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Wednesday, May 20, 2009

Everyone's An Economist

Arguably, public sentiment shifted from one of great fear to one of cautious optimism and acceptance as in, "okay, things are bad, we know that, but let's get on with life and look forward." However, in early 2009, we couldn't help but notice that everyone was or wanted to be an economist! The negative sentiment was recently highlighted in commentary from Southeastern Asset Management ("Southeastern"), a manager we respect and track from time to time. Southeastern is the investment adviser to the Longleaf Partners Funds with approximately $22 billion under management.

On 4/17/09, Southeastern released "First Quarter 2009 Commentary" and, on 5/07/09, the manager's full quarterly report was published (both can be found here). Just this week, the firm hosted its annual shareholder meeting (audio/slide presentation available at same link). We have no tie to Southeastern and are not invested in the Longleaf funds, but highly recommend a read of the commentary.

In the shareholder letter, Southeastern points out that never before in their long careers had popular attention given to macroeconomic conditions so completely displaced focus on fundamental analysis -- we summarize further: everyone is or wants to be an economist! Thanks to the rapid flow of information worldwide (Internet!), fear ran rampant last fall and into 2009 as the daily news of downward market trajectory beget more uncertainty amidst all economic participants, consumers and corporations alike. The state of the economy became top of mind literally around the world.

As a result of infatuation with macro trends and overwhelming fear, the Southeastern letter goes on to say that now is/was the best time for long-term investors to roll up their sleeves and buy high quality businesses trading at significant discounts to fair/replacement value. Although we don't have the decades long perspective of Southeastern, we concur with the key themes relayed by the firm.

Some readers may NOT be surprised that a "long only" portfolio manager is so bullish, but Southeastern supported the buy-on-fear, stocks-are-cheap view with quantitative, historical analysis on page nine of the firm's 4Q08 shareholder report (link here). The analysis compares the S&P500 earnings yield to the 10-year U.S. Treasury Yield at various points in time and was updated for this week's shareholder meeting. Their work shows that the positive S&P spread narrowed to 3.9% presently from 7.0% at March 9th market low. The yield advantage remains compelling, especially since earnings have potential to recover/grow meaningfully over time while bond coupons are fixed and, aside from TIPS, erode with inflation (whenever it arrives).

Although short-term market moves often mean very little, the letter appears prescient as fear subsided somewhat since March/April and many companies are now trading at multiples of recent lows. Examples: Central European Distribution Corp. (CEDC, $24.50), eBay, (EBAY, $18.25), Expedia (EXPE, $15.74), FedEx (FDX, $56.60), Liberty Media Interactive (LINTA, $6.18), Marriott (MAR, $23.06), Starbucks (SBUX, $13.92), and Whole Foods Market (WFMI, $21.03), Wyndham Worldwide (WYN, $11.78), and the list goes on.... Southeastern owns some of these companies.

Of course, we're cognizant of overall economic conditions: the economy is still contracting, job losses continue, government deficits are rising, and consumer spending may remain subdued in both the near/medium-term. For some sobering but insightful reads, we recommend the monthly commentary of Annaly Capital Management (NLY, $14.68, a mortgage REIT - link here). In addition, the Federal Reserve Bank of San Francisco published on May 15th "U.S. Household Deleveraging and Future Consumption Growth." The research points out just how indebted U.S. consumers are versus historical levels with telling graphs (link here).

Still, companies with durable franchises can be valued as the net present value of future free cash flows to equity holders into perpetuity. This approach illustrates that a rough patch of even several years only modestly reduces free cash flow based intrinsic values per share and gives confidence to purchase highly discounted equities despite enormous near-term uncertainty and negative growth (side bar: generally we prefer current year growth since it, along with a low multiple, can keep investors out of trouble) .

Happy investing,

Jeffrey Walkenhorst

Disclosure: long CEDC, EBAY.

© 2009 Jeffrey Walkenhorst
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