06 Aug 2012 Torray Fund - Q2 2012 Commentary ( Portfolio )
The Torray Fund gained 4.8% during the first half of 2012, compared to 9.5% for the Standard & Poor’s 500 Index. For the most part, the difference reflects a first quarter surge in speculative demand for the stocks of lower quality businesses and others selling at well- above-average price earnings ratios. Since inception over 21 years ago, the Fund has earned 9.5% annually, turning $1 into $7. Comparable numbers for the Index are 9% and $6.40.

We are pleased to report that earnings of the companies we own continue to rise in line with expectations. In addition, their collective financial condition is probably the best on record. Also good news, 28 of our 33 holdings increased dividends over the last 12 months. The market’s appraisal of these strengths, nevertheless, remains historically conservative. Over time, we believe that will change and the portfolio will generate a low- risk, above-average rate of return.

At this point, however, individual investors are so frightened they don’t want to hear anything about stocks. In fact, the majority have been fleeing the market since 2007, with domestic stock funds experiencing over $521 billion in net withdrawals while bond funds gained more than $1 trillion. A similar pattern has played out with institutions – pension funds, endowments, charitable foundations, and so on. This is all happening in the face of bond yields that are now at all-time lows, while stock valuations stand at a third of their level a dozen years ago. One of America’s largest companies recently announced that it has moved 80% of its portfolio into bonds – more than twice the historic ratio. Bond buyers, it seems, are more concerned about getting their money back at the end of the day than how much interest they earn on it. Why else would they lend the government money for 10 years at only 11⁄2% when, over the last half-century, the rate has averaged 6.7%? Bond investors have suffered a near-80% drop in income before taxes and a 4.1% annual inflation rate that has driven the dollar’s purchasing power down almost 90% over that period. It takes about $9 today to buy what $1 bought when I first entered the investment business in 1962. It seems fair to say these investors are digging themselves an ever-deeper hole, while at the same time, they apparently feel safer.

Ironically, against this backdrop, stocks are viewed as the risky asset, reflecting more than a decade of frightening volatility, two severe economic downturns and a financial panic. In our opinion, this is already discounted in the low valuations accorded quality stocks of the type in our portfolio. At some point – no one knows when – the U.S. economy and investor confidence will recover, and the public will wisely return to equities as the investment of choice.

In the meantime, we think stocks of superior businesses offer today’s investor outstanding opportunities. As an example, let us briefly examine one of our holdings, Procter and Gamble*. (The Fund’s other investments could be cited just as well.) P&G, with operations in about 80 countries, serves an estimated 4.4 billion people in 180 countries worldwide. Over its long history, earnings and dividends have gradually risen, along with the share price. Dividends have been paid annually since the company’s incorporation 122 years ago.

When The Torray Company was founded in 1972, Procter paid one cent per quarter, four cents annually. Adjusted for splits, its stock price back then was about $3.50 per share although it dropped in the ensuing market crash to a low of $2.67 on August 14, 1974. This last April, the dividend was boosted to 561⁄4 cents per quarter, $2.25 annually, to yield 3.7%. The new quarterly and annual rates are respectively 14 and 55 times higher than those paid 40 years ago. Furthermore, the new annual dividend amounts to 75% of the stock’s price back then, and those shares have appreciated about 20-fold. While this was all happening, the interest rate on bonds collapsed and, adjusted for inflation, the purchasing power of the principle dropped 84%. Now, some will say, “Sure, but you’re talking 40 years.” Our answer is that, unlike bonds, the stocks of top-notch companies, despite periodic setbacks, have gradually paid off along the way.

Speaking of bonds, Procter and Gamble’s 2.3% 10-year issue is trading at a premium to yield only 2%. Why are investors lending a solid company like this money at 2% for 10 years when they can own the business, profit from its growth in earnings and dividends and receive a current income of 3.7%? The answer goes back to the fear factor. Investors are so unnerved today they can’t think straight. The other thing they can’t do is resist buying a rising price which they associate with safety and, for the reverse reason, selling one that’s falling.

Finally, we note that today’s investor is paying no attention to the earnings return on stocks. The holdings in our portfolio are trading at an average of a little over 12 times projected earnings for the coming year, a return of 8.33%. By comparison, the same ratio on the government 10-year bond is 66-to-1, which provides the 1.5% yield we’ve noted, and that’s it. Unlike stocks, there is no compounding of growing retained earnings and rising dividend income. We always hope the stark reality of this comparison will someday sink in, but it never seems to happen.

We realize that recent years have proven a tremendous patience tester. Unfortunately, there is no cure other than to just wait things out. Please be assured that stock prices, due to their short-term speculative ups and downs, often do not reflect a company’s underlying intrinsic value. These gyrations should not be confused with making or losing money. The values of successful businesses have been rising for generations, and we believe it is only a matter of time before that reality is once again recognized in the marketplace.