the broyhill letter (q4-10)

8/7/2019 The Broyhill Letter (Q4-10)

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T H E B R O Y H I L L L E T T E R

“Balance sheet policy can still lower longer term borrowing costs for many households and businesses, and it adds to household wealth by keeping

asset prices higher than they otherwise would be.”

– Brian P. Sack, New York Fed, October 2010

“What happens to the equity markets, what happens to the dollar, and what happens to interest rates? Don’t be concerned with printing

money! Don’t be concerned with the growing Fed balance sheet or how to unwind it! The primary purpose of QE2 is to improve our fi nancial

condition. A higher stock market is good for aggregate demand, a falling dollar improves our global competitiveness, and lower borrowing costs

improve aggregate demand.”

– Larry Meyers, former Fed Governor, November 2010

“And higher stock prices will boost consumer wealth and help increase con fi dence, which can also spur spending. Increased spending will lead to

higher incomes and pro fi ts that, in a virtuous circle, will further support economic expansion.”

– Ben Bernanke, Washington Post, November 2010

I think we are underestimating and continue to underestimate how important asset prices, very speci fi cally, equity values are, not only for

shareholders and the like, but for the economy as a whole

– Alan Greenspan, December 2010

“It is vain to object that the public favors the policy of cheap money. The masses are misled by the assertions of pseudo-experts that cheap money can make

them prosperous at no expense whatever. They do not realize that investment can be expanded only to the extent that more capital is accumulated by savings. What counts in reality is not fairy tales, but people’s conduct. If men are not prepared to save more by cutting down their current consumption, the

means for a substantial expansion of investment are lacking. These means cannot be provided by printing banknotes or by loans on the bank books.”

– Ludwig von Mises, The Trade Cycle & Credit Expansion: Economic Consequences of Cheap Money, 1931

“Credit expansion cannot increase the supply of real goods. It merely brings about a rearrangement. It diverts capital investment away from

the course prescribed by the state of economic wealth and market conditions. It causes production to pursue paths which it would not follow

unless the economy were to acquire an increase in material goods. As a result, the upswing lacks a solid base. It is not a real prosperity. It

is illusory prosperity. It did not develop from an increase in economic wealth [i.e. the accumulation of savings made available for productive

investment]. Rather, it arose because the credit expansion created the illusion of such an increase. Sooner or later, it must become apparent

that this economic situation is built on sand.” – Ludwig von Mises, The Causes of Economic Crisis, 1931

FOURTH QUARTER 2010



The Year in Reveiw

Experience has taught us that the management of return is impossible - outcomes are extremely unpredictable in investing because timing is un-

certain at best. Over time, we have been “very wrong” in the short term, while ultimately proven “very right” in the long term . . . Consequently,

we have learned to focus more on what we can control - process. Judging past decisions based solely on short term results leads to unintended

consequences. Focusing on process, allows us to concentrate on long term objectives and the management of risk, and frees us from worrying about

distractions beyond our control - such as short term performance.

A relentless focus on process is necessary in good times and it is critical during challenging times. Our process is driven

by a relentless focus on capital preservation and our long-term investment objectives - to achieve maximum capital ap-

preciation commensurate with the existing risk profile of global markets. We are willing to take risk only when it is priced

to deliver attractive returns. What this means, is that we are usually playing defense, even while most market participants

are frolicking in a speculative orgy. This was clearly the case in the second half of 2010 and was even more pronounced in

the final quarter of the year. Our focus on structural problems in the global economy was overshadowed by a speculativedash back to risk assets on the heels of a marginal improvement in economic data and additional “stimulus” we cannot

afford.

Minding Our Ps & Qs

The period following a peak in LEIs is often prime time for stock pickers, particularly while the economy is gliding toward

a mid-cycle slowdown, or better yet, dancing toward a double dip. In our last annual letter, we shared our excitement about

the prospects for Quality in the coming year:

Lower correlations should translate into greater differentiation between equity returns. The conditions in place today are the most exciting we’ve

seen in many years. The strongest franchises around the globe trade at valuations not seen in decades, despite their pristine balance sheets, consis-

tent return on capital and ongoing earnings growth. As this year’s liquidity-driven junk rally left quality stocks at the starting gate, high-quality

equities simply look cheap, and are priced to deliver near double digit excess returns over their lower-quality brethren.

This was painfully not the case in 2010 as macro trends continued to drive returns. This dynamic is best illustrated in the

charts above which divide the S&P 500 into quintiles based on volatility of returns and valuation. The last few months of

2010 were characterized by investors chasing stocks with the greatest sensitivity to market fluctuations, commodity prices,

credit risk, and volatility, while abandoning those high quality securities with attractive valuations, earnings stability, and

dividend yields. Animal forces may continue to reward these factors in the near-term, but such an unusual divergence of

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FOURTH QUARTER 2010



performance and valuation in favor of the companies we own has historically been resolved by subsequent strong results.

As we stated back in April, almost immediately prior to a dramatic increase in risk aversion, such differences do not persist

in perpetuity, and are normally corrected with a bang, rather than a whimper. The chart below shows that it is unprec-

edented to go this long without having a one-day decline of at least one-third of one percent. We should be so quick to

forget the warnings of Hyman Minsky, “A fundamental characteristic of our economy is that the financial system swings

between robustness and fragility.”

‘Flation Follies

We work extremely hard to find a few extremely attractive investment opportunities each year. Our favorite investments

are those that offer us a margin of safety, provide protection against a permanent loss of capital, are structured with an

asymmetric return profile (some probability of a small loss offset by equal or greater odds of a large gain), and represent a

Variant Perception . The essence of why our views on inflation and interest rates differ from the consensus is that we believethe economies of the developed world are experiencing an extended deleveraging process rather than recovering from a

“garden variety” recession. Few historical periods are relevant to today’s economic landscape, as deleveraging processes

are a “once in a lifetime” occurrence. The last two credit bubbles in the US were followed by The Panic of 1873 and the

Great Depression in 1933. Japan’s Lost Decade(s) provides the most relevant experience outside of America. One of the

key lessons investors should have learned from Japan’s lost decade(s) was that, however low bond yields seemed to be,

they always fell lower alongside the business cycle. While cyclical economic recoveries were often accompanied by deci-

sive but fleeting rises in bond yields, the key was

to identify the long-term structural trend of

yields. That trend was lower during Japan’s lost

decade, and remains lower in the US today.

Interest rates are best explained by the ebb and

flow of economic data and have a positive cor-

relation with LEIs. Bond yields surged in 2009

alongside rising LEIs and hopes of a sustain-

able recovery. But given our massive debt

bubble, even minor rises in interest rates create

enormous dif ficulties in debt service. The re-

sult is a global economy much more sensitive to

changes in interest rates. The “choking point”

of rising rates on the economy has become

lower and lower over time, as greater and greater levels of debt act as larger and larger speed bumps for economic

FOURTH QUARTER 2010

3

Source: Bespoke Investment Group Source: Bespoke Investment Group

Source: Guggenheim Partners



growth. Put simply, with an ever increasing weight of debt on our shoulders it takes successively smaller hiccups in yields

to break the economy’s back. We believe the next “choking point” for the economy is likely to be significantly lower than

the previous ones, given the massive surge in public and private sector debt loads, the sensitivity of the economy to the

housing market and the looming threat of debt deflation. This year may ultimately look eerily similar to last in that rising

interest rates are a positive, until they are not. For now, the positive correlation between bond yields and stock prices is an

indication of investor belief in a sustainable recovery (just as it was in last year’s first quarter). Down the road, investors are

likely to view rising bond yields less as a reflection of economic growth and more as a risk of rising inflation. We continue

to believe that interest rates on the ten year above 4% are unsustainable, and will ultimately have a negative impact on risk

assets and on the economy. We are buyers of long term treasuries at these levels.

All About the Benjamin’s

Rising real interest rates are a key development to monitor in the first half of the year, as they have become a larger influ-

ence on the dollar with the recent backup in Treasuries. Real yields are now well above those available in most of the devel-

oped world, meaning the dollar can be expected to move higher versus its slow-growth peers (i.e. the EU and Japan). With

the Fed Funds rate at zero and limited room for fiscal maneuvering, markets have become extremely sensitive to changes

in the dollar. Dollar strength tends to coincide with renewed credit pressures in Europe and we expect this dynamic to

continue until Europe’s deep-rooted structural debt dynamics are resolved. Looking ahead, we expect additional declines

in the common currency in the future.

In stark contrast to Dollar Dynamics in the developed world, emerging market central banks are rapidly and steadily rais-

ing rates to fight off renewed inflationary pressures, an “unintended” consequence of US monetary policy. Global policy

makers are playing a dangerous game of financial market chicken – the harder we press on the pedal, the harder they step

on the brakes of the world’s global growth engine. The last time this happened was in 2007 (see chart above). Making mat-

ters worse, while record high commodity prices (another “unintended” consequence of QE) are being ignored thus far, a

rising trend in stocks and commodities is unsustainable. Over the past three decades, without exception, every easing cycle

has been complimented by a decline in the price of natural resources. Today, US consumers face a policy tug-of-war with

commodity prices (see chart below). Ultimately, commodity inflation (note gas prices back above $3 per gallon) causes

discretionary consumption to decrease and leads to an increase in the volatility of financial markets. We’ve seen this movie

before. Heading into the Great Recession, some countries (mainly in the developing world) were in much better shape than

others (mainly in the developed world), but most economies fell hard together.

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FOURTH QUARTER 2010

Source: Wolfe Trahan & Co, CRB, Federal Reserve



This promises to be an important theme in 2011.

Lessons Learned

Last year, we invited Charlie Ellis to present at CFA North Carolina’s Annual Forecast Dinner in Charlotte. The opportu-

nity to meet Charlie in person, a man with David Dodd’s personally signed copy of Security Analysis, was a tremendous ex-

perience. Charlie founded Greenwich Associates in 1972, and authored Winning the Loser’s Game, a timeless piece based

on an article originally written in 1975 for The Financial Analysts Journal. He suggests a few things we might consider to

improve our odds while investing in a loser’s game:

First, be sure you are playing your own game. Know your policies very well and play according to them all the time. Admiral Morrison, citing

the Concise Oxford Dictionary, says:”Impose upon the enemy the time and place and conditions for fi ghting preferred by oneself.” Simon Ramo

suggests: “Give the other fellow as many opportunities as possible to make mistakes, and he will do so.”

Second, keep it simple. Tommy Armour, talking about golf, says “Play the shot you’ve got the greatest chance of playing well.” Ramo says:

“Every game boils down to doing the things you do best, and doing them over and over again.” Armour again: “Simplicity, concentration and

economy of time and effort have been the distinguishing feature of the great players’ methods, while others lost their way to glory by wandering

in a maze of details.” Mies Van der Rohe, the architect suggests, “Less is more.” Why not bring turnover down as a deliberate, conscientious

practice? Make fewer and perhaps better investment decisions. Simplify the professional investment management problem. Try to do a few things

unusually well.

Third, concentrate on your defenses. Almost all of the information in the investment management business is oriented toward purchase decisions.

The competition in making purchase decisions is too good. It’s too hard to outperform the other fellow in buying. Concentrate on selling instead. In a Winner’s Game, 90 per cent of all research effort should be spent on making purchase decisions; in a Loser’s Game, most researchers should

spend most of their time making sell decisions. Almost all of the really big trouble that you’re going to experience in the next year is in your

portfolio right now; if you could reduce some of those really big problems, you might come out the winner in the Loser’s Game.

Fourth, don’t take it personally. Most of the people in the investment business are “winners” who have won all their lives by being bright,

articulate, disciplined and willing to work hard. They are so accustomed to succeeding by trying harder and are so used to believing that failure

to succeed is the failure’s own fault that they may take it personally when they see that the average professionally managed fund cannot keep pace

with the market any more than John Henry could beat the steam drill.

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FOURTH QUARTER 2010



The Outlook

This is the third time in the past decade

the Fed is attempting to engineer a bubble

in asset prices to stop an unwinding of the

debt bubble. This time, they have desper-

ately resorted to open manipulation of the

markets (take another look at our opening

quotes). We have no doubt that over the

short-term, market manipulation by the

Fed can stall the deleveraging process and

delay market declines. But the Fed cannotchange the basic math behind investment

returns which are based solely on deliv-

erable cash flows. The first two bubbles

burst painfully with severe consequences for investors and the global economy. Anyone willing to wager on the third? With

valuations stretched to the upside and investor complacency back to pre-crisis highs (see chart above), we are not.

Occasionally, Mr. Market offers patient investors an opportunity to play offense, usually while the great majority is still

nursing the hangover that predictably follows such periods of speculative extreme. Today is emphatically not one of those

opportunities. The latest calculation by Andrew Smithers puts the S&P 500 more than 70% overpriced based on normal-

ized measures (see chart below). We suppose some investors may be comforted by the fact that equity markets now trade

slightly below their valuation peaks of 1929 and 1999, but they are in line (or higher) than most other major peaks (i.e.

1906, 1937, 1968, etc.). It’s important to remember that the average bear market wipes out roughly half of the preceding

bull market gain. As it has now been over 90days since the last 5% correction in stocks,

a pullback is overdue as we enter 2011 with

risk assets pushed to speculative extremes,

reminiscent of other points just prior to sig-

nificant downside resolutions. Importantly,

while overvaluation alone can stubbornly

endure for longer than patient investors

would like, today’s more ominous set of

conditions has typically persisted for only a

few weeks before resolving into abrupt and

typically very steep market losses.

So we enter the New Year with the unem-

ployment rate pinned stubbornly near dou-

ble digits and roughly one in fi ve Americans

underemployed. The Fed’s Quantitative

Guessing has back fired as mortgage rates

have increased sharply and housing afford-

ability has retreated. We expect more foreclosures exacerbated by a further decline in home prices. Our political system In

Washington continues to get worse as our “leaders” prefer to point fingers rather than address the growing cancers that

hamper our future. Despite our concerns, we must manage your investments with conflicting data and more uncertainty

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FOURTH QUARTER 2010

Source: BarclayHedge

Source: Smithers & Co.



than we can recall at anytime over our collective careers. Third Point’s articulate CIO, Dan Loeb, said it best:

From an investor’s point of view, our challenge is not only to keep up with rapidly unfolding events around the world, but also to keep our per-

spective fresh and differentiated from that of our competitors. As securities analysts, we are truth seekers and problem solvers. We must satisfy

ourselves with determining ranges of outcomes and potential scenarios rather than searching for, and ultimately fabricating, absolute truths. The

only thing we are 100% con fi dent in is that we are fallible, we don’t have all the answers, and we will make some mistakes. However, if we

are honest with ourselves and our colleagues, remain attentive to our own biases and deceptions, focus on process, attempt to understand why we

erred, and engage in deliberate practice and self-observation to improve our decision making ability, we will not only minimize our errors, but also

ultimately become better people and better investors.

Mark Twain once said that history doesn’t repeat but it often rhymes. We believe that an inflection point, which rhymes

with the conclusion of previous drawdowns, is imminent. An abrupt decline that cleared overbought levels and injectedrenewed fear into the psyche of speculators might provide a better base for the typical Third Year Boom. We expect to

take full advantage of a similar entry point in the near future and built our “wish list” of investments we’d like to own

at prices we’d like to own them at, accordingly. In the past, our investors have been best served by our consistency of

thought, the conviction behind our thesis, and the discipline inherent in our investment process. This time will prove to

be no different.

- Christopher R. Pavese, CFA

The views expressed here are the current opinions of the author but not necessarily those of Broyhill Asset Management. The author’s opinions

are subject to change without notice. This letter is distributed for informational purposes only and should not be considered as investment advice

or a recommendation of any particular security, strategy or investment product. This is not an offer or solicitation for the purchase or sale of

any security and should not be construed as such. Information contained herein has been obtained from sources believed to be reliable, but not

guaranteed.

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FOURTH QUARTER 2010

the broyhill letter (q4-10)

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