Second Quarter 2003 Newsletter

Markets rebounded sharply in the second quarter and our portfolios continued to perform well against their benchmarks.

Most asset classes are now close to reasonably priced and tactical asset class plays are limited at the moment. But it is certain that the cycles of fear and greed will again create opportunities, and we are prepared to be patient in the meantime.

We have started to underweight bonds in our balanced portfolios by 5% to 10%. The proceeds will go into cash.

At this point, we don’t view the tax changes as reasons to pursue certain types of investments over others. From a portfolio-strategy standpoint, now more than ever, portfolios will be much more tax efficient if bonds and investments that throw off lots of short-term capital gains are in retirement plan accounts.

Investment Review and Outlook

What a difference a quarter makes! The powerful second-quarter rebound more than offset a tough first quarter, rewarding investors with sizable returns during the first six months of 2003. So far this year our portfolios have out-returned their benchmarks and participated strongly in the rebound. Three months ago we wrote about all the economic and geopolitical negatives. But after that rather depressing discourse we also wrote, “…there are powerful positive forces at play which must not be forgotten at a time when the glass seems mostly empty.” Many times in the past we’ve written that investors should never underestimate the ability of the stock market to surprise.

Our respect for the stock market’s ability to humble investors over the short-term is part of the reason why we put so much faith in valuation analysis, which we believe is a primary driver of investment returns over periods of several years and longer. The other reason for this emphasis is that we believe we can analyze asset values with enough accuracy to lead us to return-enhancing decisions more often than not. So, despite economic and geopolitical worries, three months ago we believed that the stock market and other “equity-like” assets were clearly undervalued. For this reason, despite our big-picture worries we believed the odds were high that we would be rewarded either sooner or later for maintaining equity exposure. In essence, we relied on that which we could confidently assess (valuations) and were influenced less by factors that we could less confidently assess (geopolitics and the timing and strength of an economic turnaround). This allowed us to resist the temptation to get more defensive. Now, three months later, the returns from equity asset classes have been impressive.

We believe we add value through the quality of our research and our ability to share our discipline. If we do not have the discipline to follow what our research tells us, then the research loses its value. At times of extreme greed and fear, this is particularly difficult because emotion clouds judgment. For that reason, we view one of the most important parts of our job as helping you to deal with the same emotional challenges.

Have Stocks and Bonds Gone Too Far?

We always get nervous when financial asset prices move sharply higher over a short time period. Contributing to our discomfort these days is the bullishness of financial advisors and investment strategists. According to several polls of both groups, optimism is higher than it’s been at any time since 1987. Huge optimism is usually a bad sign because it suggests that if investors have acted on their optimism, stock prices will have been bid too high. However, investment sentiment is just one factor and a temporary one at that, so it rarely factors into our investment decision-making process. To reiterate, most important is the valuation picture. And what is the picture now? The bad news is that there are no equity-type asset classes that appear to be huge bargains. The good news is that, based on our work, none are overvalued and some are still slightly undervalued. Our base-case assumption is that the economy recovers with interest rates increasing over the next few years so that the 10-year Treasury yield backs up to 5%. This outlook assumes inflation between 2% and 3%. In that scenario the valuation picture is as follows:


With most equity-type asset classes in a range between fairly valued and slightly undervalued, it is reasonable to wonder how current investment opportunities look relative to the risks. We’ve identified several risks over the past year:

  • Structural risks, including debt levels and the sizable U.S. dependence on foreign capital
  • Deflation, which could be a by-product of high debt level
  • Inflation, which could eventually be ignited by attempts to fight deflation
  • Geopolitical risks including terrorism.

At present, we believe equity asset classes are fairly valued and discount a “normal” level of risk. Are today’s risks “normal”? That’s a subjective assessment that is hard to make, but it is no longer clear that big-picture risks are above average.

Reasonable Return Expectations and Ways to Add Value

Current asset prices suggest returns of 6% to 9% for equity-type assets on average, over the next five years. Of course that is a base-case forecast and assumes that assets are at about fair value at the end of the period. The reality is that returns could be significantly different if growth rates are abnormally high or low, or if assets become over- or undervalued. Given our expectations, return potential relative to inflation is decent but on a nominal basis, these returns may not seem exciting. After a horrible three years don’t we deserve more? The sad reality is that returns were so high in the 1990s that they effectively borrowed from the future. The bear market brought things back to reality and beyond, and now we have had a bounce back to fair value. So as we write this at the beginning of the third quarter, returns look likely to be okay but not spectacular. How can we do better, or at least ensure that we do not fall within the lower end of the broader range?

There are no guarantees but as we focus on the important question of how we can continue to add value, we would like to point out the following:

Tactical asset class plays are limited today

Taking advantage of market overreactions is one of two primary ways we expect to add value. For much of the last three years we’ve been pounding the table about opportunities in high-yield bonds, value stocks and small-cap stocks. We unwound our overweighted positions in value last year and still hold our high-yield bond positions, although we have cut it by half in our all-stock portfolios. Today there are no table-pounding opportunities. High-yield bonds are borderline fat-pitch opportunities (more on this later) but after strong recent performance, they don’t offer the potential they did.

While no area is hugely compelling right now, there is one area of overreaction. Investment-grade bonds are clearly unattractive, and we are adjusting our portfolios accordingly (more on this below). Just because there are no great opportunities today doesn’t mean there won’t be any tomorrow. In fact, we can guarantee that there will be good opportunities in the future because they always come and go as a byproduct of investors’ ongoing swings between fear and greed. We will be patiently awaiting opportunities we can take advantage of.

Adding Value via Manager Selection

The second way we add value over time is through manager selection. Over the long run this has been a material factor in our performance. Just as we take advantage at the asset class level of the misvaluations arising from fear and greed-driven volatility, our managers similarly benefit at the security selection level. Volatility is the long-term investor’s friend.

What We Are Doing Now

As all financial assets have moved higher we have been debating two tough decisions:

What to do with bonds?

Given our very low return expectations for investment-grade bonds, it’s fair to ask why we own them. The reason is that economic risk has not gone away and bonds will be the best-performing asset class if the economy weakens again. However, we have concluded that the risk and return tradeoff inherent in investment-grade bonds does not warrant the level of exposure we have. Consequently, we have been reducing exposure in balanced accounts by between 5% and 10%. For now, this exposure will be held in cash. While cash yields are very low, cash won’t decline in value, unlike bonds. We do not view our move from bonds as long-term, nor do we view it as market timing. Rather, we view it as a fundamentally driven move that is likely to ultimately result in a future allocation to bonds at lower prices or possibly partially fund other investment opportunities that we continue to research.

Are high-yield bonds still a fat pitch?

High-yield bonds are still quite competitive with stocks but they no longer qualify as a clearly superior alternative. However, everything—including high-yield bonds—is a fat pitch compared to investment-grade bonds, and that is why high-yield bonds continue to be interesting. Their risk is similar to the risk of an equal mix of stocks and investment-grade bonds. Over the next five years, our pre-tax return expectations for a stock/bond blend is about 5% compared to 7.5% for high-yield bonds. After-tax return expectations are about 4.5% compared to about 3.7% (assuming maximum tax rates on interest and assuming a high-tax state). Investors who hold their high-yield bonds in retirement accounts have the potential to have even better comparative returns on an after-tax basis.

For taxable investors high-yield bonds remain attractive, but are they attractive enough to be considered a fat-pitch? We still put them in that category, but it would not take too much relative outperformance to force a change in our opinion regarding their fat-pitch status. In other areas, we are sticking with our small-cap and foreign equity positions, which we think offer somewhat better value than U.S. large-cap stocks (but not enough to meet our fat-pitch criteria). We see no compelling investment advantage in U.S. large-caps for either the growth or value style, at least on a statistical basis.

Thoughts on the Tax Bill

The impact of the tax bill was a positive one for investors, and it does have some ramifications on asset allocation and portfolio management decisions. Though rates have effectively dropped for all investments, they dropped more for capital gains and qualifying dividends – thus benefiting stocks more than most other assets. This means that for high-tax-bracket investors, high-yield bonds will fall from fat-pitch territory faster than they otherwise would have.

At this point, we don’t view the tax changes as reasons to pursue certain types of investments over others. The market tends to adjust fairly quickly to relative opportunities. From a portfolio-strategy standpoint, now more than ever, investors with both taxable and retirement plan portfolios will benefit from emphasizing investments that throw off income taxed at high ordinary rates in their retirement plans. That means that portfolios will be much more tax efficient if retirement plan accounts hold investments that throw off lots of short-term capital.


Unlike most of the last five years, financial asset values are not currently disconnected from reality. In this environment, we rely on:

  1. Our ability to identify exceptionally skilled stock pickers who continue to add value, and
  2. Our ability to be patient in waiting for the next fat-pitch (tactical asset allocation) opportunity.

Over the years we think we’ve developed a clear understanding of our circle of competence, and we’ve learned the importance of staying there. Part of that circle of competence involves focusing on that which we can confidently analyze, such as valuations, and staying away from the type of big-picture analysis that is so hard to get right.

Best Regards,

Jon Houk, CFP