People make a difference. Price makes a difference.
December 31, 2013
Market Summary – 4th Quarter, 2013
Individual people can have a profound impact on the world. Imagine if individuals such as Plato, Isaac Newton, Benjamin Franklin, and Nelson Mandela had never lived. At critical moments in time certain individuals act with great courage and foresight and change the course of history. We believe that Federal Reserve Chairman Ben Bernanke is such a man.
In the depths of the financial crisis and prior to worldwide quantitative easing initiatives, we penned a newsletter entitled “Never Argue with a Man Who Buys Ink by the Barrel” (1st Quarter, 2009). In this newsletter we made two assertions. First, that Ben Bernanke was the man who could save our financial system. Second, that his actions, in combination with attractively priced equity securities, offered the potential for significant wealth creation. Over the subsequent 15 quarters we continued to re-state these convictions, sometimes ad nauseum. Some mistook these convictions for “cheerleading” for equities. However, it now appears that these assertions have proven to be accurate. The reason for our optimism was not to be self-serving, but to implore our readers to act and capitalize on the greatest wealth-creating opportunity of a lifetime. People make a difference. Price makes a difference.
What comes next?
In order to appreciate what the future holds for investors, it is important to understand the past in the proper context. By the end of 2013 the stock market more than doubled off of its lows reached during 1Q09. It returned more than 30% in 2013. In fact, 2013 marked the best year for the S&P 500 Index since 1997 and the fourth best year since 1970. An overwhelming amount of the appreciation in the markets since 2009 (and particularly in 2013) was due to valuations moving away from unreasonably low levels not seen in decades and towards a more normalized level today – though valuations still remain at a discount to historical levels. These incredibly low multiples reflected a lack of confidence by investors that was underpinned by fear of the systematic failure of our financial system.
Consider that three years ago the market was burdened by the risk of (to name just a few) the breakup of the Eurozone (second largest economy in the world), a catastrophic tsunami in Japan putting further pressure on its woeful economy (fourth largest in the world), and a myriad of threats to the world’s largest economy (United States) due to political dysfunction (e.g. the potential default on government-issued bonds due to debt ceiling standoffs, sequester, government shutdown). During this time we discussed in our newsletters how the market was headline-driven and saturated with fear, selling off violently and without discrimination with the introduction and development of each systematic risk. So great was the overhang of fear that the S&P 500 Index experienced three consecutive years with double-digit percent intra-year declines (2010-2012). Double-digit percent fluctuations within a given year are not uncommon. However, three consecutive years of double-digit percent fluctuations with the market still managing a positive return in each of those years is uncommon.
Fast forward to today. Talk about dissolution of the Eurozone has been replaced with optimism surrounding its growth potential. Japan’s major stock index, the Nikkei, was up 57% in 2013. And in the U.S. the Federal Reserve has begun reducing (“tapering”) its massive stimulus program as our central bankers see the economy returning to non-artificially stimulated growth.
Productivity gains are a key component of growth. They require investment of human, monetary, and physical capital. Such investment is always an act of risk taking. The threat of systematic failure compromised what makes growth possible – corporations and individuals taking risk. Businesses are reluctant to build a new factory or develop new products if there are significant risks that the world economy is on the brink of collapse. Now that there is confidence that the global economy is free from systematic risks, businesses and entrepreneurs can focus on taking risk and growing.
The growth acceleration from here has great potential, given the present depth of the output gap (see preceding chart). The output gap is the difference between the actual output of an economy and the output it could achieve at full capacity. Throughout history the potential and actual output of the economy track closely with one other. Today, the output gap is nearly as wide as it was during the depths of the Great Recession of 2008-2009. Even assuming slower-than-normal trends for real GDP growth in the U.S. economy and the developed world, there remains significant room for strong economic growth.
Necessity is the mother of invention
While it is difficult to pinpoint exactly when this growth will take place, the current state of the world would appear to necessitate its pending arrival. When this growth potential becomes engaged, it will be a powerful force in driving stock prices higher.
Today the economies of the world face high unemployment, budget deficits, and a stagnating middle class. Our government officials and electorate will come to recognize the imperative to grow their economies, and will ultimately act with favorable pro-growth legislation. Equally important, our economy now has the powerful trifecta for a strong stock market: a recovering economy, accommodative monetary policies from the Federal Reserve, and benign inflation.
Several sectors of the economy look particularly ripe for expansion.
Energy – the great North American energy revolution continues to gain momentum. The possibility of energy independence in the near future stands to be a boon to exploration companies, production companies, and oil services companies. Furthermore, the abundance of cheap energy will also be a boon for domestic manufacturing, as lower energy costs can make U.S. manufactured products’ price competitive again. Furthermore, jobs will be created through the significant infrastructure build-out to transport this energy.
Housing – the U.S. is still in the early stages of a housing recovery, as the supply-demand imbalance is significant. New home construction is expected to reach one million this year, double the rate during the depths of the Great Recession, but 50% below what’s needed to meet future demand1. New home construction has an amazing multiplier effect on the rest of the economy – not just in construction, but also for realtors, bankers, retailers (furniture and appliances) and manufacturers.
Capital spending – corporations have been holding the purse strings tightly, but 2014 may be the year business spending finally accelerates. Equipment is aging, global growth is rising, companies are flush with cash and financing rates are low. Purchasing to satisfy pent-up demand for capital goods will have dramatic wealth-creating effects.
Fewer shares to own
Corporate executives have been aggressive in capitalizing on the opportunity presented by the low valuations of their company stock. Corporate balance sheets are awash in cash due to both internally-generated cash from operations and opportunistic debt issuances made possible by record-low interest rates. This treasure chest of cash has allowed corporations to buy back shares of their company stock in quantities not seen since before the financial crisis. In fact, companies have bought back so many shares that the number of share repurchases is now outstripping new issuance of stock.
These aggressive share repurchase programs provide a notable – and often overlooked – margin of safety to investors. With the amount of shares outstanding decreasing, corporate earnings per share are able to rise in the absence of earnings growth. This is because these earnings will be allocated across fewer shares. As a result, companies with share repurchase programs may see their stock price appreciate even in the absence of both overall earnings growth and multiple expansion. This lends further support to the belief that the Great Rotation should continue to accelerate going forward.
Acceleration of the Great Rotation
In our 2012 year-end newsletter we introduced the concept of the Great Rotation. We defined the Great Rotation as the mass migration of funds out of bonds and into stocks. The bond market, we wrote, would begin to suffer steep losses as interest rates rose in the face of stronger than expected global growth (at the time the market was assuming virtually no growth). Meanwhile, an abundance of fearful investors continued to eschew stocks – despite bargain prices and powerful business growth drivers already taking place. We hypothesized that as investors realized the losses that they were experiencing in their bonds and bond funds, they would sell them and roll the proceeds into stocks, further driving the ascent of stock prices and the decline of bonds and bond funds.
One year later, the stock market has increased by more than 30%. The Great Rotation is still in its nascent stage, but it is growing stronger. According to a December 2013 report from Morningstar, overall equity fund inflows through the end of November were the strongest that they have been since 2000. Conversely, year-to-date outflows from bond mutual funds are projected to realize their first year of net outflows in roughly a decade.
More money flowing into the equity markets will help drive prices higher, but the greatest beneficiaries will be the stocks of individual companies whose earnings are growing the strongest. People (or in this case individual businesses) and price make a difference.
2013 in review
The notion that there remain great businesses with outstanding growth prospects whose stock prices have not yet increased to reflect their potential has been a recurring theme for our newsletters in 2013.
In our first quarter letter (“Market Madness and the Value of Fundamentals”), we emphasized the importance of investing in the truly unique and special businesses run by great managers when low valuation opportunities presented themselves. We highlighted several holdings in the MPMG All Cap Value Composite portfolio that served as the foundation for our performance.
After the second quarter, our letter (“The Smooth Road to Nowhere”) cautioned investors about the risks associated with perceived safe haven asset classes due to excessive valuation levels. We emphasized that the price that one pays for an asset is the principal determinant of its riskiness, and that select equity securities offered more compelling risk-adjusted returns compared to bond and bond proxies that were more popular and more expensive. In the second half of 2013, the S&P 500 Index delivered a total return of over 15%, while bond and bond proxies lagged. The 10 year U.S. Treasury bond saw its price decline by over 4%, while bond proxies such as utility and telecommunication services indices increased by only 3% and less than 1%, respectively.
Our third quarter letter (“Bring on the Varsity”) emphasized the changing nature of the bull market that was now more than four years old. A fear many expressed is that stocks, as a whole, may have been getting too expensive. We did not necessarily concur with that perspective, more important to us was that we were shifting into a market where stock investors were showing greater discretion. Rather than a “rising tide lifting all boats,” we had entered a period where investors would pay attention to the price of a stock and its underlying fundamentals. There was risk in stocks, if you overpaid for specific issues. We felt the risk was more manageable if you paid the right price – an increasingly important factor as the bull market matures.
Not all returns are created equal
Following a banner year for the market, many investors are rightfully pleased with their one-year performance statistics. However, investors would be wise to scrutinize the results and question not only how their manager has performed over a more material and longer period of time, but also what their manager risked in order to generate that performance. In other words, “Ask not what returns your manager delivered to you, ask what your manager risked in order to generate those returns.”
Investors in index funds and ETFs should be warned: there are many constituents of these indices that are today’s Wall Street darlings and carry valuations reminiscent of the dotcom era. Amazon.com and Facebook, two mega-cap companies whose size gives them significant influence in the S&P 500 Index, sport P/E ratios of 1,444x and 146x, respectively2. Other high fliers such as Netflix, Zillow, and LinkedIn carry multiples of 100x or more2.
Conversely, we at MPMG have been creating life-altering wealth for our clients while avoiding the trending excesses that make money in the short term, but ultimately put the investor at significant risk when the inevitable correction takes place. We will continue to scour the globe in pursuit of great and underpriced businesses that offer our clients superior risk-adjusted returns. We maintain that building great wealth is more about avoiding large losses than it is about chasing gains.
We are deeply honored that you have entrusted us to create what we hope to be life-altering wealth for you and your family. We wish you and your loved ones great health and happiness in the year to come.
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.