Nasty Month for Market

Investment Manager's Letter September 2011

For the nasty month of August, the S&P 500 average was down 5.7%, and the NASDAQ was down 6.4%. Losch Management Company biggest position Berkshire Hathaway, managed to reverse its trend for the first half and beat the S&P by 4.1% (-1.6% compared to -5.7%). Let’s hope this is an omen and portends a better 2nd half for our portfolios. Losch Investment Management Company Best position for nasty August was St. Joe Company, which managed a gain of 4.4%.

In general the market remains in a mood of border line panic fostered by a combination of moderately bearish economic news aggravated by and a deep emotional hangover lingering as a result of the traumatic crash of 2008. Buffett, on the other hand is in a good mood having purchased $1.6 billion in equities in the first quarter and another $3.7 billion in the second quarter. Note that 3.4 billion of the second quarter purchases remain confidential because they were not shown on Berkshire Hathaway’s 2nd quarter 13F, which means that Buffett is still adding to the position or positions. It also indicates some new positions (all known existing positions appeared on the 13F with no change); and they are large capitalization companies, because Berkshire Hathaway has to file the name of any position that is greater than 5% of the companies market cap. There have been no new filings of 5% positions.

On an appearance on Charlie Rose Show in August, Buffett emphasized his bullish mood by pointing out that on Monday August 8th, the day that the Dow was down 619 points, he bought more stock than he had any other day this year. In view of the fact that we know he spent $3.7 billion on equities in the second quarter this “more than any other day this year” could well be a nice piece of change. Finally, for the benefit of those who had not been paying attention on August 25th, Buffett announced that he had purchased $5 Billion of a Bank of America Preferred stock that came with warrants to purchase 7% of the Company’s Common Stock. Further weakness in the market since the first of September will have presented Mr. Buffett with further opportunity to unburden Berkshire Hathaway of it mammoth cash position. In any event it will be interesting to see the Company’s 3rd Quarter Cash Flow Statement and 13F.

So, Buffett is finding a good many things to buy, and while this may or may not indicate that we are near the bottom of the current market, it certainly does indicate that current values offer a decent margin of error. A footnote should be added to the current market “Please do not expect ration behavior”. The current pricing of U.S. Treasury bonds (an investment that James Grant classifies as “return free risk”) sets a new standard of lunacy. 10 Year Treasury bonds currently yield 1.9% this compares to an earnings yield for the S&P 500 of a well over 8%.

The earnings yield is the company’s current year’s earnings per share divided the market price. This measure is particularly helpful when comparing an investment in equities to fixed income investments. On this basis, equities currently offer about four times the yield of treasury bonds. Yes the treasuries are supposedly risk free, but the 10 year maturity bonds are certainly subject to a good deal inflationary risk as an average inflation of 2% per year for the next ten years would, as Mr. Grant points out, relieve the ten year bond of any effective yield except those of a negative sort.

Granted, the companies do not payout all of their earnings, but the dividends actually paid average about 2% so even that beats the cash you get from treasuries. Paid out or not, the companies’ earnings do belong to shareholders, and earnings yield is a better measure of shareholder benefit than dividends. Otherwise why would Buffett bother with “look-though earnings”? Earnings retained by companies benefit shareholders when they are reinvested too provide future earnings growth, and as cash accumulates on the balance sheet it can be used to increase dividends, stock buybacks, and balance sheet muscle.

Examples of some cheap equities

Earnings Yield
Exxon Mobile 11.4%
Chevron 13.8%
Merck 11.8%
Pfizer 12.8%
JP Morgan Chase 14.5%
Goldman Sachs 10.7%
Wells Fargo 11.6%
General Electric 8.9%
Microsoft 11.0%
Intel 11.4%
Apple 7.3%
Procter & Gamble 7.1%

Now is Mr. Market convinced that the treasuries are entirely free of credit risk. There are, in fact, currently 70 American Companies whose credit default swaps are cheaper than the bonds of our government. This means that the market thinks there is a greater risk of default for treasuries that the bonds of these seventy companies.

The spread between the earnings yield on these high quality stocks and that 1.9% available from Treasury bonds is good measure of the current hysteria, and proof that we should not expect markets to be any more rational when they are bearish than they were when they were bullish. So, in late 2007, as the U.S. housing market was already starting to fall apart, the stock market was still making new highs. Now, with corporate profits 19% above of the 2007 high, when the S&P 500 which reached 1524 in October. With market currently trading at 1175 it is now 24% below the level of October 2007 even though earnings have increased by 19%.

Certainly, there is no guarantee that corporate profits will continue to increase this year, or that they will be up next year, but the long term trend has been that corporate profits increase by an average of something like 7% – 8% per year. For the last 30 years, corporate profits unadjusted for inflation have basically doubled every ten years, and while we cannot guarantee that profits will double in the next ten years, Losch Investment Management Company can guarantee that any 10 Year U.S. Treasury you buy today will still yield only 1.9% in the year 2021.

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