Overview
Q: Is this recovery for real?
Q: How do concerns about the economy factor into investment decisions?
Q: In today's uncertain environment, how do you evaluate potential investments?
Q: How is the Portfolio constructed today?
Q: What were your biggest mistakes and the lessons learned?
Concluding Thoughts
Overview
The chart below summarizes results through December 31, 2009 for Selected American Shares compared with the S&P 500 Index against which my co-manager Ken Charles Feinberg, our colleagues and I judge ourselves. Our goal is to outperform this Index after fees over the long term as we have done over the last five, 10 and 15 year periods as well as since Davis Advisors began managing the Fund in May 1993. Over the last decade, our results have exceeded the benchmark by 3.19% per year after fees. Although this is a more than satisfactory relative result, the Fund's absolute return of only 2.24% per year is a grim reminder that this was one of the worst decades for stock investors since the Great Depression. As large shareholders in the Fund, we know the truth of the old expression "you can't eat relative returns" and therefore seek to generate satisfactory absolute and relative returns. For the trailing five year period, while still exceeding the market, both our relative and absolute results were anemic. Finally, though we tend not to focus on shorter term results, we are glad that 2009's 31.64% return was strong on both an absolute and relative basis and that it sets us on the path toward making up the ground we lost in recent years.
In the pages ahead, we will try to put these results in context as well as share our perspective on the investment environment and our Portfolio companies. As with our semi-annual review, we have structured this report as a series of responses to the questions we are most frequently asked by shareholders. We have organized them from the general to the specific and, as always, will include a review of our mistakes as well as our successes.
Q: Is this recovery for real?
A: Less than a year ago, many investors were concerned about a new Great Depression. Prices of all asset classes, except Treasuries, were collapsing. Unemployment was surging and liquidity was evaporating. The combined market capitalization of our nation's financial institutions fell 80% on average and most of the largest were taken over, forced to raise capital or filed for bankruptcy. To make matters worse, the combination of overextended consumers, undercapitalized financial institutions, excess manufacturing capacity, and an underemployed workforce made it difficult to see what engine could pull the economy out of its nosedive. From the highs reached in 2007, the stock market fell more than 55%, reaching its low in March 2009, as investors switched more than $250 billion out of equity mutual funds.
In response to this free fall, the U.S. government and Federal Reserve pulled out all the stops, pouring liquidity into the system through near zero interest rates, huge increases in government spending, unprecedented capital investments in financial and industrial institutions, the direct purchase or guarantees of less liquid loans and securities, a ballooning of the Federal Reserve's balance sheet, and expanded access to its discount window. While some of these individual actions may be questioned and the long-term consequences of soaring government deficits have yet to be faced, there is no doubt that drastic action was required.
As time passed, these actions took hold and though the economic news has not gotten much better, it has stopped getting worse. Although such important indicators as home prices and unemployment are still significantly worse than they were a year ago, they seem to have stabilized, albeit at depressed levels. Because we were in the midst of a financial panic, stabilization or a decline in the rate of decline was viewed with enormous relief, setting off an explosive rally in global stocks. As strange as this might sound, the news that we are in the midst of one of the worst downturns in more than 50 years was welcomed simply because it was better than Armageddon. As a result, despite a shrinking economy, high unemployment and soaring deficits, the S&P 500 Index surged a staggering 68% and Selected American Shares rose more than 80% from the March lows through the end of the year.
While such huge increases in so short a time are almost unprecedented, they are as much a consequence of how far markets had fallen as they are a reflection of new optimism. An occasionally forgotten piece of math is that a 50% decline requires a 100% increase just to break even. Thus, having fallen more than 55% before recovering 68%, the S&P 500® Index still trades almost 30% below its starting point.
From a longer term perspective, even after this recent rally the S&P 500 Index is still well below where it was 10 years ago. Although the market has fallen during this decade, the companies that make up the S&P 500 Index are earning more and are thus more valuable. Specifically, at the end of 1999, the S&P 500 Index traded for 1,469 and earned about $48, implying an earnings yield of about 3%. Today, the S&P 500 Index trades for 1,115 and should earn $55-$75 this year, implying an earnings yield of 5%-7% on fairly depressed earnings.More important, when we look at the individual companies that we hold in Selected American Shares, many now have earnings yields of 7%-10%, dividend yields of 3%-4% and intrinsic values significantly above today's prices.
Although valuations still seem reasonable, many investors are anxious that the market's steep recovery means that it must be ahead of itself and that they would do better to wait for a correction. However, there is an old saying that "the market doesn't know where it's been." In other words, the returns investors earn have nothing to do with where a specific stock or the market in general was trading a year before they invested. It is also not uncommon or a sign of overvaluation when the market bounces from depressed levels. For example, after falling more than 40% in less than two years and bottoming in October of 1974, the market soared 55% in the next nine months making 1975 one of the strongest years for the S&P 500 Index in the last 40 years. Given that the market was up more than 50% and the economy was still weak, with inflation and unemployment rising and the energy crisis looming, investors who missed 1975's strong advance might have felt it would be prudent to wait for a better time to invest. If they waited, in one sense they were correct as many economic indicators continued to worsen, only reaching their nadir in the 1980-1981 recession with double-digit inflation, interest rates and unemployment. However, as is generally the case, the market recovered long before the economy, advancing another 24% the following year. In fact, in the five years following 1975's 37% gain, the market almost doubled. Clearly, those who waited until investing "felt" better paid a big price. As Warren Buffett wrote in a prescient article that almost rang the bell at the end of the bear market in August 1979:[The] argument is made that there are just too many question marks about the near future; wouldn't it be better to wait until things clear up a bit? You know the prose: Maintain buying reserves until current uncertainties are resolved, etc. Before reaching for that crutch, face up to two unpleasant facts: The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.We do not use this example of the 1970s market recovery as a forecast. We simply do not know what the market will do in the next year or two. Rather we use it to point out that stock market returns in any one year do not help predict what returns might be the following year. If investors have learned anything over the last several years, it should be the futility of short-term market forecasts.
Q: How do concerns about the economy factor into investment decisions?
A: In selecting investments for Selected American Shares, we try to determine the intrinsic value of individual businesses, an approach often referred to as bottom-up or fundamental investing. Because of our long holding period, it is likely that we will own any business we buy through many different economic environments, including at least one recession. Thus, rather than try to predict the timing of economic downturns, we try to incorporate their inevitability into our business appraisals. Specifically, we ask ourselves, "Are the businesses that we own at today's prices likely to produce satisfactory long-term returns for patient investors even if we go through periods of recession?" In our assessment, the companies that make up the Portfolio pass this threshold test.
However, it is also apparent that dramatic imbalances in the broader economic environment, such as the combined forces that created the real estate bubble, can threaten even well-capitalized companies in unexpected ways. One lesson learned from the losses incurred when that bubble burst is that we should always be looking for large but unsustainable trends in the macroeconomic environment that could have substantial effects on corporate earnings.
Today, the most glaring example of such an imbalance is the high and growing level of government debt. The monetary and fiscal implications of this trend will likely lower the value of many businesses. As a result, this top-down economic issue warrants the consideration of bottom-up investors like us.
While we often read about the high costs of last year's stimulus and financial stabilization programs, these pale in comparison with the estimated costs of fulfilling the health care and Social Security promises that our elected officials continue to make year after year. In making these promises, our government is behaving in much the same manner as previous managements of General Motors (GM). Over the decades, it was far easier for executives to make concessions and promises to workers than to deal with the unpleasant reality that such promises were impairing the long-term prospects of the company. After all, these CEOs were likely to be well into a rich retirement before the consequences of their shortsightedness took hold. Similarly, most of today's politicians will be long gone before the bill for today's promises comes due. But just as with GM, the cost of these unrealistic and unsustainable promises must eventually be faced.
It is rightly said that terrible things can happen when the policy cycle is longer than the election cycle. A chilling example of these dangers appeared last year when the U.S. Department of Treasury issued its "2008 Financial Report of the United States Government." Because we feel this report should be read by all concerned citizens, we have posted a copy of it in the "Investor Education" section of selectedfunds.com. You can also access the report by clicking here. It is written in plain English and in the spirit of Thomas Jefferson, who said, "We might hope to see the finances of the Union as clear and intelligible as a merchant's books, so that every member of Congress and every man of any mind in the Union should be able to comprehend them, to investigate abuses, and consequently to control them." There in black and white, the report accounts for the Social Security and health care promises being made today in accordance with generally accepted accounting principles (GAAP) rather than the shameful pay as you go method of government accounting. What is so frightening is that this report shows that the present value of future expenditures on social insurance programs alone already exceeds anticipated future revenue by a staggering $43 trillion, three times the size of our total economy! The report goes on to warn, "The projected growth in entitlement spending under current law... will ultimately affect every citizen in the nation.... The Government must act to bring social insurance expenses and resources in balance."
While the only responsible reaction to such data is to reduce the health care and retirement promises being made on the grounds that we simply cannot afford them, such a position would be deeply unpopular. Given that popularity is a requirement to be elected, we can assume that such reductions are unlikely until we are faced with another crisis.
A failure by our elected representatives to address these concerns has a number of important investment implications that factor into every one of our business appraisals. First of all, we assume that U.S. tax rates both on individuals and corporations will increase, perhaps substantially, in the years ahead. Because our business evaluations are based in part on after-tax free cash flow, this assumption has a direct influence on our appraisals. For example, higher taxes will tend to lower the value of companies with large U.S. earnings streams and/or overseas cash that must be repatriated. Conversely, higher taxes could raise the value of tax loss carryforwards and/or earnings that are not subject to U.S. taxation. (For examples see the discussion of portfolio holdings in the next section.)
More troubling and difficult to quantify is the fact that the government has the incentive to deflate the cost of its debts by inflating the amount of money it prints, making it likely that our country is entering a period of higher monetary inflation. Such inflation can wreak havoc on businesses that are unable to increase prices as well as cause substantial losses for investors in long-dated Treasuries and other fixed rate debt instruments. While such an outcome is not certain, investors who have been drawn to the "safety" of long-term government bonds are taking a far greater risk than they realize. In fact, we would suggest that long-dated government bonds are currently selling at bubble prices and that even though such bubbles can last a long time, they always burst in the end.
In sum, while we do not invest based on predictions about the macroeconomic environment, we do consider these troubling developments as risk factors to incorporate in our securities analysis. Just because we cannot predict the future does not mean we cannot prepare.
Q: In today's uncertain environment, how do you evaluate investments?6
A: Our approach to investing can best be summed up in former President Jimmy Carter's charge that "We must adjust to changing times and still hold to unchanging principles." Our unchanging principles include the recognition that stocks represent ownership interests in underlying businesses and that the value of these businesses is determined by the amount of cash they will generate in the future. However, the research and analytical process required to predict future cash flows requires constant adjustment to reflect the changing nature of the competitive and economic landscape.
As a result, we must always be on the lookout for changes that could dramatically alter the value of companies we might own. For example, while it is widely assumed that earnings for most companies grow over time, the nature of competition and capitalism is such that a significant percentage of companies will in fact earn less money in the future than today. For example, only a decade or so ago large and profitable companies like General Motors, Kodak, Citigroup, and Xerox were considered reliable blue-chip investments. However, since then, the share prices of these "safe" businesses have declined an average of 89% and three of the four companies reported record losses in 2009.
Therefore, when studying potential investments, we try to look beyond reputation and past results, focusing instead on factors that might increase durability and adaptability, such as balance sheet strength, competitive advantages, risk of obsolescence, regulatory risk, returns on capital, pricing power, management incentives, and geographic and product diversification.
We must also recognize that even if competitive and economic conditions for an individual company remain fairly constant, an investment can still end up to be a poor one if we overpay. A business purchased for a price of $500,000 that will reliably earn $100,000 per year will generate a 20% return. However, if the price for that same business were $2 million, the return would fall to only 5%. Finally, because companies tend to reinvest a significant percentage of their net income rather than pay it out as dividends and because managements are often willing to raise more capital by issuing debt or equity, we must also assess the probability of management making foolish acquisitions or funding low-returning capital projects.
Q: How is the Porftfolio constructed today?
A: Turning from this general discussion of how we evaluate businesses to some specific holdings in the Portfolio, the clearest example of our approach can be seen in our growing investments in global leaders such as Merck, Johnson & Johnson, Procter & Gamble, Diageo (the world's largest spirits company), Philip Morris, Heineken, and Coca-Cola. These companies share virtually all of the characteristics of durability described above, including balance sheet strength, competitive advantages, decent returns on capital, reasonable pricing power, low obsolescence risk, and geographic diversity. Yet despite these strengths, these companies on average trade at discounts to the market, with most having dividend yields that exceed the yield on Treasury bonds. Specifically, on average, these companies are generating an earnings yield of about 8% while paying a dividend yield of more than 3%. Such valuations seem particularly attractive when compared to the 5%-7% earnings yield and 2% dividend yield of the average company in the S&P 500 Index. In short, these are above-average businesses at below-average prices.
A second category of investments would include our holdings in the energy sector, which combine several top-down themes with bottom-up stock selection. From a top-down perspective, we have long believed that the combination of powerful growth in the emerging markets, steep depletion rates for some of the world's largest oil fields and the high cost of alternative energy sources would cause energy prices to rise over the long term. Further, the fact that oil is a global commodity means that it will hold its value even in times of monetary inflation, as discussed above. From a bottom-up point of view, when evaluating individual energy companies, our primary focus is not just on earnings durability (as measured by factors such as reserve life and growth in reserves per share) or on price (as measured by factors such as enterprise value per barrel of oil equivalent) but particularly on the reinvestment rate. After all, very few energy companies voluntarily liquidate. As a result, most of the money they make selling energy is reinvested in replacing the oil or gas that they just sold. Unfortunately, for most companies in the energy sector, the long-term returns on this reinvested capital have been poor due to a lack of discipline. However, our largest holdings in this sector - notably Occidental Petroleum, EOG, Devon Energy, and Canadian Natural Resources - share the rare distinction of having generated satisfactory returns on reinvested capital over the very long term. We think the managements of these companies are among the best in the sector and each company has been a big contributor to our past returns.
However, ConocoPhillips, which was once one of our largest holdings in the energy sector, has failed this test. Over the last five years, the company reinvested huge amounts in low-returning projects. As if this were not bad enough, the company also went on an acquisition binge, issuing its relatively undervalued shares in exchange for overpriced acquisitions. As a result of this lack of capital discipline, ConocoPhillips' share price has trailed the price of our other four holdings by an amazing 18% per year over the last five years. We continue to hold some shares, however, based on valuation and management's commitment to greater capital discipline in the future.
A third category is made up of our holdings in financial companies. Although we meaningfully reduced the percentage of the Fund invested in financial companies over the past five to seven years, the Fund continues to have a large weighting in financials. Specifically, our holdings in the broadly defined financial sector represent approximately 29% for the Fund versus 14% for the Index. However, it should be mentioned that this 29% includes our 4.5% holding in Berkshire Hathaway, which given its recent acquisition of Burlington Northern is likely to be shifted into a different category. Nevertheless, this large weighting warrants some examination.
While the unprecedented events of the last year have left us shaken, the fact remains that financial service is one of the world's oldest professions and unlikely to ever become obsolete. Companies like American Express, Wells Fargo & Company and JPMorgan Chase have been in business for more than a century. But even these are relative newcomers compared with The Bank of New York Mellon, which was founded by Alexander Hamilton more than 200 years ago. It is not a coincidence that these four proven companies make up the lion's share of our holdings in the financial sector.
Turning to price, financial services firms generally trade at below-average valuations in terms of both earnings and dividends. For example, the four companies just mentioned trade at average P/E multiples of 12-15 times our estimated range of their 2010 earnings compared with the market multiple of 15-20 times. This discount may be even wider as these companies benefit from industry consolidation, the collapse of the shadow banking sector and reductions in bad credit costs. In fact, over the next three to five years, earnings at these companies could increase 50%-100%. We should note, however, that some of these positives are likely to be offset by a more hostile political, regulatory and fiscal environment. Finally, we view it as a positive that all four of these companies are run by the same managements that prepared and guided their companies through the financial crisis.
Beyond the investment rationale and examples given above, we must make two further observations about the financial sector. First, we have made several investments in the sector that proved to be mistakes. We will discuss these in detail in the answer to the next question. Second, the financial category is a broad one that includes many companies with diverse business models. Yet the financial media tend to paint all financial companies with the same brush. For example, anyone who follows the financial media might reasonably think that the entire sector has done terribly over the last five years. However, over the last five years companies such as Wells Fargo, JPMorgan Chase, Berkshire Hathaway, and Goldman Sachs, all of which we own, have not only outperformed the financial sector but have actually beaten the market too. In fact, even if we include our painful mistakes such as AIG and Merrill Lynch, the Fund's aggregate holdings in the financial sector fell only about half as much as the average financial company in the S&P 500 Index over the last five years.
A final category of Portfolio investments might be called companies that do not fit into a category. Some like Berkshire Hathaway and Loews are quasi-holding companies with investments in a range of industries. Others like CVS Caremark and Express Scripts are neither retail companies nor drug companies but rather a type of distribution channel that should benefit from the aging of America and growth in generic drugs. Companies such as Sealed Air, the maker of bubble wrap, and Iron Mountain, a document storage company, are so unusual as to be almost unique. Even companies like Costco, Harley-Davidson and Bed Bath & Beyond are difficult to lump together with others in their industry as each company uniquely dominates a narrow subcategory of its particular industry. As a result, while we often describe the Portfolio in terms of categories, the fact that so many holdings defy easy categorization is a reminder that, in the words of John Train, "Investing is the art of the specific."
Q: What were the biggest mistakes and the lessons learned?
A: As always, we must begin a discussion of mistakes with some definitions. Most important, we do not label an investment a mistake simply because it trades below our purchase price. In fact, it is probable that every company we buy will trade below our purchase price at some point, simply as a result of the unpredictability and vagaries of short-term results. Furthermore, it is the nature of markets that value and price often diverge for long periods of time. In euphoric times, such as during the Internet bubble, the stock prices of many companies exceed their value. In times of panic and dislocation, the value of many companies exceeds their prices. In such periods, the poor performance of an individual stock or even the Portfolio as a whole may indicate deferred returns rather than permanent losses. For example, a company purchased at $10 per share that has an intrinsic value of $20 is a good investment even if its price falls to $5 for some period of time. However, in other cases falling stock prices reflect substantial declines in the value of the underlying business. In these cases, we were mistaken in our business appraisals.
In our last several reports, we described our two largest mistakes in great detail. As we noted then, our investments in AIG and Merrill Lynch subtracted about 1.5% per year from our trailing five year returns. Because these companies remain the largest detractors from our five year results, we have left our last two reports on our website and commend them to your attention. (Please see the "Portfolio Manager Commentaries" section of selectedfunds.com to read these reports.) Both positions were subsequently eliminated and, although it is of little consolation, we would note that both AIG and Merrill Lynch (which was subsequently converted into Bank of America) currently trade at prices that are below the average price at which we sold them in 2008 and 2009. The lessons learned from these mistakes were valuable and deserve reexamining.
First, the chief executive officer of any large financial institution must have the skills, experience and discipline to also serve as the chief risk officer. Both AIG and Merrill Lynch were run for a number of years by executives who clearly failed this important test, although in our opinion these executives were not the ones pilloried in the press. We consider it both striking and unfair that executives like John Thain and Ed Liddy were disproportionately blamed for the gross mismanagement of their predecessors. Their predecessors sowed the seeds of collapse but left just before the bitter harvest. The fact that they walked away with obscene severance packages only adds insult to injury.
Second, both investments were grim reminders that, because of leverage, stupidity in even a relatively small part of a financial firm can bring down the entire enterprise. AIG's global insurance operations and Merrill Lynch's outstanding network of financial advisors were both the largest and most profitable parts of their respective firms. However, the steady profits of these huge and well-run operations were swamped by the losses at what were essentially small proprietary trading desks. In other words, the idiocy of a tiny minority overwhelmed the competence of the vast majority.
Finally, both mistakes reinforced the importance of liquidity. Net worth and earnings power may be valuable, but in times of crisis only cash matters. Both companies faced calls on cash that was simply not available. Worse, their attempts to raise the cash by selling assets during a time of panic simply added gasoline to the fire by driving down asset prices further. As Warren Buffett has rightly said, it is dangerous "to count on the kindness of strangers in order to meet tomorrow's obligations."
Before ending this section, we must note that it is likely that the largest mistakes we made in 2009 will never show up in our financial statements. This is not because we are glossing over them, but rather because they were mistakes of omission. In other words, our costliest mistakes during this financial crisis may well be the investments we failed to make when others were panicking. Wells Fargo, for example, traded roughly as low as $8 per share and American Express as low as $10. Had we increased our position by about 2% in each of these companies, we would have more than made up the cumulative losses we suffered in AIG and Merrill Lynch. Such mistakes of omission are rarely discussed and yet, as the example above shows, they can be just as costly to long-term returns.
Concluding Thoughts
Having just come through one of the worst decades for stock investors during the last century, commentators and the public are more pessimistic than ever. The economy is uncertain and most investors feel anxious and discouraged. For long-term investors, this combination should be as welcome as a sale at the grocery store. After all, pessimism creates low prices and low prices lead to high returns. In the words of the great investor Sir John Templeton, "Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria." Ten years ago the euphoria of a new millennium led to lofty valuations and a decade of poor returns. While we cannot know what the next decade holds, the fact that it begins in pessimism is truly cause for optimism.
Before ending this report, Ken and I want to highlight one other cause for optimism - our colleagues. We have never had a better team in terms of character or capability. In particular, we would like to single out Stephen Chen and Danton Goei whose insights, recommendations and results have been important contributors to shareholder returns.
On behalf of all of us at Davis Advisors, we thank you for your continued trust. ■
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