(Download a .pdf version of this letter here.)
November 5, 2008
Market Comment
In light of the fact that October was the worst monthly performance in broader markets since October 1987, we thought we would break with our usual practice and provide a formal monthly update. In conversations with our own clients and discussions with Evan and your clients over the last month, we have detected unmistakable concern. This is understandable and we want to provide some additional context for future conversations you may have with clients. We’ll start with the bad news first and then provide some good news and thoughts about where we stand.
The Bad News:
As we wrote in our third quarter letter:
To say that the events of the last several months are unprecedented,
while overused, is not an exaggeration – we have witnessed the near
collapse of the world’s banking system. Coupled with mutual fund
redemptions, hedge fund redemptions, and increasing fears of a global
recession, these events have erased approximately 25% of the total
value of U.S businesses since the end of the third quarter, as measured
by the S&P 500, leaving the index down more than 40% since its
October 2007 highs…
In late September and Black October, as the month is coming to be called, ongoing strain in the global financial system led to dramatic events unfolding with frightening velocity. For the month of October, the S&P 500 closed down nearly 17% from its September 30th level in spite of two days in which the index was up in excess of 10%. It was a month that saw the S&P record its second worst week ever (-18.2%) and one of its fifteen best (10.5%) ever.
In an environment where weekly returns began to resemble traditional annual returns, volatility created tremendous fear. The VIX, a common measure of expected annual equity market volatility, was up more than 100% at its intra-month high before finishing up 52% for October. At its highest level (almost 90), the VIX implied monthly volatility of more than 25% – for reference, annual volatility has averaged approximately 20% over the last 80 years. The month saw just three trading days with a daily price change in the S&P 500 of less than 1%. Over the 50 trading days ending October 31st, the average daily change in the S&P 500 was 3%. According to Bespoke Investment Group, the only period in which the average daily move in the index has been higher was during the Great Depression. Daily swings of 1,000 points in the Dow Industrials, while disturbing, became somewhat less extraordinary.
The sell-off and volatility wasn’t confined to stocks. Assets historically uncorrelated with U.S. equity returns suffered along with the rest, which highlights the truism that correlations converge to +1 in distressed markets. As measured by the Commodity Research Bureau (CRB) Index, commodities declined more than 22%, making October the worst month in the history of the index. Corporate bonds were lower, leveraged loans and bank notes traded at levels unthinkable just six months ago, and international and emerging markets were dismal. Real estate and real estate-backed assets continued to perform poorly. Pick an asset class other than short-term U.S. government securities or the U.S. Dollar and odds are it was a poor month – even Gold was down.
Client accounts followed the poor performance of the broader markets. Plainly speaking, October was the most difficult month for performance since Value Architects opened its doors full time. All year long we have used words like difficult, arduous, trying, and demanding to describe the market environment. In October, we could add awful to our list of adjectives and our results reflect it. A number of our core holdings, including Fiserv, Legg Mason, Microsoft, National Semiconductor, US Bancorp, Alleghany, and Unilever, were down in excess of 15%. Within our model holdings, just one position was positive for the month (ironically it was a financial services company – The Bank of New York Mellon) and the average price decline for our positions was nearly 21%. We finished the month down 16.8% and the year-to-date period down 26.0% in the All Cap Composite.
The Good News:
With the bad news is out of the way, we’ll highlight some positives.
First, the VAAM All Cap Equity portfolio outperformed the S&P 500 and Russell 3000 for October (+13 bps and +92 bps, respectively). Likewise, the VAAM Balanced portfolio outperformed the Balanced Index by 51 bps in October. We also continued to add value as measured by relative outperformance in the year-to-date period. The All Cap Equity portfolio has outperformed the S&P 500 by 692 bps and the Russell 3000 by 718 bps from the beginning of the year through the end of October. Likewise, the Balanced portfolio has outperformed the Balanced Index by 256 bps through the end of October. As a result of somewhat increased equity exposure, we have given up some of the relative performance advantage we had enjoyed in the first three quarters of 2008. While we are pleased to be beating our benchmarks, make no mistake, we are NOT satisfied with our performance.
Second, despite the rapid drop in market value in our holdings, we continue to believe the business values of the companies we own are largely unchanged, suggesting that the gap between fair value and market value has increased significantly. This should lead to satisfactory future performance as we struggle through a period that Bill Miller recently coined “deferred outperformance” in value oriented strategies. We have always tried to identify situations in which we could purchase a dollar worth of assets for 75 to 80 cents. Today, we believe many of our core holding are 50% undervalued.
Third, from where we sit today, we view the truly dire possible outcomes from the ongoing financial crisis as increasingly remote thanks to a global economic response that is slowly showing signs of traction. You can reference our third quarter letter for more details on this point, but we remain encouraged by recent moves in LIBOR, credit spreads, and commercial paper. It will not happen overnight, but we believe the system will slowly recover. However, it is important to remember that we are in the midst of collateral crisis, not a liquidity crisis. As such, the process of deleveraging will be drawn out and may cause additional spasms. We listened to an investor call hosted by Capital Trust, a highly respected CRE debt investment company, recently in which CEO John Klopp said:
“We are in the midst of a galactic de-leveraging of the entire system.
And I think the result of that will be that many, many assets… will end
up being owned by somebody other than who owns them right now.”
Mr. Klopp is among the brightest and most capable CRE debt professionals in the world and when smart people speak, we pay attention. By no means do we think the deleveraging process is over or that smooth sailing is ahead. We do think however, that doomsday scenarios are increasingly less likely to play out.
Fourth, speaking of smart people and as referenced in our third quarter letter, Charles T. Munger, Warren Buffett’s business partner, recently pointed out that the stock market has rarely performed worse on a ten year rolling basis, yet corporate profit expansion has never been better. In our view, this is very likely setting the base for a new bull run. Buffett himself recently wrote “equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Today, my money and my mouth both say equities.” We also believe this market is awash in high quality businesses on sale. As we referenced in our recent letter, indiscriminant selling, regardless of its root cause, has left the shares of some of the highest quality businesses in this country priced as if earnings will fall more than 30% and never recover. Shares of many lesser enterprises are priced as if they will not survive the current downturn at all. Stifel’s own Richard Cripps recently published an interesting piece entitled “Time for the Investor” that provides an interesting historical perspective, is well reasoned, and echoes our own thoughts.
In closing, we view much of what has happened in the last month, and more broadly the last year as a natural part of the creative destruction implicit in capitalist systems. We continue to be very comfortable with the portfolio we own. Moreover, the market appears to be slowly recognizing the value we see in several of our core positions – many of which have rallied strongly from the October lows. Successfully navigating the current environment continues to require a discerning process and patience, but we firmly believe we have the right method, the right people, and the right partners to deliver long-term outperformance. As our most valued partner, we appreciate your continued support and remain committed to earning your trust.
Rick Konrad
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