If you are willing to look across the valley of the shadow of doubt and invest with a long-term perspective, the market is offering an unusual opportunity to build positions in some great franchise companies at attractive valuations.
To be sure, there is cause for concern. In our view, the domestic economy is already in a recession or well on its way. The credit markets are in grim shape and could get worse as problems spread from sub-prime mortgages to prime mortgages, auto loans, credit cards, and any other form of debt tied to the marginal borrower. Employment growth is also deteriorating, further exacerbating credit problems, and inflation is picking up. We could go on, but you get the picture.
That being said, we believe stock prices of many very good companies already reflect a lot of bad news and are at valuation levels that in our view make them very attractive long-term investments. They could easily lose more value in the coming months but should be worth substantially more in the coming years. Nobody rings a bell at the bottom, and good things tend to happen to great businesses: they exceed low expectations, they do transformative deals, they buy-in stock or get bought out. We would rather risk being early than absent. If they get cheaper, we will happily buy more.
Following the chain of cause and effect:
The economic downturn is playing out according to our expectations, kind of like watching a train-wreck in slow motion.
As we have written in the past, periods of excess are usually marked by periods of contraction of equal and opposite magnitude and duration. The current woes in housing, and sub-prime mortgages were brought about by a long-term cycle of easy money, free spending and complacency about risk. This cycle worked its way through Main Street and the broader economy, fueling consumer spending with easy access to credit through mortgages, home equity loans, credit cards, and financing for autos, furniture, appliances and a host of other stuff. It also worked its way through Wall Street and the world of high finance, fueling a frenzy of leveraged buy-outs and high-yielding structured investments that worked their way onto balance sheets and into investment portfolios across the globe.
This excess needs to unwind itself and this process takes time as individuals and institutions work to contain their risks and shore up their balance sheets. For consumers, the combination of declining housing values, rising costs, more limited access to credit and concerns about employment will take a toll on spending.
For most businesses - and especially economically sensitive ones - caution will also prevail. We would expect to see managements work to limit risk by scaling back growth and capital spending plans, cutting costs, reducing headcount, paying down debt and building cash. Financial institutions, in particular, need to restore confidence in their balance sheets. We would also expect company managements to give cautionary guidance this earnings season since few people know how the year will play out and even if things are currently going swimmingly, it is better to underpromise and over-deliver.
Until recently, employment has held fast and inflation has remained contained. We now see signs of rising unemployment and more significant price increases in food, energy, and raw materials. Both matter a lot. Employment is a much more important driver of consumer confidence than housing values, and the recent deterioration in the jobs data makes us more cautious on our economic outlook.
Global growth remains strong, especially in the developing economies of China, India, Brasil and any place that sells a lot of oil such as Russia and the Middle East. Although the secular winds continue to be favorable for these economies, a downturn in the U.S. as well as softening in Europe – which we believe is also happening- represents a meaningful headwind that will result in slower growth abroad. The good news is that it may also ease pressure on commodity prices, especially oil.
So enough with the doom and gloom already…
Every cloud does have a silver lining. We have found over time that the best investment opportunities are found when confidence is low and fear is high, if you are willing and able to take the long-term perspective. This is difficult because as much as investors profess to take the long view, they are unduly influenced by short-term events, all exacerbated through the sensational looking glass of the media. As a result, there are significant distortions in the market between actual and perceived risk and opportunity.
We therefore reiterate our opening statement that if you are willing to look across the valley, the current environment offers a rare opportunity to invest in great companies - primarily in out-of-favor sectors - at attractive valuations.
We list below seven important investment themes that shape how we look at the equity markets into 2008:
1) The U.S. is on sale.
Or for sale, in the case of companies that desperately need to raise capital. Many good companies are selling at levels that make them attractive acquisition targets for domestic and foreign competitors. A weak dollar also makes the U.S. a particularly attractive place for foreign investors to invest, even as domestic investors continue to shift their money overseas. Expect a steady flow of global mergers, acquisitions and capital investments, which will help to support valuation levels.
2) The strong get stronger:
Periods of adversity also happen to be periods of opportunity for well managed and capitalized companies. While their competitors struggle and falter, they have a rare opportunity to gain competitive advantages by increasing market share, taking customers, buying good assets on the cheap, introducing new products and entering new markets. Focus on best-of-breed businesses with strong franchises and durable competitive advantages.
3) Cash is king:
2008 will be the year of the balance sheet. Recall that last year managements of cash-rich companies were being criticized for not using it to make acquisitions, buy in stock, or pay out a special dividend. Although a large cash balance does tend to reduce a companies return on capital at a point in time, there is a lot to be said for keeping some money for a rainy day. Today, with rain clouds in abundance, these same managements look pretty smart and are sitting in the cat-bird seat. Their balance sheets are not in question, and they have the opportunity to put that capital to work much more advantageously. Focus on companies that generate strong cash flow and have healthy balance sheets.
4) As go the financials so goes the market:
If the financials continue to do poorly, we do not believe the market can do well. Another leg down in financials will likely signal larger problems in the economy which will affect all parts of the market, including the stalwart industrial, energy and basic materials sectors. On the other hand, if there is not another major leg down, and the market rebounds, high quality financial stocks should do very well. They are already discounting a lot of bad news. We are stepping into quality financial names, especially those with minimal or no credit risk. We are likely early, but the opportunities are far greater than the risks.
5) Babies get thrown out with the bathwater:
The heavy use of ETFs and sector funds that group companies together by industry or sector creates valuation distortions in the market place. In some cases, very good companies are getting put on sale for no fault of their own. They’re just associated with the wrong sector at the wrong time and are deemed guilty by association, even if their specific business fundamentals remain strong. Besides financials, bargains can be found among the ranks of consumer discretionary and small cap stocks.
6) Global economy slows but also helps U.S. economy:
If the United States has the flu, then other economies, developed and developing will at least get a sniffle. Global growth is strong, but it is not immune to what happens in the United States, which remains the worlds largest consumer. Even a small change in domestic consumption has big implications for marginal growth rates abroad and the valuations that investors have placed on those growth rates. Conversely, a growing global economy creates growing demand for U.S. goods and services including technology, capital goods, consumer products, drugs, and even financial services. A weaker dollar makes U.S. exports even more attractive. This foreign demand should help to mitigate the softness on the domestic front.
7) Technology should do particularly well.
We still think large-capitalization technology companies offer an attractive combination of value, growth and business quality. These are some of the best capitalized and most innovative companies in the world. They are tied to the secular trends of global growth, and the evolution of the internet and wireless communication, and should be resilient - but not immune - to a domestic or global slowdown.
We think that the problems facing the economy are significant and will be long-lasting. The United States in particular, may suffer a hangover from its liquidity binge for years to come. That being said, our economic problems are not fatal and in many cases, the market has discounted an irrationally bleak forecast. In other cases (think industrial, energy, and international) it is overly optimistic. Too many investors are thinking and acting the same way, which tends to lead to diminishing returns for the crowd, and more favorable opportunities for those willing to think and act differently.
In the near-term, investors are more likely to look into the valley than across, and to see risk more than opportunity. The market is likely to trade lower as a result, creating more opportunities for long-term investors to build positions in great companies at great prices.
Jurika, Mills & Keifer, LLC