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Sam

Chairman's Corner

Sam Stewart, Chairman of Wasatch Advisors and President of Wasatch Funds, weighs in on investing practices, the market, and our portfolios.

letter to shareholders

It's Always Something

DEAR INVESTORS: Anyone who watched Saturday Night Live in the 1970s probably remembers Roseanne Rosanadana, the hilarious parody of a news correspondent played by the late...  click to read more 
(January 7, 2015)

Wednesday January 7, 2015

It's Always Something

DEAR INVESTORS:

Anyone who watched Saturday Night Live in the 1970s probably remembers Roseanne Rosanadana, the hilarious parody of a news correspondent played by the late comedian Gilda Radner. In concluding her commentary, Roseanne would summarize with her now-famous catch phrase:

“Well, it just goes to show you. It’s always something. If it’s not one thing, it’s another.”

In a sense, that’s what I’ve been saying over and over again — with some slight but hopefully interesting variations — in my quarterly messages since the global financial crisis found a bottom in 2009. It’s good to know I’m not alone in feeling that I’m writing alternative versions of a similar message. Jason Zweig, the “Intelligent Investor” columnist for the Wall Street Journal, once said: “My job is to write the exact same thing between 50 and 100 times a year in such a way that neither my editors nor my readers will ever think I am repeating myself.”

For most of the time since the end of the crisis in 2009, stocks have been moving up strongly, but the global economy has been the “something” that’s been causing me concern. More recently, the markets have become increasingly erratic, and the level of stock valuations has also become “something” that makes me cautious.

ECONOMY

If I had to choose a single word to summarize the global economy, that word would be “slog.” Most of us have hoped, and many have predicted, that at some point all cylinders of the global economic engine would kick in so the engine would run smoothly. To date, this hasn’t happened. Instead, one or more cylinders have always been misfiring. The result is that the global economy is not yet off to the races.

The following exhibit, which has been reprinted from a recent Goldman Sachs report, depicts housing starts and homebuilding trends. The data was compiled by the Department of Commerce and Blue Chip Publications. Actual housing starts are shown versus median forecasts of prominent (a.k.a., “Blue Chip”) economists.

Overpredicted Economists

While the exhibit clearly shows that there’s been a homebuilding recovery subsequent to the decline ending in 2009, the actual recovery has generally lagged forecasts — even after these forecasts have mostly been revised downward.

The situation for homebuilding is analogous to the economy as a whole. Although the data depicted in the exhibit only cover actual and forecasted housing starts, the picture created by the data also reflects the weakness of the broader economic recovery since the end of the global financial crisis. Like housing, the broader recovery has continued to lag forecasts. And it will be a long slog to reach an environment in which most individuals are optimistic regarding their careers and financial prospects. Another important point from the exhibit is that forecasts, whether they come from Blue Chip economists or Wall Street analysts, are inherently unreliable.

So why hasn’t the global economy reached cruising speed? Just like Roseanne Rosanadana said, if it hasn’t been one thing, it’s been another. Recall that in 2011, the Japanese earthquake and tsunami led to the closure of the Fukushima Daiichi nuclear power plant. Together, these events disrupted the global supply chain, creating further impediments to economic recovery. In 2012, we had the European debt crisis featuring the potential bankruptcy of several Southern European countries. Following the debt crisis, Prime Minister Shinzo Abe’s devaluation of the Japanese yen caused disruptions in 2013. And in 2014, the world saw a particularly sudden oil-price collapse. We can only wonder what disturbances may occur in 2015.

I’m not going to attempt a full-blown forecast for 2015. But I would note that while lower-priced oil is a blessing for many countries, it is a curse for others. Importers of energy resources — including many European countries, Japan, China and India — should benefit. Conversely, countries such as Russia, Iran, Nigeria and Venezuela currently depend on higher-priced oil for their prosperity. Economic woes resulting from lower oil prices threaten the political stability of these countries.

Even prior to the oil meltdown, Russia invaded Ukraine, ISIS threatened the Middle East, and Boko Haram plagued Nigeria. While we hope that such violent movements will be contained, we mustn’t forget Jim Grant’s rejoinder to Ben Bernanke’s 2007 statement that problems in the subprime mortgage market seemed likely to be contained: Yes, Grant noted, they would be contained — contained to the planet Earth.

Here in the United States, there will be some negative second-order effects as lower oil prices put the brakes on the shale-energy boom that was taking place in the middle of our country. This will mean fewer jobs, less ancillary construction and, ultimately, less spending from those affected.

While I’ve outlined my reasons for caution, my economic outlook is not gloomy. There are also plenty of reasons to be optimistic. For example, the oil-price decline of about 50% since June will probably have more positive effects than negative effects. In some parts of the U.S., gas at the pump is now selling for less than $2 per gallon. Most economists agree that a large drop in oil prices is tantamount to a significant tax cut. This means many consumers will have more money to spend at retailers and restaurants, and manufacturers will generally see increased demand and rising profits. So lower oil prices may further reduce inflation and raise GDP growth.

In addition, unexpected improvement in November’s employment report helps assuage my caution about the economy. During most of our five-year recovery, stronger employment data seemed to be just around the corner. Not anymore. The U.S. is now seeing both job increases and rising wages. It’s no longer deniable that we’re in the midst of an expansion. The economic briquettes discussed in my previous messages have caught fire and are burning on their own without the Federal Reserve’s lighter fluid (a.k.a., quantitative easing). Still, the fire is far from the intensity of a normal recovery.

MARKETS

All in all, though the details have changed in my recent quarterly messages, the conclusion has not: The economy is growing, albeit slowly. In the 1970s and 1980s, nominal GDP gains often exceeded 10% per year. But in the recovery since the end of the global financial crisis, nominal GDP growth has mostly been below 4% per year. As the stock market usually takes its cue from the economy, we would have expected tepid performance from stocks, reflecting slow economic growth. So the market’s dramatic rise from the 2009 lows indicates that stocks mostly have been ignoring cues from the economy.

In the last two years, nominal GDP grew about 8% (cumulatively, not annualized) and S&P 500 earnings rose approximately 20%. Yet the stock market, as measured by the S&P 500® Index, gained a whopping 50%. For 2014 alone, the S&P 500 advanced 13.69%, with 4.93% coming in the fourth quarter — which was the eighth straight positive calendar quarter. Small caps did even better for the quarter, with the Russell 2000® Index moving up 9.73%.

International stock markets generally had less impressive returns, which was consistent with the outlook from my previous quarterly message. But I have to admit that I was surprised by the strong performance in the fixed-income markets. The intermediate-term Barclays Capital U.S. Aggregate Bond Index gained 1.79%, and the long-term Barclays U.S. 20+ Year Treasury Bond Index shot up 9.35% for the quarter.

The recent performance of stocks creates a potential disconnect between company fundamentals and market prices. As a result, I think stock valuations are rich. Note that I use the word “rich” rather than the word “excessive” to describe valuations. Only with the aid of hindsight will we be able to determine if current stock prices are excessive. This is because stock prices reflect expectations about the future. And who knows for sure what the future will bring? If most of the global economic and political issues facing us today are resolved favorably, current stock prices may prove to be not only justifiable, but conservative. In addition, technology has enabled businesses to expand — and sometimes to dominate — industries in ways that may not have been feasible less than a decade ago.

I’ll give you an example of a company that has defied typical valuation metrics because it has played a surprising and pivotal role in transforming the transportation industry. During a recent trip to Paris, the line for a taxi was so long that I decided to search for an alternative way to get into the city. The cause of the long line was a strike by many of the city’s taxi drivers, who were creating intentional traffic jams to protest competition from Uber Technologies.* And while there are legitimate regulatory questions posed by the affected taxi drivers, there are undeniable benefits of Uber’s mobile application — which brings together customers and providers of on-demand personal transportation services.

Now consider that Uber was founded less than six years ago, but currently operates in 53 countries and more than 200 cities world-wide. More shocking is that the company is presently valued at over $40 billion. Talk about the “creative destruction” and the rebirth of an industry!

My point regarding Uber is not that the company is necessarily a great investment at the present valuation. Indeed, Uber’s stock is not even publicly traded. Instead, my point is that the actions of entrepreneurs, the policies of governments, and the forces of geopolitics can rapidly create massive changes in the world that are very difficult — if not impossible — to predict. While these changes can sometimes be negative, over the long term developments in the world are more often positive and contribute to robust economic growth.

WASATCH

At Wasatch Advisors, we always approach the market as if it were a market of stocks rather than a stock market. We are much more focused on the fates of individual companies than we are on the error-prone macro analysis discussed above. This doesn’t mean that our stocks are beyond being influenced by the trend of the market, but it does help explain why our stocks tend to resist that trend. We usually lag in a rip-roaring bull market. Conversely, we usually avoid the extremes of a raging bear market. The poster child of this tendency was the 2000 – 2002 bear market during which Wasatch stocks held up well as a group, while the market plunged more than 40%.

When analyzing companies, we use both qualitative and quantitative techniques. We most often talk about our qualitative techniques, which include visiting companies (and their peers) to assess competitive advantages and the quality of management. In these comments, I’d like to describe the more quantitative techniques of analysis we apply to a company’s financial statements. These techniques are very important to us because we believe “the numbers tell a story.” We want to be thoroughly familiar with the story that the numbers are telling us in case it varies from the story that management is telling us.

Many of you have heard us talk about our use of DuPont analysis, which is our most basic quantitative tool. DuPont analysis is a technique for looking at company fundamentals that was initiated by the DuPont Corporation in the 1920s. Our DuPont analysis begins with a single-page display of a company’s financial statements for the past several years, as well as basic financial ratios such as growth rates, margins and returns on investment. When we come across a company that seems interesting, the first thing we do is run a DuPont analysis so we can assess the story the numbers are telling us to see if our interest is justified. If the numbers confirm our interest, then we go to work on researching that company. If the numbers are not supportive, we move along in search of more promising companies to analyze.

Less well-known is our use of multi-factor models that allow for extensive comparisons across countries, sectors and industries. Like DuPont analysis, our multi-factor models obtain many of the same inputs from several years of financial statements (covering cash flows, profitability, returns on capital, etc.). But our multi-factor models also score the financial inputs, giving us a better sense of the relative rankings in aspects such as quality and cash-flow consistency. While DuPont analysis is based on looking at companies one at a time, our multi-factor models add another dimension by simultaneously presenting an array of fundamental characteristics for many companies.

Another important benefit of our multi-factor models is their help in detecting problems related to the companies we already own. While we strive to become aware of such problems before they are manifest in a company’s financial statements, a multi-factor model operates as an additional set of eyes.

Often based on our DuPont analysis and/or our multi-factor models, we decide where to drill down for more company-specific information. And before we actually buy a stock, we generally create a company-specific earnings model that projects the company’s key financial results for several years into the future. An earnings model can help us understand the sensitivity of earnings in response to changes in underlying metrics such as margins and asset turnover. An earnings model also offers an excellent framework for our discussions with management about the company’s prospects.

Combined with our qualitative analysis, these quantitative techniques help to ensure that we have a firm understanding of the story, the strategy and the numbers for the companies we’re assessing.

We sincerely thank you for the confidence you’ve placed in us to invest your hard-earned money.

Sam Stewart

 

 

Information in this document regarding market or economic trends, or the factors influencing historical or future performance, reflects the opinions of management as of the date of this document. These statements should not be relied upon for any other purpose. Past performance is no guarantee of future results, and there is no guarantee that the market forecasts discussed will be realized.

CFA® is a trademark owned by CFA Institute.

© 2015 Wasatch Advisors, Inc. All rights reserved.

*As of December 31, 2014, Wasatch Advisors was not invested in Uber Technologies Inc., which is a privately held company.

DEFINITIONS

A bear market is generally defined as a drop of 20% or more in stock prices over at least a two-month period.

A bull market is defined as a prolonged period in which investment prices rise faster than their historical average. Bull markets can happen as the result of an economic recovery, an economic boom or investor psychology.

Gross domestic product (GDP) is a basic measure of a country’s economic performance, and is the market value of all final goods and services made within the borders of a country in a year.

Quantitative easing (QE) is a government monetary policy used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

Valuation is the process of determining the current worth of an asset or company.

The S&P 500 Index includes 500 of the United States’ largest stocks from a broad variety of industries. The Index is unmanaged, but is a commonly used measure of common stock total-return performance.

The Russell 2000 Index is an unmanaged total-return index of the smallest 2,000 companies in the Russell 3000 Index, as ranked by total market capitalization. The Russell 2000 is widely used in the industry to measure the performance of small-company stocks.

The Barclays Capital U.S. Aggregate Bond Index covers the U.S. investment-grade fixed-rate bond market, including government and corporate securities, agency mortgage pass-through securities and asset-backed securities. To be included in the Index, the security must meet the following criteria: must have at least one year to final maturity, regardless of call features; must have at least $100 million par amount outstanding; must be rated investment-grade or better by Moody’s Investors Service, Standard & Poor’s or Fitch Investor’s Service; must be fixed-rate, although it can carry a coupon that steps up or changes to a predetermined schedule; must be dollar-denominated; and must be nonconvertible. All corporate and asset-backed securities must be registered with the SEC, and must be publicly issued.

The Barclays U.S. 20+ Year Treasury Bond Index measures the performance of U.S. Treasury securities that have remaining maturities of 20 or more years.

You cannot invest directly in these or any indices.