The Death of Equities…Again?
September 30, 2011
Market Summary – 3rd Quarter, 2011
If you believe – as I have always believed – that the value approach is inherently sound, workable and profitable, then devote yourself to that principle. Stick to it, and don’t be led astray by Wall Street’s fashions, its illusions, and its constant chase after the fast dollar. Let me emphasize that it does not take a genius or even a superior talent to be successful as a value analyst. What it needs is, first, reasonable good intelligence; second, sound principles of operation; third, and most important, firmness of character.” – Benjamin Graham, Barron’s, Sep. 23, 1974
The stock market collapse of 1973-1974 has been largely ignored by market historians and writers, despite the fact that its severity was on par with what happened in the depths of the 1930s Great Depression. In the 1970s, the U.S. economy was in unchartered waters, simultaneously fighting both a recessionary and an inflationary environment. Psychologically, in the wake of Vietnam and Watergate, the country was reeling. OPEC was newly formed and flexing its muscle, creating oil shortages and long lines at the gas pumps.
By the end of 1974, the average U.S. stock had lost 70% from its peak value and the bear market was in its sixth year, twice as long as the worst bear market of the Depression era. Capitalism appeared to be in retreat. Business Week, an ordinarily upbeat publication, abandoned all hope for a market recovery and published a cover story in 1979 that foretold a hopeless future entitled “The Death of Equities.”
Stock prices declined so dramatically that they bore little relation to underlying values. Money managers who aggressively bought into a group of stocks that were known as the “Nifty Fifty” (considered to be impervious to the business cycle and therefore safe at any price) at 80 times Price/Earnings ratios were suddenly reluctant to buy proven companies with P/E ratios of 10 times or less. This was the start of a transformation that found professional money managers obsessed with measuring themselves against benchmark performance indices on a quarterly basis rather than on generating solid, long-term returns.
It was then that Benjamin Graham, the father of value investing who taught his investment principles to Warren Buffett and others, came out of retirement t o write an article for Barron’s entitled “The Renaissance of Value.” The quote above is excerpted from the article. Graham challenged investors to boldly act on their beliefs and take advantage of the incredible buying opportunity created in a time when many were too frightened to invest in stocks. Graham implored investors to act with conviction and to trust their value-based philosophy by acquiring stocks that were cheap and out of favor, not to wait for when they had run up and been validated by the masses.
Warren Buffett had closed his investment partnership in 1969 because he believed that attractive opportunities had disappeared from the market. He enthusiastically returned in 1973, initially with lackluster results. His net worth, as measured by Berkshire Hathaway’s price, was cut in half as the market continued to decline in 1974. Undeterred, Buffett maintained an aggressive “buy” posture and shared his enthusiasm with Forbes magazine by defiantly stating, “Now is the time to invest and get rich.” His thinking was out of the mainstream at the time, but Buffett’s confidence was rewarded with spectacular wealth creation and he earned the moniker, “The Oracle of Omaha.”
Treading on familiar ground
We at MPMG are no strangers to irrational market fads like the aforementioned investing landscape of the 1970s. Our approach of indentifying stocks of quality companies to be included in the All Cap Value Composite portfolio that offer solid, long-term value has been tested at other times as well. In the late 1990s, the mania for everything technology-related briefly rewarded unproven companies with much perceived promise but no profits. Undeterred by this market craze, we remained steadfastly committed to the value philosophy espoused by Benjamin Graham. Over the short-term the All Cap Value Composite underperformed relative to our benchmark indices, but over the long-term our conviction was richly rewarded as the discounted stocks that we bought then formed the foundation of our portfolio that outperformed the S&P 500 Index for 11 of the next 12 years*.
Today’s market is testing us yet again as fear is driving investor decisions. $75 billion was withdrawn from equity mutual funds in a four-month period through mid-September, exceeding the amount of money pulled from stock funds during the period when fear gripped the market following the collapse of Lehman Brothers in 2008. At times like these, pessimism can get carried away and the dour mood tends to overtake the psyche of most individual investors. Our sense is that the fears of significant downside risk to the economy are overblown and may have already been priced into the market.
In our opinion, the investment landscape is materially safer and more promising than it was during the financial crisis of 2008. While problems exist, we do not believe that Greece is the “new Lehman” and the collateral damage from a possible banking crisis in Europe will likely not cause a systematic failure of world banks. In the United States, banks are well capitalized with a surplus of over $1.2 trillion. Corporations are sitting on record cash piles and more than 700 companies in the S&P Composite 1500 Index have shown year-over-year revenue growth of 10% or more. Household debt obligations, which had reached unprecedented and unsustainable levels in 2008, are at their lowest levels since 1992.
Despite our belief that definitive evidence exists to support the hypothesis that the world is not ending, headline news from May through September of this year drove the markets into a negative state of compression. The lack of political leadership on both sides of the Atlantic Ocean reflected through the eurozone crisis and U.S. debt ceiling standoff, the downgrading of the U.S. credit rating by Standard & Poor’s, and the menacing activities of High Frequency Trading strategies (more on this later in the letter) all contributed to a fear–driven and irrational selling binge that sent virtually all stocks sharply lower.
The holdings of our portfolio were not immune to this sell-off. Companies in the industrial sector, which produce goods used in construction and manufacturing and make money on the belief that the world economy will not merely continue to exist, but will expand and flourish, were hit particularly hard. Given that our portfolio has a reasonable weighting of industrial stocks, the fear that the eurozone would collapse and take the rest of the world down with it caused our portfolio to decline in value more than the S&P 500 Index during the third quarter of 2011.
Periodic underperformance by managers with records of long-term success is, unfortunately, not uncommon. In fact, the recent underperformance of top fund managers has become so widespread that it was the subject of the cover story of Barron’s on October 8th entitled, “On Sale Now! Top Stockpickers.” Furthermore, a recent study of top-performing managers with exceptional long-term performance records demonstrates that short-term underperformance is so common that it is almost inevitable.
This study looked at 192 top-performing managers over the 10-year period between 2001 and 2010. All were in the top 25% of their peer group over that timeframe, but given any three year period nearly all of them underperformed so greatly that they fell into the lower half of performance in their peer group and some were even among the worst performers (bottom 10%) for a three-year period. Despite these painful short-term troughs, all of these managers ultimately managed to create exceptional amounts of wealth over the longer 10-year period.
This study illustrates that short-term underperformance is not uncommon in the process of long-term value creation. It is further evidence that investors are not well served trying to “time” the market. Investors that recognize this are less likely to make potentially disastrous changes to their personal portfolio by attempting to “time” the market by withdrawing funds just before markets deteriorate and then return to the market in advance of its ascent.
For years investors have been warned about the perils of market timing, citing the often-quoted figure that investors who missed out on 90 of the best trading days over a 15 year period (less than 2% of the days) would see a 22% gap in the performance of the S&P 500 Index – a loss of -15.3% versus a gain of 6.8%. The less often cited figure is that missing out on the 90 worst trading days would likely produce a similar outsized gain. We at MPMG believe that the current markets are highly compressed due to so much cash having been pulled from the markets and now toiling in either cash or low-yielding short-term securities. As a result, we believe that the likelihood of a dynamic move upward in the market is considerably more likely than an equally volatile move lower and that investors are better served by staying fully invested so as to be positioned for sizeable long-term gains when cash and, more importantly, confidence and rationality return to the market.
Rather than worry about timing the market and its short-term fluctuations, we at MPMG put our efforts into constant and rigorous evaluation of stocks already in our portfolio and those that could potentially be added. Our portfolio today includes some of the world’s elite companies that:
- create needed products and services that are not easily duplicated;
- possess strong growth prospects;
- produce industry-leading returns;
- maintain healthy balance sheets;
- employ talented executives and, in many cases;
- pay dividends that yield significantly more than U.S. Treasury Notes.
Given the remarkably low valuations assigned to these great businesses with bright prospects we, like Warren Buffett in 1974, believe that “now is the time to invest and get rich.”
The ABCs (and HFTs and ETFs) of today’s volatile markets
Along with other irrational forces at work in the market today, one cannot ignore the maddening volatility that exists. As we mentioned in our special update in August, the source of most of this volatility can be traced to a computer-driven system strategy known as High Frequency Trading (HFT). More than half of the volume on the exchange is a result of HFTs, much of it done within Exchange Traded Funds (ETFs). ETFs are designed to replicate the performance of an index (such as the S&P 500) or a subset of an index (such as stocks in the financial sector).
ETFs have surged in popularity over the past few years and make up nearly a third of all of the value of U.S. equities traded on a daily basis. That percentage tends to spike in times of volatility. ETFs are required to rebalance their portfolios every day in order to replicate their desired index and, in our opinion and the opinion of many other market professionals, are a key culprit in the sharp increase in daily trading volume that takes place at the end of each trading day. A good example – on October 4th, a day of no particular distinction in the financial world, the market fell throughout the day, but then shot up 4% in the last hour of trading.
HFTs try to identify short-term trends in the broad market or in a particular security. They seek to capitalize on the trend by trading large volumes of securities in a short period of time, often holding positions for only seconds. Each trade may only squeeze out a penny or less of profit, but they are executed in such large volume that they create the potential for millions of dollars in short-term profits. HFTs start the day with no positions and end the day in the same state, while producing almost as many losing trades as winning trades.
The New York Times reports that the daily turnover of stocks “rose to 8 billion shares in the United States today from 6 billion in 2007.” That is the same year when the Securities and Exchange Commission (SEC) fully did away with the “uptick rule” that restricted the short sale of a stock (betting on its price to decline) to periods after the stock had moved higher in price.
The uptick rule, implemented in 1938, prevented groups of investors or large institutions from shorting large quantities of “borrowed” stock in a bear market. It guarded against fear-driven trading, preventing traders from collectively driving down a stock price that is already going lower, and thereby limiting the impact of a potential self-fulfilling prophecy of declines. It is believed that the absence of the uptick rule may have contributed to much more severe and frequent market declines.
We believe strongly that the uptick rule should be reinstated and that although short sellers have a role to play in our market, allowing rampant trading to take place only exacerbates the level of volatility that exists in the market. Given the impact that today’s technology can have on regular investors, the rule would serve an important purpose in helping to temper some of the volatility we have seen in recent times.
Tales of the demise of equities are greatly exaggerated
The late Steve Jobs, co-founder of Apple and legendary technology visionary, promoted a slogan in the late 1990s – “Think Different.” This campaign pointed out that some of the movers and shakers of our time – from Mahatma Gandhi and Martin Luther King, Jr. to Bob Dylan and Albert Einstein – went against mainstream thinking in their times.
Today, simple optimism represents “out of the mainstream” thinking in the investment world. We have never been fond of the conventional wisdom and have found that the ability to “think different” is a key attribute for a successful value investor.
Our own thinking about today’s world includes some facts that get little play in the media or among the investing public, but that remind us that the prospects for making money in stocks remain solid. These facts include:
· Progress toward a eurozone solution. European leaders, though struggling to agree on a solution to what is primarily a problem of debts held by their largest banks, coming to a resolution that preserves the eurozone, even if the answers prove to be painful.
· A new global middle class continuing to emerge. The developed world once had about 500 million workers. Today, we have added another two billion people to the global work force. From an investment perspective, billions of new consumers worldwide represent opportunity.
· Corporations remaining resilient. Most have reported solid earnings growth despite a lackluster global economy. The ability of corporations to generate profits has to be considered a sign of improved management and efficiency in many firms, which bodes well for the future of many companies as the economy recovers.
· Stock valuations looking attractive. As mentioned in our last newsletter, the Equity Risk Premium (earnings yield less the yield on the 30-Year U.S. Treasury Bond) is at a multi-decade high. Stocks are cheap by that measure.
As was the case in 1979, the tales of the equity market’s demise have been greatly exaggerated. There are many reasons to believe that the current environment offers remarkable investment opportunities. The world is still growing demographically and economically, creating more profit potential for companies positioned to benefit from that growth. The stocks of many of these quality companies are attractively priced, offering a generational opportunity for long-term investors.
The sprinters, like the high frequency traders, can have their days, but for the rest of us, the marathon of building wealth over a lifetime continues. A “firmness of character,” as Graham described it, is a valuable trait in times like these.
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.