Stocks rallied in the first quarter of 2011 in part because the Fed is trying to push up asset prices. This is an effort to spur a positive psychology and to create a wealth effect that will stimulate economic growth. Other reasons for the rally include record corporate earnings at a time when stock prices are still about 15% below their peak, the extension of tax cuts, and less focus on the situation in Europe.
We performed better than the overall market. The S&P 500 Index provided a total return of 5.9% for the quarter while your account rose by XX%. Your balance grew from $XX at year-end to $XX at the end of March.
The biggest questions for the market involve government policy, not corporate prospects. Will the Fed’s program of quantitative easing continue? Will the debate over the federal debt ceiling force a more contractionary fiscal policy?
Predictions for the course of the market very often fall into a very narrow band, with a bunch of dull-sounding forecasters calling for a “trading range”. But the divergence of views is greater than normal today. You have savvy market analysts such as Laszlo Birinyi calling for another two years of a bull market and a target for the S&P 500 of 2100, a move of about 60% from current levels. He calls the period akin to 1982 – a time of high unemployment, debt crises in Mexico and elsewhere, and fear of a continuation of the unstable markets of the 1970s. Others such as Bill Gross of Pimco say that asset prices have been artificially influenced by government policy and are unsustainable. The great unknown is whether the private sector is strong enough to maintain economic growth without continued federal stimulus.
We have profited in large measure by focusing on stocks with increasingly valuable assets – whether in energy, silver and gold, or leveraged investment firms such as Blackstone or KKR. We remain underweighted in consumer stocks, which hurt during their rally late last year but helped during the first quarter as higher energy prices and continued joblessness stifled demand. We are also less focused on health care stocks.
Let me focus on KKR and Blackstone. We bought the stock of Kohlberg Kravis Roberts (KKR) in March. KKR looks for undervalued assets and makes leveraged buyouts. It seems like an odd time for such a stock to be cheaply valued but we bought it when my system projected a compound annual return on the stock of nearly 30%. We got in at around $16, with analysts calling for earnings of $2.09 this year and $2.45 next year. Why is it trading at a PE ratio of only 8? One possible answer is their exposure to the biggest leveraged buyout (LBO) of all – Texas Utilities in 2007. My letter at the time took a skeptical view:
“… liquidity’ ” was driving the market ever higher with a $32 billion buyout of Texas Utilities – the largest buyout ever. I was at an investment conference in Colorado with CEOs and CFOs of major corporations and remember saying to whoever would listen that when the main bullish argument hinges on “liquidity”, I get uneasy.”
We weren’t quite at the top then, but we were only months away from the beginning of a disastrous change in trend. However, now it seems that we’ve gone from euphoria over LBOs to downright pessimism. It seems to me that KKR is being penalized for TXU even though they have written down 80% of their equity. Further, TXU is principally engaged in natural gas and coal based energy. These energy sources should do well in the wake of the nuclear disaster in Japan. So we own KKR. Earlier, we bought Blackstone – again betting on a rise in the value of their underlying assets. We have an unrealized profit of about XX% on the initial position after only a few months of holding it. We’ve done quite well in these stocks at a time when most other financial stocks have done poorly.
We have also done quite well in the energy sector. After a frustratingly long period of lackluster results, Exxon is finally paying off. We saw Chevron as a better relative value and added that as oil prices began their rise. More recently, we noticed an expansion in refining margins – known in the industry as the “crack spread”. In simple terms, a refiner dumps $100 worth of crude oil into a refinery and turns it into gasoline and heating oil, and hopes to sell the product for something more than $100. Right now, refining margins are wider than usual and refiners have been the hottest energy stocks. We own Valero, and have done well in it – but not as well as I had hoped even though the stock rose 29% for the quarter. Valero had hedged its bets and sold more product than usual in the forward market, so it has benefited less than it might have from the large gains in refining. [Thus I have added more Tesoro Petroleum because there appears to be more bang for the buck right now in that refiner.]
The precious metals have been good to us in the past year as concerns over excessive printing of money and consequent debasement of the dollar have led to a rise in gold prices. Gold has leveled off, at least for the time being, and we have cut our holdings somewhat. The historical price ratio between gold and silver had gotten out of line, and silver has been playing catch-up recently. We have increased our weightings of silver relative to gold in the past few months, and have profited accordingly.
That is a decent summary of assets plays.
We have also looked for opportunities based on innovation or compelling valuation in the tech sector. Here, we have had mixed results which we will categorize as good, bad, and frustrating. A small company called Universal Display (symbol PANL), based in nearby Ewing, falls into the “good” category. The company is on the cutting edge of organic (phosphorescent) light emitting device (OLED) technologies used in backlit screens. The stock has moved sharply higher this quarter. I’d love to own more of it, but it is small and potentially as volatile on the downside as on the upside if the economy weakens or a better mousetrap comes along. Baidu, the Chinese search engine, has also had a strong run this year. So has Priceline.
Intel and Cisco fall into the frustrating category. Intel is trading at a PE of only 10, but lost 3.2% this quarter. Cisco had a terrible period, losing 14.9%. It is also trading at a PE of about 10, and it just started paying a dividend. A decade ago, this same stock was trading at a PE ratio of over 100. It is absolutely amazing how market psychology changes. These stocks are good values. It is hard to see how they go much lower, and one never knows when they might rally. A return to a PE ratio that merely matches the market would mean a gain of about 40% in either of these stocks.
Bad were stocks like Oplink Communications. It was cheap at $19, moved all the way to $28, but then slid right back again. Some other tech stocks were almost as volatile, but the sector as a whole performed well during the quarter. I use stop-loss orders to limit downside volatility in portfolios. In periods like 2008, that strategy works well. In quarters like this when the market rebounds, that discipline is obviously less effective.
We have been light in the consumer sector. It is ironic that although asset prices are doing well, consumer confidence is not. The University of Michigan recently reported that confidence is at the lowest level since November 2009 due in part to the sharp rise in energy prices. Not surprisingly, consumer cyclical stocks as a group have lagged the overall market, rising 2.9% versus 5.9% for the S&P 500. Some estimates say that each $10 increase in the price of oil cuts about 0.3% from GDP growth.
We do not think that housing prices will boost consumer confidence in the next year or two. Notes The Economist (March 3): “At least prices in America are back to their long-run average compared with rents.” By its measure, homes are cheaper here than almost anywhere in Europe. Median home prices are now 2.8 times median family income, which is relatively cheap. However, if fixed rate 30 year mortgages are harder to get as Fannie Mae and Freddie Mac are restructured, there will be more downward pressure on housing prices. Right now, you could get a 15 year mortgage for about 4.25% or a 30 year mortgage for about 4.875%. On a $500,000 home, those monthly payments would be $3761 and $2646 respectively. If the option of paying $2646 a month for all 30 years is limited, many people will be forced to buy less house. If the yield curve continues to steepen, the resulting higher rates would also be a bearish influence on home prices.
We are mindful that a change in Fed policy could lead to a sudden change in trend. Three members of the Federal Reserve’s Open Market Committee (consisting of 12 members) have now expressed doubts about the wisdom of continuing with aggressive stimulus. Has the stock market become a game of musical chairs where everyone thinks they can get out when the Fed stops the music? Or do Laszlo Birinyi and other bulls have the correct long term view? And are worries about Congress and fiscal policies overblown? After all, the government shutdown in 1995 helped mark the beginning of a bull market, not an end to one.
When we look at stocks sporting a PE of 10 that are capable of growing earnings at faster than 10%, we know that history teaches that investing in such securities pays off well over time. Moreover, there are some companies that have grown earnings at over 20% and are still reasonably valued relative to their earnings. We have done well over the long haul by finding and investing in these situations. We’ll do our best to continue in that manner, and appreciate your confidence.
* 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.