Buffett, Gross and Siegel: Finding Opportunities in Today’s Markets

In past newsletters, I have used quotes from Winston Churchill, Benjamin Graham and Warren Buffett to set the tone for my remarks. This letter once again invokes the opinions and shares the perspectives of Buffett, as well as PIMCO’s Bill Gross and Professor Jeremy Siegel from the University of Pennsylvania’s Wharton School.

These three gentlemen are among today's most respected stock market observers. We all know of Warren Buffett. Bill Gross was Morningstar’s fixed income manager of the decade. Wharton scholar Jeremy Siegel is considered today's leading stock market historian. Before examining their views, let’s take a brief look at second quarter results.

Market performance in the second quarter

Although developed markets registered solid gains in the first quarter, the second quarter was a different story. Frequent volatility highlighted ongoing concerns arising from growing inflation threats in emerging markets, sovereign debt worries in Europe and a downgrading of growth forecasts for the global economy.

Markets in April rose nicely but dropped sharply in both May and June. The latter was saved from even sharper drops due only to a last minute upside rally during the final four days of June which reduced the total quarterly loss to about minus one percent.

Warren Buffett: “Betting on America”

In interviews, Buffett has referred to his recent acquisition of the Burlington Northern railroad as "betting on America." Buffett has been consistent in his positive outlook for the U.S. economy, looking past short term events to focus on American ingenuity and resolve and its ability to attract the best and the brightest from around the world.

Warren Buffett is consistently voted the greatest investor of all time. In the 46 years he's run Berkshire Hathaway, annual growth in book value has exceeded 20%, more than twice the gains for the U.S. stock market index. Even more remarkable, Buffett's numbers are after tax, while the index's gains are pretax. And while he lagged in individual years, in his last letter to shareholders, Buffett pointed out that there has never been a five year period where Berkshire Hathaway underperformed the S&P 500 index.

To put his record into dollar terms, $1,000 invested in 1965 under Buffett's stewardship would have grown to over $4 million by the end of 2010. By contrast, the same $1,000 invested in the S&P 500 index would have risen to $62,620.

Here's an excerpt from Buffett’s 2011 letter to investors, published in February.

“Last year - in the face of widespread pessimism about our economy - we demonstrated our enthusiasm for capital investment at Berkshire by spending $6 billion on property and equipment. Of this amount, $5.4 billion - or 90% of the total - was spent in the United States. Certainly our businesses will expand abroad in the future, but an overwhelming part of our future investments will be at home. In 2011, we will set a new record for capital spending - $8 billion - and spend all of the $2 billion increase in the United States”.

Buffett went on to say the following:

“Pessimism is so often wrong because people assume a world where there is no change or innovation. They simply extrapolate from what is going on today, failing to recognize the new developments and insights that might alter current trends.”

And he addresses the “doom and gloom” scenario we hear about so often:

“Money will always flow toward opportunity, and there is an abundance of that in America. Commentators often talk of ‘great uncertainty’. Throughout my lifetime, politicians and pundits have constantly moaned about terrifying problems facing America”.

“Yet our citizens now live an astonishing six times better than when I was born. The prophets of doom have overlooked the all-important factor that is certain: Human potential is far from exhausted, and the American system for unleashing that potential - a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War - remains alive and effective."

Bill Gross: “The Case for Equities that Pay Dividends”

My second expert is someone who's not nearly as well known to the investing public - but is a household name among professional investors

As manager of the PIMCO Total Return Fund—the world's largest bond fund—Bill Gross has turned in a track record matched by few others. He was named Morningstar Fixed Income Manager of the Decade. His notoriety stems in part from his willingness to take contrarian views. In 2010, he went on record talking about the "new normal" of lower growth, higher inflation and increased risk in holding sovereign debt.

Earlier this year, he turned negative on U.S. government bonds, recommending high quality corporate bonds and foreign government bonds instead of U.S. Treasuries.

In a June 7 interview on CNBC, he also discussed the appeal of dividend-paying equities:

"In terms of the stock market,...some (corporate stocks and utility stocks)…. yield 3 ½ to 4 percent in terms of their dividend yield compared to a negative ½ of 1 percent in U.S. Treasuries………and (also) there's a huge gap and a huge differential if an investor is willing to take a minor downgrade in terms of credit (leaving risk-free Treasuries in favor of corporate bonds).

“Corporations are in the catbird seat. They've got cheap financing and cheap leverage. They've got cheap labor and the ability to move from one country to another at their will. And so corporations basically have done very well and will probably continue to do so."

Gross did, however, add a note of caution:

“But to expect (corporate) margins to expand at the expense of labor here in the U.S.—at the expense of laying off additional workers, relative to their wages, real wages and their total nominal wage growth—I think is an unrealistic expectation. I think corporations basically are at the top in terms of profit margins. This doesn't mean that stocks are going to go down. It simply means that the catbird seat basically has been taken advantage of and that their heyday is probably in the past as opposed to the future."

Jeremy Siegel: "Why valuations are attractive"

My third expert is Jeremy Siegel, considered today's leading stock market historian. His book “Stocks for the Long Run” examines 200 years of financial market performance and has been ranked as one of the most influential investment treatises of all time. Among Siegel's claims to fame is an article in The Wall Street Journal in March of 2000, at the peak of the internet bubble, warning about the excesses in tech stock valuations. In a June 28 interview on Business News Network, Professor Siegel (who is almost perpetually unabashedly bullish) explained why he remains positive on US stocks:

"We've almost never seen valuations (on the U.S. stock market) this low when interest rates are as low as they are today .... Relative to bonds today, I've almost never seen such compelling values."

And here's why he—as does Bill Gross—likes dividend paying equities:

"History shows that dividend paying stocks beat inflation and are good investments for income, especially in the early stages of a financial recovery such as we see today ... The top 100 dividend yielding stocks of the S&P 500 over the last half century beat the index by 2 ½ percent and did so with lower risk."

What this all means to investors

In today's low interest rate environment, it's hard to make a compelling case for holding cash reserves, except as:

1. A portfolio diversifier or;
2. As a source of liquidity.

As for bonds, Bill Gross represents the growing sentiment that the risk in bonds is greater than the reward, as economies recover and interest rates start to rise.

This leaves equities as the only remaining major asset class to consider. Whether you adopt Bill Gross' "lesser of two evils" view of stocks as compared to bonds, or you simply join Warren Buffett and Jeremy Siegel in embracing stocks more enthusiastically, there is arguably value in owning high quality equities that pay dependable dividends. Today’s mutual fund managers are finding quality companies with strong cash flows that provide a comfortable dividend stream along with potential future dividend growth.

For the past few years now, our clients know that we’ve tilted the equity component of client portfolios towards funds that feature lower volatility, or “beta” readings. These more conservative, lower “beta” funds often tend to generate strong cash flows and above-average dividends through their holdings. Of course, these ‘higher quality', less volatile holdings do not always outperform portfolios containing companies with weaker balance sheets and which generate lower dividends. But over long periods of time, higher quality stocks generally outperform. And in the case of dividends, the yield generated will provide a floor for stock prices in the event of extreme downside volatility.

In 2008, all equities dropped dramatically, regardless of quality. And since March of 2009 we've seen a snapback rally in funds which favor riskier and more highly leveraged equity investments—those with higher “beta”. Since the equity allocations we choose are less volatile, our portfolios tend to lag in strong bull markets, but have proven to outperform in down markets. This has again been the case during the 2nd quarter.

Thank you for reading this newsletter and for your continuing interest.

Sincerely,

Andrew J. Fama, Principal

Andrew J. Fama Asset Management, LLC

Registered Investment Advisor

*Past performance is no guarantee of future results*

*Nothing contained in this quarterly newsletter should be construed as investment advice*

 

 

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