Letter – 2014 Q2

The stock market continued to grind higher this quarter.  It feels like The Little Engine That Could that is trying to pull a reluctant economy along with it.  Although the stock market has outpaced gains in the overall economy for quite awhile, until recently these gains have been readily explainable by a price-earnings ratio that was too low.  But now overall valuations are no longer too low, so corporate earnings have to continue to grow in order to justify ongoing improvement in the market.  Analysts continue to raise earnings estimates, and that has given investors a degree of confidence in current price levels despite a weak GDP during the first quarter.  Notably, there was some divergence in the marketplace.  The S&P 500 Index had a total return of 5.23% for the quarter.  But smaller cap stocks lagged, with the Russell 2000 Index up only 2.05%.  Our average stock account gained 5.00%. *

In last January’s letter, we said that the market had room to rally further because the equity risk premium was high, and remained reasonable even if adjusting for a rise in real interest rates  back toward historical norms.  To refresh, the equity risk premium is the difference between the earnings yield on stocks (earnings divided by price) – and the yield on the 10-year Treasury bond.  Since year-end, interest rates have fallen and earnings estimates have risen.   So even though stock prices have also risen, the equity risk premium is more bullish now.  All else equal, that bodes well for stocks.  In January, we said: “We now have a yield on 2013 earnings of about 5.95%… and the ten year Treasury ended the year at 3.03%.  That produces an equity risk premium of 2.92.”   Now, we conservatively estimate 2014 S&P earnings at about $117.  That gives us an earnings yield of 5.97% (reciprocal of SPX 1960 / 117).  With the ten year Treasury at 2.53%, that produces an equity risk premium of 3.44 – more favorable for stocks than in January.  Of course, earnings could decline and/or rates could rise, but this is what we know today.

That is a macro view.  To bolster it, I did a gut check at the micro level by looking at the valuation of our ten most widely held stocks.   We calculate the “payback period” of each stock; ie, how long it would take the current projected earnings stream to add up to the stock price.  The unweighted average payback period is 8.52 years.  So if you give me $1,000 and I give you back $2,000 in 8.52 years from now, your compound annual return on that money will be 8.46%.  No guarantees, of course, but that is what we see as the central probability.  For better or worse, it is pretty consistent with the conventional wisdom about likely stock returns in the next few years.

I hope it goes without saying that many things could upset this fairly encouraging picture.  If oil prices move substantially higher, a recession could be triggered.  If events spin out of control in Iraq, Ukraine or somewhere else (remember Cyprus?), it would be bearish.

Goldman Sachs recently published a somewhat more cautious view.  They put the forward PE of the S&P 500 at 16.5 and noted that with real interest rates between 1 and 2 percent, the average PE ratio since 1976 has been 13.5.  Compared to this yardstick, they see the market at an 18 percent premium.

Yet another way of valuating the market is by comparing stock market capitalization to GDP. Warren Buffet has called this measure “probably the best single measure of where valuations stand at any given moment.” He told Fortune Magazine’s Carol Loomis in 2001:  “If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%–as it did in 1999 and a part of 2000–you are playing with fire.”  As of today, this ratio is at about 127%.   In the past century, the ratio has ranged from 20% to 180% — which strikes me as too volatile and imprecise to be useful in the short-term.  Moreover, there are too many adjustments to both GDP and market valuations to be assured of apples-to-apples comparisons over time.  Consistent with Buffett’s comment, this yardstick is most useful at extremes.

One final note about valuation.  Until recently, smaller stocks had been running ahead of large cap stocks such as those in the Dow, and some of those small cap valuations did get out of line.    That explains why the S&P 500 Index had a much better total return this quarter than did the Russell 2000 Index which reflects smaller cap stocks.   The S&P 500 Index did 3.2% better than this broader measure.  We tracked the Russell 2000 pretty closely in 2013 when it was stronger than the S&P but this year we gravitated toward higher quality large cap stocks and consequently we are tracking much more closely to the stronger S&P 500 Index.  The largest caps do not feel bubbly to me; look at the difference in PE ratios on some of the country’s largest companies between March 2000 and now:

Microsoft    59.7        14.0
GE             41.7        15.3
Exxon        22.0        13.2

Let’s take a quick look at some of our other noteworthy stocks.

Greenbrier  (GBX) makes railroad freight cars.  Demand has risen sharply because there are not enough freight cars (or pipelines) to move crude oil and natural gas, as well as other commodities, from point of origin to population centers.  So Greenbrier has provided a total return of 76% so far this year.  It is no longer cheap (nor particularly rich), so now we are in a situation of trying to let our profits run.

Speaking of tight capacity in transportation, the airline stocks have continued their climb.  We have lightened up a touch, in part because they have had a good run and are getting expensive and in part because the rise in oil prices has me a bit concerned.

We’ve added some to our position in Chevron, the world’s fourth-largest oil company.  We should either do decently given the 3.3% yield, or perhaps very well if the rise in oil prices is sustained.

Hewlett Packard continues to push gradually higher, and gained 7.8% for the quarter.  It seems to be executing well on a restructuring plan, and growth in services and the lure of 3D printing keep this stock interesting.  It still has a payback period of only 7.44 years, implying a compound annual return of 9.75%, and that is based on estimated earnings growth of only 7% per year – a conservative estimate – but hardly a guarantee.

We continue to like Blackstone.  This manager of alternative investments provides substantial diversification, and 5.7% dividend yield, and a payback period of only 7.2 years.  The stock had a flattish quarter, but has returned 6.7% so far this year and 72% over the past 12 months.

In our last letter, I noted that Met Life and Prudential were very close to all-time highs.  They are both higher now; the lesson is to let profits run as long as something is still a reasonable value with a fundamental outlook that has not materially changed.

We increased our exposure to utilities by buying Southern Company when its 4.8% dividend yield became especially favorable relative to Treasuries.  We also added to our holdings in Verizon for the 4.3% dividend yield and the apparent stability in the stock.

Our champion for the quarter is Amkor Technology, which provides semiconductor testing and packaging services.  It gained 71%.  But this stock is too volatile to be the cornerstone of a retirement plan; it has dropped as much as 29% in a quarter even since 2008.

We have many other very profitable positions, but not everything in our core holdings has worked out as I had hoped.  This quarter’s worst purchase was Unisys (UIS).  My system put it in our prime box on the basis of valuation and earnings momentum back in April.  But the stock had poor earnings and reversed course sharply, and we got out at a loss.  What can I say?  The system isn’t perfect, and I’ve gone back over it and concluded only that many other turnaround bets with similar statistical characteristics have worked very well.  This one did not.

Another disappointment is that Lululemon became an even bigger lemon.  Earnings were growing at over 30% per year through 2013, but have stalled since their infamous “see through” yoga pants came out about 15 months ago.  The stock has fallen in half since then, so we bought in.  It has great potential if they can get their act together again.  The company’s founder owns 27% of the outstanding stock, and the company plans to buy back 10% of the outstanding shares, so at a minimum the stock should stabilize.

Finally, Oracle took a dive late in the quarter on a small earnings miss that raised concerns that the company is lagging competitor Salesforce’s effort in the world of cloud computing.  But as Barrons noted after that news:  “Oracle is a good company with good technology and a chief executive with drive and ambition. Its stock, at a recent $40.52, was trading for less than 12 times next year’s expected earnings, and that’s before giving the company credit for its cash pile.”  That’s cash of $32 billion and a total market cap of $180 billion.  Despite the stumble, we still like Oracle.

In sum, our returns were good but certainly not stellar this quarter due to some disappointing stocks and the relative weakness in the Russell 2000 Index.  It is also true that the health care sector was well behind energy and utilities this past quarter, and that also put a small dent in our relative performance.  There are still good values to be had, and despite the 2.9% drop in Q1 GDP the economy continues to slowly mend.  We continue to look for good investments and to monitor the macro forces than can affect stock prices.  We’re happy to answer any questions or address any concerns at any time.  We’re in every day, and check emails day and night.  Thanks for your business and 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.

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