Appended to this letter is a summary on the lion’s share of topics that seem to be keeping people up at night. Please call to discuss these any of these issues or to offer additional comments. Last quarter we communicated our expectation that above consensus economic growth would probably materialize in 2010, and at least through the first quarter, this has been dead wrong. Our optimism came from the close contacts we keep with the companies we follow which usually we expect to grow sales at around two and a half times the rate of GDP growth. We have been encouraged by sales growth for the companies we follow, yet first quarter GDP growth was a puny 2.7%. There seems to be one simple explanation for sales growth of our portfolio companies vaulting to more than five times GDP growth: the companies we follow generally dominate their industries. And as we have said time and time again, the strong should emerge from the crisis even stronger at the expense of weaker, more poorly run competitors.
Presumably individual investors are taken by the numerous circulating comparisons to the 1930s and general uncertainty because money continues to flow out of stock mutual funds and into bond mutual funds. Historically their timing is so bad that this is good news for long term investors who can stomach taking an unpopular contrarian view. At the pit of the depression in 1932, President Hoover enacted the largest tax increase in US history; for example, the top marginal tax rate was increased from 25% to 63% - and President Roosevelt later increased it to 79%. Smoot-Hawley increased tariffs on international trade and the economy suffered mightily for these government policy errors. In our opinion the sum total of effects of policies that President Obama has considered would not hold a candle to the policy errors in the 1930s. It is worth further mention that President Obama has been woefully unsuccessful in many critical policy endeavors.
In summary, we view the current situation and market conditions in a favorable light and look forward to catching up with you soon.
Tuesday, September 21, 2010
Tuesday, May 25, 2010
Exerpt From 2010 First Quarter Letter To Clients
Coming out of a severe economic recession we think it is “normal” to have a swelling of popularity around an outlook akin to today’s “new normal” (sluggish economic growth with persistently high levels of unemployment). We suspect the “new normal” is rooted in the mantra of “this time it is different,” and that is “normally” wrong. The Chief Economist for DuPont recently spoke at the Richmond Association of Business Economics and commented that the strength of an economic recovery is directly related to the magnitude of the downturn and that the current pace of economic recovery is right in line with what one could project using prior economic cycles. Such a projection yields an expected initial economic growth rate above 8.0%, yet we surmise the “new normal” view only expects economic growth between 2% and just over 3%. It is also interesting how some pundits have stated that the decline in economic activity from inventory destocking was normal, but increase in economic activity from inventory restocking is to be discounted as a temporary event. Either way, we expect 2010 economic growth to be well above the average forecast, though economic forecasts do not affect the long term value we see in your holdings.
It is also interesting to look at the movies that lead box office sales, as an indication of the state of mind of the US population. The top three movies of 2000, presumably with a genesis in 1999 which was preceded by a decade of stellar economic growth and a massive bull market, fit the broad category of “amazing feats of the common man” (Mission Impossible 2, Gladiator, and Cast Away). Yet three of the top five movies of 2009, presumably with a genesis in 2008, fit the broad category of “the innocent suddenly facing the possibility of the end of the world” (Avatar, 2012, and Transformers). As an aside, Planet of the Apes hit theaters at the height of the Vietnam Conflict and was re-released in 2001. Being weary of crowds at extremes, this would normally make for a fine opportunity to identify stocks which inappropriately reflect an end of the world scenario.
The present phases of the psychological market cycle seem to be progressing nicely. Our estimation is that most people have moved past despondency and depression. The next phase is one of hope. I can share that I have had conversations with a handful of clients each of whom estimated their portfolio values to be nearly twenty percent below where they actually were. A great many people were concerned about an “end of the world scenario” as GE’s stock price declined from $40 to $18, and not as many are relieved to see GE’s stock price rise from $6 to $18. But once everyone is relieved, we think the stocks of GE’s and many others will be higher.
It is also interesting to look at the movies that lead box office sales, as an indication of the state of mind of the US population. The top three movies of 2000, presumably with a genesis in 1999 which was preceded by a decade of stellar economic growth and a massive bull market, fit the broad category of “amazing feats of the common man” (Mission Impossible 2, Gladiator, and Cast Away). Yet three of the top five movies of 2009, presumably with a genesis in 2008, fit the broad category of “the innocent suddenly facing the possibility of the end of the world” (Avatar, 2012, and Transformers). As an aside, Planet of the Apes hit theaters at the height of the Vietnam Conflict and was re-released in 2001. Being weary of crowds at extremes, this would normally make for a fine opportunity to identify stocks which inappropriately reflect an end of the world scenario.
The present phases of the psychological market cycle seem to be progressing nicely. Our estimation is that most people have moved past despondency and depression. The next phase is one of hope. I can share that I have had conversations with a handful of clients each of whom estimated their portfolio values to be nearly twenty percent below where they actually were. A great many people were concerned about an “end of the world scenario” as GE’s stock price declined from $40 to $18, and not as many are relieved to see GE’s stock price rise from $6 to $18. But once everyone is relieved, we think the stocks of GE’s and many others will be higher.
Wednesday, January 13, 2010
Excerpt from 2009 Fourth Quarter Letter to Clients
So where are we now? We are in one of the most exploitable stages of the emotional cycle of investing. We think some people are still despondent, most people are depressed, and some people are starting to feel hopeful. We characterize despondency as a state of mind in which one has an aversion to mental activity, specifically an aversion to thinking about investments. When despondent people start thinking again they become depressed. We characterize depression as a state in which people do not want to own stocks but they do not want to sit on cash; the end is not in sight; change is desired but nothing is trusted; so many questions remain unanswered the problem cannot be solved; turning to experts yields even more confusion because their opinions vary wildly. Asset values have recovered significantly from March 2009 which is requisite for people to move from depression to feeling hopeful. We think the start of feeling hopeful is marked by contemplation of questions about the recovery in stocks being for real or the evidence of stabilization being enduring.
This is one of the most exploitable conditions because we believe:
• Tremendous amounts of information have been garnered since Lehman Brothers went under sixteen months ago (the financial crisis ended, the economy recovered, business has generally stabilized, employment has stabilized, residential values have stabilized, housing has stabilized, energy prices have stabilized, even the commercial real estate crisis seems to have passed the midpoint).
• Yet today with the S&P 500 at 1133, it is 5% below where it closed on the day Lehman Brothers declared it would file for Chapter 11 bankruptcy, credit markets froze, and stocks tumbled.
• Ten trillion dollars is available to flow into equities
• Most people are despondent/depressed
Over the past ten years Wal-Mart’s earnings doubled and dividends quadrupled as the company expanded internationally with masterful success. The stock has basically been flat for ten years with the primary difference being that ten years ago Wal-Mart traded with a PE above fifty and today it trades with an estimated PE of thirteen. It has been a situation where one could sleep well with the company and sleep on the long flat stock chart. Do not be surprised if stocks of the Wal-Mart ilk comprise a portion of purchases in the coming months. Such a thesis may also be timely as it would seem a likely recipient of investment dollars from the newly hopeful.
This is one of the most exploitable conditions because we believe:
• Tremendous amounts of information have been garnered since Lehman Brothers went under sixteen months ago (the financial crisis ended, the economy recovered, business has generally stabilized, employment has stabilized, residential values have stabilized, housing has stabilized, energy prices have stabilized, even the commercial real estate crisis seems to have passed the midpoint).
• Yet today with the S&P 500 at 1133, it is 5% below where it closed on the day Lehman Brothers declared it would file for Chapter 11 bankruptcy, credit markets froze, and stocks tumbled.
• Ten trillion dollars is available to flow into equities
• Most people are despondent/depressed
Over the past ten years Wal-Mart’s earnings doubled and dividends quadrupled as the company expanded internationally with masterful success. The stock has basically been flat for ten years with the primary difference being that ten years ago Wal-Mart traded with a PE above fifty and today it trades with an estimated PE of thirteen. It has been a situation where one could sleep well with the company and sleep on the long flat stock chart. Do not be surprised if stocks of the Wal-Mart ilk comprise a portion of purchases in the coming months. Such a thesis may also be timely as it would seem a likely recipient of investment dollars from the newly hopeful.
Thursday, December 10, 2009
Excerpt from 2009 Third Quarter Letter to Clients
"The prospects for earnings growth in the S&P 500 have never been better, literally. There is a non trivial chance that earnings grow 22% in 2010 and 22% in 2011. We know that earnings for the S&P 500 have never grown by more than 20% in the last twenty two years, and estimate that to be true since the index was created in 1957. Furthermore, such unprecedented earnings growth would still fall short of the peak earnings reached in 2007.
Trillions of dollars were taken out of stocks as people 'panicked out' during the recent financial catastrophy. Over the course of the second half of 2009, 2010, and 2011 with solid or even unprecedented earnings growth it is hard to imagine people would not 'panic in'. The stage is set for a potential bull market, though there is a legion of wrench wielding monkeys that may interrupt the process."
Excerpt from 2009 Second Quarter Letter to Clients
"Confidence grows as fast as a palm tree and falls as fast as a coconut. In terms of the simile, our economy is at the point where the coconuts are on the ground. It will take time for confidence to recover, and most people will not feel especially good for some time to come. However, I believe the worst is behind us.
In May, factories were making cars at the rate of 4 million/year, people bought cars at a rate of 7 million/year, and old cars were being turned into scrap metal at a rate of 10 million/year. Auto production must double or triple to satisfy even low levels of demand and this will positively affect the entire economy. It will not happen overnight, but as the economy rebounds, confidence will slowly be restored.
The major theme in your portfolio is an emphasis on companies that can do well without a major economic recovery and may well benefit from inflation. Such companies would fit the broad category of distributors. Well run industry leading distributors may benefit most from a sluggish recovery as many lesser quality competitors go out of business. Inflation is the biggest wild card over the next five years. Bernanke et. al. have done an admirable job of steering the economy away from a depression. But it is unclear if the economy has been steered toward inflation, and since this is uncharted territory it will be a year or more before we know. Distributors should see the value of their inventory rise and sales increase if inflationary effects take hold. They are usually one step ahead of higher prices by the nature of the business model."
Excerpt from 2009 First Quarter Letter to Clients
"Everyone seems to be wondering if the lows of the stock market have been reached. In early March a headline indicated that the Dow Jones Industrial Average was at the lowest levels seen in twelve years. Twelve year lows have only been witnessed two other times. One occurrence marked the exact bottom of the 1974 bear market and the other occurrence came about three months before the bottom during the Great Depression. In both instances, unemployment continued to rise and the economy continued to decline after the Dow Jones Industrial Average bottomed. It can be argued that the economy was different after both crises but that American ingenuity found opportunities for growth. These occurrences do not prove that it is over, but it does provide perspective as to how severe the decline has been.
In the insightful expression of Yogi Berra, “It ain’t over ‘til its over.” And since it might take six months to distinguish between a bear market rally and the start of a new bull market, we will remain invested in what we consider to be great companies.
The financial and economic devastation from this crisis will eventually provide fertile ground for expansion of certain surviving companies. Now more than ever it is important to know what you own and why you own it."
"The prospects for earnings growth in the S&P 500 have never been better, literally. There is a non trivial chance that earnings grow 22% in 2010 and 22% in 2011. We know that earnings for the S&P 500 have never grown by more than 20% in the last twenty two years, and estimate that to be true since the index was created in 1957. Furthermore, such unprecedented earnings growth would still fall short of the peak earnings reached in 2007.
Trillions of dollars were taken out of stocks as people 'panicked out' during the recent financial catastrophy. Over the course of the second half of 2009, 2010, and 2011 with solid or even unprecedented earnings growth it is hard to imagine people would not 'panic in'. The stage is set for a potential bull market, though there is a legion of wrench wielding monkeys that may interrupt the process."
Excerpt from 2009 Second Quarter Letter to Clients
"Confidence grows as fast as a palm tree and falls as fast as a coconut. In terms of the simile, our economy is at the point where the coconuts are on the ground. It will take time for confidence to recover, and most people will not feel especially good for some time to come. However, I believe the worst is behind us.
In May, factories were making cars at the rate of 4 million/year, people bought cars at a rate of 7 million/year, and old cars were being turned into scrap metal at a rate of 10 million/year. Auto production must double or triple to satisfy even low levels of demand and this will positively affect the entire economy. It will not happen overnight, but as the economy rebounds, confidence will slowly be restored.
The major theme in your portfolio is an emphasis on companies that can do well without a major economic recovery and may well benefit from inflation. Such companies would fit the broad category of distributors. Well run industry leading distributors may benefit most from a sluggish recovery as many lesser quality competitors go out of business. Inflation is the biggest wild card over the next five years. Bernanke et. al. have done an admirable job of steering the economy away from a depression. But it is unclear if the economy has been steered toward inflation, and since this is uncharted territory it will be a year or more before we know. Distributors should see the value of their inventory rise and sales increase if inflationary effects take hold. They are usually one step ahead of higher prices by the nature of the business model."
Excerpt from 2009 First Quarter Letter to Clients
"Everyone seems to be wondering if the lows of the stock market have been reached. In early March a headline indicated that the Dow Jones Industrial Average was at the lowest levels seen in twelve years. Twelve year lows have only been witnessed two other times. One occurrence marked the exact bottom of the 1974 bear market and the other occurrence came about three months before the bottom during the Great Depression. In both instances, unemployment continued to rise and the economy continued to decline after the Dow Jones Industrial Average bottomed. It can be argued that the economy was different after both crises but that American ingenuity found opportunities for growth. These occurrences do not prove that it is over, but it does provide perspective as to how severe the decline has been.
In the insightful expression of Yogi Berra, “It ain’t over ‘til its over.” And since it might take six months to distinguish between a bear market rally and the start of a new bull market, we will remain invested in what we consider to be great companies.
The financial and economic devastation from this crisis will eventually provide fertile ground for expansion of certain surviving companies. Now more than ever it is important to know what you own and why you own it."
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