Onward and Upward – Highlights from Edgemoor’s Summer 2014 Newsletter

In this latest installment of our quarterly report, my colleagues and I share some observations on the market’s solid gain in the second quarter of 2014, offer our outlook for the economy and markets, present our thoughts regarding the view among some that the markets are overheated, and discuss three of the securities we are currently buying: Apple (AAPL), Devon Energy (DVN), and Gilead Sciences (GILD).

Click here to go to the full report on our website.  Following are a few highlights:

- After the market’s modest rise in the first quarter, stocks picked up steam in the second quarter.  The S&P 500 index gained 5.2%, the best second-quarter performance since 2009, on improving economic conditions and expectations of continued low interest rates.

- We forecast further, modest gains for the stock market as the economy increases the pace of its recovery and corporate earnings follow.  In this environment, picking specific securities that trade at a discount, as opposed to buying the broad market, can make all the difference.

- We remain wary of bonds given current low yields and expectations of increasing interest rates in 2015, and we continue to favor the total return potential of high yielding equities and other income generating securities.

- Former Fed Chair Ben Bernanke committed the Fed to keeping rates low to boost the economy’s recovery from the financial crisis, and current Chair Janet Yellen is continuing this same strategy.  So far, inflation has remained tame, freeing the Fed to continue its stimulative policies until the economy appears to be strong enough to continue expanding without the Fed’s assistance.

- Economic data seem to confirm the widely held belief that the 2.9% drop in gross domestic product during the first quarter was an anomaly caused by severe winter weather.  The U.S. economy is showing signs of vigor, and we expect continued steady growth.

- The combination of steady economic growth, low interest rates, and low inflation creates a favorable environment for stocks.

- One of the central tenets of our value-oriented approach to investing is that purchasing specific securities at a discount to fair value, based on a detailed analysis of fundamental measures, is the best way to succeed.  Even in today’s market, we are able to find enough stocks available at a discount to fair value to create a diversified portfolio with appreciation potential greater than that of the broad market.

- There will be a correction at some point – we do not know when, but we have not seen a decline of 10% since 2011.  Given the near impossibility of timing a correction perfectly, we think the best strategy is to hold securities that should perform relatively well through any downturn and bounce back when the market recovers.

As always, feel free to contact us if you have any questions or comments.  For more information, visit our website.

Jordan Smyth and the Edgemoor Investment Advisors Team

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Business Cycle Update

Fidelity recently published an update on the business cycle (access the report by clicking on this link) that provides a good overview of current conditions in the global economy and an outlook for specific regions.  Included is commentary regarding low volatility, not only in the markets but also in various economic indicators, which increases the risk of investor complacency.  Fidelity’s outlook for the U.S. is relatively strong, with Europe running a close second and other regions around the world more mixed.

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Are We in a Boom or a Bubble?

Seeking both the promise of capital appreciation and also current yields that are often better than those found in the bond market, investors have flocked to stocks and bid up valuations.  The S&P 500 currently trades at a multiple of 16.5 times forward earnings, slightly higher than the long-term historical average.  We consider this valuation to be reasonable in light of historically low interest rates that should lead to higher corporate earnings.

A recent article in The New York Times (“Welcome to the Everything Boom, or Maybe the Everything Bubble,” July 7, 2014) points out the widespread increase in valuations across asset classes and sectors over the past few years, even in places like Spain that were crushed during the financial crisis.  Unlike at previous market peaks, according to the author, there are no bargains available today:

The high valuations now aren’t as extreme as those of stocks in 2000 or houses in 2006; rather, what is new is that it applies to such a breadth of assets. In 2000, when the stock market was, with hindsight, a speculative bubble, other assets like bonds, emerging market investments and real estate looked reasonable.

While we agree with his observation of a broad rise in valuations for entire sectors or asset classes, we disagree with the notion that investors must make the choice he presents, one between either low returns or the acceptance of greater risk in exchange for the potential of higher returns.  One of the central tenets of our value-oriented approach to investing is that purchasing specific securities at a discount to fair value, based on a detailed analysis of fundamental measures, is the best way to succeed.  In other words, buying at a discount increases the possibility for future gains and protects against downturns.  We do not restrict ourselves to buying only an entire asset class or sector.

Even in today’s market, we are able to find enough stocks available at a discount to fair value to create a diversified portfolio with appreciation potential greater than that of the broad market.  The average price/earnings ratio of the stocks we hold is currently approximately 12x, a significant discount to the S&P 500 index and a reflection of our value philosophy.

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Buffett and Munger: Still at the Top of Their Game

At the largest ever Berkshire Hathaway Annual Meeting on May 3, with approximately 40,000 stockholders in attendance, Warren Buffett and Charlie Munger rose to the occasion and were at the top of their game.  Buy good companies, let their managers run them, and invest the capital they generate has been their mantra from the outset, and it is still working.

Net income of $19 billion for Berkshire Hathaway in 2013 was an all-time record.  But net income is not a good measure of Berkshire Hathaway’s real value, whether it be the 31% increase in 2013 over the prior year or the 4% decrease in the first quarter of 2014 from the same period a year earlier (due to a drop in insurance underwriting profits which were unusually high a year earlier).

To comprehend the intrinsic or true value of Berkshire Hathaway, it is necessary to understand its three components.  First is the ownership of 68 non-insurance operating companies led by railroad BNSF and public utility Berkshire Hathaway Energy.  These operating subsidiaries now account for more than two-thirds of Berkshire’s annual net profit.

Second is Berkshire’s insurance company business and its rapidly growing $77 billion of reserve “float” invested in stocks, the largest four of which are Wells Fargo, Coca-Cola, American Express and IBM.  Profits from Berkshire’s stock portfolio are vastly understated since only dividends received by Berkshire are reported as net income, not the share in earnings these stock holdings represent nor their gain in market value.  The unrealized gain in Berkshire’s stock portfolio increased $11 billion in 2013, but none of it reported as income.

The third component is the value of future earnings which Berkshire will make from investment of its growing retained earnings.  Berkshire retains all its earnings for reinvestment with enormous stockholder approval.  Ninety-seven percent of Berkshire’s shareholders rejected a proposal that the company pay a dividend.

For the past 49 years, Berkshire has compared the book value of its shares to the S&P 500 Index.  During that period of time, Berkshire’s book value per common share has compounded at an annual gain of 19.7% compared to 9.8% for the S&P including dividends.  The recent criticism of Berkshire for the underperformance of its book value per share compared to the S&P over the last five years represents a misunderstanding of what the company is all about.  Berkshire is a value oriented investor which outperforms the S&P in years when the market is down or marginally up, underperforms the S&P when the market is unusually strong, but outperforms the S&P over the course of full business cycles.  Going back to 2007 before the Great Recession began, Berkshire’s increase in book value has outperformed the S&P.

It should be noted that Berkshire’s book value significantly understates the intrinsic value of the company.  Taking all aspects of Berkshire’s intrinsic value into account, Warren and Charlie make a strong case that Berkshire’s shares are worth much, much more.  Warren is so confident of this that Berkshire is committed to aggressively repurchase its shares if they ever fall below 120% of book value.  At just 139% of current book value today, investment in Berkshire’s stock looks very attractive.

Here are some other interesting take–aways from Berkshire’s Annual Meeting.

  • Warren’s $1 million bet with New York asset manager Protégé Partners that the performance of a low cost S&P 500 Index fund would beat that of five Protégé selected hedge funds over ten years is working overwhelming in his favor.  Six years into the bet, the total return of the S&P fund is up 43.8% compared to 12.5% for the hedge funds.
  • Both Warren and Charlie think that Federal Reserve Chairman Ben Bernanke did a heroic job during and after the market crash of 2008-2009, and they like what his successor, Janet Yellen, is doing now.  On a cautionary note, they point out that we are in uncharted waters with the Fed holding short term interest rates near zero and purchasing billions upon billions of US government debt securities for over five years.  Warren describes it as a movie we have not seen before and don’t know how it ends.
  • Both think that the federal government should continue to provide guarantees of properly underwritten home mortgages to keep their interest rates low, but not through any form of public/private vehicle such as Fannie Mae or Freddie Mac.
  • Both concur that the Canadian oil tar sands are a significant long term energy asset for the future, but neither has an opinion as to whether they are a good investment opportunity at this present time.
  • Both feel that after they are no longer around, the management of Berkshire will remain excellent.  Warren has recommended a successor CEO to the board; Warren’s investment protégées Todd Combs and Ted Weschler are each managing portfolios in excess of $7 billion which are outperforming the S&P 500 Index; and Warren’s son, Howard Buffett, has been designated future non-executive chairman to preside over a future CEO change should it become necessary.

At Edgemoor Investment Advisors, Berkshire’s stock is still on our buy list, for many good reasons.

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Treading Water in Choppy Seas – Highlights from Edgemoor’s Spring 2014 Newsletter

In this latest installment of our quarterly report, my colleagues and I share some observations on the market’s modest gain in the first quarter of 2014, offer our current outlook for the economy and markets, and discuss three of the securities we are currently buying: Capital One (COF), WellPoint (WLP), and Realty Income (O).

Click here to go to the full report on our website.  Following are a few highlights:

- Following the market’s huge surge in 2013, volatility returned in the first quarter of this year.  Despite some jitters, the S&P 500 index and the Barclays U.S. Aggregate Bond Index both rose slightly.

- We continue to believe that stocks are likely to rise modestly through the remainder of the year, though we predict more volatility and expect to see stocks decline again temporarily, as the S&P 500 index has not suffered a 10% correction since 2011.

- In contrast, we consider bonds overvalued and forecast negative returns as rates rise over the next year.

- Harsh winter weather took a toll on the economy, but most signs point to continued slow, steady expansion.

- New Federal Reserve chair Janet Yellen seems committed to providing ongoing support of the U.S. economy by keeping interest rates low, while at the same time slowly weaning the economy and markets off the Fed’s bond purchases.

- The combination of steady economic growth, low interest rates, and low inflation creates a favorable environment for stocks.

- Emerging markets were an area of concern, particularly in late January.  The strengthening of the U.S. dollar and economy has caused investors to shift money from emerging markets into U.S. investments.  In addition, credit conditions and economic prospects in China are uncertain, and most analysts expect a slowing of expansion there.

- Russia’s activities in Crimea also shook markets, though the impact on the global economy appears to be minimal so far.  Of particular concern is the effect of any changes in the flow of energy resources to Europe.

- We still favor master limited partnerships, high-yielding common stocks, convertible securities, real estate investment trusts (REITs), and preferred stocks for our income investments.

- High frequency trading has been in the news lately, and we are glad to see regulators looking into its implications on markets.  However, due to the size of our trades and the long holding periods of our investments, we do not believe that high frequency trading materially impacts our returns.

As always, feel free to contact us if you have any questions or comments.  For more information, visit our website.

Jordan Smyth and the Edgemoor Investment Advisors Team

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