2nd Quarter 2019

At the half-way mark of 2019, the U.S. is marking 10 years of continuous economic growth.   The current cycle of economic expansion is poised to become the longest ever recorded in this country’s history based on statistics from the National Bureau of Economic Research. The longer the current expansion lasts, the more commentary swirls that it will end soon, followed by an inevitable and deep recession. Such pessimism is likely a residual memory from the severity of the 2008-2009 financial crisis. But while it is true the economy may be in the later phase of expansion, there are a number of structural advantages and recent reforms in the U.S. economy that may lessen the degree or length of a future downturn.

Evidence of comparative advantages in the U.S. economy relative to other economies can be found in the performance of the global stock markets. Since October 2007, the beginning of the financial crisis, international stock markets (excluding the U.S.) remain approximately 25% below their previous peaks. The U.S. S&P 500, however, has gained about 80% over the same time frame. This disconnect between the U.S. and the rest of the world goes against conventional wisdom, given that globalization and trade has generally linked and synchronized economies. The U.S. has enjoyed a robust stock market, low unemployment, and gross domestic product (GDP) growth that is the envy of the rest of the world. 

Data from the National Bureau of Economic Research suggests that U.S. economic expansions are lasting longer, while economic contractions have become substantially shorter in duration.   

Outside of the U.S., it’s a different story. Since the beginning of the Great Recession, over 10 years ago, U.S. GDP has grown 34% in real terms versus -2% in the Eurozone, -15% in the UK and only 7% in Japan. In addition to the sovereign debt crisis and subsequent austerity measures, Europe’s economy has been shackled by substantial amounts of regulation, restrictive labor laws and a macro central bank dictating a one-size-fits-all policy for 19 separate economies. Japan has been in a deflationary cycle for decades due to a declining population, a high-debt burden and a static corporate environment that avoids restructuring. Investment in the UK has been stifled by the uncertainty over Brexit and the prospect of a decidedly anti-growth / free enterprise alternative should the opposition party win the next election.

There is a strongly held perception that Wall Street’s analysts tend to call a stock a “strong buy” when its price and earnings are high and to label it a “sell” after its price and earnings have fallen. Many investors also tend to follow the momentum of the market, wanting to invest when the market is rising and sell when the market is falling. Such investors and even some sophisticated stock analysts confuse the high earnings during favorable economic times with the average earnings power of the company. Investments purchased at peak earnings or at high multiples often do not offer an adequate margin of safety or long-term rate of return.

Value investing is conceptually easy to grasp but a difficult discipline to practice as it runs contrary to a herd mentality. 

Margin of safety is a fundamental principle of value investing, which states that an investor will purchase a stock if it is priced below its intrinsic value. Intrinsic value is the economic value of a company based on its long-term earnings power. The difference between the purchase price and the intrinsic value is the margin of safety. The greater the difference, the larger the margin of safety that provides an extra cushion in the event of future pressure on earnings from a myriad of factors (economic, market or company specific). Prices fluctuate more than intrinsic value, meaning opportunities exist to take advantage of irrational pricing and market psychology. 

The purpose of margin of safety is not just to preserve the initial capital investment, but to improve upon it. When a stock is purchased below its fair or intrinsic value, the expectation is that in some future time period the stock price will converge with its fair value in a rational market. If the growth expectations end up being correct, an investor who has bought at the discounted price will ultimately earn a superior rate of return.

Our First Quarter Letter noted that the current bull market celebrated its eighth anniversary on March 9, 2017. Value investing and margin of safety concepts are not so attractive in rising markets. The essence of value investing is finding a veritable bargain, which can be difficult in an aged bull market. As we’ve mentioned before, value investing is conceptually easy to grasp but difficult to practice as it runs contrary to a herd mentality. It entails researching investment options in depth, usually to discover the stock is fairly priced even though it shows some value attributes. It requires patience and a willingness not to participate in market momentum or a particular sector fad. It also requires fortitude to invest “in the foulest of weather.” Purchasing stocks in a declining market without knowing the bottom can be challenging. Stocks tend to trade at their greatest margin of safety during negative economic periods when investors are overly pessimistic.