Letter – 2012 Q4

The two best years for the stock market since 2000 were 2003 and 2009; the first was a rebound from the tech crash and 2009 was a rebound from the banking crash. 2012 was the next best year. The S&P Index itself provided a total return of 16.0%; the Vanguard S&P 500 Index fund returned 15.82%. It happened as individuals remained fearful and in the aggregate pulled a modest amount of money out of stocks. The Investment Company Institute reports this figure as $110 billion, but net outflows were more like $20 billion because exchange-traded funds have been taking market share from mutual funds.

The year 2012 is tougher to categorize. It certainly was not a rebound year. I would call it a classic “wall of worry” year. There were many good reasons to be afraid. Greece was going to implode, and larger European nations might have followed. China was going to have a “hard landing”. We had a tense election, and are now on the precipice of the “fiscal cliff”. And let’s not forget the Mayans!

What is a wall of worry? It is a series of quite legitimate reasons not to invest. But in reaction to the factors cited above, the most important question is too often ignored: how much of currently known risk is already discounted in prices? Our view is that there have been many good values in the stock market because people have been too afraid to commit capital. While this sounds like a wholly qualitative judgment, our decision-making is in fact very data-driven.

Case in point – the housing stocks. These stocks peaked in July of 2005. They had to bottom somewhere, and we have had our Biblical seven lean years there. A variety of housing indicators had either started to turn up or at least stopped their downward momentum. We bought a fair amount of Hovanian early in the year, more than tripled our money in most of that position, and added more housing stocks as the year went on.

All in all, we had a good year. I can’t call it a great year because I had one foot on the brake pedal during parts of the year; guilty exactly of a little bit of the wall of worry phenomenon. We do our best to maximize appreciation while being very mindful of capital preservation. It is much easier to beat the market in rebound years (as we did in 2003 and 2009) than in wall of worry years. But we notched sizeable gains; your account was up 14.25% in 2012. We ended the year on a high note, gaining 0.66% in the fourth quarter versus (0.38%) for the S&P 500.

A few things in particular impacted our relative performance. Dividend stocks lagged the overall market by nearly 4% this year. We have used dividend stocks as a wealth-conserving tool. Utility stocks were actually slightly lower on average this year. We believe it is prudent to provide some exposure to international markets. Asia has exhibited the strongest GDP growth of any region in the world, and we think it makes long-term sense to invest there. But it can be a wild ride. The MS Emerging Markets Index wound up gaining 15.1% in 2012, but its weakness early in the year hurt us in the short term. There is potential for huge growth — the same index gained 72% in 2009. We believe that with the leadership succession finally settled in China, a great deal of uncertainty has been removed and capital will be more readily deployed and economic growth will again accelerate there. Another factor that impacted relative returns was the surprising performance of many low-quality stocks versus issues considered by “the street” to be of higher quality. The 50 stocks in the S&P 500 with the worst analyst ratings have gained 16.3 per cent this year; the 50 stocks with the best ratings have gained 12.7%. http://www.theglobeandmail.com/globe-investor/inside-the-market/when-analysts-say-sell-buy/article6079975. Whether speaking of management, financial strength, or business models, over the long term we firmly believe that quality counts.

So let’s talk a little bit more about the attractive valuations that we see. In our last letter, we cited stocks such as MasTec (MTZ), United Therapeutics (UTHR), Avis Budget Group (CAR), Owens Illinois (OI), and Microsoft (MSFT), Oracle (ORCL), and Intel (INTC). Here are the results for the last quarter and year:

Name Ticker Price 3 Mo YTD
Avis Budget Group In CAR 19.82 28.87 84.89
Intel Corp INTC 20.62 9.00 14.97
Microsoft Corporation MSFT 26.71 10.25 2.89
MasTec, Inc MTZ 24.93 26.55 43.52
Owens-Illinois Inc OI 21.27 13.38 9.75
Oracle Corporation ORCL 33.32 5.91 29.90
United Therapeutics Corp UTHR 53.42 -4.40 13.06
AVG GAIN 8.55 24.14

Not bad, but you don’t get everything you want exactly when you want it. The 8.55% quarterly return projects out to a 34.2% annualized rate of return. As you see, these stocks also did well on average for the entire year, but we were not in all of these stocks at the beginning of 2012. Microsoft has been the worst, and I should have waited until after the introduction of Windows 8 before buying more of it. Investors are worried about Intel as the world migrates from computers to smaller devices. United Therapeutics continues to grow earnings at a rapid clip, but there is always uncertainly around FDA approvals and they have had trouble with one hypertension drug

The point is that a valuation-based discipline should continue to provide superior results over time. But I had a mentor, one of the nation’s billionaire investors, when I was in my early 30s. He said that he could be highly and equally confident in two investments made on the same day, and have very different results from them. The table above bears out both points; you cannot be sure on any single investment but the approach in the aggregate tends to do quite well over time.

Okay, so what about Apple? In our last letter, we noted that earnings momentum would likely slow as competition grew, and that management was starting to do some stupid things that risked the brand. Since then, Apple has in fact done terribly. We think the stock has been plagued by three things: (i) the fundamental considerations around earnings momentum and branding, (ii) tax selling before the anticipated rise in capital gains rates, and (iii) computer generated selling in response to downward price momentum. Factor (ii) is temporary and (iii) is likely to be temporary. Hopefully we managed our position reasonably well by taking about one-quarter of our shares off the table at an average price of about $640. Apple went as low as $501 and ended the year at $532. Apple is still a solid long term hold based on valuation. It has over $100 cash per share. That means you are paying about $420 per share for earnings of between $49 (the average estimate) and $43 (the lowest of 44 estimates). This works out to a cash-adjusted PE ratio of between 8.6 and 9.8 – incredibly cheap for a company that has grown earnings at a compound annual rate of over 50% over the past five years. Earnings growth can slow substantially before valuation becomes an issue, but we will monitor earnings estimates carefully and manage the position accordingly.

Our biggest recent adjustments have been an increase in exposure to China, and Asia more broadly. We have also increased exposure to gold stocks, which has turned out to be premature. But most smart money agrees that gold stocks are ridiculously cheap relative to the level of bullion itself, and that relative value should win out in the end. We have modestly increased our weighting in the financial sector. And we have initiated a position in Lions Gate Films, which is the newest stock in our “prime box” (ie, it satisfies our top quartile criteria for both growth and value). Lions Gate is an innovative company; its biggest release is The Hunger Games. It also owns the second largest DVD film library in the world, with movies ranging from Dirty Dancing to It’s A Wonderful Life and On Golden Pond.

So what is in store for 2013? There are bound to be some downdrafts as Washington continues to dither over the fiscal cliff. Tax rates on both capital gains and dividends may well go up. And yet a number of big brokerage house studies indicate that such changes affect stock prices by less than one would expect. Year over year earnings growth is projected to be somewhere between 3 and 7 percent for the first half of 2013. Accordingly to Standard and Poors, the current forward 12-month P/E ratio for the index is 12.6 versus the prior ten-year average of 14.2. That suggests the potential for PE expansion of 12% just to get back to the mean level for the decade. Add 5% earnings growth and we have the potential for another double digit year. The forward PE ratio has not dipped much below 11 in the past decade, so it is reasonable to assume that there is good downside protection should earnings be realized near expectations.

Finally, here is some perspective on a decade worth of average annual returns on various asset classes. The major asset classes available to the average high net worth investor are stocks, bonds, real estate, cash, gold and hedge funds.

Compound Annual Growth Rate

Asset Class 2003-2012
S & P 500 4.95
US Treasury 10 Yr 6.01
Real Estate Inv Trusts  (Vanguard REIT Index) 7.11
Gold 17.01
Hedge Funds (Barclays Hedge Fund Index) 6.87
Byrne Asset Management 9.09

As you can see below, our returns have exceeded the returns for each of these asset classes except gold by a considerable margin.

Although there are other types of assets that provided double digit returns over the past decade, none of them are suitable for a substantial portion of an overall portfolio. For example, although gold did very well and should continue to be a part of most portfolios, it can be quite volatile in the short term and its collapse in 1980 reminds us of why we don’t put all the eggs in one basket. Canadian stocks outperformed the US over the past decade due to a more stable banking system, and a heavy weighting in gold and energy shares. We have had reasonable exposure to Canada, but again, we maintain allocations that are prudent. The emerging markets had an average annual return of 13.77% but are incredibly volatile and have lagged the US in recent years. These countries are the best hope for high GDP growth, and we are gradually moving a bit more into emerging markets as valuations have gotten more attractive. The Alerian Master Limited Partnership (MLP) Index shows a 13.77% average annual return over the past decade. We have owned Master Limited Partnerships (MLPs) except in situations where the K-1 tax documents make it too inconvenient. By prudently allocating some money to categories such as these, we believe that we have brought the benefits of diversification to you in the form of both enhanced returns and reduced overall risk.

The S&P 500 was the worst major asset class in the past decade. It is exceedingly rare for an asset class to repeat another decade as the poorest performer.

We’ll end on two administrative notes. First, we have added a new member to our team. HENRIK RUMMEL is a 2009 graduate of Harvard, who joined us shortly after representing the United States in the 2012 Olympic Games and winning a bronze medal in rowing. He joins us as an analyst, and will become a portfolio manager upon satisfying all of the regulatory requirements. The only bad news, at least from my narrow standpoint, is that yours truly remains the only employee of Byrne Asset Management without an 800 math SAT score. The good news is that I believe that my colleagues bring rigorous analytical and risk management skills to the investment management process.

Also, we are required once a year to send you a privacy statement and an SEC form ADV Part 2 that describes various aspects of our business. The privacy notice is enclosed; the SEC form ADV Part 2 will come with our first quarter letter.

This comes with our gratitude for your business and continued confidence, and with all good wishes for a wonderful 2013. We’re here for you, so please don’t hesitate to contact us anytime we can be of service.

* 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. As one can not invest in an actual index, for comparative purposes we show returns and other statistics of the Vanguard 500 Index Fund, a mutual fund that very effectively tracks the performance of the Standard & Poor’s 500 Index.

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