Excerpts From Our Quarterly Letter To Clients
Following are excerpts from a selection of our letters to clients included with our quarterly appraisals. This selection dates from 2008 — the height of the financial crisis. In our quarterly letters, we typically discuss the current investment background and other factors of interest to our clients.
The information provided herein represents the opinions of David Wendell Associates and is not intended to be a forecast of future events, a guarantee of future results, nor investment advice.
- Second Quarter, 2017
- First Quarter, 2017
- Fourth Quarter, 2016
- Third Quarter, 2016
- Second Quarter, 2016
- First Quarter, 2016
- Fourth Quarter, 2015
- Third Quarter, 2015
- Second Quarter, 2015
- First Quarter, 2015
- Fourth Quarter, 2014
- Third Quarter, 2014
- Second Quarter, 2014
- First Quarter, 2014
- Fourth Quarter, 2013
- Third Quarter, 2013
- Second Quarter, 2013
- First Quarter, 2013
- Fourth Quarter, 2012
- Third Quarter, 2012
- Second Quarter, 2012
- First Quarter, 2012
- Fourth Quarter, 2011
- Third Quarter, 2011
- Second Quarter, 2011
- First Quarter, 2011
- Fourth Quarter, 2010
- Third Quarter, 2010
- Second Quarter, 2010
- First Quarter, 2010
- Fourth Quarter, 2009
- First Quarter, 2009
- Fourth Quarter, 2008
- Third Quarter, 2008
- Second Quarter, 2008
The major market indices continued their march to new record highs in the second quarter, with both the Dow Jones Industrial Average and the Standard & Poor’s 500 finishing up some 8% and the technology-rich Nasdaq up over 14%.
Estimates for economic growth during the first quarter were boosted to a 1.7% increase versus the previous readings of 1.2% and 0.7%. Happily, the S&P 500 saw its strongest year-over-year growth in earnings since 2011 and 75% of the companies beat estimates, surpassing the five-year average of 68%.
The current economic expansion is now about 96 months old, just over twice as long as the historical average of 47 months. With the S&P 500 up some 258% from its low of March 2009, some on Wall Street have begun talking about the “R” word. While growth has been sluggish and the actions of central bankers around the world a concern, there are few convincing signs of an impending recession.
In fact, recent data suggest that the economy may be perking up. Even so, growth will likely hover around the 2% trend of recent years unless tax and regulatory reform is actually accomplished.
Needless to say, we remain focused on high-quality companies whose revenues, earnings and dividends are likely to advance at better than average rates in the coming years, no matter what goes on in Washington, London, Brussels or Beijing.
Our companies are typically leaders in their fields. With their above-average reinvestment rates, they are able to devote considerably more resources than the merely average company to developing new products and services and expanding their markets without relying on debt financing. We expect them to perform well in all sorts of economic conditions.
We are pleased to report a number of promotions. Ledge Mitchell is now Chairman. His wise guidance and seasoned experience has been very helpful in the past and we are looking forward to continuing our work with him in the years ahead.
Peter Boland has been promoted to President. Peter joined us in 2000. He is a key member of our team and an all-around great person to work with. Kathryn Shea has been promoted to Senior Vice President. Kat has been with us for over 30 years and worked closely with David Wendell. She is thoroughly steeped in our long-term growth stock investing philosophy and discipline. Anne Farris has been promoted to Vice President – Operations. Quite literally, without Anne and her crack administrative team keeping things running smoothly, we would be in quite a pickle!
Finally, I will take the title of Chief Executive Officer, whose duties and responsibilities I have been performing for nearly 20 years. I also remain the Treasurer of the company.
We have updated our Forms ADV Parts 2A and 2B to reflect these promotions. These are government forms required by the Securities and Exchange Commission. We have no material changes to report as of this time, but if you would like a copy of our updated Forms ADV Parts 2A and 2B, please let us know and we will be happy to mail them to you. They are also available on our website at www.davidwendell.com if you would like to view them online.
Also enclosed is our firm’s statement on the privacy of your confidential information. Government regulations require that we provide you with a copy of the statement each year. Of course, this written statement only reaffirms the policies and practices that we have strived to adhere to over the years.
All of us at David Wendell Associates wish you and your family a happy, healthy, sunny and fun summer!
All in all, it was a quarter for the record books. In January, the Dow Jones Industrial Average breached the 20,000 mark for the first time. The following month, it closed higher in a dozen straight sessions — a feat last accomplished 30 years ago. Finally, in March both the Dow and the Standard & Poor’s 500 continued to reach new highs before backing off a bit. At quarter-end, the Dow was up 4.6% and the S&P 500 5.5%.
Much of the action was based on “the Trump Trade” — Wall Street’s expectations for infrastructure spending, tax cuts and regulatory rollbacks. The markets paused in March — its longest losing streak since 2011 — when it became apparent that the new Administration’s agenda, such as healthcare reform, may not be as easily accomplished as assumed. But as we go to press, investor enthusiasm has returned and the markets are back to gaining.
Some observers have dubbed this “a strange rally,” with a number of historical links, between volatility and stock prices for example, seeming to have broken down. On days when the S&P 500 has moved up, the VIX, a measure of volatility, has also moved higher. Usually they move in opposite directions — as stocks rise, volatility decreases. Traders on Wall Street apparently fear both a meltdown and a melt-up and are hedging their bets both ways.
Ties between “soft” and “hard” economic data are also behaving oddly. Consumer confidence has risen to its highest level since December 2000, but activity data, such as retail and housing sales and business spending, continue to point to the same moderate growth seen since the Financial Crisis. In other words, soaring optimism is far ahead of actual improvement.
Wall Street, of course, is not immune to its own exuberant craziness, as seen in the recent initial public offering of Snap, a disappearing message app popular among teenagers. The company went public in early March and its stock soared 44% on the first day of trading, making its 26-year old founder an overnight billionaire. The shares have since backed off and are currently 25% off their high.
The company has a number of interesting fundamental characteristics — for example, it has yet to make a dime. Last year, the company lost $515 million on sales of $404 million. This year, it might lose $3.7 billion.
Snap’s ownership structure is unconventional, to say the least. The shares carry no voting rights — in other words, shareholders have no say in how the company is run. But management is generous with its employees. Last year its stock-based compensation expenses (stock options) were around $1.7 billion, which comes out to about $1.4 million per employee. This compares to Facebook’s average of $230,000 and Alphabet’s (Google’s) $144,000 per employee. Stock options have the ultimate effect of diluting investors.
Last November the company introduced sunglasses with a built-in camera for $129 and began calling itself a “camera company.” As one reporter asked, “So, you wonder, do cool, photo-grabbing shades make Snap worth a cool $31 billion?” The response from the editor of a high-tech investing newsletter, “It’s the kind of offering that can only happen after the second-longest bull market in history, when investors are delirious with their invincibility.”
We know we are not invincible, but we also know that fundamentals matter and that there is no substitute for investment quality. The companies we have recommended over the years tend to have outstanding characteristics: solid financial statements, leading and expanding market shares, pipelines of new products and services, experienced management teams and shareholder-friendly boards of directors. We expect them to continue growing their revenues, earnings and dividends in the years to come. Snap, not so much.
On another topic, we have some bittersweet news to share. After 36 years with the company, our friend, colleague and partner Jane Barr has decided to retire as of the end of June. Jane was the first person my father, our company’s founder, hired and she worked closely with him in the early days of the firm and as it grew over the years. When my father passed away unexpectedly, Jane was like a rock and helped us all through that very difficult period. We are eternally grateful and wish her the very best in her new life.
But before she leaves, we are going to have one blow-out of a retirement party. Please mark Friday, June 16th on your calendar, 4:00 to 7:00 pm. The party will be held in our offices and we hope you will attend — just call Laura Zabkar at 1-800-545-4791 so we can make sure there is plenty of champagne and hors d’oeuvres for everyone.
No matter how you slice it, last year was a doozy. As our partner Ledge Mitchell said, “We saw everything in 2016!” Of course, the two big standouts were the U.K.’s “Brexit” vote and the U.S.’s election results — neither of which was anticipated by the “experts.”
With the post-election lift-off, the Dow Jones Industrial Average ended the year up better than 13%, the Standard & Poor’s 500 9.5% and the Nasdaq Composite 7.5%. As we go to press, the Dow is still flirting with 20,000 — powered by Wall Street’s expectations that a more business-friendly environment is in the making.
Recent economic data is behind some of the enthusiasm. The third quarter had the fastest growth in two years, and was revised up to a 3.5% expansion pace versus a previous estimate of 3.2%. The revision was due to business investment and personal consumption and this means that the “mix” of growth looks good for the coming year.
Earnings, too, are adding to the combustion. Fourth-quarter profits for the Standard & Poor’s 500 are widely expected to be some 3% higher than a year ago, building on a similar gain in the third quarter. Looking ahead, the improved outlooks for the financial and energy sectors likely will mean solid results for this year too.
With the voting surprises here and in the U.K., serious questions have arisen concerning the validity of predictive computer models, particularly in economics. One observer noted that such models, used by a majority of central banks around the world, are too narrow and rely on equations to explain a world where many things just don’t add up. They also lack historical perspective.
Predictive models are also widely used by polling organizations and Wall Street, particularly large institutional investors such as hedge funds. Many of these firms repositioned their portfolios based on their expectations of the election results. Now, after dreadful year-end results, many of these funds are scrambling to re-reposition themselves for this year. And so it goes . . .
In our firm, our analytical work is based on facts, observable data and, of course, our judgment developed over nearly forty years of investing experience. In other words, at David Wendell Associates we do our own thinking.
Last year was a year of surprises and there certainly could be more in store this year. However, the companies we tend to recommend have experienced management teams and long track records through all sorts of market, business and economic conditions. They also tend to have dominant positions in their industries and strong financial statements. With their below-average levels of debt and their above-average quality rankings, we have every confidence these firms will continue to thrive in the coming years.
Finally, on a different note we urge you to review your statement from your custodian every month. One of our clients was the recent victim of cyber theft. A portion of the funds have been recovered and the custodian is working to recover the balance, although we have been told the process could take six months to a year to complete.
We do not have all of the details yet, but apparently the theft was accomplished by linking the thief’s credit card to the client’s money market fund. We think this may have been done using a check written on the money market fund which, of course, had the account number printed at the bottom.
Please! You know your own finances better than anyone. Review your monthly statement and if you see anything odd or unexpected, do not hesitate to give us a call. We are happy to help and would rather do it sooner than later.
The major market indices experienced everything from wild swings to quiet lulls in the third quarter. Even so, the Dow Jones Industrial Average is up just over 4% year-to-date while the Standard & Poor’s 500 has advanced a tad over 5%.
In September, alternating fears ran rampant on Wall Street and the markets seesawed back and forth. First up was the Federal Reserve and a potential rate hike. When that failed to materialize, a relief rally set in and the market averages moved back to their earlier all-time highs.
Then, concerns about a too-big-to-fail German bank causing another global financial crisis sent the markets careening again. Those fears have since abated and now investors are circling back to concerns about central bankers and their plans for economic stimulus. Basically, Wall Street has become highly sensitive to even modest shifts in sentiment and traders are selling first and asking questions later.
The main reason behind this pins-and-needles mindset is the slow growth economy. While the economy is expanding, it is the slowest expansion on record since the late 1940s. Unfortunately, this trend is likely to persist over the next few years.
For the second quarter, economic growth was revised up to a 1.4% annual rate, which was better than the 1.3% rate widely expected. Business investment was up as were inventories and net exports. Overall, unemployment is just 5%, core inflation is near 2% and wage growth is accelerating. A boost in interest rates is likely soon although, as some observers have noted, the Federal Reserve keeps getting spooked by market fluctuations and global worries.
We were encouraged by a number of reports that came out over the summer that more companies are reporting results that conform with Generally Accepted Accounting Principles (“GAAP”). In our First Quarter newsletter, Minding the Gap, we discussed how some companies have used alternative, non-GAAP measures that present their earnings results in a more favorable light. The Securities and Exchange Commission frowns on this and is now requiring companies to give GAAP figures greater weight in their earnings reports. This should make it easier to analyze a company’s earnings and evaluate the attractiveness of its shares for current purchase. It should also highlight high-quality companies that have kept such shenanigans to a minimum.
Finally, we are extremely pleased to announce that Kathryn Shea has been promoted to Vice President. Kat joined our team in 1986 and worked closely with my father and Jane Barr in the early years of our firm. In many ways, both she and the firm have grown up together.
Along the way, Kat gradually assumed new duties and responsibilities and she has been a full-fledged portfolio manager for about twelve years now, in addition to continuing her work on research, analysis and other special projects. Kat is a valued member of our team and we all wish her wish her continued success. Congratulations Kat!
The financial markets took another wild turn during the final week of the quarter. Heading into the United Kingdom’s referendum on European Union membership, the major market indices were up about 3% for the year-to-date.
But after the unexpected “leave” vote, markets around the world sold off and both the Dow Jones Industrial Average and the Standard & Poor’s 500 dropped into negative territory — down about 2% for the year. Then emotions cooled, the markets recovered and both finished the quarter back up about 3% each.
Measuring from the lows reached during the first quarter’s historic zigzag, both the Dow and the S&P 500 were up almost 15%. If nothing else, volatility seems to be this year’s theme in the financial markets.
First-quarter GDP growth was revised up to an annual pace of just over 1%. Exports were higher than initially thought, as was spending on research & development and software. In April, consumer spending grew at the fastest monthly pace since 2009 and it continued with another healthy increase in May.
Contrary to the fearmongers, there are no signs of a recession or a financial crisis. In fact, there is plenty of liquidity in the system and banks are well capitalized. Inflation appears to be stable and there is scant likelihood that a fourth round of quantitative easing will take place. Increases in interest rates seem to be on hold for the time being.
As to the referendum, both the U.K. and the EU currently are jockeying for negotiating leverage. The vote was non-binding so the U.K. could decline to act or some sort of reduced membership along the lines of Norway or Switzerland could be sought. One observer equated this to a “social” membership in a country club — access to the swimming pool but no golf.
At any rate, if the U.K. does decide to proceed, the process could take two to three years. It maintains a trade deficit with the European Union, meaning that it buys more from than it sells to EU countries, and this would undoubtedly be a factor in any future negotiations.
Overall, companies in the Standard & Poor’s index derive about 45% of their sales from abroad with approximately 8% from Europe and only 2% from the United Kingdom.
Given the recent swings in the financial markets, we think it only sensible to continue focusing on leading, high-quality companies with demonstrated track records and superior fundamental characteristics.
Of the twenty-five most widely held companies by our firm’s clients, the vast majority are currently rated “A++” for financial strength by Value Line, an investment research firm. About one-fourth of the companies are rated “A+” and the remaining handful rate either an “A” or a “B+”. A company in bankruptcy or reorganization would be rated a “C” or “D” on Value Line’s scale. Thus, these are some of the most financially strong and stable companies in the world.
No matter what happens, we would expect these companies to comfortably weather any disruptions resulting from the “Brexit” vote. These companies came through the financial crisis with flying colors and there is no reason to think that they will not continue to grow their revenues, earnings and dividends per share in the years ahead.
On another matter, we are very happy to announce that Neil G. Bleicken has joined our firm as Vice President. Neil has 20 years of experience in professional investing and most recently was a portfolio manager at Harvest Capital in Concord, New Hampshire. Prior to that, he was at Ropes & Gray in Boston, Massachusetts and was an equity analyst at two institutional firms and a regional brokerage firm for fifteen years. Neil has a B.A. from Georgetown University and an M.B.A from Duke University.
The past quarter was a wild, and historic, roller-coaster ride on Wall Street. In mid-February, the Standard & Poor’s 500 was down 10.5%, but by the end of March it finished up almost 1% — only the second time since 1928 that the index fell more than 10% during a quarter yet finished in the black.
On Wall Street, the volatility unsettled many big, institutional investors, causing heavy selling pressure from hedge funds, mutual funds, oil-based sovereign wealth funds and others. As one observer noted, “the fast money traders ruled the quarter.”
Numerous international concerns were behind the institutional selling. Economic growth around the world has been lackluster with China a particular worry for those who bet big on the yuan. Central bankers in Europe have introduced negative interest rate policies that require large depositors to pay the banks for holding their funds. These policies do not have good track records and Wall Street was rightly concerned about the further spread of this experiment.
Against this backdrop were concerns that interest rates would rise again in the U.S. after last December’s meager increase. However, at the end of March, Federal Reserve Chair Janet Yellen stated that given the global economic and financial situation, the pace of rate increases would likely be slower than previously indicated. With that, the Street was off to the races.
In the U.S., the economy continues to chug along. The latest revision to GDP indicates an expansion of 1.4% in the fourth quarter, up from a prior estimate of 1% and an initial one of 0.7%. Overall, it looks like the economy grew at an annualized pace of 2.4% last year, which was better than widely expected.
In our just-completed fundamental review and analysis of our companies, we were particularly concerned about the impact of the strong dollar on earnings last year. Many of the leading, high-quality companies that we focus on have operations all around the world, which is a good thing as markets and economies continue to develop. However, when we are in a strong dollar environment, earnings can take a hit when local currencies are translated into dollars for accounting purposes. In general, the dollar is strong when global investors view the U.S. as a safe haven, which is currently the case.
While there was an impact on earnings last year from the strong dollar, overall we were quite satisfied with the progress of our companies. They tend to be the leaders in their growing and expanding markets and they have top-notch management teams with demonstrated track records through all sorts of economic and business conditions.
Even though some on Wall Street have labeled the current period “a world turned upside down,” we have every confidence that our companies, as a group, will continue to grow their revenues, earnings and dividends in the years to come. Having a long-term point of view is a real advantage for investors — the short-term traders on Wall Street have to sweat every twist and turn in the markets.
Wishing you and your family a very pleasant spring!
With the strong dollar, a slowing Chinese economy and weak commodity prices, stocks basically took the year off. For 2015, the Standard & Poor’s 500 was down 0.7% while the Dow Jones Industrial Average was off 2.2%. Thanks to a handful of technology stocks with price/earnings ratios in the stratosphere, the NASDAQ finished ahead by 5.7%.
In the U.S., recent manufacturing data was at the lowest level since 2009, primarily due to woes in the energy sector. The services segment, a larger portion of the economy, still appears to be expanding nicely. Overall, with solid gains in employment and wages as well as positive trends in housing and consumer spending, currently there are no signs of a recession on the horizon.
While full-year economic data will not be known for another month or so, the economy likely expanded at about a 2% rate last year. This would be slightly less than the 2.5% rate seen in both 2014 and 2013. It is important to note that despite the massive decline in oil prices, the economy did grow last year. At the end of the day, growth is growth, even if it is slow growth. In 2016, it will likely continue to plug along at a similar pace.
The Federal Reserve Bank finally raised interest rates last month by a modest 0.25%, the first such increase in almost a decade. Observers on Wall Street expect another 3 or 4 hikes to bring the Federal Funds rate up to around 1% by year end. Inflation is currently about 0.5%, well below the Fed’s 2% target. However, other influences may be at work – excluding food and energy, core inflation has been fairly stable at over 1% for a number of months.
As we go to press, financial markets around the world are rattled by events in China, concerns about slowing global growth and rising geo-political tensions. In particular, China’s financial regulators have been experimenting with new rules for controlling trading on the country’s stock exchanges. At the same time, the Chinese government devalued the country’s currency to make its exports more attractive in overseas markets. It should be noted that the trading curbs only apply to China’s in-country exchanges, foreigners are not allowed to trade in those venues. However, some large institutional investors undoubtedly made bets on China continuing to support both its currency and its stock exchanges and the unwinding of these bets is likely partly to blame for the sell-offs around the world.
In such an environment, we think it is important to remain focused on quality and fundamental strength. Owning the shares of high-quality companies whose earnings and dividends are increasing at superior rates is the most effective way we know to successfully invest for the long haul. As we have shown in the past, it is the growth in earnings and dividends per share that leads to higher share prices over time.
Despite the turmoil on Wall Street, our companies continue to develop new products and services, expand their markets and increase their earnings. Due to superior management, they are also able to increase their dividends per share at rates faster than that of the average company. We remain optimistic about their future prospects and confident in their current abilities.
All of us at David Wendell Associates wish you and your family the very best for a happy, healthy and prosperous New Year.
Unfortunately, the summer months were not kind to the stock markets. The Standard & Poor’s 500 fell almost 7% while the Dow Jones Industrial Average and the NASDAQ were both down well over 7% in the largest percentage decline since 2011.
Around the globe, results were far worse. Japan’s Nikkei 225 was off more than 14%, China’s Shanghai Composite over 28%, the MSCI Emerging Markets Index some 18% and Europe’s Stoxx 600 nearly 9%.
Market traders were beset by worries, including a slowing economy in China, a strong U.S. dollar and a long-overdue, but again postponed, interest rate increase by the Federal Reserve Bank. The refugee situation in the Middle East combined with Russia’s recent moves in Syria also played a part in dampening sentiment.
In fact, by the end of September the worries were so bad that positive news was all but forgotten. For example, the economy’s growth rate for the second quarter was finalized at 3.9%, up from an earlier estimate of 3.7% and an initial reading of 2.3%.
Both consumer spending and business investment were strong and inventories were revised down, a positive for future growth, while corporate cash flow climbed to a new record high. The economy may moderate towards the end of the year, but it should continue to expand slowly and, importantly, there is no recession in sight. Many of our high-quality, financially strong companies have held up remarkably well and we expect them, for the most part, to continue to turn in superior results in the years ahead.
For the most part, it was a “ho-hum” quarter with both the Dow Jones Industrial Average and the Standard & Poor’s 500 posting modest losses. The Dow fell almost 1% while the S&P 500 was off 0.2%, breaking a nine-quarter winning streak. For the first half of the year, the Dow is down a little over 1% while the S&P 500 is barely in positive territory, up a scant 0.2%.
On the last day of the quarter, however, the stock market saw its biggest one-day loss of the year as investors wrestled with fears of Greece defaulting on its debt and possibly exiting the Eurozone. In Wall Street’s parlance, a “Grexit”.
Greece also has dominated the news during the first week of the current quarter. Some media reports have compared the situation to the collapse of Lehman Brothers in 2008. But as one wag noted, “Greece is Detroit, Not Lehman”.
First, it is worth noting that since it became an independent country in 1829, Greece has been either in default of its debt or in the process of re-structuring it over 50% of the time.
More importantly, the current crisis began over five years ago when Greece announced that it had been understating its deficit figures for years, basically since it adopted the euro in 2001. At the time, this added further turmoil to the global financial markets which were still reeling from the financial crisis.
The point is that since then, financial markets, institutions and firms have had plenty of time to reduce their exposure to the country and to prepare. In contrast, the collapse of Lehman Brothers was completely unexpected and caught everyone unawares.
Interestingly, the economies of Greece and the metropolitan area of Detroit are roughly the same size. In 2013, Greece’s Gross Domestic Product was about $240 billion while Detroit’s was some $224 billion. The Eurozone’s economy is roughly equal to that of the U.S., so any “financial contagion” will likely be manageable. Political contagion is something else entirely, though, and the coming weeks will be telling for the Eurozone.
In the U.S., business conditions are improving. Manufacturing beat consensus estimates and has now signaled expansion for a 30th consecutive month. New orders, the most forward-looking index, rose for a third consecutive month and now stands at its highest level so far this year. The labor markets are also improving, which could be indicative of an economic rebound in the second half.
And in an encouraging trend, U.S. companies have been pouring money into research and development at the fastest pace in 50 years. For the five-month period November 2014 through March 2015, companies have funded R&D at an annual rate of $316 billion — about 1.8% of GDP. This is the largest share ever for the private sector, up from 1.7% last year and 1.6% for the seven years from 2007 to 2014.
More spending on research and development could encourage businesses to invest more heavily in new equipment and eventually lead to higher growth rates. Some observers think this may already be under way. Orders for long-lasting goods such as equipment and machines rose in April, ending a recent downturn in capital spending.
We remain committed to high-quality, financially strong companies with solid fundamental characteristics. For the vast majority, their management teams of experienced professionals have successfully charted courses through all types of economic, business and market conditions around the globe. There is no reason to think they will not continue to do so in the years ahead.
Also enclosed is our firm’s statement on the privacy of your confidential information. Government regulations require that we provide you with a copy of the statement each year. Of course, this written statement only reaffirms the policies and practices that we have emulated over the years.
Wishing you and your family a very enjoyable summer!
During the quarter, the major market indices advanced to new highs before falling back. For the year-to-date, they are essentially flat — the Dow Jones Industrial Average is down a bit at 0.3% while the Standard & Poor’s 500 is up a bit at 0.4%.
Once again, concerns on Wall Street are mounting about the effects of the unusually cold winter, as well as falling energy prices and the West Coast port slowdowns. While the economy expanded at a 2.2% annual rate in the final quarter of 2014, many expect growth in the first quarter to be about 1% or so.
A similar scenario was seen last year with the polar vortex slowing first-quarter growth, which then rebounded strongly. Importantly, the long-term trend of slow and steady appears intact: in 2014, the economy increased at a pace of 2.4%, up from the 2.2% rate logged in 2013.
Even though the coming weeks may see some rockiness in the financial markets, we remain confident in the high-quality companies we tend to favor. Their management teams are experienced and have been around the block a few times. Their leading market positions and expanding shares should stand them in good stead even if Wall Street has the “jitters.” Finally, their strong balance sheets and overall financial fitness should help them continue to grow at above-average rates over the long haul.
Wishing you and your family all the best for a very pleasant spring!
The major market indices advanced to new highs during the quarter with the Dow Jones Industrial Average closing above 18,000 and the Standard & Poor’s 500 above 2000 for the first time ever. For the year, the Dow was up 7.5% and the S&P 500 saw an 11.4% gain. Since the lows of the financial crisis in 2009, the S&P 500 has increased over 200%.
Most economic measures are continuing to improve. The latest reading shows the economy expanding at a 5% clip, its strongest pace in 11 years. Consumer spending, which accounts for 68% of the economy, has been boosted by the dramatic fall in energy prices. It is expected to continue rising as wages and employment data strengthen. For the year, the nation added 2.95 million jobs, making it the best year for employment growth since 1999. As one observer noted, “It appears we have reached an inflection point.”
Outside of the U.S., the picture is not so bright. The Eurozone, the world’s second-largest economy after the U.S., is beset with lethargy and Germany, its largest economy, is struggling to stay even. China’s economy posted a better than 7% advance in the third quarter, but it has been grappling with slumping real estate, weak domestic demand and sagging industrial production. Japan’s economy has contracted for two consecutive quarters and may be heading into another recession.
Thus, the U.S. has become in many ways the asset class of choice for investors around the world. U.S. corporate profits and cash balances are at record levels and the dollar has surged, up 13% against the euro and 15% against the yen since the end of June. With the strong dollar, capital that had been flowing into emerging markets since the financial crisis is now hotfooting it back to the U.S. If the U.S. economy continues to improve — there currently are no signs of a recession in the making — the dollar will likely continue to strengthen and this should bode well for many U.S. equities.
But even with all of these tailwinds, investors should remember the keys to successful investing over the long haul are having a sensible investment plan, taking a disciplined approach and above all, maintaining a healthy attitude.
Some twenty-five years ago, the late David L. Babson, the noted investment counselor, observed that even among those investors who do have a plan for their portfolio, they too often do not stick with it through thick and thin:
“In periods of pessimism, they end up selling stocks when they should be buying. And when optimism prevails, they become lured by rumors, greed or bad advice into speculating when they should be investing.”
We are nothing if not disciplined. Thus, we will continue to invest in high-quality leading companies with solid fundamental characteristics and above-average prospects for the future. After all, it is the only sensible thing to do!
We are happy to announce that Lorrie R. Maker has joined our team. Lorrie is an Operations Assistant and will be working closely with Anne Farris, our Operations Manager. We are all looking forward to working with Lorrie in the years ahead and we hope that you will join us in welcoming her to our firm.
Finally, all of us at David Wendell Associates wish you and your family the very best for a New Year filled with joy, health and prosperity.
During the quarter, both the Dow Jones Industrial Average and the Standard & Poor’s 500 reached all-time record highs — 17,280 for the Dow and 2,011 for the Index — and ended the period up 1.3% and 0.6%, respectively. Year to date, the Dow has risen 2.8% and the S&P 500 6.7%.
Recent economic data show the U.S. economy growing at the fastest pace since 2011, regaining steam after the rough start to the year. Gross domestic product expanded at an annualized rate of 4.6% in the second quarter, revised up from a previous estimate of 4.2%.
Manufacturing activity, as measured by the Institute for Supply Management, showed increased business spending, particularly on constructing manufacturing plants, and was a major factor in the upward revision of second-quarter results. More recently, although unemployment fell below 6% for the first time since 2008, a real bright spot was the jump in the ISM services employment index which reached a new post-recession high.
However, anxiety and volatility have returned to the financial markets. The abrupt departure of the founder of Pimco, the world’s largest manager of fixed-income securities, has upended the bond world. In addition, several large hedge funds saw their values collapse after they lost a lawsuit over shares of Fannie Mae and Freddie Mac purchased in a bet made during the financial crisis. The Federal Reserve is on track to end its quantitative easing program and some are concerned about possible side effects. And finally, worries about Ebola, ISIS and Putin are not helpful to anyone’s outlook.
In such times, it is a sound investment principle not to go along with the prevailing mood, especially the mood on Wall Street. Investor emotions sometimes can influence share prices far more than cold, hard facts. And fear frequently leads to tunnel vision, which can obliterate the broad perspective that underlies successful long-term investing.
Over the 35 years since our firm’s beginning, we have found that maintaining a broad perspective comes easier when quality is first and foremost. In fact, quality has always been the linchpin of our investment philosophy. Our analytical work focuses on financially strong companies with solid fundamental characteristics, long track records and experienced top-notch management teams. These are the types of companies that not only survive but thrive in all sorts of business and market conditions.
Since the financial crisis, quality as an investment concept has gained traction and a number of firms have published various statistical analyses of high-quality companies over long periods of time and under different scenarios.
Last July, Standard & Poor’s Dow Jones Indices released a report entitled “Quality: A Distinct Equity Factor?” The study included a variety of statistical tests comparing high-quality to low-quality companies under different economic and market conditions. One of the conclusions was that quality tends to persevere over time:
“. . . high-quality stocks have outperformed low-quality ones on an absolute and a risk-adjusted basis over longer periods of time. This may illustrate that investors have historically been compensated for holding high-quality stocks.”
We’ve seen this time and time again in our clients’ portfolios, but it is nice to know that the benefits of owning high-quality companies have been statistically confirmed.
All of us at David Wendell Associates wish you and your family a very pleasant fall season.
The major market indices advanced during the quarter with the Dow Jones Industrial Average up some 2% and the Standard & Poor’s 500 4.7%. For the half-way mark of the year, the Dow has risen 1.5% and the S&P 500 slightly above 6%.
Recent economic data looks encouraging. Private sector jobs rose 1.33 million through the end of June, the most job growth in the first six months of any year since 1998. The unemployment rate is now down to just over 6% compared to its 7.5% reading a year ago. And in manufacturing, new orders are at a seven-month high.
Economic growth estimates for the first quarter were recently revised down again to a near-3% contraction in GDP, apparently due to a bad combination of winter weather, inventory drawdowns, falling exports and slow consumer healthcare spending. At this point, it appears likely to be a one-off event. Nevertheless, we think it makes sense to continue focusing on leading high-quality, growing firms with solid fundamental characteristics and management teams experienced in all phases of the business cycle.
Also enclosed is our firm’s statement on the privacy of your confidential information. Government regulations require that we provide you with a copy of the statement each year. Of course, this written statement only reaffirms the policies and practices we have emulated over the years. All of us at David Wendell Associates wish you and your family a very pleasant summer.
During the first quarter of the year, the Standard & Poor’s 500 advanced a bit over 1% while the Dow Jones Industrial Average declined almost 1%. After last year’s strong showing, the markets seem to be pausing for a “breather.”
On Wall Street, concerns are mounting about the effects of the brutal winter on the economy. Some think that weather may have slowed growth from the December quarter’s 2.6% rate to possibly less than 1% for the period just ended. As one purchasing manager noted responding to a regular government survey, “We need spring.”
Even if the polar vortex chilled first-quarter earnings, recent March data is encouraging. Sales of automobiles and trucks were at the fastest pace in seven years and the labor report also showed a rebound. In fact, private sector employment exceeded its previous peak reached in early 2008.
Overall, the U.S. economy remains on track for modest expansion with low inflation. After-tax corporate profits rose an impressive 8% to a new all-time high last year. The leading companies we favor typically increase their earnings at above-average rates and then reinvest in the future growth of their businesses at superior rates as well. Even if it takes a while for spring to truly arrive, or if other issues crop up, we have every confidence in our high-quality companies and their top-notch management teams.
Fourth Quarter, 2013
In 2013, the major market indices had their best year since the 1990s: the Dow Jones Industrial Average increased over 26% and the Standard & Poor’s 500 Index almost 30%. Since its low reached in March 2009, the S&P 500 has risen 173%, some 66% more than the prior “V-shaped” recoveries of 2003-2008 and 1996-2000.
On Wall Street, 2013 has been dubbed “The Year of the Boring Investor.” Buying and holding a portfolio U.S. stocks beat out the complex hedging and tactical timing strategies used by hedge funds and other large, institutional investors. The shares of U.S.-based companies also bested many other asset classes, including commodities, bonds and emerging markets. As one investment wag noted, “the more colorful your pie chart, the worse you did.”
An improving economy as well as low interest rates helped power the markets. At the beginning of the year, the unemployment rate was 7.8%, but by November it had fallen to 7%. In the third quarter, economic growth came in at just over 4%, representing a year-over-year increase of 46%. For the entire year, the economy likely grew at an annual rate of about 2½%, below its long-term average of 3%, but decent nonetheless.
Interest rates on the benchmark 10-year U.S. Treasury note recently passed 3%, but are still below their long-term average of over 6%. Since the 1960s, when interest rates have been below 5% and rising, stock prices have tended to trend upwards as well.
Going forward, the Federal Reserve will begin reducing its bond-buying program by a modest $10 billion a month starting in January. With the Fed also committing to keeping interest rates low until the unemployment rate is well below 6½%, Wall Street seems to have overcome its “taper jitters,” at least for the time being.
We think that owning the shares of high-quality, leading growth companies continues to make sense in the current investing environment. Even with the slow-growth economy, many of the companies we have recommended in recent years have expanded their revenues through innovation and the development of new products and services. They also have entered new markets and geographies. Their top-notch management teams have kept profit margins healthy and earnings per share growing. For companies that pay dividends, over the last several years their Boards of Directors have generally increased the dividend at superior, above-average rates. There is no reason to think these companies will not continue to reward their shareholders in the years ahead.
“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to heaven, we were all going direct the other way — in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only.”
Charles Dickens, A Tale of Two Cities (1859)
The major market indices continued to advance during the quarter, with the Dow Jones Industrial Average up 1.5% and the Standard & Poor’s 500 increasing 4.7%. For the year-to-date, the Dow has increased over 15% and the S&P 500 nearly 18%. Many of the companies we follow have seen their share prices reach all-time highs this year with an ebullient mood seeming to be the norm on Wall Street.
The U.S. economy is continuing to plod along, slowly improving. Estimates vary as to the impact of the government shutdown, with some economists predicting fairly significant effects in Gross Domestic Production while others thinking that any negative effects will likely be minimal. In the seventeen prior government shutdowns, furloughed employees were paid in full once the budget battles were over. Also, about half of the 800,000 furloughed government workers already have been ordered back to work.
One bright spot is that growth in the Eurozone is picking up after the recession of the last two years. This is a good development for global growth and will help U.S. companies with operations around the world.
In the current highly charged environment of political tit for tat, it is easy for investors to focus only on the short term and become anxious and discouraged. As part of our work, we maintain a long-term point of view. One of the characteristics we look for when we analyze a company is its track record for paying dividends.
The decision to pay or increase a dividend is made by the Board of Directors and is based, in large part, on the company’s success in growing its revenues and earnings and its outlook for future growth. If a company is successful in bringing out new products or services, its revenues are likely to grow and with good management, its earnings should too. Companies with long track records of paying and increasing their dividends have gone through all sorts of business and economic conditions, including periods of extreme dysfunction in Washington.
We recently reviewed the track records of a number of dividend-paying companies we have recommended over the years. Of these twenty-five high-quality companies, 20% have increased their dividends each year since the early 1970s, a terrible time in the economy and on Wall Street. Four of these companies have increased their dividends each year since the early 1960s. With the exception of one company which started paying a dividend two years ago, all of the companies paid and increased their dividends throughout the financial crisis.
In short, despite the turbulent times over the last 40 to 50 years in society, in Washington, in the economy and on Wall Street, the management teams of these leading growth companies figured out how to keep introducing new products and services and how to keep growing their revenues, earnings and dividends. We think these are the companies to own in the best of times, in the worst of times and in all the times in between.
The major market indices continued to advance with both the Dow Jones Industrial Average and the Standard & Poor’s 500 Index increasing some 2% during the quarter. Year-to-date, the Dow is up almost 14% and the S&P 500 over 12%.
But in just the last few weeks, Wall Street came down with a bad case of “Fed jitters.” In June, Federal Reserve Chairman Ben Bernanke noted the central bank could begin winding down its $85 billion-a-month bond-buying program later this year and possibly end it altogether by the middle of next year. Basically, the Fed sees the economy improving enough so that its quantitative easing programs might be scaled back, especially if, as forecasted, growth picks up and unemployment goes down.
On Wall Street, Bernanke’s comments triggered a chain reaction of selling as large institutional investors immediately adjusted their strategies and prepared for the end of “easy money.” Gold in particular was hit hard falling 23% in price, its biggest quarterly decline since gold futures began trading in 1974. Bonds were also affected with the Barclay’s investment-grade corporate-bond index declining over 3%.
Emerging markets, once the darlings of Wall Street, saw their biggest drop in nearly five years on concerns about China’s economy and the political unrest in Brazil, Egypt, Portugal and Turkey, among others. A popular emerging market index, the MSCI EM stock index, dropped over 9% in the quarter.
In contrast, the shares of many of the companies we have recommended over the years more than held their own during this tumultuous period. In fact, an increasing number of firms on Wall Street, having tried everything else, now are touting the benefits of investing in top-notch companies with high profit margins, high reinvestment rates and the ability to regularly increase dividends.
The important thing to remember is that the economy is improving and the extraordinary measures taken during and since the financial crisis may not be needed in the future. That is a very good development. But with traders second-guessing their latest reckonings, almost every day on Wall Street has turned into “Opposite Day.” As one wag put it, bad economic news is seen as good for stocks while good economic news is seen as bad for stocks.
Our standards remain unchanged. We continue to focus on the common shares of high-quality, financially strong companies with solid fundamental characteristics. Their management teams tend to be composed of experienced professionals who, in the past, have successfully navigated through difficult economic conditions as well as the vagaries of Washington politics. There is no reason to think they will not continue to do so in the future.
All of us at David Wendell Associates wish you and your family a sunny, safe and pleasant summer.
Both the Dow Jones Industrial Average and the Standard & Poor’s 500 Index hit record highs during the quarter with the Dow finishing up over 11% and the S&P 500 increasing 10%.
Institutional investors and professional traders were behind much of the rally and one wag dubbed them “Tina” investors, as in “There is No Alternative” to stocks. With interest rates low and quantitative easing in effect around much of the globe, many on Wall Street see equities as the only way to achieve decent returns.
But Wall Street also is on tenterhooks, quickly reacting to any news not passing muster. This “shoot first, ask questions later” attitude is based on concerns over if and when the Federal Reserve will change its stance on quantitative easing. To date, the easy money policy has been good for the equity markets but Wall Street is concerned about what will happen should the Fed change its position.
Although many investors are focusing on the labor markets for early divination of the Fed’s intentions, this data, like most economic data, is subject to constant revisions. Thus, the markets may be volatile as Wall Street digests each new release.
Nevertheless, the economy continues to improve slowly. With fiscal cliff and sequestration concerns fading, businesses and consumers appear to be getting back on track.
Gross Domestic Production has expanded for 15 consecutive quarters and the housing market has improved to the extent that it is no longer a drag on the economy or on consumer sentiment. Construction spending is increasing and should lend important economic support. Finally, industrial production has almost fully recovered with production of business equipment at a new all-time high.
We remain encouraged by the progress of many of the companies we follow. With their strong and growing businesses, they are able to generate healthy cash flows and thus keep their debt levels low and their balance sheets pristine. There is every indication that they will continue to grow their businesses, and thus their revenues and earnings, in the years ahead. With their shareholder-friendly Boards of Directors, we expect that they also will continue to increase their dividends at above-average rates.
The year was dominated by uncertainties manufactured in Washington, but the U.S. economy continued its steady improvement despite the elections, the “fiscal cliff,” and the difficult planning environment confronting both businesses and investors.
Third-quarter economic growth was revised upwards to 3.1% while unemployment dipped to 7.8% — still above its 50-year average of 6.1% but well below 2009’s rate of 10%. The housing market too has improved and new home sales have increased about 38% from 2011’s all-time low. Consumer sentiment as well is up from the lows seen two years ago.
The stock markets reflect this progress. The Dow Jones Industrial Average finished the year with a better than 7% gain while the Standard & Poor’s 500 Index was up over 13%. Gold, which just a few years ago was the “go-to” choice for many on Wall Street, saw a paltry, fractional increase of only 0.06%.
Inflation, the bane of all investors, is still contained at an annual rate of 1.8%, well below its 50-year average of 4.2%. Some pricing pressures may be developing -– in the food & beverage sector, for example — but the Federal Reserve thinks that overall inflation will run at or below its 2% target during the next year or so. If and when inflation does begin to rise, over the last forty years when inflation has been low and rising, equities have typically performed better than either bonds or commodities.
For the coming year, one thing is certain, unfortunately. The tax deal between Congress and the White House left a number of “fiscal cliff” issues unresolved, guaranteeing more political brinkmanship. In late February, Congress will likely have to boost the debt limit once again. In the beginning of March, the automatic spending cuts, which were deferred in this week’s deal, are scheduled to kick in and at the end of March, there may be a government shutdown unless Congress approves funding through September 30.
But even though the political games will continue, high-quality, growing companies, such as the ones we have recommended over the years, should continue to excel. One of the key fundamental characteristics we look for in analyzing a company is an experienced management team.
More than any other factor, the quality of management is crucial to a company’s long-term success. Management teams must be able to do more than just cope with a constantly changing environment, they must be able to thrive in it. Many of the traits we favor, such as a leading position in a growing market and consistent long-term earnings and dividend growth through the different phases of the business cycle, are directly attributable to management.
We suspect that even though the management teams of our companies were just as frustrated as we were by Washington’s antics, they too were busy figuring out how to make the best of a bad situation.
A few years ago, the phrase “the lost decade” became popular on Wall Street. It referred to the ten-year period from 1998 through 2008 when the broad range of stocks in the Standard & Poor’s 500 Index did not keep pace with other types of investments. Those ten years were punctuated by several market bubbles, two recessions, a terrorist attack, and a near melt-down of the global financial system.
Nevertheless, a group of high-quality, growing companies that we follow had a cumulative ten-year mean share price increase of 80% over the period 1998 through 2008. In contrast, the cumulative ten-year price increase for the S&P 500 was just 1% over the same period.
In terms of dividends and earnings per share, revenue and reinvestment rates, our group of high-quality, growing companies was far superior to the average company in the Index. The complete analysis can be found in our Second Quarter, 2009 newsletter “Was the Decade Really “Lost”?” available on our website www.davidwendell.com.
The point is that top-notch, high-quality growth companies have excelled before in difficult times and there is every reason to think that they will continue to surpass the merely average company in the years ahead — no matter what political grandstanding and showmanship emanates from Washington.
We, just as our companies’ management teams, will continue to monitor the situation and be on the lookout for opportunities throughout the year. In the meantime, all of us at David Wendell Associates wish you and your family the very best for a New Year filled with joy, health and prosperity.
A year ago, shell-shocked investors had just come through a rough summer, culminating in the first-ever downgrade of U.S. Treasury debt. In contrast, this summer saw a two-month rally on Wall Street some have described as “furious.” For the quarter, the Standard & Poor’s 500 advanced 6% while the Dow Jones Industrial Average saw a better than 4% increase. Year-to-date, the S&P 500 is up over 16% while the Dow is up over 10%.
At the same time, economic growth for the second quarter was revised down to a pace of 1.3% and for the third quarter, a rate of only 1.5% is now expected. For perspective, the historical, long-term rate of U.S. economic expansion is 3%.
Growth overseas is moderating too with much of Europe in recession and China’s economy slowing. For S&P 500 companies, a number of pre-announcements have led analysts to lower their current earnings expectations — the average company in the Index may see an earnings decline for the first time in three years. Some economists have boosted the likelihood of a recession — in one case to a chance of 25% in the next year.
Thus, the factors behind the market’s recent gains are likely to be for other than fundamental reasons and it is prudent to be cautious, if not skeptical, in such an environment.
For example, last spring hedge funds and other large institutional investors with short-term horizons reduced their equity holdings on fears of a European meltdown. Having “sold in May and gone away,” their performance was lagging into the summer months and they apparently charged into equities, speculative and otherwise, in an effort to catch up.
The “plenty money” policies of the Federal Reserve also are contributing to distortions, both in the financial markets and in the economy.
The Federal Reserve recently initiated a third round of quantitative easing, nicknamed “QE3.” Under this new program, the Fed will buy $40 billion of mortgage-backed securities each month. This will artificially suppress mortgage rates and the hope is that the housing market will be stimulated and thus spur growth in the broader economy.
In a change from prior programs, this round of easing will last as long as the Fed feels it is necessary or until there is “substantial improvement” in the jobs market. Interest rates, currently at historically low levels, are now expected to remain so a year longer than before, until at least mid-2015.
The Fed’s first quantitative easing program ran from November 2008 to June 2010 and was aimed at strengthening the balance sheets of financial institutions in the aftermath of the crisis. The new money was used to buy mortgage-backed securities as well as short-term Treasury notes. Purchases during QE1 averaged about $100 billion per month.
The second program, QE2, started at the end of 2010 and lasted about 10 months. Its goal was to jump-start the sluggish economy and purchases then averaged about $75 billion a month.
This time, with QE3 and the continuation of another program called “Operation Twist,” roughly $85 billion a month will be injected into the economy. Some economic wags have said the new program should really be called “QE4-ever.”
One effect of the new money injections combined with low interest rates is to encourage investors into areas, such as equities, with better yields than the current bond markets — thus the recent rally.
Having tried multiple stimulus programs, it is fair to ask why the economy is not in better shape. As Fed Chief Benjamin Bernanke has repeatedly stated, “monetary policy is not a panacea.” Quantitative easing cannot offset the toll of any steep tax hikes and spending cuts, including the upcoming fiscal cliff. Congress is responsible for fiscal policy and, unfortunately, it is not likely to do anything until after the November elections.
For U.S. businesses, this uncertainty has meant a delay in investment and spending decisions until a clearer framework for planning emerges. Management teams also are waiting to feel more confident about their operating environments.
In Europe, some countries have begun to take fiscal steps to deal with their slowing economies and financial crises. France recently announced a plan to impose a 75% tax rate on incomes over €1 million ($1.3 million), as well as a new 45% tax rate on incomes over €150,000 and a doubling of capital gains taxes. Spain also is raising income, consumption and excise taxes and other countries will likely follow similar paths. Whether or not these efforts help solve the current problems remains to be seen.
Thus, markets and economies around the world are facing a host of challenges. With Wall Street’s persistent focus on the short-term, “bits and pieces” of daily current events, it is vitally important for investors to keep a long-term perspective.
We continue to recommend the common shares of high-quality, financially strong companies with solid fundamental characteristics. Since the financial crisis, the vast majority of these companies have outperformed the merely average firm. With their long operating histories, strong balance sheets and high cash reserves, they have the wherewithal to withstand a slow-growth economy.
They are frequently the number one or two leaders in their market segments and typically have maintained their positions through the different phases of past economic cycles. Their management teams tend to be composed of experienced, top-notch individuals who know how to deal effectively with short-term problems without losing sight of long-term goals.
Many of these companies now have very attractive dividend yields and over the years, their boards of directors have proven track records of increasing the dividend rate to benefit shareholders. With interest rates low and expected to remain so for the next few years, this is an important consideration.
We remain confident and optimistic about the vast majority of companies we have recommended over the years. Many of them are among the finest companies in the world. They have been through tough times before, should come through these times just fine, and are likely to continue to grow their revenues, earnings and dividends over the years, well into the future.
After an encouraging start to the year, the major market indices suffered a rocky second quarter: the Dow Jones Industrial Average fell over 2% while the Standard & Poor’s 500 Index saw a more than 3% decline.
Sovereign issues in Europe and slowing growth in China, as well as healthcare reform and the coming “fiscal cliff” in the U.S. all converged to form Wall Street’s focal point of fears. Even so, for the year-to-date, the Dow has advanced 5% while the S&P 500 is up more than 8%. Around the globe, the U.S. has fared better than many markets — for example, the Dow Jones Global ex-U.S. Index has seen only a 1% increase for the year-to-date.
Recent economic data only added to the medley. Initial estimates for manufacturing activity in June were substantially below expectations, leading to concerns that the economy could slide into a recession.
However, other data do not support this thesis. Manufacturing employment has been steadily increasing at an annualized rate of 3% for the year and the most recent data for factory orders were positive and above expectations. Also, both the housing and construction industries have been improving and business investment spending is strong as well.
Furthermore, first-quarter profits for non-financial companies in the S&P 500 Index came in at all-time highs and balance sheets remain healthy and strong. Estimates for the remainder of the year indicate continued growth in earnings and dividends.
Looking at the historical relationship between manufacturing activity and the economy, if the activity rate for the first six months of the year is annualized, an economic growth rate of 3.5% is suggested. On the other hand, if the rate for just the month of June is annualized, a pace of 2.4% is indicated. Both of these figures are well above the 1.9% expansion rate seen in the first quarter of the year.
Wall Street’s psychological outlook seems to be bruised, if not battered, and only focused on day-to-day issues — in other words, the extreme short-term. In such an environment, more important long-term trends easily can be lost in the shuffle.
For example, one developing trend could have very positive effects in the U.S. in the years ahead. An increasing number of multinational companies are returning their manufacturing operations to the U.S. from overseas locations. This is known as “reshoring” and it is happening because over the last decade, factories in the U.S. increased their cost competitiveness while the expected benefits of “offshoring” to low-cost countries did not materialize. Some of these returning companies include Caterpillar, Coleman, Ford and NCR, among others. In addition, a number of foreign companies are setting up operations in the U.S., such as the recent announcement by French manufacturer Airbus.
As the year progresses, many of Wall Street’s current fears will likely ease. Regardless, high-quality, financially strong companies with expanding markets and growing earnings and dividends should continue to do relatively well.
Finally, the Wall Street Journal recently reported an encouraging tidbit: in the years where the Dow Jones Industrial Average rose in the first half of the year, it finished the full year in the black 88% of the time. In addition, gains were extended from the year’s mid-point 71% of the time.
With an 8% increase in price, this was the best first quarter for the Dow Jones Industrial Average in 14 years and the 1,000-point gain was its biggest quarterly showing ever. The Standard & Poor’s 500 increased 12% in the quarter and crossed the 1,400 level for the first time since the financial crisis began. It is now less than 1% below its peak in 2007.
In the U.S., the manufacturing sector is on an expansion track and recent production data indicates the trend will likely continue. The service sector is growing even more rapidly and has been expanding for 27 straight months. Corporate profits, currently at record highs, as well as other economic data, seem to suggest that the economy may be growing at rates faster than the official data indicates. Economic growth in the fourth quarter was 15% above the twenty-year average.
Europe, however, is altogether a different story. During the quarter, Greece was able to complete its debt restructuring with relative calm and this helped brighten investor sentiment. But Spain, Portugal and Italy remain in dire straits. Overall, it may be years before the Euro zone debt problems are resolved, if ever.
Some analysts on Wall Street are concerned that slowing international growth and high commodity prices may hinder corporate earnings growth this year. We recently conducted an analysis of our top twenty-five client equity holdings for the five years from 2007 to 2011. This period encompasses the financial crisis, the recession and many of the Euro zone troubles. As of December 31, 2011, our top twenty-five client equity holdings were:
|Abbott Labs||Johnson & Johnson||Qualcomm|
|Automatic Data Proc.||McDonald’s||Stryker|
|Church & Dwight||McCormick & Co.||Sysco Corp.|
|Colgate-Palmolive||Nike “B”||United Technologies|
|IBM||Procter & Gamble|
What we found was that even though the management teams of these companies were dealt hands from the same deck of cards as all managements, they were still able to meaningfully outperform the average company.
Over the 2007 to 2011 period, these companies, as a group, maintained funding for their research and development activities at rates far superior to those of the companies in the Standard & Poor’s 500.
By continuing to develop and introduce new products and services, this group of companies increased their revenues at rates much higher than that of the average company. And through excellent management, they increased their average operating margins each year while the typical company was barely able to maintain its operating margins.
Not surprisingly, the earnings per share of these companies increased at faster, more consistent paces than that of the S&P 500, as did their total return. Total return is defined as capital appreciation plus dividends, so it includes Wall Street’s recognition of their above-average performance through the rising prices of their common shares.
In a nutshell, we think that if these companies, and others like them, can turn in such superior results during a once-in-a-lifetime crisis, they can certainly out-manage the average company in the years ahead. Quality and financial strength are important for a number of reasons, not least of which is investment success over the long haul.
After twelve months of natural disasters, political brinkmanship and fears of a European meltdown, the Standard & Poor’s 500 Index finished the year virtually flat while the Dow Jones Industrial Average increased almost 6% in price.
These were far better results than others around the world. Among the 37 widely followed international stock indices, the average price decline last year was 12%. In the Euro Zone, stocks fell over 15% while some emerging markets, such as Brazil, dropped about 17%. China and India each fell more than 20%.
For large, institutional investors it was a rough year. On average, hedge funds lost some 5%, making a third straight year of lagging behind stock market returns. Supposedly constructed to thrive regardless of market conditions, some funds were undone in 2011 by wild swings in the stock markets. As fears about Europe reached a crescendo in August, many fund managers raced to reduce their stock holdings, only to miss out on the rebound in October.
Their strategy of placing large, highly leveraged bets was upended too. Some high-profile funds were battered by their concentrated exposures, such as in Europe, which did not work out as modeled. One such fund lost more than half its value.
In contrast, the shares of many high-quality, leading growth companies performed admirably last year. These companies, with their strong fundamental characteristics, dominant market positions and experienced management teams, sailed relatively unscathed through the summer storms.
Last year also highlighted the difference between placing bets based on modeled assumptions and investing based on common sense.
In a period of heightened volatility and great uncertainty, investing in financially robust and managerially sound companies makes more sense than wagering on the shifting sands of politics and policies. Many of the companies we have recommended over the years appear poised to continue their superior record of building market share, increasing revenues and growing earnings and dividends.
And economic data continues to point to an improving economy. Manufacturing now has grown for 29 consecutive months while the service sector has remained in expansion territory for 25 straight months. Even the housing and construction industries seem to be on the mend.
Some Wall Street analysts have declared that the U.S. is the only place on which they are bullish for 2012. We think that quality is the place to be, where ever it is found, this year and in the years ahead.
It was a tough summer for the financial markets. The Standard & Poor’s 500 Index fell 14% during the quarter and was down 10% for the year. Political bickering, Washington vitriol and shrill headlines in combination with fears of a Euro zone debt crisis and the first-ever downgrade of U.S. Treasury debt, all contributed to the dismal showing.
Too, concerns about the U.S. economy have been rising, although most economists are not currently forecasting a recession. Weekly economic data, as opposed to data reported on a monthly or quarterly basis, continue to show strength. Over the last two months, weekly retail sales, steel production, rail car traffic and hotel occupancies have all been stable with no indication of a downturn.
Monthly data, such as that for the manufacturing and construction industries, also show no sign of recession. In fact, the recent results for the ISM manufacturing index, a survey of 400 companies in twenty major industries, not only beat expectations but climbed to its highest level in three months.
Many companies started the quarter in fine financial shape. Operating income for S&P 500 companies set an all-time high, well above the previous tally set in 2007. Margins were at near-record levels and cash flow was very strong, likely surpassing the record levels achieved in the first quarter. Cash dividends paid jumped almost 20%, the best showing since 2006, and share buybacks appear to have surpassed their previous record amounts set in early 2008.
The schism between headlines and facts is not unnoticed. Thomas Stemburg, founder of Staples and now General Manager of the Consumer Fund of Highland Capital Partners, recently appeared on the cable business news channel CNBC. He was asked about the economic headwinds facing the companies in his fund. He replied: “Gosh, you know, every day I watch your show and I get concerned, then I go back to the office and look at the sales reports and they are just fine thank you . . .”
The possibility of a sovereign debt default in Greece is even making the local headlines here in New Hampshire. What is not often reported is that Greece has a long history of defaulting on its debt. By some estimates, has been in default 51% of the time since its independence in 1830. Globalization has made financial markets and institutions increasingly interconnected and co-dependent, thus the fears that yet another Greek default will spread across Europe and into the U.S.
However, in contrast to 2008, there is abundant liquidity in the financial system and most of its parts, such as short-term corporate and bank-to-bank credit functions, are operating normally. Greece and the Euro zone do have serious structural issues to address and the process will take years. But in the short-term, a managed event, such as the defaults of GM and Chrysler in 2009, is the likely solution — after, of course, a few rounds of political brinkmanship.
It can be difficult for even experienced investors to remain optimistic, focused and disciplined in times such as these when, overwhelmingly, the consensus dictates otherwise.
Out of curiosity, we reviewed our clients’ holdings for the shares of companies purchased during the 1970s — also a period of falling real estate values, a stock market crash, corporate bankruptcies, volatile oil prices and partisan strife. Shown below are holdings from the June 30th appraisals of four different client portfolios:
|Number Of Shares||Company||Date Purchased||Amount Invested||Current Market Value||Annual Income|
|7,000||Colgate-Palmolive||1970-1971||$ 2,177||$ 142,000||$ 3,712|
|20,000||McDonald’s||12/18/72-12/24/73||$ 33,583||$ 1,760,000||$ 48,800|
|3,200||Automatic Data Processing||1977||$ 2,285||$ 150,400||$ 4,608|
|5,300||Abbott Labs||1979||$ 5,097||$ 270,300||$ 10,176|
Notice the difference in the amount invested and in the market value as of June 30th, 2011. Notice also the difference in the amount invested and the total annual income — in each case, the annual dividend income being received each and every year is more than the amount that was originally invested, in most cases significantly more.
These are real world examples of investing in high-quality growing companies and of holding on to them through thick and thin. Traders and speculators who jump in and out of the market, and hedge funds relying on computer models and algorithmic trading programs, rarely see such results. And they do not have the “sleep well at night” benefit that comes with investing in top-notch management teams with long track records of increasing their companies’ revenues, earnings and dividends.
This is why we have so much confidence in the companies we follow and recommend for the years ahead. This is also why we view this period as an opportunity: many of the companies we follow are currently appraised at valuations significantly below their long-term averages.
For example, the S&P 500 is currently appraised at a price/earnings ratio of 11 times 2012 projected earnings while its average p/e ratio over the last decade is 17 times. This represents a current discount of 35%.
A group of top-rated, high-quality companies that we have recommended over the years is currently appraised at a 30% discount to its average p/e ratio over the last decade. Thus, many of the best companies in the world are currently appraised at deep discounts to their historical averages. This is why Warren Buffett has announced that his Berkshire Hathaway fund, for the first time ever, will be buying back its shares in the coming months.
Whatever the future may hold, we think owning the shares of great companies with superior prospects makes tremendous sense. We hope this letter has been helpful to you in reviewing the current investing environment. If you have any questions or would like to discuss anything, please feel free to give us a call.
Wall Street continues to be rattled by a host of worries — among them a sluggish U.S. economy, rising energy and commodity costs, the end of the Federal Reserve’s monetary easing program, unrest in the Middle East, the after-effects of Japan’s disasters, and the true state of the Euro zone’s financial system. Through the week of June 24th, the Standard & Poor’s 500 Index was essentially flat for the year.
But during the last week of the month, Wall Street pushed aside its fears and rallied mightily. For the second quarter, the Index was flat but year-to-date through June 30th, it was up 5%.
Recent data does show some key economic indicators as still expanding. In the U.S., manufacturing has strengthened and the housing market appears to be on better footing. In Japan, industrial output is snapping back and disruptions to global supply chains are not as bad as initially feared. In fact, they are easing. One recent study found that over the last decade, many global manufacturers built redundancies and alternatives into their systems, making them more resilient to external shocks.
Some of the worries, though, will likely continue for the remainder of the year. In addition, many investors will be monitoring closely politics and policies, both here and abroad, over the coming months. In this investing environment, it makes sense to focus on the fundamental underlying characteristics of a company as well as the track record of its management team.
Many of the companies we have recommended over the years continue to display earnings momentum with expanding revenues and healthy margins. Their seasoned management teams tend to have stellar track records, having successfully navigated the financial crisis and recession and positioned their companies well for future growth. Add to this their financial strength and overall quality and you can understand our confidence in these companies as investments for the years ahead.
The Dow Jones Industrial Average advanced some 6% for the quarter, its best first quarter results in twelve years. The Standard & Poor’s 500 Index was not far behind, with a better than 5% rise.
Economic data here and around the world show continuing improvement. U.S. corporate profits hit a record high at the end of last year — making a near perfect “V-shaped recovery” from the Panic of 2008. Jobless claims have been in a downward trend since March of 2009 and both inventories and payrolls have picked up in recent months, a sign we may be moving into a more promising phase of the business cycle.
The global economy also is continuing to strengthen. Estimated growth rates for many emerging economies, such as Brazil, Russia, India and China, are generally rising and many commodity-based economies, such as Australia and Canada, are also expected to grow at above-average rates.
However, there are a number of uncertainties and, as one wag put it, “it’s the unknowns that are unknown we’re dealing with.” Upheavals in the Middle East and North Africa and the tragic events in Japan may begin to affect growth in the coming months. Oil prices have already risen on the unrest in the Arab nations.
Japan may prove to be a larger issue with its radiation problems and potential supply chain disruptions. Until the nuclear facilities are stabilized, it is impossible to forecast what any potential effects may be.
In global supply chains, Japan is an important link for component parts, mostly in the automotive, industrial and technology industries. Many observers expect that if, after three months, damages from the earthquake and tsunami are not resolved, production may slow but other countries, such as Taiwan, Korea and China, will likely pick up any slack.
Following the earthquake and tsunami, we reviewed our companies for their exposure to Japan. For the most part, we do not expect any long-lasting issues but will continue to monitor the situation. The country has already reconstructed some of the roads that were destroyed in the earthquake. As the English philosopher and economist John Stuart Mill wrote in 1899:
“What has so often excited wonder (is) the great
rapidity with which countries recover from a state of
devastation; the disappearance, in a short time, of all
traces of the mischiefs done by earthquakes, floods,
hurricanes, and the ravages of war.”
We also are pleased to announce that William H.L. Mitchell, “Ledge”, has joined our firm. In 1985, Ledge and two other partners founded Johnston Reid & Mitchell, an investment counseling firm also located in Portsmouth. Upon the retirement of his last partner at year-end, Ledge joined forces with us in January.
Prior to founding JR&M, Ledge was a Vice President at David L. Babson & Company, the same company from which my father hailed. David Babson, the founder of that firm, was a highly respected investor and one of the originators of the long-term growth stock investment philosophy, which we, and Ledge, follow to this day.
Over the years, Ledge has been a good friend of the firm. In fact, after we left our Maine office in 1994, Ledge came over (with a bottle of champagne) to welcome us on the very first day we opened our office in Portsmouth. With his long experience as an investment counselor and his deep knowledge of the financial markets, he is a welcome addition to our team and all of us are looking forward to working with him in the years ahead.
Since last summer, the economy has continued to strengthen and now investor psychology is markedly bullish. Wall Street ended the year with double-digit gains — the Standard & Poor’s 500 was up almost 13% while the Dow Jones Industrial Average increased 11%.
Indeed, there is much to be optimistic about. Strong demand here and abroad helped the manufacturing sector post its 17th consecutive month of expansion. And since mid-2009, real gross domestic production has increased at an annual rate of 3.25%, faster than the long-term average of just over 3%.
Profits were up 26% in the third quarter for non-financial companies, to the highest level seen in four years. Many companies are boosting their expenditures on research and development, investing in new plant and equipment and expanding into new markets — all trends with positive ripple effects.
Over the next year, rising costs for energy, raw materials and other inputs may impact margins and thus corporate profits. But the strong fundamental characteristics as well as the market dominance and pricing power of the high-quality, growing companies we prefer should stand them in good stead if inflation does pick up.
All of us at David Wendell Associates wish you and your family a happy, healthy and prosperous New Year.
Last month, the Dow Jones Industrial Average saw its best September in over seventy years, rising almost 8%. For the year-to-date, the DJIA is up about 4% and the Standard & Poor’s 500 just over 2%.
Also notable last month was the pronouncement that the recession that began in late 2007 actually ended over a year ago, in June 2009. This would make it the second-longest economic downturn since the Great Depression, which lasted for 43 months. But at 18 months, it would be only two months longer than the downturns of 1973-75 and 1981-82, both of which lasted 16 months.
Interestingly, this recovery seems to be following a pattern similar to those seen at the end of each recession over the past 40 years. As the recession ends, there is an initial sharp increase in economic activity. This is followed by a brief pause lasting for two-to-three quarters. Then, economic growth picks up and resumes its upward track. Historically, the last segment to improve in a recovery is the jobs market.
Overall, the data show an economy continuing to recover. The manufacturing sector just logged its 14th consecutive month of growth. Consumer spending and personal income have also increased. These seem to indicate that the recovery has moved from its initial phase of rebuilding inventories for businesses to a new phase based more on good old-fashioned demand from both consumers and businesses.
However, many uncertainties remain and will continue to affect corporate decision making until at least the November elections. Recent data show that cash assets on corporate balance sheets have grown to extreme and unprecedented levels. For industrial S&P companies (non-financial, telecom and utility companies), cash balances have increased 28% since 2008 and 1% since the beginning of this year.
Of course, many of the leading, profitable and well-managed companies that we have recommended have grown their cash balances at much faster rates. But in terms of the big picture, the level of these cash balances is significant as, once unleashed, the funds could contribute meaningfully to the rebounding economy.
We are also very pleased to enclose a recent article written by our partner Peter Boland. It was published in the Portland Press Herald just a few weeks ago and is entitled “High-Quality Stocks Reward Wise Investors”. We thought you might enjoy Peter’s observations on the outlook for leading, quality companies with growing earnings and dividends.
For the second quarter, the Dow Jones Industrial Average fell 10% while the Standard & Poor’s 500 declined almost 12%. For the year-to-date, the indices are down 6% to 8%, compared to stock market declines of 10% in Europe, 11% in Japan and almost 27% in China.
Up until the end of April, the U.S. economy was recovering, albeit more slowly than in past cycles. But May and June were brutal: a disruptive Icelandic volcano, a deepwater and as-of-yet uncontained oil spill, a still-unexplained stock market “flash crash”, a European sovereign debt crisis, and heightened concerns about our nation’s fiscal policies all helped sour the outlook, sending many investors to the sidelines.
But there is a distinct disconnect between Wall Street’s take and the outstanding results many U.S. companies are actually achieving. Looking at the big picture, almost a third of the companies in the S&P 500 have either increased or initiated new dividend payments. As of mid-year, dividend payouts have increased some $11 billion. Only two companies in the S&P 500 have decreased or suspended their dividends this year, compared to 78 companies that cut payouts in 2009. That year, dividends were cut by a record $37 billion.
The point is that companies do not, in general, increase or declare dividends unless they are feeling confident about their prospects going forward. Dividends are paid with real money, funds which could be needed for other purposes when times are bad. Thus, the actions of these companies seem to belie the widespread atmosphere of pessimism and fear.
Many of the leading, high-quality companies we have recommended over the years are increasing their dividends, and earnings, at above-average rates. This is important as we know of few other ways to combat the effects of inflation. And the high current dividend yields available on many stocks offer a decent alternative to low bond rates without venturing into exotic, riskier areas. The companies we follow tend to have seasoned management teams that have been around the block a few times and know how to operate in difficult conditions. Most continued to grow their businesses through the financial crisis.
A recent economic study compared the current recession to the Great Depression of the 1930s in terms of length and severity. The Great Depression lasted over 4 years and saw a 27% decline in real gross domestic production. In contrast, the current recession is just under 2 years old and has seen only a 4% decline in real GDP.
In emotional times such as these, it has always been a sound investment principle not to go along with the prevailing mood and to remember that the outlook is never all black or all white. There are a number of observations pertinent in assessing the current situation:
- The important long-range trends have not changed.
- Due to strengthening economic fundamentals, the current recession is more likely to end sooner rather than later.
- The earnings and dividend progress of many high-quality companies, as well as their underlying fundamental characteristics, are intact, and, in many cases, at record levels.
- The stock market is always unpredictable and its major turning points almost invariably occur for reasons that are obvious only in hindsight.
During the quarter just completed, the Standard & Poor’s 500 advanced about 5% and the Dow Jones Industrial Average just over 4%. This is a far cry from a year ago when the major market indices were down some 12-13% and many investors were discouraged. But by the end of the year, the economy had gained traction and was expanding at its fastest pace in over five years.
Recent data indicates the expansion is progressing nicely but more slowly than in prior recoveries. This time exports and business spending on equipment and software are leading the way rather than consumer spending and housing. Even with the unemployment picture, consumer spending looks to be nearing its prerecession high.
In spite of the improving situation, the stock market currently has a high “wall of skepticism” to climb. A theory popular on Wall Street projects that the average annual growth rate for the economy will be an anemic 2% for years to come. However, there are some factors in place that may lead to faster growth.
For example, over the last decade U.S. manufacturers have increased their productivity dramatically. They have become more experienced and more effective at competing in markets around the world. As spending on technology continues to increase, this advantage is likely to widen, creating positive ripple effects throughout the economy.
The vast majority of high-quality companies we have recommended over the years are in fine shape. They successfully navigated the financial crisis and are now well-positioned for the future. We think they will continue to expand their markets, both at home and abroad, and increase their earnings and dividends at superior rates.
December 31st, 2009 marks the end of a tumultuous year. On a total return basis, the Standard & Poor’s 500 increased 26% and the Dow Jones Industrial Average almost 22% for 2009.
Last week also marked the end of what some have called “The Lost Decade” and others “The Decade From Hell”. For the ten-year period ending in 2009, the S&P 500 lost 10% while the NASDAQ did worse, falling some 42%. The Dow was the lonely bright spot, eking out a 9% gain in total return for the decade.
In contrast, many of the companies we have recommended fared remarkably well over the past ten years, as we discussed last summer in our newsletter Was The Decade Really “Lost”? The vast majority of our companies, with their high reinvestment rates, increased their revenues and grew their earnings at faster-than-average paces. The companies that paid dividends raised them at better-than-average rates over the last ten years. All in all, it was by no means a “lost decade” for many of the companies we follow.
The reasons why so many of our companies thrived, and why we have so much confidence in them for the years ahead, are their quality, their fundamental characteristics, which include strong balance sheets, and their management teams. The road to investment success is never quick and easy, and often quite bumpy. However, the patient investor who focuses on the qualities that matter is likely to be well rewarded over the long haul.
For the quarter just ended, the major market indices declined some 12-13%, making this the sixth consecutive quarter in negative territory and the longest such stretch since the mid-1970s. Even so, the mood on Wall Street has largely improved in recent weeks.
One reason is that a clearer picture of the economy is emerging. Collecting and reporting economic data always involves a time lag. In a sense, the direction the economy is heading is gleaned by looking in the rear view mirror. Recent data indicates that both households and businesses are adjusting quickly and meaningfully to the financial crisis.
By the end of last year, consumers had significantly reduced their debt — in fact, household debt shrank for the first time since data collection began in 1952. Mortgage debt, comprising about three-fourths of all household debt, now has declined for three quarters in a row. And for the first two months of this year, savings as a percentage of income was at the highest two-month average in more than 10 years.
On the corporate front, businesses have been dealing with the recession for more than a year now. Their managements also responded quickly: payrolls have been reduced, expenses have been trimmed and inventories drawn down. As we discussed in our First Quarter, 2009 newsletter (Solid and Sustainable: Growth Company Dividends), the number of companies conserving cash by cutting their dividends has risen dramatically over the last six months.
From an economic standpoint, the rapid pace of these adjustments is important. Before the economy can get back on the road to recovery, past excesses have to be eliminated and it appears that this is happening. All of these actions contribute to setting the stage with favorable conditions for recovery — when demand eventually picks up.
And that part of the equation is largely in Washington’s court. The financial crisis has, in many ways, blunted the natural recuperative powers of the economy. Much of the government’s massive efforts — fiscal stimulus, monetary easing and direct bank support — have been directed both at healing the economy and restoring confidence in the financial system. If these efforts are successful, recovery may begin later this year.
Regardless of when overall demand picks up, the vast majority of the companies we have recommended over the years have been dealing quite well with both the financial crisis and the recession. These companies tend to be the leaders in their fields, with dominant market shares, intense research and development efforts, and a steady stream of new products and services. As a group, they have been increasing their sales, growing their earnings and raising their dividends since the crisis began.
It is always worthwhile to read a company’s Annual Report, particularly the CEO’s Letter to Shareholders. Many of our companies have just published their 2008 reports and phrases such as “discipline”, “a clear strategy”, and “a thoughtful approach to running the business” indicate the proactive stance of these management teams. They also describe their resilient businesses, their history of sustainable growth and their fundamental characteristics as key to success in difficult economic conditions. One company even discussed its “street-fighter mentality”.
With their healthy balance sheets, conservative practices, and seasoned management teams, we think these high-quality companies will come through this period just fine.
For the year, the Dow Jones Industrial Average was down about 32% while the Standard & Poor’s 500 fell almost 37% on a total return basis. Some of Wall Street’s previously “most favored” spheres saw worse performance — India and China were off 50% to more than 60%, and many commodities, including energy, metals and food products, have fallen 40% or more.
Since our last letter, the financial crisis deepened and the Federal government redoubled its stabilization efforts. To its credit, many of these measures appear to be working — the commercial paper markets, the short-term borrowing on which many companies rely, are functioning again and corporate lending is picking up too. A shocking disclosure by a hedge fund manager seemed to barely cause a ripple in the financial system, although the human suffering was, and may continue to be, profound.
Also during the quarter, the world’s major economies slipped into recession. Japan and Germany are facing deepening economic woes amid their own structural issues and both may see a contraction later this year. The U.S. officially has now been in recession for more than a year. But this may mean that, absent government policy blunders, the ground work for recovery is already being laid.
In fact, several analysts have noted “signs of life” amid the wreckage. For example, in addition to the pick-up in commercial activity, some consumer sectors are improving. Housing is more affordable now than it has been in years, and consumers are responding to historically low mortgage rates. Refinancing activity increased five times in recent weeks.
Since the financial crisis began some eighteen months ago, the companies we have recommended have held up quite well. As we discussed in our last letter, their healthy cash flows, low debt levels, conservative financial practices, good management teams and great businesses have stood them in good stead throughout this difficult period.
It’s a point well worth repeating — our analytical work has always focused on companies with growing demand for their products and services, in expanding market segments, and in areas where research and development leads to new products and services. These are the companies on the forefront of economic growth and progress, not on the bleeding edge of Wall Street’s latest concept.
As we have noted before, unless the underlying fundamental characteristics of a company have changed, the company’s intrinsic worth does not change with the ups and downs of the stock market. Our companies continue to expand their businesses, they continue to develop new products and services, and they continue to turn in above-average earnings and dividend progress. In short, they are great businesses with superior prospects.
Since our last letter, and indeed in just the last month, the investing environment has changed dramatically.
In September, the financial markets teetered on the edge of the abyss, investors panicked and Wall Street was upended. Several storied firms disappeared while others were acquired. Unfortunately, at this point, there is no telling when the metamorphosis might end.
For the year-to-date, the Dow Jones Industrial Average is down 18% while the Standard & Poor’s 500 Index is off 21%. Many international markets are down over 30%, with some approaching declines of 40% to 50%.
The effects of the credit crisis are rippling through the domestic economy and spreading to foreign shores. Just last month, economic growth in the U.S. was slowing but was offset by strong international trade. Now, with other countries undergoing their own credit crisis, a recession appears unavoidable — especially as long as the global credit markets remain in disarray.
But even amidst the carnage, there are some bright spots. For example, it is likely that many of the financial games played on Wall Street in recent years will finally be put to rest. Investors were encouraged to venture into areas where the potential rewards were highlighted, the risks downplayed, and fundamental characteristics ignored. Now they are learning the difference between investing and speculating, as all good lessons are learned, the hard way.
The credit crisis and its aftermath are forcing the Administration, Congress and Wall Street to finally confront a problem that has not cured itself. It has stimulated greater coordination between the world’s Central Banks and the U.S. has given financial support to several countries to stem the effects.
At the end of the day, it is very likely that the bad financial apples will be purged from the system and that better regulation will be in place. Should this happen, the global financial markets are likely to end up in much better shape than they have been for years.
Overall, the high-quality companies that we have recommended in recent years have held up quite well during this period. We expect them to emerge from this crisis relatively unscathed.
As we have noted before, these companies have dependable earnings growth and have sustained their superior growth through economic slowdowns and recessions in the past. Their management teams are experienced in operating under a variety of business and economic conditions and appear to be dealing with the current crisis quite well.
More to the point, these companies usually have a fraction of the level of debt an average company has and they tend to be less reliant on the credit markets for their day-to-day operations. They also have much higher than average levels of cash in the “corporate kitty”. This means that they are in good financial shape to deal with whatever else is in store.
In these uncertain times, it is important to remember that the intrinsic worth of a portfolio does not change unless the underlying fundamental characteristics of the investments have changed. Our companies continue to expand and enter into new markets, they continue to develop new products and services, and they continue to turn in superior results in their earnings and dividend progress.
At the mid-point of the year, the financial markets are still straining from the subprime mortgage/credit crisis mess. For the year-to-date, the Dow Jones Industrial Average has fallen over 14% in value — but this pales beside other major global indices. Germany is off 20% and India is down 33% while China’s Shanghai exchange has declined 48% since the beginning of the year.
Recent data indicate that the U.S. economy remains resilient. Economic growth has slowed, but it is still positive and final results consistently have been above Wall Street’s expectations. However, inflation has picked up steam both at home and abroad.
Here, inflation’s current pace is just over 4%, above its long-term average of 3%. In Japan, inflation has reached a ten-year high while in the Euro area it nearly has doubled in just a year’s time. The emerging world is grappling with inflation rates reaching into double-digit territory.
In such an environment, it is important for investors to remain focused on quality and fundamental strength. Owning the shares of high-quality companies whose earnings and dividends are increasing at superior rates is the most effective way we know to combat the insidious effects of burgeoning input costs and prices. As we have shown in the past, it is the growth in earnings and dividends per share that leads to higher share prices over time.
As a group, the companies we have recommended over the years have healthy balance sheets, low levels of debt, leading market positions and revenues growth at above-average rates. Their profit margins tend to be higher than average and most are rising, even in the current environment.
Despite the travails in the stock market, our companies continue to develop new products and services, expand their markets and increase their earnings. Due to superior management, they are also able to increase their dividends per share at rates faster than that of the average company. Healthy increases in dividend income are always a good thing, and even better in periods of rising inflation.
Many investors on Wall Street are belatedly re-evaluating their tolerances for risk, contributing in part to the market’s recent action. As it will take some time for the credit crisis to work its way through the financial system, the stock markets are likely to remain bumpy through the rest of the year. Despite these challenges, we are confident that a portfolio consisting of some of the best companies in the world will ride through this period just fine.