Review & Outlook

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

First Quarter

9 April, 2009 by Mark O'Brien in Quarterly Letters

Last quarter, indeed the last 17 months, have been brutal for investors, our clients included. Not one of our clients owned the highly-leveraged derivative securities that paid handsome profits before self-destructing, and pitching the entire world-wide system into chaos. Yet our clients, and countless other innocent bystanders, have suffered severe financial losses. It is not fair.

And there is not a lot that one can do; indeed, about the only thing is not to make matters worse. As the expression goes: First, do no harm. Last quarter it would have been easy to make matters worse. In early March the Dow sank to 6500. Having fallen nearly 40% in 2008, it fell another 20% in 2009, and the scariest part was the year was just getting started. We received a number of telephone calls asking if it were not time to sell everything while there was still something left to salvage. We said no, fortunately, for that was the moment of capitulation, when the outlook was darkest. It was March 2. Thereafter stocks started to climb. As I write they are still climbing, up over 20% from the early March low to over 8,000 on the Dow Industrial average. If stocks average 10% a year, they did twice that in the last month.

But we are not out of the woods, as I discuss below, and there will probably be plenty of opportunity for self-inflicted financial wounds down the road. Is there anything one can do to avoid them? One way might be to return to the earlier custom of focusing on income rather than price change. Portfolio income is the sum of interest and dividends earned and received from bonds, preferred stocks, money market funds and common stocks in a given period of time. Common and preferred stock pay dividends quarterly, money market funds pay interest monthly and bonds semi-annually. These periodic income payments go into one’s account (we track every dollar) where one can save the money or give it away or use it to pay bills. Thus portfolio income is real and permanent in a way that price change is not. Investors came to focus on price change in the modern era, especially in the 1980s and 1990s when stock prices were soaring, and dividends were puny in comparison. But with those days gone, an income focus can give one the perspective to resist selling “everything” at the next moment of capitulation.

Our typical portfolio is today generating about the same income, expressed in dollars and cents, as it was a year ago, even as stock prices have plummeted. So if one is able to pay the bills out of income, one is able to wait this thing out, however long it takes. But one wants plenty of diversification. Recent news from General Electric shows why. Though perhaps the most famous American company, GE slashed its dividend 66% last quarter. Companies in the financial sector are most at risk of cutting dividends (half of GE is a bank – – GE Capital). In 2007 financial stocks paid about 30% of all stock-market dividends; in 2009 that figure will fall to around 8%. Taken together stock dividends could fall as much 20% in 2009. While most of the drop will come from companies in the financial sector, some companies in other sectors are at risk too. Altogether one has to be picky about the companies one owns. Buying a stock index, which is like buying the entire stock market, virtually assures that one’s dividend income will fall in 2009. Thus this is the time to pick individual stocks and not market indices, as we do.

But given the highly uncertain economic outlook, should one still own stocks in the first place? I think so. According to Barron’s Magazine, Washington has pledged $14 trillion to stimulate the economy. The Federal Reserve is monetizing debt, which is a fancy way of saying it is printing money. The Obama administration budget plan would result in budget deficits averaging $1 trillion a year for the next 10 years, reports the Congressional Budget Office. Washington seems prepared to live with inflation if it can help the economy avoid Depression-style deflation and unemployment. If inflation is indeed what ensues, then stocks will hold up better than fixed-income assets like bonds. Consider that McDonalds can always increase the price of a hamburger and pass some of that along in higher dividends.

Normally we rebalance stocks quarterly, trimming what has done well, buying what is cheap. In recent months we stopped rebalancing; we have not been adding to financial stocks, even though they have never been so cheap, nor have we been selling dividend-paying consumer staple stocks, like General Mills or Procter & Gamble. We are skewing stock holdings to domestic U.S. companies that pay dividends, that have the possibility of increasing the dividends, and that have little debt.

The other part of our portfolios, the bond portion, generates a fixed and unchanging stream of income. But if hyper-inflation is the enemy of bonds, and if inflation appears likely, why would we own bonds at this time? There are several answers. For starters, we could always be wrong about inflation. There is a huge tug of war between inflation and deflation and no one knows for sure which is going to win. So one wants to hedge his bets. Another answer is that corporate bonds and tax-free municipal bonds appear unusually attractive right now, even adjusted for the risk of inflation. For instance, investors in the investment-grade corporate bond market are assuming a default rate of 40%; the average is 0.9% and the worst ever was 2.4% in 1970. Some corporate bonds may actually go broke, but not 40%. So we like investment-grade corporate bonds, and tax-free municipal bonds. We do not like U.S. Treasury bonds, which appear excessively expensive and vulnerable to a pick-up in inflation.

In sum we expect 2009 will be an up year for stocks. Longer term we are not so sanguine. Power is shifting from Wall Street to Washington. Governments are not as efficient as markets at allocating capital to its highest and best uses. It appears that government as a percentage of the economy will rise to World War II levels. Marginal tax rates too are likely to rise to levels reached in those years. Overall we expect slower growth. On the plus side there will be opportunities, because change always creates opportunities.


Mark O’Brien