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Curb Your Enthusiasm
1/9/2004
Like Larry David, the main character on HBO's hit comedy series, we often find it uncomfortable to embrace good fortune: we've learned it often pays to be a bit paranoid when others are complacent. "Curb Your Enthusiasm" covers the mundane, daily life of a neurotic, angry Hollywood writer who seems perpetually dissatisfied even when times are fortuitous (in fact, Larry David co-created "Seinfeld", and his character is reminiscent of curmudgeon George Costanza). We at Harris Associates are not quite as anxiety-ridden (hopefully!) as Larry-after all, we have been sensibly optimistic in the face of broad investor pessimism over the past year or so-but as our clients know, our investment process always includes a healthy dose of skepticism. So today, while most investors (and our clients) celebrate 2003's remarkable stock market performance, we want to exercise care; we are fully aware there are likely hidden bumps in the road ahead. The long-term story, as we will discuss, still looks pretty favorable for stocks, but the market's recent rise-the strongest year for the S&P 500 since 1998-creates greater short-term risk as valuations have risen and new buying opportunities have become more scarce.
The market's strong showing since late 2002 reflects the favorable resolution of a number of issues investors found fearsome. As we have reminded our clients over the past few years, most investors have increasingly focused on headlines and short-term macro fears rather than long-term likelihoods. The list of concerns included: the approaching war in Iraq; terrorism; a weak global economy; possible deflation; corporate governance scandals; and most importantly, the painful memory of a three-year bear market for stocks. Despite today's enthusiasm, the mood in October 2002 was decidedly pessimistic. We wrote:
...Most investors have felt enormous pain for the past several years. This pain has created an air of intense fear that has spread throughout the economy and our markets. Investors have responded by selling their stocks and mutual funds and heading for apparently greener pastures. But the argument for stocks today rests firmly on several foundations...Stocks look to be much more attractive than bonds...And investor sentiment is extremely negative, setting the conditions needed for market recovery.
In fact, things turned out even better than we imagined. In Iraq and the Middle East, the worst fears never materialized: Saddam is in custody, Gadhafi has opened Libya to inspectors, and the vast majority of nations-France, Germany, Russia and China-have joined the anti-terror campaign and proved helpful. At home, massive fiscal and monetary stimulus kept deflation and deep recession at bay. Strong productivity has boosted profits to an all-time high, capital spending is growing once again and consumer confidence is up. And so investors have decided to put to work some of their low-yielding cash reserves (about $300 billion of net inflow to equity mutual funds in the past twelve months).
With all this bright news, one would imagine we're jumping for joy around Harris Associates. In fact, our enthusiasm is muted: despite gratifying recent market performance, we have found the last several months to be quite frustrating. First, the market-in a broad sense-seems to adequately reflect the improved earnings picture and favorable external environment. Depending upon the particular measure used, the P/E ratio for the S&P 500 (using consensus 2004 estimates) hovers near 20x, an above-average figure that clearly reflects positive investor sentiment. More importantly, we've had a more difficult time identifying individual stocks or even sectors that might offer new purchase opportunities-there seem to be few clear valuation anomalies given the breadth of market recovery over the past year. Many investors may prefer a high stock market to maximize their current spending power, but we must admit that as long-term investors, we occasionally prefer an environment of uncertainty, pessimism, fear and thus low valuations. The idea, after all, is to buy low.
Even though we don't make economic forecasts, it's worth noting the long-term economic story remains pretty favorable. Worldwide GDP growth appears to have gathered meaningful steam over the past few quarters, and even the more sluggish European and Japanese economies are growing again. The U.S. economy in particular has proven to be remarkably resilient, and the case for further growth is strong, driven by higher profits, rising capital spending, additional stimulus from last year's Bush tax cuts, low inflation (the lowest in 40 years!), and a better-than-expected budget deficit picture. Many are worried the recovery is endangered by sluggish employment growth, but it would be risky to bet against improvement in the jobs picture. The headlines shout loudly about lost manufacturing jobs, but that trend has been in place for fifty years (and is even occurring in China right now!). The fact is that rising productivity and the migration of production and services to lower-cost sources raises living standards. The U.S. economy's dynamism and adaptability remain important strengths, and the employment story is likely to continue to improve now that businesses are spending again. Overall, there are no obvious clues the economic fundamentals will disappoint, and so the economic backdrop looks as good as it has in quite some time.
There is another support for investor enthusiasm: low tax rates. The recent tax law changes support higher P/Es, all else equal. With taxes on dividends and capital gains now at 40-year lows, the taxable investor earns a higher return on stocks, thus justifying higher prices at the margin. In fact, the stock market in the late 1950s/early 1960s (when interest rate and tax conditions were similar) supported fairly high P/Es for some time. In any case, today's P/Es don't look nearly as wacky as those seen in the nosebleed late-1990s.
All of these factors argue for satisfactory long-term returns from equities, particularly compared to prospective returns from bonds or cash. With interest rates already near historical lows and the economy in recovery, fixed income investors might be fortunate to simply earn the current low coupon on their bond investments. Stocks, on the other hand, offer the opportunity to piggyback economic progress while delivering rising and tax-advantaged dividends to a degree not seen for some time. Today, even if stocks as a group are close to "fair value", we believe long-term returns are likely to outpace most other major asset classes. We must remind ourselves there are no truly "safe" investments-even low yielding money market funds face inflation risk.
But the short-term picture is less clear to us. Our analysts have found it challenging to identify new buy candidates in recent months. As we like to describe our investment philosophy, we aim to pay 60 cents or less for the stock of a business we think is worth $1.00 (our sell target is typically in the range of $0.90-$1.00). While at any time the stocks in our portfolios cover the whole spectrum between our buy and sell targets, today our average holding trades near the middle of this range. While this level still offers acceptable returns-and easily justifies maintaining equity ownership-the upside is definitely less than we would prefer given our value-oriented roots and conservative demeanor. It does not support unbridled enthusiasm.
The optimism reasserting itself in the stock market is certainly welcome news to those who suffered so greatly after the Bubble popped. But it is not, in our opinion, time to "Party Like It's 1999"; we worry that some areas of the market increasingly reflect outlandish growth expectations that will prove very difficult to achieve for the second time in the past half decade. The momentum players whose focus is rarely on company fundamentals or valuation face a demanding future if their assumptions are based on a continuation of the red-hot market of the past year. Such an outcome is certainly possible, but the market's rise offers little cushion should unexpected obstacles appear. Our position in this environment is to maintain exposure to equities as long as individual stocks trade below our value estimates. Obviously, we continue to look for new ideas for our portfolios, but we expect to maintain our well-known discipline. As much as possible, we also want to emphasize quality businesses for our portfolios: strong cash flow dynamics, sensible management teams and strong balance sheets. Thankfully, many such stocks remain among the most reasonably priced in the market today, and so we feel well positioned for an environment that would bring out the best of Larry David or even George Costanza. To be clear, we see absolutely no evidence to support a breakdown in the long-term story for equities, but a bit of caution seems just right for today's market.
Edward S. Loeb
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