03 Sep 2010 Clipper - Q2 2010 Commentary ( Portfolio )
Because of the enormous risks in today’s economy, characteristics such as durability and adaptability should be especially highly valued. But despite these risks, shares in many global leaders are trading at or near their lowest absolute and relative valuations in decades, creating a significant opportunity for long-term investors. The best way to understand this opportunity is to take a moment to consider the alternatives. For example, money market funds now yield close to zero and in some cases actually have surcharges that result in a negative yield. That means money market investors today are simply accepting a zero percent return as their best case. But when (not if) we enter a period of inflation, real returns on money market funds will be negative and holders will suffer real losses in purchasing power.

Turning to intermediate and long-term U.S government bonds, these have done so well for so long, investors feel safe owning them. However, as is usually the case, those asset classes that investors feel are the least risky are often those that are in a bubble. For example, in the years leading up to the worst real estate decline on record, people could hardly imagine losing the equity in their home. In fact, the higher prices went, the more real estate seemed like a low-risk sure thing and the more comfortable people were increasing their leverage. Today the same is true of intermediate and long-term government bonds. A 10-year U.S. Treasury bond, for example, currently yields less than 3%. Because interest rates have fallen steadily for almost 30 years, few bond investors can recall more than a temporary period when bonds declined in value. Investors who know history, however, realize that the last time interest rates were at today’s levels, bonds went on to decline in value for more than 20 years. What’s more, on an inflation-adjusted basis, investors in U.S. Treasuries lost more in those 20 years than stock investors did during the Great Depression! It is striking today that the dividend yield alone on many high quality and durable companies is higher than the coupon on a 10-year government bond. In addition, this dividend generally represents a payout of less than half of earnings. This means investors in these equities are currently receiving an earnings yield more than twice the yield on bonds and a dividend yield that roughly matches. Furthermore, because such businesses maintain a certain amount of pricing power, these earnings and dividends should be somewhat inflation-protected compared to bonds whose real yields erode in times of inflation...

...While we would agree that it is likely that many emerging markets will grow faster than the United States, there may be ways to capitalize on this trend that involve less risk than blindly buying some foreign index. For example, in our view, where a company earns its money is more important than where its stock is listed. Although the S&P 500® Index is considered a domestic stock index, the companies that make up the Index earn roughly half of their profits outside the United States. In other words, although companies like Procter & Gamble, Coca-Cola and others are truly global companies, they often trade at a discount to foreign companies with similar growth prospects because they are wrongly perceived as domestic companies. As a result, they offer investors a good combination of exposure to higher growth economies such as China and India at a lower valuation and with better diversification, governance, liquidity, and financial transparency.

Coming through one of the worst decades ever for stock investors, commentators and the public are more pessimistic than ever. The term “black swan” was recently popularized by author Nassim Taleb to describe the rare, high-impact and hard-to-predict events that roiled financial markets in the last decade. But black swans are nothing new. The future has always been full of unpredictable but significant events.

What is new today is the assumption that black swans must necessarily be negative. While recent history is full of many negative surprises, investors and commentators have forgotten that many high-impact, hard-to-predict events are enormously positive for society as a whole and capitalism in particular. For example, over the last several decades biotech and pharmaceutical companies (like Merck) have produced almost miraculous cures to diseases that have plagued humanity for centuries. Is it possible in the years ahead that they will find a cure for costly and horrifying diseases like Alzheimer’s, Parkinson’s and diabetes and in doing so produce huge unexpected savings for our health care system? How about energy? Over the last several years, innovative companies have developed new technology that allows them to tap vast reserves of cheap, clean natural gas trapped in domestic shale formations. Is it possible in the years ahead there could be breakthroughs in solar or even nuclear technology as well as energy transmission and storage that could dramatically reduce the economic, political and environmental costs of energy?