The Long Run Quarterly Letter: April 2009
After a fall of extraordinary loss and disillusion and a winter of such strange and oppressive weather here in New England that it seemed the heavens themselves were aligned against us, we all find ourselves looking toward the spring and the promise of new beginnings. Recent news has provided glimpses of what the press has been calling “green shoots” rising up from the economic mulch:
• Home sales numbers are showing some signs of life as existing home sales rose 5.1% in February.
• Banks are showing significant advances in operating profits, suggesting that government support may be helping. Wells Fargo kicked off the earnings by announcing their best quarter in history. Other banks have announced their intentions to pay back TARP funds ahead of schedule.
• The Association of Individual Investors’ asset allocation survey, conducted monthly since November of 1987, showed a record high allocation of 45% in cash in March and a record low allocation of 41% in equities – showing significant cash waiting on the sidelines and suggesting that the selling tide may be ebbing soon.
• The wider U.S. market has lifted 25% from the lowest of bear market lows in March, and some important stock groups – including energy and technology – have not revisited the lows that they set last November.
So, there is some reason to be encouraged. But, we would argue that we are entering more into a period of stabilization than into a period of true economic recovery. We have moved from the frightfully fluid atmosphere of crisis – when many were concerned that the global financial system was in immediate danger of collapse – but now find ourselves in a remorseless economic environment where entire industries are disappearing before our eyes and a large portion of the population has been forced to redraft life plans.
It took many years of accommodation (and greed) to inject such extraordinary leverage into the global financial system, and it will take years – and not mere months – for it to be worked off. Many corporate balance sheets still are in need of significant repair, and individual savings rates must continue to rise – not only to support consumption going forward, but also to repay the debt that fueled consumer purchases over the last cycle. And yet we still face considerable current challenges in the economy. Credit card defaults accelerated in March at the fastest pace our credit sources have seen, unemployment continues to rise and the wall of commercial lending debt coming due stretches out for years and totals in the hundreds of billion of dollars.
This tough economic backdrop demands discipline and precision from investors seeking to win gains in equity investments from the current discounts in the market. There is opportunity to find better than average returns in selected equities over the next three to five years, but we also see potential for significant damage in many segments of the economy over that period. There will be winners and there will be losers, so this is certainly a time to know what assets you hold and to be clear-minded about why you own them. Moving forward, investors should not lose sight of the painful lessons taught to us all so recently:
1. Avoid over-diversification. Over the last decade, many investors were pushed into a wider and wider mix of asset classes to “improve their risk profile” through the magic of diversification. Diversification makes sense, however, only when it is supported by strong fundamentals across investment mix. A new era of managers has amplified the benefits of diversification, inviting significant investment into higher-risk asset classes, and has lost sight of the need to assure quality and transparency in underlying investments. Unfortunately, as many learned in 2008, there is a fine line between diversification and exposure. Pension accounts that had moved into CDOs, high-yield instruments and multi-alpha hedge fund products to replace fixed-income reserves saw their liquidity evaporate. Families that had moved significant wealth into oversized investments in emerging markets, commodities futures, real estate and high-octane hedge funds suffered debilitating losses of capital. The over-engineering of a portfolio is no replacement for insightful investments in quality assets.
2. Balance sheet. Balance sheet. Balance sheet. In a period of de-leveraging, companies with significant debt on their balance sheet are at a distinct disadvantage. Many firms are now saddled by the weight of interest payments, the prospect of expensive refinancings and the potential for asset sales. Low-debt competitors are free to acquire weakened companies, to invest in research and development and to support their shareholders. Companies representing our top 25 holdings delivered average earnings growth of 10% and average dividend growth of 14% in 2008, while the S&P 500 saw earnings decline by 41% and dividends grow by only 2% for the year. >
3. There are no shortcuts. Investors have been sold on the concept of “silver bullet” investments for some time now. Hedge funds started as the tonic that would provide equity-like returns with bond-like risk and quickly became the most popular option for accelerating returns outside of the normal rules of the market. In general, hedge fund investments have proven to be disappointing – showing remarkable correlation to the very markets they were supposed to outclass. In numerous specific instances, less-transparent hedge funds failed completely. Today, gold is sold as the ultimate elixir. It is marketed (continually on radio and television – and even during half-time of the Super Bowl) as an answer to both inflation and deflation, as a guard against an imminent decline in the dollar, and as a safe haven in the event of total failure in the banking system. If this were really the promise of gold, wouldn’t prices per ounce have pierced $2,000 by now? The truth is that gold prices have been supported by money flows based on current fears and not by functional demand. When the curtain is drawn back, gold will likely disappoint.
With these lessons in mind, we will continue to explore productive investments in areas where demand is resilient and sustainable, and we will study industries going through dynamic and progressive change to uncover new market opportunities. So, we till the soil carefully and see promise for growth ahead, but we also expect a longer frost than early signals might suggest.
