The market that cried wolf
December 31, 2011
Market Summary – 4th Quarter, 2011
One of the golden rules of media is that bad news sells and that the sensationalism of world events sells sensationally. Local evening news programs have been doing this for years, teasing you with a warning of imminent disaster that you absolutely must be made aware of . . . right after the upcoming commercial break.Most of us have become immune to these predictable local nightly news features that profile relatively benign and easy to understand risks. The stories that made headlines in the financial and economic markets in 2011, on the other hand, were exceptionally complex and had far reaching implications that threatened the entire world. In the past year, we saw:
- A devastating earthquake, tsunami and subsequent nuclear power plant crisis in Japan that disrupted worldwide manufacturing;
- The Arab Spring that dethroned long-entrenched Middle East dictators – and the subsequent soaring of world energy prices;
- A sovereign debt crisis that threatened the very existence of the European Union and its common currency;
- The United States debt-ceiling standoff that shook consumer confidence in our bifurcated partisan government;
- The downgrade of the U.S. credit rating by Standard & Poor’s;
- Stubbornly high unemployment showing few signs of improving in the short term; and last but not least,
Extreme volatility in the stock market.
Given the complexity and constant evolution of these situations, it was understandable that many of us relied on the commentary and interpretation of these events by the perpetually negative perma-bears that occupy the media.
Psychological Bear Market
Neuroscientists have found that humans evolved the need for emotion before the need for logic. This makes sense when one considers that early man living in the wild needed to be able to react to threats around him immediately in order to survive. From a survival point of view, a false positive (running from a shadow) is better than a false negative (not running from a real threat – such as being eaten by a saber-toothed tiger).
Given that humans are hardwired so that fear trumps logic (and from an investing standpoint, fear trumps greed), the loss of consumer confidence throughout the year and the subsequent sell-off that occurred in the market makes sense in retrospect. As the following chart shows, consumer confidence was in steady decline throughout the year before ticking up in December, while the extraordinary flight from U.S. equities was the most significant in recent memory for any year when the broader index ended the year in positive territory.
Negative investor sentiment persisted throughout the year, despite several facts demonstrating the strength and profitability of U.S. corporations. Consider:
- The S&P 500 Index’s corporate earnings likely finished 2011 at $97.02 per share, an all time high and more than 15% higher than 2010.
- Revenue growth was a key contributor to earnings growth, posting close to a double-digit increase in 2011.
- Almost 70% of the companies in the S&P 500 Index posted profits per share in excess of analyst expectations during the 3rd quarter (most recent data available, as 4th quarter figures were still being tabulated).
Experience has taught us that in a rational market, stock prices should reflect expectations of corporate earnings and cash flow. If the actual financial performance of companies exceeds expectations, higher stock prices should result. However, a corresponding broader market move upward in light of stronger profits has not only failed to materialized, but actually has been met with multiple contraction (giving less value to each dollar of additional earnings).
As a result and as illustrated by the chart below, the market appears to be grossly undervalued. Expectations for earnings growth remain high, as shown by the high estimated (or “forward”) earnings per share. Yet the price/forward estimated earnings ratio for the market, a measure of value of stocks, has not kept pace. This gap is an indication that we are stuck in a psychological bear market – filled with pessimism and frequent sharp downward moves in stock prices despite the presence of strong economic growth and increasing corporate profits.
History shows that this imbalance cannot continue forever. It will ultimately correct itself and reward patient investors. Unfortunately, the timing of this upward correction remains unknown.
MPMG’s 2011 Performance
It would be disingenuous of us to produce a 2011 end of year newsletter without a comment on performance. The MPMG All Cap Value Composite posted a loss in 2011, while the S&P 500 Index was able to eek out a modest gain. Although the performance of the MPMG All Cap Value Composite sustained a steeper decline in 2002, this year felt much worse given that the broader S&P 500 Index ended the year in positive territory. We value the trust you place in us and are as frustrated by the results of the past year as you may be.
The central theme of all of our newsletters in 2011 has been fear in the markets and how fear has lead to irrational market activity. Markets fluctuated wildly despite the strong performance of some individual companies – many of which are holdings in the portfolio. 2011 certainly had its share of negative headlines, but we at MPMG, while mindful of these disruptions, were loath to dismiss the positive developments that were occurring throughout the world.
Some of the best performing asset classes in 2011 were perceived safe havens: United States Treasury bonds (which now yield close to zero in exchange for tying up your capital for 10 years or longer) and utility sector companies with little to no growth and that pay out much of their earnings in the form of dividends (with historically modest dividend yields). Contrary to these low yielding and temporarily popular assets, the MPMG All Cap Value Composite portfolio has a healthy allocation to companies in the industrial sector, agriculture, water, “big data” technology – investment themes based on the premise that the world economy will not merely continue to exist, but flourish. Given the fearful sentiment that dominated the market in 2011, these positions were some of the hardest hit as the outlook for world growth deteriorated.
During this tumultuous year we continuously evaluated our holdings in light of the negative headlines and each time determined that, in the long term, keeping these positions would be in the best interests of our clients. We recognize that we stand to be criticized for ignoring that, in the short term, perception is reality and that these waves of negative headlines would take their toll on the psyche of the market.
Readers of our previous newsletters are no doubt aware that we pride ourselves on thinking differently from the herd. We view it as our responsibility not to act irrationally with the rest of the market, but to instead hold fast in our value-based philosophy. This means purchasing reasonably priced stocks of outstanding companies when opportunities such as we see today present themselves. The pursuit of creating long-term wealth for our clients, rather than providing short-term gratification, requires patience and perseverance.
A Look Back at Our Convictions in 2011
Throughout the year our newsletters focused on facts in order to illustrate where we felt that the masses were letting emotion trump logic. We have also stressed that no one can predict how the market will perform in the coming weeks or months and that in the short-term markets may be driven by fear. However, long-term wealth creation is ultimately driven by investing in strong businesses at favorable prices:
In our April letter (“A Note to the Headline-Weary Investor”) we outlined a litany of headlines that gave investors heartburn and led to the market’s subsequent erratic behavior. We noted one cannot predict where the market would be in a year and that while in the short run weak market sentiment or a struggling economy can delay the benefits of owning a good company at the right price, patient investors would be richly rewarded. We also noted facts that revealed that the economy was recovering following the Great Recession and that concerns of a double-dip recession were unwarranted.
In July (“Give Us Your Negativity, Your Natural Disasters, Your Black Swans Yearning to Breathe Free”), we recognized that fear remained the driving market emotion. Investors perceived that every problem would spread throughout the world, ultimately resulting in another economic pandemic. Stocks that make up the S&P 500 Index were on pace to generate record profits in 2011 despite the fact that equity valuations were stuck near 2008 credit-crisis levels. We noted that focusing on facts, not news commentary, would reveal that significant good news in the market was being ignored. This presented a tremendous opportunity to build positions in strong businesses at bargain prices. We also boldly predicted that European sovereign debt issues did not pose a Lehman Brothers–like risk to the market.
Three months ago (“The Death of Equities . . .Again?”) we pointed out that there was precedence for fear driven markets that ascribed little value to the stocks of great companies producing strong profits. This precedence was set in the 1970s. When fear dissipated, investors returned to their senses and shareholders of these companies were richly rewarded. Most notably, this was when Warren Buffett emerged as one of the world’s great investors.
While we were correct in many of our assertions about the state of the economy and the strength of companies, the market – up until now – has yet to focus on these facts and instead remains fixated on the “sky-is-falling” headline du jour.
A Random Walk Through Graham and Doddsville
As we discussed in our last newsletter, short-term underperformance is an unfortunate casualty in the process of creating long-term wealth. The value investment philosophy espoused by Benjamin Graham and David Dodd requires buying stocks that are currently out of favor, but whose businesses and long-term prospects remain strong. The reasons for their being out of favor may differ. Sometimes companies may have a disappointing quarterly earnings report, but the cause for the shortfall is temporary and non-recurring. Sometimes their industries are temporarily out of favor because their businesses are designed to thrive during later stages of the economic cycle. Whatever the cause, the ability for a value investor to see through these temporary problems and identify solid businesses is of paramount importance. The fact that these stocks have temporarily fallen out of favor should be a reason for investors not to panic, but instead to be opportunistic.
The following table is an analysis of the performance of some of the world’s great investors, the “superinvestors”, as Warren Buffett himself called them in an article that he wrote in 1984. Analyzing the long-term performance of these value-based investment managers quickly reveals their returns to be spectacular, particularly when compared to the S&P 500 Index. Equally striking, however, is the number of years that they underperformed the benchmark index.
Note that the dramatic, long-term outperformance of the market is oftentimes accompanied by short-term periods of underperformance. These “superinvestors” laid the foundation for their remarkable returns by building positions in winning companies at the precise time when the broader market was rejecting these stocks. They effectively capitalized on the dispersion between price (what you pay) and value (what you get).
As is often said, valuing a business is part art and part science. There is no magic formula for successful investing. The ability to opportunistically identify and buy companies when they are a bargain ultimately enables one to outperform the market more effectively than the use of any currently in-vogue short-term strategy.
Great investors occasionally experience short-term negative results, but their ability to create outstanding long-term returns cannot be achieved by simply replicating an index or trying to avoid temporary periods of underperformance. Successful investing is sometimes painful and intimidating. However, deviating from popular consensus is necessary in order to achieve sustained periods of tremendous outperformance compared to an index.
Macroeconomic Forces Necessitate a Paradigm Shift
Our conviction about equities and the opportunities available in this depressed market are not presented without consideration for the excessive indebtedness facing the world’s developed economies. Balance sheets of the U.S. and European countries are in spectacularly poor condition. These sovereign debtors face increasing debt service costs through a combination of rising interest payments due on a larger debt balance and, ultimately, higher interest rates required to issue new debt. As a result, a generation of irresponsible government spending threatens to produce slower worldwide economic growth unless new government policies to foster economic growth are implemented.
Were this exclusively an economic problem, the diagnosis and subsequent solution would be fairly straightforward. However, this remains primarily a political issue and the implementation of the remedy remains at the discretion of elected officials whose motivations may run contrary to sound, long-term fixes.
Because of the political nature of this problem, we believe that necessity will be the likely arbiter of the solution. The ultimate solutions will likely require an incremental reduction in government spending and reflationary policies, as well as pro-growth legislation. With reflationary policies designed to expand the economy, fixed income investments would lose value and become less attractive. Equities, on the other hand, are better positioned in a reflationary environment. Companies should be able to pass along higher input costs and maintain stable profit margins. Consequently, equities stand to benefit from pro-growth initiatives while fixed income investments are unable to participate in this growth.
We still see reasons for optimism in equities, but it is important to emphasize that no one can predict the market over the short term. Rather than following the masses and trying to invest in what is currently popular – a sure way to get caught up in excesses – we will continue to embrace our proven investment philosophy and selectively acquire overlooked companies that we believe will create opportunities for superior wealth creation over the long term.
The last time we at MPMG saw such a great discrepancy between price and value was in the late 1990s, when traditional companies like Philip Morris, Apple, and Newmont Mining were considered the wretched refuse compared to the high-flying and seemingly limitless potential of the dot-com companies. In the short-term the MPMG All Cap Value Composite portfolio underperformed the market (by more than 20 percentage points in 1998)*, but these positions would become the cornerstone of a portfolio that beat the market on a cumulative basis by almost 2.5 times over that market cycle (January 1999 through December 2007). Expanding this time period through the end of 2011 (and thereby including the Great Recession and our underperformance this past year), the MPMG All Cap Value Composite portfolio still beat the S&P 500 Index by 2.3 times dating back to January 1999*.
We have tremendous conviction that the current holdings of the MPMG All Cap Value Composite portfolio, once again forgotten and unappreciated, will create exceptional long-term wealth for our clients.
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.