February 20, 2009
Dear Client
After some optimism at the end of 2008, the market (S&P 500) has turned down again in recent weeks and currently trades near the lows of last November. Not only are we dealing with the worst economy since the Depression, but now there is talk of nationalizing some of the country's largest banks. The new administration has some good ideas (and some bad ones too) but has failed to communicate these ideas well and to implement them quickly. Unemployment is rising quickly, and many economists now expect that it will reach 10% during this recession. While that does not come close to the Depression era's 25% unemployment, it is daunting nonetheless.
I wish I could tell you exactly how the US and the rest of the world will pull out of this deep slump, but I can't. I believe the stimulus package and some of the government programs to loosen credit will help, but ultimately it is a matter of people regaining the confidence to buy things and to take risk. That is hard to predict.
Also hard to predict is how far the market can fall before it stops going down. In the short-term markets are driven by fear and greed, in this case mostly fear. In the long-term, emotion is replaced by rational decision-making. I am much more confident about how the market will perform over the next 5 years than over the next few weeks.
We have just about finished earnings reporting season, and companies consistently said three things: 1) The quarter was bad, about as expected. 2) 2009 is going to be a tough year. 3) They are cutting costs and restructuring to position the company for the eventual recovery. Generally speaking the stocks we own are financially secure, and in many cases their competitors are pulling back. For example Accenture, which competes in the consulting and business outsourcing market, has over $3b in net cash. Its competitors include Satyam, which is for sale after the CEO was accused of fraud, and BearingPoint, which recently declared bankruptcy. As the global economic picture improves, Accenture should thrive due in part to weakened competition.
Another reason I am optimistic about the long-term future for our holdings is the unusually attractive valuations we see in the stock market today. I have talked in the past about Viacom and its strong cable network franchises like Comedy Central, MTV and Nickelodeon. I expect earnings for Viacom to fall 10-20% this year due to weak advertising trends and the strong dollar. However, I expect Viacom's free cash flow (the cash the company generates after paying all its expenses, interest and capital requirements) to be over $2 per share. With the stock trading just above $15 per share, the "free cash flow yield" - think of it as a cash-on-cash return - is close to 15%. Government bonds yield 2-3%, but with Viacom we can essentially get a 15% yield in a terrible economy. In a more rational environment, investors will bid up a stock like Viacom to reduce the yield to a more normal level, like 7.5%. That would suggest a doubling in the stock from the current price.
More generally I believe our overall portfolios have the same kind of potential, and here is why. Historically the stock market has traded at about 15x earnings. Our top 20 holdings, which most of you own, trade at a P/E level of about 11x on 2009 earnings (of the 20 stocks I excluded one outlier on either end). And that is on a depressed earnings level. Suppose that earnings for our stocks increase 45% over the next four years (not much of a leap considering the low 2009 base) and that the P/E multiple returns to the 15x long-term average. Our stocks would double. So I am willing to take the risk that the market may fall further, because the upside over the next several years is substantial.
It has been a frustrating period in the market. I am hopeful the worst is behind us, but I have little conviction about when and where the market will bottom. I am also hopeful that the next several years will bring much better investing results, and in that I have great conviction.
Please feel free to get in touch with me at your convenience.
Thanks,
Bill Jacobs
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