Three months ago we reiterated the curious upside-down market environment: “quality” appeared to be priced cheaply while “risk” looked expensive. Our own frustration was drawn from the market’s recent (and persistent) disregard for stronger, dominant businesses while investors’ love affair with commodities, emerging markets and similar asset classes blossomed. In effect, financial market valuations appeared quite compressed with little differentiation among assets of widely varying quality and risk. In support of our view, an analysis of our Approved List showed strong fundamentals (yet unrewarded price performance) compared to those of what we believe to be much weaker businesses. We also highlighted a few anecdotes such as Russian and Iraqi government debt (trading at seemingly narrow spreads above US Treasuries), perhaps reflective of speculation and overconfidence among many investors.

In early May, without much warning – perhaps Bernanke’s loose lips? – investors were reintroduced to financial market volatility. Many of the world’s hottest markets seized up, as investors tried at once to squeeze through the exit door. Over the course of the next several weeks, price volatility measures (which had been at 10-year lows) doubled, and investors who had come to rely on the positive price momentum of these commodity and emerging markets suffered significant reversals¹:

Admittedly, these markets generated huge returns in the past few years, but these declines from peak levels wiped away in some cases up to two years worth of price gains; it was a painful reminder to those investors that risky assets are, in fact , risky. But none of this should have been surprising – it’s really the same story we’ve seen many times before as investors search for high returns without regard for risk. The euphoria created by rapid price momentum and high real returns on investment draw more and more capital until the system becomes unstable and is susceptible to the slightest change in sentiment. In the case of metals and mining companies, for example, rising commodity prices have lifted returns on capital for these businesses to more than double their long-run averages. But these high returns have also boosted spending for new capacity, and inventories are now rising. We believe future returns are highly likely to fall, just as they have in every instance of a rising commodity price. A year ago the headlines identified rising global demand and tight supply in nearly every commodity, but we are now seeing plenty of anecdotal evidence of meaningful supply responses: huge buildups in Chinese coal inventories, crashing lumber prices, the biggest expected increase in oil supplies in three decades, etc. For those who banked on high prices for an indefinite period, the current environment is quite unsettling.

It’s been our suspicion for some time that these speculative markets have drawn a meaningful amount of investment capital away from the higher quality businesses we’ve favored in our portfolios in recent years. In addition to significant reported flows toward funds focused on emerging international markets, some recent estimates show a 20-fold increase in funds dedicated to commodity investing since 1999. While accurate data is difficult to come by, the size and speed of this phenomenon has led us to suspect these markets have come to be dominated by investors driven more by short-term momentum than patience (it certainly would not be the first example in recent memory). With the benefit of hindsight, it would have been wonderful to participate to a greater degree in these market trends over the past two years. But the historical fact remains that these markets typically offer a higher level of risk that is only occasionally priced to adequately compensate long-term investors such as us. In recent letters we have plainly stated our aversion to chasing these markets, and it now looks as if that prudence is being recognized.

That is not to say our concern with the stability of some commodity markets leads us to a suddenly pessimistic view of the U.S. or global economy, or even the financial markets. We have been impressed with the persistent level of growth worldwide over the past several years and believe many positive elements are likely to foster further growth, albeit at a reduced pace. It has been a Goldilocks environment – neither too hot nor too cold – driven by new technologies, strong productivity, intense global competition, and strong corporate profits. In fact, three consecutive years of double-digit profit growth for U.S. businesses have even helped slash the budget deficit, which is now running at less than 1.5% of GDP. The economy’s vitality is further expressed in the explosion in merger and acquisition activity, where bulging cash balances are driving activity to record levels. While financial players are driving some fraction of this bustle in an attempt to deploy client funds, a substantial amount of the M&A activity is aimed at improving the global positioning of corporate players worldwide, a more constructive aim.

At the more important portfolio level, we do think it’s worth the risk of repeating ourselves in order to briefly review the favorable factors underpinning our enthusiasm. First is the strong record of fundamental operating performance for our holdings: as a group, our Approved List has generated double-digit revenue and operating profit growth over the past three years while reducing debt and generating greater amounts of cash for capital projects, dividends and share repurchase. Today, our holdings tend to be larger, higher return, more industry-dominant businesses than we have owned in a very long time, and this upgrade in quality is deliberate given the market opportunity set. As owners of these businesses, we have been very satisfied with their operating performance and per share value growth.

An equally important factor is the great valuation compression we have detailed in recent commentaries. We would strongly argue that today’s compressed market fails to differentiate among businesses of varying quality and risk: we see high quality businesses with dominant franchises priced at parity with second-tier alternatives. Our recent trades have been designed to take advantage of this opportunity – to own businesses with reliable cash earnings power, good growth prospects and solid balance sheets – without paying a premium to do so. Broader market data supports the notion of this opportunity: according to ISI Group, the P/E ratio of the S&P 500 (a larger company index) has declined by 50% over the past five years, rivaling the P/E ratio compression during the bear market of 1973-74. Given solid profit growth and below-average interest rates, we believe the stock market, at about 15x current year earnings, would seem to offer better opportunities than most other asset classes. As stock prices have continued their stall, the price compression we’ve highlighted has only become more severe. And so, in our opinion, the opportunity remains meaningful.

While we strongly believe the valuations of our current holdings set the stage for improved absolute portfolio performance in the coming years, valuation itself is unlikely to be the sole catalyst that moves stocks higher from current levels. We are encouraged, however, that the reappearance of volatility in the broad investment environment will remind investors there is rarely a free lunch. We have always prided ourselves on playing a more disciplined game than many of our competitors, and while this has required some patience in past quarters, recent market volatility highlights the long-term benefits of our current positioning. We would certainly admit the continued presence of numerous macroeconomic risks – housing, energy disruptions, inflation/interest rates – but as we have previously argued, these broader risks seem well-discounted by investors. Most importantly, a lackluster equity market has generally been the friend of investors like us, and it has provided us with a wonderful opportunity to own some very strong businesses – with below-average risk profiles – trading at large discounts to intrinsic values. Our level of conviction remains quite high, and we look forward to further recognition of our portfolios’ strong position.

Edward S. Loeb
quarterlynews@harrisassoc.com

¹Price changes represent peak-to-trough market price performance during Second Quarter of 2006.