How do we determine when a stock is falling whether we believe it is temporarily out of favor or has turned into a value trap? There are two main risks that we assess when valuing a company. Financial risk relates to how a company is capitalized (debt ratios, excess cash, etc.), the realism of its reporting practices, and most importantly its ability to withstand bad times without having to resort to short-term solutions that are not in the long-term interests of the company. Operating risk relates to the accuracy of future estimates of a company’s ability to produce free cash flow from its basic business. Thus, the accuracy of our valuations is based on our ability to accurately predict future excess cash flow.
We do not want to accept financial risk because a company’s inability to withstand bad times could result in permanent damage to a company’s valuation. Material losses in a portfolio are far more damaging to the portfolio’s long-term financial health than material gains. Let us not forget a portfolio that increases 80% followed by a 50% loss is down 10%, not up 30%. A $100,000 portfolio that increases 80% in year one appreciates to $180,000…a 50% decline in year two results in a portfolio worth $90,000 at year-end.
Our methodology of defending against financial risk is to seek companies that generate, or are expected to generate, excess free cash flow, have financial statements that are understandable and in accord with economic reality, and have balance sheets that can withstand bad times. Excess cash flow companies can buy back stock, raise the dividend, make strategic acquisitions when others may not be able to, and do not have to adopt short-term strategies that are not in the long-term interests of the company. These companies represent outstanding acquisition candidates.
THE CURRENT ENVIRONMENT
As a final note, all stocks are vulnerable to rising interest rates and the resulting impact on investor psychology. As interest rates rise, stock valuations tend to decline as U.S. Treasury securities represent a competitive lower risk alternative to investing in equities. However, it is significant to note that current interest rates are no higher than they were from 1995 to 2000 when the ten-year U.S. Treasury rate averaged 6.34% (the current ten-year rate is approximately 5%). The psychology of crowds can change in a minute, and rather than joining crowd psychology, we choose to take advantage of overreactions caused by what we believe is “groupthink”.
On December 31, 1999, the S&P 500® Index closed at 1,469.25 On June 30, 2006, the Index closed at 1,270.20, which amounts to an approximate 13.5% cumulative decline over the five and one half year period. In 1999, the S&P 500® Index companies earned $45.00 a share whereas in 2006, our current estimate is $85.00 a share. The price earnings ratio of the S&P 500® Index has fallen from 32 times earnings in 1999 to under 15 times estimated earnings for 2006.
We believe that the market has finally grown into its earnings shoes. Although our cash position is currently in excess of 15%, we are beginning to find values in larger companies such as American Express, AIG International, 3M and Cisco, which are not only new holdings, but first time holdings for the Fund. It stands to reason that if earnings have almost doubled over a time period in which the market is down, values should begin to emerge. We believe that despite the negative psychology surrounding the stock market, opportunities are beginning to develop, which we believe could increase our chances of achieving the Fund’s investment objectives.
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We do not want to accept financial risk because a company’s inability to withstand bad times could result in permanent damage to a company’s valuation. Material losses in a portfolio are far more damaging to the portfolio’s long-term financial health than material gains. Let us not forget a portfolio that increases 80% followed by a 50% loss is down 10%, not up 30%. A $100,000 portfolio that increases 80% in year one appreciates to $180,000…a 50% decline in year two results in a portfolio worth $90,000 at year-end.
Our methodology of defending against financial risk is to seek companies that generate, or are expected to generate, excess free cash flow, have financial statements that are understandable and in accord with economic reality, and have balance sheets that can withstand bad times. Excess cash flow companies can buy back stock, raise the dividend, make strategic acquisitions when others may not be able to, and do not have to adopt short-term strategies that are not in the long-term interests of the company. These companies represent outstanding acquisition candidates.
THE CURRENT ENVIRONMENT
As a final note, all stocks are vulnerable to rising interest rates and the resulting impact on investor psychology. As interest rates rise, stock valuations tend to decline as U.S. Treasury securities represent a competitive lower risk alternative to investing in equities. However, it is significant to note that current interest rates are no higher than they were from 1995 to 2000 when the ten-year U.S. Treasury rate averaged 6.34% (the current ten-year rate is approximately 5%). The psychology of crowds can change in a minute, and rather than joining crowd psychology, we choose to take advantage of overreactions caused by what we believe is “groupthink”.
On December 31, 1999, the S&P 500® Index closed at 1,469.25 On June 30, 2006, the Index closed at 1,270.20, which amounts to an approximate 13.5% cumulative decline over the five and one half year period. In 1999, the S&P 500® Index companies earned $45.00 a share whereas in 2006, our current estimate is $85.00 a share. The price earnings ratio of the S&P 500® Index has fallen from 32 times earnings in 1999 to under 15 times estimated earnings for 2006.
We believe that the market has finally grown into its earnings shoes. Although our cash position is currently in excess of 15%, we are beginning to find values in larger companies such as American Express, AIG International, 3M and Cisco, which are not only new holdings, but first time holdings for the Fund. It stands to reason that if earnings have almost doubled over a time period in which the market is down, values should begin to emerge. We believe that despite the negative psychology surrounding the stock market, opportunities are beginning to develop, which we believe could increase our chances of achieving the Fund’s investment objectives.
Read the complete report
Also check out:
