FPA Capital Fund Letter to Shareholders
Thanks to Steve F. for passing this along.
The stock market has a much rosier outlook than we do at this time, and is discounting a significant recovery in earnings. We think such a recovery is unlikely with banks pulling back on their lending, the consumer still stretched, and the government providing a temporary, but not permanent, boost to demand via its stimulus spending and abnormally low interest rates. The government spending is financed with record budget deficits, which is leading to an explosion in fiscal debt that is clearly not sustainable.
For 2010, the consensus is for the S&P 500 to earn $78. To achieve this estimate, sales will have to grow 6% and the after-tax margin hit 8.1%. The sales growth seems plausible, but the margin appears very optimistic to us, since the highest net margin we've achieved in the last twenty-five years excluding financials was 7.7% in 2007. In fact, the average net margin the last two and a half decades has been 5.3% according to a Morgan Stanley study. Thus, the 8.1% margin in the forecast implies a 50% improvement over the long-term average. We do not think this is very probable, and if it does happen, it is not likely a sustainable long-term margin. If we assume the future will be a little better than the past and use a long-term margin of 6.3% for the S&P 500, we calculate $60 in earning power. If this is correct, the S&P 500 currently trades at 20x its average earning power. Since 1900, the geometric mean P/E ratio for the broader market has been 14x, and the arithmetic mean P/E ratio has been 16x. This means a decline of 20-30% would just put the market in line with its long-term averages.
The discrepancy becomes even larger in 2011, when the consensus estimate for the S&P 500 uses a 9.1% after-tax margin, which is 70% higher than the long-term mean. We bring this to your attention, because it is one of the largest differences we have seen on record between the S&P 500 earnings estimates and what we believe the long-term earning power is. There is nothing wrong with looking through rose-colored glasses; we just don't think it fattens the pocket book. What makes us different is our willingness to use periods of optimism, such as now, to let go of stocks that are at or above their fair values, and keep the proceeds in cash until we find attractive investment opportunities. Most other managers will either keep the stocks that are priced above fair value or deploy the proceeds in marginal ideas, but very rarely will they let cash build when there aren't many attractive investment choices. As a result, the cash level for the industry has historically hit trough levels when the market has peaked. Then, as everyone scrambles to build cash levels when the market is declining, cash levels rise into a falling market, producing attractive investments for those that are willing and able to take advantage of them. The experience in 2008-2009 was no different.
The lifeblood in the U.S. economy is credit generation. Thus, we continue to be concerned about bank lending and its impact on sustainable economic growth. In 2009, U.S. banks had their biggest decline in lending since 1942. Bank industry lending was down 7.4% in 2009 according to the FDIC and the Wall Street Journal. In the early 1990s recession, lending was down less than 5%. The FDIC estimates the number of banks at risk for failing are at a 16-year high at 702. More than 5% of all loans are at least three months past due, which is a 26-year record. This recent data does not point toward a pickup in bank lending any time soon.
The consumer is not as well as the stock market would like us to believe. Consumers still have record levels of debt. The amount of household debt went from $7 trillion in 2000 to close to $14 trillion in 2008 or north of 120% of disposable income. This doubling in household debt is severely limiting households' ability to maneuver. Households tried to lower their debt load in 2009 and succeeded in reducing it by 1.7% to $13.5 trillion. They are finding that it is easier to add debt than reduce it, in particular when the value of your major asset, your house, is declining in value. Another predicament is unemployment running at 9.7%, and the unofficial unemployment rate of 16.9%, which adjusts for discouraged and part-time workers. This is a large segment of the population that is likely to have continued difficulties. Coupling this with a wealth hit of one year's worth of income, primarily from home price declines, we believe the consumer is in no shape to support a strong recovery.
As consumers are trying to overcome record levels of debt, high unemployment levels, severe hits to their wealth, they will get hit by the largest tax increase ever in 2011. For consumers, taxes will increase by $636 billion over 10 years: $338 billion as Bush tax cuts expire, $179 billion from eliminating itemized deductions, and $118 billion from a capital gains tax hike. On the corporate side, there is another $353 billion in tax increases over 10 years. The corporate tax increases will impact the employment recovery as businesses slow hiring and cut back to protect the bottom line. The personal tax increases, we believe, will have a more severe impact since they are hitting a consumer already wobbling from high debt, high unemployment levels, and significant wealth hits. These tax increases do not even take into account the recently passed healthcare legislation. For instance, for the first time ever, a 3.8% Medicare tax on investment income, which includes interest income, dividends, capital gains, rents, royalties and annuities, will be applied starting in 2013.
It is the government that has been the driver of the economy since the housing collapse. Few people realize that transfer payments, which are distributions of income in the market system, are now north of 19% of disposable income, according to MacroMavens. This explains how the consumer is able to spend 108% of his/her disposable income excluding employment benefits, and not drive debt through the roof. Without these large transfer payments and a continuation of them, consumers would soon find themselves at the mercy of credit. And credit is not as forthcoming now as it was during the home price appreciation boom, when savers used their homes to cash out trillions of dollars. We want to see how the economy stands on its own two legs without large fiscal stimulus help from the government and suppressed interest rates, and how the record large 2011 tax hikes impact the consumer, before we call it a victory
We can't help but be concerned about the government's lack of fiscal discipline. Our fixed income team has calculated that over the next two fiscal years, U.S. government debt could be between $14.4 and $15.1 trillion. Assuming 5% nominal growth in the economy, this produces a debt to GDP of 92% to 96%. Several rating agencies have said that once debt to GDP goes north of 80%, the credit rating may come under review.
The most recent Congressional Budget Office (CBO) report outlined government spending as a percentage of GDP over the next ten years. What we found fascinating was how three entitlement programs, Social Security, Medicare plus Federal Medicaid, and net interest to lenders, are set to swallow an ever-increasing portion of GDP. These three items accounted for 11.2% of GDP in 2009, and in ten years, they are set to increase by nearly fifty percent to 16.2% of GDP. The biggest increase is coming from net interest to lenders as deficit after deficit adds up. The CBO estimates that deficits will average about $625 billion annually from 2011 through 2020. To put this in perspective, that is $2,100/year in debt for every person in the U.S., including children. Over ten years, this becomes $21,000 for every person, and that does not include the interest expense tied to this debt, which is significant.
Because of our reservations about the difficult choices facing the U.S. consumer, in particular when the largest tax hikes on record hit in 2011, along with continued large fiscal deficits run by the U.S. government and the resulting debt and net interest expense that it leads to, we have focused our investments in companies that have real assets with significant value, such as our energy companies, and companies with large export components. We are focused on sticking to our knitting, which is to buy leadership companies with a history of profitability, strong balance sheets and good management teams, when they are available at deep value prices. When we are not able to find such investments, cash will generally grow as a result of trimming stocks that are at or above fair value. We believe volatility has returned, both on the downside and upside, and think the current environment will likely present attractive investment opportunities over time, allowing us to deploy capital intelligently according to our criteria.
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