July 2, 2008
Dear Client:
With the rapid decline in the stock market the past several weeks, I wanted to share some thoughts about where things are going. The Dow Jones Industrial Average entered bear market territory today, down over 20% from its high last year (client accounts generally have not lost as much). The economy is facing daunting challenges from oil prices, commodity inflation, rising unemployment, continued housing weakness and problems in the banking system. It can be hard to see how we get out of the mess.
There are a few positives, however. Interest rates remain at fairly low levels, far below the crisis levels of the early 1980s. The weak dollar, which has been part of the cause of $140 oil, has strengthened US competitiveness. That should provide some support to the economy. Plus, I believe the employment picture will turn out better than expected. As we recovered from the last recession, companies were generally cautious about hiring. The result is that many firms are already running fairly lean, and there are fewer opportunities for huge payroll cuts throughout the country. Certainly a large number of Wall Street bankers will be losing their jobs, but overall I think the situation isn’t dire.
Still, today we are dealing with what is sometimes called “stagflation” – a stagnant economy coupled with inflation. My view is that stagflation is not a stable condition. If the economy doesn’t start to improve, demand will fall far enough that prices will come down. At that point the Federal Reserve can resume interest rate cuts, and things can start to get better.
What does this all mean for the stocks we own? In my opinion it means better times ahead, because I view stocks today to be very attractive. As I have written before, the most compelling evidence of a stock being undervalued is when it trades at a discount to what a rational buyer would pay for it. Today the discounts for our stocks are growing. For example, Kraft Foods trades at about 13x next year’s earnings, a large discount to the 20x multiple being offered to buy Anheuser-Busch, another strong consumer brand with weaker international opportunities than Kraft. I believe Kraft would deserve at least the same multiple from a private buyer yet trades far below that level. We have numerous other examples, with Viacom, Equifax and Willis all coming to mind.
My point is that stocks are as attractive today as they have been in some time. They could become more so, but the level of risk we have holding them today is, in my view, much lower.
Finally, I am going to repeat some points I have made in the past about investing. I hope you will find them useful to keep in mind during difficult markets.
1. Over longer time periods, say 10 years, stocks have typically performed better than bonds and cash. I believe any money you will not need over the next 10 years should be invested in stocks rather than bonds and cash.
2. I believe we own high-quality businesses. Stocks like Willis, Lockheed Martin and Nike are franchise companies with established competitive advantages from scale, high barriers to entry and trusted brand names. They are well-managed and trade at a discount to my estimate of intrinsic value. Over time these companies should win in their markets, and ultimately their stocks should follow.
3. I have great confidence in the long-term strength of the US economy. Eventually the housing mess will be cleaned up, inflation will subside and consumers will spend more freely. I cannot accurately predict when this will happen, but history has shown our economy to be very resilient.
4. The stock market is inherently unpredictable if you take a daily, weekly or monthly perspective. The catalyst that will turn the markets around could come from any number of possible events. We simply don’t know what it will be or when it will happen. And I don’t feel comfortable jumping in and out of equities on the hope that I could accurately predict something that is almost impossible to predict.
So we continue to own stocks, despite the near-term risk of further declines, because in the long run I believe it is the best way to build wealth without taking excessive risk.
As always, please feel free to contact me with any thoughts or questions.
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