Hello Everybody,

For those of you that have been following me for some time, you probably know that in addition to being passionate about investing, I absolutely love history.  When the two mesh, I get really interested.  Last night, I stumbled upon an investment letter that was truly fabulous.  Now I will warn you, it is quite long and unless you have a general interest in these things, you might not get through it.  I’m going to summarize a few key points and how it relates to your current investments with TTCM.

The article goes over various periods in U.S. stock market and economic history starting in 1900 and ending in the current period.  Obviously, the U.S. has gone through an enormous amount of turmoil and has had its share of great times too.  The article measures investment performance over the periods and the key issue is really the valuations going into the respective periods.  When valuations were low, returns over the next 10-15 years were generally quite positive.  When valuations were high, returns in the following years were either bad or lackluster.  High valuations can go higher for a period of time, maybe a few years or more, but at some time the market becomes that weighing machine and prices fall accordingly.  Conversely, low valuations can always go lower for a period of time but the long-term investor can take advantage of these periods, which are almost always followed by very strong returns.

Going into the current environment, valuations are very high, particularly when you adjust for inflation using the Shiller Index, which shows the market about 60% more expensive than historical averages.  Interest rates have very little room on the downside and it would seem that as the years go by, we will see higher rates.  This has a gravitational drag on valuations and when people expect they might lose money, valuations can go lower than one would expect.  Of course while the bull spirits are at the controls, many ideas and books come out showing why the strategies that have worked the last 5-10 years will keep working and you’d be a fool to do anything different.

A perfect example is index funds currently, which seem to have weekly articles advocating them.  I am not saying index funds are a bad investment when markets are inexpensive, they can be great and will tend to outperform a wide variety of managers.  What I will say is that this is probably one of the worst times to invest in an index fund, as the vast majority of stocks are extremely expensive and have been buoyed by artificially low interest rates.  I could literally write 25 pages on the below article because it brings up so many good points and omits others, but I will keep it as short as possible to keep your attention.

The logical question is:  If the market is very expensive and there is severe downside risk, how do you reduce the risk and actually position accounts for a strong likelihood of attractive profits?

The answer is:  You have to go deeply against the grain.  This means staying away from mutual funds and index funds, which are too exposed to the expensive parts of the market.  This means eschewing bonds.  This means concentrated positions in the stocks that are still deeply undervalued and that trade at huge discounts to historical averages.  The biggest example is financials.  We literally have a potential presidential candidate that 7 years after the Financial Crisis is most commonly known for her rhetoric on wanting to break up the banks.  All I’m trying to show is that negativity in this sector is still so extreme and that is why we can buy many of the best names at discounts to book value, despite the fact that book values have been growing and the businesses are improving dramatically from where they have been the last few years.  In addition, the financials would be the biggest beneficiaries of higher interest rates when that does ultimately happen, although I’m not forecasting any significant increase in the next year.  The bottom line is that by buying the most out of favor areas, but ensuring you are investing in well-financed businesses with strong growth prospects, we can see very different returns than the overall market.  As opposed to the S&P 500, which is trading at a Price to Book Ratio of about 2.81, our portfolios trade on average below book value. That is one of the most extreme variances you will ever see.

That is why it is important not to get too caught up in short-term fluctuations.  We are trying to catch the big moves and protect capital.  This is a similar strategy to what the big value investors did in the late 1990’s to avoid the Tech crash and make a lot of money.  Remember we won’t be right because people agree with us, but instead we will be right because our understanding of the facts will be correct.  I hope you’ll enjoy the article below:


Martin Capital Management 2015 Investor Letter – Why We Worry Top Down But Invest Bottom Up