First, let’s be clear: 2008 was an awful investment year.

Second, the year might also be summarized by this familiar exchange:

Elaine: …I will never understand people

Jerry: They’re the worst!

Seinfeld, among other things, offered a cynical view of the human condition. More often than not, Jerry, Elaine, George and Kramer were harshly critical of most anyone they met. To them, other human beings – despite eons of biological, social and economic development – were not only untrustworthy or corrupt, but also a severe nuisance! And that’s about how we feel looking back at 2008: how could human beings act so badly? Logic would dictate that, over the years, humanity should advance. After all, haven’t we become more knowledgeable, more capable, more principled? But in the first decade of the 21st century, how does one explain Illinois Governor Rod Blagojevich, who ignored – with profanity-laced bravura – the obvious scrutiny of investigators and apparently tried to auction off a U.S. Senate seat? How about Marc Dreier, the well-known New York attorney who created phony securities to defraud hedge funds, only to be captured in Toronto in early December while impersonating someone else to complete a fraudulent deal? Don’t forget Elliott Spitzer, the self-righteous New York Governor who was felled by the same sword he wielded so brazenly in his own anti-crime efforts. What were these guys thinking?

And then there is Bernie Madoff, whose recent arrest not only overshadowed these other bad characters but also added a tragic and painful exclamation point to 2008. Madoff’s Ponzi scheme flourished for years despite published skeptics who highlighted his firm’s unusual structure and secrecy. Madoff controlled both investment decision-making as well as custody of client underlying securities, necessary requirements for executing his fraud but red flags for anyone concerned with how he generated such stable returns in seemingly every market environment. It’s worth noting that at Harris Associates, in addition to the transparency that comes from investing in publicly-traded equity and debt securities of sufficient size and liquidity, we do not exercise any custodial control over the securities our clients own. We regularly reconcile our own client statements with position and trading information from the custodians that hold the actual securities, a mundane (yet important) check in the current environment. And while we would admit the allure of steady and predictable investment performance, we have always reinforced to clients the inherent volatility of markets, as well as the absence of a free lunch. Return and risk, as Madoff reminds us, are joined at the hip; if the story sounds too good to be true, it probably is.

Madoff and the others also highlight the current bear market in trust. The recent scandals have clearly undermined investor confidence, but in many ways, the damage had already been done: the collapse of an over-leveraged housing market, shoddy analytical work by the rating agencies and banks that propelled the bubble, plus off-the-charts volatility and across-the-board market declines in 2008 that embarrassed most investment professionals (who now need to redefine for their clients the magnitude of a “bad year”). Even though our own view of the landscape offers plenty of reasons to remain optimistic and invested, we readily admit the government’s deepening involvement – while understandable and necessary in many respects – hardly helps rebuild confidence. The various government liquidity, bailout and takeover plans – and the constant revisions and additions in recent months – have added a feature of complexity and uncertainty that fail to inspire confident investment decision-making.

It would be a vast understatement, then, to call the massive rush into Treasuries as ironic. While it’s understandable that burned investors would gravitate to the apparent safety of U.S. government securities, the magnitude of the move seems way overdone given not only the rushed (but crucial) fiscal and monetary responses, but also yields which border on the absurd. With 30-year Treasuries below 3% and short-term T-bill rates dipping below zero on occasion in recent weeks, the faith that Uncle Sam will guarantee and protect purchasing power during and after the current crisis seems to be without question. While the past year’s experience injects a large dose of humility into any investment discussion, we cannot embrace the investment proposition of shifting funds to long-term Treasuries where the best-case outcome delivers something close to zero (before inflation). While we do have a certain degree of faith in, for example, the strength and ideals of our Republic, that doesn’t mean that as value investors we must invest patriotically or blindly. Admittedly, the massive flows into Treasuries and money market accounts are driven more by fear and the need for liquidity than high investment expectations, but the risks may be just as great as those who wrongly chased New Economy stocks a decade ago. Our balanced, taxable portfolios do own some shorter-term Treasuries where price risk is minimal, but the potent mix of: 1) fear-driven flows into long-term government paper and 2) an equally fearful policy response which, in a nutshell, seeks to create inflation every day, leads us to search for better investment alternatives for our clients.

Admittedly, it’s not easy to get past the brutal barrage of bad news. We now know the recession started over a year ago. Homebuilding activity has continued its crash since the peak in 2005. Over-leveraged consumers are under intense pressure as job losses accelerate. Every statistic released in recent months confirms significant economic weakness, and nearly everyone agrees the numbers are likely to get a lot worse. The reported GDP decline of this cycle may surpass that of every economic downturn since the Great Depression. And the torrent of bad news seems to hit us every day – an exhausting loss of hope akin to that experienced by Bill Murray’s character in Groundhog Day: Will this ever end?

But to gravitate to the so-called “risk-free” asset class at this point runs counter to the opportunistic sensibility our firm has exercised for over three decades. In the rearview mirror, the U.S. stock market just finished its worst annual performance since the 1930s, and stocks as an asset class have underperformed Treasuries for the past decade. These historical facts now provide false comfort to investors who have recently fled seemingly riskier securities for Treasuries but do nothing to ensure even capital preservation with the prices of risk-free assets at such extended levels today. Recall that bear markets (and bubbles, too) are generally driven to extremes by emotion as much as valuation or other fundamental factors. When emotions run high, however, basic discussions about valuation, competitive positioning or financial strength tend to be ignored, as they are today. Fear and greed rule, not dispassionate analysis. And the policy responses – fiscal and monetary – as well as the adjustments by individual businesses to a tougher environment may also be overlooked as tangible healing suffers from inevitable time lags. In this context, we are very reluctant to bet on an outcome where returns from Treasuries – over a reasonable investment time frame – will dominate other investment prospects.

In fact, the inventory of attractive opportunities grows daily. Our primary focus is squarely on businesses with the financial strength to weather a harsh environment where investors have marked down the price to a significant discount to our best estimate of the enterprise’s intrinsic worth. Across the board, our analysts have assumed substantial weakness in earnings and cash flow for an extended period. Still, our Approved List of stocks trades at levels we have rarely witnessed: based on our sense of “trend” profitability, our stocks trade at less than 10x earnings, less than 6x cash flow and at near 50% of fair value. Furthermore, the average industrial business we own covers its debt costs 10-to-1 (as of 9/30/08), a reassuring indicator of financial strength. One could easily question our future earnings estimates in the midst of a steep economic slowdown, but even if our analysts have overestimated trend earnings by 50%, our stocks still sell at not much more than the average historical market P/E ratio. In the context of rock-bottom risk-free yields, we believe this state of affairs implies an unmatched relative comparison, if not a once-in-a-generation absolute opportunity.

Years from now, market historians will look back on this rotten period with predictable certainty. They will weave a story of a market slide that was driven by not only structural instability (too much leverage within a naturally cyclical environment) but also the mistakes of individuals (Greenspan, mortgage bankers, credit analysts, Madoff) who helped destroy trust in securities markets. As this era shows, humans have a real talent for outdoing each other! After the old structures fell and individuals were punished, as the story will be told, a subsequent period of rebuilding ensued: regulatory structures were redrawn, businesses adapted to new realities and trust once again returned. Today, it is impossible to know the how or the when of the second part of the story, but we believe it will occur, if only because so many people today fear it will not. Our experience, long-term focus and faith in the raw fundamentals of businesses that we own give us confidence that the prospective returns are attractive for equities. We recognize the path to recovery is unlikely to be straight, but we also know that to ignore the current set of facts guarantees low returns, above-average risks as well as a lost chance to rebuild portfolios once confidence and trust inevitably return.

Edward S. Loeb
quarterlynews@harrisassoc.com