Centre Street Cambridge Corporation

Private Investment Counsel

Commentary

October 2009

A ship in harbor is safe, but that is not what ships are built for.
–William Shedd

It is a principle as ancient as it is wise: capital should be put to productive use and not safely hidden away earning no return. Representing a society’s (or individual’s) accumulated surplus, its proper employment is in investment to enhance the community’s well-being and benefit future generations. But obtaining these benefits comes at a price. Just as a sea captain faces the possibility of a storm when a ship puts to sea, so, too, does investing entail inevitable risks that must be accepted and prepared for. Ships are designed to take a beating. Capital commitments should be “seaworthy” as well.

The worldwide financial crisis and collapse in securities markets which followed in its wake have revealed that many of the commitments made in recent years were anything but ship-shape, leading to enormous losses. In response, owners and managers of capital have moved large sums to money funds and treasury bills, which offer safe harbor but virtually no yield. This might not be bad policy if the alternatives entailed high risk and offered meager potential rewards, but since the crisis began, unusually attractive investments have at some times become available (and in greater numbers than we have seen in years) while risks were considerably reduced. As a result of fear and timidity, opportunities for increasing wealth have been missed.
                                                                       
The manner in which so many investors large and small have conducted themselves during the “Great Recession” of 2008-2009 is by no means unique in the history of financial market disasters. First, a long period of economic calm and rising markets induces people to embrace price “momentum” and forget the importance of valuation in investing. Eventually, as markets become increasingly divorced from underlying fundamentals, some unexpected news or event breaks the speculative spell and induces waves of selling. Increasing market volatility leads to more selling and heavy losses. Not surprisingly, many would-be investors flee to the safety of cash and nurse their wounds, often for long periods of time.

This behavior of going to extremes can be traced at least in part to faulty conceptions of risk and equally flawed procedures for dealing with it. Just as it would be foolish for a ship to set sail in the face of an approaching storm, it would be best for investors to avoid the financial equivalent: upheavals or poorly-judged ventures that could permanently impair capital and sink any hope of enhancing wealth. Whereas foul weather is easily perceived, and experienced navigators recognize the telltale signs of impending storms, the threats to financial well-being are harder to see as they are often greatest during periods of smooth sailing when few signs of rough seas ahead exist, even for the seasoned operator. The “Great Moderation,” as it was known in the middle of this decade, was one such period, characterized by relatively small price changes and narrow valuation differences between assets of differing quality. Similarly, the months preceding the Crash of 1987 and the bursting of the Dotcom bubble in 2000 were calm, and optimism over the outlook for the economy and advancing stocks was high. It is for this reason that the widely-held theory which views price volatility as the major threat in the financial markets is so fundamentally misguided.

Viewed solely from the perspective of volatility, the last several months have been risky in the extreme, with equity prices fluctuating with hurricane-like force, first falling and then rising over 50% during a relatively brief time span. Such price instability may have negative economic consequences as it dampens asset values (not to mention spirits), and experiencing fluctuations of this magnitude can indeed be harrowing. However, price variability is actually of no direct concern for the investor; on the contrary, it should be of great interest. At the height of the turmoil, for example, many companies saw their stock prices cut in half or more, due to fear of the negative impact on their businesses from an impending recession. When viewed with emotional detachment, however, one could conclude that there was no real rationale for the steep price declines and that most of these companies would go on more or less as before when the economy recovered. Eventually people will view the sharp drops in market capitalizations as having been in fact a great buying opportunity. Throughout our economic history this has always been the case. When one prominent market operator of a century ago was asked the recurring question “Will the market go up?,” he replied “It always has.” Nevertheless, the daunting aspect of volatility and fear that prices will fall still further inhibits rational calculation and prevents most market participants from perceiving and exploiting the opportunities.

Investors for whom volatility and “market risk” are figments of statisticians’ imaginations have reacted to the crisis in a very different way. For us the optimistic markets leading into 2007 were fraught with risk and offered little reward in return. On the other hand the ferocious storms of the last two years meant smooth sailing ahead as valuations were reduced. Our focus on price level and expected return has been rewarding thus far. As in the case of bond yields, the two move in opposite directions: as prices fall, expected returns rise, all other things being equal. When viewed from this perspective, far from being a risk, the great volatility of the past year has been the investor’s friend, bringing exceptionally low prices in some cases, thereby greatly enhancing the prospects for good returns in the coming years.

Offering a glimmer of hope for those not fortunate enough to be part of the bonus and golden coffin culture, someone is making money in stocks this year in spite of the fact that the public is still avoiding equity funds and that market skepticism reigns among the soothsayers. The major market averages gained 15-16% in the third quarter alone, bringing year-to-date results for the broader gauges of stocks to about 17%. (Had this been any other year, market enthusiasm would be high, and there would be no talk of stocks “getting ahead of themselves.”) Foreign markets did even better. European bourses rose 18-21% in the September quarter. “Emerging” markets continued their exhilarating moves upward: a broad index of this group rose 20%, atop the second quarter’s 34% pop. Most of the money moving around the money-management system ended up in fixed-income funds, however, continuing the “flight to safety” and stability. Bond funds attracted over $200 billion through August. In an interesting twist, in spite of the trepidation over stocks, it was in the lowest quality bonds where most of the action took place. If you didn’t like stocks, but still wanted “equity-like” results, the best place to go was apparently junk fixed-income.

On a sobering note—while the latest news from the markets has been positive, equities are still down over 30% from their peak two years ago. If that were not enough to give pause, Standard and Poor’s points out that stocks would have to gain nearly 40% by year-end in order to break even for the decade since 1999. Bond fans correctly observe that investors in risk-free treasury notes have done better over the same period. Equity returns always look poor after a plunge in prices occurs, so no conclusions regarding long-term results from stock versus bond investments should be drawn from the current picture. Recall also that stock prices were quite high in 1999 (and historical returns relative to bonds very attractive), making for low expected returns at that time (valuation matters!). That stocks declined subsequently is not surprising. This should be food for thought for bond enthusiasts who now are paying record prices for treasury securities.

The Yard Sale Investor

We have long felt that yard sale and flea market enthusiasts possess the ideal temperament needed to become good investors. With eyes trained to spot objects of real usefulness and value among the flotsam and jetsam of Saturday morning basement-clearings, they develop a true investor mind set. There is no concern about whether the prices for items will rise or fall after purchase, or with their “growth” potential. Value is based on what is known in the here and now. Securities can be viewed in the same fashion. While certainly not the only way to approach the stock market, it does have an excellent pedigree, and a long and successful history besides.

There are many similarities between flea and stock markets. Both are venues for the trading of “secondary” goods—items being handed off by their original buyers. As any yard sale aficionado will tell you, most of the stuff is just junk, as is the case with stocks, only with stocks “junk” status is somewhat more difficult to determine, and, to be fair, beauty can definitely lie in the eye of the beholder. It may be the case that a stock’s price is simply too high, or that the company’s business or balance sheet are in terrible shape. To the trained eye attractive situations stand out among the detritus. After a while the investor develops an almost innate ability to spot gems where others see nothing of interest or value.

Yard-sale-like investing comes into its own during market collapses because its adherents are ready to take advantage of such situations and do so with gusto. It’s as if an “Everything Must Go!” sale takes place and all types of goods from expensive jewelry to old baby clothes gets dumped with equal abandon. Commonly used yardsticks such as “growth” or “value” fall by the wayside as bargains appear throughout the stock list, permitting even the finest merchandise to be purchased cheaply. This has been a good year so far for us yard-sale cheapskates.

 

Dennis Butler, MBA, CFA