Letter – 2009 Q3

A year ago, things were dire.  Few envisioned this much of a recovery in the financial markets.  Yet stocks just had their best quarter since 1998.  Many people have missed good returns as the stock market has climbed the so-called wall of worry.  We have been pretty much fully invested, and have profited accordingly.

The S&P 500 provided a total return of 15.6% for the quarter, and your account gained 16.2%.  I feel good that we have done better than the market during both the decline and the current rally.  The S&P 500 Index is still 9.2% below its level a year ago.  Your account is up 1.08%.  You had a balance of $xx on last September 30, 2008 and $xx as of the quarter just ended – well ahead of the market over the past 12 months.

We were overweighted in financials in the spring as they rallied sharply, but have cut back our exposure there.  Banks may find that they marked down impaired assets too much, and revaluations may now boost earnings.  At least some of that by now must be discounted in the prices of bank stocks.  We have been underweighted in the consumer sector, as there is little evidence that people are spending freely again.  We have missed some profit opportunities in that sector, and in my efforts to preserve capital, we got out of certain retail positions such as Ann Taylor with a much smaller profit than we should have had.  The market may be anticipating a return of the consumer, but the consumer stocks seem to be discounting an awful lot of good news.  There is starting to be talk of GDP growth as high as 4-5% for the fourth quarter.  But even if this occurs, it may be led more by the industrial companies rather than retailers.  Thus we are sticking to our valuation discipline.

We remain somewhat overweighted in energy stocks.  This was the best performing industry group over the past five years, and there is no clear reason to believe that the sector will weaken.  We did a little worse than we might otherwise have in these stocks because of our natural gas holdings.  Natural gas had been trading at one-third of where it should be in BTU-equivalent terms to oil, and has recently moved higher as industrial use has picked up and as worries about a cold winter increase.  This has produced recent gains in stocks such as Penn West (PWE; + 27.7% for the quarter) and Helmrich & Payne (HP; + 28% / qtr).
So what now?  There are a number of indicators that provide useful guideposts, but there are mixed signals.  Foremost are earnings and earnings momentum.  Is this market cheap or expensive?  The S&P 500 Index closed the third quarter at 1057.  Analysts project operating earnings of $54.09 for the index in 2009.  So the current PE ratio is a somewhat rich 19.5.

A high current PE ratio is justifiable for two reasons.  First, interest rates are extremely low.  Second, the market is discounting to some degree a return to more “normal” earnings.  So the current PE ratio is justifiable as long as earnings come through as anticipated.  Companies have cut costs substantially, so any increase in revenues should flow right to the bottom line.  This great operating leverage creates the potential for more positive earnings surprises like those that have occurred in recent months.  Early estimates are for the S&P 500 Index operating earnings to be $72.96 in 2010 – a 35% gain over 2009.  That translates to a quite reasonable forward PE ratio of 14.5.  Even so, aggregate earnings estimates are only about 4% higher than they were three months ago.  We are tracking earnings closely, and are sensitive to any slowing of momentum here.

We are seeing a wider range in valuation among individual stocks than the norm.  Some stocks remain good buys while others appear to be overpriced.  As you may recall, we look at the consensus earnings estimates for a company, and project that prospective earnings stream out far enough to calculate how long it takes for those earnings to add up to the current stock price.  When that payback period gets too long, the yellow lights start flashing in my mind.  I remember back in 2000, General Electric’s projected earnings stream wouldn’t pay back the stock price for a full 14 years.  GE was at 60.  That was unsustainable, even for a top-notch company.  Who knew that the stock price would fall to 6 over the course of a decade?  The only other stock in my universe that had such a long payback period was Enron.  Amazing how lemmings can drive prices to extremes without any critical thinking.

Today, one-quarter of the 800 stocks that we follow have a payback period in excess of 12 years.  That seems too long.  Our discipline of insisting on reasonable value may cause us to miss out on some “momentum investments”, but we would rather stick with sound fundamentals.  The wide range of valuations in the market today creates opportunity and makes sound stock picking all the more important.  The valuation game is made even trickier because some cyclical stocks are very cheap relative to “peak” earnings but quite expensive relative to current earnings.  US Steel is such a company.  It is extraordinarily cheap relative to peak earnings, but if there are no promising signs of substantial earnings growth, the stock is expensive.  We bought the stock at 2.2 times peak earnings, but have already taken a modest profit on a portion of the position as the stock has retreated 14% from a recent high.

There are other methods that can help us evaluate the current state of the overall market.  I often say that I look at the 200 day moving average of the S&P 500 Index not as a predictive tool, but as an indicator of trend.  I am cautious when the market is below its 200 day moving average, and assume that we are in a bear market until there is persuasive evidence to the contrary.  Now we are well above that average, and the same presumption is true with regard to a bull trend.  The major question I have is whether we are too far above the 200 day average.  Have we gone too far too fast?

Many corporate executives seem to think so.  The summer has seen insider selling on an unprecedented scale.  Fortune Magazine reports that corporate officers and directors have been selling shares at a pace last seen just before the onset of the subprime malaise two years ago.  According to research firm TrimTabs, there were $31 worth of insider stock sales in August for every $1 of insider buys.  A normal sell to buy ratio is about 2.5 – 1.  Insiders were heavy buyers in March.  There is an argument that insider activity is not as useful an indicator now as it has been.  Given the enormous plunges in many stocks in the past year, it may be that some insider selling is simply an effort by senior executives to diversify their holdings.

Even if insider selling is a bearish indicator, overall asset allocation by the general public leaves plenty of room for more upside in the market.  Harris Private Bank reports that whenever assets in money market mutual funds exceeded 25 percent of the market capitalization of the Standard & Poor’s 500 index, stocks have rallied over the following two years.  This ratio jumped to an almost-unheard of level of more than 60 percent on March 9.  In mid-September, there was about $3.5 trillion in money market funds versus a market cap for the S&P 500 of about $9.4 trillion.  The ratio comes to 37 percent, well above what Harris Bank identifies as bullish.  Of course, even if cash leaves money market funds, it does not all have to flow into stocks.  More money is going into assets such as corporate bonds and gold.  Some may be moving overseas.

One thing I did not like about the quarter is that some of the junkiest stocks had the best percentage returns.  Gannett (newspapers), Freddie Mac (toxic debt), and United Airlines all more than doubled.  I would not want my fortune to depend on any of these companies.

Our overall thesis remains the same – as long as government stimulus is aggressive, it is bound to be good for the market.  As that stimulus gets cut back, we need to closely monitor whether the private sector is responding as it should.  We are also mindful that our increased debt levels of public debt could cause the US dollar to continue to deteriorate – though less against the Euro than most other currencies.  Finally, to repeat something I said in my letter of April 2007:  “I get uneasy when the main bullish argument hinges on ‘liquidity’.  Just because people have money doesn’t mean they have to spend it.”

We continue to see plenty of opportunity.  However, much of it is more singles and doubles rather than home runs.  For instance, many solid utility stocks are paying dividends of 5 or 6 percent.  If they appreciate a mere 5%, we have a double digit total return.  Nothing wrong with that.  Pipeline enterprises such as Kinder Morgan (KMP) and Enterprise Products (EPD) offer even higher yields (about 7.7%) with reasonably stable stock prices.

We will continue to take appropriate risk on stocks where we might double our money or more.  For instance, the Case-Shiller index of housing prices has stabilized.  The housing stocks have taken a tremendous beating over the past three years, and finally seem to be turning.  Hovnanian was up 62% during the quarter.  Timing these turns is not easy, so we don’t heavily weight investments in such volatile stocks.

Speaking of a deteriorating dollar, we have built some exposure to China and other Asian markets into your portfolio.  Princeton professor and financial author Burt Malkiel has provided some useful analysis of China.  In a recent Barron’s interview, he noted that at official exchange rates, China has 5% of the world’s GDP. If you did a purchasing-power adjustment, they’ve got 10% of the world’s GDP. Almost no equity investors have anything like that percentage in China. China is only about 1.5% of the world’s index funds.

The bottom line is that we have moved more toward stocks with good dividend yields in stable businesses.  I would rather sacrifice a little upside than overpay for stocks that appeal primarily to momentum investors.  There are plenty of good things to choose from, and I hope we can close out the year with results that are as much ahead of the market as we are now.  I’m always happy to discuss things with you in greater detail, so please don’t hesitate to call or email.


* Past performance is not necessarily indicative of future performance. Results for individual clients may vary. Results are not audited. Byrne Asset numbers reflect the addition of certain dividends and deduction of all fees. S&P numbers are based on the total return of Vanguard’s S&P 500 Index Fund.

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