The good news is that the S&P 500 Index provided a 10.6 percent total return in the first quarter of 2013. Once again, we outperformed the market – but not by enough to brag about this time. This has been the best first quarter since 1998 (when the S&P 500 gained 13% in the opening quarter – and 26% for the full year). The potentially bad news is that the market has already advanced about as much as most analysts predicted for the full year. As the quarter ended, the Dow Industrial Average exceeded its October 2007 high by over 400 points or nearly 3%. However, the more widely used benchmark, the S&P 500 Index, barely got its chin over the bar, waiting until the last day of the quarter to post a marginal new all-time high of 1569 (versus 1565).
The S&P closed within two points of its all-time high on Friday, March 15. Then it stalled. What better time for Murphy’s Law (“anything that can go wrong will go wrong”) to kick in than St Patrick’s Day? Who’d have thought that a small island with a GDP the size of Vermont’s could create such havoc? Who’d have thought to look east of the Bosporus to find trouble in Europe?
The financial crisis in Cyprus matters for two reasons. First, there is renewed fear of a precedent for exiting the Euro. Second, the initial plan to confiscate a portion even of insured Cypriot bank accounts led to long lines at ATMs. In turn, this led to concerns that panic could develop in countries such as Italy and Spain. The run on Northern Rock Bank in England in September 2007 was one of the first cracks that led to the mess in 2008. Despite these concerns, the markets have remained resilient – particularly here in the ultimate safe haven.
Notwithstanding the usually sound talk about the benefits of diversification, stocks in the USA were the place to be over the past three months. The MSCI European index gained only 2.83%. Even worse were emerging markets (down 1.79%) and China (down 4.53%). According to Bloomberg, emerging markets on average have done 46% better than developed markets during bull runs (for example, 14.6% versus 10%). But not this time. Emerging markets are inexpensive and have perplexed a lot of smart people lately. Our modest exposure to China and other emerging markets detracted from our otherwise good performance. Your account gained 10.84%. We began the quarter with $ and ended it with $ .
The market’s performance thus far should not be too surprising. In our last letter, we noted “the potential for PE expansion of 12% just to get back to the mean level [of 14.2] for the decade.” This PE expansion is pretty much the story of the quarter. The S&P 500 ended at 1569. Earnings for 2013 are estimated at anywhere from $103 to $111. This produces a PE ratio for 2013 of somewhere between 14.1 and 15.2. With interest rates this low, it is reasonable to project a PE ratio that is above the mean for the decade. But at some point, the economy has to grow for the stock market to continue its rally. GDP grew at 3.1% in the third quarter of last year, but only at 0.1% in the fourth quarter. We’ll keep a close eye on GDP numbers, employment growth, and earnings releases as the year unfolds.
We continue to look for stocks that we believe can outpace the market, using our discipline that begins with a reasonable valuation as measured by a low projected payback period. In our last letter, we noted that Lions Gate Films came into our so-called “prime box” – meaning an optimal combination of good earnings momentum and a low payback period. Lions Gate gained 44.9% for the year to date. We’re hoping for comparably strong results from some of our more recent purchases.
I normally shy away from airline stocks because the industry is so volatile and littered with failures. But these stocks have gotten exceptionally cheap at the same time that the industry has consolidated and given certain airlines essentially an oligopoly position, rendering limited competition and more pricing power. For instance, Delta Airlines is projected to pay back its stock price within five years if current trends hold; that implies a compound annual return of nearly 15%. It has exceeded that pace since our purchase. Other airlines were a mixed bag. Some more aggressive accounts have an 85% gain in Alaska Air. However, we have not done well with Hawaiian Airlines, which is perceived as perhaps too leveraged.
Private equity firms that are publicly listed also hold great promise. Even with solid gains for the quarter, these stocks remain reasonably inexpensive and also offer high dividend yields. These firms are gathering assets for “alternative investments” at an impressive rate. They have the reach and expertise to make alternative investments that are beyond the reach of most investors; for instance, I’ve heard of cap rates (earnings divided by invested assets) above 12% on Asian real estate deals backed by AA rated credits. Moreover, most of these firms get a substantial portion of their compensation from so-called incentive fees that tend to kick in when markets are at are levels that drive new peaks in investment accounts. Thus we own firms such as Blackstone, KKR, and Apollo. Blackstone rose 29.5% for the quarter, but after such appreciation its earnings stream is projected to pay back the stock price in 6.2 years – and it still has a dividend yield of 8.5%
We made one investment that deviated just slightly from our normal valuation discipline. I bought shares of defense contractor Raytheon (RTN). The stock is at about a 30% discount to its pre-2008 valuation, and owns Hughes Electronics. That puts the company at the forefront of the struggle against internet hacking and electronic warfare in general. The stock yields a healthy 3.8%. Value Line projects an annualized return of 8 to 15% on these shares.
Some of our mainstays were just okay this quarter. Microsoft has been stuck in neutral forever. It trades at a PE multiple of just 10, yet it continues to post double-digit earnings growth. It gained 8% for the quarter. Oracle recently had announced disappointing earnings, and fell 3% for the quarter. But it returned 31% last year, and it isn’t in any long term danger. We’ve discussed Apple ad nauseum in previous letters; it lost 16% for the quarter to close at $442 but may well have bottomed at $419 in early March. On the other hand, Celgene was great – rising 47% for the quarter. Ironically, our more conservative accounts profited nicely from the purchase of Heinz by Warren Buffet. On the other hand, some of our more aggressive accounts gained 50% on our “dogs of the Dow” bet on a turnaround in Hewlett Packard. Other individual holdings all have their stories, but for now we like where we are.
I could go on about individual holdings, but for now, the big picture seems okay. The Fed remains stimulative. Demand for housing has strengthened substantially. Companies have record amounts of cash. Congress plans to keep the government going until at least the fall. Bonds are simply not as attractive as stocks. Although things feel reasonably good, we know that markets do not move in straight lines. And Cyprus reminds us that we cannot foresee every potential risk. But a reasonable risk-reward matrix suggests that equities are a good place to be; some very smart people say the only place to be. We’ll continue to look for stocks that we think can enhance overall equity returns.
We thank you for your continued confidence. Virtually all of our new clients are referred by existing ones, and we are grateful for that. As you know, our service goes well beyond merely investing. We’re here to help you with financial matters in any way we can. Feel free to contact us with any questions on whatever matters you might wish to discuss