When adjusted for the interest rate environment using the 10-year Treasury bond, the chart shows that these large company stocks have gone from being 35% overvalued in 2000, down to 27% undervalued by the end of 2005. This is a 62% swing in value as measured by P/E's when adjusted for interest rates. This helps to explain why as of late we have been able to find a handful of large company stocks which we believe represent real bargains. The last time we saw this type of concentration of large company stocks selling at "bargain" levels relative to interest rates was back in 1993. Prior to that, we would have to go back to the early 1980's.
The chart below shows why we believe large company stocks are the cheapest sector of the market at this time, and therefore a pocket of value for the CM Advisers Fund. The chart shows that in the year 2000, large company stocks (as represented by the 300 largest stocks in the Russell 3000 index) had an average price-to-earnings ratio ("P/E") of 25.5. Five years later, at the end of 2005, these large company stocks traded with an average P/E of 18.6. This is a 27.06% decline in this ratio. In other words, on average, we believe these 300 stocks are cheaper (based on P/E's and interest rates) than they were six years ago in 2000.
Conversely, small company stocks (as measured by the smallest 300 stocks in the Russell 3000), have gone from an average P/E of 11.4 in 2000 to an average P/E of 26.1 by the end of 2005. When adjusted for the interest rate environment using the 10-year Treasury bond, the chart shows that these small company stocks have gone from being 4.7% undervalued in 2000, to more than 60% overvalued by the end of 2005. This is a 64.7% swing in value as measured by P/E's when adjusted for interest rates. This general overview of small company stock valuations, as measured by P/E ratios, helps to explain why we have not been able to find as many bargains in this sector during the recent past.
-------------------------------------------------------------------------------
During the same time the Price/Earnings Ratios of large companies declined from 25 to 18, the Price/Earnings Ratios of small companies increased from 11 to 26.
-------------------------------------------------------------------------------
Large Company Stocks Small Company Stocks
-------------------- --------------------
2000 25.5 2000 11.4
2001 23.7 2001 16.4
2002 17.3 2002 14.5
2003 18.9 2003 19.6
2004 17.4 2004 23.0
2005 18.6 2005 26.1
-------------------------------------------------------------------------------
The 10 year bond rate is used as a valuation metric. Our research
shows that large company stocks routinely sell at a P/E that is a 10%
premium to the 10 year bond rate. Very small companies (less than $600
million market cap) sell for a 30% discount. On that basis small
company stocks were slightly undervalued in 2000 and 60% overvalued in
2005. Large company stocks were overvalued by 35% in 2000 and were
undervalued by 27% in 2005.
Not only do recent price-to-earnings ratios suggest that there are many undervalued securities in the large company sector, but the majority of the earnings being produced by many of the large companies that are part of the Fund's asset mix are free cash flow. This is significant, as "free cash flow" is the true bottom line cash that companies can put in their pockets (the bank) after all expenses have been paid. Free cash flow may be used by companies to buy back shares of stock, pay out dividends, and undertake expansion or strategic acquisitions.
When companies show that the majority, if not all, of their earnings are free cash flow, investors generally categorize these earnings as higher quality than the earnings of companies that have little or no free cash flow. Our historical research shows back in the early 1980's, large companies generally produced earnings that on average were about 65% free cash flow. Today, many of the large companies now held by the CM Advisers Fund have earnings that are 80% to 100% free cash flow. Therefore, not only have we been able to find many large companies selling for prices we believe to be at bargain levels, the earnings they are producing, as measured by free cash flow, are high quality earnings when compared to earlier periods of time.
In addition to equities, we also found pockets of value in several fixed income securities during this past fiscal year. At the close of the previous fiscal year (February 28, 2005), the CM Advisers Fund had 1.44% of the Fund's net assets invested in fixed income securities, excluding short-term U.S.
Treasuries. Just one year later, at the close of the latest fiscal year (February 28, 2006), long-term U.S. Treasury bonds, intermediate U.S. Treasury notes and corporate bonds represented 13.84% of the Fund's net assets. Why?
At the end of 2003 the Fed Funds rate was 0.98%. However, with the economy coming out of recession, equity markets recovering, and the real estate market performing quite well, the Federal Reserve was expressing concerns over inflation. As such, they began to raise the Federal Funds rate (the interest rate which a depository institution lends immediately available funds {balances at the Federal Reserve} to another depository institution overnight).
By the end of 2004, the Fed Funds rate had increased to 2.16%, an increase of more than 120% in just one year! Although the growth of China and India had been putting pressure on commodity prices, and the U.S. economy had been growing at a healthy pace compared to the early 2000's, inflation fears, in our opinion, were grossly over done. However, with the general belief that higher inflation was
all but certain, the Fed Funds rate continued to rise hitting 2.63% by March 2005. This was a 21.76% rate increase in just one quarter!
With no foreseeable end to Fed Fund rate increases in sight and large numbers of investors believing high inflation was all but certain, many investors began selling their bonds at a rapid pace. Bonds do not typically perform well during periods of high inflation because their principal values move inversely with
interest rates. During the month of March 2005, investor's mass exodus from bonds in such a short period of time caused the long bonds to be oversold. This over-selling caused a decline in the price of the bonds to such a low level that we deemed them a pocket of value and thus, invested a portion of the Fund's assets into intermediate and long-term U.S. Treasury fixed income securities.
Over the next 6 months, the 25-year U.S. Treasury Strip appreciated more than 15.29% (03/01/05 through 09/01/05 per Century Management), making it more than 12% of the Fund's net assets as of 08/31/05. Applying our internal risk and reward analysis, we exercised our sell discipline and realized a portion of this gain, selling approximately one third of this position on September 1, 2005. At the close of the Fund's fiscal year, the Fund continues to hold 8.07% of its net assets in the 25-year U.S. Treasury Strip as we believe it continues to be a value.
Our approach to money management remains simple but disciplined. Best said, we look to achieve the highest total return with the least amount of risk. To accomplish this, our first preference is to buy stocks at deep discounts relative to their private market (intrinsic) values, as this offers us the greatest potential return over the long run. Our second preference is to look for bonds that offer a total return that is approximately 2.5% to 4% above inflation to help increase our total return. If neither stocks nor bonds offer favorable return potential, cash becomes the investment of choice. In exercising our value discipline, we wait for the bargains to come to us; we do not chase investments. The proof of this is that since the Fund's inception in May 2003, we achieved an average annual total return of 9.32%, while at the same time having averaged 59.10% in cash and cash equivalents. We believe that this approach will serve the long-term investor well.
The chart below shows why we believe large company stocks are the cheapest sector of the market at this time, and therefore a pocket of value for the CM Advisers Fund. The chart shows that in the year 2000, large company stocks (as represented by the 300 largest stocks in the Russell 3000 index) had an average price-to-earnings ratio ("P/E") of 25.5. Five years later, at the end of 2005, these large company stocks traded with an average P/E of 18.6. This is a 27.06% decline in this ratio. In other words, on average, we believe these 300 stocks are cheaper (based on P/E's and interest rates) than they were six years ago in 2000.
Conversely, small company stocks (as measured by the smallest 300 stocks in the Russell 3000), have gone from an average P/E of 11.4 in 2000 to an average P/E of 26.1 by the end of 2005. When adjusted for the interest rate environment using the 10-year Treasury bond, the chart shows that these small company stocks have gone from being 4.7% undervalued in 2000, to more than 60% overvalued by the end of 2005. This is a 64.7% swing in value as measured by P/E's when adjusted for interest rates. This general overview of small company stock valuations, as measured by P/E ratios, helps to explain why we have not been able to find as many bargains in this sector during the recent past.
-------------------------------------------------------------------------------
During the same time the Price/Earnings Ratios of large companies declined from 25 to 18, the Price/Earnings Ratios of small companies increased from 11 to 26.
-------------------------------------------------------------------------------
Large Company Stocks Small Company Stocks
-------------------- --------------------
2000 25.5 2000 11.4
2001 23.7 2001 16.4
2002 17.3 2002 14.5
2003 18.9 2003 19.6
2004 17.4 2004 23.0
2005 18.6 2005 26.1
-------------------------------------------------------------------------------
The 10 year bond rate is used as a valuation metric. Our research
shows that large company stocks routinely sell at a P/E that is a 10%
premium to the 10 year bond rate. Very small companies (less than $600
million market cap) sell for a 30% discount. On that basis small
company stocks were slightly undervalued in 2000 and 60% overvalued in
2005. Large company stocks were overvalued by 35% in 2000 and were
undervalued by 27% in 2005.
Not only do recent price-to-earnings ratios suggest that there are many undervalued securities in the large company sector, but the majority of the earnings being produced by many of the large companies that are part of the Fund's asset mix are free cash flow. This is significant, as "free cash flow" is the true bottom line cash that companies can put in their pockets (the bank) after all expenses have been paid. Free cash flow may be used by companies to buy back shares of stock, pay out dividends, and undertake expansion or strategic acquisitions.
When companies show that the majority, if not all, of their earnings are free cash flow, investors generally categorize these earnings as higher quality than the earnings of companies that have little or no free cash flow. Our historical research shows back in the early 1980's, large companies generally produced earnings that on average were about 65% free cash flow. Today, many of the large companies now held by the CM Advisers Fund have earnings that are 80% to 100% free cash flow. Therefore, not only have we been able to find many large companies selling for prices we believe to be at bargain levels, the earnings they are producing, as measured by free cash flow, are high quality earnings when compared to earlier periods of time.
In addition to equities, we also found pockets of value in several fixed income securities during this past fiscal year. At the close of the previous fiscal year (February 28, 2005), the CM Advisers Fund had 1.44% of the Fund's net assets invested in fixed income securities, excluding short-term U.S.
Treasuries. Just one year later, at the close of the latest fiscal year (February 28, 2006), long-term U.S. Treasury bonds, intermediate U.S. Treasury notes and corporate bonds represented 13.84% of the Fund's net assets. Why?
At the end of 2003 the Fed Funds rate was 0.98%. However, with the economy coming out of recession, equity markets recovering, and the real estate market performing quite well, the Federal Reserve was expressing concerns over inflation. As such, they began to raise the Federal Funds rate (the interest rate which a depository institution lends immediately available funds {balances at the Federal Reserve} to another depository institution overnight).
By the end of 2004, the Fed Funds rate had increased to 2.16%, an increase of more than 120% in just one year! Although the growth of China and India had been putting pressure on commodity prices, and the U.S. economy had been growing at a healthy pace compared to the early 2000's, inflation fears, in our opinion, were grossly over done. However, with the general belief that higher inflation was
all but certain, the Fed Funds rate continued to rise hitting 2.63% by March 2005. This was a 21.76% rate increase in just one quarter!
With no foreseeable end to Fed Fund rate increases in sight and large numbers of investors believing high inflation was all but certain, many investors began selling their bonds at a rapid pace. Bonds do not typically perform well during periods of high inflation because their principal values move inversely with
interest rates. During the month of March 2005, investor's mass exodus from bonds in such a short period of time caused the long bonds to be oversold. This over-selling caused a decline in the price of the bonds to such a low level that we deemed them a pocket of value and thus, invested a portion of the Fund's assets into intermediate and long-term U.S. Treasury fixed income securities.
Over the next 6 months, the 25-year U.S. Treasury Strip appreciated more than 15.29% (03/01/05 through 09/01/05 per Century Management), making it more than 12% of the Fund's net assets as of 08/31/05. Applying our internal risk and reward analysis, we exercised our sell discipline and realized a portion of this gain, selling approximately one third of this position on September 1, 2005. At the close of the Fund's fiscal year, the Fund continues to hold 8.07% of its net assets in the 25-year U.S. Treasury Strip as we believe it continues to be a value.
Our approach to money management remains simple but disciplined. Best said, we look to achieve the highest total return with the least amount of risk. To accomplish this, our first preference is to buy stocks at deep discounts relative to their private market (intrinsic) values, as this offers us the greatest potential return over the long run. Our second preference is to look for bonds that offer a total return that is approximately 2.5% to 4% above inflation to help increase our total return. If neither stocks nor bonds offer favorable return potential, cash becomes the investment of choice. In exercising our value discipline, we wait for the bargains to come to us; we do not chase investments. The proof of this is that since the Fund's inception in May 2003, we achieved an average annual total return of 9.32%, while at the same time having averaged 59.10% in cash and cash equivalents. We believe that this approach will serve the long-term investor well.
