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S T. J A M E S I N V E S T M E N T C O M PA N Y
I N D I V I D UA L P O RT F O L I O M A N AG E M E N T
INVESTMENT ADVISER’S LETTER
APRIL 15, 2010
W W W. S T J I C . C O M
2 7 1 6
FA I R M O U N T
DA L L A S,
T X
S T R E E T
7 5 2 0 1
F I R S T Q UA R T E R L E T T E R
MARKET COMMENTS
After a brief drop in January and early February, the riskier end of the stock market is back in favor. This market surge includes small‐cap stocks, stocks badly hurt by the financial crisis and those equities most dependent on global economic growth. Safer stocks, those that St. James prefers, are out. This was not the case between January 19th and February 8th, when the Dow Jones Industrial Average fell 8% on concern that the global recovery would stall. Since this inflection point, the Dow is up 12% and investors are turning to the same stocks that led the market higher in last yearʹs big rally. By a number of measures, the smaller and lower‐quality stocks are once again out‐performing larger, higher‐quality equities: o
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The 50 smallest S&P stocks have substantially out‐performed the 50 largest stocks. Companies with junk bond ratings have out‐performed those with investment‐grade ratings. The 50 stocks with the highest price‐to‐earnings ratios, compared with analystsʹ expectations for their 2010 profits, are up double those companies with the lowest price‐
to‐earnings ratios. The most heavily shorted stocks are up double the least‐shorted stocks. Companies rescued by the U.S. government have also fared well, as American International Group fell 22% from January 19 to February 8, and has since rebounded to $36 per share, or 67%. American International Group trades on hope rather than fundamentals. If the company’s assets were liquidated today, the stock would be nearly worthless as AIG carries $102 billion in government debt and $45 billion in private debt. Although the company recently announced the sale of two large Asian insurance operations, completion will only reduce AIG debt to $111 billion. Even if the debt were somehow repaid, there is still $46 billion in preferred stock in line before the common equity. Fortunately for AIG, the U.S. Treasury is charging 0% for this preferred stock. If the Treasury charged a rate of 8% on this preferred stock, AIG would need to pay out roughly $27 in preferred dividends per share of common stock. As analysts expect AIG to earn $4.89 this year, the sale of AIG’s Asia and Japan divisions means the company will lose about $2.50 of that $4.89 estimate for earnings. Obviously the simple math does not work for this company. And yet in the space of only seven weeks, the company’s common stock jumps by 67%. Financial stocks, which were among the most damaged during the bear market, have been among the strongest gainers this year and last year. U.S. financials are up 21% since February 8, based on financial stocks in the Financials Select Sector SPDR. Since the bottom on March 9, 2009, financials have outperformed the S&P 500 by 150%. As was the case last year, sectors St. James Investment Company, Page 2
perceived as safe have been the weakest performers since February 8 – such as dividend‐paying utility and telephone companies. When we look back at the last twelve years, starting from the implosion of Long Term Capital Management (LTCM), the market has rallied by 60%, followed by a 50% selloff, followed by a 100% rally beginning in 2003, followed by a 60% selloff, followed by a 70% rally beginning in March, 2009. And yet, the equity market is essentially flat over that period of twelve years – tremendous volatility but no gains. The simple lesson may be that an investor will not lose out by going long after a 50% collapse from the high; nor are they likely to feel much pain from selling into a 70% rally from the low. Investors chasing the lower quality names at this juncture in this rally are probably unwise. Blackrock is the largest asset manager in the United States with more than $3.3 trillion in assets under management. Blackrock remains firmly bullish on the economic recovery although they do caution that risks remain. In their latest strategy note, Bob Doll, the company’s equity strategist, highlighted several of the risks facing the markets, but maintains that equity markets have largely priced these risks in. “In summary, we believe that the recession probably ended in June or July of last year, and while the jobs market normally lags in a recovery, the lag has been unusually long in this case. Nevertheless, the March payrolls report signaled what we believe is the start of a long‐awaited rebound in the employment picture, which should be beneficial for the broader economy. As fiscal and monetary stimulus begins to fade over the coming months, the economy is going to require some self‐sustaining mechanisms to kick in, and growing employment levels would certainly be beneficial. Over the course of the next year, we expect that the economy will successfully shift from an economic recovery to an economic expansion. This environment of continued improvement in the economy combined with still low interest rates and improving corporate profits, represents a sort of “sweet spot” for risk assets. As such, we think it makes sense for investors to continue overweighting equities and credit‐related fixed income assets and underweighting cash and Treasuries.” St. James Investment Company, Page 3
After reading Mr. Doll’s commentary, several points come to mind. First, the reality is that the economy is not the market. Too many investors assume that there is a certain cause‐and‐effect relationship between one and the other. There is a relationship, but it is usually only apparent in hindsight. Secondly, there is not one mention of valuations in his entire commentary. Valuation determines entry price and entry price is a critical component of an investment’s rate of return. It is not difficult to appreciate that stocks in general are overvalued and unattractive right now. The Wilshire 5000 is an index of U.S. stocks from ExxonMobil all the way down to stocks of less than $1 million in market capitalization. Today, the Wilshire 5000 is selling for around 22.9 times earnings. Think of it this way, the stock market is offering to pay you about 4.37% a year on your money. We doubt most investors find a return of 4.37% that exciting—risk does not justify reward. Contrast the stock marketʹs offer of 4.37% a year and no guarantee with the governmentʹs offer to pay you a guaranteed 4.74% for 30 years on money you lend it today by purchasing a 30‐year treasury bond. It is not much better, especially when you consider that the governmentʹs 4.67% is a pretax return. After‐tax earnings on government bond yields are less than 3%. Why would anyone lend to the government at that yield today? In general what about owning stocks? It is one thing to get Wal‐Mart at 12 times pretax earnings (8.3% earnings yield), with its exceptional business model, consistent profit margins and perpetually rising dividend, or Microsoft at 13 times pretax earnings (7.7% earnings yield). But 22.9 times earnings for a market index? The safest corporate bonds do not offer anything much better than stocks or treasuries. Moodyʹs double‐A bond yield forecast for the month of March is 5.56%, or about 17.8 times pretax earnings. Aside from earnings yields, cash dividend yields offer little excitement for investors. The Wilshire 5000ʹs cash dividend yield is still under 1.9% ‐‐ at that level an investor will double their money every 37 years. A third way to look at stocks is to compare their total market value to the size of the U.S. economy. As of the latest report by the Bureau of Economic Analysis, the United Statesʹ current dollar GDP is $14.3 trillion. The entire market capitalization of the Wilshire 5000 is approximately $13.3 trillion. Therefore, stocks trade around 93% of GDP. Ideally, stocks are attractive at less than 80% of GDP and cheap at 50% of GDP. The stock market is not compensating investors adequately for the risk they are taking. The market does not offer enough earnings or enough dividends. To clarify, that does not mean that there are absolutely no stocks cheap enough, safe enough, and just plain good enough to buy today—consider Microsoft. While a broken financial giant on government life support (AIG) is up 20% year‐to‐date, Microsoft is down about 3%. Microsoft is the most valuable company in the technology sector and is just beginning its largest product upgrade cycle in nearly two decades. Microsoft St. James Investment Company, Page 4
generates huge free cash flow, pays a 2% dividend and currently trades at a sizeable discount to our estimate of fair value for the company. Microsoft’s highly rated Windows 7 operating system was released in the fourth quarter of last year, succeeding its disappointing predecessor, Vista. However, the majority of businesses did not upgrade but continue to use Windows XP, which first appeared in 2001. There is clearly demand for Windows 7 after most businesses passed on upgrading to Vista. Microsoft Office 2010 is the next product in the upgrade cycle queue followed by SharePoint 2010, a product platform for businesses. Microsoft’s Bing search engine has increased its market share to 11.5% and is increasingly becoming an alternative to Google’s dominant search engine. Whatever short‐term concerns cloud analyst opinions about Microsoft over the next quarter or two are immaterial to the company’s long term value. Microsoft’s software is firmly entrenched in most homes and organizations and will continue to create value and return cash to its shareholders. Microsoftʹs trailing free cash flow is about $18.7 billion. With the enterprise value (market capitalization + debt – cash) at $229 billion, the stock sells for just above 12.5 times trailing free cash flow, a cash earnings yield of about 8%. We would make the argument that Microsoft is a better and safer investment than U.S. Treasuries. Microsoft pays a shareholder 3% more yield than long‐term Treasuries. Treasury coupons cannot grow. A Microsoft ʺcouponʺ can and will continue to grow. Vista sold 180 million copies and was considered a failure. Windows 7 has received very strong reviews and should sell considerably more than Vista’s 180 million copies. That higher level of sales is virtually all profit. If Microsoft generates $20 billion in free cash flow for the fiscal year ending June 30, 2010, and it could, the stock will be valued at 11.3 times free cash flow. Microsoft also provides ʺgrowth insurance,ʺ in the form of an ongoing, massive share repurchase program. On share repurchases alone, all else equal, the stock could appreciate significantly over the next year or so. And while AIG and Microsoft have little in common, the market’s willingness to bid up AIG’s stock while Microsoft languishes is a stark reminder that markets are a popularity contest in the short‐term. INVESTMENT PHILOSOPHY
Sir John Templeton, widely considered one of the top investment legends of the 20th Century, built a billion‐dollar fortune investing in the stock market and selling mutual funds to the public. In June 2005 he penned a number of predictions in a memo he titled “Financial Chaos”, three years prior to his death in 2008 (at the age of 95). Fortunately, his son recently released this memo found among his belongings. In short, Templeton believed that the peak of prosperity was behind us, dangers were more numerous and larger than at any time in the last 90 years, and countries around the world would experience financial chaos for many years. In hindsight, Templeton was right on target in his assessment of the world. The question is, how much more ʺfinancial chaosʺ is there still to come? Templeton says it will last ʺmany St. James Investment Company, Page 5
years.ʺ The main reason is that none of the excesses Templeton was so worried about have been resolved—the excesses have mostly been shifted to our government’s balance sheet. Take the homebuilding industry, for instance. Of all the industries that had overcapacity, the homebuilding industry was one of the worst. It built over 1.5 million new houses per year between 1998 and 2006. In 2005, the homebuilding industry built over 2 million new houses. New home sales are currently running around 300,000 a year. Meaning, there is significantly more capacity than the industry needs. And yet not a single major homebuilder has gone bankrupt since the credit crisis exploded in 2007. The government assisted the industry with a number of tax breaks and subsidies. And thanks to a strong stock market rally, the homebuilding industry has been able to recapitalize itself by selling more shares to the public. Templetonʹs memo predicted this kind of absurd government support, too. ʺVoters are likely to enact rescue subsidies which transfer the debts to governments.ʺ So where does Templeton suggest one put their money to protect it from this “financial chaos”? John Templeton liked stocks. More specifically, he liked businesses with perpetually wide profit margins and operations all around the world: ʺNot yet have I found any better method to prosper during the future financial chaos which is likely to last many years than to keep your net worth in shares of those corporations that have proven to have the widest profit margins and the most rapidly increasing profits. Earning power is likely to continue to be valuable, especially if diversified among many nations.ʺ In other words, if you are worried about continuing financial chaos, you could do worse than buy stock in companies like Johnson & Johnson, Procter & Gamble, Wal‐Mart, Novartis, Kraft, Medtronic and ExxonMobil. The beauty of this approach is simple ‐‐ if Templeton is wrong and the worst of our economic troubles are behind us, these stocks should still perform well. However, the lesson is that an investor must stay focused on what really matters: price of assets in relation to value, sources of cash flow, margin of safety, and entry price. Importantly, an investor must avoid becoming overly fixated on variables they cannot control. Yes, graphs like the following one give us pause at times, but our investment objective is always to purchase companies like Microsoft at the right price. St. James Investment Company, Page 6
The authors of an article published in The Journal of Finance (Volume LV, No. April 2000) came to the logical conclusion that ʺtrading is hazardous to your wealth.ʺ The two researchers studied over 66,465 online trading accounts for a period of six years, from 1991 through 1996. They found that the average traderʹs returns were about 6.5% less than the overall market—the average mutual fund manager routinely performs only 4.8% worse than the market. In general, the more active the average trader is, the more he loses as there is too much competition. As a trader, you must compete against firms like Renaissance Technologies, SAC Capital and Goldman Sachs, firms with billions of dollars of trading capital and floors full of PhDs sifting through mountains of data with unlimited computer processing power. Fortunately, creating wealth through the ownership of publicly traded equities is not nearly as complicated as Wall Street would have you believe. Jim Rogers, author of Investment Biker, summarized the simple truth to investing and creating wealth: “Take your money and put it in Treasury bills or a money‐market fund. Just sit back, go to the beach, go to the movies, play checkers, do whatever you want to. Then something will come along where you know it is right. Take all your money out of the money‐market fund, put it in whatever it happens to be and stay with it for three or four or five or 10 years, whatever it is. Youʹll know when to sell again, because youʹll know more about it than anybody else. Take your money out, put it back in the money‐market fund, and wait for the next thing to come along. When it does, youʹll make a whole lot of money.” Warren Buffett does not day trade – he invests. When asked about managing money, Buffett gave this simple advice, “Your default position should always be short‐term instruments. And whenever you see anything intelligent to do, you should do it. That just means you should keep your money in cash and wait for an investment to come along which you understand well, is safe, and looks like a winner.” There is just one problem with this simple strategy of sitting in cash and investing only when circumstances are ideal‐‐human nature. Nobody wants to be patient. Yet patience and discipline create a sustainable advantage in a market driven by short term concerns. Warm regards, Robert J. Mark Larry J. Redell Portfolio Manager William R. Sachs Brian C. Mark St. James Investment Company, Page 7
S T. J A M E S I N V E S T M E N T C O M PA N Y
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ounded St. James J
Invesstment Com
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2010Q1
St. James Invvestment Companyy, Page 8