October 10, 2008

Dear Investor:

The climate is terrifying, markets have been routed, and any words we have must come as hollow comfort, given the losses of the past week. Fear is really the only market element right now and investors are toppling over each other to get out, willing to accept very poor prices for their stocks. Excellent, cash-rich blue chips like Microsoft and Johnson & Johnson are selling at unprecedented low prices—prices that already reflect a collapse in the economy.

Think of your stock portfolio in comparison to your house or co-op. Your house is going down in value as you read this—and has probably plummeted in value over the past three years—but you’re not panicked by it since you don’t see the falling price flash before your eyes, and because you don’t get a painful monthly statement highlighting those losses. You wouldn’t leap to sell your home if the market irrationally offered you $200,000 for your $2 million dollar apartment. Obviously, you live in your home, so the analogy is a little stretched. But the core idea is the same: good stocks represent equity stakes in quality businesses and are assets of real value, much like a house. To sell them at panicked prices doesn’t make much sense, even if they go still lower before they turn higher.

This type of selling, known as capitulation, usually marks bottoms, but I can’t say when this horrible market will find its natural resting place. That said, yesterday’s collapse had all the classic signs of a massive capitulatory low which has often defined a bottom in past cycles.

It would be natural to think that markets will never, ever go up again. In the past week, they only went down. Psychologically, it’s impossible to connect with the idea that markets can go up. Just as in the frigid winter it becomes impossible to imagine summer’s warmth, it becomes a cognitive difficulty to see through this to the other side. But markets will go up again. In 1999, investors didn’t believe stocks would ever go down again. This caused panicked buying. Those who bought at that top learned the hard way—that market psychology can turn on a dime. If we are near a bottom, and history tells us the likelihood of that is high, then those who exit now are making the mirror image mistake of 1999. They are selling out of panic, possibly at the low.Despite what anyone tells you, market movements in the short-term cannot be predicted.

The only thing that can be predicted is value, as defined by good companies selling for cheap prices. The market is full of valuable companies selling at bargain-basement prices. Since this is the only knowable fact, it’s best to stay the course with long-term money. This explains why all the great long-term investors are buying, not selling (unless forced to by redemptions): Warren Buffett, Christopher Davis, Marty Whitman, Lou Simpson, Charles Brandes and the list goes on. They follow a principle we believe in deeply—that short-term market ups and downs can’t be predicted. The sensible investor, therefore, buys what’s undervalued and sells what’s overvalued, regardless of panic, market conditions, or any other distractions such as instinct, gut or hunches.

At this point in the cycle, after close to 40% declines on the major indices, there’s virtually no point in history where stocks would not beat cash on an aggregate five year basis thereafter.  The one exception (out of 950 or so total months over the past eight decades) is a seven month window from 1931-2, during the Great Depression. This represents less than 1% of months in our stock market lifetimes. The odds do not favor selling at this point. Only another Great Depression would change this equation. I don’t believe we’re going into another Great Depression for reasons described in my past letters. Therefore, I believe the risk-reward for long-term money favors equities. I know I said the same thing a week ago, so this contention may lack credibility, but I stand by it since the fundamental economic facts have not changed.

Again, the important thing is a sensible asset allocation. One of the purposes of an asset allocation is to assign a specific amount to equities, from which the investor does not deviate too much, in order to take emotions and guesswork out of the process. A heavy equity allocation is still the best approach for those who won’t tap money for three to five years, since there are very few periods in financial history where large-scale market recovery wouldn’t occur by then. Those who need money within three years should have enough in bonds or cash to cover that need. Those who are in retirement should have a significant bond component to cushion equity declines. Though bonds—especially corporates, and even munis—have also been sold off dramatically in recent weeks, bonds mute volatility and are the best insurance policy against equity declines.