Market Commentary – October 9, 2009 by Brian Durno, CFA

Brian DurnoThe last time I checked the Forbes 500 List of the Wealthiest People in the World, it did not contain a single macro-economic forecaster. Acting as an agent or employee for a large financial institution in a highly public role is a sure way to earn a handsome salary. Reading them is much like reading about your favorite hockey team, it’s fun reading and gives you something to talk about, but it doesn’t help you figure out if your team will win tonight. Ultimately, the problem with forecasting economic data is that even if you are exactly correct in your prediction (which none of them are), it still does not necessarily help you make any money in the stock market.

In March of this year, there were not too many positive headlines about our macro-economic situation or its forecast (the TSX hit an intraday low of 7,479.96 on March 6th.) Today (Friday October 9th) we are at 11,436.92 for a 52.9% gain (excluding dividends) and there are many headlines telling us how much better off we are now than in the depths of the recession.

The TSX’s seven-month rally ranks among the strongest since the great depression and one of the broadest in history. Valuation levels have increased to well within historical norms and are no longer obviously cheap.

Below is a brief description of the temperament that we believe is required to profitably navigate the stock market based on the general level of valuations.

There will often be no news item or information that is publicly available that will help guide your decision; you must trust your fundamental research. Time spent “thinking about it” can cost you a lot of easy money. Cheap valuations are an unusual occurrence in the broad market but more frequent on an individual stock basis.

Effort must be expended on finding those companies that have not participated in the optimistic valuations of the larger group. Time spent “thinking about it” is often rewarded. Investors must be disciplined and adhere to their basic research and only buy companies that are trading at a discount to their estimated value of the business. Reasonable valuations are a common state for the broad market and individual stocks.

If you own a company that has become overvalued, you must have measures in place to ensure that you sell at the first sign of weakness or even better, sell when the company reaches your full estimate of its value. In most cases this will be far too early – but as they say, it is better to be too early than too late. Expensive valuations are much more common for individual securities than for the broad market in general.

There are 1,276 companies in our financial database. From that list, our research has identified 149 that are classified as “A” businesses. These are businesses that will be around for many years to come and earn a reasonable return on their invested capital. There are another 60 companies that are close to making it to our “A” list and we watch their developments very closely. That leaves us with 209 companies that matter.

The big winners this year have been the energy (XEG), financial (XFN) and technology sectors (XIT).

tsx_sectors

Unfortunately for value investors, the financial and energy sector make up almost 60% of the TSX index (add in materials and those three sectors account for 78% of the TSX). For some valuation perspective, the banks are trading at just over 2.1x book value, which is about right at the 10-year average for this metric. The banks troughed at about 1.2x book value in the spring (a level that had not been seen since the early 1990’s). Therefore, the price that people are willing to pay for the banks has increased about 75% in only seven months. Nine months into the year, 2009 already ranks third of the 10 best years for bank share performance since 1957. Surely, valuations can go higher (they peaked at about 2.7x in 2007 which is 29% higher than today’s valuation) but clearly the easy money in banks has been made.  We are comfortable waiting for one-foot hurdles instead of seven-foot ones.

And now the good news for value investors. While this recent rally has been incredibly broad based, not all sectors or stocks have participated. The consumer, utilities and telecommunications sectors have severely lagged the performance of the TSX.  These sectors and the 16 companies I spoke of earlier that are experiencing weakness in their share prices are what we watch closely. With a little luck, there will be more added to our list. One thing that you can count on is that prices will fluctuate. Even in normal economic times, it is not uncommon for valuations to change by 30%-40% in a year for stable companies. It is in those periods of weakness that we have the most interest and watch for diligently.

One last point about the recovery. In the US, non-farm employment has declined by about 5% from peak employment levels prior to the recession (or about 7.1 million jobs).  This compares to a 3.1% decline in the double-dip recession of the 1980’s, 1.5% decline in the early 1990’s recession, and 2% decline in the early 2000 recession. One sneaking trend that has not been given much attention is the length of time it has take for labour markets to heal from recession. In the US, the four recessions experienced between 1969-1982, the average length of time to regain pre-recession peak employment was about a year.  Recent recession experience has been much different. The early 1990’s recession took about two years to regain pre-recession peak emloyment, and the early 2000’s recession took almost three years. One of the largest factors contributing to GDP growth during the first year of recovery from a recession is consumer spending. Given the large declines in employment, it is uncertain how powerful a force consumer spending will be during this recovery. Time will tell and in any case even knowing this answer would not set us up for easy profits in the stock market.

We may have stopped drowning but we are a long ways from shore.

In the end, we cannot control the prices being offered to us by the market but we can control the price we’ll pay for our stocks.

As you know, we have 100% of our net worth (excluding our homes) invested alongside our unitholders in the Investment Partners Fund so we are laser focused on what we are doing and very concerned about capital preservation.

We are cheap and that won’t change, but for now, we are cautious.

Brian Durno, CFA
JDM Investment Partners
The Investment Partners Fund