Review & Outlook

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

Fourth Quarter

13 January, 2010 by Mark O'Brien in Quarterly Letters

Stocks rose about 20% in 2009 (the Dow up 19% and the S&P 500 up 24%), which by any measure would make it a very good year. But investors are hardly happy. That’s because the ten-year period ending December 31, 2009 was one of the worst decades, in terms of wealth building, in the last 200 odd years (Wall Street Journal, Dec 21 09) . As for the strong showing in 2009, it was a bit like sprinting the final stretch of a race after everyone else has finished. So what? Last place is still last place. What investors cannot forget is how many great American institutions did not survive the decade: American International Group, the world’s largest insurance company; Citigroup, the world’s largest bank; General Motors, the world’s largest auto manufacturer; Fannie Mae and Freddie Mac, the world’s largest mortgage lenders. And then there was the destruction of Lehman Brothers, Bear Stearns, Merrill Lynch and the rest of Wall Street, not to mention the hundreds of so-called “New Economy” Internet companies. All those jobs lost, all those shareholders wiped out. The wealth destruction was staggering. No one is exuberant (though most are relieved) that 2009 made a strong finish.

In terms of O’Brien Greene, we did better than survive; we made money over the past ten years. Firm-wide performance was considerably better than the performance of the S&P 500-stock index (the S&P 500 is the customary standard of comparison in the investment business).  Our portfolios vary a good deal from one to the next, but on average they rose about 30% as compared to a 9% loss in the S&P 500 index over the 10 year period.

So why did our portfolios go up some 30% when the S&P 500 fell in price? The big reason has to do with the start of the 10-year measurement period, when we chose not to participate in “New Economy” Internet stocks; and later on in the decade, when we chose not to buy new kinds of debt with funny names like “collateralized debt obligations” and “No Doc” mortgages, even though these forms of debt had triple-A ratings, relatively rich yields, and the patronage of big institutional investors. In avoiding these New Economy innovations, we gave up some short-term performance, but in the long run our portfolios rose 30% on average when “No Doc” mortgages and collateralized debt obligations joined the ash heap of good ideas gone awry.

So where are we today, as we start the new decade? Investors are still cautious and fearful, which suggests the stock market rally still has some room to run. For instance most of the money withdrawn from money market funds last year (some $500 billion) went into bonds. It looks like investors are less interested in price change and “beating the S&P 500” (the focus of the early years in the last decade) than they are in more responsible goals, like locking in a stable stream of income. Low-quality stocks – – meaning companies with high debt and sagging demand, like the autos, banks and mortgage companies – – are looking a bit toppy. Who is buying them? Mostly hedge funds. They got too cheap in 2008 and the first quarter 2009, and for the rest of 2009 soared in reaction. Meanwhile stable and high-quality stocks like Exxon and Procter & Gamble have been marking time.

Our portfolios own high-quality stocks. They are up nicely through December 31, 2009 (in double-digit figures) but the S&P 500 is up even more at 24% thanks to the boost from the low-quality sectors. Anyone trying to best the price performance of the S&P 500 must own more of the banks, auto companies, mortgage companies, than are in the S&P 500 index.  We think unemployment is too high and consumer sentiment too uncertain to play this game. Thus we would still own stocks, but leave the low-quality sectors to the hedge funds, regardless of how well they are doing in the here and now.

Further out in the decade, what does it look like? The past 10 years saw the risk-return relationship stood on its head:  the less risk one took, the more one’s reward – – the very opposite of the normal risk-reward relationship.  It was one of the few such periods in American market history when risk-taking was punished.  We are unlikely to have another such 10 year period. Rather in the decade ahead, we expect a return to the old rules of valuation when stocks (known in the business as a “risk asset”) do better than bonds and money market funds. We would add a qualification, though: while we pick stocks to outperform other asset groups, we don’t think stocks will equal their annual historical rates of return of 10%.

The reason we think stock returns will lag their historical average is that dividends are low. Over the past 85 years, stocks have paid dividends of 4.2% a year. Presently dividends are about 2% a year, and companies are not in a position to increase them. We think stocks can appreciate 5.3% a year, which is their historical average, because the most populous nations of the world (India, China, Indonesia, Brazil) are industrializing, and likely to take over from American consumers as the driving force behind world economic growth. Even so one arrives at a total stock return (2% dividend plus 5% price appreciation) in the 7% range, which is materially lower than the historical return from stocks of 10%.

We don’t expect bonds to pick up the slack. In fact, high quality bonds have done so well in recent years that we don’t think they have much appreciation left. The trends that fueled the rally in bonds (mostly the big decline in inflation from double digits in the early 1980s to virtually nonexistent today) seem ready to reverse course. If inflation returns and the Fed raises interest rates in response, bonds will be lucky to return their coupon of 3.8% a year (using the 10-year Treasury as a proxy of the bond market).

Altogether, then, expectations are muted, in contrast to those of ten years ago, when the sky was the limit, and market commentators spoke of a New Economy, a peace dividend, the triumph of market capitalism and the end of history. But muted expectations are not a bad thing, and a return to average, or even slightly below average, is a lot better than what we have had the past ten years, and we will be grateful for that.

Sincerely,

Mark O’Brien