Compass October 2011

In this issue:

Compass is the quarterly newsletter of Creekside Partners. All information is obtained from sources deemed to be reliable, but is not guaranteed as to accuracy. Nothing in this newsletter should be construed as financial or investment advice to any reader. All material herein is the copyright of Creekside Partners

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Market Re-Entry Strategy: Cheap, with a Tailwind

As we go to press with this quarter’s commentary, all eyes are on Europe. Over the past few months, the US stock market has seemed to rise and fall based on the daily news trajectory from across the pond. We say, “seemed,” because, well, it seems that way.

But we also think that US stocks entered the second half of the year significantly over-valued. By our valuation methodology, in early July the S&P500 was about 28% above the middle of a fair value range. Today, most of that excess has been corrected.

When stocks correct downward from a high point, the standard commentary will point the finger to causes outside the stock market. The talking heads on the financial news shows willsay US stocks fell because of the housing market, or because of Greece, or defense cuts, or the election cycle, or the Fed…there is always something to blame.

But the best answer to, “Why did stocks fall?” is a tautology. A tautology is an explanation of something that is circular, redundant, and often annoyingly pointless.

If I asked my running coach why I keep losing races, he might answer, “Because those other guys run faster than you.” An answer that, while correct, is circular and pointless.

Why do stocks fall from an overvalued level? Because they were overvalued.

We started the year with an underweight to core large-cap stocks. With some reductions to holdings in May and again in early September, we currently own about 40% of the amount of stocks we would have in more normal times. Having dodged part of the recent decline in global stock markets, we now turn our attention to the question of re-entry. While the global economy is sputtering at the moment, we expect humanity to eventually get on with the business of productive activity.

A meaningful re-entry to the stock market will be driven by our two pillars of investment decision-making:

Valuation and Economic Conditions.

Valuation has proved the more important of these.

By valuation, we mean not the market price, but rather the intrinsic worth of a company (or index of companies) – what it should sell for, compared to what it is actually selling for.

Just as there is an acceptable price you would pay for a particular amount of, say, apples… there is an acceptable price to pay for a particular amount of ongoing company earnings. That amount is what you would consider fair. Fair means to pay a price that is likely to deliver satisfying investment returns.

Longtime readers and clients might recall that we place a value on the stock market by looking at longer-term, sustainable earnings. In a method popularized by Robert Shiller in his book Irrational Exuberance, we take the average of inflation-adjusted earnings over a 10-year period to arrive at the “E” in the familiar P/E ratio. This “Shiller P/E” has proved robust and predictive of not just sustained earnings levels, but also of the underlying valuation of stocks. It serves to knock the peaks and valleys off of the short-term earnings that companies report, providing a more reliable picture.

As we go to press, the Shiller P/E of the S&P500 is around 20. The long-term average is closer to 15. Does that mean 20 is too high? The answer is, maybe – a price of 20 has often delivered good results in the past, but has equally often proved disappointing. In the chart below, we have plotted on the vertical axis the Shiller P/E at the time a portfolio was purchased, for every month since January 1901. Along the horizontal axis is the annualized inflation-adjusted return an

investor would have earned over the 7 years following that purchase. We define “good results” as earning at least 3.5% above the rate of inflation. We have drawn a red vertical dotted line through the 3.5% result. Data points to the right of it are good; those to the left are not-so-good. (See box at bottom right to read the reason why we use 3.5%.)

At a purchase price of 20, results have been mixed. Sometimes you’ve made good money; sometimes not. The group of circled outlier “good” points (when stocks were expensive, yet still delivered strong returns) is entirely from the late-90’s tech bubble, an episode unlikely to repeat anytime soon.

What is clear from this chart is that, the cheaper you buy, the more often you do well. The more expensive you buy, the worse you tend to do. The vast majority of “good results” occur when a portfolio is acquired at a P/E less than today’s.

The chart also shows that valuation alone does not predict your success. It is but part of the system. Paying the right price dramatically improves your odds, but another level of analysis is needed. And that next level is the tricky one, and is one that will help govern our decision to eventually re-enter the stock market.

The next level of analysis is to figure out whether we, and stocks, have a headwind or a tailwind. A tailwind would be a rising economy, a strong move toward full employment, increases in real household incomes and their savings rates, etc. A headwind would be rising or high unemployment, falling real household incomes, stagnant consumer spending and business investment, etc. We don’t think many would disagree that we face a headwind at the moment. Times of headwinds characterize the points on the chart that fall to the left of the 3.5% line. Poor results can occur even when stocks were bought at attractive prices.

In our experience, it is easier to detect growing headwinds than tailwinds. By the time it is clear that the economy is recovering and that corporate earnings are on the rebound, stocks have often already moved significantly higher. This means that a value investor will often need to jump back into the market just as the economic headwinds are blowing the hardest. We don’t think the headwinds are even blowing very hard at the moment. We don’t make predictions of recessions, recoveries or even earnings levels…but people for whom we have a great deal of respect are predicting stormy weather.

Therefore, we are not eager to re-enter the stock market when (1) valuations are still a little rich, and (2) the headwinds are steady or even growing. We are not likely to wait for an obvious turnaround in the economy. While the condition of the economy has figured large in our decision to underweight stocks going back more than a year, the underlying valuation will be the primary driver of a decision to buy.

The next thing we think about is, when we do re-enter the stock market, what will we buy? The “benchmark” approach would be to buy mostly the S&P500, and also a bit of a global stock index such as the EAFE. That approach has been hard to beat over the past few decades. But the world is a different place today. Even though most companies in the S&P500 generate large portions of their earnings from overseas activities, we want an even greater exposure to global growth. The engines of global growth going forward are going to be the emerging market countries, including most of Asia and South Asia.

We have long been reluctant to make a major commitment of money to direct investment in emerging market stocks and bonds. While we will surely own some measure of those assets, the dominant portion of our stock exposure will be to a select group of large, globally-oriented companies that generate their earnings all over the world, including in emerging market countries. Further, we will sort that set of large global companies into those that pay consistent high dividends. For whatever reason, the value and importance of dividends has been forgotten by a generation of investors.

The chart below shows three paths. The highest one, in blue, shows the growing value of a stock portfolio since 1950, with all dividends reinvested. The next line, in green, shows the value of that portfolio adjusted for inflation. The lowest line shows the value of that inflation-adjusted portfolio with no dividends. Dividends are important, and we think they will be even more important going forward.

As we begin to build back up to normal stock allocations, we will be focusing on large, globally-operating companies that pay high dividends. The key factor in buying is, above all else: Buy at a price that gives you high odds of success.

Rick Ashburn & Andy Hempeck

The Baked-In Return on Stocks

Why 3.5%? In the table to the left, we say that “good” returns are at least 3.5% annualized, adjusted for inflation. We arrive at this figure by computing the “baked-in” return on stocks. This is the amount of return you would realize if you owned a large stock portfolio essentially forever, and only needed to compute your own valuation from time to time. The S&P500 pays a dividend rate of about 2.0%; dividends tend to grow approximately with inflation. The S&P500 companies have achieved a long-term increase in earnings per share at about 1.5%, also adjusted for inflation. Each share therefore grows in real value at this rate: about 1.5%, plus inflation. Combining the income portion with the valuation growth portion, we get a total “baked-in” return of 3.5% plus inflation. This is the minimum amount that an owner of stocks should expect to earn over a reasonable holding period.

Major Asset Classes Valuation

Economic Factors
Headwind or Tailwind?

Inflation. The reported money supply grew 10.3% over the past year — a significant acceleration from a year ago. The money supply growth rate continues to tick upwards as the Fed tries to stimulate wage and price inflation. Inflation year-over-year totaled 3.8%. So far, the increase in the money supply is largely remaining bottled up in banks. If/when a recovery gets going in earnest, watch for spiking inflation. Or…an asset bubble. Generally speaking, an expanding money supply stimulates the economy.

Bond Interest Rates. Rates on quality bonds are low and going lower. To the point that we have been buying fewer bonds these days. If we can’t get our target hurdle rate of 3-4%, we’re going to stay in liquid short-term bonds for the time being. High Yield bond yields have risen significantly. Not quite high enough yet, but we are watching closely. Low rates are good for the economy; bad for investors.

Debt Crisis. The global explosion of cheap credit that got rolling in 2002 and came to a screeching halt in 2008 has caused a cascading series of troubles. While some of that debt has gone away (through default and other write-downs), the vast majority still exists. Huge portions of debt are on public balance sheets, including our Federal Reserve. Other portions are in banks — European banks have an inordinately high exposure to troubled debt of some of the peripheral European countries.

That debt will need to be paid down, nationalized, inflated away…something has to happen. And none of those somethings are good for economic growth.

Employment & Wages. On CNBC about a year ago, Rick Ashburn quipped that the economy was “circling the drain.” This remark was in relation to employment, and remains true today. The US economy is still not growing fast enough to absorb new entrants to the work force, let alone the long-term unemployed.

We recently came across a report that inflation-adjusted household incomes are back to 1996 levels. It’s shocking to think that the median American family hasn’t had a raise or increase in standard of living for 15 years. It’s a tough cycle to climb out of, and goes partway toward understanding the chronic weakness of this “recovery.”

2011 Year-to-Date Index Returns

Large-Cap U.S. Stocks

Small-Cap U.S. Stocks

Foreign Stocks (Developed)

Emerging Market Stocks

Muni Bonds

Taxable Bonds


(year-over-year August 31)








Wherever possible, we use the returns on Vanguard Index Funds as the benchmark figures for various asset classes.

Readers wishing to review the actual performance record of a composite of our client portfolios should call or email us at