from home. The work from home movement could be one of the more consequential changes of the pandemic. The total business commercial office footprint per employee may be reduced permanently. While companies are still assessing the productivity of working from home, and employees may have mixed feelings and concerns, this has staying power at some level. The implications for commercial real estate are potentially enormous. There are also implications for restaurants and many other service businesses that depend on office workers.
Many companies are already making changes in anticipation of the home office movement. Recall the great toilet paper shortage in the early pandemic months. Yes, hoarding was an immediate cause. The other cause is less generally well-known and understood – the toilet paper industry is actually two industries, residential and institutional. They have different logistics, manufacturing, and quality (you probably know that.) When demand shifted to homes, the industry could not meet residential demand quickly enough. Now some of the leading paper manufacturers are adding home production while reducing institutional capacity. (If they are wrong, we may all be fighting for that last roll at the office.)
Prepared for the Unknown
Parthenon opened for business in early March 1999. Over the two decades since then we have experienced, among less impactful events, the Tech bubble and bust, the 9/11 terrorist attacks, the 2008 financial crises, and now a global pandemic. In spite of those extraordinarily challenging events, the total annualized return on the S&P 500 since our first day through 2020 was 7.23%. This return, though, was only achieved if an investor was able to stay the course and not be forced out during the worst of the market declines. We did not predict those events, nor can we predict those that will occur over the next two decades. But we can, and will, work to position portfolios to withstand the future inevitable deleterious economic and geo-political events of the future. In those challenging periods of the past 20 years, we were never forced to take analytically unsound investment actions. It is imperative to position financial portfolios to provide the stability and strength for rational thought even in the most trying economic and market circumstances. This provides a long-term investor the ability to ride through the valley, take advantage of opportunities, and reap the rewards of long-term compounding.