Our third quarter and year-to-date returns were accomplished with roughly 40% of fi rm assets invested in higher yielding corporate bonds, 35% in equities, and the remaining 25% held in cash equivalents.
On a risk-adjusted basis, we are satisfied with our returns.
Buy and Hold?
During the stock market’s bull run from August 1982 until March 2000, the S&P 500 had a stunningannual return of 19.22%. It became widely accepted that investors ought to simply buy stocks, sit tight, and let the returns roll in. In fact, this period’s market return was driven largely by the hyper-return between January 1, 1995 and March 31, 2000: 26.5% annually on the S&P 500. A tremendous body of literature has, in our view, incorrectly weighted this history and argued that investors ought to simply buy and hold stocks.
This idea has been forcefully put forth even in the face of extended periods of zero to-low returns from such an approach. In reality, the picture is complicated and does not lend itself to easy one-line investment mantras.
Many in the financial services industry selling the perpetual attractiveness of stocks are keen to point out the long-term rate of return on stocks: since January 1926, the S&P 500 has returned 9.66% a year, inclusive of dividends (Ibbotson Associates). Not bad, particularly if you have a very long time horizon.
As Mark Twain quipped, “Get your facts first, and then you can distort them as much as you please.”
However, lengthy periods of return drought are common in equity investing. First, the period of ’82 to ’00 referenced earlier was an absolute anomaly. A generation of investors before, having parked money in the stock market from 1964 to 1974, witnessed an annual return of only 1.6%. Ten-year Treasury bonds returned 3.38% during the same period. Similarly, the past ten years have yielded an annual rate of return of negative 0.4% through September 30, 2010. The ten-year Treasury annual rate of return during this period was 7.08%.
In fact, when viewing every rolling fi ve-year period since January 1, 1926 (beginning in each of the 958 months during this period), nearly 30% yielded less than a 5% annual rate of return. Further, the data show that whether the holding period was three, fi ve, or ten years, only about 60% of such periods yielded an annual return of 8% or greater. Moreover, in 53% of the 898 ten-year periods since 1926, investors did not actually receive the often quoted 10% equity annual rate of return.
Thus, the general assumption heralded by the mainstream fi nancial services industry that the investing public can blithely drop money in the stock market and earn a roughly 10% annual rate of return is not supported by the data.
Nonetheless, buy and hold adherents have arguments. The odds of achieving a positive return aresquarely in the favor of long-term equity investors. For instance, 94% of the 898 ten-year periods since 1926 netted a positive investment result. Further, 82% of the 982 three-year periods and 87% of the 958 five-year periods resulted in a positive return. This strongly supports the idea that if an investor holds a broad portfolio of U.S. stocks for a considerable period, he or she is unlikely to lose money.
In our minds, the table above raises a few questions. First, if a roughly 40% chance exists that an investor will earn less than an 8% rate of return, shouldn’t a credit instrument that pays 8% and is deemed “money good” be considered a strong alternative to receive a capital commitment?
Second, is there a more active investment stance than strict buy and hold that does not claim to make market predictions, but instead sensibly pays strict attention to price in order to minimize investment losses?
We believe the answer to both questions is “yes.”
Jeremy Siegel helped provide the intellectual underpinning to buy and hold when he published Stocks for the Long Run in January 1994. Since its publication, the S&P 500 has returned roughly 7.1% annually inclusive of dividends.
Later in this letter, we highlight a recent bond purchase, Helix Corporation, wherein we locked in a 9.5% yield for fi ve and a half years in what we believe is a very strong “money good” credit. Which is the better investment: 9.5% “money good” or stock market optionality?
Not shown in any long-term stock market data returns are the sometimes gut-wrenching market swoons that investors must endure for that return. To wit, there have been two 50% market drops in the past ten years.
Interestingly, value investors are often among the strictest adherents to a buy and hold philosophy even though their intellectual inspiration comes from a man, Benjamin Graham, who was more nuanced on the subject and placed his emphasis on price, not holding period. In various editions of The Intelligent Investor, Graham provided views on market levels. He thought that the “market level [was] favorable for investment in 1948 and 1953” but “dangerous” in 1959 and “too high” in 1964.
Looking at valuations in 1964, Graham was clear: “Speaking bluntly, if the 1964 price level is not too high, how could one say that any price is too high?” Regarding the market in 1972, he said it was “unattractive from the standpoint of conservative investment.”
Thus, Graham, the father of a bottom-up, company focused investment process, paid attention to overall market valuation levels. That said, Graham was first and foremost a bottom-up investor and believed that a “consistent and controlled common stock policy” was superior to market and/or economic judgments.
Graham’s nuance was reflected in his belief that stocks ought to represent between 25% (low side) and 75% (high side) of an investor’s portfolio based on relative attractiveness. In essence, he argued that price should be the chief determinant of portfolio allocation.
History has not been kind to those willing to ignore price. Jeffrey Applegate, former chief investmentstrategist at Lehman Brothers, said the following in the April 10, 2000 edition of BusinessWeek: “Is the stock market riskier today than two years ago simply because prices are higher? The answer is no.” The market was priced at 43x earnings (based on Robert Shiller’s price-to-earnings (P/E) ratio calculation using trailing ten years data) and total market capitalization stood at 185% of GDP.
Today, ten years later, the Dow Jones Industrial Average is still below the level where it stood when the chief strategist of one of Wall Street’s most sophisticated fi rms spoke those words.
At today’s market level, we note two valuation metrics. First, the S&P 500 now stands at 21x earnings (using Shiller’s P/E methodology). The median P/E is 16x dating back to 1926; 14x for the period prior to 1982 and 21x since 1982. (Graham believed that it was plain wrong to use trailing twelve months or next twelve months data, and instead argued that corporate profi ts ought to be viewed in the context of a business cycle.)
Second, according to Federal Reserve data, the overall public stock market is now priced
at roughly 100% of GDP, a 33% premium to the past fi fty years’ median level of 75%. For us, this data is informative, but not decisive. In other words, with patience and effort, we should still be able to identify specifi c price/value discrepancies even though not much “low-hanging fruit” is currently available, in our opinion.
Market enthusiasts can rightly point to a forward price-to-earnings market ratio of 12x on the S&P 500: $95 estimated 2011 earnings divided by a current index of roughly 1,175. However, the $95 is predicated on a net earnings margin of 9.5% versus a historical median closer to 7.5%. In fact, next year’s earnings estimate is based on 25% earnings growth (compared to 2010), but only 8% revenue growth, reflecting how much of next year’s corporate earnings is coming from margin expansion.
Historically, profit margins have shown a strong tendency to revert to the mean because that’s what takes place in capitalism.
Additionally, there is little question that in today’s low interest rate environment, equities may wellcontinue to capture investors’ attention.
The discussion here should in no way be viewed as an argument that we, or anyone else, can predict aggregate stock market movements in the short or medium term. Nor should it be construed that we are tending away from stocks.
Here is what we are saying:
■ Long-term stock market returns often trumpeted by the financial services industry mask a muchmore complicated intraperiod return reality.
■ Price is the investor’s best friend, not holding period.
■ Some market environments offer better value than others.
An Alternative to Buy and Hold—Opportunistic Capital Allocation
Opportunistic capital allocation (OCA) offers us the fl exibility to exercise commonsense judgment.
First, although the press headlines are dedicated to the stock market’s daily activities, we believe that, at times, corporate bonds can provide a superior risk-adjusted return given their senior position in a company’s capital structure.
Second, we believe that when a company’s price begins to approach a conservative estimate of its intrinsic value, the security ought to be sold, period. We manage business, economic, and market risk by being price conscious not just at the point of purchase, but throughout our holding period. Such price consciousness necessitates both harvesting gains and minimizing losses.
In this regard, we are different from traditional deep value investors that place a strict emphasis on buy and hold.
Finally, our company-specific decision-making process makes the buy and hold debate less relevant to us since the debate is really a broad market discussion. We are not buying “the market.” Instead, our focus is on a rigorous analysis of a specific company’s assets, earnings power, and possible conversion events in light of a particular price.
Market levels may tell us the odds of fi nding suitable investment candidates, but they do not serve as investable ideas in and of themselves.
Later in this letter, we discuss our recent investment in Cogent, which was acquired by 3M subsequent to our purchase and well illustrates our efforts to be in front of technology merger and acquisition trends (in part the result of huge corporate cash balances that are earning nearly zero) that occur more or less independent of the public stock market.
In our view, no asset—equity, debt, real estate, or commodity—possesses inherent investment meritindependent of the price paid to own it. We are content and committed to sitting perfectly still in the absence of what we believe are high margin of safety situations; i.e., clear and significant price/value discrepancies.
We will continue to visit companies, interview key industry contacts, and leverage allavailable resources to identify investment candidates that we feel offer compelling risk/reward characteristics.
Make no mistake: we are passionate about equity investing and the outsized gains that areavailable when finding companies that possess hidden assets, resource conversion possibilities, or that stand in front of strong business, industry, or secular growth trends. However, it is imperative to be highly price conscious in our pursuits.
Our Top Purchases
Helix Energy Solutions Group, Inc. 9.5% 1/15/16 Bonds. Helix is both an offshore marine contractorservicing the oil and gas exploration and development industry and an owner/operator of oil and gasreserves located in the Gulf of Mexico. Helix’s marine contracting business is involved in numerous subsea activities such as installing pipelines; inspection, repair, and decommissioning services for production platforms; and well plugging and abandonment services.
Helix also owns interests in several offshore production platforms that serve as hubs for the collection, processing, and transportation of oil and gas from offshore wells to onshore refineries and distribution facilities.
We purchased Helix bonds because of their compelling 9.5% yield-to-maturity for fi ve-and-a-half-year paper. Helix is a classic sum-of-the-parts asset valuation given its three distinct businesses.
The sum of Helix’s parts comes to about $2.5 billion of asset value: marine contracting business at $950 million at 6x EBITDA estimates; oil and gas reserves at just over $1 billion based on a private market value of $2.50/Mcfe; and $400 million for the company’s production facilities (a 25% discount to the company’s cost basis in the hubs).
As of June 30, 2010, Helix had $1.3 billion of net debt including the present value of future asset retirement obligations from producing wells in the Gulf of Mexico. With almost 2x asset value to net debt, the bonds provide a particularly attractive investment given the contractual strength of the security.
Helix has a public equity market capitalization of just over $1.1 billion resulting in a net debt to enterprise value of 50%. Finally, we believe the significant open market purchases of stock (which are junior to our bonds in the capital structure) by the company’s Chairman and CEO, Owen Kratz, underscore our investment thesis.
Cogent, Inc., COGT.
Cogent is a leading vendor of biometric security solutions, with specific expertise in digital fingerprinting. Cogent’s products are used by U.S. agencies and foreign governments, as well as law enforcement organizations in several countries. The firm has won several large, strategic, multiyear contracts that we believe underscore the strength of its products while providing management good visibility into future revenue. Against the backdrop of greater public and private sector investment in security, we thought Cogent’s integrated system of products and services, combined with reference wins at major U.S. agencies and foreign governments, made for an interesting investment candidate.
Admittedly, shipments under large government contracts can vary greatly from quarter to quarter.
Governments buy or deploy products when it fi ts their operating schedules and not based on ninety-day quarterly reporting periods. Therefore, we spent extra time validating Cogent’s large contracts and, in the process, uncovered a pipeline of additional opportunities.
When we analyzed Cogent’s balance sheet and fi nancial statements, we found we could acquire a “growth” business at a deep discount. At the time we purchased its common stock, Cogent had a market capitalization just over $780 million. With an unlevered cash balance of $270 million or just over $5.70 per share at June 30, 2010, its enterprise value was just $510 million. Cogent generated $58 million in operating cash fl ow in fi scal year 2009 (on revenue of $130 million), resulting in a cash fl ow yield greater than 11%.
In short, we decided to invest in the common equity of a business that was delivering strongcash fl ow, had above-average visibility and a pipeline of potentially large contracts, buttressed by a rocksolid balance sheet.
Against our litmus test of “Would we take this company private in a heartbeat?” we came away with a resounding “Yes.”
Apparently, 3M felt similarly, and on August 30 announced it would acquire Cogent for $10.50 per share, representing a meaningful premium to the public stock price.
DG FastChannel, Inc., DGIT.
DGIT’s proprietary network allows for the secure and timely distribution of advertising-agency-generated advertisements to broadcasters, cable companies, and other media outlets.
We became familiar with DGIT a year ago while researching media companies, but because it was tagged a “high growth” stock it w as not within our price parameters.
DGIT preannounced its third quarter earnings and revenue estimates, disappointing Wall Street analysts. In a matter of weeks, the company’s stock dropped roughly 60% as the growth crowd exited en masse, allowing us access to a debt-free, cash-rich balance sheet with strong, albeit at-risk, free cash flow characteristics. The company’s stock rebounded soon thereafter, allowing us a quick and successful exit.
As part of our research process, we hired an advertising agency to help us better understand emerging competitive threats and ultimately decided that handicapping the company’s future earnings was too difficult. It is our belief that DGIT’s 20% margins will likely come under significant pressure, and we no longer felt comfortable with the position at its appreciated price.