Comments 2010

September 2010

A few thoughts on Medtronic:

Investors are thought to be rational and only act after having gone through an in depth analysis. There are times when we wonder whether this is the case. Take the reaction to the earnings announcements of Medtronic. The company is one of the major MedTech firms in the world and a leader in defibrillators, stents, spine surgery, treatment of diabetes and neuromodulation (pain control). Earnings per share grew from $2.92 in 2009 to $3.21 in 2010. The stock crashed by 10% to $32.

Today the Price-Earnings Ratio is 9 times, the earnings yield for April 2011 is 10.7% and the free cash flow yield even 12%. As shareholder these earnings belong to me, even though they are only partially paid out as dividend. Dividend yield is 2.8%. Earnings growth is expected to average 6-8% over the next few years. It is slightly lower than in years past, but still considerable. As an investor I have to compare this to what I get for riskless investments like cash and treasuries. Cash yields only about 0.25%, 10 year treasuries approximately 2%. Despite these huge differences in favour of stocks like Medtronic or Johnson & Johnson, most investors prefer to keep cash or invest in treasury bonds. It’s unlikely they truly believe that these stocks will yield less than treasuries over the long term, but they are afraid of further market declines. They look at the investment world not objectively, but with a rear view mirror. Since these stocks have declined over the last few years the thinking goes, they will continue to decline over the coming months. So let’s sell and stay in cash or treasuries, which lately have done well. This could become a costly mistake.

August 2010

In May, financial indexes started to flash red. Greece and other southern European countries appeared to be unable to service their debt burden. The common currency, the Euro, plunged down. Media and politicians consulted financial experts and economists, who all came to the conclusion the situation was serious and there were no solutions at hand. In the end, the European Central Bank and the governments of the most important member countries decided on a huge support package for the weaker countries and the currency, but to no avail, the crisis continued. In the end it was decided, to subject the most important European banks to a stress test, to make sure they were able to survive a severe crisis. Almost all of them succeeded. Scepticism still prevailed, the conclusion being the test was too easy. But the market all of a sudden changed his mind: many banks and financial stocks jumped in a few days by 10%. What had happened? The results were decent, prices had been severely depressed and pessimism had gone too far. There is also the insight that Europe is willing and able to prop up and defend its major banks and its currency.

July 2010

On July 1 the €442 billion bank-lending program of the European Central Bank is ending. The Central Bank introduced the lending program 12 months ago to ensure adequate liquidity within the European banking system and to encourage private-sector lending. A year ago the ECB was eager to set an early end to these emergency measures, but the crisis of confidence in some weak debtors like Greece and other countries of the Union has forced a change of mind. Now the lending-program will have to be extended on similar terms. These facilities are a lifeline to banks in Greece, Spain, Portugal and Ireland, until confidence returns and they gain access again to interbank lending. The turbulence around financially weak European debtors and the speculation against the Euro have vividly demonstrated how fragile the world financial system remains one year after the crash. It takes very little and general mistrust spreads, money is being horded and the flow of credit dries up. That is what led to depression during the thirties.

This leads us to the overwhelming influence of fear, which has always been present in markets. The best-known gauge of investor panic is the Chicago Board Options Exchange Volatility Index or VIX, which is also called the fear index. It reflects premiums on options on the S&P500 index. A high reading occurs in times of stress. Its long-term average is about 20 , last May it surged above 30. During Lehman’s collapse it hit 60. The moments of greatest panic occurred during the financial crisis in Russia in 1998, the panic engendered by the collapse of the Long-Term Capital Management Fund a few months later, the dotcom crash in 2000/02 and the September 11th terrorist attack in 2001. Studying theses indexes and analysing the causes of these outbursts can help us to gain perspective in a situation and to free ourselves from emotion. We learn that in every crisis, without exemption, the index will rise, sometimes spectacularly, but once the crisis has passed the zenith it will head back to the average. The lesson is not to sell during a spike of this fear index, rather to sit tight or to buy. The fear index, properly interpreted, is another plus at our disposal to succeed in a difficult stock market.

June 2010

We have to acknowledge that we live in a time of deep seated uneasiness and doubt. May 2010 has been the worst performing May since 1940. We Europeans suffer in addition under the crisis of the Euro. This is a bad awakening after the surprisingly fast recovery from the financial and real estate crash of 2008/09.

Why this sudden turn in sentiment? We have the impression that the recovery went too far too fast. The increased confidence was probably less the result of growing conviction but fear to miss a rising market in an improving economy. A “Flash Crash” in New York and a quickly spreading distrust of the Euro have eroded investor confidence badly. Government debts had already been growing for a while, but explosively since the financial crisis. Financial difficulties of Greece brought to light some weaknesses in the formation of the European Monetary Union and created doubt about its longevity. The Union has now decided to establish a huge program to defend the currency and to guarantee orderly functioning money flows to their economies and banks. Markets have taken note but are not yet fully convinced. What has brought about this sudden mistrust of the Euro? Purchasing power is approximately equal. It can only be fear of a future debasement of the currency. Presently inflation is maybe 1%, a low rate. Europe has to start, similar to the USA, a reduction of a historically high indebtedness. There is a risk that cutting expenses and investments will lead to a recession. Another way to lighten indebtedness is through inflation. The USA as a country with one Federal Reserve, one fiscal and financial policy may have an edge over Europe with one European Central Bank, but numerous fiscal and financial policies. To conclude from this, that the ECB will be less effective in fighting inflation is a rash, not well considered conclusion. The ECB has so far been very successful in maintaining price stability. It will be a huge task for both monetary authorities to reduce public debt, avoiding deflation like in Japan and maintaining purchasing power. A point in favour of the Euro: the recent weakness increases competitiveness of European exports in a crucial time. We find scepticism against the Euro has been overdone.

May 2010

The precarious indebtedness of Greece is at the moment the predominant worry of investors. Many see the Euro and the whole European Union at risk, if this problem can’t be resolved quickly. Many worry, that the small Greek state is just a precursor of what will happen to most of the industrial countries, which have hugely indebted themselves to fight the subprime crisis and the ensuing recession. There is a growing uneasiness and doubt whether these states have the will and the tenacity to shrink oversized debt loads to manageable levels. Inflation or a debasement of currencies are looming, if they fail. We are not yet convinced that Greece is making every effort to resolve the financial crisis on its own. Whether they will succeed is uncertain. However, this crisis is now making headlines in the European Union; the limits of indebtedness are a topic and are discussed everywhere, even in countries like Germany. This is positive. The danger of a depression has receded, now the containment and reduction of a huge dept moves to the foreground. International organizations, governments, companies and individuals work intensively on possible solutions. Nations like Ireland and Lithuania have introduced radical measures like reducing salaries of employees by 10-20% and cutting expenses massively; a short while ago such drastic actions had been considered as unfeasible, but the population has swallowed them. These countries are on the way to recovery. Greece, whose citizens tried to solve the problems with strikes, is suffering and has lost its creditworthiness. Those who act irresponsibly are being punished. The lesson will not be lost on other candidates, who had hoped to muddle through without hurting their voters unduly. Debt markets could be helped by the fact that this crisis broke out early in a small economy. We take comfort from the fact that other debtors have now been warned and will do everything to avert a similar humiliating situation. Risks and problems can be overcome, if they are recognised and being worked on. Extremely dangerous are those, which grow unobserved in obscurity and suddenly burst on an unsuspecting public. This is not the case in the present crisis.

April 2010

One year ago the market was at the bottom of its fall and worries about the future abounded. In the 12 months since then, a lot has changed. Markets have rebounded in a V-shaped manner and confidence and optimism have replaced despair and fear. Economic news flow is not exhilarating, but it is encouraging and nowhere as bad as feared only a few months ago. Question is: Are the good times for real and will they last or are they artificial, brought by an abundance of cheap money and endangered by the formation of new bubbles?

Two famous US economists, who happen to be old friends, take opposite positions in this all important question. Robert Shiller, author of “Irrational Exuberance”, has correctly predicted the last two major crashes, the Technology Bubble in 2000 and the Real Estate and Financial Crisis of 2008/9. Today he is again worried about the future of the stock market. He points out that since 1991, stock prices have been undervalued only during 7 months, too short a time to correct excesses and reckless behaviour. Massive injections of cheap money by Governments and Central Banks have stopped the crisis from running its full course and have also prevented it from correcting excesses in a painful, long lasting way, which would preclude an early return to similar detrimental behaviour. History tells us, if periods of undervaluation are too short, the lesson may not stick, behaviour could become reckless again and returns could be below average.

Jeremy Siegel, author of “Stocks for the Long Run” strongly opposes this assessment. In his view, stocks today are cheap and the outlook is promising. Both professors agree that long term P/Es have been at 16 times earnings. Shiller uses for his analysis a 10-year average of earnings to smooth short term swings. His P/E ratio stands at 20 and indicates a small overvaluation. Siegel looks at earnings estimates for this year. He arrives at a P/E of 15 times, an undervaluation. In addition, he points out that after a recession, a slightly higher P/E of 18.5 times is appropriate. Therefore he is quite optimistic.

On whom should we rely? Shiller is clearly the man to turn to for predicting trouble, excesses and forming bubbles. He has a very fine sensitiveness for this. Trouble is, he remained cautious and somewhat pessimistic at the bottom of the market. Siegel, on the other hand, badly misjudged the dangers of the gathering storm. But he was very bullish at the bottom and able to profit from the bargains. The truth probably lies somewhere between the two. We just have to rely on the right man at the right time.

March 2010

The past 2 years have been painful and instructive for our investors. In the crash of 2008 we have lost almost 30%, but have recovered almost 26% in the upswing in 2009. First, staying power and perseverance have been tested to the extreme, followed by a swift recovery. These are extraordinary years, but they have happened and they will happen again. Many frightened owners will ask themselves: do I want and am I capable to expose my assets to such gyrations in value?

Long term performance studies have demonstrated repeatedly, that investments in stocks on average produce returns of about 4% to 5% after adjustment for inflation. On the other hand, bonds and savings accounts have only provided returns of 0 to 2% in real terms. Therefore, anybody who is serious in his desire to grow his wealth has to invest in stocks and accept their volatility. Warren Buffett and Charlie Munger have on many occasions stressed the fact that owners of stocks have to reckon with market crashes of up to 50%. If they lack such a capacity for suffering, they should stay out.

Investors, who seriously desire to grow their wealth, should make sure they will not be wavering in the face of extreme stress and adversity. They should work to increase their capacity to face a crisis. Most important is an awareness of history, which puts the present in perspective. People, who lack this, are living in the crisis. Those, who also look backward and forward, extend their horizon, they are more relaxed, considered and less emotional.

Many investors, including pension funds, insurance companies and banks, believe they are capable to be invested only in benign and cheery times and to get out of harms way early enough. This is a huge illusion, as history has illustrated on many occasions. The past teaches us that we can’t avoid hardship, but with an appropriate attitude we will survive it and thrive in the future.

February 2010

A comparison of recent headlines with news from January 2009 shows two different worlds. In January 2009 the mood was terrible, the USD was strongly appreciating as people continued to scale down risk, unwind carry trades and seek the safety of US Treasury Bonds. Forecasts of doom were ubiquitous and investors extrapolated the previous months into the future and expected the S&P 500 to fall further to 450-400 and possibly lower. Capitulation came on March 6, without any good news underpinning it, and from then on the market never looked back. January 2010 started with the inauguration of the tallest building of the planet in Dubai amid fireworks, and continued with a series of large takeovers, such as Novartis-Alcon, Heineken-Femsa and Kraft-Cadbury. On Wall Street, practically nobody forecasts stock markets to have a negative year, with high expectations for emerging markets and more modest albeit positive for developed markets. Only in the last few days, few dark clouds have re-appeared such as the trouble in Greece: so far investors take them as isolated, solvable difficulties. The vagaries of stocks over the last couple of years are a stark reminder of how difficult it is to time the market in the short term, and how tricky it is to make January predictions for the following 12 months. As value investors, we try to ignore this “noise” and focus on fundamentals. While there are always plenty of reasons to worry about the future, we keep our attention on the companies we have invested in: we own several businesses with strong market position and high free cash flows relative to both their capital invested and their market value (e.g. pharmaceuticals and medical devices). We also own a few companies with more modest competitive advantages but still trading at bargain prices, and several of our bonds have reasonably optimistic prospects thanks to massive re-financings through 2009. We don’t know what the markets will bring in 2010, but that’s the case every year. As always, we rely on a collection of good businesses whose prices reflect modest expectations: over time, this is a good combination for capital preservation and growth.

January 2010

The financial crisis of 2008/9 has made us painfully aware of the fact, that savings and wealth not only can grow, but can wither away very fast. This knowledge is not new for those who study history and the ups and downs of civilisations, but during times of prosperity it gets easily forgotten. All of a sudden, private investors, pension funds, banks and insurance companies have been reminded that the paramount task of capital investment is not to loose money.

The decade just ending has shown the worst performance for equities of -0.51% per annum since statistical data has been collected in the US in 1834. During the decade of the depression in the 1930s, investors lost on average 0.21% in nominal terms, but they had a positive return in real, inflation adjusted terms. Negative returns after adjusting for inflation showed the decades of 1910-19 (during World War I) and the 1970s with the oil crisis. All other decades have been profitable, sometimes modestly, sometimes generously. Many among us remember the very prosperous years from 1980 to 1999. It is worth mentioning that they have been preceded and followed by the disappointing 1970s and by the equally sobering decade just ended. From the diagrams we learn, that lean decades with negative results are followed by periods with average returns of 10% or more. The figures show that those, who are able emotionally and financially to hang on for such long stretches, can count on being rewarded in the next decade. Every ebb is followed by a high tide. It is reasonable to assume that future returns on equities and profitability of businesses as a whole will not differ materially from those of the past, despite the fact that economic activities have changed profoundly over so many years. The dark red fields merit special attention: they indicate devastating crash-years with declines from 40% to 60%, the dreaded “black swans”. When they hit, they spread fear and horror. Confidence and initiative are being paralyzed, and despair and hopelessness befall people. Luckily these crash-years too, like the decades, are almost always followed by a strong reversal on the upside, similar to what we have just witnessed in 2009. It is somewhat worrisome, that the frequency of these almost fatally catastrophic years seems to increase. After one in 1974 we had one in 2002 and then again in 2008. We don’t know whether this is an aberration or whether we will have to cope with tougher times.

The causes for the miserable results of the past decade are in hindsight quite clear. The culprit was too high a valuation due to “irrational exuberance”, unrealistically high expectations by enthusiastic investors late in the 1990s and at the beginning of 2000, elated by huge progresses in information technology. In 1999, the Standard & Poor’s 500 index, calculated by Prof. Shiller as a 10-year moving average and adjusted for inflation, had a Price-Earnings Ratio of 40. The same ratio stands today at 20, slightly above a long term average of 16 times earnings. It is amusing and sobering to look at the performance of the stocks most frequently recommended ten years ago by analysts with the highest reputation: these then very popular stocks are all down from 40% to 80%. Winners have been relatively unknown securities. The widely believed notion that you just have to own the best growth companies, almost without regard to price, because these economic athletes would grow so much faster than the rest and have a much higher profitability has once again proven a popular fallacy. Most of these outliers, after a short surge, met heightened competition and had to revert to the mean; some even only took off in the stock market, but never had a success economically. Value investors, who avoided the technology-frenzy, did slightly better, but they later on got clobbered by the seemingly cheap financial stocks. As a general rule investors have to be very price conscious and should never overpay, even if the outlook is exceedingly rosy. In addition they have to watch leverage and make sure management is able to handle it.

An important reason for poor performance is the frequent switching from seemingly non-performing, lagging stocks into those with momentum, which are in favour and are being talked about. Every driver knows a feeling of frustration, when the other lane is moving faster than his own. Many investors long for action and movement. When nothing happens, they get impatient and seek information from banks, brokers, the newspapers and television. Then they acquire a stock, which promises to have a bright future. Chances are that they move into a sector and a company favoured by the public, which has already moved up in price. They risk buying an expensive security and selling a neglected one. This is buying high and selling low, the biggest sin an investor can commit and the opposite of what he originally intends to do. Chasing performance with momentum may be suitable for a trader, but is rarely profitable for the normal investor. Often the newly purchased stock is unable to fulfil the high expectations, pricewise and economically, it falls out of favour and the price sinks as investors abandon it. The impatient shareholder is disappointed and moves on to the next promising venture. DALBAR, a company which analyses money movements in and out of equity funds, has calculated that the S & P 500 index has returned 8.4% per annum from 1988 to 2008. The average investor, according to their analysis, has only gained 1.9%, because of his frequent switching and timing of the market. There are many other studies which show similar results.

This is a subject we have often mentioned in the past. The past teaches us to try to act contrary to the prevalent mood and notion of the market. We have to question whether the most loved stocks are really outstanding and not too expensive and on the other hand, whether the laggards, those with momentary problems and setbacks, are not so cheap that one day they will rebound and give us a satisfactory return. Even mundane businesses at very low prices are rewarding.

In our time we witness once again that those who build the highest building in the world tend to overstretch themselves. Historically hubris, longing for prestige at any cost and self-aggrandizement have led sooner or later to setbacks and trouble. Some studies support also the conclusion that firms which pay their chief executives the highest salaries likely perform below average and have also an inferior profitability. Most banks, insurance companies and investment houses have recently supported these conclusions.

Bubbles and crashes have not only their painful side, they also offer opportunities. Many bonds of financial institutions declined meaningfully during the crisis, pressured by the growing investment losses, the highly uncertain outlook and everybody’s urgent need to deleverage. We have been able to take advantage of this situation. The resulting profits are a small consolation for the adversities suffered.

Commentary to the statistics: Download PDF (Chart)
The colours in the squares show the performance of each year since 1834 in the US. The dark red squares are the years with catastrophic crashes, “black swans”, with losses from 40% to 60%. At the bottom on the right are returns for the S & P 500, nominally and inflation adjusted, since 1910, the start of this index. On the upper right are the decade’s cumulative returns since 1834, without adjustment for inflation.