Review & Outlook

Our take on the investing, financial, & economic themes of the day

First Quarter

12 April, 2007 by admin in Quarterly Letters

The quarter began well enough. Stock prices rose steadily and smoothly, accelerating the strong pace set last year. But then Tuesday February 27 dawned. The Dow Jones Industrial Average fell over 400 points, or about 4%. Observers struggled to come up with coherent explanations, and generally failed. Whatever the reasons for the sell-off, it wiped out the gains on the year in the space of a few hours. Stocks continued their slide for a few weeks until finally, mercifully, they rebounded in late March. By the end of the quarter the stock market wound up about where it was at the beginning of the year. What to make of the February 27 mishap? One thing is certain: compared to 1987, when the market fell 21% in a single day (our first year at O’Brien Greene!), it was small potatoes. But even so it was a healthy reminder that (1) investors are unusually skittish and (2) there is plenty to be skittish about.

Take geopolitical risk. It is hard to talk about this grim subject in the context of portfolio management. Stock and bond prices, dividend and interest rates, corporate profit growth, and all the other metrics of portfolio management, lend themselves to the precision of mathematical analysis. Geopolitical risk does not lend itself to this sort of hard analysis. It is a wild card. In the investment management business, if not in other areas of life, factors that cannot be measured tend to give way to factors that can. Thus it is understandable that nearly all the professional talk in the financial media is about economic and investment trends and not about another 9/11-like event, which, for all its murkiness, is no less real.

The likelihood of another 9/11-like event is high enough that investors should be more cautious than they would otherwise be. This would mean higher quality stocks and a higher ratio in money market accounts and bonds than these assets might otherwise warrant on the basis of their long-term rates of return. It would also mean broadening diversification into non-USA equity and fixed income securities. Why not put everything in money market accounts and bonds? In times of war, the stock market tends to do well, whereas the bond market tends to do poorly. Why not be really careful and put everything into gold? Suffering a terrorist attack is not like losing a war, with industries and economy destroyed. No matter who attacks us, America will still be the world’s biggest producer, exporter, seller, saver and innovator. Betting against American enterprise entails a different and perhaps greater set of risks.

What of the economic and investment forces that can be measured? Here the picture is mixed, though on balance the outlook for high quality stocks, which make up the bulk of our portfolios, is relatively good. Thanks to years of very strong corporate earnings, stocks are about half as expensive as they were in 2000 (stocks trade at 17 times earnings today as compared to 33 times earnings in 2000). And stocks are inexpensive compared to their principle competitor, U.S. Treasury bonds. The earnings yield of stocks (dividends plus retained earnings divided by stock price) is about 6%. The yield of a 10-year Treasury bond is about 4.5%. Usually bonds yield more than stocks; now it is the other way around. There’s no guarantee that stocks won’t

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become even cheaper in the months and quarters ahead. Eventually, though, there is a reversion to the mean when stocks and bonds fall into line with their historical relationships.

There’s a curious phenomenon on Wall Street that also bodes well for blue chip stocks. Hundreds of new private equity funds are buying up majority stock positions in a number of undervalued blue chip companies and then breaking the companies up and selling them off in pieces. They have discovered that the sum of the parts is presently greater than the whole. Altogether some $585 billion in common stock disappeared last year. In the current year (2007) the pace of stock buyouts is accelerating with some notable names, like Texas Utilities and the Chicago Tribune, leading the parade. In the sentence above I called these buyouts a curious phenomenon. What did I mean? Pension, endowments, and other sophisticated institutional investors are lining up to invest in private equity funds that in turn invest in blue chip stocks – – less an annual management fee of 2% and 20% of the profits. Why not just invest in blue chip stocks and cut out the middle man? Indeed, that’s our question as well.

What is on our worry list? Former Secretary of the Treasury and Harvard President Larry Summers got us thinking the other day. According to Summers, there is simply too much risk capital “out there.” Central bankers around the world have kept interest rates artificially low in order to prop up profits and employment in local economies. For years speculators have been able to borrow at 0%, or close to it, and then invest the proceeds in get-rich-quick schemes in India, China, Russia, Brazil and Wall Street. As one would expect, there are now asset bubbles around the world. Summers would be the first to attest that it is easier to pump up asset bubbles than deflate them. But one way or another, something has to let the air out. The markets at risk appear to be emerging markets, junk bonds, and hedge funds.

What about the much-publicized bankruptcies, and near-bankruptcies, in the sub-prime housing and auto sectors – – are these on our worry list? The answer is no. The economy seems to be handling them, which is interesting, because a generation ago weakness in either housing or autos would have plunged the American economy into recession. The American economy appears to have changed for the better. The service sector amounts to about 80% of employment, and it is relatively immune from inventory swings and cycles. The American consumer, who accounts for 70 to 80% of aggregate spending, feels good about his employment prospects, which is not surprising considering the economy is at full employment. It was feared that people would feel poorer and stop spending if their houses fell in value. It hasn’t happened; people are still spending money. Indeed, the weakness in housing and autos has acted as a healthy restraint on inflationary pressures from commercial real estate and energy, which continue strong.


Mark O’Brien