Q1 Chairman's Letter to Shareholders: Bernanke’s Backyard Barbecue(April 04, 2013)
Dear Fellow Shareholders:
If you watch financial news programs on a regular basis, you’ll often see some short-term charts alongside a Wall Street talking head who’s frantically answering questions about how to invest based on the latest economic and market events. Can you imagine Warren Buffett appearing in this way, with periodic interruptions as he barks orders through a headset to buy and sell individual companies? Not likely.
The difference here is that the Wall Street talking head is a trader, while Warren Buffett is an investor. Buffett focuses on long-term company fundamentals, which is what we try to do at Wasatch Advisors. So when I’ve recently been asked about my views regarding the all-time highs in the stock market, I have a mixed reaction. Clearly, the surge in stock prices is very impressive. But an equally valid point is that the U.S. market is only now reaching the heights it achieved more than five years ago. From my perspective, rather than focusing on the headlines about record levels in the market, I prefer to spend my time trying to find the World’s Best Growth Companies®— and buy them at what I believe to be reasonable valuations.
I don’t place much emphasis on new highs in stocks. After all, Peter Lynch used to say that he invested based on his expectation that stock prices would rise every day — which implies new highs on a daily basis. But I do believe it’s important to have views on both the fundamental and sentiment factors that drive the economy and the markets. These factors have direct and indirect influences on the companies in which we invest, and on the prices at which we can buy or sell them.
Some of the most-important factors I see today are the actions of the Federal Reserve (Fed). Under Chairman Ben Bernanke, the Fed has engaged in unprecedented levels of “quantitative easing” by buying government securities to support bond prices and reduce interest rates. In fact, the Fed has committed to these low rates at least through 2015. For those of us who’ve spent any time around a backyard barbecue, Chairman Bernanke’s approach is analogous to pouring massive amounts of lighter fluid on the grill and hoping the charcoal briquettes eventually catch fire.
To continue the barbecue analogy, the use of lighter fluid certainly produces an impressive blaze in the short term. But the real key is to create a sustainable fire in the economic briquettes. The question remains: Is the lighter fluid simply burning off, or is the economy starting to fire on its own? We probably won’t know the answer to this question until Chairman Bernanke runs out of fluid or has a change of heart regarding the efficiency of his actions.
My views concerning economic conditions are shaped by the data. And based on the data, conditions remain mixed with a bias toward a muddling economy with slow growth. On the negative side, the Congressional Budget Office recently forecast that real gross domestic product (GDP) in the U.S. will grow at only 1.4% for 2013, down from the 1.9% estimate for 2012. On the positive side, retail sales have been decent, jobless claims have declined and the unemployment rate edged down slightly in February to 7.7% from 7.9% in January.
Among the problems we face in our economy today are too much debt (including future Medicare and Social Security obligations), a sizable and seemingly unending budget deficit, and artificially low interest rates. As I discussed in last quarter’s commentary, the Fed’s extreme measures to support asset prices and investor sentiment have allowed the balance-sheet recession to linger on. This means that bad debts remain on the books of our government, our banks and our corporations. Until these bad debts are resolved — paid off or written down — through a painful but necessary cleansing process, we will not have a healthy lending environment. In addition, somewhat higher interest rates are needed so that savers, the would-be providers of capital, are incentivized with reasonable returns on their investments. Currently these savers, both individual and corporate, are largely encouraged to be hoarders of capital because the potential returns seem low relative to the risks.
My advice to Chairman Bernanke would be to put a cap on his bottle of lighter fluid because loose monetary policy can be inflationary over the longer term and is not a good tool for promoting capital investment, growing the economy and creating jobs. Instead, I believe Bernanke should more forcefully encourage the president and Congress to pursue sensible fiscal policies that address infrastructure, education and the bad debts currently being ignored in our financial system.
While I believe economic conditions lean toward slow growth, the stock market certainly caught fire during the first quarter of 2013. Including reinvested dividends, the S&P 500 Index was up 10.61% in the first quarter after being down 0.38% in the fourth quarter of 2012. Conversely, the bond market as represented by the Barclays Capital U.S. Aggregate Bond Index was down 0.12% for the first quarter of 2013. I continue to warn bond and bond-fund investors of the significant risks to principal when we eventually experience a sustained rise in rates.
Despite my concerns about the economy and the Fed’s policies, I remain somewhat bullish on stocks for a few main reasons. First, academic research suggests that slower GDP growth does not necessarily translate into poor stock returns. Second, I’m finding companies that are beating their competition in a tough economic environment by providing better, faster and often less expensive products and services. Many of these companies are selling at reasonable price/earnings multiples with strong growth rates and sometimes-attractive dividend yields. Third, stocks are potentially good hedges against the eventual rise in inflation because an inflationary environment allows companies to increase prices, which can lead to higher earnings and stock valuations.
Another important point is that a slow-growth economic environment is a good backdrop for strong stock-pickers who can sort out the best companies. At Wasatch Advisors, we’ve historically found many of what we believe to be the best companies in the small- and micro-cap areas because these areas are often less well-researched and the companies are usually faster growers. More recently, I’ve also found good opportunities among mid- and large-cap stocks. In particular, I think many big-cap technology companies are amazingly inexpensive.
The two Wasatch mutual funds I currently manage — the World Innovators Fund (co-managed with Josh Stewart) and the Strategic Income Fund — have significant allocations to mid- and large-cap stocks for the reasons described above. Some of the holdings in these funds have been selling at price/earnings multiples in the high single digits or low double digits. What I find so attractive are the combinations of these types of valuations with growth rates that exceed the price/earnings multiples and substantial dividend yields. In addition, the fact that the companies are larger gives investors the potential for less risk. In my career, I’ve generally had good success with stocks bought at such reasonable valuations.
A final point I’d like to make regarding the markets is that I believe diversification is now more important than ever. This is why I’ve diversified my small-cap U.S. stock investments with some larger-cap and international names. Similarly, I think holding a portion of a portfolio in cash is a wise form of diversification because it gives investors the ability to put money to work at attractive valuations when stocks suffer periodic corrections.
I’m pleased to announce that four of our Wasatch mutual funds received a total of six 2013 Lipper Awards on March 14, 2013. These awards recognize mutual funds that, relative to peers, have delivered consistently strong risk-adjusted performance whereby smaller downside losses are given even more importance than larger upside gains.
The Wasatch Emerging Markets Small Cap Fund (WAEMX) was recognized as #1 over both the three-year and five-year periods ended December 31, 2012 among 308 and 219 emerging markets funds, respectively. This recognition was earned for the second year in a row. The Emerging Markets Small Cap Fund was previously recognized in 2012 for its three-year performance ended December 31, 2011 among 296 emerging markets funds. The Wasatch World Innovators Fund (WAGTX) was honored as #1 over both the three-year and five-year periods ended December 31, 2012 among 144 and 72 global multi-cap growth funds, respectively. The Wasatch International Growth Fund (WAIGX) received the Lipper Award for #1 performance for the three-year period ended December 31, 2012 among 111 international small/mid-cap growth funds. Finally, the Wasatch-Hoisington U.S. Treasury Fund (WHOSX) earned the Lipper Award for the #1 ranking over the five-year period ended December 31, 2012 among 20 general U.S. Treasury funds.
All of us at Wasatch Advisors are very proud of these awards, in part because they cover a wide range of our fund strategies.
With sincere thanks for your continued investment and for your trust,
P.S. As always, please be sure to read the prospectus before investing in any fund.
Dividend yield is a company’s annual dividend payments divided by its market capitalization, or the dividend per share divided by the price per share. For example, a company whose stock sells for $30 per share that pays an annual dividend of $3 per share has a dividend yield of 10%.