Graham & Doddsville, an investment newsletter from the students of Columbia Business School, has proven in the past to be a must-read for value investors – and the most recent issue didn’t disappoint. The fall 2012 issue had a fantastic interview with Joel Greenblatt, the managing partner of Gotham Capital, in which he talked about his start in investing, how he’s changed as an investor over time, and the responsibility he feels successful financial professionals have to give back to society. In that interview, Mr. Greenblatt gave an interesting answer in response to a question about selectivity when adding positions to his portfolio (bold added for emphasis):
“One of the things I said in “You Can Be a Stock Market Genius” is if you don’t lose money, most of the alternatives are good. Even if you don’t know what the upside is – if you just know there’s upside – you can create scenarios where you have an excellent risk/reward. Positions with limited down-side are the types of positions that I have loaded up on in the past. Not the positions with the biggest payoff. I could buy a lot knowing that I wouldn’t lose much and that there were good possibilities that it was worth a lot more over time. At the very least, I knew that my downside was well-protected and so I could create an asymmetric risk/reward by saying if I don’t lose much, there are not many alternatives other than to make money.”
This quote is particularly relevant today, for the simple reason that the majority of investors appear concerned with one thing – yield and capital preservation. To date, this has resulted in huge inflows to fixed income ETF’s, as well as run-up’s in both telecommunications and utilities, which offer sizable dividend yields and are assumed to be the safest place to hide in the scary world of equity investing.
Using the 10-year as our example, treasuries appear to pass the first bar – the U.S. government will repay that bond someday, so you’ll get your principal back in 2022 in addition to your sub-2% annual yield. However, real risk isn’t measured in terms of nominal capital preservation: It’s measured in terms of purchasing power – and on that front, Treasuries look very risky indeed. Let’s look at a simple example recently presented by Leon Cooperman: This simply looks at the return on a 10-year purchased at 1.5% (like it was a few weeks ago), and the rates it could potentially move to a few years down the road (assuming it follows the historical precedence of tracking nominal GDP, which is simply the summation of real growth and inflation, this doesn’t require much– even 2% real global GDP growth and 2% inflation gets us to a 4% yield):
|2012||2015||Total Return||Average Annual Return|
Remember, this is the what many people assume is the “safe” asset; in reality, Treasuries look a lot more like return-free risk – and most retail investors, who think that they have avoided risk by ditching the equity markets and instead loaned some money to Uncle Sam, are setting themselves up to potentially get slaughtered, as they’ve done time and time again.
Compare that to a company like Procter & Gamble (PG), which has paid a dividend for 120 years, has increased it every year for over half a century (at a rate approaching 10% per annum), and currently yields 3.30%. The company is on solid financial footing, trades at a reasonable multiple to earnings and free cash flow, has pricing power to mitigate the effects of inflation, and is priced for limited growth in the future despite a huge – and decades-long – market opportunity coming from billions of individuals who, much like their development market counterparts, want products that make their lives easier and better; as David Winters recently put it, “You’ve got a lot of people and they all want to look good; it’s just a basic human emotion, and the Chinese are just like everybody else.”
This isn’t a big secret – and in 2000, Procter & Gamble rode the market tide that lifted all boats, partly due to talks of the huge surge in demand that would come from the developing world. At that time, the stock peaked just shy of $60 – or about 50x the split-adjusted earnings for fiscal year 2000 of $1.235 per share. The performance of P&G common stock since that time shows what happens when years of unattainable growth are priced in by the market – eventually, that stock is due to take a beating. Yet, compare the current 10-year Treasury investor of 2012 to the guy who bought P&G at the peak – on a 10-year basis (with the benefit of hindsight), we can see that the long-term equity investor (due to slight capital gains plus the growing dividend) still managed to outpace the bond buyer who’s holding long term treasuries sporting a sub-2% yield.
Yet even with the benefit of hindsight, long term investors still grab Treasuries in the name of “safety” – despite the fact that P&G, which would’ve outperformed today’s bonds even from the 50x starting point, trades at a normalized multiple of well under half that level.
When I look at the financials for P&G (along with companies on a similar trajectory like PepsiCo, Johnson & Johnson, etc), I think their current valuations (and even more so a few months ago) exemplify exactly what Mr. Greenblatt is talking about; it’s a situation where there’s plenty of upside potential, with almost no real risk of permanent impairment of capital. The same thing is true with Berkshire Hathaway (NYSE:BRK.A)(BRK.B), yet even more so – in this case, the plenty of upside potential and limited downside risk was solidified by an open buyback at a price just a couple percentage points below the market price – and with tens of billions in capital to support that floor. I think time will show that investors in situations like BRK.B and PG will trounce long-term Treasuries over a period of five or more years; considering that most people have a time horizon extending years (if not decades) into the future, I think the decision for the intelligent investor is crystal clear.
About the author:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, "Patience followed by pretty aggressive conduct."
I run a concentrated portfolio, with a handful of positions accounting for the majority of my equity holdings (currently two). From the perspective of a businessman, I believe this is adequate diversification.