Here it is:
Do you still think quality can lead the market?
I think it can, although the indexes generally did better in the first quarter than many active managers, including those like ourselves with a distinct quality bias. This wasn't surprising for a number of reasons: Stocks as a whole have been on a strong roll since last June, and quality companies generally did very well on both an absolute and relative basis through the end of 2012. So a bit of give-back was not entirely unexpected, even if it was somewhat disappointing that many of our portfolios fell short of the Russell 2000 Index through the end of March.
Have the Fed's recent policies had an effect on the market's behavior?
Yes, we have to factor in the ongoing effects of the zero-interest-rate environment and the Fed's quantitative easing policies. As much as I think the effect of these policies is diminishing, I also think there's no question that more highly-levered companies continue to benefit from easy money and historically low interest rates. At the same time, high-quality companies—particularly those with strong balance sheets—don't appear as attractive to investors because low-quality businesses aren't paying the same kind of price for high leverage that they typically would. The 10-year Treasury rate went past 2% several times during the first quarter, which to me signals the last phase of the positive effects of the Fed's policies for lower-quality companies. I don't see quality necessarily leaping to market leadership if rates begin to rise, but I do think that companies with strong balance sheets and high returns on capital should do better the closer we come to a more historically normal interest rate environment.
In spite of the fact that there are still serious fiscal issues to work out, the market seems content to ignore it all and instead concentrate on the prospects for companies.
Do you expect the bull market to continue?
Yes, I think the conditions remain favorable for equities. What's most interesting to me is how the market has recently been able to tune out a lot of seemingly ominous political news. When Congress and the President failed to produce a long-term plan to tackle the deficit, the market mostly shrugged and continued to climb. When sequestration began to take effect in the aftermath of the stalled budget negotiations, stocks once again paused then resumed moving upward. So in spite of the fact that there are still serious fiscal issues to work out, the market seems content to ignore it all and instead concentrate on the prospects for companies. This of course is in stark contrast to what we saw in 2010, 2011, and most of the first half of 2012, when the markets seemed to react to little other than macro headlines that were themselves largely driven by political events. So I think the market can continue to move in a positive direction. Of course, an occasional correction is part of any bull run, and I would expect a few downdrafts anywhere in the range of five to10% along the way. As we've seen from the banking crisis in Cyprus, there are always surprises and challenges that none of us can predict. Some of these unforeseen events will help the market and some will reverse its progress.
Do you think we'll see a budget deal out of Washington before the end of the year?
I think we will see a deal at some point, probably by the end of the year. However, like a lot of people I also thought we'd have one earlier this year before the sequester took effect. I think what's important is that the market seems to have priced in much of the positive effect of an eventual budget agreement. For a while, the consensus was that share prices would really accelerate once a deal was struck, but I think the market has moved on under the implicit assumption that fiscal sanity will return to Washington at some point.
What is the case for active small-cap management today?
The greatest challenge that we as a firm have faced since the 2008 financial crisis has been the struggle of active management approaches like ours versus passive approaches, including ETFs. Over 40 years we have seen a number of styles come and go—the "Nifty Fifty" in the '70s, junk bond mania in the '80s, large-cap and Internet-based tech stocks in the '90s, deep value through much of the previous decade, and currently the interest in passive approaches or higher-yielding investments such as REITs. Resisting these trends, we have always operated on the principle that fundamental analysis, informed by knowledge, experience, and a consistently executed investment approach, would provide an edge over long-term time horizons. We remain wedded to a goal of above-average absolute returns and we're sticking with our search for attractively priced quality because that's what we think works best.