Letter – 2010 Q1

I ended my letter of July 2009 by outlining an “optimistic scenario” in which the S&P 500 could return to the 1200 level. Few believed it at the time. Well, we’re almost there. A lot of people still don’t believe it – which may be a good thing for the market.
We are well-positioned enough to have outperformed the market, but are not as aggressively positioned as some others. I have tilted your portfolio a bit more toward stocks with good dividends and have limited exposure to companies that depend on rapid growth or a resurgent consumer.

The S&P 500 Index had a total return of 5.4% for the quarter, and your portfolio rose by 5.58%. There are some mutual funds that did better, but these funds are very often the ones that fell by 45% or more in 2008. I don’t think it is a great time to be too much further out on the risk curve. But I do think that there are opportunities to make good money by focusing on intrinsic value. Better yet, we can do so in stocks that have traditionally been quite stable. Exxon Mobil is a good example.

When we had a 50% year in 2003, I would have considered Exxon Mobil too stodgy for that investment environment. Exxon gained about 18% that year and closed at a price of $41 with oil at about $30. Since then, oil is 170% higher. Although Exxon has outpaced the stock market since 2003, it is up substantially less than crude oil itself. There is no perfect way to value the stock. But I’ve looked at it in three ways.

First, I regressed Exxon’s stock price versus crude oil over the last 20 years. That regression equation shows a .86 correlation and indicates that for the March 31 crude price of $83.76, Exxon should trade at $78.31. It ended the quarter at $66.98, below this predicted value by 14.5%.

The company earned $2.56 a share in 2003 and thus had a PE ratio of 16 based on that closing price of $41. It earned $3.98 in 2009 and ended the year at $68.19 for a trailing PE of 17. So what’s the big deal? The company is projected to earn $5.73 in 2010 and thus trades at a forward PE of only 11.6 based on the March closing price of $66.50.

Next we looked a little further down the road. Analysts see earnings of $7.31 in 2011 and continued earnings growth of about 14% annually over the next few years. If these analysts are correct, it will take 7.02 years for the earnings to add up to the stock price (ie, our “payback period”). Over the past decade, Exxon’s stock price has implied a payback period averaging 9.5 years. Though this mean is slightly higher than the payback period of most stocks, if valuation returned to that level, the stock would trade at $98.50 – 47% higher than its March 31 price. Morningstar estimates XOM’s fair value at $87, which is between our two projections.

We did the same analysis for a number of other stocks. If Intel’s valuation returned to its mean payback period of the past decade, the stock would be 27% higher than its March 31 price. Of course, that data includes both the tech bubble and tech bust, so the period encompasses a wide range of valuation parameters. Value Line sees a compound annual return on this stock of 13% to 21%, versus about 8.5% for the overall market. Pfizer is also 27% below its mean valuation, IBM is 14% below, and Aflac is 18% cheap by this measure. Value Line projects above average returns on IBM and Aflac as well, and a market rate of return on Pfizer. Stocks such as Proctor & Gamble and American Express seem more fully valued. But the bottom line is that there appear to be some very reasonable valuations among certain of the large cap stocks.

One can’t just look at numbers in a vacuum, so next we ask what could go wrong with these valuation projections? Well, in the case of Exxon, perhaps we’ll all be driving electric cars in five years. China’s economy could pause and slow the growth in international demand for energy. Over the long haul, nuclear power could substitute for more oil. But all of these possibilities should be baked into the current earnings projections, and right now Exxon is quite cheap relative to those expected earnings. That has traditionally been a good time to buy. As you can see, Exxon is a fairly large position. It has been a drag on our performance so far this year, returning negative 1.2% for the quarter. As the old saying goes, the stock doesn’t know we own it. Nevertheless, stocks and markets do have a tradition of reverting to mean valuations. Pharmaceuticals were the rage a few years ago. Analysts loved Pfizer at $35, but didn’t like it at $14. Now it is at $17. Betting on a reversion to mean levels paid off numerous times in the past.

We scour for value based on these and other measures. For instance, I have used the price to peak earnings ratio at times to identify cheap entry points in potential turnaround situations. This has helped us in banking and steel and even Ford (for the most risk tolerant accounts) in the past year.

I have also looked more toward utilities and other stocks with good dividend yields, especially since dividends have accounted for 44% of overall return on stocks since 1926. However, that was not true this quarter as utility stocks were a small drag on our overall performance. Gold was also a drag on the portfolio this quarter as the dollar strengthened versus the Euro, but as discussed in previous letters, the fundamental case for owning some gold remains strong. Finally, we are invested in foreign (mostly Asian) exchange-traded funds as well. They have also underperformed so far this year (eg, China was 5% lower), but they present great growth prospects in the long term and an intelligent diversification in the short term.

Back in 2008, the S&P 500 had traded down to the 1200 level as it foreshadowed a fairly normal recession. Then came the Lehman failure and the resulting panic. That panic is over, and now the 1200 level reflects an effort to climb out of the recession that was unfolding before panic set in. There are ongoing worries about whether the economy can quickly recover from such a severe shock. In fact, the market’s 4% downdraft in late January took place when market guru Robert Prechter spooked some market professionals by saying on CNBC that another big move down was beginning to unfold. You could feel certain hedge funds placing that bet in the wake of his comments. But the market bounced back, and has proven resilient despite these lingering fears.

So the big question is whether this is a reasonably normal climb out of a steep recession or whether we are ascending a cliff where the headwinds of debt and unemployment will make the foothold ever more tenuous. Moody’s.com chief economist Mark Zandi is one of the most articulate economists out there and reflects my view:

“The probability of going back into recession is still low. It is about 1 in 4, 1 in 5. But that is too high, and, more important, if we do go back into recession – if all economists are wrong and we do go back into recession – it will be very painful, it will be very difficult to get out of it. So I think it is very important to guard against that.”

Zandi has opined that government policies should be enough to keep us from sinking back into recession. Other economists agree, as emphasized by Barron’s:

WHILE MANY AMERICANS WORRY about the economy sliding into another recession, economists don’t. Blue Chip Economic Indicators, which polls about 50 economic forecasters every month, reports that not a single one of its respondents expects a second dip in 2010 or 2011.


Even though I believe our risk control mechanisms are better than most, it is this non-trivial possibility of a sudden reversal (and my distrust of consensus among economists) that keeps us from being overly aggressive in the market right now. For instance, we really don’t know yet what the effect will be of the Fed ending its so-called quantitative easing, which involves buying over $1.2 trillion of mortgage-backed securities in the past year and effectively underpinning that market.

Our bottom line is that there is reason for cautious optimism. The market remains consistently above its 200 day moving average, and strong buying came in when we got near that level in early February. As I have said repeatedly, I don’t see any predictive value in moving averages, but I do regard them as an indication of trend. There are enough stocks that are still reasonably valued.

The overall market is fairly valued as well. Bottom-up estimated earnings for the S&P 500 Index for 2010 are estimated at about $78 versus about $56.86 in 2009, for a gain of 37%. This puts the market’s forward PE ratio at about 15 – which is reasonable particularly given current interest rates. Measured on a quarter over quarter rather than annual basis, the S&P’s quarterly earnings are about 25% higher than they were a year ago. The cautionary note is that revenues have grown by only about 6.7% in the same time frame. Revenue growth lagged earnings growth in the 2003 recovery as well, but this is still something we must watch closely. Earnings have grown so far more due to cost-cutting than top line growth in the average business. Finally, earnings comparisons will get tougher later this year as we move further away from the depths of the recession.

The things that were supposed to go wrong this year have not (at least yet). The Greek and PIIGS crisis (Portugal, Italy, Ireland, Greece and Spain) have not blown up the world. Commercial real estate has not blown up the regional banks; in fact, those stocks are rallying.

The economy has shown signs of life. Consumer spending has increased modestly for five straight months. GDP grew by 5.6% in the last quarter of 2009 and is expected to grow at 2.5 to 3% in early 2010. Job creation figures for March were the best in three years. Corporations have a record $2 trillion in cash. But the news is not uniformly good. For instance, construction spending in February dropped to the lowest level in more than seven years.

We continue to monitor economic developments and company-specific news in the hope that we can continue to search out the best relative values at a given point in time. The year is off to a good start, and our 12-month return is now 51.7%. I doubt we’ll be able to keep up that pace, but we’ll do our best.

* 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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