Why am I here? (And why do I feel so much anxiety?)
June 30, 2012
Market Summary – 2nd Quarter, 2012
Why am I here? Whether this question is on the tip of their tongues or deep in their subconscious, investors have been asking themselves why they continue to trust their money to the stock market. The mood of the market is dour, and everywhere investors look there is reason for anxiety:
The potential break-up of the euro as a common currency;
The possibility of Europe entering a deep recession that spreads globally;
The looming “fiscal cliff” here in the United States that threatens higher taxes and deep spending cuts that could drive our economy back into a recession; and,
A renewed lack of trust in Wall Street given the latest news that some of the world’s largest banks manipulated LIBOR.
These issues are real, and the potential ramifications are significant. Investor concerns are magnified when one considers that the median net worth of American families declined by approximately 40% between 2007 and 2010, driven mostly by a broad collapse in home prices1.
Meanwhile, the equities market is performing better than most people realize. Since the end of 2008, a time when the outlook was very pessimistic, the S&P 500 has averaged a return of more than 14% per year, significantly better than the post-World War II average of 11%.
Nevertheless, many investors today have a comparable degree of apprehension, with many asking questions such as, “Why am I here?” and “What can you do to protect my money?”
Why am I here? Why is MPMG so committed to equities?
The simple reason is that stocks are the greatest wealth creation vehicle in history (well, perhaps the third greatest behind wealthy parents and marrying well). Stocks have delivered almost twice the annual return as the next best asset class (bonds)2. You don’t have to be a powerful business titan or benefactor of a large inheritance to own world class and industry dominating businesses. Stock ownership of select companies provides the average person with the opportunity to own businesses and participate in the spectacular wealth that these companies create. These aren’t ordinary businesses that an average person can start on their own with limited capital. These companies are industry leaders that provide unique and needed goods and services. They have the ability to grow, increase prices, and withstand troubled economic times. They generate significant cash after all of their expenses have been paid, and then have the opportunity to re-invest this additional cash back into the business so that it can continue to grow and the wealth created by the company can be expanded further. When there is cash left over after re-investment, the company returns it to stockholders through dividends and/or stock repurchases. This is how great fortunes are made. Stock ownership allows the average investor to participate in this wealth creation.
A good investment takes place when one buys a great company at the right price. By almost every metric available today (Price/Sales, Price/Book, Price/Cash Flow, Price/Earnings), stocks – particularly those of industry leading businesses with significant growth opportunities – are very inexpensive. We aren’t brazen enough to claim that stocks can’t still get cheaper, but we are confident that they present compelling value at these levels, and that over the long term patient investors will be rewarded.
Investing in stocks isn’t simply a luxury available to those with sizeable risk tolerances. It is a necessity for all of us. Americans are living longer and this additional lifespan takes place when most Americans are retired and relying on passively-generated investment income. Furthermore, Americans have seen their purchasing power decline by more than 25% over the past 10 years due to inflation (almost 2.4% per year). This annualized loss of purchasing power is greater than the return that one can earn investing in currently-low-yielding U.S. Treasury bonds, and as a result these bonds offer a negative real return. Businesses, on the other hand, are able to pass through higher costs brought about by inflation and preserve purchasing power. While some individuals may believe that investing in stocks is too risky, the fact remains that not investing in stocks is a far greater risk.
Why am I here? Shouldn’t I be defensive and investing in safer asset classes?
It is ironic that assets that have traditionally been viewed as safe-havens in tumultuous markets, such as Treasury bonds and high dividend paying stocks, are now, in our opinion, extremely expensive, and therefore, fraught with risk. As we learned with real estate prices in 2008 and technology stocks in 2000, no asset is safe at any price. Risk is best managed by buying inexpensive assets. Right now the asset class offering the greatest risk-adjusted return is multi-national equities. Within this asset class you must still find the right companies.
Amidst global economic uncertainty, fear has been the dominant emotion in the market, and emotional investors have been running to perceived safe haven investments such as U.S. Treasury bonds. As the following chart shows, demand has driven the interest rate paid to investors in a 10-Year U.S. Treasury bond to historic lows, and these assets are now valued at levels similar to technology stocks at the peak of the dotcom bubble. Investor panic can be found in segments of the equity markets as well. Investors have been bidding up the prices of “defensive” stocks such as U.S. utility companies that they believe will provide comfort in these uncertain times. These regulated companies have no exposure to Europe, possess virtually no growth prospects, and have limited ability to increase prices as a means of either passing higher costs along to customers or increasing profits. Because of the limited growth prospects there is limited need to reinvest earnings back into the business. As a result, many of these companies are able to pay a large portion of their earnings out as dividends. These stocks traditionally trade at a discount to the market because they offer little growth in the form of either expansion or higher profitability. However, anxiety-ridden investors are so desperate for perceived safety that these stocks now trade at a premium to the broader market – including companies that possess far greater growth and cash flow generating capabilities.
We take a different approach to the issue of how to protect a portfolio. In our view, paying the right price for an asset is the key to managing investment risk over time. Many of the companies that we believe offer solid long-term appreciation potential also happen to be among the best values in the market today. At current prices they are so inexpensive that much of the risk has already been removed from the investment. These stocks appear to offer a unique investment opportunity not only to create great wealth, but also to protect investors from significant losses. This is why we remain invested in the stocks of select businesses.
Why am I here? Why have stocks been so resilient?
If the over-indebted nations of the world stand to take down the global economy and inflict 2008-size losses on our net worth, it stands to reason that the stock market would be testing its lows rather than its highs. After all, the stock market is viewed as a leading indicator and predictive of things to come. Yet, the market has remained incredibly resilient.
Since the beginning of 2008 the world economy has successfully withstood an onslaught of seemingly catastrophic shocks to the system, including (but certainly not limited to) a global credit crisis, the implosion of the world’s housing markets, and the debt-ceiling standoff that resulted in the downgrade of the U.S. credit rating. Yet despite all of this turmoil the S&P 500 Index managed to post a cumulative gain of 2.4% (including dividends) from the beginning of 2008 through June 30, 2012. The investor trauma of 2008 was similar to that experienced during the Great Depression. Yet stocks of quality companies have protected investors, who have been able to recover their losses in the stock market. Conversely, we suspect that the bond market will be painfully unforgiving to investors once interest rates inevitably start to rise from their historically low levels.
This positive performance of equities in the face of impending doom begs the familiar question, “why am I here?” Why hasn’t the market traded lower if, as the old bromide suggests, the market is predictive of things to come? Could it be that most of the bad news that has us in a panic has already been priced into the market?
The chart below tracks the flow of funds into and out of both equity and fixed income mutual funds. It reveals the inverse relationship between the flow of funds between equity and bond mutual funds: funds tend to flow into one asset class at the expense of the other. In addition, the disparity in the flow of funds occasionally becomes exceptionally large before snapping back to historical levels. Finally, these moments when the flow of funds is most heavily weighted towards one asset class tends to signal that the favored asset has become exceptionally overvalued, and a correction is coming. The current chasm between funds flowing out of equities and into bonds makes a strong case to buy equities now.
If retail investors are leaving the stock market, how does one explain the ascent of the S&P 500 Index? How can stock prices increase when demand for equity mutual funds is plummeting?
We believe that while retail investors that invest in mutual funds are leaving the market, the increased demand for stocks is being met by professional investors who manage assets for some of the world’s biggest institutions – the so-called “smart money.” Unlike retail investors, institutional investors are more likely to let reason, as opposed to emotion, drive their investment decisions. These professional investors are eager buyers of quality businesses trading at deep discounts from which the mutual fund crowd is running. We believe that these professional investors stand to profit immensely when investor fear dissipates. While we recognize that our optimism for the equity opportunity could be untimely, one must also acknowledge the likelihood that non-professional investors who are fleeing the market will be as incorrect as they were when they rushed into the market in 2000.
Why am I here? What investments are going to help me reach my objectives?
One of our great strengths as professional investment managers is having the fortitude to stand by our beliefs when our research differs from public opinion. The last time that our beliefs conflicted so greatly with the rest of the market was during the dotcom era. In 1997 and 1998 the MPMG All-Cap Value Composite portfolio underperformed the broader indices as overvalued companies with questionable business models and limited (or no) cash flow continued to go up in price.
Our detractors told us that we didn’t understand the “new economy,” and our reluctance to make speculative investments in the technology sector was a tragic mistake. Over the short term, following the herd and riding the momentum of a bubble worked for those investors. Thankfully, we remained true to our beliefs and eagerly bought stocks of great companies that were trading at steep discounts to the market simply because the names of these businesses didn’t end with “.com”. These investments laid the foundation for the portfolio outperforming the S&P 500 Index for 10 straight years and creating life-changing and long-term wealth for our clients.
We have seen irrational and emotion-driven markets before and, based on our success in exploiting the inefficiencies of the dotcom era, we remain confident in our ability to find undervalued, misunderstood, and unloved stocks that will serve as the foundation for future gains.
Below are two examples of undervalued, misunderstood, and unloved stocks currently in our portfolio.
Life Technologies (LIFE): LIFE is a life sciences company that provides instruments and consumables to scientific researchers. Recently named as one of the world’s 50 Most Innovative Companies, LIFE has developed a new DNA sequencer that will be able to map the entire human genome in less than a day for $1,000. This instrument’s short run-time and low cost has the potential to move DNA sequencing from labs into clinical settings, presenting a multi-billion dollar market opportunity. Its core business, however, remains an industry-leading and patent-protected portfolio of consumable products used for biotechnology research. This consumables business provides a recurring stream of revenue that accounts for 80% of total sales with outstanding gross margins. The stock has traded down due to concerns of government funding for research, but the stock now trades at less than 10x next year’s estimated earnings, far too low for a strong cash flow generating company with a highly defensible market position and spectacular growth opportunities.
Cisco Systems (CSCO): CSCO, the dominant player in Internet Protocol-based networking equipment, was once one of the most overvalued stocks of the dotcom craze and traded at almost 100x earnings. Most investors cringe at the mention of the company, as the stock price has fallen from $80 back in 2000 to under $20 today. However, the fact that overzealous investors drove the stock price to unsustainable levels is not the fault of the company. Since its 100x valuation, CSCO has managed to triple its revenue, earnings, and cash flow. Revenue is expected to grow around 5% per year and earnings at close to 10% per year, yet the stock trades at less than four times next year’s earnings when one takes out the $9 of cash per share in the bank. While the company will likely never be valued at close to 100x earnings, its current valuation of 4x earnings is far too low for a growing and dominant market player with improving margins.
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.