3rd Quarter 2020

This year, the U.S. federal government’s debt relative to gross domestic product (GDP) is expected to be at the highest level since World War II. This rise is due to the major fiscal response by the Administration and Congress to the COVID pandemic coupled with deficit spending trends in recent years. The Federal Reserve Bank of St. Louis projects this year’s level will be well over 100%. Only a handful of economies such as Greece, Italy and Japan have debt loads that exceed their economies. The last year U.S. debt exceeded GDP was in 1946, when it was at 106% after four years of war. 

The novel coronavirus that swept the globe in early 2020 also compelled the Federal Reserve to intervene in an unprecedented fashion. Its aggressive and swift action calmed financial markets, which led to a rebound in many asset prices. The Fed lowered its main interest rate back to near zero in March. It has ramped up its bond buying programs – known as quantitative easing – to pull down long-term rates. Between mid-March and mid-June, the Fed’s portfolio of securities held outright grew from $3.9 trillion to $6.1 trillion. The Fed introduced multiple temporary lending and funding facilities to help institutions with borrowing needs. It has indicated its easy money policy, with low interest rates, will continue for the indefinite future.

4th Quarter 2018

Concerns of increasing debt levels, tightening monetary policy, technology stock valuations, potential trade wars and slowing eurozone growth coalesced in the 4th quarter to fuel a higher level of volatility. At nine-and-three-quarter years, the bull market is the longest on record and one of the best performing. The S&P 500 has risen 333% from its bottom in 2009 to its most recent peak before the 4th quarter turbulence.

Some market pundits question whether the bull market will make it to its 10^th birthday in March 2019.  Investors seem nervous about its longevity. A bull market doesn't technically end until there’s a bear market resulting from a 20% drop from its peak. This particular bull market is unusual in that it followed the 2008 financial crisis, which was so severe in that it was second only to the Great Depression in US history.

Extended volatility can offer a window to buy solid companies at reduced prices since the herd behavior of bear markets often depresses prices below their long-term economic value.

The good news is that the global economy still shows signs of robust health. Gross domestic product (GDP) growth topped 4% in the second quarter, the best expansion since 2014, and unemployment at 3.7% is at a 49-year low. Rising interest rates also indicate an increasing demand for funds. Rates tend to climb when the economy is humming. A recent bank study found that companies’ price/earnings multiples expanded during half of recent rising interest rate cycles and contracted during the other half, indicating that the market is agnostic about a gradual change in rates.

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.