We are pleased to report that after a strong fourth quarter, our three long-only stock funds ended 2019 with gains of 34.5% (Value), 33.6% (Partners Value) and 36.1% (Hickory). Partners III, despite its hedges, returned 34.2%. The S&P 500 had a good year as well, rising 31.5%. The Balanced Fund, with less than half the portfolio invested in stocks, shined with an 18.0% return. And while one-year returns are not as important as the long-term record (see performance table), itâs all right to celebrate them, just a little.
On the fixed-income front, interest rates remained depressed, and spreads (the extra yield available by taking credit risk) remained thin. Despite a very unattractive opportunity set of potential investments, Short Duration and Core Plus managed to earn solid returns of 4.2% and 7.6%, respectively. For more detail on the fixed income environment, Tom and Nolan elaborate further in their quarterly Fixed Income Insights.
Market Commentary
After a big move up in the stock market, investors tend to get acrophobia. Commentators (whose business depends on raising anxiety levels) bring up various versions of âwhat goes up, must come down.â Stocks do go down sometimes, but the importance of market swings in both directions is usually exaggerated.
Looking back at the past two years might give some perspective. A one-year gain of 31.5% for the S&P 500 is unusually good. However, in the fourth quarter of 2018, we had a 20% market decline due to fears of further Fed increases in interest rates. As such, much of the 2019 gain merely represented a return to the previous Octoberâs highs. A similar exercise would show that the annualized gains off the 2009 extremely depressed market bottom (down approximately 55% from the 2007 peak) are much less impressive when viewed in a longer time frame. This is not to say that stocks are historically cheapâthey are notâbut we have experienced expensive markets before, and we do not believe that the current situation is at all dire.
Valuation CyclesâWhere Are We Now?
We have written before about how the market has gone through several long stretches of valuation (the price paid for company earnings often measured by price-to-earnings (P/E) ratio) expansion and contraction. Between 1966 and 1982, companiesâ earnings roughly doubled, but prices, despite some wide interim swings, ended the 16-year period close to where they started. This means that valuations dropped by half. By contrast, from 1982 to 2000, P/E ratios more than quadrupled, and stock prices rose more than tenfold. In this case, valuations skyrocketed. Hence, a major bull market.
These protracted periods of valuation compression and expansion present different opportunities for investors. During a long, choppy sideways market, hopes rise and fall, and individual company performance matters. Understanding what makes businesses tick helps investors distinguish between good long-term compounders and flashes in the pan. We would maintain that this is the environment in which active portfolio management adds the most value.
During a long bull market, investors are compensated for taking more risk. Rising stocks attract more capital, which makes them rise some more. Momentum investing and âtrend-followingâ are rewarded. Value considerations (applying analysis and reasoning, aka thinking) prove counter-productive and passive strategies flourish.
The Role of Interest Rates
The economic and geopolitical backdrops for these two periods (1966-1982 and 1982-2000) were obviously different, and stock markets are moved by a myriad of factors. However, one significant variable at play in both was the level of interest rates. Rates were generally rising during the first period, as inflation was triggered by the Mideast oil crisis of the â70s, and Paul Volkerâs Fed stamped it out with 20% short-term rates. High yields available on bonds posed serious competition for stocks and helped deflate valuations.
Rates generally fell during the second period as monetary policymakers remained intent on keeping credit cheap and readily available. The financial fuel was plentiful and helped inflate the tech stock bubble that finally popped in 2000.
Our current bull market, dating back to 2009, has also been characterized by very accommodative monetary policy and record-low interest rates around the world. Freshly printed money by the trillions (literally) has been pumped into global bond markets through quantitative easing in an attempt to stimulate business investment and economic activity. This action would normally be expected to result in price inflation, but trade wars and other uncertainties discouraged capital investments by businesses. As a result, we see inflation in paper assetsâstocks and bondsârather than in the prices of goods and services.
In their âcollective wisdom,â investors have decided that relatively good economic growth and cheap, abundant credit are the right ingredients for continuing to buy stocks. This is not an unreasonable response, but we would argue that both the monetary policy and investor response to it have been carried too far. Today, stocks are expensive by historical standards. This does not mean that they will go down, but the higher the starting price, the lower the odds of further robust near-term appreciation.
Outlook and Game Plan
We predict that we will see a shift from P/E expansion mode to another period of contraction in which valuations moderate. We would expect that the U.S. and global economies will, on balance, continue to grow and that businesses will do well over time. It would be natural, though, for interest rates to return to levels higher than todayâs and for P/E ratios to return to more modest levels. The adjustments could be gradual or sharp and dramatic, and history would suggest we will have some periods of each.
This is not terrible news for investors. A relentlessly rising bull market is nice, and we are happy to have benefitted from it. Going forward, though, most of our portfolio returns should once again come from the growth in the value of the businesses we own. Our appraisal of a companyâs value to its owners is based on estimates of future cash flows, or âownersâ earnings,â and we use a 9% discount rate. This means that if our estimates are accurate, we could pay 100% of business value and expect to earn a 9% annual return on the investment. We have a healthy degree of humility about our ability to estimate future cash flows, so we try to buy stocks when they sell at a significant discount to full value to add a âmargin of safety.â Still, with our current estimate of average price-to-value levels in the high-80%, we feel good about our portfoliosâ return potential.
We have come a long way since a year ago when we felt like kids in a candy store. We were aggressive buyers then, and we appreciate our shareholdersâ faith in sticking with us through a turbulent period. The path forward will be a bit more complicated, but we welcome the challenge. We believe that our greatest value-added for our investors is our knowledge of the companies we own and our sense of their underlying value. This understanding of value and context makes all the difference when chaotic market conditions arise.
A Final Note
As the holiday season winds down, on the heels of a terrific year, gratitude is the word that naturally comes to mind. All of us at Weitz are grateful for investors who have stuck with us through thick and thin. Without you, our mission loses purpose. We are also thankful, every day, for the chance to invest alongside such a talented, passionate, high-class group of people. The core of our investing team has been together for many moons, and we recently added new voices with fresh perspectives to the mix. While our team-based approach is rooted in bedrock principles, we are continuously enhancing the process. As Gandhi and others have said, it is imperative that we âcontinue to grow and evolve.â We made significant progress during 2019, especially on streamlined work plans, and we are excited to build on that momentum into a new decade.
IMPORTANT DISCLOSURES
The opinions expressed are those of Weitz Investment Management and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through 1/10/2020, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor's specific objectives, financial needs, risk tolerance and time horizon.
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