Friday, January 30, 2009
Thursday, January 29, 2009
How could this have happened? In a flourishing country in which people are focused on making money, how could you have had three extended and anguishing periods of stagnation that in aggregate --leaving aside dividends-- would have lost you money? The answer lies in the mistake that investors repeatedly make--that psychological force I mentioned above: People are habitually guided by the rear-view mirror and, for the most part, by the vistas immediately behind them.
Now, there was a smart man, who did just about the hardest thing in the world to do. Charles Darwin used to say that whenever he ran into something that contradicted a conclusion he cherished, he was obliged to write the new finding down within 30 minutes. Otherwise his mind would work to reject the discordant information, much as the body rejects transplants. Man's natural inclination is to cling to his beliefs, particularly if they are reinforced by recent experience --a flaw in our makeup that bears on what happens during secular bull markets and extended periods of stagnation.
Now, if you had read that article in 1979, you would have suffered--oh, how you would have suffered!--for about three years. I was no good then at forecasting the near-term movements of stock prices, and I'm no good now. I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two.
But I think it is very easy to see what is likely to happen over the long term. Ben Graham told us why: "Though the stock market functions as a voting machine in the short run, it acts as a weighing machine in the long run." Fear and greed play important roles when votes are being cast, but they don't register on the scale.
By my thinking, it was not hard to say that, over a 20 -year period, a 9.5% bond wasn't going to do as well as this disguised bond called the Dow that you could buy below par--that's book value--and that was earning 13% on par.
Let me explain what I mean by that term I slipped in there, "disguised bond." A bond, as most of you know, comes with a certain maturity and with a string of little coupons. A 6% bond, for example, pays a 3% coupon every six months.
A stock, in contrast, is a financial instrument that has a claim on future distributions made by a given business, whether they are paid out as dividends or to repurchase stock or to settle up after sale or liquidation. These payments are in effect "coupons." The set of owners getting them will change as shareholders come and go. But the financial outcome for the business' owners as a whole will be determined by the size and timing of these coupons. Estimating those particulars is what investment analysis is all about.
Now, gauging the size of those "coupons" gets very difficult for individual stocks. It's easier, though, for groups of stocks. Back in 1978, as I mentioned, we had the Dow earning 13% on its average book value of $850. The 13% could only be a benchmark, not a guarantee. Still, if you'd been willing then to invest for a period of time in stocks, you were in effect buying a bond--at prices that in 1979 seldom inched above par--with a principal value of $891 and a quite possible 13% coupon on the principal.
How could that not be better than a 9.5% bond? From that starting point, stocks had to outperform bonds over the long term. That, incidentally, has been true during most of my business lifetime. But as Keynes would remind us, the superiority of stocks isn't inevitable. They own the advantage only when certain conditions prevail.
The tour we've taken through the last century proves that market irrationality of an extreme kind periodically erupts--and compellingly suggests that investors wanting to do well had better learn how to deal with the next outbreak. What's needed is an antidote, and in my opinion that's quantification. If you quantify, you won't necessarily rise to brilliance, but neither will you sink into craziness.
On a macro basis, quantification doesn't have to be complicated at all. Below is a chart, starting almost 80 years ago and really quite fundamental in what it says. The chart shows the market value of all publicly traded securities as a percentage of the country's business--that is, as a percentage of GNP. The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment. And as you can see, nearly two years ago the ratio rose to an unprecedented level. That should have been a very strong warning signal.
For investors to gain wealth at a rate that exceeds the growth of U.S. business, the percentage relationship line on the chart must keep going up and up. If GNP is going to grow 5% a year and you want market values to go up 10%, then you need to have the line go straight off the top of the chart. That won't happen.
For me, the message of that chart is this: If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%--as it did in 1999 and a part of 2000--you are playing with fire.
Wednesday, January 28, 2009
Unfortunately, we have just passed through a period in which confidence was blind. It was not based on rational evidence. The trust in our mortgage and housing markets that drove real-estate prices to unsustainable heights is one of the most dramatic examples of unbridled animal spirits we have ever seen.
Tuesday, January 27, 2009
Monday, January 26, 2009
Friday, January 23, 2009
With economies and financial markets, it seems that if you stare hard enough and long enough at the fog of battle, you occasionally get a glimpse of what may be going on when a favorable wind blows. This, for me, is decidedly not one of those occasions. It is obvious to all of us that these are momentous days in which government actions may well have make-or-break impact, but my confidence in government and leadership is at a low ebb. (Although I must admit my confidence has increased enormously in recent weeks in all areas outside of finance. Even in finance it has increased a little.) Economic advice for President Obama covers the waterfront, and even the near-consensus case for great stimulus is lacking in historical certainties or intellectual rigor. Everyone seems to be guessing at strategies and outcomes, knowing clearly that the best strategy would have been to have avoided getting into this pickle. The current disaster would have been easy to avoid by making a move against asset bubbles early in their lifecycle. It will, in contrast, be devilishly hard to get out of. But, we are deep in the pickle jar, and it seems likely that, in terms of economic pain, 2009 will be the worst year in the lives of the majority of Americans, Brits, and others. So break a leg, everyone!
It would be helpful at a time like this to have a Quarterly Letter that sounded convinced of something … anything. So I apologize for overtly tickling around the edges. I do not apologize, though, for pointing you to the best thing I have read in The New York Times in a very long time: the article by Lewis and Einhorn does a great job of summarizing where we are and how we got here, as well as offering some helpful advice for the future. My contribution is to address a few peripheral topics that have accumulated over recent quarters as more important topics have dominated.
Related previous post: NY Times Op-Ed from Michael Lewis and David Einhorn
Portions of Susie Gharib's interview with Warren Buffett will air in the January 22nd & 23rd broadcasts of NBR. The complete interview is available below. You can also read the complete transcript.
Tuesday, January 20, 2009
Quoting history’s most widely taught treatise of wartime engagement seems appropriate as we reflect upon the recent quarter, and for that matter, the year that was 2008. There is certainly no doubt that 2008 was a battleground for most investors. The events of the last year challenged numerous fundamental assumptions and theories on investing. In investment parlance, correlation across asset classes turned out to be much higher than imagined, volatility reached levels never seen before, governments responded in unexpected ways, and assumptions regarding expected returns were severely challenged. In everyday parlance, everybody got scared at the same time.
Of course, the paradox is that what would appear to make most investors feel better in the short-term (e.g. safety, cash) is not what drives investment performance over time. To the extent that emotion should be allowed to influence investment decisions, it should be in the context of taking advantage of someone else’s emotions. When Mr. Market wants in, he wants in. When he wants out, he wants out. Of late, he has really wanted out!
At Oak Value, we do not invest in a way that just makes us feel better today. We try to minimize the influence of emotions on our investment decisions by always seeking the high ground. After more than two decades in the business of investing, experience has provided us with a good definition of our “high ground.” This recent experience has only served to reinforce our longstanding belief that the Oak Value Fund (the “Fund”) and its shareholders are best served by focusing our time, resources and capital on advantaged businesses. From this vantage point, we have found that it is much easier to keep emotion out of the decision making.
When asked for our market forecasts, we invariably disappoint. We simply do not attempt to predict the market. Although we know from past experience that when markets change direction, the action can be swift. We do not invest in a way that contemplates catching updrafts or avoiding downdrafts. We focus on businesses. We seek to manage risk the same way that the management teams that run the businesses in the Fund’s portfolio manage risk – through a thorough understanding of the underlying businesses. We do not put our faith in a statistical model that shows we have a 95 percent chance of not getting blown up. We do not ignore the economy; we incorporate what we believe ought to happen over the long term, based on highly conservative assumptions. Within this framework, we look for businesses built on the high ground – those with durable competitive advantages. We place ourselves alongside what we consider to be competent management teams whose objectives mirror our own long-term horizons. Once we conclude that we have an attractive margin of safety, we buy.
Berkshire Hathaway – Simply put, insurance companies make their money by being paid to take on others’ risk and then investing what they are paid (float) until claims are made or the exposure expires. This is a business where the “high ground” is defined by only taking risk when the price is right and only investing capital when the potential returns are attractive. Success in these activities is highly dependent on having more capital than others when capital is in high demand. Broadly speaking, insurance company valuations were negatively impacted during the quarter by investor concerns over impact of the decline in market value of their investments on their capital adequacy and liquidity. Though shares of Berkshire Hathaway outperformed the overall financial sector, they declined meaningfully during the quarter. The uncharacteristically high volatility of Berkshire shares was due at least in part to concerns regarding a series of long-term insurance contracts (puts) the company has written on various global stock market indexes. As long as global equity markets remain under pressure, there will be headline risk associated with this issue, but we are confident in the long-term value of these contracts. In our opinion, Berkshire remains disciplined in its pricing of risk, opportunistic in its investing and conservative in its capital positioning.
“One who, fully prepared, awaits the unprepared will be victorious” - Sun-Tzu, The Art of War
Monday, January 19, 2009
This mental chaos explains how people can respond so quickly and intuitively to so many different circumstances. But it also entails a decision-making process that is more complicated and messy than previously thought.
Biases abound. People who’ve been told to think of a high number will subsequently bid much more for an item than people who’ve been told to think of a low number. As Jonah Lehrer writes in his forthcoming book, “How We Decide,” there are certain circumstances (often when there are many options) in which gut instincts lead to the best decisions, while there are other circumstances (sometimes when there are a few options) when calm deliberation is best.
Most important, people seek relationships more than money. If behaving a certain way helps a stock trader or a regulator fit in with his crowd, he’s likely to keep doing it without too much rigorous self-examination.
Friday, January 16, 2009
Thursday, January 15, 2009
Wang Chuanfu, the founder and chairman of BYD Co., a Chinese battery and car maker, thinks he's got a shot.
On Monday, Mr. Wang is expected to pitch the F3DM to U.S. consumers, during a news conference at Detroit's North American International Auto Show, which opens to the public Saturday. His venture has already attracted the attention of industry veterans and investors, including Warren Buffett.
Mr. Wang's strategy: capitalizing on the electric car's low barriers to entry. Few products are as complex to develop and produce as gasoline-powered automobiles, which are assembled with thousands of precisely engineered parts. But electric cars use only basic motors and gearboxes, and have relatively few parts. Aside from perfecting the battery itself, they're far easier and cheaper to build -- and that makes for a level playing field.
Tuesday, January 13, 2009
In my opinion, there are two key concepts that investors must master: value and cycles. For each asset you’re considering, you must have a strongly held view of its intrinsic value. When its price is below that value, it’s generally a buy. When its price is higher, it’s a sell. In a nutshell, that’s value investing.
But values aren’t fixed; they move in response to changes in the economic environment. Thus, cyclical considerations influence an asset’s current value. Value depends on earnings, for example, and earnings are shaped by the economic cycle and the price being charged for liquidity.
Further, security prices are greatly affected by investor behavior; thus we can be aided in investing safely by understanding where we stand in terms of the market cycle. What’s going on in terms of investor psychology, and how does it tell us to act in the short run? We want to buy when prices seem attractive. But if investors are giddy and optimism is rampant, we have to consider whether a better buying opportunity mightn’t come along later.
Here’s another way to put it, from The Wall Street Journal of November 24,
When it comes to booms gone bust, “over-investment and overspeculation are often
important; but they would have far less serious results were they not conducted
with borrowed money.”
That statement wasn’t made in reference to current events; that was Irving Fisher writing 76 years ago (“The Debt-Inflation Theory of Great Depressions,” Econometrica, March 1933). Borrowed money lets economic units expand the scale of their activity. But it doesn’t add value or make things better; it just makes gains bigger and losses more painful. There’s an old saying in Las Vegas: “The more you bet, the more you win when you win.” But they always forget to add “. . . and the more you lose when you lose.”
In one of those beautiful phrasings that demonstrate his mastery of language, Jim Grant of Grant’s Interest Rate Observer has described liquidity and leverage as “money of the mind.” By this he means they’re intangible and ephemeral, not dependable like assets or equity capital. Someone may lend you money one day but refuse to renew your loan when it comes due. Thus, leverage is purely a function of the lender’s mood. The free-and-easy lending of 2003-07 has turned into an extreme credit crunch, and the unavailability of credit is both the root and the hallmark of today’s biggest problems. Those who expand the scope of their operations on the basis of borrowed money should always consider the possibility that lenders will change their mind.
Friday, January 9, 2009
Consistency is crucial. As Ericsson notes, "Elite performers in many diverse domains have been found to practice, on the average, roughly the same amount every day, including weekends."
Evidence crosses a remarkable range of fields. In a study of 20-year-old violinists by Ericsson and colleagues, the best group (judged by conservatory teachers) averaged 10,000 hours of deliberate practice over their lives; the next-best averaged 7,500 hours; and the next, 5,000. It's the same story in surgery, insurance sales, and virtually every sport. More deliberate practice equals better performance. Tons of it equals great performance.
That's a lot to focus on for the benefits of deliberate practice - and worthless without one more requirement: Do it regularly, not sporadically.
For most people, work is hard enough without pushing even harder. Those extra steps are so difficult and painful they almost never get done. That's the way it must be. If great performance were easy, it wouldn't be rare. Which leads to possibly the deepest question about greatness. While experts understand an enormous amount about the behavior that produces great performance, they understand very little about where that behavior comes from.
The authors of one study conclude, "We still do not know which factors encourage individuals to engage in deliberate practice." Or as University of Michigan business school professor Noel Tichy puts it after 30 years of working with managers, "Some people are much more motivated than others, and that's the existential question I cannot answer - why."
The critical reality is that we are not hostage to some naturally granted level of talent. We can make ourselves what we will. Strangely, that idea is not popular. People hate abandoning the notion that they would coast to fame and riches if they found their talent. But that view is tragically constraining, because when they hit life's inevitable bumps in the road, they conclude that they just aren't gifted and give up.
Maybe we can't expect most people to achieve greatness. It's just too demanding. But the striking, liberating news is that greatness isn't reserved for a preordained few. It is available to you and to everyone.
Control of attention is the ultimate individual power. People who can do that are not prisoners of the stimuli around them. They can choose from the patterns in the world and lengthen their time horizons. This individual power leads to others. It leads to self-control, the ability to formulate strategies in order to resist impulses. If forced to choose, we would all rather our children be poor with self-control than rich without it.
It leads to resilience, the ability to persevere with an idea even when all the influences in the world say it can’t be done. A common story among entrepreneurs is that people told them they were too stupid to do something, and they set out to prove the jerks wrong.
But here’s where the rest of the story starts. Gladwell says nothing about individual differences within those groups or cohorts – why only some in that fortunate group go on to great success. He does not raise the next set of questions like: Why didn’t all the members of the school club that gave the young Bill Gates that early access to a computer become billionaires like him? Or why didn’t all the Jewish lawyers born in 1930 become huge successes like the handful of cases Gladwell focuses on?
Here a good part of the answer no doubt can be found in which individuals among those groups has a higher level of competencies like adaptability and initiative, the drive to continually improve performance, and empathy skills like sensing how another person thinks or feels. Such abilities give a person the drive to achieve, the initiative and the interpersonal effectiveness that success in a field like software (drive and initiative) and law (add in interpersonal effectiveness) require.
A massive amount of data collected by companies on their own people suggests that such personal abilities are the secret ingredient in success over and above those Gladwell describes so ably. The data I’m referring to derives from “competence modeling,” in which companies systematically analyze the abilities found in their stars (those in the top ten percent of performance by whatever metric makes sense for that specific job or role) but not found in counterparts who are mediocre. A goodly amount of these abilities – like initiative, the drive to achieve, and empathy — are in the emotional intelligence domain. Competence studies show that the higher a person goes up the organizational ladder, the more prominent the role these personal abilities play in performance. In other words, the more successful someone is, the greater the contribution of this skill set to his or her triumph.
Thursday, January 8, 2009
Assessing sustainable demand for many industries now seems difficult. When, if ever, will global construction activity regain the levels achieved in a worldwide synchronised boom, assisted by a credit bubble, coinciding with what may have been the most construction-intensive stage of China's recovery? Thinking of the excesses of the Middle East, and of the conviction with which many individuals around the world have accumulated multiple properties "for investment" without any regard to the rental yield and maintenance costs, I would guess this will not be for many years. This may be just as well for the planet, but I am not sure how one should currently evaluate the manufacturers of steel or construction machinery. Riding out a couple of bad years against a rising global demand trend is one thing: assessing the costs of adjustment to lower demand and the profitability thereafter seems more difficult. Of more immediate interest to us are those Japanese companies with world-leading technologies and reasonable 'normal' returns, for which valuations are cyclically depressed but with identifiable limits to how far a replacement cycle can be stretched and where it may therefore be possible to estimate sustainable demand with sufficient reliability to invest with a margin of safety. My sense is that there are significant opportunities here, and suggestions would be appreciated.
At present, I am uncertain how to prioritise various different types of equity opportunity - for example the steady cashflow generators which may still command PEs in the high teens, versus capital goods makers which may be on fractions of book and less than 4 times historic earnings, but with no certainty as to when earnings, or in some cases even revenues, may resume.
The last tough environment was in 1987, but that was a sudden shock and not a big event. Within a year the markets had recovered. In the Dot Com era the markets were caught in a mania, but the current crisis is much worse than what occurred at the end of that bubble, which was contained in the tech sector.
You would have to go back to 1974, when even the smartest investors were down 50% or 60%. I cannot say whether the market is as under-valued today as it was then, but certainly we are seeing valuations for companies in our portfolio that are comparable to those of 1974.
What are the lessons of the Madoff affair? Do you expect hedge fund liquidations to further reduce valuations in the first quarter?
Anyone who wanted to be liquid was already headed in that direction. If not, as investors withdraw funds, they will put pressure on the remaining hedge fund limited partners, unless the fund closes and does not allow redemptions.
I was extremely surprised that anyone would invest simply on a level of trust. I believe in “trust but verify.” Even businesses that might seem to operate simply on trust really employ a level of verification. For example, in the Diamond District in New York, millions of dollars may appear to change hands simply on the basis of a handshake. But, behind the scenes, there is a careful evaluation of the diamonds that were just sold. Those transactions take place at a single point in time and, if something goes wrong, the participants will never do another transaction. In Madoff’s case, investors continued to put money in over many years, without any verification.
There was a tremendous amount of social pressure to invest with someone who was perceived as brilliant and charitable. It was a social phenomenon.
You must have an independent source of verification. We have a large bank as a custodian, along with independent auditors and law firms. Our shareholders get statements provided by a secure independent third party. My money is in the fund too. We must avoid any possibility of collusion, which is why we rely on independent auditors.
What should investors expect from the market in 2009?
I don’t mind tough questions but this is an impossible question. There are two ways to invest – either predicting or reacting. I admit I have no skill at predicting. To predict would be foolish, so we react. We invest based on free cash flow relative to the price of a stock.
We could be bouncing around the bottom of the market. But I don’t know whether the true bottom will come in 31 days or 31 months. Prices today are as attractive as I have seen in my career and it will be worth the wait for the market to deliver the true value of these companies.
Monday, January 5, 2009
First part – “The End of the Financial World as We Know It”:
AMERICANS enter the New Year in a strange new role: financial lunatics. We’ve been viewed by the wider world with mistrust and suspicion on other matters, but on the subject of money even our harshest critics have been inclined to believe that we knew what we were doing. They watched our investment bankers and emulated them: for a long time now half the planet’s college graduates seemed to want nothing more out of life than a job on Wall Street.
This is one reason the collapse of our financial system has inspired not merely a national but a global crisis of confidence. Good God, the world seems to be saying, if they don’t know what they are doing with money, who does?
Incredibly, intelligent people the world over remain willing to lend us money and even listen to our advice; they appear not to have realized the full extent of our madness. We have at least a brief chance to cure ourselves. But first we need to ask: of what?
Second part – “How to Repair a Broken Financial World”:
Mr. Paulson must have had some reason for doing what he did. No doubt he still believes that without all this frantic activity we’d be far worse off than we are now. All we know for sure, however, is that the Treasury’s heroic deal-making has had little effect on what it claims is the problem at hand: the collapse of confidence in the companies atop our financial system.
Weeks after receiving its first $25 billion taxpayer investment, Citigroup returned to the Treasury to confess that — lo! — the markets still didn’t trust Citigroup to survive. In response, on Nov. 24, the Treasury handed Citigroup another $20 billion from the Troubled Assets Relief Program, and then simply guaranteed $306 billion of Citigroup’s assets. The Treasury didn’t ask for its fair share of the action, or management changes, or for that matter anything much at all beyond a teaspoon of warrants and a sliver of preferred stock. The $306 billion guarantee was an undisguised gift. The Treasury didn’t even bother to explain what the crisis was, just that the action was taken in response to Citigroup’s “declining stock price.”
Three hundred billion dollars is still a lot of money. It’s almost 2 percent of gross domestic product, and about what we spend annually on the departments of Agriculture, Education, Energy, Homeland Security, Housing and Urban Development and Transportation combined. Had Mr. Paulson executed his initial plan, and bought Citigroup’s pile of troubled assets at market prices, there would have been a limit to our exposure, as the money would have counted against the $700 billion Mr. Paulson had been given to dispense. Instead, he in effect granted himself the power to dispense unlimited sums of money without Congressional oversight. Now we don’t even know the nature of the assets that the Treasury is standing behind. Under TARP, these would have been disclosed.…
Rather than tackle the source of the problem, the people running the bailout desperately want to reinflate the credit bubble, prop up the stock market and head off a recession. Their efforts are clearly failing: 2008 was a historically bad year for the stock market, and we’ll be in recession for some time to come. Our leaders have framed the problem as a “crisis of confidence” but what they actually seem to mean is “please pay no attention to the problems we are failing to address.”
Friday, January 2, 2009
First of all, you need a risk manager who knows the business -- not somebody who knows everything about statistics but who has never been in the job. And you had risk managers who were statisticians. They could tell you what should happen most of the time.
But what should happen most of the time is a heck of a lot different from what will happen on a bad day. So they extrapolate history, but the trouble is that history changes.
One of the great lessons is beware of platitudes, such as "There has never been a national decline in home prices." If you believe that there has never been a national decline in home prices and that there never could be, then you bid home prices up to levels that don't allow for the risk of widespread losses, because you concluded it could never happen. Then the fact that they are at those new high prices introduces, in itself, the risk of a national home-price decline.
How did you and your colleagues at Oaktree react to the conditions that led up to the credit crisis?
I wrote a memo to our clients a few years ago titled "It Is What It Is." It said the first job of a money manager is to understand the environment you are operating in and its ramifications, and to act accordingly. We don't make predictions around here, and we didn't predict the things that are happening now. We said, though, that we were living in extremely bullish, euphoric and overconfident times, in which prospective returns are low and risk premiums are low, and that it wasn't a time to take risk.
There's been a lot written about how retail-mortgage underwriting standards deteriorated. What about standards for underwriting deals?
We were in a period in which people weren't afraid of losing money; what they were afraid of was missing out on deals. So the competition to make deals got stronger and stronger, and people wanted to preserve and increase their share of the deal market.
If you are a car manufacturer and you want to sell more cars, you would try to make a better car. But if your product is money and everybody's money is the same, how do you increase your market share? You participate in an auction in which one person says, "I will take [returns of] 7%," and another person says, "I will take 6%," and another person says, "I'll take 5%." So it is a race to the bottom. And since everybody's money is the same, for the most part, the way you compete is by making your money cheaper, and this cheap money is what drove markets.
When we spoke two months ago, you said it wasn't the day after Christmas in terms of buying opportunities. What do you see now?
It is hard to say. If the world turns out to be reasonable, or at least within the context of what people are girding for today, then things are cheap. We know the world is going to get a lot worse over the next one, two or three years, but we don't know by how much. So, to say that things are cheap today is what I would call the perceived merits. But there are a lot of shoes yet to fall, and the merits could certainly deteriorate in the next year or so. I wrote a memo to my clients in September titled "Nobody Knows," and I stand by that title. If you are a smart person, that's all you can say.
The yield for U.S. stocks is around 3.5%. Historically, earnings and dividends have grown about 4.5% per annum. So if you have 4.5% growth and a 3.5% yield, that's an 8% return. I'm sure your readers would love to hear a forecast of double-digit returns, especially given the biggest bear market since the 1930s. However, our starting point was from valuation levels that were so very rich that we are now merely back to levels that could provide long-term returns of around 8% from current levels. There are segments of the bond market where we can almost assuredly do better.
The problem I have with stocks -- and it is a very simple problem -- is that while stocks are nicely priced, they aren't attractively priced relative to their own bonds. The savagery of September, October and November was more drastic for bonds than it was for stocks. A 40% drop in stocks is big. A 20% to 30% drop in major categories of bonds is immense. So the take-no-prisoners market actually widened the opportunities on the bond side even more than on the stock side.
Investment-grade corporate bonds are a vivid example of that. The yield spreads over stocks is averaging about six [percentage points] right now. If you can get a 3.5% yield on stocks and 9.5% on the same company's bonds, which is going to give you the higher return? The stocks will, if they show earnings and dividend growth faster than 6% -- but historically that's a stretch. So the bonds have been savaged worse than the stocks have, and actually represent the most interesting opportunity.
Yes, investment-grade bonds. But for bonds below investment grade, the spreads are quite extraordinary. By the end of November, spreads had widened out to nearly 20 percentage points above Treasuries and also above the corresponding stock yields. Suppose 40% of those bonds go bust next year. And suppose that you get 50 cents on the dollar back on the bonds that go bust. By that point, you have lost your spread of 20 percentage points.
But such a scenario has to happen every year, until the high-yield bonds mature, in order to merely match Treasury returns. A 40% default rate every year for several years would be truly without precedent. So I view 2009 as an "ABT" year -- Anything but Treasuries. The less you hold in Treasuries, the better you are likely to do.