The crosscurrents of economic data and sentiment continue to confuse more than clarify. Although much of the economic news is positive, many commentators still feel compelled to portray the world’s situation as “fragile,” “troubled,” or even “on the brink.” The new buzzword for the decade, “new normal”, appears to be as overused, and thus potentially meaningless, as was “paradigm shift” was in its day. We are all supposed to hunker down and expect less from everything (the economy, the government, the markets, etc.) because of this idea of the “new normal.” This possibly myopic outlook is a direct consequence of the events of the recent past. The psychic and financial injury from the credit crisis, recession and bear market have left deep scars, which are still tender. They are a bright reminder of the pain of the past, but are they really a good indicator of things to come?
From an equity investor’s point of view, the crisis ended a while ago, with the S&P 500 just about where it was before all the trouble became obvious. From the viewpoint of an unemployed person, things still may not look very rosy. This, alas, is the challenge of investing in the capital markets. Most of the time, we have to deal with a big bundle of positives, negatives and grey areas, trying to make sense of it all amid these crosscurrents. Rarely do investors operate in clear waters with a favorable tailwind. More frequently, they are faced with choppy waters, variable winds, with a chance of a hurricane somewhere in the forecast. Yet, those who are patient and persistent are most often able to reach their destination safely.
First Quarter Review
The stock market logged another good performance in the first quarter, pushing its string of positive return quarters to four. This was preceded by SIX consecutive quarters of negative returns. If this is part of the “new normal,” we say “keep it coming!” The first quarter results were just about the same as the fourth quarter – up 5.4%.
The market struggled a bit in January and early February, as it pulled back about 8% from the January peak. This kind of retracement is quite normal and can be expected in bull markets. From the mid-February lows, the market rallied strongly through the end of the quarter. At the risk of sounding redundant, we would note that the same forces which drove the market higher last year were still in force during the first quarter – rising corporate profits, low interest rates, mixed sentiment and an excess of cash on the sidelines.
Retail investors have fallen in love with bonds. According to Liz Ann Saunders, Schwab’s Chief Equity Market Strategist, bonds grew to a record high 25% of individual investor portfolios in February. This shift appears to have been caused by a desire to achieve higher returns than the cash market is offering, but at the same time reflects considerable skepticism about the stock market. Historically, whenever an asset class reaches a peak level (like bonds are now), the subsequent returns for that asset class most often trail others. The peak in stock ownership happened in early 2000 (the end of the tech bubble). The peak in cash ownership happened in March 2009, the point from which both stock and bond returns have dramatically outpaced cash returns.
Here’s what the first quarter looked like by the numbers:
|1st Qtr 2010
|Trailing 12 Months
|Dow Jones Industrial Average
|MSCI EAFE Small Cap
|MSCI Emerging Markets
|Barclays Aggregate Bond
|Barclays Municipal Bond
|Dow Jones Commodities
Patience is a Virtue
One of the marvels of each new spring is the re-emergence of the color green. Every year the bland grays and browns of winter are, without fail, replaced with the verdant hues of the new season. Unless one is a farmer, this transformation may appear to be a bit magical, or at least effortless. In reality, while we endure the cold and darkness of winter, the cells within plants are already planning and preparing for the rebirth of the green. One amazing feature of plants is that they are very patient in their development and growth. Patience as a concept and how it may apply to the investment decision making process is a theme we wish to explore in this edition.
“A HANDFUL OF PATIENCE IS WORTH MORE THAN A BUSHEL OF BRAINS.” – DUTCH PROVERB.
In a world where instant gratification has become the universal goal, patience as a virtue may seem a bit dated or old fashioned. We want what we want and we want it now! How often do we find ourselves impatiently waiting for the microwave to hurry up and cook our burrito? Some might even suggest that patience is a hindrance to getting ahead; that it’s a fault rather than strength. Ambrose Bierce, the 19th century American writer and critic, summed up the negative side of patience this way: “Patience: A minor form of despair disguised as a virtue.”
Yet many great leaders of the past had good things to say about it. U.S. President John Quincy Adams offered this: “Patience and perseverance have a magical effect before which difficulties disappear and obstacles vanish.” The American author Hal Borland made this observation: “Knowing trees, I understand the meaning of patience. Knowing grass, I can appreciate persistence.” It is likely that some might consider patience a passive exercise, requiring no more effort than sitting at the depot waiting for a train. In reality, great strength and benefit can be found in the exercise of true patience – that is, actively working towards worthwhile goals, and not getting discouraged when results do not materialize as quickly as expected.
The Stanford Marshmallow Study
In the 1960s, a Stanford University psychology professor, Walter Mischel, created a simple experiment designed to measure self-control in 4-year olds. He offered his subjects a marshmallow and explained that if they could wait for the experimenter to return from an errand before eating the treat, the reward would be an additional marshmallow.
The results? About one-third of the group ate the marshmallow immediately. Another third ate it before the researcher returned. The final third waited the whole time and received the reward of a second marshmallow. We find it not too surprising that only a minority of four-year olds had the ability to wait.
Over the years, Mischel returned to his study group to assess whether or not the ability to wait (patience) had any implications in other aspects of life. As it turned out, the children in the bottom third of the group – those who could not wait – struggled a bit in life and displayed more behavioral problems. Those who could wait (the top third) tended to be more positive, better motivated, and achieved better grades in school, higher incomes and had better relationships.
The Law of the Harvest
The adage “You reap what you sow” may have Christian roots, but it is a concept widely understood and believed in many religions and ideologies. This agrarian proverb, which at its heart means simply that actions have consequences, no doubt resounded forcefully to reapers and sowers of the past. Centuries later this concept was packaged in a slightly different fashion as “There ain’t no such thing as a free lunch.” The famous economist Milton Freidman even used this concept as a title of one of his best selling books. The idea was even featured in a landmark music video by Dire Straits – “Money for Nothing.”
So, the concept is out there, but do we really believe it? For everyone who thinks that hard work will be duly and objectively rewarded, we find someone else buying a lottery ticket. For everyone following the “normal” path to a profession (college, working up the corporate ladder, etc.), we find some drop-out millionaire who tells us it’s all just luck. Honest hard work may be a virtue, but cutting corners (or even breaking the law) may be a faster way to riches (just ask Bernie Madoff!).
Despite of how one really, truly feels about this reaping and sowing concept, it continues to be a very powerful model for work, choices and consequences. The farmer, after all he or she can do – plowing, fertilizing, seeding, watering, and so forth – must sit back and wait. No amount of effort can make the plants grow faster. Yet this patience is not wholly passive either. There is a great deal of on-going work – weeding, monitoring the soil, maintaining the proper moisture levels and so forth, but ultimately the seeds will germinate and the plant will grow on their own timetable. The farmer must ultimately wait until it’s time for the harvest.
Patience in Investing
Investing isn’t exactly like farming, but the law of the harvest has some application here. To some people investing is simply an exercise akin to gambling. One buys a stock and it either goes up or down – by a little or by a lot. To many, it must seem very random. From the perspective of the professional investor, there is an element of randomness, but the entire process is much more like farming than gambling.
Also true is that “investing” is not just one thing. “Investing” encompasses a broad range of styles – from the actions of the short-attention-span day trader to very long perspective of an endowment manager and everything in between. However, fundamental investors with time horizons longer than a few weeks, find that patience and persistence are necessary attributes for success. Within the subset of fundamental investors, the “value investor” has gained a reputation for being among the most patient of investors.
To many observers, the value investor appears to be playing a different game than other investors. To most non-professionals, the “story” of the stock seems to be its most compelling element, and may often be the determining factor in investing in that stock. To the value investor, the story is clearly secondary; it’s nice to have a good story, but valuation is always the key motivation.
The value investor will spend most of his or her efforts in measuring the value of a stock. The basic idea here is to buy stocks which appear to be significantly undervalued. They can get this way due to some operational misstep, a disappointing quarterly earnings number, a lawsuit, a government fine, or simply being in an out-of-favor industry. Companies which are difficult to analyze or are boring often have stocks which are undervalued. Lack of attention from Wall Street analysts is another factor that can lead to undervaluation.
Most value investors can explain very clearly why a stock is undervalued and what valuation would be more reasonable. What they generally don’t know is when that appreciation will happen. Maybe an example from the past will better illustrate this concept.
The legendary value investor, John Neff, identified metal stocks (steel, copper, aluminum, etc.) as being very, very cheap in the early 1980s. After reaching this conclusion, he began buying them for his portfolio. The first year nothing happened. The stocks remained cheap. The second year passed – still nothing. This is where patience as an investor becomes critically important. By the third year, lesser mortals might have thrown in the towel on this investment. Not Neff. By the third year, metal stocks were the largest sector bet in the portfolio. And just as he expected (although could not predict the timing of), these stocks staged a massive rally – driving them to levels five, six or more times his original investment.
From this we can see that the value investor is very much like the farmer. Once the cheap stock is in the portfolio, the value investor will just have to wait. True, this is not a passive activity – monitoring fundamentals and re-testing the thesis are important, but ultimately time will be needed for the stock to grow to its full valuation. Sometimes this happens quickly (with a takeover bid for the cheap stock), and sometimes it takes a long time, like John Neff’s metal stocks.
The famous investor Sir John Templeton once said, “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.”
We would submit that this new bull market was born in March 2009 amid a massive amount of pessimism. A year later it feels clearly nestled into the “skepticism” stage. Despite all the positive economic and market data, investors, especially individuals, seem preoccupied with the negatives – real or simply perceived. From our perspective, everything appears to be very normal for a new bull market and economic recovery. Despite how much the “new normal” is promoted by economists and market commentators, there is actually very little evidence of it. During the recession, GDP fell by 3.8%, marking the worst recession since the Great Depression of the 1930s. Although it was a tough one, the structural integrity of the economy remains in solid shape. Consumer spending over the same period fell only 1.8%. The great consumer de-leveraging, which was supposed to hurt GDP for a long time, didn’t happen. The consumer was not the cause of the recession and has returned to a normal pattern of consumption in the recovery. Pent up spending by corporations is a bigger driver for the recovery right now and is expected to grow stronger over the next few years.
Overall, corporations appear to be in great shape. Balance sheets are clean and full of cash. Cash flow is very strong and is likely to be used for any number of stock marketfriendly actions: raising dividends, buying back stock, merger activity, capital spending, and so forth. Earnings have been stronger than expected for four quarters in a row now and revenue growth is even surprising on the upside. The latest measures suggest that a great deal of cash remains on the sidelines. The average investor is still not convinced that this economic recovery and bull market are real. This too is a positive, in our view.
With the stock market up some 70% from the March 2009 lows, some have suggested that the “easy money” has been already made in stocks. Some will look at the macro picture and conclude that emerging markets are the place to be, or that computer stocks (or whatever) are the best investments out there. We don’t approach investing this way. We are solidly value investors looking at the companies, one by one. We never buy “the market.” We rarely make big calls on sectors. We have emerging market exposure, but it will never be a huge part of our portfolios. Even after this big run in the market, we are still able to find solid companies with stocks trading 35-40% below what we consider fair value. Our experience has taught us that there are always good companies to own.
Yields on the best-quality bonds have already begun to rise. We think that investors, who sought the perceived safety of these bonds, may wake up one day and see losses in their “safe” bond positions. This gradual rise in interest rates could be another motivation for investors to consider stocks. The bond market is much larger than the stock market and even a small amount of bond money moving into stocks could impact the stock market positively. Lower-quality bonds still represent good value, as do municipal bonds. We think selectivity will be more important this year for bond investors. We are very comfortable owning the bond funds we do. Also, the bond ladders we created for many of our clients are performing well and as expected.
All in all, we are as comfortable as we can be about the prospects for the economy and the markets. As always, we are patiently waiting for our value stocks to bloom, but are also actively searching for new ones each and every day. As long as we can find them in abundance (like right now), we feel pretty confident that the bull market is likely to continue.
Wolf Group Capital Advisors