03 Sep 2010 Clipper - Q2 2010 Commentary
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?

27 Aug 2010 Video: Christopher Davis on Consuelo Mack WealthTrack
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...

08 Mar 2010 Clipper - Q4 2009 Report
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.

01 Sep 2009 Clipper Fund - Q2 Report
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.

27 May 2009 Investing in Hell with Chris Davis
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...

06 Mar 2009 Clipper Fund - Annual Report
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.