We entered 2009 where we left 2008 . . . still bullish. In fact, in addition to the constructive stance outlined by The Broyhill Letter, we were bullish enough to share a few additional direct emails with clients, family and friends during the first quarter of the year. In January, our “Market Outlook” for the year set the following tone:
“Economic conditions are likely to remain challenging throughout the year, but the amount of stimulus building in the pipeline makes a cyclical rally in equities increasingly likely. We are certainly not wildly bullish today, but we believe most of the perceived threats are priced in and we have likely experienced “the point of maximum pessimism” which has historically represented a tremendous opportunity for long term investors.
“The consensus is looking for a rally and we all know the consensus is almost always wrong. But I think there is a very good chance that the consensus is wrong in underestimating the magnitude of this move. Barron’s recently reported the results from their annual survey of Wall Street strategists and the average the group in aggregate is looking for an 18% gain in the market this year. Better yet, the top recommendations were Health Care and Consumer Staples. Not a chance defensive sectors lead the way in a bull market. This is quickly getting to be a very crowded trade and most measures of mean reversion we watch show the deep cyclicals (materials, industrials, etc.) extremely oversold. While we are not yet willing to back up the truck into the financials and consumer discretionary sectors (secular risks are still tremendous here), we have covered many of our shorts here and are beginning to look at more cyclical longs that still fit the High Quality bill.
“After selling nearly all of our emerging market exposure after the group got massacred in July and August, we are beginning to nibble here as well. Asian and Latin American markets are deeply oversold and offer better value than developed markets. The quantitative models we run monthly are showing aggregate risk levels for global equities at historic lows. Lower prices and reduced risk levels, combined with exploding liquidity and extremely oversold momentum, are conditions typical of powerful advances in equities.”
Accordingly, we discussed our bullish thesis on China and Emerging Market Equities in the Q1-09 Broyhill Letter, which we reiterated a few months later in, Blowing Bubbles. Obviously, we haven’t remained quite so bullish on Chinese growth since then. Our tone and positioning has changed with price and sentiment, as we first noted one year later in, A Cautionary Fable. But the setup in early 2009 was drastically different than it is today, as fixed asset investment has since spiked to dangerous levels. The difference being that four years ago, investors were on the front end of a historical surge in money and credit:
“The story in China is fairly simple. It is the only country that has actually implemented a broad based and large scale stimulus program, and the impact is beginning to show. The sheer size of the investment, relative to the size of the economy, is approximately twice as large as the U.S. fiscal stimulus program. They are in the fortunate situation of having ample resources to do this. The Chinese economy operates in an authoritarian regime where political power is firmly controlled from the top allowing the Chinese government to implement its policy initiatives very effectively. This is a rare moment where an authoritarian regime has its advantages. A recovery in the Chinese economy that will likely lead the global economy will be distinctly bullish for Chinese equities as well as for stocks in markets closely related to the Chinese economy, including a number of China’s neighbors in Asia and commodity producers around the globe. The massive resource requirements of the Chinese economy imply a compelling long-term case for the commodities asset class as the economy recovers.”
The charts below illustrate the action in the Shanghai Composite pre and post credit boom:
We changed gears in Q2-09, focusing on our favorite Switch Hitter at home. Our investment thesis on the technology sector at the time was based on the belief that the industry offered the best of both worlds – an economically sensitive group of stocks with fortress-like balance sheets:
“There has been a dramatic change in capital markets since the turn of the millennium, but the Technology industry in particular has undergone a metamorphosis over the last decade. At the height of the go-go nineties, the sector sold at over 50 times peak earnings and at an average free cash flow yield of less than 2% while the long bond offered almost 6%. Implied growth expectations were questionable at best. Since those exhilarating days the sector has been rationalized, and today’s survivors offer a current free cash flow yield of 9%. After a long stay in growth stock purgatory, a different beast has emerged, and now the numbers are skewed in investors’ favor. While the growth outlook isn’t what it was in the heyday of the 90s, the fundamentals rest on a much stronger foundation.
“Technology’s long stay in growth stock hibernation has, in all likelihood, come to an end as the bottom in fundamentals looks to have been around the turn of the year. Considering the depth of the current cycle, margins have held up extraordinarily well. Following the bubble bust, businesses tightened their budgets to a point where investment dramatically undershot its long-term trend. As a result, earnings should prove less cyclical than prior cycles when investment in technology had overshot. The survivors offer strong operating leverage, global franchises and unparalleled financial flexibility. The consensus neither anticipated nor believed the underlying shift in the sector, and despite their rhetoric, current yields tell us that skepticism has yet to be extinguished. While no longer trading at depression extremes, the sector still offers a free cash flow yield more consistent with those seen at major cyclical troughs. More than any other sector, Technology offers what interests us most: an under-represented and under-valued opportunity with improving fundamental trends.”
The Q’s rallied 55% in 2009 and tacked on another 20% gain in 2010. For what it’s worth, this remains one segment of the market where we are still finding pockets of value today, but watch out for those landmines!
Our first two letters of the first year of this recovery carried a very bullish tone. As we noted then, “Our favorite macro theme for this year has been cyclicality. We believe government efforts to reflate will be successful and see stocks discounting a brighter outlook over the course of the year.” That’s exactly what we saw during the first three quarters of 2009. So we took a step back in October, and considered what we believe is one of the most common and most dangerous assumptions in finance.
In the Q3-09 Broyhill Letter, we outlined our views on asset allocation. With the crisis still fresh in investors’ memories, we felt it was an important time to consider lessons learned, or at least those we hope should have been learned:
“It’s been said that no crisis should go to waste, and experience shows that every bear market leads to important changes in investor behavior. Now that the credit bubble has burst, we believe investors need to reassess the virtues of diversification. They would be well served to look beyond the traditional models of portfolio construction which provided a false sense of confidence at exactly the wrong time. To better protect capital against large draw-downs and increase long-term returns, investors should only increase risk exposure when justified by expected returns. The long term average real return from the stock market is about 6.5%. But average rarely happens! Investors that routinely construct “diversified” portfolios on the basis of “average” long-term returns have overlooked one critical point – starting valuations matter!! In fact, valuation remains the single largest determinant of expected long term returns. The rules change with the opportunity set.
“Many investors look down on dynamic asset allocation as mere “market timing.” Getting the timing right on asset class moves is extremely difficult in any given year. But over ten years, the odds are clearly in our favor. Coming up with reasonable estimates of fair value for various asset classes is certainly achievable; an investor who refuses to do so is making the dangerous assumption that expected asset class returns are not dependent on starting valuations. We have a view at Broyhill that you can’t be so long-term that you don’t pay attention to current events. Or as Keynes morbidly reminds us, in the long run, we are all dead. Rather than waiting for “average” (as Jeremy Siegel might suggest), we think asset allocation begs for a tactical component that is very hard for many investors to deal with because they aren’t structured to think about the big picture. Thinking “macro” doesn’t mean being an eternal pessimist; it just means making sure you are getting paid for taking risk.”
Our last letter of the year struck a notably different tone after a record surge in risk assets off the lows reached in early 2009. I recall writing it very clearly. We had spent months putting together our collective research on agriculture and I was finalizing the draft when a snow “storm” (defined as one or two inches in North Carolina causing the entire state to shut down) kept me at home for the day. For better or for worse, me and Stella spent the day doing exactly what most kids do on a snow day in December. We read “This Time Is Different” by Carmen Reinhart and Kenneth Rogoff cover to cover. You could say that the mood in our office was a bit more somber the following day.
As a result, we tossed aside our yet-to-be-published letter on agriculture, and began writing our Q4-09 Broyhill Letter on the emerging Sovereign Debt Crisis. We certainly weren’t the first to warn of the troubles brewing in Europe, but you could say we gave investors a comfortable head start on the damage to come:
“A generation of reckless debt accumulation has left us at a difficult crossroads. Markets have grown entirely dependent upon an extraordinary degree of government stimulus to remain afloat. But that stimulus is not without cost and is ultimately dependent on investor confidence and willingness to finance careless spending. History suggests that there is a limit to such deficit spending and the cost of abusing this privilege will end tragically. As a percentage of total global defaults, sovereign debt defaults remain at a generationally low level. That can change, especially when one considers the record amount of sovereign debt issuance by governments in mature economies. Indeed, the database compiled by economists Carmen M. Reinhart and Kenneth Rogoff spanning eight centuries of government debt and default, suggest as much.”
While Greece may have already been front-page news at the time, most investors believed the issue was “contained” – and few were looking at the bigger picture or the larger risks ahead:
“In our opinion, Spain poses an even greater threat to the strength of the Eurozone and the Euro given the country’s much larger economy, much larger housing bubble, and much greater levels of leverage than most of the developed world. Spain is still wrestling with the collapse of a decade-long housing boom that has hurled the broader economy into a deep recession, sent tax revenues plummeting and social welfare costs soaring. Spanish housing indices reached greater heights than most other global housing bubbles, yet have declined only single digits from their peak. The bubble looks even more extreme when viewed as a ratio to rent, where The Economist puts the market 55% above fair value.”
The charts below illustrate the cost of insuring your farm against a PIGS default since then:
European leaders have been behind the curve ever since. But three years later, we exhausted ourselves worrying about Europe’s sovereign debt crisis. And so we took the logical next step as European equities fell to multi-decade lows, trading at single-digit normalized earnings multiples – we bought them, as noted in a Brief Update on Portfolio Strategy last year.