Over the years, the Adviser has developed a list of characteristics that it believes help companies to create shareholder value over the long term and manage risk. While few companies possess all of these characteristics at any given time, the Adviser searches for companies that demonstrate a majority or an appropriate mix of these characteristics.
First Class Management
- Proven track record
- Significant alignment if interests in business
- Intelligent allocation of capital
Strong Financial Condition and Satisfactory Profitability
- Strong balance sheet
- Low cost structure
- High returns on capital
Strong Competitive Positioning
- Non-obsolescent products/services
- Dominant or growing market share
- Global presence and brand names
After determining which companies it wishes to own, the Adviser then turns its analysis to determining the intrinsic value of those companies' common stock. The Adviser seeks common stock which can be purchased at attractive valuations relative to their intrinsic value. The Adviser's goal is to invest in companies for the long term.
Period: Q4 2012
Portfolio date: 31 Dec 2012
No. of stocks: 25
Portfolio value: $971,690,000
|Stock||% of portfolio||Shares||Recent activity||Reported Price*|
|hist||AXP - American Express||13.03||2,202,333||$57.48|
|hist||BRK.A - Berkshire Hathaway CL A||9.78||709||$134060.65|
|hist||COST - Costco Co.||9.32||916,391||Reduce 2.66%||$98.81|
|hist||CVS - CVS Caremark Corp.||8.54||1,715,900||$48.35|
|hist||L - Loews Corp.||7.37||1,756,800||$40.75|
|hist||CNQ - Canadian Natural Resources||7.19||2,418,674||$28.87|
|hist||BK - Bank of New York||6.84||2,585,889||$25.70|
|hist||Y - Alleghany Corp.||5.46||158,303||$335.42|
|hist||OAK - Oaktree Capital Group LLC Cl A||5.45||1,163,709||Reduce 29.20%||$45.49|
|hist||GOOG - Google Inc.||4.38||60,000||$709.27|
|hist||WFC - Wells Fargo||2.85||811,300||$34.18|
|hist||HOG - Harley-Davidson||2.52||502,260||Reduce 23.54%||$48.84|
|hist||RHJIF - RHJ International||2.26||4,150,595||$5.29|
|hist||MSFT - Microsoft Corp.||1.66||603,229||$26.72|
|hist||AMP - Ameriprise Financial Inc.||1.64||255,169||$62.63|
|hist||TXN - Texas Instruments||1.55||485,300||$30.95|
|hist||BBBY - Bed Bath & Beyond||1.51||262,500||$55.88|
|hist||HPQ - Hewlett-Packard||1.34||912,300||$14.25|
|hist||DEO - Diageo plc||1.31||436,860||Add 1.51%||$29.13|
|hist||JBHGF - Julius Baer Holding AG||1.28||349,130||Add 10.34%||$35.60|
|hist||RE - Everest Re Group||1.28||113,500||$109.95|
|hist||MKL - Markel Corp.||1.00||22,400||Buy||$433.44|
|hist||GS - Goldman Sachs Group||0.96||73,100||$127.56|
|hist||BPHA3 - Brazil Pharma SA||0.80||1,100,000||$7.03|
|hist||CIOXY - CIELO SA||0.69||239,965||$27.83|
* Reported Price is the price of the security on the portfolio date. This value is significant in that it indicates the portfolio manager's confidence in the stock at that price and suggests at least some level of undervaluation and/or margin of safety.
Sector % analysis
Articles & Commentaries
More than past results, our optimism about the future is based on our Portfolio today. In other words, while history presents a positive statistical picture, the most important basis for our optimism is the strong fundamentals and attractive valuations of the individual companies that make up Clipper Fund now.
As equity investors, we never forget that stocks represent ownership interests in real businesses like Costco, American Express, CVS Caremark, and Berkshire Hathaway.5 Over the long term, the growing value of these businesses will determine our success, not the fluctuating prices of their stocks. As a result, while we recognize that the prices of the stocks we own have been disappointing in recent years, the revenue, earnings, cash flow, and dividends of the vast majority of the companies we own have continued to make progress during this difficult period. Furthermore, virtually all of these companies have strengthened their balance sheets by reducing debt and, in the case of all of our financial holdings, also increased capital and reserves.
While we are always glad to own companies with such durability, resiliency and growth, the cornerstone of our optimism is that these companies in aggregate currently trade at a discount to the averages. The combination of above-average businesses at below-average prices is not one that investors often see.
In recent manager commentaries, we have outlined the investment rationale for many of our most important holdings. As these holdings remain in our Portfolio and as their valuations remain comparable, we would recommend these commentaries for anyone who would like greater detail about specific companies. However, there is one important characteristic many companies in the Portfolio share that we have not previously discussed that we believe is a critical differentiator. This characteristic is one of the reasons we are so confident about the Portfolio going forward.
To understand this characteristic, it may be helpful to consider a typical company in our Portfolio trading at a price-earnings multiple of 13 times earnings.6 Now suppose that this company (like many in our Portfolio) dedicates a third of its earnings to dividends, retains a third to fund its business and spends the remaining third to repurchase its own shares. Finally, assume over the next five years that this company is only able to grow its earnings 3% per year and that its price-earnings multiple remains the same at 13 times earnings. Here is the question: What return will shareholders of this company earn over this five year period?
At first glance, the obvious answer would seem to be 3% per year. After all, earnings only grew 3% per year and the price-earnings ratio stayed at the same 13 times earnings. Although this seems obvious, it is wrong. The correct answer is that shareholders of this company would have earned more than 8% per year over this five year period. The secret to this surprising result is one of the most important and underappreciated characteristics of our Portfolio, namely that we put great emphasis on how the earnings generated by the companies we own are allocated. In this example, the one-third of earnings allocated to dividends added about 2.5% per year to the stock return. The one-third of earnings allocated to share repurchases added another 2.5% per year to the return since earnings and dividends were then spread over fewer shares outstanding. As a result, the combination of a reasonable dividend yield and disciplined share repurchase turned a 3% growth in earnings into a more than 8% return to shareholders.
Our investment focus on capital allocation is one of the primary reasons we think Portfolio returns can be satisfactory even in an anemic economic environment. For those who would suggest that our expectation for even 3% profit growth is too optimistic, we would note that during the last 12 years, our country absorbed the bursting of the Internet bubble, two recessions, September 11th, the invasion of Afghanistan and Iraq, the housing bust, the financial crisis, and a 12 year bear market. Yet despite all of these enormous and in some cases unprecedented headwinds, earnings still grew roughly 6% per year for the S&P 500® companies overall. As a result, while not a worst case, 3% seems a realistic and sober expectation.
Perhaps more important, disciplined share repurchase means that should stock prices fall farther, reported returns might look disappointing but growth in intrinsic value per share would accelerate, increasing our eventual returns. In Berkshire Hathaway’s 2011 annual report, Warren Buffett explains this counterintuitive dynamic by noting when Berkshire buys “stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well. . . . The logic is simple: If you (own) . . . a company that is repurchasing shares, you are hurt when stocks rise. You benefit when stocks swoon.”
This logic becomes clear if you imagine that you own a business with only one other partner. If you plan to gradually buy out your partner’s interest in the business, then you would want the business to do well and your partner to sell you shares at a lower price rather than higher price. What is true when there is only one other shareholder is equally true when there are thousands of other shareholders. Buying at lower prices increases future returns.
The fact that so many of our companies are repurchasing shares at low prices is an important silver lining to the weak market performance of recent years. In addition, because this topic is so poorly understood and rarely discussed by market commentators, it is a source of differentiation for our Portfolio that should help relative returns in the years ahead. Amazingly, almost 70% of the total Portfolio and 80% of our top 20 holdings repurchased shares last year. Because share repurchases and dividends should be such important contributors to our future returns, we are able to be more dispassionate about both stock price volatility and our sober economic outlook. Put differently, with disciplined capital allocation many of our Portfolio companies should be able to build shareholder value in the face of an anemic economy while actually benefiting from the market volatility that worries so many investors.
As stewards of our clients’ savings, we firmly believe in the discipline of providing a review of our most significant mistakes. Before beginning, however, we should emphasize we do not consider an investment a mistake simply because its stock price has declined below our purchase price. Given the truth of the old saying that the only people who buy at the bottom and sell at the top are liars, every company we buy will likely trade below our purchase price at some point. Similarly, we do not consider an investment a mistake simply because it is controversial or the subject of negative articles in the press.
However, the fact that we do not define a mistake in terms of critical press reports and declining stock prices does not mean that we ignore them. Such negative events often reflect or contain new information that must be considered when assessing value. Successful investing requires balancing the patience and discipline needed to maintain conviction when our work is correct with the open-mindedness and humility required to admit mistakes when new information proves it wrong.
As a result, we label an investment a mistake when we meaningfully reduce our estimate of a company’s intrinsic value. In the worst cases, usually caused by some combination of leverage (e.g., Lehman Brothers, Fannie Mae, Freddie Mac), low-cost competition (e.g., General Motors, Kmart), obsolescence (e.g., Polaroid, Kodak), or fraud (e.g., WorldCom, Enron), the company is unable to ever return to profitability and equity investors are essentially wiped out. While we avoided all of the examples mentioned above, we estimate that the intrinsic value of our costliest mistake, AIG, declined more than 80% on a per share basis. No other mistake has been remotely as costly. More important, we strongly believe that the extraordinary circumstances of the financial crisis combined with the lessons we learned during that process make the possibility of another such loss far less likely.
Over the last three years, the biggest detractors from our results were RHJ (Ripplewood Holdings Japan), Bank of New York Mellon and Hewlett-Packard. In our last report, we wrote at some length about Bank of New York Mellon, concluding: “At today’s price. . . . the fact that the shares now trade at a low multiple on depressed earnings leaves us optimistic that Bank of New York Mellon will add to our future returns and that we will earn back some of this loss in the years ahead.” Our view has not changed since and for those wanting more background we would commend our earlier commentary, which is available in the commentaries section on clipperfund.com.
Although certainly not a well-known company, RHJ is a public investment company formed by the very successful private equity firm Ripplewood and incorporated in 2005 in Belgium due to that country’s favorable tax structure. Ripplewood’s founder Timothy Collins is RHJ’s largest shareholder. For the position of chief executive officer, RHJ recruited Leonhard Fischer, a well-regarded executive with extensive experience in financial services. RHJ’s portfolio was initially focused on Japan and included several electronics and auto component manufacturers, which we appraised above their net asset value or book value. We invested for two important reasons. First, the company was led by a team of executives who owned a meaningful percentage of the shares and had a long-term record of value creation. Second, the shares traded at a discount to their net asset value. In short, we judged that the shares represented a good combination of growth potential at a value price.
We were wrong. Since 2006, RHJ’s net asset value (NAV) has declined a staggering 59%, from about €20 per share to €8 per share. The biggest loss came from the company’s investment in the auto parts company Honsel whose 2008-2009 collapse eliminated €3.35 of NAV, though there were other losses as well. Given this record, it is reasonable to ask why we continue to own RHJ. The answer is that at €4, RHJ trades at just one half of NAV, and only marginally above the €3 of net cash the company has on its balance sheet. Moreover, unlike 2006, the majority of the remaining portion of NAV is made up of the company’s investment in storied private bank and asset manager Kleinwort Benson, which RHJ purchased during the depths of the financial crisis in 2009. RHJ has divested all but an insignificant residual of Kleinwort’s legacy investments, is working to restore Kleinwort to attractive returns and is opportunistically searching throughout Europe for assets that distressed European banks may be forced to sell. While this strategy is promising, we are chastened by RHJ’s record and our own mistaken analysis. Furthermore, because of management’s record of value destruction, some discount to NAV is warranted. However, with the shares trading at 50% of a fairly clean NAV and only slightly above net cash on the balance sheet, we have decided to hold them for the time being.
Unlike RHJ, the largest detractor from our three-year returns is a household name whose troubles have been well reported. We first purchased Hewlett-Packard for Clipper Fund at $48 per share in 2008, a year in which the company earned $3.38 per share. Since then, the earnings have grown nicely, particularly considering the economic backdrop, and should top $4.00 per share this year, an increase of almost 20%. Unfortunately, during this same period, Hewlett-Packard’s share price has fallen approximately 60%. What happened?
The short answer is that while earnings per share have grown and Hewlett-Packard’s core businesses have done well, the company went on a buying spree that has wiped out tens of billions of dollars of value and saddled the company with more than $20 billion of debt. On top of this, over the last 13 years, the company has had a staggering seven CEOs, four of whom were forced out and two of whom were interim.
While all of this turmoil has had a substantial cost, we continue to own the shares because we believe that the company’s underlying businesses have remained far more stable than the chaos on the company’s board and in its executive suite would indicate. Furthermore, the combination of debt and a loss of credibility make it nearly certain that the company will not make another major acquisition for a long, long time. In short, while we would not suggest that Hewlett-Packard is a wonderful company with great prospects, we would argue that at less than five times current year earnings (which despite everything are only slightly lower than last year’s), the company is priced as if its businesses are collapsing. The investment opportunity lies in the fact that there is no evidence of this. On the contrary, the majority of the company’s earnings come from fairly stable businesses such as printer supplies, services, software, and large enterprise solutions. If we are right, then just like Philip Morris in the 1990s or the pharmaceutical companies more recently, Hewlett-Packard’s stock could prove a satisfactory investment simply if the business does not collapse. Given that the company is priced with more than a 20% earnings yield, we think this is a reasonable expectation and, in fact, have added to the position as the shares fell.
At a recent shareholder meeting, one longtime shareholder asked why we spend so much more time discussing our mistakes than our successes. After all, he said, during the same three-year period in which Bank of New York Mellon, RHJ and Hewlett-Packard subtracted from results, American Express, Costco and Berkshire Hathaway more than made up the lost ground. The most eloquent answer to this question came from Microsoft’s founder Bill Gates who said, “Success is a lousy teacher.” All investors make mistakes. In reviewing them so thoroughly, it is our hope to extract future value from past losses. As my grandfather Shelby Cullom Davis said, “The value of a mistake lies in the lesson learned.”
Poor stock market returns and disappointing relative results have made the last decade difficult for our investors. In this report, we have outlined our rationale for holding fast to our investment discipline and for expecting improved returns in the decade ahead. We do so not to be promotional but instead to help ensure that investors who have come through these difficult times with us will be with us for the brighter days that we believe lie ahead.
This positive view of the future may sound out of place in a present so characterized by nervousness, pessimism and uncertainty. After more than a dozen years of sluggish economic growth and poor stock market returns, investors are giving up on stocks and flocking to the perceived safety of cash and bonds. USA Today captured the mood perfectly with a front-page headline declaring, “Invest in Stocks? Forget About It!” The article went on to disparage stock investing, saying that the “long-running story about how stocks are the best way to build wealth seems tired, dated and less believable…the (new) mentality (is) . . . get-me-out, wait-and-see, bonds-are-safer. . . .”
This article is as much a product of its time as the articles in 1999 and 2000 trumpeting Internet stocks and predicting that the Dow Jones would be at 40,000 by now. What these articles have in common is that they ignore valuation. Back when the press and pundits loved equities, the market was at an all-time high, valued at 30 times earnings, or a 3% earnings yield, while a government bond yielded 7%. Today, when the same publications are advising investors to “forget” about equities, the market trades at 14 times earnings or a 7% earnings yield and pays annual dividends in excess of government bonds, which now yield a paltry 2.4%.
In the face of such negative articles and press reports, the desire to sell stocks 12 years into a bear market in order to buy bonds at their all-time high or hold cash with a zero percent interest rate is perfectly understandable from a psychological point of view. However, it is likely to be significantly wrong from an economic point of view. Nervousness, pessimism and uncertainty have driven down prices and the golden rule of investing is that low prices increase future returns.
As a result, while it is our general tendency to moderate expectations, we want to be emphatic about our conviction that stocks at today’s prices are the most undervalued large asset class available to investors. What’s more, because we accept Warren Buffett’s definition of risk as “the reasoned probability of . . . (an) investment causing its owner a loss of purchasing power over his contemplated holding period,” we also consider stocks among the lowest risk asset class for long-term investors, especially compared with cash and government bonds. The idea that cash and low yielding government bonds are “risk free” is one of the most dangerous fictions there is. After all, a dollar hidden under a mattress 50 years ago has lost more than 80% of its purchasing power and now can only buy what 20 cents used to buy. It is hard to understand how an asset that has declined 80% in value over 50 years can be considered risk free. Yet despite an 80% decline in purchasing power over 50 years, investors continue to describe holding cash as “risk free.”
Our positive outlook for stock returns is not based on a rosy economic outlook. The deflationary trends from global deleveraging continue, Europe is a mess, Washington dysfunctional, and Asia slowing. But today’s low valuations discount a great deal of bad news. Furthermore, because our companies tend to pay dividends and repurchase shares, they should be able to generate satisfactory investor returns even with relatively anemic earnings growth. In short, by remembering that stocks represent actual ownership in real operating businesses, investors can focus on the quality, durability and profitability of these businesses and tune out the blaring headlines, day-to-day noise and rampant pessimism. While no one can know for sure what the future holds, we do know that our Portfolio is made up of strong companies generating an earnings yield of close to 8%, much of which they are returning to shareholders. These facts are what make us look to the future with optimism.
As we said at the beginning of this report, we are deeply disappointed at the unsatisfactory results of Clipper Fund in its years under our management. We know we have ground to make up and, for the reasons outlined in this report, we have confidence that we are moving in the right direction. But if actions speak louder than words, then maybe a better indicator of our confidence is the fact that during the last five years, your portfolio managers, our firm and our families have increased the number of shares of the Clipper Fund we own from roughly 724,000 to 1.2 million today. Although we cannot promise better results, we have at least put our money where our mouth is.
On this week’s Consuelo Mack WealthTrack, two Great Investors of the Ben Graham and Warren Buffett school of value investing. WealthTrack exclusive Chris Davis shares three generations of investment lessons he is applying at the Davis Funds. Wintergreen Fund’s David Winters explains his market and peer beating global strategies.
By far the most important reason we believe the next five years should be better than the last lies in the economic characteristics and valuations of the companies that make up Clipper Fund.10 Bearing in the mind the risk of overgeneralizing, especially given John Train’s observation that “investing is the art of the specific,” the Portfolio today can roughly be divided into three categories. The first is made up of companies that are under a cloud whose reputations and valuations have suffered because of management missteps, lackluster execution or worse than expected results. Although subjective, this category would include companies such as Harley-Davidson, Bank of New York Mellon, Hewlett-Packard, CVS Caremark, and ConocoPhillips. Because these companies are currently unpopular, their shares can be purchased at low valuations. Moreover, in each case, we have reason to believe the fundamentals will improve and the companies will regain some of their lost luster. If this happens, shareholders can benefit from both improved earnings and an improved multiple of earnings, a compounding effect my grandfather referred to as “the double play.”
A second category is made up of companies whose relatively small size, complexity or illiquidity means their stocks are poorly understood or followed by relatively few. In this subjective category, we would include companies like Oaktree Capital, RHJ International, SKBHC Holdings, and even Loews Corporation. Although each of these companies is run by owner operators with proven records of success, they tend to be relatively illiquid or not well known and thus not attractive to many large investors. In the years ahead, we hope to show that one of the advantages of Clipper Fund’s relatively small size is the opportunity to take meaningful positions in such companies.
The third category makes up the majority of Fund assets. Companies in this largest and most important category might well be characterized as world leaders. This category includes some of the highest quality companies we have ever owned. We believe a significant percentage of them are best-of-breed across a range of different industries. Think of American Express, Wells Fargo and Goldman Sachs in financial services; Costco in retailing; Procter & Gamble in consumer products; Merck and Roche in health care; Diageo and Coca-Cola in beverages; Canadian Natural Resources in energy; Berkshire Hathaway in insurance (and many other industries); and Microsoft and Texas Instruments in technology. These companies tend to have deeper moats, stronger balance sheets and often more pricing power or lower costs than their competitors. Many also have broad product portfolios and wide geographic diversity that gives them exposure to higher growth economies around the world. These attributes helped many of these companies deliver strong business results straight through the worst economic downturn since the Great Depression. A number of our holdings, including Merck, Coca-Cola, Wells Fargo, and Berkshire Hathaway, actually took advantage of the financial crisis by making opportunistic acquisitions and others such as Texas Instruments and Microsoft repurchased a meaningful amount of their outstanding shares at distressed prices.
However, the economic characteristics of these leading companies are only half the reason we are so optimistic about future returns. The other half of the equation is valuation. Because the stock market works like a pari-mutuel system, businesses with such wonderful characteristics will tend to trade at high valuations, which in turn can make them poor investments. While above average valuations may be appropriate for above average businesses, they decrease the likelihood investors will earn an excess return. As expected, during most periods, investors who wanted the safety and security of owning some of the world’s most durable businesses had to give up some return by paying higher than average valuations. Such valuations reached bubble levels in the Nifty Fifty era of the early 1970s and again in the late 1990s when many such global leaders had dividend yields of less than 1% and traded at more than 30 times earnings.
However, since then, there has been a dramatic reversal. An interesting way to look at this reversal is to use the top 100 companies in the S&P 500® Index as a proxy for the sorts of companies we own. In a recent report, our friend Robert Hagstrom of Legg Mason highlighted the fact that over the last 11 years, while the S&P 100® Index declined 11.2%, the S&P SmallCap 600® Index and the S&P MidCap 400® Index actually gained an astonishing 134%.11 He concludes, “By almost any historical measurement, the drubbing big-cap stocks have endured in both duration and magnitude is unprecedented.” The huge difference in trailing returns has led to big changes in valuations. According to Robert, the MidCap and SmallCap Indexes trade at 22 times and 28 times trailing earnings while the S&P 100® Index trades at approximately 15 times trailing earnings.
While the valuation of the index of very large companies is attractive, the valuation of the individually selected companies that make up this portion of Clipper Fund is even more attractive as these holdings are currently priced around 12 times our estimate of this year’s owner earnings. Owner earnings is a measure of earnings that differs somewhat from generally accepted accounting principles (GAAP) in ways that we believe make it a more accurate measure of economic versus accounting reality. For example, in determining owner earnings, we normalize tax rates and credit costs, add back historic depreciation while deducting maintenance capital spending, deduct the costs of adequately funding pension liabilities, and so on.
With low valuation as the final piece of the puzzle, we would conclude this largest portion of Clipper Fund’s portfolio currently exhibits a rare combination of (1) lower than average risk, as measured by our companies’ balance sheet strength, competitive position and low risk of obsolescence;12 (2) durable, long-term growth prospects as indicated by their product portfolios, geographic diversity and attractive returns on retained equity; and (3) low valuations as indicated by the fact they are priced at a substantial discount to our estimated range of fair value. In our view, this is the perfect combination in an uncertain environment that may include anything from a robust economic recovery to another economic or financial crisis.
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?
An exclusive television interview with third generation value investor Christopher Davis. This former Morningstar “Money Manager of the Year” discusses how family tradition helps him find long term financial values...
Less than a year ago, many investors were concerned about a new Great Depression. Prices of all asset classes, except Treasuries, were collapsing. Unemployment was surging and liquidity was evaporating. The combined market capitalization of our nation’s financial institutions fell 80% on average and most of the largest were taken over, forced to raise capital or filed for bankruptcy. To make matters worse, the combination of overextended consumers, undercapitalized financial institutions, excess manufacturing capacity, and an underemployed workforce made it difficult to see what engine could pull the economy out of its nosedive. From the highs reached in 2007 through the trough in March 2009, the stock market fell more than 55% and Clipper Fund almost 66%.
In response to this free fall, the U.S. government and Federal Reserve pulled out all the stops, pouring liquidity into the system through near zero interest rates, huge increases in government spending, unprecedented capital investments in financial and industrial institutions, the direct purchase or guarantees of less liquid loans and securities, a ballooning of the Federal Reserve’s balance sheet, and expanded access to its discount window. While some of these individual actions may be questioned and the long-term consequences of soaring government deficits have yet to be faced, there is no doubt that drastic action was required.
As time passed, these actions took hold and though the economic news has not gotten much better, it has stopped getting worse. Although such important indicators as home prices and unemployment are still significantly worse than they were a year ago, they seem to have stabilized, albeit at depressed levels. Because we were in the midst of a financial panic, stabilization or a decline in the rate of decline was viewed with enormous relief, setting off an explosive rally in global stocks. As strange as this might sound, the news that we are in the midst of one of the worst downturns in more than 50 years was welcomed simply because it was better than Armageddon. As a result, despite a shrinking economy, high unemployment and soaring deficits, the S&P 500® Index surged a staggering 68% and Clipper Fund jumped more than 92% from their March lows through the end of the year.2
While such huge increases in so short a time are almost unprecedented, they are as much a consequence of how far markets had fallen as they are a reflection of new optimism. As suggested at the beginning of this report, an occasionally forgotten piece of math is that a 50% decline requires a 100% increase just to break even. Thus, having fallen more than 55% before recovering 68%, the S&P 500® Index still trades almost 30% below its starting point. The math is worse for Clipper, which after falling almost 66% and rising more than 92%, is still about 35% behind its starting point.
From a longer term perspective, even after this recent rally the S&P 500® Index is still well below where it was 10 years ago. Although the market has fallen during this decade, the companies that make up the S&P 500® Index are earning more and are thus more valuable. Specifically, at the end of 1999, the S&P 500® Index traded for 1,469 and earned about $48, implying an earnings yield of about 3%. Today, the S&P 500® Index trades for 1,115 and should earn $55-$75 this year, implying an arnings yield of 5%-7% on fairly depressed earnings.3 More important, when we look at the individual companies that we hold in Clipper Fund, many now have earnings yields of 7%-10% and intrinsic values significantly above today’s prices.
Although valuations still seem reasonable, many investors are anxious that the market’s steep recovery means that it must be ahead of itself and that they would do better to wait for a correction. However, there is an old saying that “the market doesn’t know where it’s been.” In other words, the returns investors earn have nothing to do with where a specific stock or the market in general was trading a year before they invested. It is also not uncommon or a sign of overvaluation when the market bounces from depressed levels. For example, after falling more than 40% in less than two years and bottoming in October of 1974, the market soared 55% in the next nine months making 1975 one of the strongest years for the S&P 500® Index in the last 40 years. Given that the market was up more than 50% and the economy was still weak, with inflation and unemployment rising and the energy crisis looming, investors who missed 1975’s strong advance might have felt it would be prudent to wait for a better time to invest. If they waited, in one sense they were correct as many economic indicators continued to worsen, only reaching their nadir in the 1980-1981 recession with double-digit inflation, interest rates and unemployment. However, as is generally the case, the market recovered long before the economy, advancing another 24% the following year. In fact, in the five years following 1975’s 37% gain, the market almost doubled. Clearly, those who waited until investing “felt” better paid a big price. As Warren Buffett wrote in a prescient article that almost rang the bell at the end of the bear market in August 1979:
[The] argument is made that there are just too many question marks about the near future; wouldn't it be better to wait until things clear up a bit? You know the prose: Maintain buying reserves until current uncertainties are resolved, etc. Before reaching for that crutch, face up to two unpleasant facts: The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.
We do not use this example of the 1970s market recovery as a forecast. We simply do not know what the market will do in the next year or two. Rather we use it to point out that stock market returns in any one year do not help predict what returns might be the following year. If investors have learned anything over the last several years, it should be the futility of short-term market forecasts.
Questions about the overall market are the most common we receive. Unfortunately, the only answer we can give to such questions is, “We don’t know.” While hundreds, if not thousands, of people make a living as market and economic forecasters, there is overwhelming evidence that such short-term forecasting is impossible. As John Kenneth Galbraith observed, “The function of economic forecasting is to make astrology look respectable.”
Although the media is now filled with fawning interviews with those strategists who correctly predicted the bear market, these are not the same strategists who were lionized for predicting the bull market. Reputations for astute forecasting tend to be short-lived.
When interest rates are very low, as they are today, bondholders stand to lose on two fronts. Their starting coupons are low and they face the prospect of price erosion should interest rates rise. Such conditions in the past led to 20 and even 30 year periods in which bondholders suffered negative real returns. Thus, if we define risk as the possibility of having a negative real return over a long period of time, then bonds at today’s interest rates are far riskier than stocks. While investors may feel safer in bonds, the toxic combination of low coupons and the likely prospect of higher future inflation means bondholders are likely to be more vulnerable to long-term wealth destruction than stockholders.
The Selected and Clipper manager reflects on the notion that you make most of your money in a bear market, you just don't realize it at the time...
While capital market downturns are nothing new, the dislocation and panic that swept through the markets in 2008 were unique in scale, severity and pace.
Turning to the economy, as is often the case, the capital markets have been leading indicators. What began as a financial crisis tied to falling real estate prices is swiftly becoming a broad-based economic crisis. Consumer and corporate spending are in a free fall. Auto sales for example fell a staggering 35% in the fourth quarter alone. Unemployment is increasing sharply as are virtually all other negative indicators. As these metrics deteriorate, however, it is worth remembering that the front side of a recession is always the scariest.
As always, the only value of mistakes lies in the lessons learned. Looking back at the crisis of 2008, the lessons can be reduced to a single word: liquidity. In a nutshell, we learned that while the answer to the question, How much long-term debt is appropriate for a given company? varies by industry and business, the answer to, How much short-term debt is appropriate for a given company? should almost always be zero. In 2008, even companies with plenty of earnings and equity relative to their debt found themselves shut out of the credit markets.
Because a bear market presents the opportunity to benefit from earnings growth, dividend yield and multiple expansion, I had always been a bit jealous of the opportunities that my father and grandfather were given in the terrible bear markets of the last 60 years. Now that our generation has finally been given the same opportunity, I recognize the wisdom of the saying, “Be careful what you wish for.” In a time of fear and panic, investments will never seem as straightforward as the example given above. More important, even if investors can recognize such opportunities with their heads, their stomachs often have other ideas. As legendary manager Peter Lynch observed, “The key organ (for investment success) is your stomach. Everyone has the brainpower, but not everyone has the stomach for it.”
In today’s bear market, investors are racing for the exits. Cash is pouring into “riskless” securities like short-term U.S. Treasuries with virtually no yield. Although such a choice feels good, it is, given the near certainty of inflation, likely to prove very costly. Meanwhile, investments in high grade common stocks, which feel like a terrible choice, are likely to prove very profitable and are almost certain to outperform cash over the next decade.