January 7, 2014

Dear Investor:

Nearly all stocks appreciated last year. Nearly all bonds lost money.

According to Bloomberg, 460 out of the S&P 500 rose in value in 2014. A monkey (or a money manager–same thing) throwing darts could have done well as long as the dartboard was on the “stocks” wall. Sadly, most investors were not focused on stocks, mired as they were in fighting the last war, paralyzed by fears of market declines and still nursing the multiple hangovers of financial collapse, debt ceilings, and other macro fears.

Statistically, most were sitting with the bulk of their assets in fixed income. Over the past few years, pension funds and other institutions had just 45% of their assets in stocks; before the crisis, they averaged more than half. These lemmings bought high and sold low, precisely the opposite of what you’re supposed to do. But pension fund boards are more concerned with looking wrong than being wrong. As a result, they do what others do. As Buffett famously wrote in his 1984 shareholder letter: “Most managers have very little incentive to make the intelligent-but-with-some-chance-of-looking-like-an-idiot decision. Most would prefer failing conventionally.” He added: “Lemmings may have a rotten image, but no individual lemming has ever received bad press.” How true.

For those who stayed committed to stocks, the rewards were large, with all the major indices posting returns over 20%. Macro risks faded and valuation won out, as investors finally came to realize that cash flow yields on stocks trumped bonds by a wide margin.

The two big losers were long-term Treasury bonds and Gold, down 13% and 28% respectively. For those who didn’t believe money could be lost in bonds, it was a sobering year, as the paltry yield of a couple percent could not make up for principal losses in excess of 15%. For gold bugs, it has been a debacle.

In the wake of huge stock gains and bond losses, the temptation might be to rebalance into fixed income, as reversion to the mean would imply a reversal of fortune this year. Stocks are still cheap, however, and bonds are still expensive. Until the 10-yr Treasury yield moves above 4%, this is likely to be the case.

The advantage now runs toward foreign stocks and away from the domestic and consumer staples stocks that have made so much money over the past year. Europe and Japan still present the best opportunities. Though Japanese stocks returned over 40% last year on average, they still trade at a mere 34% over book value, vs. 140% for the S&P 500. Europe is the most compelling value, with 8%-10% free cash flow yields. Emerging markets are also cheap with yields along the lines of Europe.

We are putting most new money toward these considerable bargains overseas.