Letter – 2014 Q1

After sprinting ahead in 2013, the market paused this quarter to catch its breath and re-assess economic conditions, geopolitical events, and corporate developments.  It was down in January, and up nicely in February.  Then March came in like a lamb, and went out like a lion – the S&P 500 finished moderately higher for the month but biotech, health care and a range of other stocks got hit hard.  The final full week of the quarter was the Nasdaq’s worst week in 11 months and the Russell 2000’s worst week in 22 months.  That hurt us, turning a good quarter into a mediocre one.  While the S&P 500 Index managed to produce a positive total return of 1.8% for the quarter, the Nasdaq Composite returned only 0.5% and the Russell 2000 (which measures the broader market) provided a total return of 1.1%.  Our return for the quarter was 1.35%. *

There is a robust debate about the overall market’s valuation, which in our view, would shed more light with more focus on the wide dispersion in valuations in the current environment.  Let’s discuss both in turn.

The consensus is that the market is pretty fairly valued – no longer cheap, but by most measures not too expensive either.  The forward price earnings ratio of the S&P 500 Index was 15.7 at quarter-end, calculated by dividing the 1872 index level by $119.40, the current estimate for 2014 earnings. Analysts that I follow put the average forward PE ratio over the past 35 years at 13.8.  That average includes periods in which interest rates were considerably higher. Looked at another way, as per last quarter’s discussion of equity risk premium (on the web at https://byrneasset.com/letter-2013-4.html), the reciprocal of the PE ratio is know as the earnings yield, and it is currently 6.38%.  That seems pretty healthy relative to a 2.72% yield on the ten-year Treasury. At 3.66%, the equity risk premium is .74% more attractive now than the 2.92% level at the beginning of the year.

As is often the case, there are certain worrisome signs out there.  Margin debt is at or near a record high, but it is hard to tell if this very bearish or rather a distortion due to hedging or a natural fallout from money supply expansion.  Another indicator that gives pause is that the ratio of total stock market capitalization to nominal GDP rose to 1.25 at the end of last year, exceeding the 2007 peak of 1.12.  This is the highest reading since late 2000. However, the PE ratio now is nowhere near what it was then.

Worldwide GDP growth is also worrisome.  By some measures, China’s economy is slowing at a more rapid rate than Japan’s did after that market peaked back in 1989.  China is still growing its GDP at about 7%, but the situation bears watching.  Domestic GDP numbers also bear watching as growth estimates for the first quarter are dropping.  The debate among economists is whether it is weather-related or something more fundamental.

The bond market is a generally a good gauge of the outlook for GDP growth.  When the economy is robust and the demand for money is strong, the price of money in the form of interest rates tends to go up.  So far this year, interest rates have gone down and bonds have rallied.  Utility stocks often track bond prices, and utility stocks have been the best performing sector in the stock market so far this year.  We don’t own many utility stocks and we certainly do not play them for short-swing profits.  Our underweight has hurt our relative performance somewhat.  But with the Fed signaling that interest rates are likely to rise, this sector is not likely to do well over time – unless our economy turns out to be a lot more like Japan’s than we’d like to imagine.

Our bottom line is that the market is fairly valued.  It is more susceptible to a sharp selloff due to some exogenous shock than was the case a year or two ago.  Thus I am more inclined to limit drawdowns.  Beyond that, if we pick reasonably valued stocks, we should do okay.  So let us turn to that topic – the dispersion of values in the current market.  Some things seem pretty pricey.  Facebook bought WhatsApp for $19 billion.  This is a five year-old company with 50 employees, so it is valued at $380 million per employee!

At a slightly more mundane level, let’s look at Autodesk (ADSK).  It is a good company that makes computer-aided design software.  Definitely a cool product.  But it has grown earnings at a compound annual rate of only 3.8% over the last six years, and at an even slower rate in the past three years.  Nevertheless, the average analyst following the stock predicts earnings growth of about 10.5% annually going forward.  Based on current estimates, even if that growth comes to pass, it would still take 15.5 years for its projected earnings stream to add up to the stock price.  Doubling in 15.5 years indicates a compound annual rate of return on money of 4.57%.  You can get a 3.5% dividend on Chevron, and hope for 1.1% annual appreciation – which seems like a much less risky proposition.  Of course, maybe Autodesk will come out with breakthrough software that lets you talk to a computer and it then designs the perfect house for you.  The serious point is that some things are priced very rich for a reason, but more often things are priced rich because people are irrational.  So we tend to stay away from stocks with such valuations (Autodesk being one example of many) absent some compelling fundamental case.

That is especially true when we can buy good companies that are projected to pay us back in six or seven years.  Let’s consider Hewlett Packard.  The stock has marched steadily higher since late 2012 as investors gained confidence in Meg Whitman and her restructuring efforts.  The company earned $2.68 per share back in 2007 and ended the year at $46.  According to Value Line, it earned $2.62 per share in 2013 and was recently priced at $32 – 31% cheaper than in 2007.  We calculate a payback period of about 7 years on this stock – which translates into a compound annual return of 10.4%.  That is a better prospective return than that offered by Autodesk.  Needless to say, there are no guarantees in any of this.  It is just a question of trying to put the probabilities in our favor.

In a similar vein, a number of bank and insurance stocks are trading at payback periods in the 6.5 to 7.5 range.  That translates into projected compound annual returns in the range of 9.6% to about 11.2%.  While financial stocks tend to trade cheaper than many other stocks, these sectors seem reasonably priced now and have done well for us in recent months.  In fact, JP Morgan traded at a new all-time high just days before the quarter ended.  Met Life and Prudential were very close to all-time highs.

Six months ago, we noted that airlines were particularly cheap.  They have appreciated considerably but remain one of the cheapest sectors.  It is a much more efficient industry today, but it certainly remains cyclical.  Thus a payback period of 8 years can quickly turn into 10 years or more with a sudden drop in earnings estimates.  But so far, so good.

Needless to say, we don’t get everything right.  Most analysts agree that emerging markets are priced quite cheaply relative to the US.  But cheap has gotten even cheaper, and we can’t time the turnaround.  A number of short-term rallies have been frustrating and short-lived.  Moreover, we thought that the last meeting of the Chinese Central Committee was a bullish embrace of capitalism.  Maybe so, but the debt overhang and other factors have led to a sharp slowing of GDP growth in China and that has affected stock prices there and beyond.  Usually some international diversification is a good thing.  Not so in the last few months – sorry.

If I can be accused of anything this quarter, it is cowardice.  I pulled back a little both when it looked like the Argentine devaluation might have ripple effects and when the Ukraine situation looked dicey.  Either one could have had a worse outcome, so some focus on capital preservation is warranted.  Ironically, the scrutiny of biotech stocks on Capitol Hill turned out to be a more bearish influence than either Argentina or Ukraine.  The biotech sell-off began in reaction to a letter from some congressional Democrats questioning the pricing of certain drugs – notably Gilead’s $1000 per pill Sovaldi which treats hepatitis-C.  The selling spilled over into other biotech names and into so-called momentum stocks (such as Google) in general.

Gilead fell 14.4% in March after rallying from $20 to over $80 in the past two years.  Celgene has also been a great stock, but lost 13.2% in March.  We try to ride good stocks for as long as possible, but balance that goal with an effort to not let too much profit melt away.  For example, we had an unrealized gain of 2.7 times our money in Jazz Pharmaceuticals at its peak.  This was a $60 stock just a year ago.  It hit a high of $176 in late February before ending the quarter at 138.  Jazz still has a reasonable payback period of 8.6 years, and that is assuming growth that is only half of what it has achieved in recent years.  So while we lightened up a bit, we do our best to hang in there.  The biotech sector has been a boon for us over the past year, but certainly hurt us toward the close of the quarter.

On balance, letting winners run is a good strategy.  I still remember when the optimistic price targets for Apple were $115.  Selling at $125 might have made you a short-term genius, but then the stock went up more than five-fold from there.  So I think that it is generally better to lighten up when there is some indication of a medium or long term trend change.  That in turn means that you are going to get out only after some amount of decline from peak prices – but hopefully also after a large amount of advance from base prices.  That is what happened to us this quarter in some of the aforementioned healthcare related stocks.  Our core positions are reduced but still largely intact as this sector still has reasonable values and much fundamental promise.

As money comes out of such situations, we do our best to recycle it into more promising things.  Right now, I am seeing some opportunities but not as many as I would like.  We have taken a reasonably large position in a company called Greenbrier (GBX).  This outfit has a market cap of only about $1 billion; it is a specialty manufacturer of rail cars.  There is a huge demand for freight cars to move oil and gas from the middle of the continent to the coasts.  We already have a good profit in this stock and it is still reasonably priced with a payback period of 9.4 years.

We have also recently bought into EMC, the data storage company.  This technology leader reached the $100 level back in 2000, and it has taken a long time for the valuation to become attractive.  In addition to its own storage business, EMC also owns 80% of virtualization software provider VMware, which has been growing rapidly.

Needless to say, we will continue to look for attractive opportunities and are confident that our methodology puts the probabilities in our favor over the long term.  We hope that is true over the short-term as well, but short-term outcomes can be more random – as the biotech stocks have demonstrated.

The bottom line is that the market still seems on pace to produce the high single digit returns that we expected at the start of the year.  We can do better if corporate revenues and earnings pick up a bit.  We can do worse if the geopolitical situation worsens or if the economy can’t maintain GDP growth of around 2%.  We continually monitor these conditions, as well as our individual holdings.  The quarter was solid if not spectacular, and we appreciate your confidence and business.  Please do not hesitate to get in touch with any questions or if we can help in any way.


* 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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