For those unsure of the facts, Security Analysis is considered THE seminal work on value investing, and Graham and Dodd represent the founding fathers of a fundamental investment approach that has proven its worth and importance over 75 years. It is more than ironic that such an influential and renowned piece of work – still used as a textbook today – emerged during the worst economic and market downturn our nation has ever witnessed. Graham and Dodd advanced many important concepts, but from today’s vantage point, one is struck by the discipline they advocated amidst the market lows following the Crash of 1929. While the economy and markets reeled – equities were in serious disfavor – Graham and Dodd understood that an economic recovery would someday arrive as would the market recognition of underlying value. Then, attractive returns could once again be delivered to those owning cheaply priced securities which could survive the stress and unpredictability of their era. The authors offered no insight as to how or when the economic cycle would turn; instead, they placed their faith in the fundamental strength of individual companies, their intrinsic value and the inexorable process of value recognition.

These same concepts are firmly embedded in our own DNA at Harris Associates, and our core philosophy is a critical tool to help combat the natural tendency of investors to panic during periods like this. For too many months, we’ve all witnessed an unrelenting flow of bad news, and admittedly, we believe a rapid economic and market reversal is unlikely. Yet our value discipline has highlighted a sizeable value opportunity, and within client guidelines we have sought to at least maintain equity exposure by emphasizing the strongest businesses trading at discounts that continue to amaze us. In recent weeks, thankfully, this discipline delivered some much-needed encouragement to our client portfolios as the market enjoyed another solid bounce from depressed levels, indicating that the fundamental factors we regularly emphasize might once again be in ascendance. Overall, however, it was still a negative quarter for the market.

That’s NOT to imply we’re confident the worst is completely behind us. When Graham and Dodd penned those words 75 years ago, the Dow Jones Industrial Average was in the midst of a 23% decline, merely the eighth decline of more than 20% since the market’s 48% “Crash” in late 1929. Pundits of that era had already been humbled by false recoveries: two massive rallies in 1932 and 1933 that each took the DJIA up more than 90%! The roller-coaster of the 1930s would continue, culminating in another 49% capitulation in early 1937. Bull and bear runs (i.e. alternating changes of more than 20%) are, sigh, a regular feature of market history despite the illusion of stability that comes from examining long-term averages. Even with the S&P 500 (as of 3/31/09) off about 50% since its slide began in October 2007, most would probably be surprised by the magnitude of the year-end bounce we all enjoyed just a few months ago (+24%). These gyrations are humbling – and humiliating – reminders to all market prognosticators.

It makes one wonder why Graham and Dodd even bothered writing. The Crash of 1929 wiped out many investors, and the subsequent economic Depression put a premium on holding plain old cash. Trading volume on the stock exchanges dried to a mere trickle as the 1930s wore on, as most remaining investors were literally incapacitated, dazed by the flood of new government programs, intense market gyrations and depressing economic woes. Every market surge and retreat brought investors more exhaustion, as well as increasing skepticism over the long-term role of equities. As we also know, even the activist approach by President Roosevelt failed to deliver the needed quick fix to the economy. The situation bears some obvious similarity to today’s set of challenges: an economic decline now stretching toward 18 months in duration and of greater magnitude than anything we’ve seen in generations; an activist government trying anything and everything; and a dreadful stock market that has driven many investors away from equities.

It would be foolish for anyone to completely dismiss the potential for a full replay of the 1930s, but the circumstances really do argue for a different pathway. Briefly, the current economic decline – GDP is off about 1.5% so far from the peak – pales in magnitude to the earlier period when GDP shrank 46% between 1929 and 1933. It’s probably fair to say that mechanisms such as unemployment insurance, bank deposit insurance and the current level of ongoing government spending have all served to cushion the economic pain so far versus 75 years ago. In addition to the massive fiscal stimulus plans we read about each day, the economy has already been helped by some meaningful monetary and other stimulus, including rock-bottom interest rates (30-year mortgages now below 5% and housing affordability at a new high), and falling energy prices (gasoline costs alone down by about $20 billion a month). And even though we have a great deal of skepticism about how all the newfangled Treasury and Fed programs like TARP, TALF, PPIF and others might actually play out, the fact is that in recent months credit spreads have narrowed, corporate bond issuance is at record levels and we have seen several major mergers announced.

These improving indicators, however, are still overshadowed by some real questions that no one can truly answer: Will the massive fiscal programs and associated deficits do more harm than good? Do the banks have enough capital? Will inflation come roaring back? How big is the risk of rising trade barriers? The uncertainty these issues raise is exhibited most clearly in the huge reservoir of cash now sitting in money market and savings accounts (by some accounts, upwards of $8 trillion, more than the entire market cap of the S&P 500). Evidence is also plentiful throughout the corporate sector, where businesses – just as unsure as investors about the economy’s trajectory (and also burdened by concerns of future availability of capital) – have slashed inventories and capital budgets. As we detailed in last quarter’s letter, the lack of confidence is pervasive, and the atmosphere of caution creates its own negative feedback loop. Everyone now seems to have battened down the hatches. But what if investors have become too pessimistic? What if the storm ends up being just slightly less than our worst fears? What happens when the marginal business decides it’s worthwhile to order a little more inventory? What is the impact when some investors decide that owning a debt-free, robust business with a solid dividend (and at a cheap price) outweighs the near-zero yield on his cash? What happens to market prices when they already reflect a worst-case outcome…and then there is a positive surprise?

Yes, these are rotten times. But markets adjust, and it seems as if more and more of the current market level is based predominantly on investors and companies looking at each other for answers that no one can provide. As Graham and Dodd so well explained, securities prices in the short run are really the product of the collective action of millions of investors who look to the market itself for investment guidance. But the market price at any given time may be quite divorced from reality: fear, greed, panic, comfort all tend to rule the day more than true fundamentals. Over the longer run, however, we strongly believe the intrinsic value of the business will be uncovered, and securities owned at a meaningful discount to that value should deliver positive investment returns. At some point, we believe investors will begin to anticipate recovery, and the fear that has driven so many individuals to hold cash will subside; the fundamental attractiveness of equities will become more apparent, and market prices will better reflect fair value.

We cannot, unfortunately, prove to our clients this day will come soon (if we have learned anything recently, it is humility). Anecdotally, we perceive a lot of scared investors, oversized cash reserves and market gyrations that tend to reinforce and confirm investors’ caution. We observe nearly unlimited government intervention designed to prevent the worst-case economic outcome. We also see, just as occurred in the 1930s, historical performance charts that further reinforce a negative outlook for stocks despite the irrelevance of rearview mirror investing (in fact, just like similar periods, the prospective returns for stocks from the depths of the mid-1930s were excellent for the next 5, 10 and 20+ years). As Graham and Dodd might contend, the current depressed prices of the fundamentally strong businesses we own in our portfolios argues for very attractive returns in the coming years. With all of our experience and judgment, we believe the odds are decidedly in our clients’ favor.

Edward S. Loeb
quarterlynews@harrisassoc.com