I have just finished the worst year in my history.
My 10STX model fund at Marketocracy ended the year down 42%. It is remarkable that we were still positive (up 8%) as late as September 22nd. But to lose over half a portfolio in two months really takes some doing but we managed it.
Volatility in Q4 was jaw dropping. Portfolio positions plunged and lurched 10-20% in a day - sometimes in minutes. In Q4 the S&P 500 moved more than 5% up or down (mostly down) on 18 trading days. There have been less than 20 such days in the last 50 years.
As markets plunged, some $30 Trillion of wealth was wiped from global markets. The U.S. alone has given up some $7 Trillion of wealth since the 2007 highs. Some of this wealth was ours.
The S&P 500 closed the year down 37%. It was the worst down year since 1931. The MSCI World Index (Gross) finished down 40%. Brazil, Russia, India and China all fell over 50%.
In 2007, we did not add meaningful value relative to the market's return despite a good first half. This year, despite a good first half, we have also failed to add value. If we do not add a significant amount of value (alpha) over the market in 2009, we should be fired. Clients would be better served in an index fund. Some of you may not be inclined to wait for a third year.
While getting our head handed to us in 2008, we were not alone. We had some very good company. Mr. Warren Buffett's Berkshire Hathaway (nyse: BRK-A) (a holding in the 10STX model fund until late 2007) fell around 45% from its 2007 high. Mr. Martin Whitman's Third Avenue Value Fund (TAVFX) was down 46% for the year. Bill Miller, of Legg Mason Value Trust (LMVTX), and famous for outperforming the S&P 500 for 15 years straight, finished the year down 55%. There were so many violent twists and turns in 2008 that very few people got it right and of those who did a lot of them STILL lost a lot of money.
Mr. Buffett has said "predicting rain doesn't count; building arks does." We clearly didn't build an ark and we can be faulted for that. But we did have anchors to windward. But when the Cat 7 hurricane of October/November came, nothing held.
Ken Heebner, who manages CGM Focus Fund (CGMFX), was one of those who saw the gathering storm coming in real estate and mortgage related financing. He built an ark and made good money for his clients in 2007 with big, brave and fearless short positions (a bet they will go down) in homebuilders and mortgage companies. As the storm raged in 2008, he moved into energy and finance and got his head handed to him. CGMFX finished the year down 48%.
One of the most stunning revelations in 2008 concerned Mr. Nouriel Roubini, Professor of Economics at the Stern School of Business at New York University. He has been dubbed Dr. Doom by the media and is widely credited for seeing the entire storm coming in all its ravaging glory. Surely, Dr. Doom, seeing it all coming and getting it all right built an ark? Well no. A recent article in Newsweek states "despite his prescience, he's suffered just like the rest of us: he's remained fully invested in stock index funds through the market downturn, causing his portfolio to plummet." If he's in index funds he took a 40% haircut as well. And he got it right.
We've looked carefully at what we did wrong in 2008. Closely matching the market in the worst year of our lifetimes is no comfort. We are supposed to be better. We are supposed to keep our clients safe. We are supposed to produce alpha. We didn't do it.
Here are the updated returns for 10STX model fund at Marketocracy as of 12/31/08:
Notes:
- Inception Date is 10/12/2000
- Returns for 10STX is after virtual transaction fees, SEC fees, and management fees
- Returns for S&P 500 Index are with dividends reinvested but without any fees
- Returns for MSCI World index is Gross with dividends reinvested
This long-term track record was built using strict value investing disciplines. While not perfect on a year to year basis, they have served us well over time. These valuation metrics center on liquidation values, net tangible assets, low price to earnings, and low debt among others. Long-term safety is supposed to come from a careful and balanced blend of these metrics (as well as sector and currency diversification) across the portfolio.
For over 8 years I have averaged 20% per year. Over that same time period, the S&P 500 has lost 3% per year and the MSCI World (Gross) index lost 2% per year. The numbers are quite remarkable. Over an 8+ year stretch, I have produced 23 percentage points over the U.S. market, and 22 points over the global market. (also - I've kept track of my own investing over the last 17 years and my tenstocks portfolio has returned 21% per year vs. 7% for the S&P 500 and 2% for the MSCI World (Gross) index during those same 17 years)
Apart from that, two other things are worth mentioning. First, competition for stocks (meaning downward price pressure) can be expected to come into the market anytime something else, with an equal or lower risk profile, offers more than 7%. Second, that a diversified investment on the U.S. or global economy, bought and held for 8 years would have produced less return than a money market fund.
There is something else here too.
S&P 500 (500 stocks) = -2.9%
MSCI World (1600 stocks) = -2.0%
10STX (10 stocks) = 19.9%
Over an 8-year time span, which includes 2008 (the worst market year in 77 years), the market is saying you can pay dearly for the perceived comfort of diversification. Careful disciplined portfolio concentration outperforms. The price for concentration is extreme price volatility over the shorter terms.
When we look at what we did wrong in 2008, we conclude the answer is 'not much'. Some people may not be happy to hear this. We did produce value coming into October '08. We were only down 2.1% versus S&P down 19.3% and MSCI World down 23.8%. By any reasonable standard, we had done our job coming into Q4.
One of the things we got right in the first half was exiting all our energy positions by early summer. In June we wrote to a client "Oil is around $140 a barrel. The energy market is starting to feel like a very crowded trade. For us, it evokes the image of an overloaded Filipino ferry. It might get where it wants to go but we don't want to be on it if it doesn't. As a result, we have sold our energy investments."
Over the next months, oil fell from $140 to around $35 a barrel - a drop of 75%. As smart (or lucky) as we were to get out at the top in energy, we were quickly stupid (or unlucky) enough to start buying the positions back way too early and still took a pasting.
Another thing we did right in the first half was not to buy back into Elan when its share price collapsed from $37 to $10. We reviewed Elan (an old friend) and came up with a valuation in the $14-16 range. We were very tempted to take a first bite at $10 but didn't. It recently traded as low as $5. At sub $7 it's a reasonable buy here but we will probably pass.
So, if we did all right coming into Q4, what the hell happened to blow us away so badly in October/November? Simply put, we believe all fundamental valuation metrics were ignored and abandoned by the market in a panicked rush for the exits. In desperate sudden need for liquidity as the credit markets froze up and redemption demand soared, hedge funds, banks, mutual funds and insurance companies, etc, sold off what they could as fast as they could. In many cases, firms, unable to sell the paper garbage they wanted to get rid of, were forced to sell what they didn't want to get rid of. If there was a market for it out the door it went. Panic feeds on itself. In many cases, selling prices simply uncoupled from any standard measure of true value. When nobody is interested in what something is worth, investing based on value is not going to work and it didn't in Q4 in spectacular fashion.
However, if disciplined concentrated value investing has worked (on average) over the last 17 years, do we stop doing it because it failed to work for two months? We don't think so.
There is a huge amount of cash piled up on the sidelines. It amounts to about 75% of the total value of the U.S. market. This cash is making less than 2%. Right now we are experiencing deflation. The next concerns will likely be inflation and dollar devaluation. Staying in cash will not protect you from either. The incoming Obama administration is readying a stimulus package that could well reach one Trillion dollars.
Combine the money already on the sidelines with the new money rolling off the printing presses and you have a powerful force to re-inflate the economy and push stock prices higher.
We start 2009 with the 10STX model fund stocks priced considerably under value as measured by P/E, price to book, and current yield.
Quite simply, nobody can get where they want to go in this world making 2% on cash.
There is a new bubble forming in treasuries and another forming in gold (we prefer oil and gas which is taken out of the ground and burned). The cash will have to move somewhere. We believe, given the relative valuation spreads, it will move back into stocks.
So what's the timeline?
We don't know. But we think it will be about a year for the Obama recovery package to filter through to the economy. The market often moves about six months ahead of economic data so we may see some stability/improvement by mid year 2009. Meanwhile, some of that sidelined cash should start finding its way back to the market as fear and forced selling subsides.
But there are some negatives. Bad news will continue to roil the market at least through mid year. 2009 S&P 500 earnings could come in as low as $50. If we assign a bad recession bottom P/E of 10 to those earnings we could see the S&P 500 sell down to 500 although we think it unlikely. More possible as a worst case scenario is a brief retest of the recent 740-840 range. Another question mark on the market is there continues to be good value available on corporate debt. It is reasonably easy to find decent paper paying better than 7% which, as noted above, gives some competition to common equities.
Reaching for our crystal ball, we think several themes are likely to be prominent over the next year or two. Hard assets and commodities will likely do well from current depressed levels as inflation and currency devaluation hedges. They will also benefit from increased demand as the global economy begins to recover. We have started nibbling at some discounted real estate that offers hard asset protection and produces good current income.
When we seek shelter from global political risk, inflation, and possible continued dollar depreciation, as well as seeking hard asset investments with good future supply/demand characteristics, we like Penn West Energy. It closed 2008 at $11. Annual oil demand has fallen only once in the last fifty years (1983). The International Energy Agency forecast global production will drop roughly 7% a year going forward while demand will increase. It is noted that Mr. Bill Gates and Mr. Warren Buffett flew to Alberta recently to take a first hand look at the oil sands. While there may be short term weakness in the price of oil due to slower demand, we think 2009 and beyond will see higher oil prices.
Now a few closing notes.
We have had a jarring and painful 2008. I have received many emails, especially in Q4, expressing understandable concern. Overall, you have been truly wonderful. I thank you for your support and continued trust in me.
Also, I am a strong believer in keeping my mouth shut and letting the results do the talking. Over the long term, the results have generally spoken favorably. I spend a lot of time reading opinions, articles and reports. I listen to talking heads on Bloomberg. 90% of everything I read, see and hear is total garbage and an utter waste of time. Not too long ago I told someone that "increasingly investors will need to produce more return on their capital and with conventional mutual funds wallowing in mediocrity it becomes a smart proposition to at least consider alternative methods and vehicles where the emphasis is less on the talk and more on the walk." In 2007 and now in 2008, there hasn't been much 'walk'. But I still don't like talking. When we have a reasonable year, I don't usually do a year end letter. For 2008, it's all I've got.
I wish you all a happy, healthy, peaceful and more prosperous 2009.
Christopher Rees
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