How would you describe the current state of the market?We're in a very interesting market period right now. One would think people would be euphoric given that popular equity indexes have been achieving new highs. Yet there is an underlying concern about all of the geopolitical issues that we've had to deal with over the last few years.
In general, it seems that people are still fairly cautious. While cash flows are just starting to come back to equities, they're most likely coming out of cash. I don't believe that we've seen the big shift yet from fixed-income investments into equities that some people have been talking about.
I think it's really been more beginning of the year funding and minor rebalancing between equities and fixed income. The good news is that there's a lot of cash for stocks still out there and trailing return patterns favor equities.
When you look at individual stocks, it's a real mixed bag. Some valuations are very extreme. People are excited about social media and the Cloud, so we see companies involved in these newer areas at very high valuations.
On the other hand certain areas of the market are still quite depressed and absolute valuations look really attractive to us. While the markets have rebounded strongly, there's a lot of disparity to the point where I'd say, in general, the market's overall valuation seems to be in the mid-range.
In addition, people's investment horizons are very short right now, so the longer we extend our horizon, the more extreme some of those different valuations can appear.
What areas of the market look most attractive right now?Many companies in tech hardware are so out of favor that we're starting to see some LBO activity—Dell being the best known example.
In spite of the popularity—and rich valuation—of many Cloud-computing companies, many businesses that make the hardware that go into Cloud services or server farms are trading at single-digit multiples.
We see a lot of opportunities in Technology. The fact that two tech industries that operate in the same sector and benefit from the same themes can have such wildly divergent valuations is one sign of the kind of interesting market we're in currently. We are also still enthusiastic about Energy and Industrials.
Do you think investors have begun to start paying more attention to company quality?Not really—I don't think they're paying much attention to individual company fundamentals at all lately other than current yield.
As money has been moving back into equities, there has been a strong preference for indexes and ETFs—derivatives, in effect—not individual companies.
Of course there are exceptions, but I don't think we're in the majority yet. There have been brief periods over the last nine months where quality has prevailed, but for the most part, lower-quality companies have done better over the last five years. Clearly, this is a function of a zero interest-rate environment.
I recently read in Grant's Interest Rate Observer that a zero interest-rate environment is like taking the shot clock out of a basketball game. When there is no pressure to perform, a lesser-skilled team can play keep away from a better team, keep the score down, and even have a chance to prevail from time to time; whereas when there is pressure to invest—and pressure to earn a higher return on capital because of the risk-free rate being higher—that will benefit the more talented team, which are higher quality companies in this case.
What have been your biggest challenges as an investor over the last three to five years?When a discipline such as ours, which has worked well for a long time, goes out of favor for what seems like an eternity now—though it's actually been a couple of years—maintaining patience and staying disciplined become increasingly difficult.
Certainly when we own things that aren't working, the pressure to change becomes greater and it's hard to block out the noise and remember how we got to where we are. I'm finding plenty of opportunities, but explaining why those selections have underperformed the benchmarks has become the most difficult part of the day-to-day routine.
But we're operating with a discipline that's worked well for 40 years. It has had its out-of-sync periods before—though not as many as long as the one we're currently enduring—and it is a challenge. It's a challenge for our shareholders to hang in there, and it's important for us to keep communicating the importance of discipline and patience.