A time to remember
December 31, 2006
Market Summary – 4th Quarter, 2006
We said goodbye to a truly great man in 2006. As investors, all of us should thank him for his work. Economist Milton Friedman espoused free market theories that influenced not just our economy, but those of many nations worldwide.
Friedman was the most influential economist of the second half of the 20th century. What may be most impressive about his legacy is that Friedman not only was instrumental in the direction of U.S. economic policy, particularly from 1980 on, but his influence spread globally.
The fall of the Soviet communist bloc may have had as much to do with Friedman’s economic theories as was the arms race. It is said that reformers across Eastern Europe were reading Friedman’s philosophy in the years leading up to the fall of the Berlin Wall, a time when capitalism thrived while communism stumbled. Lawrence Summers, Bill Clinton’s Treasury Secretary, said even Democrats must admit that today we are all “Friedmanites” when it comes to economic philosophy.
Ironically, Friedman first plied his craft as part of the Franklin Roosevelt administration during the depths of the Great Depression. Later on, he came to blame the Federal Reserve for the degree of economic hardship the country suffered in those gloomy days. He felt the Fed turned what could have been limited to a severe recession into a major catastrophe by presiding over a decline in the money supply. Back in 2002, a Fed official, speaking at Friedman’s 90th birthday party, conceded that Friedman was right, admitting “We (the Fed) did it. We’re very sorry.” That official was Ben Bernanke, the current Federal Reserve Chairman.
Let the markets work
We are big fans of the Friedman doctrine that calls for severe limitations in the government’s role as it relates to the economy. In everything from floating exchange rates to the importance of money supply in the management of the economy, Friedman made the best case for free markets. Over time, his approach won wide acceptance. His 1980 book and documentary series, “Free to Choose” should be considered a watershed event for how people view the workings of the economy. It helped to turn the tide toward Friedman’s laissez-faire style vs. the then dominant Keynesian approach, where government could impact demand for goods and services and the inflation rate. He had an amazing way of taking complex subjects and making them understandable for the Main Street American.
Consider the impact on the markets. For the 26-year period ending in 1980, the Standard & Poor’s 500 returned, on average, 9.25% per year. Not bad! For the past 26 years, when “Friedmanism” had been the defining theory of U.S. economic policy, the S&P 500 has generated an average annual return of 12.65%. We can’t say that is all due to Friedman, but certainly the increasing prominence of his free market philosophy proved to be enriching to investors large and small.
Coming off the “stagflation” era of the 1970s, where events like the Arab Oil Embargo threw our economy into turmoil, America was ripe for a different approach, and Milton Friedman was patiently awaiting his chance (he was already 68 years old). When Ronald Reagan took office in 1981, his philosophy was compatible to Friedman’s, and the U.S. took a turn toward more free markets.
Friedman’s theories were a driving influence in the development of free market economies outside of the U.S. as well, in such diverse places as Chile, Iceland and Estonia.
His convictions went well beyond economics as we think of it in the strictest sense. Friedman applied his libertarian philosophy to other issues as well, even calling for decriminalization of prostitution and drugs. He often cited his work with a committee studying the military draft as his proudest accomplishment. During the Vietnam War, hundreds of thousands of young American men were drafted and sent off to fight in a war few came to believe in. Still, the general view was that America needed a draft to maintain its strong military presence, particularly given the state of the Cold War.
Friedman is credited with turning the study committee around to the point of view that the country would be better served with an all-volunteer military. The draft was eventually abolished and only recently have there been any rumblings about bringing it back.
Milton Friedman will be missed, but as investors we should hope that his ideas will continue to drive the economic system here in the U.S. and around the world – a matter of increasing importance as globalization becomes more of a fact of investing life.
Professor Jeremy Siegel, featured at our inaugural Speaker Series event in 2006, reminded us that much of our investment opportunity in the 21st century will be tied to the potential created in overseas markets. Let’s hope that Friedmanomics continues to hold sway around the world, keeping markets free and open and giving investors reasons for continued optimism.
Here are a few of our favorite quotes from Milton Friedman to give you a sense of how he viewed the world:
“If you put the federal government in charge of the Sahara Desert, in 5 years there’d be a shortage of sand.”
“Nothing is so permanent as a temporary government program.”
“Inflation is one form of taxation that can be imposed without legislation.”
“Many people want government to protect the consumer. A much more urgent problem is to protect the consumer from government.”
“Only the government can take perfectly good paper, cover it with perfectly good ink and make the combination worthless.”
“The most important single central fact about a free market is that no exchange takes place unless both parties benefit.”
“Underlying most arguments against the free market is a lack of belief in freedom itself.”
How are we doing?
Since we’re looking back, it is a good time to review the past couple of years of quarterly newsletters, and see what has transpired since then. We do our best to make our newsletters stimulating, educational and thought provoking. Those who follow our writings have probably gathered that we’ve emphasized several themes. Now you can check the record and compare our thinking to the reality that followed.
Theme #1 – Draining the Dollar
4Q 2005 – Who wants to be a 1/2-millionaire?
2Q 2006 – Deficits without tears?
Our message: The dollar has lost tremendous purchasing power, about 95% of it since the Federal Reserve was created in 1913. The government has been free to print more money (the Fed holds the power of the printing press). The key point is that investors need to be more cognizant of the importance of growing assets fast enough to maintain purchasing power.
Since then: Inflation has been a modest 2.5% in 2006, due in large part to favorable trends on gas prices. Still, purchasing power continues to erode. Based on the Consumer Price Index, what was worth a dollar in 1970 is worth 19 cents today. In the last 6 years there has been an additional erosion of about 17%, based on official CPI data. We are concerned the official inflation numbers don’t accurately measure the bite in the pocketbook confronting individuals and families. Consider the increasing role of health care costs on most consumer pocketbooks as a prime example. Also, little has been done to control the federal budget deficit, as evidenced by the high rate of pork barrel spending approved by Congress in recent years.
Our thinking today: The rapid growth of new money is still an issue. An estimate by the FRC Money Forecast Letter is that the money supply has grown by $3 trillion (!) in the last three years. The Fed appears to be free and easy with the printing press. That puts more pressure on the purchasing power of the dollar. And with a new Congress in place under Democratic control, we look at the prospects for more austere spending with a skeptical eye. If the government can have a huge deficit in a time when the economy is considered to be healthy, what would the deficit be if a recession occurs? The Federal Reserve would, in our opinion, have to pump more money into the system, further deteriorating the purchasing power of the dollar.
In this environment, some portion of the portfolio should be associated with tangible assets, like real estate, natural resources and precious metals. The price of gold was up nearly 23% in 2006 (compared to flat prices for oil). We should note that the gold company stocks we own were a mixed bag last year. Goldcorp gained 27%, while Newmont Mining was down 15%. But mining stocks should benefit if the price of the metal increases, and we still believe our patience will be rewarded.
Theme #2 – Still playing a waiting game for growth stocks
4Q 2004 – Jeremy Siegel’s ‘Growth Trap’
3Q 2005 – Waiting for the dice to get hot!
Our message: Contrary to popular opinion, growth stocks are not poised to return to prominence. Value investing is still in the best methodology.
Since then: In every year since 2000 value stocks have outpaced growth stocks. Many investors are still “Waiting for the Dice to get Hot” on the technology sector, a group which has been abysmal. The last three years alone, the Morgan-Stanley High Tech 35 Index (the cream of the crop) has earned an average annual return of about 6%, compared to 10.44% for the S&P 500.
Our thinking today: Little has changed from what we talked about two years ago. Let’s start with the term “growth stock”, an investment euphemism which implies that value stocks can’t grow. History tells us that this is not the case. It leaves the impression that a “growth stock” must grow in value. In fact, growth investing involves chasing performance and hoping a rapid rate of earnings growth will see you through. In recent years, this strategy has failed to consistently generate results comparable to good value investing.
Theme #3 – The bigger they are, the less they return
1Q 2005 – Voting machine or weighing
Our message: Too many big, popular stocks are too expensive and are not positioned to perform well. We showed an example that from the end of 1999 to April 15, 2005, the S&P 500 Index lost 22.2%. 16 of the 25 largest stocks that make up the S&P 500 were in the red in the new millennium, down 39.59% on average.
Since then: The Index has recovered some. From 12/31/99 through 12/31/06, the S&P 500 is now down just 3.47%, a big recovery from 20 months ago. A number of big company stocks have regained ground too in that same period. There are still 16 of the 25 largest stocks in the Index down since the end of 1999, with that group showing an average decline of 32.42%. This is not much of an improvement, just 7.17% less of a decline in 20 ½ months.
Our thinking today: Big stocks have enjoyed some recovery recently and may not look as expensive as they once did, but in general, these household names seem to offer little opportunity to investors. Once again, we suggest little benefit can be achieved by investing in arbitrary categories (i.e. large cap, mid cap etc.) rather than investing by understanding the fundamentals and essence of each business (i.e. valuation).
Theme #4 – The case against non-investment
2Q 2005 – They paved paradise and put up a parking lot
Our message: Hedge funds have been all the rage for institutional investors, and are now available to individuals. We questioned whether hedge funds are appropriate for private investors, because they focus on short-term investments and charge hefty fees. We also questioned whether they really reduce risk. Since 1994, the S&P 500 Index outperformed a hedge fund index in 7 of 11 years.
Since then: The CSFB/Tremont Hedge Fund Index edged out the S&P 500 7.61% to 4.91% in 2005, but in 2006, the S&P outperformed the Hedge Fund index 15.79% to 13.86%.
Our thinking today: We still think long-term investors need to consider long-term fundamentals as an underpinning to their investment strategy. Hedge funds have their place, but probably not in the portfolios of most individuals with a long-term perspective.
Theme #5 – Opportunistic investors can also be
1Q 2006 – It’s hard out here for an optimist!
Our message: The market attitude when 2006 began was quite sour. The economy seemed to be in a funk, the specter of high oil prices hung over our heads, and many were cool about the potential for stock returns in 2006. We pointed out that it is at times when the markets are pessimistic that investors need to be faithful and maintain a long-term perspective to ride out the storms.
Since then: The stock market rebounded in the second half of 2006, enjoying a double-digit gain for just the third year since 1999.
Our thinking today: There’s still no shortage of red flags for the markets. That’s why we maintain a selective investment approach (based on buying good stocks at a good price). But 2006 stands as yet another prime example of how investors have to keep bad news in the proper perspective to reap rewards.
A big theme we emphasized prior to the five listed here was the idea that energy companies were well positioned for a rally given our view of supply-demand trends for oil. We correctly anticipated that oil prices would surge, and that’s exactly what happened. At the beginning of 2005, the price of a barrel of crude oil was around $43. By the end of 2005, it had risen 40%. In 2006, oil prices began at $61/barrel and ended in the same place, after peaking near $75/barrel. The price drop in recent months has been encouraging for the economy though the volatility in the oil market is a recent development that creates challenges for investors. Those new to our portfolios may be a bit concerned about the impact the recent drop in oil prices has had. Yet for the year, a number of our energy stocks enjoyed positive returns. More important than short-term blips in the oil market is to keep in mind the long-term supply/demand situation. For example, ConocoPhillips announced recently that its reserves rose 300% in 2006, but most of that was due to acquisitions of existing reserves. New discoveries represent only 10% to 15% of reserves. It seems likely that other oil companies will report similar trends regarding new finds. The world is currently consuming oil faster than it’s being replaced. Given that reality, it may be smart not to become complacent about “depressed” oil prices.
The energy story is like many of our long-term themes in that it generally continues to apply and is part of our ongoing thought process as we make investment decisions. Our concern is not just what will impact the markets and our specific investments over the next year, but over a number of years. That’s the nature of how we invest.
Our view is that the best way to think of the markets is not as a casino where “bets” are made, but as a vehicle where investors can find businesses at attractive prices that don’t currently reflect their full future value. We don’t believe it is healthy for corporations to chase earnings on a quarter-to-quarter basis. That same idea applies to our investment approach – we don’t chase performance on a quarter-by-quarter basis either. Companies that provide superior, long-term investment potential, driven sometimes by “big picture” economic and geo-political forces and other times by their own fundamental factors offer the best opportunity for our investors. This continues to be our focus and a philosophy that provides solid, long-term results.
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.