“Alas, even after the most memorable party, reality always returns.”

Not much. Not much at all. That’s what the market has done lately, and that is also a pretty good description of the results for the entire first half of 2004. Are we in the proverbial calm before a storm, or perhaps in the eye of the storm which began in March of 2000? Either way, a change for the worse seems to be looming.

Blind Enthusiasm

The markets have been a fun place since March of 2003 and investors have enjoyed the party so much that they are failing to notice that the band is packing up (the bandleader, of course, being that great author of fabulous bubble music, Alan Greenspan) and the intoxicating punchbowl has nearly run dry. All of which has been provided to the crowd without immediate charge, through the liberal use of borrowed money. Even worse, tomorrow, the partygoers will wake up with a hangover, only to be confronted with the reality of paying their share of the party expenses. Alas, even after the most memorable party, reality always returns.

With the lackluster market environment, we are puzzled by the persistently high level of investor enthusiasm, which has not subsided as the market has lost upside momentum. Investors seem to have no fears and have become very complacent. That attitude has historically not fostered higher equity prices, and which gives us a heavy dose of skepticism.

Stagnant Results Signal A Looming Decline?

To do our small part in bridging the gap between investor sentiment and market fact, we include below a review of popular market averages as of mid-year:

Returns averaging less than 3% for the last 6 months seem to be showing that the popular bullish investor-sentiment is becoming neutralized by market resistance.  This has been particularly evident as we have moved into July.

But we must understand that the actions of investors generally move blindly into the future based on their tendency to focus only on the short-term rear view mirror:  We are still far below the highs of early 2000, but the bounce over the last 5 quarters has been spectacular indeed.  These results, of course, are those that investors now project into the future.

So what is reality?  What would the market look like if we do return to a reality that is something closer to how things have averaged over the last 50 years?  Consider this:

The above are just very broad and rough illustrations, but the fact remains that the market has a long way to go on the downside if things are to eventually return to “normal”.  With history being our guide, equities remain materially overvalued by almost any measure, even after taking into account today’s low, but rising, interest rate environment.

One quarter ago, we foresaw the current momentum loss accompanied by ominous storm clouds, and we feel gratified that the results over the last 90 days have been confirming our earlier analysis and comments.  Here’s what we said in mid-April:

“Over the decades, there have been a few pivotal periods of shift that have significantly affected investors – both positively and negatively.  Whether or not a particular investor ends up on the winning side of such events is determined by the ability to uncover the early warning signs and, perhaps more importantly, to correctly adapt investment strategy to the emerging direction of the primary trend.  We believe we have come again to such an important pivotal point.”

“In our opinion, the first quarter of 2004 represented an inflection point worthy of influencing substantial revisions in portfolio allocations.  The historically virtuous nature of globalization for the U.S. has now become the primary force behind a looming decline in many categories of U.S. equities. With globalization as the root cause for many onerous events spawned in our economy, we believe we are at the leading edge of a vicious cycle that will result in an inflationary price environment for tangible assets, along with a deflationary value trend for financial assets.  As such, we are advocating a major change into a commodity-based, “hard asset, weak dollar” investment strategy.”

The Real Estate Market

With the roots of excessive asset valuations in our nation being firmly set in gargantuan credit creation, we believe one direct result of this profligate credit may be a looming set of problems at Fannie Mae and Freddie Mac.  If serious disturbances do develop at these two bedrock foundations for the residential real estate market, the economic implications would be substantial and far reaching.

It is for these reasons that we are not including some categories of debt-laden real estate when we are discussing investment in “hard assets”.  As we say below, housing has become more of a financial asset than a tangible real asset, and financial assets, particularly those purchased with heavy leverage, are an area we wish to increasingly avoid.  This is especially true if such assets are going to need to be liquidated to service the rising expense of heavy debt loads.

More of our earlier comments:

“In an effort to get us out of the economic doldrums caused by Globalization, our economic authorities (over the last three years) have engineered record fiscal stimuli and the loosest monetary policy ever seen, fueling money and credit creation at a scale that has no precedent in history.  So far this program has done little to get the economy going again, but it did create the greatest credit and debt bubble the world has ever known.”

“Rather than going into capital investment, the profligate money and credit creation went blindly into asset markets: stocks, bonds and housing. When the equity bubble popped in early 2000, the consumer simply moved on to the incipient housing bubble, helped by the Fed-created bond rally, which pushed mortgage rates sharply downward. The obvious result was rampant and excessive mortgage finance. While the consumer continued to experience poor income growth, they offset this income loss simply by borrowing more.”

Later in the commentary, we concluded:

“We are entering a world where markets will be led by commodity-based “real” investments, and where financial assets, particularly those asset prices fueled and supported by massive debt, will experience a long period of decline, if not outright blow-off.  This will be indicative of an economy that is characterized by both deflation and inflation at the same time.”

“The sad and repetitive record clearly shows that all market bubbles throughout history were created by excess liquidity. This time around it’s no different, as the massive money wave in the U.S., which was financed by low interest rates, has created a huge bubble in financial assets. The price inflation of these assets, fueled by cheap money, has pushed those assets to risky and unsustainable levels. In the case of housing, it is now more of a financial asset than a traditional tangible asset. Simply put, just about anything not tangible is overpriced and in danger of significant price decline.”

“You’re Never Forced to Swing at a Pitch"

Moving on to a discussion of our current portfolio structure, an important observation is that right now nobody wants cash, and that is probably a very good reason to hold it.  At Summit, our accounts are temporarily holding large cash reserves, and that puts us in the minority among all investors, but yet in some very good value investor company.

While holding cash may be no fun at the moment, we are quite confident that our reserves will become much more valuable before long, as the price of money (interest rates) starts getting marked up, and the price of stocks gets marked down. In any case, we sold individual stocks when they became overvalued relative to their worth as a business, and we will not purchase respective individual replacements until our target companies come into an acceptable price range to allow for our purchase.

In a recent article, value investor and author Whitney Tilson discussed why many successful value investors are holding cash. We apologize for the length of the Tilson quote below, but we include it to reinforce the fact that most true value investors seem to be cash-heavy at this point, a portfolio structure that is consonant with the current account makeup of the accounts managed by Summit: Holding cash right now is not market timing it is simply the strict application of value investing.

“For a value investor like me, this is the most difficult investment environment in at least 10 years. Not because the overall market is hugely overvalued -- given the apparent strength of the economy and the growth in corporate earnings, I think it's moderately overvalued. The problem is I can't think of any sector of the market, or any asset class at all, that is distressed, and that's the type of situation value guys typically buy into. Large caps, mid caps, small caps, growth, value, industrials, financials, tech, services, retail, commodities, private equity, high-yield bonds, treasuries -- the list goes on and on, and none of it is cheap.

“So what is one to do? For most investors, especially institutions and mutual funds that have a mandate to be fully or nearly fully invested at all times, the answer appears to be to look for investments that appear cheap on a relative basis (and then, I suspect, cross one's fingers and pray). According to the Investment Company Institute, stock mutual funds today hold just 4.3% in cash, slightly less than the average of slightly more than 5% over the last seven years.

“But investing in unattractive assets is a recipe for disaster. If you can't find something smart to do, which I define as a situation in which you're certain you've found a 50-cent dollar and are trembling with greed, then don't do anything! While it's no fun earning a microscopic return on cash, it's far more painful to make a bad investment and lose money (trust me, I know!). The beauty of investing is that, to use Warren Buffett's famous analogy, you're never forced to swing at a pitch.

“ I am always scouring the investment universe for juicy pitches, and I'm finding that they are few and far between these days, which is why the funds I manage are holding 35% cash, near their highest levels ever. I'd be worried that maybe I was looking in the wrong places or had set my hurdle for investing too high if other investors I respected were putting all of their capital to work, but as best I can tell, we value guys are pretty much all in the same boat.

      Piles and piles of cash

“Let's start with Warren Buffett, the head of our church (I call it the Church of Graham and Dodd). Berkshire Hathaway sitting on $70 billion of cash and bonds, nearly half of the company's $152 billion in total assets (excluding finance and financial products), reflecting Buffett's view that "we still find very few [stocks] that even mildly interest us." (And this was from his 2002 annual letter, which was written when stocks were much lower than they are today.)

“Not surprisingly, Buffett's right-hand man, Wesco Chairman Charlie Munger, shares Buffett's views: $1.1 billion of Wesco's $2.5 billion in assets (44%) are in cash. Munger wrote in his 2003 annual letter that "as in 2002 and 2001, Wesco found no new common stocks for our insurance companies to buy."

 “Mason Hawkins and Staley Cates, who run the outstanding Longleaf Partners funds, are holding 23%, 24%, and 29% cash in the three funds they manage. And Seth Klarman, author of Margin of Safety and founder of the hugely successful Baupost Group, said recently that he's holding 50% cash. Finally, the 12 “Buffettesque Superinvestors” that I profiled earlier this year are sitting on an average of 30% cash.

      Difficulty holding cash

“While one might think that it's easy to hold cash, it is in fact very difficult, especially for a professional money manager. Imagine sitting in a meeting with a potential investor who naturally asks, "So, what are your favorite ideas today?" To answer, "We really can't find much to buy these days, so our largest position by far is cash" isn't likely to result in an investment, is it?

“And there's pressure from existing investors as well. Hawkins and Cates wrote, "Clients often want to see activity as proof that a manager is earning his fee. Some clients might wonder why they pay a manager to sit still."

“There's also relative performance pressure. As Klarman noted in his 2003 annual letter:

In a short-term, relative-performance-oriented world, earning next to nothing on cash creates a compulsion to invest, even when all investment alternatives appear overvalued. Choosing their position, most investors prefer to hope that something expensive becomes even more expensive, especially when it has recently been doing exactly that. Holding cash, which they find barely tolerable when markets are falling, is anathema when markets are rising...

Today's investors remain almost single-mindedly focused on relative performance, their results compared to the market's. Their behavior is understandable in an environment where, for most professional investors, short-term underperformance is often rewarded with client redemptions. This is especially the case since "long-term oriented" looks a lot like "being wrong" until proven otherwise. Since no one can know if it is your long-term orientation or your incompetence that is causing poor performance results, it is hard for disappointed clients to stay the course. Career risk for individual managers adds to the pressure. To avoid underperforming in a rising market, many professional investors have a mandate to remain fully invested. After three years of a grueling bear market, one might have thought investors would have developed an appreciation for an absolute return focus consistent with capital preservation, but old habits and ingrained tendencies die hard. If keeping up with an overvalued and rising market is your goal, cash is an unacceptable anchor to drag around.

“Finally, it's psychologically extremely difficult to sit on one's hands. Buffett wrote in his 2002 annual letter "The aversion to equities that [we] exhibit today is far from congenital. We love owning common stocks...." And Klarman lamented in April that "psychologically, this is the hardest time in my career. We sit at the office and throw Nerf footballs around. We're figuring out what to order for lunch at 9:30 a.m." In his annual letter, he elaborated:

It is one thing for a value investor to know that in the absence of opportunity you should hold cash. It is quite another to actually do it. It is particularly difficult to sit on your hands when others are probably speculating. We find that it is not a temptation to speculate that pulls at you, so much as a desire to be productive. Doing nothing is doing something, we have argued again and again; doing nothing means prospecting for potential investments and rejecting those that fail to meet one's criteria. But emotionally, doing nothing seems exactly like doing nothing; it feels uncomfortable, unproductive, unimaginative, uninspired, and, probably for a while, underperforming.

One's internal strains can be compounded by external pressures from clients, brokers, and peers. If you want to know what it is like to truly stand alone, try holding a lot of cash. No one does it. No one knows anyone who does it. No one can readily comprehend why anyone would do it.

      What holding is not

“It would be easy to dismiss those of us who are holding so much as market timers, which is indeed a sucker's game. But that's not what we're doing. Hawkins and Cates wrote: "We are not making an asset-allocation decision. We are not making a bet against the market. Very simply, we have not found qualifying investments, and we are unwilling to force it." Klarman agrees: "It's not a timing thing. It's just a lack of opportunities. We don't try to time the market, regardless of our top-down views. We worry top-down, but we invest bottom-up."

Summing Up

We are paid to form intelligent opinions and invest accordingly. But money management is a humbling business, and we must constantly be aware that our analysis may be incorrect and we must be willing to adjust accordingly. We normally have a firm conviction that we are right, but are always asking ourselves: “What is the risk if we are wrong?”

Right now, we think that the weight of the evidence shows that, at best, the upside potential for most stocks to continue the gains of the last five quarters is marginal at best. Meanwhile, many stocks are now selling well above their true value when viewed through the prism of being shares of an actual operating business: To continue to own such shares does not offer an acceptable risk-to-reward ratio, with the chance of making another point or two being far outweighed by the possibility of a much larger decline.

We are presently comfortable with the select shares that we do own, and we are equally comfortable with the cash reserves our accounts carry at this point. We are patient in our resolve to not swing at every pitch that comes along, knowing that, in time, enough “fat pitches” will come our way to allow us to maintain our good long-term batting average.

John Dickerson
July 16, 2004

© 2004 John Dickerson
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