The Long Run Quarterly Letter: July 2007
The past three months gave many reasons to doubt the direction of the economy and markets. A lack of political leadership has led to rising tensions in North Korea and the Mid-East. A change in economic leadership has left many questioning the vagueness of the current Federal Reserve policy. Studies indicating that 30% of corporations have been involved in manipulating stock options have certainly undermined whatever authority our business leadership thinks they have earned.
As a result, it should not be surprising that stock prices retreated over the past quarter, especially since a decline was a bit overdue. Stocks had increased in value for the past four quarters in a row with the S&P 500 up a very healthy 12% during that time. In the past three months, some of these gains were lost as the S&P 500 declined by 1.4%.
While the decline in the market appears relatively modest on the surface, the internal volatility was enormous. In both mid-May and June, the “herd” mentality of the market came under attack. The accepted wisdom had been that commodities and emerging markets were the safe investments. This safety was certainly fleeting as gold had its worst single-day percentage decline in 25 years on June 13 and India’s stock exchanges plummeted by more than 35%.
The main culprit for this volatility was tightened liquidity – the higher cost of borrowing money. The Federal Reserve’s seventeen consecutive interest rate increases were not the primary factor behind the higher cost of liquidity. Rather, it was the Bank of Japan’s decision to end their Zero Interest Rate Policy and actually begin to charge interest to borrowers. For years, hedge funds have turned to Japan for cheap loans to fund their speculative plays. When it became clear that this door to easy leverage was closing, the exit from trendy investments such as commodities and emerging markets became quite constricted and prices plunged. While our clients were not exposed to these sectors, we still worry about the impact that these declines can have on leveraged investors and the economy. As a result, we still think it makes sense to avoid most financial stocks and recent speculative favorites including real estate and commodities.
Higher interest rates will lead to slower economic growth over the coming months. In an effort to reduce speculation and contain inflation brought about by $75 per barrel oil, interest rates are rising around the world. As the media has flip-flopped between citing the risks of high inflation and a recession over the previous few months, we expect the term “stagflation” to rear itself from its slumbers of the 1970s. Stagflation equates to too little growth and too much inflation and likely will become the risk du jour.
Though we expect interest rates to be increased again in the U.S., we are not yet ready to change our outlook for modest economic growth. While we were in the forefront of predicting a slowdown in the U.S. consumer, we think renewed growth in Japan, as well as the continued emergence of middle classes in China, India, and Latin America, will offset a good deal of our domestic problems. But we will be particularly selective with investments. It is not lost on us that for the first time in several years, the number of companies with falling debt ratings outnumbers those with rising debt ratings.
As overall market risk increases, we emphasize the importance of sticking to our investment disciplines. Sound balance sheets are even more important now as interest rates rise and the cost of carrying debt becomes more burdensome. Management innovation is ever more critical in this changing global landscape. Economic growth will become more uneven as the U.S. consumer contracts, and, in this environment, companies with clearer paths to consistently strong earnings will command higher valuations. As contrarian investors, we will continue to look for the unloved assets. We note that the stocks of large companies are selling at their cheapest valuations versus the broader stock market in more than twenty years.
Sustainable Investing. For the third year in a row, we had the pleasure of being invited to serve on a panel to choose the twenty most sustainable companies in the world. The list is put together for The Progressive Investor, a publication of Sustainable Business.com. The panel includes representatives of investment firms around the world and gives us a glimpse into the latest trends in sustainable business innovations. In a period dominated by political tensions and high oil prices in the news, investors should not lose sight of the innovations that are defining corporate leadership and setting the groundwork for future growth.
We were responsible for nominating several of our favorite companies on this year’s list. The new addition that we were most excited about was Novartis, the large Swiss health care company that we have recently introduced into the portfolios of many clients. Novartis not only has been an advocate of climate change solutions, but last year made what we consider to be the most meaningful breakthrough in the sustainability debate: a commitment to paying sustainable wages. It surveyed all of its 78,500 employees in 140 countries around the world and found that 93 were paid less than a sustainable wage. It immediately gave each of these workers an appropriate salary increase. Not content to stop there, Novartis this year is asking all of its suppliers to follow its example and pay a living wage to its employees.
If you would like a full listing of the Sustainable Business 20, please let us know.
We also have exciting news on our next IMAX film project, Water Planet. A number of clients have chosen to invest in this film which is being produced in conjunction with MacGillivray Freeman Films, our partner on our last film, Coral Reef Adventure. Though the film was originally set to premier in 2007, we have set it back to early 2008. Deckers has agreed to become a major sponsor of the film and a 2008 rollout corresponds more closely with their marketing efforts. Given the growing importance of fresh water issues around the world, we believe this film will play an important role in contributing to national discussions in the next major election cycle.
