After a very strong first quarter, the stock market took back about three-quarters of those gains by early June only to rally strongly in June – particularly on the last day of the quarter. The market’s retreat was due to sobering economic news – slowing job creation at home, perceived slowing in the Chinese economy, and a cut in the credit ratings of many banks. Concerns about the lack of both will and capacity of European leaders to deal with their mounting debt problems also contributed to market weakness – until the last day in June when Germany’s Angela Merkel indicated willingness to move closer to a unified European banking system by allowing bailout funds to go directly to banks in the Eurozone.
Despite the rockiness of this quarter, we are still well ahead for the year; the average pure equity account was up 6.22%. That is quite reasonable particularly in relation to alternative choices out there. With all of the dark economic clouds, I think these returns are in large measure due to the good values we can find in selected spots as prices discount at least some of the economic worries.
This quarter, the S&P 500 Index generated a loss of 2.4%. Broader measures of the market were weaker; the Nasdaq Composite dropped 5.1% and the Russell 2000 Index lost 3.8%. According to the New York Times, the average US stock mutual fund dropped 4.2% for the period. Unfortunately our returns were closer to these measures. Our average pure equity account lost 5.38%. Our more conservative accounts did better; this was not a period in which risk-taking was rewarded. Some of our biggest holdings were quite simply disappointing. Certain stocks that have generated good profits over time took a breather this quarter. And a few choices, while consistent with a selection system that has done well over the past decade, were simply disappointing and frustrating.
Top among the frustrating positions was Seagate Technology (STX). Seagate was featured on the cover of Barron’s in early April as an extraordinary value in the rapidly growing data storage area. My system projected a compound annual return on the stock in excess of 30%. A sure thing; oops, a reminder that there is no such thing as a sure thing. Or, as I learned early on: “the stock doesn’t know you own it.” The stock’s price reflects a tug-of-war between the rapidly increasing demand for storage capacity versus the continually falling price of computer chips as manufacturing gets ever more efficient. The stock lost 7.3% this quarter but remains substantially higher for the year.
Apple (AAPL) also cooled off this quarter. After gaining 48% in the first quarter, this stock lost 2.6% in the latest period. Apple trees don’t grow to the sky, but the stock still seems very cheap. Price to earnings ratios usually bear some relationship to earnings growth. At the peak of the tech bubble in 2000, these PE ratios were often much greater than the growth in earnings. Now we have the opposite situation. Apple’s earnings have nearly doubled in the past year, but the PE ratio on the stock is only 12.5. Unless earnings slow dramatically, the stock should continue to do very well.
Celgene is another major holding that hit a rough patch this quarter. It is an outstanding, well-managed company. But after gaining nearly 15% in the first quarter, the stock began drifting lower in early April. Then it slid 11% when a key drug (Revlimid) faced a delay in approval from the European Union, and lost 17% for the quarter. Thanks again, Europe.
Then again, we did not get much help from the East either. Asian economies have been growing at a considerably faster rate than ours. Most sophisticated investors believe that stock prices in these emerging markets are cheap. But these markets have done poorly this year, in part because of declines in many Asian currencies relative to the dollar. So while some foreign exposure is generally a good diversification, this hurt our overall performance in the quarter just ended.
There were some other bad stock selections. We’d be better off in JP Morgan if I’d just waited another day or two before buying; we knew that a $2 to $5 billion loss did not justify a hit of several times that to the stock. To keep this letter at an appropriate length, I won’t recite all disappointments. And to keep things in perspective, we finished in the middle of the pack relative to equity mutual funds – hardly terrible in what I regard as a particularly difficult quarter.
There are bright spots. Significantly, the housing market appears to be bottoming and housing stocks advanced this quarter, albeit in a volatile and irregular fashion. Sales of new US homes are at a two year high. Hovnanian was the top performing stock in the S&P 500 Index early in the year, then took a nosedive, and has since recovered to return 18% for the quarter. DH Horton (DHI), another homebuilder, gained 21% for the quarter. Needless to say, a bottom in real estate prices could go a long way toward stabilizing our economy.
In my last letter, I noted that utility stocks had underperformed the market by quite a bit in the first quarter but I wanted to hold on to them because they “will likely outperform if and when we hit turbulent patches later this year”. We held on, and these were some of our better performers; some sported double digit returns for the quarter. Stocks don’t have to be exciting to be good. In fact, Verizon was one of the best performing stocks of the quarter.
What lies ahead? Investors will watch the monthly non-farm payroll numbers carefully to see if we can keep creating jobs at a reasonable pace. President Obama says the private sector is doing fine; others are not so sure. The downgrade of banks means that they have to build up their capital cushions, and that is less money that they can lend. So these downgrades will cause credit to contract, and all else equal, that will have a negative effect on economic growth. The debate surrounding the so-called “fiscal cliff” will come into sharper focus in the months ahead. Experts project that there could be a fiscal drag of $700 billion if we go forward with the end of the Bush tax cuts, increases in FICA taxes, and the automatic spending cuts that Congress agreed to in the last debt limit battle.
The larger debate, both domestically and in Europe, is between the proponents of stimulus versus the advocates of austerity. Economists such as Paul Krugman argue that government must do all it can to stimulate growth. Others say that while early fiscal stimulus may have helped us avoid a depression, there have been diminishing returns to more stimulus with lots of new debt but very little growth. The question is – where is the tipping point? At what point does government debt become so great that some form of restructuring is inevitable? This spot is hard to pinpoint. But Harvard economist Ken Rogoff has co-authored a book which demonstrates that sovereign defaults (in various forms) are more common than generally realized. And this is nothing new – Scottish philosopher David Hume wrote in 1752: “When a government has mortgaged all its future revenues, the state lapses into tranquility, languor and impotence.”
It is said that if you are in a rowboat in the middle of the river a quarter mile above Niagara Falls, it is too late. No matter how hard you row, you are going over because you weren’t prudent while you could have been. So the debate is over whether more fiscal stimulus now pushes us too close to the edge, or whether it gives us the strength to push away. I am afraid that too many decision makers in the private sector are worried about the tipping point. If that is the case, then fiscal stimulus directed at public sector growth may be counterproductive as it does more to discourage new investment by private sector actors (who account for about 80 percent of all economic activity in the United States).
The same debate is raging over the European situation. It will eventually resolve itself, either through bailouts, defaults, currency devaluations or a combination of those things. Many smart observers believe that there will be a “V” bottom in those markets. But those observers don’t know if that will occur in a month or a decade. If there is an agreement to issue Eurobonds (i.e., paper backed by the EU as a whole rather than just individual nations), that would probably mark a bottom because it would be seen as the same kind of central bank action that stabilized the American economy back in 2008.
Since we can’t predict the future, the best thing we can do for you is focus on absolute valuations, and the best relative values. The dividend yields on many stocks remain very attractive relative to what can be realized in the fixed income markets. And many stocks have very attractive payback periods. As a reminder, we calculate a payback period by taking consensus earnings estimates and seeing how long it takes that projected stream of earnings to add up to the current stock price. If you can turn $100 into $200 in seven years, your compound annual rate of return is 10.4%. There are a good many stocks with payback periods of under seven years.
The related calculation that we do is to assume that at the end of a five year holding period, the PE ratio of a stock is equal to the realized growth rate in earnings. So we project out estimated earnings to year 5, assign the appropriate PE ratio, and calculate a future expected stock price. We relate that to the current stock price and calculate a projected compound annual rate of return. There are a good many stocks where our system projects a compound annual return in the double digits. Sometimes these stocks have good runs, and then pause. The pauses in strong performers such as Apple and Seagate hurt our relative performance this quarter.
So as long as there are promising investment situations such as these out there, we will pursue them. We’ll do our best to figure out which earnings estimates are reliable, and which may not be. Over time, this approach has helped us to outperform the S&P 500 Index by a considerable margin. We’ve done it about two-thirds of the time over the past decade, which means a third of the time we’ve had a quarter where we’ve underperformed – such as now. But we believe that this investment discipline will continue to produce good results over the long haul.
Moreover, the USA continues to be a great place to grow and invest. We have a legal system that in contrast to Europe has produced a viable federal system, and in contrast to China protects intellectual property and fairly rewards innovation. We have natural gas reserves that will help make the heartland a highly competitive industrial powerhouse once again. We have the world’s finest colleges and universities. Over time, we’ll capitalize on all of this.
* Past performance is not necessarily indicative of future performance. Results for individual clients may vary. Results are not audited. Byrne Asset numbers include all actively managed equity accounts and reflect the reinvestment of dividends and deduction of all fees.