Q3 - 2003 Investment Update October, 2003
General Commentary
It should be obvious to us all that no one truly knows the direction that the financial markets are going to head in the short-term with any degree of certainty. This fact has led to a nearly unanimous voice on Wall Street that argues for setting an asset allocation (stocks, bonds, hedge funds, etc.) and sticking to it through all seasons. The unintended consequence of this recommendation has been that although investment managers may lose money for their clients they proclaim victory for losing less than the stated benchmarks. In our industry lingo this is called generating relative outperformance. As has been said many times, “you can’t eat relative performance”. Our industry seems to have lost sight that our mandate should be to make our clients money by investing wherever money can be made.
We would not attempt to argue that it is possible to time the market in the short-term. And, we believe that the percentage of assets invested in any one asset class is the main driver of overall performance. However, we do think that it is a very natural process (although not an easy one) for a thoughtful investment professional to have opinions as to whether certain financial instruments are over or under-valued. The willingness to act on this information does not constitute market-timing but rather the ability to allocate capital in a prudent manner. It closely resembles the decision of a CEO when determining where to invest the resources at his/her disposal or in a more specific example whether to issue stock (if he/she feels their stock is overvalued), debt (if the interest rate environment is favorable) or cash to use as currency to buy another company.
In analyzing an investment the first question to ask is not how much can be made but how much can be lost. Considering today’s environment for stocks, the risk of significant loss seems much greater than the incremental gain. On the interest rate front, an improving economy should lift rates higher possibly causing a rate increase by the Fed in 2004. As a result, we will hold our bond positions and not commit new money into fixed income until the early or middle part of 2004. The following commentary provides further thoughts into these observations:
Stocks and the US Economy
It’s official. We have been in an economic recovery for over two years now. No new jobs have been added however so it has hardly felt like things are getting better. Companies have continued to reduce their costs to the point of experiencing profitability with flat or declining sales. When sales do pick up it should bode extremely well for the collective bottom lines of American businesses. The economy is providing mixed signals (although with a positive bias) which has the stock market in a fit of stops and starts. This is not unexpected. If all of the signs were positive and pointed upwards it would take all of the fun out of making predictions! We don’t anticipate businesses hiring additional workers until they are running at full capacity.
In large part due to the productivity gains over the recent years, demand will need to increase sharply before this happens. Adding jobs immediately and substantially is not a necessary ingredient at this stage for the economic recovery to continue. Additionally, business inventories have been run down and their replenishment should extend the recovery’s momentum. Perhaps most importantly, we are living in a time of extraordinary fiscal and monetary stimulus.
We don’t think this market will be characterized by the idea of a “rising tide that will lift all boats”. Well-managed companies, those with a balance sheet that is properly aligned, and those that can continue to manage their cost structure in a period of increasing sales should benefit the most with stock prices that outperform the general market.
Bonds
We recently ended a 20-year cycle of decreasing interest rates that began in 1982. Short-term rates are around 1% and even lower in money-market funds after expenses. They don’t have room to go much lower. So, what happens next? If the cycle for the last 20 years was trending down and we are now near 0% it is logical to conclude that the next cycle should trend up. What is not evident is the period of time over which this will occur. It is not hard to imagine that over the next few years interest rates should be higher than they are today. A period of rising rates and falling bond prices is called a bear market. For those investors who hold bonds they should see the principal value decline. This should not be an issue provided the bonds are held to maturity and do not default before they get there. There should also be an opportunity over the next 12 months for those investors looking to establish new positions in bonds as they will be able to lock in higher rates.
Sometimes very simple observations are the most telling. Berkshire Hathaway, the investment holding company controlled by Warren Buffett, recently issued $1.5 billion in 5 and 10-year notes. The combined factors of his credit rating, which is the highest rating possible by Standard and Poor’s, and the lowest interest-rates in 45 years, have allowed him to borrow money at ridiculously low rates. To say that Buffett has shown aptitude in the past at gauging where to find value in the capital markets is a gross understatement. Berkshire Hathaway’s recent actions send a pretty clear signal that rates are going higher, and soon.