Friday, February 5, 2010

Who’s Afraid of a Sideways Market? - By Robert Hagstrom

First discovered via My Investing Notebook. The excerpts and article linked to below is an abridged version of the piece for Morningstar. I actually recommend you read the complete piece straight from LMCM: HERE. If for nothing else, the complete piece lists some of the best individual stock performers during the 1975-1982 period, which will give one a good idea of the types of companies that can perform well in a tough, inflationary environment. A couple of companies that jump out are the ones run by great capital allocators like Teledyne (Henry Singleton) and Loews (the Tisch brothers). And here's a few of the companies on the best-performer list that were held by the Sequoia Fund during that period: Gillette, Tandy, and Capital Cities. And a few held by Berkshire Hathaway during that time were General Foods, Capital Cities, Kaiser and Time. Both Berkshire and Sequoia also held pretty big positions in The Washingon Post, Aluminum Company of America, R.J. Reynolds and a couple of advertising companies (Interpublic and Ogilvy & Mather) during this time. At cost, R.J. Reynolds and General Foods appear to be Berkshire's biggest investments around the end of this time period, although The Washington Post and Geico grew to be very large positions through stock appreciation. Capital Cities/ABC became - by a fairly sizable amount - Berkshire's largest position by the end of 1986 (see the 1981 excerpt from Warren Buffett's letter at the end of this post for more on Buffett's interest in Capital Cities, which also fits the great capital allocator category while being run by Tom Murphy).

It has been a generation since investors have experienced a prolonged sideways market (although they were not uncommon through most of the 20th century). The last major sideways market occurred from the mid-1970s until the early 1980s. On Oct. 1, 1975, the Dow stood at 784. Nearly seven years later, on August 6, 1982, just before the beginning of the great 1980s Bull Market, the Dow closed at the exact same 784. The price return over the seven-year period was zero.

Some stock market forecasters have drawn analogies between what happened in the late 1970s and what may be happening today. There are concerns about the rate of corporate profit growth against the backdrop of a weak economic recovery. There are also worries about contracting market multiples and rising inflation and interest rates.

We decided to study the behavior of the last sideways markets after recalling the exceptional investment performance generated between 1975 and 1982 by Warren Buffett at Berkshire Hathaway and Bill Ruane at the famous Sequoia Fund. Over these seven years, the book value of Berkshire Hathaway and the net asset value of Sequoia Fund generated cumulative total returns of 676% and 415%, respectively, and average compound annual returns of 34% and 28%, respectively. Remember, Buffett and Ruane were not traders. They bought and held outstanding companies.


So…..who should be afraid of sideways markets? With no long-term trend in place, it will be tough for momentum investors to produce sustainable profits. Index investors could also be in for a rough time. If the price of the index is little changed in the coming years, the most index investors can hope for is a paltry 2% annual dividend.

Who should not be afraid of sideways markets? Stock-pickers! Whether the approach is to select high dividend paying stocks or companies that are growing shareholder value at an above-average rate, I believe the game is now in the hands of those investors who can identify mispriced stocks.

Whether we are in for a sideways market for the next several years is open for discussion. The point is to remind investors, despite the average returns of a broad index, that there are significant opportunities for those who understand the variations within the system. No matter how the stock market behaves, or how the underlying economy performs, there will be, in the words of Stephen Jay Gould, a “spread of excellence.” In financial ecology, there are always changing patterns and trends to improvement. As such, the investment landscape favors the stock-picker--perhaps now more than ever.


Related excerpt from Warren Buffett’s 1981 Letter to Shareholders:

In fairness, we should acknowledge that some acquisition records have been dazzling. Two major categories stand out.

The first involves companies that, through design or accident, have purchased only businesses that are particularly well adapted to an inflationary environment. Such favored business must have two characteristics: (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital. Managers of ordinary ability, focusing solely on acquisition possibilities meeting these tests, have achieved excellent results in recent decades. However, very few enterprises possess both characteristics, and competition to buy those that do has now become fierce to the point of being self-defeating.

The second category involves the managerial superstars - men who can recognize that rare prince who is disguised as a toad, and who have managerial abilities that enable them to peel away the disguise. We salute such managers as Ben Heineman at Northwest Industries, Henry Singleton at Teledyne, Erwin Zaban at National Service Industries, and especially Tom Murphy at Capital Cities Communications (a real managerial “twofer”, whose acquisition efforts have been properly focused in Category 1 and whose operating talents also make him a leader of Category 2). From both direct and vicarious experience, we recognize the difficulty and rarity of these executives’ achievements. (So do they; these champs have made very few deals in recent years, and often have found repurchase of their own shares to be the most sensible employment of corporate capital.)