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The Hardest Job

It is a well-known axiom on Wall Street that "the money follows the performance." Invariably, after equities have enjoyed a prolonged uptrend, there are those investors, both institutional and individual, that decide it is time to change investment managers, to increase equity exposure or even to reenter the equity market itself. Ever since the cycle low in March of 2009, investors of all classes have been fleeing equities for the perceived safety of bonds. Throughout virtually all of this period, bonds have been "certificates of confiscation," as the pre-tax yield on US Treasuries and cash instruments has been negative. Anyone holding Treasury bonds at this time must be convinced that outright deflation is just around the corner. If that were the case, then those who own the higher yielding credit bonds would likely face large losses. Given the determination of central banks worldwide to support asset prices and stimulate economic activity, the risk of outright deflation is exceedingly remote, especially in this country.

Indeed, the US, above all developed economies, enjoys the best demographic profile, the strongest position in advanced technologies, a growing advantage in traded goods, as its reliance on imported energy declines and as it benefits from an improving relative cost position, since wages here have been essentially stagnant, while those in many emerging economies are rising rapidly. A modestly weaker trade-weighted dollar, some transportation cost advantages and local incentives are helping as well. Moreover, US households have deleveraged significantly since the onset of the financial crisis. Lower debt levels and low interest rates have greatly reduced the household debt service burden. Moreover, there is enormous pent-up demand, not only for new automobiles and new housing units, but even for corporate capital equipment, particularly for next generation technology. The US economy may be growing at only a 2% pace, but a major industrial renaissance is underway which will improve the growth rate and support an extended period of rising corporate profits.

"So what's the problem?" you ask. Simple. As always, the stock market has long recognized all of these positive fundamentals, and even as many have been selling stocks to hide in cash instruments and bonds, knowledgeable investors, including corporate managements themselves, have been steadily accumulating equities and have driven the S&P 500 Index 130% higher off its 2009 low. Now along comes a prospective new client who says, "I hear you've been performing well. Take over the management of my account and let me share in your success." No businessman turns away a chance for incremental revenues, but the task of overhauling a portfolio constructed by another party is extremely difficult. First of all, the new manager doesn't have high conviction regarding many of the existing holdings, so it becomes a guessing game to know which ones to sell immediately and which to hold on to at least for the time being. Secondly, since the valuation of equities has already increased from a single digit P/E to approximately 14X this year's estimated S&P 500 earnings of $110, it is obvious that the easy money has been made, though, of course, it didn't seem so easy at the time. Those who note that the S&P's P/E has averaged about 15X for a long time must also realize that number is merely an average, and in view of all the macro volatility in today's world, it may prove to be a difficult target to reach in the near term. A newcomer to equities today must now rely mainly on profit growth for the bulk of his future returns. We believe this is a good bet, but earnings growth comes about only gradually, while P/E multiple expansion occurs much more rapidly. Finally, and perhaps the most difficult task for an investment manager, is to select which of his favorite holdings is still attractive for new money purchases. With the popular market averages at or near their all-time highs, no responsible manager can simply fill up a portfolio with the names his existing clients have already owned for some time and which presumably have appreciated significantly since their original purchase cost. This is, of course, the fundamental fallacy of investing in a mutual fund (whether actively managed or passive) because in those vehicles the new cash inflow is simply spread over the existing holdings. To us, this makes no sense. A prudent investment manager needs to find new opportunities, or he must wait patiently and allow the market's inherent volatility to bring some of his favorites back to prices which offer a favorable risk/reward potential. Likewise, the client needs to have patience, which is unlikely since he/she now regrets not having participated during the bull run up to this point and tends to want instant gratification.

It is at this point in a market cycle when it becomes all too easy for equity investors to fall into "value traps," buying shares of companies that are statistically cheap but, upon careful analysis, deserve to be. Conversely, one must be alert to the natural erosion of P/E ratios, as great growth companies begin to confront either increased competition or simply the law of large numbers. Finally, investment managers must resist the temptation to sacrifice quality or to venture outside their traditional investment style in search of outperformance. There are always some special situations which arise, such as companies with disruptive, "game changing" new products, new management teams, companies exiting non-core businesses, companies emerging from bankruptcy, etc. These usually offer attractive opportunities, no matter at what level the market averages are, but they rarely are found in sufficient quantities to build an entire portfolio.

Accordingly, while we remain extremely optimistic about the non-inflationary growth prospects of the US economy over the next few years (notwithstanding our dysfunctional government), and we expect corporations to continue to garner an important share of that growth in the form of rising earnings, we are equally convinced that from this point forward, worthwhile investment rewards will require considerable patience. Also, as equity valuations rise further, stock market volatility may well increase, and stock prices will become more vulnerable to some exogenous news event, which will seem catastrophic at the time. Newcomers to equities must have the staying power not to be faked out by such an event and not to liquidate their holdings. As a general rule, we believe that even if one or more of the currently known worries should come to pass, the negative impact on equities will be temporary. In the financial crisis of 2008-9 the global financial system and economy came as close to ultimate catastrophe as one could imagine. Yet we all survived. That, in itself, is good news for all investors.