The Best Trade I Ever Made

January 3, 2011

People frequently ask me, "Joe, in your 30 years as a stockbroker/investment advisor, what was the best stock trade you ever transacted?" The answer to that would unquestionably be US Airways. (The following story is to serve only as an example. It is not intended as a solicitation or offer to buy or sell any security mentioned)

Back in the early 1990's, similar to today, the world was recovering from a deep recession brought about by the downfall of banks and savings and loans due to the collapse in real estate prices (yes, real estate has on a number of previous occasions experienced severe declines in price). That recession caused a substantial decline in air passenger traffic which subsequently took down the stock prices of all the airlines, as many of them had subjected their balance sheets to significant amounts of leverage during the proceeding economic expansion. After doing careful analysis I came to the conclusion that US Airways was worth a great deal more than was reflected in its stock price (I was to find out years later that Warren Buffet came to the same conclusion a few months before I did. He tends to follow me from in front). So I placed assets from a number of my aggressive clients into the company. A few days later news broke that British Airways was going to plow huge amounts of money into US Airways and the stock exploded. Less than two weeks after I bought it my clients had more than tripled their money. Not wanting to be a pig about this I sold all of our US Airways shares and locked in that profit.

You would think that this series of events would have made me a hero to my clients and I would possess their undying gratitude. But no, that was not the case. The response a few months later from a number of my clients is best exemplified in a comment from one of my best clients' wife. They had just picked up their tax return from their accountant and she couldn't wait to come in to my office and gripe. "Our CPA told us that YOU cost us $32,000 in taxes thanks to your "brilliant" US Air stock trade!" "But,"said I, "you made over $80,000 in profits in one week from a $30,000 investment." To which she responded, "Don't go trying to confuse things. The bottom line is we are out $32,000 because of you." Sometimes, no matter what you do, no one is happy.

I recount this story because it reminds me so much of the way the world views things today. For example, news hit the wires on Sunday night that North Korean dictator Kim Jung-Il died. Kim Jung-Il was considered one of the most unstable and dangerous leaders in the world by many people. He kept most of his people in abject poverty while he lived in relative luxury. So, one would presume that the news of his death would lead the world's financial markets to a sizeable "relief rally." But no! On the news of his death, the world's financial markets fell on average about one percent because the world was more concerned that they didn't know how bad the next guy could be.

In short, the attitude of the world today is much like that of the wife of my client nearly 20 years ago. . .no matter what happens, no one is happy.

This year looks to have been a pretty good year for everything except stock prices. The economy has begun to show signs of digging out of its slump, with over one million new jobs being created in 2011. This figure is less than exciting, given where we historically would have been in a recovery phase, but certainly much better than the roughly 1/2 million job losses in 2010 and the staggering 6-million job losses in 2008/09. Every report I've seen from the Federal Reserve shows that the U.S. consumer is in ever- stronger financial shape, as household debt has plummeted while household savings has increased. Indeed, according to the latest Federal Reserve report, U.S. household "Financial Obligation Ratio" (this is the percentage of household income which people have committed to mortgage and consumer debt payments, vehicle leases, rent, insurance and property taxes) has declined to 16.1%. That is the lowest it's been since 1985!

Concomitant with those economic figures, the 500 largest companies in America (the S&P 500**) should book an 18% increase in their earnings, while on average companies increased their dividend by 6%. Additionally, these companies will likely show a 6% increase in book value (in my opinion the most important measure of a company's worth). Along with all of this, both corporations and consumers will also likely end 2011 with more cash on their balance sheets than at any time in history. And yet, investors were mostly disappointed in 2011 as the stock market (as defined as the S&P 500) ended the year exactly where it started for a total return of 0%. But, according to S&P, if you take out the performance of the 50 largest companies, the remaining 450 companies finished the year losing about 10% in market price. The MSCI (an index of 24 stock markets across the globe) finished the year with a total rate of return for 2011 of -5.94%.

But that the stock market has declined in the environment outlined above isn't all bad news. Often high stock prices bring about over-valuation, which then results in a correction at the very least, and sometimes in a market crash. Back in 1987, the stock market doubled in just the first eight months of the year -- this resulted in "The Great Stock Market Crash of October '87." In the second half of the 1990s, the "Dot-Com Boom" sent stocks to record high valuations, and was therefore merely the precursor to the three year bear market now known as "The Dot-Com Bubble Bust." In retrospect these trends are obvious -- extreme over-valuation or under-valuation will eventually correct itself, and that's not a terrible thing.

According to my personal research and calculations, on December 31, 1999 the stock market was 29% overvalued. A severe and lengthy decline was inevitable. Today, using the same metrics, my research tells me that the stock market is 24% under-valued*. This does not guarantee a bull market. However, when stock prices fall in the face of rapidly rising earnings, dividends, and book value, stock "under-valuations" become mathematically more and more severe, just as their over-valuations did in the late 1990's. This would seem to suggest that some correction is bound to follow.

None of this means the stock market is certain to rise in value in 2012, or that dividends are sure to increase -- after all, past performance is no guarantee of future results. And yet, our research has led us to believe that stocks have become nearly as undervalued today as they were overvalued at the end of "The Go-Go Nineties." We see this as a moment of real investment opportunity. The volatility we experienced in 2011 will, of course, almost certainly continue (the USA is strongly divided in its political beliefs during an election year, Europe is coming to grips with flaws in the construction of the European Union, there's debate over whether China will engineer a soft landing off of their boom years, and of course we can expect the usual headlines of trouble in the Middle East, earthquakes, hurricanes, and other unforeseen tragedies). Still, our conviction is that, for the long term investor, the poor performance of 2011 has only delivered an opportunity to acquire ownership in world class businesses at low valuations rarely seen in a quarter of a century. We believe investors with a long term horizon, who can look past the corresponding volatility, would be well served to take advantage of the attractive valuations available in a number of world class companies.

NOTE - *Today the S&P 500 sells at only two times book value and twelve times after tax profits. Both are valuation levels that have been seen only once since December, 1987 (right after "The Crash"). Historically, one earns a higher level of income from interest on bonds than one would receive in dividends from stocks. But the S&P 500 has declined so much in value, while the typical company in that index has simultaneously raised their dividends, that today the S&P 500 yields more income than does a ten-year Treasury note.