04 Sep 2010 Torray Fund - Q2 2010 Commentary ( Portfolio )
As a result of this massive capital shift, the market remains locked in the doghouse, even though stocks, compared to bonds, are now the cheapest they’ve been in 60 years. This shows once again that investors can’t stop viewing life through a rearview mirror, favoring assets that have done the best and rejecting those that have performed the worst. Economic and business fundamentals play no role. It’s all about the direction and momentum of prices. Inevitably, when trends reverse, those on the wrong side of the equation suffer losses. Put another way, if all the money ends up in one place, you can be sure it’s the wrong place.

The situation today is dramatically different. While stock prices are up significantly since the spring of 2009, they remain undervalued and evidence suggests the financial crisis has passed. Earnings have risen and balance sheets are strong with cash at record levels. The price-to-earnings ratio on stocks in The Torray Fund averages about 12-to-1, representing an earnings yield of 8.3%. If these earnings are reinvested and P/E’s on the portfolio remain flat, the collective value of the businesses will double in less than nine years, although actual Fund returns may differ. Should earnings grow, which we’re confident they will, fundamental underlying results will be even more favorable. By comparison, a decade ago, the market’s P/E ratio was 26-to-1 for an earnings yield of less than 4%. At that rate, it takes 18 years for money to double. Just as important, the financial and competitive strengths of quality businesses provide a solid cushion against permanent loss. Over the nearly 40 years we’ve been in business, there have been nine market declines, three of them severe. The shares of most solid companies nevertheless recovered and rewarded their owners over time.

We have mentioned in past letters that in the early ‘80s, raging inflation drove bonds down and interest rates up by unimaginable percentages. Before the cycle ended, 30-year governments yielded over 15%, nearly four times present-day rates, yet investors wouldn’t touch them. We will add here that as it relates to the risk of inflation, government bonds are no more than I.O.U.’s, dependent for payback on the printing of money by an entity that can print all it wants. Our opinion is that investors, in the long run, will fare much better owning a diversified list of profitable growing businesses. If stocks were to take five years to advance a mere 10% — an unduly pessimistic scenario in our view — their return would exceed interest payments to maturity on today’s five-year government bonds (1.57%). Assuming dividends don’t increase, which seems unlikely, the total return would still be nearly three times that of the latest five-year issue. For those seeking a shorter-term investment, prospects are slim. Three-year IBM bonds pay 1% and 2-year governments, 1/2 of 1%.

In earlier letters we have critically addressed the numerous murky financial innovations that have rattled markets and frightened the public to the point where countless investors have abandoned stocks. Hardly a day goes by that we don’t hear about it from friends and acquaintances. Any faith they had in long-term investing is now gone and relentless criticism of the approach by doomsayers has only reinforced their skepticism. The new message is forget buy and hold, start trading, nail down profits and cut losses at the first sign of trouble. But this is not new. Speculative trading has been a prominent feature on Wall Street for over 100 years, though as far as we know, nobody’s ever made money at it for long.

This new paradigm has triggered a shift in focus by stock analysts and market strategists from studying long-term business fundamentals to predicting next-quarter earnings and guessing their likely impact on share prices. Regrettably, these forecasts and how they pan out have become the central theme of TV business shows. Our position is that quarterly earnings are largely meaningless in a long-term context, a point that’s been made over the years by a number of thoughtful corporate CEO’s. We suspect a lot of them wish analysts would just drop the subject. The only certainty about earnings is they fluctuate. Despite this reality, business show hosts work themselves into a frenzy every three months as the fabled “earnings season” comes around. When reports are due, there’s teeth gnashing and nail biting about whether sales, earnings and cash flow will beat, meet or miss analysts’ targets. Typically, if just one measure falls short by a percentage point or two, the stock sinks. Many of our holdings have succumbed to this, only to recover in subsequent days or weeks. In other cases, if the numbers meet expectations, the shares go down anyway. This often reflects bets by speculators that have bought in thinking the news will be good, intending to sell if they’re right. If they are, they unload in a flash, sending the price down before anyone can figure out what’s going on. It brings to mind the old Wall Street adage, “buy on the rumor, sell on the news.”

Without getting into detail — we’ve discussed this before — flash trading and other computer-controlled strategies, along with machinations of the type just noted, are the major cause of today’s market volatility. Their defenders claim these tactics benefit the public by improving liquidity. The truth is long-term investors don’t need liquidity. They’re not buying to sell the next day, week, or year, and, in any event, over time, how much difference can five or ten cents a share make? The fact is the operators of these schemes are in the business of making money the fast way, even if it’s only in fractions of pennies per share on positions reportedly held for only seconds or minutes. The gain may not sound like much, but on the billions of shares they trade each day — estimated at 40%-70% of the Exchange’s volume — it adds up. This has to be a zero sum game — that is, they can’t all be winning. If they are, someone else must be losing, and most likely it’s the public.