Why Don’t We Sell Everything?

By Michael K. Farr and Taylor D. McGowan

We’ve recently received questions from clients that go something like this, “If you are so nervous about the stock market after it has run-up 40% in 3 months, why do I have only 10%-15% cash in my equity portfolio?” This is an excellent question. I think the answer to this question deserves more than a sentence or two.

First, we remain positive on the stock market long-term. The 40% move in the stock market over the past 3 months has taken the PE on the S&P500 from 11x 2009E EPS to 15.5x 2009E EPS. Stocks obviously aren’t as attractive now as they were three months ago. However, the current PE multiple is roughly in-line with the market’s long-term average. This multiple is significantly more attractive than it was at the turn of the century when the S&P500 traded at roughly 25x. The dividend yield on the S&P500 is currently 3.0%. If we assume that corporate earnings will grow at an average rate (~5%) over the next 5-10 years and assume no change to the current PE multiple, one could reasonably expect long-term returns from the market of 8% or so (e.g. 5% EPS growth rate + 3% dividend yield and no change to the PE multiple) from current levels. This is less of a forecast and more of a rough estimation based on 100 years worth of stock market data. This type of return would not be far from the market’s long-run average and it would compare very favorably to the types of returns that the market has generated over the past 5-10 years. This type of return would also compare favorably to the returns offered by the 10 year treasury, which currently yields 3.59%.

Second, we don’t actually know what the market will do. We believe that our guesses on this topic are educated to be sure. Farr Miller’s investment team is extremely experienced, thoughtful, and skilled. However, we are smart enough to know that neither we, nor anyone one else, knows for sure where the market is headed. After all, if Warren Buffett professes not to know where the economy is headed, how could we possibly say otherwise? If we start with this basic assumption, which is that we can’t forecast the future with much accuracy consistently over long periods of time, then it would be irresponsible to set up client portfolios to adhere to our potentially faulty macro forecasts. Instead, we take the view that we don’t know what will happen and given that we don’t know, which companies are we most comfortable owning over the next five years? The companies that we are most comfortable owning typically have the following characteristics: 1) a long track record of growing EPS faster, and in a more stable fashion, than the overall market, 2) great balance sheets, 3) high free cash flow generation, 4) high returns on capital, and 5) great management. If we buy 30-40 companies with these characteristics across a variety of industries at reasonable valuations, then we should have a reasonable chance of generating returns in excess of the S&P500 over long-periods of time. This has been the case since the firm’s inception in 1996 and we obviously hope that this track record (e.g. our fully-discretionary equity composite is ahead of the S&P500 over the 1 yr, 3 yr, 5 yr, 7 yr, 10 yr, and 12 yr periods) will continue going forward.

So does this mean that our macro forecasts play no role in our investment strategy? The answer is “no.” We are fundamental, bottom-up stock pickers. However, most companies are impacted one way or another by the economy. Thus, our macro view comes into play as we are building long-term earnings forecasts for each company. Our strict discipline has allowed us to make changes within our portfolio (e.g. significantly reducing our exposure to financials in 2007 and refusing to chase hot commodity stocks in the first half of 2008) that allowed our clients to miss a lot of the pain that the market wrought last year. However, it is important to realize that these changes were not made based on our macro-economic forecasts. We sold most of our financial stocks in 2007 because the stocks appeared over priced based on our view that earnings growth would have to slow as the housing market started to slow. A portion of this expectation for slower growth was based on some macro assumptions. We didn’t chase commodity stocks because we didn’t believe that the stocks were pricing in any sort of chance that the global economy would slow down as a result of the crisis in the U.S. Instead, we found stable companies such as our consumer staple and healthcare companies even more attractive given the environment.

We continue to stick to our discipline. We buy companies that we believe are attractive long-term investments and we sell companies that we believe offer our clients subpar long-term returns. Our cash levels have built up a little in the past two months as we’ve found more companies to sell than to buy after such a sharp recovery in the market. Cash is a residual of these buy and sell decisions. Our client portfolios have recently become even more conservative after this recent 40% run-up. This has not been a conscious, top-down decision. Instead, our individual stock picks have left the portfolio more conservative because the riskiest names have bounced the hardest over the past 3 months and have thus become less attractive while the safest stocks have not participated. This phenomenom can be seen in our recent decisions to trim our JP Morgan position after its sharp run-up from the March lows and our decision last week to buy Wal-Mart, which has not participated much in this rally.

We will likely continue to write about our macro views. The fact is that there are only so many ways to tell clients that we are buying good companies at reasonable valuations and holding them for a long time. This, of course, is what we are actually doing! We hope that we are being too conservative. If our concerns are not misplaced, we are comforted by the fact that the companies that we own are generally the ones that should weather whatever the market throws at us over the coming years. The slightly larger than normal cash position would allow us to add to great companies at even better prices. This is the way that we invest our own money. Clients invest alongside with us. Everyday we commit our own dollars and those of our families to the discipline we preach. We are always willing to sacrifice opportunity rather than principal!

Hang in there,