2011 Third Quarter
Based on this past quarter's news, I could come up with 1,001 reasons not to buy stocks right now. Our own government came very close to defaulting on their debt payments during the last two months and the government divide between the Democrats and Republicans seems as wide as ever. Standard and Poor's - one of three main credit agencies - came out and lowered their credit rating on U.S. debt from AAA to AA+ and partly blamed the lack of government cooperation as a reason for this downgrade. Greece and many of their friends within EuroLand continue to scare investors from stocks due to their flirtations with their own default risk. Add to this mix an increased possibility of the U.S. entering another recession and you have a recipe for some poor stock market returns in the past three months. I could go on and on about reasons to avoid stocks and run for the hill, but I don't have to...you have read and listened to the news reports.
As you know by now, the stock market does not move in a straight line - it takes zigs and zags to get to the result we are looking for. The fact that the Dow Jones Industrial Average rose or fell more than 1% in 29 of the past 43 trading days is mind boggling, but not surprising. Everything I have read lately says that we should get used to these volatile sessions - they are part of the fabric of investing in stocks at this time. One of my main concerns is that many small or young investors may be scared away from investing in stocks due to this market volatility. This would be a tragic mistake. As we can all agree, stocks should be purchased as an investment and not as a speculative gamble. The high frequency trading that individuals or institutions partake in is nothing more than casino gambling and is not based in the strong fundamentals of buying companies that are deeply discounted with solid balance sheets and positive cash-flows. It is upon this premise that our value funds base their philosophy.
And therein lies the truth of the matter. Value managers love volatility. Think of them as managers with a wish list of stocks to buy. When the total stock market index has a sale of 10 to 20% off, the managers will check their wish list for any companies selling at values they believe are discounts. Some managers, like our friends at First Eagle, will hold cash until stock market sales come about; others will remain fully invested in stocks. As we all know, holding a lot of cash will place a drag on the portfolio when stocks are red hot. Obviously, we trust that if something has changed in the corporation's underlying model that the managers would take this into account, but otherwise these managers are like kids in a candy store. In fact, Warren Buffett felt intrigued enough with the general negativity placed on stocks this past quarter that he went out and re-purchased his own Berkshire Hathaway stock. He felt it was selling at a discount to where it should have been selling. I have mentioned this before in a previous quarter-end letter but it bears repeating here: Sir John Templeton made a lot of his money on the eve of World War II when things looked pretty bleak. What we face today is peanuts compared to what Mr. Templeton's generation was faced with in 1939.
So, what is an investor to do in this climate? As Chuck Royce - manager of Royce Total Return - says in his third quarter commentary: "Be patient and take the long view." Many of the issues we are confronting can be solved by people. Whether that is through bi-partisan support in Congress or by France and Germany coming together to form a strong coalition that will be there to support European banks invested in bonds from Greece. The bottom line is that I don't know what will spark the stock markets in the near-term. However, we do know that stocks as measured by the S&P 500 are selling with a P/E ratio of 11 when the historical average is 15. While they were cheaper in 2008, I don't believe this is a repeat of that year. Mr. Royce continues, "I think the current mood is so unrelentingly negative that even a small-scale positive surprise could shift the mindset of investors to a positive perspective." The managers at First Eagle Overseas add: "So the world is imperfect, but equities are being priced to deliver reasonable real returns for long-term investors against a back drop of no real returns on government bonds. In our view, equities remain the least worst choice for a long-term investor."