Broker Check

Quarterly Newsletter January 2004

Quarterly Newsletter | January 2004

For investors, the years from 1999 to 2003 amounted to a severe test and for many it was an excruciatingly painful experience. The truth is that in our investment lives, just as in the rest of our lives, we are always being tested. We are tested on the clarity of our investment philosophy and process. We are tested on our intellectual honesty with respect to our belief in that process, for if we don’t believe then we will not stay true to it when times are tough. And, we are continuously tested on our ability to stay disciplined and resist the many temptations that can pull us away from our philosophy and circle of competency. These temptations include pursuing hot investment trends simply because they are hot, investing based on gut feel, or cutting corners on our research.

The year 2003 may have been the final chapter to the bubble run-up and collapse that started in the late 1990s. Just as the most fervent bull-market revelers tend to experience the greatest suffering when the music stops, those that latch on to doomsday scenarios fail to recognize that bad times end too. In the worst case, former bubble investors morphed into gloom-and-doomers and missed the 2003 market rebound after participating in the worst bear market since the 1930s.

For those investors who didn’t let pessimism get the best of them, 2003 was a hugely rewarding year, with all equity-type assets delivering very high returns. We entered the year cognizant of the risks and were therefore unwilling to take an extremely aggressive posture. However, I also believed stocks, REITs, and high-yield bonds were undervalued and we maintained exposure to these asset classes. After a very rough first quarter, characterized by war fears and economic uncertainty, the markets rebounded and continued to perform well through the end of the year. More conservative investments, namely, investment-grade bonds, delivered only slightly positive returns as investors were not rewarded in 2003 for avoiding risk.

It Was a Nice Year, But What About The Future?

In looking forward, a useful place to start is by assessing what has and hasn’t changed from a year ago. Here are some key factors and how they compare to a year earlier:

  • Cyclical, macroeconomic risks have substantially declined. The economy is in recovery and gaining strength. Deflation risk is much reduced.
    • Capital spending is bouncing back
    • Consumer spending has been very strong
    • The labor market is beginning to improve
    • Manufacturing activity is surging
    • Loan delinquency rates are declining
  • The economic recovery is global with most parts of the world showing signs of increasing economic activity.
  • The uncertainty of an impending war is gone.
  • Terrorism and geopolitical risks continue to be impossible to predict.
  • The U.S. budget deficit is higher.
  • Investors are willing to take risks again.
  • The potential for earnings growth is more limited. Earnings experienced a powerful rebound from depressed levels and are back near their long-run trend line. This rebound has supported capital spending and bodes well for the labor market. Consensus earnings growth forecasts for the U.S. stock market for 2004 are 12%.
  • The dollar moved sharply lower against a number of currencies and is sharply lower against the euro.
  • The current account deficit (mostly driven by the merchandise trade deficit) remains a significant long-term issue and is a major factor in putting downward pressure on the dollar.
  • Household debt-service levels remain near historic highs compared to disposable income.
  • Interest rates are higher but still very low on an absolute basis. Rates are very likely to move somewhat higher over the next few years.
  • Equity markets are sharply higher compared to a year ago. But because stocks started the year undervalued and earnings have surged, they have not moved into overvalued territory.
  • There are not any clearly undervalued asset classes. REITs, high-yield bonds, and small-cap stocks all had big years in 2003, eliminating their undervaluation.

Collectively these factors (and others) impact the investment climate. The influence of these many variables makes this period complex, but not necessarily more so than any other historical period. My approach to complexity is to simplify the analytical challenge presented by so many hard-to-evaluate moving parts.

This process allows us to play off of our strengths in valuation work and asset class knowledge (including risk assessment), and to avoid being dependent on the ability to analyze big-picture factors that we are cognizant of but, like others, can’t confidently and consistently forecast correctly. Trying to rely on analysis of those big-picture factors would result in a lower success rate for our decisions. Although bull markets tend to steam ahead over some years, leadership often changes. Our system of analyzing and monitoring over 50 world wide asset classes for both risk and return and gradually shifting into top performing asset classes has kept our portfolios performing well. For example, although small companies have outperformed larger companies for several years, many pundits are forecasting a shift to large cap dominance. Should this occur, we will look for opportunities to make this tactical asset allocation.

At this time of year it’s common for people in our business to make a return forecast for the year; even though one-year return forecasts are speculative. This is because over periods as short as one year, long-term fundamentals may not be the driver of returns. Instead, returns are at least as likely to be driven by investor psychology, which can be impacted by things like geopolitics, scandals, short-term economic surprises, and other unpredictable factors. For these reasons it’s better to talk about a range of possibilities. From an equity market standpoint, an improving economy, decent-to-good earnings-growth possibilities, an increased propensity for investors to take risk, and rising, but still relatively low, interest rates together suggest that stock returns could make it into the low double-digit range, and with luck maybe even reach 20%. However, plenty of uncertainty remains, including geopolitics, the declining dollar, and reasons to question the strength of consumer spending (given a sharp decline in mortgage refinancings and less growth in fiscal stimulus). And by the second half of the year, investors will be thinking about 2005, with the possibility that fear of further interest-rate increases may lead to greater caution. Terrorism uncertainty and the small chance of a dollar crash are the biggest wildcards I can see that could result in lower returns.

In the meantime we will bet on horses ridden by great jockeys. My conviction in the mutual fund managers we are betting on is high. This has been and continues to be an area where I can add a lot of value from a performance standpoint.

Final Comments (I Hope) On the Fund Scandal

Fund investing continues to give us the ability to easily hire and fire managers, choose from a large universe of managers and, within that universe, find a handful of exceptionally skilled investors, and to opportunistically access many asset classes. Moreover, the cost for doing this has been quite reasonable in my opinion and more than made up in performance. As mentioned above, this success is a function of my investment philosophy, process, and discipline, part of which focuses on the shareholder orientation of the funds we own. Going forward, ethical lapses are far less likely to be an issue than in the past given the fallout of the fund scandal of 2003. But shareholder-oriented business practices will still be a big issue and one that I will continue to focus on. The bottom line is that while I have always recognized the shortcomings of mutual funds, I continue to view the fund universe as one that gives us a handful of excellent choices and the flexibility to apply our fundamentally based approach to tactical asset allocation in a very effective way—one which, in my opinion, could not be as efficiently implemented using any other investment vehicles.

I welcome comments and questions.                                              Mike Durant, January 9, 2004