Valuations Favor Stocks

Stocks: The second quarter of 2010 was not good, with Mr. Market struggling between optimism, and finally caving in to pessimism. A slide of over 11% for the quarter ensued. Thus far in July we have recouped about 6%. We continue to selectively make purchases in areas that appear undervalued and underappreciated for their earnings stability, necessity, and stable of products. As an example of our risk-adjusted approach to equities, we have favored new purchases in oil and oil drillers, health care companies, mining/materials, and telecomm. While the broader stock market trades at 15x earnings, we are finding exceptional companies trading between 5-10x earnings, which provides a greater “margin of safety” in investing. We focus on bottom-up company analysis within a greater context of top-down global macro analysis, global demand, and currency issues. In fact, valuations of the strongest, best-managed, highly capitalized multinational businesses are priced at a deep discount (about 35%) to where they have traded on a normalized 10 year basis.

As a consequence of low interest rates, investors are very interested in purchasing higher yielding securities. This has led some to some investors buying longer 10-30 year bond maturities as they reach for yield, which frankly we view as a mistake. Though we have not yet seen investors flock to higher dividend paying securities in the stock market, it would not surprise us to see this movement gain momentum going forward. Corporate balance sheets have improved dramatically, and it is now possible find stable stocks with healthy dividends whose yield exceeds the 10/20/30 year bond.

Bonds: Investors continue to throw money at the bond markets with little consideration to the risk inherent in choosing an asset class that is grossly overpriced. The yield on the 10 year Treasury bond implies investors are paying a price-to-earnings ratio of 34x for these interest payments. Over the past three years, $572 billion has flowed into bond mutual funds. Over the same period, nothing has flowed into stock mutual funds. Corporate cash levels are at the highest percentage of total assets ever, and total cash sitting in money market funds stands at $9.4 trillion, also the highest level in history. The message is that we are on the right track in terms of how we value cash flows, particularly the entities that produce those cash flows. We would rather own a high quality corporation, trading at 5-10x earnings, paying a 4-5% dividend (that can grow relative to inflation) than an asset class (10 year Treasury) trading 2x stock market valuations that on a risk-adjusted and inflation-adjusted basis are likely to lose money over the next decade. Are we facing a future “lost decade” in the bond market?

Value Investing
This is worth repeating from Bill Miller, legendary investor:

“If your expectation is that we will outperform the market every year, you can expect to be disappointed. We would love nothing better than to beat the market every day, every month, every quarter and every year…Unfortunately, when we purchase companies we believe are mispriced, it is often difficult to determine when the market will agree with us and close the discount to intrinsic value…
Our goal is to construct portfolios that have the potential to outperform the market over an investment time horizon of three to five years without assuming any undue risk. If we achieve that goal, we believe we will be doing our job, whether we beat the market each and every year or not.”

At ACCIMI we agree strongly with Bill Miller’s view. Often it takes time for the market to capture the intrinsic value of securities. While there are those who “believe” in the EMH (Efficient Market Hypothesis), we note that it is extremely important to realize that an “efficient” market doesn’t mean the market is “always rational”; in fact the inverse is quite true. “Efficiency” means that the market will efficiently produce a price, matching a buyer with a seller. “Efficient” pricing led to extremely high valuations in 1999/2000, and extremely low prices in March 2009—but was it rational?

Our media, and the certain parts of the financial services industry, continue to focus on the shorter term-- economic announcements hit the wire and investors are led to believe that all of this information is important and that it will have a direct impact on a company’s performance. Nothing could be further from the truth. In fact, sometimes we can capitalize on investors’ shortsightedness by taking advantage of lower prices over a short period of time. Over a five year period, the price of a stock will largely track the fundamentals of the company, and its actual earnings rather than its quarterly economic reports.

Re-flation of Assets
The economic debate has centered on deflation versus inflation. Based upon a fiat currency (our currency has been this way since we went off the gold standard), inflation is always preferable to deflation. Deflationary risks are to be avoided if at all possible, and by this measure the Fed seems to be succeeding, though there *are* some deflationary signals that exist. In a reflationary period it is quite possible for all types of assets to go up in value, commodities and stocks could decouple in favor of commodities and commodity-related enterprises between 2011 and 2012. In such an environment, it is important to remember “why we invest”, which is to outpace inflation. If the stock market goes up 30% but oil and other commodities go up 60%, you will have wanted more exposure to those sectors within the market.

In a long-term inflationary environment, we expect that foreign currencies may also be useful vehicles, but not as clearly as precious metals and commodities. The reason is that the U.S. is certainly not the only country demonstrating open-checkbook monetary and fiscal policy here. That means that currency positions largely represent the choice of which currency is "less bad." It's quite likely that hard assets such as precious metals and other commodities will advance relative to a wide range of currencies, which is another way of saying that we would expect inflation to be largely a global phenomenon. Conversely, while some currencies will most probably depreciate less than others against a fixed basket of commodities (i.e. exchange rates between different currencies will fluctuate even in a global inflation), those choices may turn out to be more subtle. And what is the distinction between inflation and debasement of a currency in real purchasing power?

Well, the real difference is that the government gets yelled at for the former, and gets an invisible hall-pass for the latter. So bet on the latter. A doubling of the money supply in the last 18 months, again using the Milton Friedman formula, and monetization of debt, yields a currency that is worth half its value in purchasing power. Here’s where it gets even trickier though: let’s say that much of the rest of the world agrees in principle to also print more and more money, as a coordinated effort. Now what? Is a new global currency standard emerging? Nearly all developed economies are behaving badly in terms of fiscal and monetary discipline. We do expect that there will be relative valuation differences in currencies and policies that will provide a basis for currency positions as we gradually transition from a low-inflation world eager for safe-havens to a post-credit crisis inflationary outcome several years from now. But the most likely beneficiaries (and the securities that we would be inclined to accumulate on significant deflation fears), are likely to be commodities, agriculture, oil, and precious metals. As usual, we'll respond to the data as it emerges, but the foregoing is a reflection of where we would expect the opportunities to emerge.

This Time Is Different, Or Not: History As Prequel
On a historical basis, every major stock market peak of the 20th Century was followed by a crash in the U.S. dollar five years later. People who kept their savings in dollars saw the purchasing power of their savings shrink substantially. Commodity prices had triple-digit rises in the mid-1930s and speculators once again made a fortune. Based upon this precedent, we could foresee a raging bull market in commodities (due to a falling US dollar value, big inflation, or both) somewhere between mid-2011 and the fall of 2012.

History has shown that stock markets move in very broad cycles. Up cycles usually give us sustained earnings growth, P/E multiple expansion, and upward sloping economic indicators. Common characteristics of down cycles usually show low/no earnings growth, P/E contraction, and downward sloping economic data. For down cycles, the cause of the final multi-year leg down is nearly always different. However, a bottom is usually finally in place once the major economic indicators are completely gutted, along with P/E multiples, and trailing long term stock returns. Interestingly in March 2009, the items just listed matched the 1982 lows, and arguably March 2009 was a more extreme bottom. Interestingly, in 1983 once the initial spike of new orders occurred post-recession, there was much talk of a “double dip”, leading stocks to trade in a broad range for six to nine months. Sound familiar?

Positioning Globally for Any Environment
The sectors we like most are commodity-related equities, including oil, coal, mining, agriculture, metals; we also like select healthcare, medical device, and biotech companies as well as a few select technology names that exhibit reasonable valuations (Growth At a Reasonable Price, GARP). The reasoning for our commodities-related/oil/metals bent is many-fold: 1) they are needed , (2) they appear undervalued and are economically sensitive; if they drop due to a weaker environment it shouldn’t be disastrous due to their inherent value, and if the market goes up, they go up too, (3) commodities are priced in US$, so if the dollar goes down, it takes more US$ to buy them, meaning the producers of these commodities will have higher earnings, (4) during inflationary periods they tend to hold up the best, (5) if we experience a currency devaluation for whatever reason (and inflation is but another means of achieving this), see #1-4. So we are adding positions that can withstand gale force winds based on macroeconomics and/or deliver strong earnings.

Mortgages
Recently the 30 year fixed mortgage dipped to about a 60-year low. Take advantage of this now, especially if you currently hold an adjustable rate mortgage.

Fixed Income Commentary
In the context of our general comments on Treasury securities, high grade corporate bonds look relatively attractive. In fact high grade corporate bonds are now trading on a near-equal basis with Treasury securities, meaning that sovereign debt is trading on credit-worthiness and balance sheet strength (instead of on ability to tax). As far as we know, this has never occurred before in history. Well, after all, who would you trust more to pay back a loan right now? Warren Buffett or the U.S. government? We’d choose Buffett.

Treasury securities with longer maturities should be avoided at all costs in this environment. TIPS offer some inflation protection, but are based upon CPI numbers which are controlled by a government currently desperate to avoid automatic increases in budgetary items based upon CPI.

CA Municipal Bonds
The CA political atmosphere is heating up. Our prediction: Whoever wins will usher in a new era of “hope” for CA, and then around April or May of 2011, it will become quite apparent that CA is drowning in debt, and the CA legislature will fail Californians yet again. We are already beginning to lower our exposures to CA municipals, even short term durations. Both AMBAC and MBIA, the primary issuers of muni debt, are in big financial trouble, and by law they cannot issue municipal debt at a higher rating than their own firm. At some point the Federal government will need to act as a backstop for municipal debt in all 50 states, 48 of which are drowning in red ink.

Big Question Posed: So are we headed for a double-dip recession? Or not?

We read volumes of research, and frankly the signals are mixed, with some research pointing to an “oversold” condition, and some research pointing to an “overbought” condition. The truth is that nobody knows, and because nobody knows we are erring on the side of finding high quality businesses trading for 5-10x earnings (versus 15-17x for the S&P 500). If we run into a double-dip recession, we have already established a huge “margin of safety” by purchasing companies that are trading a low multiples relative to their asset base, balance sheets, dividends, and prospects. If we go into expansion mode, the market may begin to appreciate these companies via expanding market multiples. So in total we feel that our allocation to stocks looks attractive on a risk-adjusted basis.

However, we view our economy as being at an inflection point based on “which policies” are adopted going forward. Pro-growth, pro-incentive, lower-tax policies would be welcomed by the markets, and we think would propel them to new highs. Concerns over our debt burden would be assuaged by a higher growth economy that could service its debt service (due to the higher growth). This becomes a virtuous cycle, particularly to our creditors, who might then not have concerns about buying our Treasury bonds. An anti-growth, let-the-tax-cuts-expire policy (otherwise known as a tax increase), coupled with some of our impending new laws (higher regulation equals higher costs, healthcare is a new entitlement program) could be the thing that propels us downward. The historians out there like to overlay the Great Depression stock charts over the last several years—and it looks strikingly similar, so “policy” does matter. With all of the recent efforts to not repeat the Great Depression, it would be a shame to replicate it because of what looks like such an easy call on policy matters. There could end up being a bipartisan compromise based on the Administration’s latest efforts to extend unemployment benefits (i.e. Republicans could counter “OK, but we want tax cut extension”), though tax cuts are a primary issue of this November’s elections. If the polls are correct, something like tax cuts or stimulus could transpire by April of 2011-- lots of uncertainty in the interim.