VIEW FROM EDGEWOOD
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ECONOMENTS
Edgewood Management LLC
July 7, 2006
The View from Edgewood
This was a whiplash quarter for the financial markets. Equities had been trading sideways from the end of March until May 11th when, at the same time it raised interest rates, the Federal Reserve’s accompanying statement seemed to indicate that inflation was more of a problem and would require more interest rate increases than the markets had been expecting. This proved quite destabilizing and led to six weeks of vastly increased market volatility relative to the last rather quiescent several years. Only when the Fed again raised rates on June 28th, and seemed to indicate that the economy was decelerating, which should lead to slowing inflation over “the medium term”, did the market take a deep sigh of relief and proceeded to have its best single day in three years. We feel the Fed is close to done, but to try to pinpoint whether it is with one or two more increases is foolhardy. We do believe that with interest rates being raised for over two years the economy and the housing market in particular will slow down, and that within a year Mr. Bernanke will be cutting rates again.
We also strongly believe that growth stocks are as cheap as they have been in over ten years. Edgewood is continually comparing what a conservative investor can expect to make in a high-quality, low risk equity investment versus other asset classes. The most conservative or “risk free” comparative asset benchmark is the 10 year United States Treasury bond. Using this as a starting point, the interest rate, or bond yield (BY) paid is then compared to the earnings derived from owning the shares of a company, or group of companies in the case of your portfolio. Currently our growth portfolio has a price to earnings ratio (P/E) of 19 on 2007 earnings; its inverse, the earnings yield (EY), is 5.3%. The 10 year treasury is currently yielding 5.2%.
Now take that same 5.3% earnings yield and divide it by the 10 year US Treasury Bond yield (BY) that today stands at some 5.2% or so. One gets an earnings yield to bond yield relationship (the EY/BY) of some 1.01. Over time an investor can thereby compare the return on different asset classes and see if they are within their historical ranges or not, and act accordingly in adjusting their portfolios. Typically, over the last 20-25 years, a group of high-quality predictable growth companies has had an EY/BY that equated to about 75% of the yield available on the 10 year US Treasury bond, whereas for the lower growth S&P 500 it has been at closer to 90%. In both cases, when it strayed much below this relationship, investors were well served to be on guard. It meant that greed was the order of the day as investors were putting up with comparatively low earnings yields versus bonds and therefore discounting bonds as being “uninteresting”. This was clearly seen prior to both October 1987 and the start of 2000.
On the other hand, we have seen repeatedly that if the earnings yield was near or above the bond yield, then it usually meant that fear was stalking equity land. Today that very much seems to be the case, the ratio of 1 shows valuations are attractive. Fear leads to money making opportunities for the patient and well informed investor, as eventually the earnings to bond yield relationship comes back into line.
While we are not happy with May and June’s market action, we are optimistic about the outlook for your companies. Edgewood’s growth portfolio has a projected five year company profit growth rate of some 18% per annum. This means their earnings are growing at a rate that should allow their profits to double in less than 5 years. The bottom line is that top quality growth equities are currently at extremely attractive valuations relative to almost any other asset class, whether bonds, real estate, private equity, other stocks, or commodities. We therefore expect to see your portfolios appreciate significantly over time.
All the best for a wonderful and prosperous summer.
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