21 May 2010 FPA Capital - Q1 2010 Commentary ( Portfolio )
Being a loyal value investor is generally a lonely endeavor. That is, liquidity typically rises as bullish sentiments prevail and valuations become rich. On the other hand, when investors' fear levels rise and valuations plummet, those with liquidity and a keen eye toward great values are in a position to purchase attractive securities at bargain-basement prices. This has been our modus operandi for decades and partially explains the excess returns we have produced over the years. We do not intend to change our stripes and cast away our strategy just because we lag behind the market in the short run, whether it be one quarter, one year, or even a couple of years.

In the short run, say over a few quarters or a couple of years, the stock market tends to move with the predominant sentiment of that time. A little over a year ago the market was consumed with the scary prospect of a total financial collapse of our capital markets, and many stocks declined 60-80% from the prior highs. Today, the market is moving higher as if that dreadful event was not possible and a brighter economic future is preordained. These two extremes are both unlikely.

The stock market has a much rosier outlook than we do at this time, and is discounting a significant recovery in earnings. We think such a recovery is unlikely with banks pulling back on their lending, the consumer still stretched, and the government providing a temporary, but not permanent, boost to demand via its stimulus spending and abnormally low interest rates. The government spending is financed with record budget deficits, which is leading to an explosion in fiscal debt that is clearly not sustainable.

For 2010, the consensus is for the S&P 500 to earn $78. To achieve this estimate, sales will have to grow 6% and the after-tax margin hit 8.1%. The sales growth seems plausible, but the margin appears very optimistic to us, since the highest net margin we've achieved in the last twenty-five years excluding financials was 7.7% in 2007. In fact, the average net margin the last two and a half decades has been 5.3% according to a Morgan Stanley study. Thus, the 8.1% margin in the forecast implies a 50% improvement over the long-term average. We do not think this is very probable, and if it does happen, it is not likely a sustainable long-term margin.