06 May 2011 Century Management Advisors - Q1 2011 Commentary ( Portfolio ) We believe the stock market at-large and CMAFX have greatly improved over the past two years. With that said, looking forward, we believe that the growth rate of the U.S. economy will likely be slower than its long-term historical average of 5% to 6% over the next few years. In addition, we also believe that corporate America’s near peak profit margins of roughly 9.5%, as reported by Bloomberg Finance, L.P., will not be sustainable over the long run. Thus, at current price levels, it is our belief that the average stock is selling at or just above its fair value today.
However, if we were to normalize earnings (i.e., use the 20-year average profit margin of 5.7% on the S&P 500 Index or even the median of 6.3% as reported by Bloomberg Finance, L.P.) instead of using peak margins, or use the 20-year average return on equity of 13% instead of Bloomberg’s projected 16.8%, and were to adjust interest rates to their long-term historical average (65-year Moody’s Baa corporate bond yield averages 7.5%), we believe, as a whole, the U.S. stock market is selling between 12% to 15% above fair value today. This suggests that while we are optimistic in our long-term view on the economy and future stock market returns, the short term could be volatile and needs to be approached with caution.
On the other hand, if the growth rate of the economy was back to its long-term historical average of 5% to 6% and some of the issues surrounding unemployment and housing were improved, we believe valuation metrics such as the current price to earnings (P/E) ratios for stocks would be considerably higher, especially when adjusted for the current low inflation and low interest rate environment.
Therefore, while we believe that stocks in general are currently not at bargain-basement prices, they are selling at price levels that give them the potential for good returns over the long run (i.e. five years and beyond), especially when compared to other asset classes. We do not project these higher returns to go in a straight line as we fully expect that the stock market will continue to be volatile, especially in the short run.
Moreover, we believe it is quite possible that over the next year or two we could experience another recession. However, we believe this next recession, if and when it occurs, will last two or three quarters and be more on the mild side, as compared to the sharp and extremely painful recession that we experienced two years ago.
By sticking to our value discipline, we believe this kind of market volatility should present us with the opportunity to buy stocks when we believe they are selling at prices that discount what seem to be many insolvable problems, i.e., bargain prices. However, when we cannot find bargains that meet our strict investment criteria, we will continue to hold cash or cash equivalents.