How you view the level of the stock indexes depends on your perspective or starting point. We just passed the five-year mark from the bottom of the bear market in October 2002. The markets had a strong five years and have done very well since July 2006. That sounds like a bull market.
Take a longer viewpoint and the returns are not as impressive. Index fund shares that were purchased in 1999 and 2000 have earned modest returns, lower than those from treasury bills for the most part. Even those shares purchased in 1997 and 1998 earned mediocre returns. In the mid-1990s we began worrying about the prospect of another period similar to 1966-1982, when the market indexes were stuck in a wide trading range. Buy-and-hold investors fared poorly during that period, as they have since the late 1990s.
Perhaps we are stuck in a period similar to 1966-1982. Perhaps that the recent record highs in major indexes mean we are out of the trading range and the bull rally has more room to run. But trying to predict the markets is not the route to long-term investment success. Better returns are earned by investors who look for mis-valuations and insist on having a margin of safety in each of their investments. A key to long-term investment success is to avoid large losses. It is better to give up some gains when an investment gets overvalued than to hold on and ride the investment down to a lower valuation.
Instead of trying to forecast the markets, we focus on where the risks are. We reduce or eliminate investments with the highest risk and increase our holdings of those with low risk. Let’s look at where the risks and opportunities are today.
Sector and Balanced Managed Funds
Technology and commodities are among the hottest investments for the last year. They have not been in our portfolios for good reasons.
Technology stocks seem to be rising based on momentum and speculation. The final prices for technology products continue to fall, and business capital spending is not exactly robust. Consumers are spending on electronics, but only as prices decline. Valuations for many technology stocks are fairly high. Also, as in the late 1990s, investors are starting to buy stocks of companies with strange names and untested businesses.
We owned commodities early in their bull run, but they are at much higher prices now. While global growth has increased demand and prices, investment speculation also is behind the price increases. There also is the risk that if global growth pauses after this five-year surge, commodity prices could plummet. There is little margin of safety in commodities.
International stocks continue to be the leaders of the world’s capital markets and also of these portfolios. We continue to earn solid gains from Longleaf Partners International, which is up 20% for the year. The fund is a deep value investor. It purchases only stocks that management believes are selling for about two thirds of their intrinsic value as estimated by the fund’s analysts. The fund looks at more than numbers. It also evaluates management, competitive position, and future earnings potential.
Longleaf’s managers warned in their second quarter Letter to Shareholders not to become exuberant about the gains in international stocks. The strong returns in global markets have pushed prices to the point that management is having trouble finding stocks selling cheaply enough to add to the portfolio. Cash in the fund is increasing. The decline caused by the credit crisis last August was some help, but stock prices recovered quickly. Even so, management remains optimistic about the prospects for the global companies it owns.
Also benefiting from the global boom is another deep value fund, Wintergreen Fund. We added David Winter’s fund last month as the credit crisis sell off hit its bottom.
Wintergreen is another margin-of-safety buyer that searches the globe for good companies selling at big discounts to their real values. It also will let cash build when it does not find companies that meet its criteria. The fund declined less than most during the credit crisis and quickly surged beyond its pre-crisis level. It is up almost 25% for the year and 8% for the last month. That’s pretty good for a fund that puts safety first.
A little over 30% of the fund’s stocks are in the U.S. The next biggest allocation is over 12% in Hong Kong, which primarily is a way to profit from the boom in China. Its largest holdings are Japan Tobacco, Wynn Resorts, Jardine Matheson Holdings, Berkshire-Hathaway, and Consolidated-Tomoda Land. About 15% of the fund is in cash. Its biggest sector allocation is to financials. That is a real testament to the fund’s stock picking ability, since financials took the biggest beating in the credit crisis and are the laggards in the U.S. indexes this year.
Manager David Winter was a longtime employee of the Mutual Series funds and has demonstrated his ability to identify undervalued stocks and put together a portfolio that outperforms the market indexes. Most importantly, his fund has less risk of significant losses than the indexes or most other global funds.
Risk control is a key element of our international stock investments. The international markets can be more volatile than U.S. markets. Instead of seeking the highest short-term returns, we are invested in two funds that buy only stocks selling at discounts and that have lower risk than the alternatives.
Last month we also ventured back into the public real estate markets with Third Avenue Real Estate Value. This is another fund that buys only companies selling at discounts to the private market value estimated by the fund. It declined less than most other real estate funds did in their bear market this year.
A key advantage of TAREX is that is it takes advantage of the international boom by purchasing shares of real estate companies around the globe. After the big decline manager Michael Winer wrote to shareholders, “Well-funded, opportunistic investors are now able to buy at bargain prices.” He said that the correction priced in all the bad news related to the credit markets. The fund estimated that within a few months U.S. REITs went from selling at 10% premiums to net asset value to 20% discounts.
The laggard in our portfolio continues to be Oakmark Select. The fund concentrates in 30 or so stocks and also looks for those selling at deep discounts to management’s estimates of their value.
The fund has a number of winners, such as McDonald’s and YUM Brands. But it also owns several companies that lag well behind the market. It is exposed to U.S. housing through Washington Mutual, Home Depot, and Pulte Homes. It also owns Limited Brands, which like many retailers has had disappointing sales lately. A lack of commodity-related companies and big global brands also hurt relative performance.
Management believes that the laggards in its portfolio are well-managed and selling at attractive prices. In fact, they are priced as though investors expect a recession while most other stocks are not. The fund will stick to its successful long-term buying criteria and will not chase companies that have done well in the recent past and now are highly valued.
We will continue holding the fund. Washington Mutual and some of the other troublesome stocks already have had good bounces. The fund has proven itself over the years and says the companies operations are performing better than their stocks. We will give them more time to let their strategy pan out.
Rounding out these portfolios, of course, is the “hedge fund” Hussman Strategic Growth. Hussman has a bifurcated strategy.
The fund buys a diversified portfolio of stocks that have high earnings growth but attractive valuations. The fund’s stock picks have outperformed the major market indexes since the fund’s inception.
The second part of the strategy is to use options to either hedge or leverage the portfolio. Fund management uses a series of indicators to determine the market valuation and the market climate. If both the valuation and climate are negative, the portfolio might be completely hedged against a market decline with options that gain in value if the indexes decline. If both factors are positive, the portfolio might be leveraged with options that rise with the indexes. When the indicators are mixed, the fund might not use options or be partly hedged or partly leveraged.
For some time, the fund’s indicators have shown the broad market to be overvalued and overbought. This does not mean management expects a bear market or a crash. Instead, its studies show that conditions similar to today’s result in low average returns for the next ten years. The low returns often are the result of a generally rising market that is interrupted by steep market declines that erase 50% or more of the previous gains.
The conservative strategy of Hussman Strategic Growth allows us to take more aggressive positions in the rest of the portfolio. This fund should rise during any extended market decline, and that should offset any losses incurred in our other funds. When the market rises, Hussman will hold steady or rise modestly while the other funds will have strong returns.
This strategy enabled us to earn strong, solid returns over the last few years despite the wide fluctuations in the market indexes.
Income Growth and Income Portfolios
Interest rates and bonds still are adjusting to the after-effects of the credit crisis. Treasury rates generally are drifting up as investors ease their way back into riskier investments.
There still are some warning signs in the fixed income markets. Treasury rates are rising, as are rating on investment grade corporate bonds. Since the end of the credit crisis, yields on riskier bonds have declined. One would expect these yields to decline after the crisis ended, because at the worst of the crisis they were at extreme levels. But they have settled in at levels that do not reflect their risk.
The result of these changes is that the spread between yields on treasuries and riskier bonds is wider than before the crisis, but it still is only at or below long-term average levels. Income investors still are not being paid enough to take the risks in these bonds.
The performance of high yield bonds shows the stages of the crisis. Before the crisis, Price High Yield was up about 2.5% for the year, and Vanguard High Yield returned about 1%. By late July, Vanguard was down over 6% for the year and Price showed a 4% loss. By mid-October Price recovered enough to be down just under 1% for the year and Vanguard’s loss for the year was under 2%. Riskier funds have had strong recoveries but remain well below where they started the year. Despite the wild fluctuations of the last few months, investors still are not being paid enough to take risks in the fixed income markets.
Jeff Gundlach, chief investment officer of TCW and manager of the TCW Total Return fund, believes that the mortgage crisis is in its mid to early stages. There should be more restructurings and defaults over the next two years as the aggressive loans taken out in 2005 and 2006 have their interest rates reset at higher levels and borrowers try to refinance. In the corporate high yield bond market, defaults or at or near record lows. It remains to be seen if that level can be maintained in the next few years if economic growth remains low and businesses that were purchased the last few years with large amounts of debt try to make their interest and principal payments.
After all the credit market fluctuations this year, most bond funds have either no gain for the year or losses. Investors in money market funds or short-term bonds are on track to earn 4% to 5% for the year with none of the fluctuations or risks of loss of the other fixed income choices. Don’t be a yield hog. Manage risk and the income and gains will take care of themselves. November 2007.