Throughout our years of managing assets and creating wealth, we've come to observe that market and investor sentiment stirred by the press can often overstate both the positive and negatives, so we typically assume that things are rarely as dire or delightful as commentators pronounce.
2003 was the year of the bad news that wasn't. Ever since the bear market began, some questioned whether our economy and markets were undergoing a decline that would be measured not in quarters, but in decades. We countered that we were simply amid a cyclical, not secular, decline and that the proper reaction was to position ones portfolio for economic expansion.
Now, even after a profound market recovery, the current concerns bantered around in the press include a jobless recovery, the trade deficit, the budget deficit and the large levels of consumer debt. Although on the surface these are concerns, we feel that none of them present a major obstacle to growth. The concern of a jobless recovery is quickly fading as employment numbers have surprised to the upside the past two months. Additionally, remember that employment is a lagging indicator as companies wait until they are confident that additional staff is necessary from a cyclical perspective.
We also believe the trade deficit is the result of a few factors: first, our country has been the engine of growth for the developed nations and as a result, we consume more than non-growth countries such as Japan and most of Europe. Secondly, we are the worlds sole super-power with tremendous assets that are coveted the world over. The accounting reality of a trade deficit is an investment surplus, meaning that the world has invested heavily in our bonds, equities, real estate and other corporate assets. Given our economy's standing, it's clear why so many investors in other parts of the world choose to place some of their assets in the US.
Although some are concerned about the current government deficit, it is largely the result of a cyclical recession and war-time spending, and by itself only a minor concern (although the current regulatory and government spending trends in the US are not encouraging). Furthermore, consumer debt levels are not troubling either, because the debt level is primarily in well-securitized housing and borrowed at historically low fixed mortgage rates. Actually, the debt service levels for consumers currently stands at the 40-year average, indicating that consumers are able to service their debts as well today as they have been during the past 40 years. Put another way, the low savings rate of consumers is a function of their higher investments in housing, with more people owning homes today than at any other time in the past.
So, although the press focuses on the negatives, things are not nearly as bad as they seem. Indeed, throughout our years of managing assets and creating wealth, weve come to observe that market and investor sentiment stirred by the press can often overstate both the positive and negatives, so we typically assume that things are rarely as dire or delightful as commentators pronounce. Avoiding reactions to such overstatements is part and parcel of our focus on maintaining a consistent balance between risk and reward at all times.
Among Equities
Entering 2003, on the heels of scandal ridden, bear-bitten 2002, many investors and financial pundits questioned whether our markets were in secular decline. We consistently maintained that, despite the extent of the downturn, the economy was going through a cyclical phase of market clearing due to overcapacity in some economic sectors. Notwithstanding the additional geopolitical tensions, we positioned our equity strategies for economic recovery. As events in Iraq unfolded and the worst predictions fell by the wayside, the market climbed the proverbial wall of worry as we anticipated.
Despite our long-term positive outlook, however, we did not simply invest in low-quality companies, such as those with negative earnings, as this runs counter to our core investment philosophy that requires a company to demonstrate not only growth, but also exhibit indicators that such growth is sustainable. Given these parameters, it is typical for our equity strategies to lag in the earliest phase of a recovery when purely speculative stocks enjoy large gains, which is what occurred over the short term in 2003. With that said, our strategies closely tracked the market for the year, with less volatility.
The 4th quarter demonstrated a broadening of the 2003 rally as the overall equity markets advanced strongly for the period. In fact, the S&P 500 recently completed a string of gains for six consecutive weeks, a feat that hasn't been accomplished since early 1998. While investors continued to be buoyed by strong economic data in late 2003, geopolitical news also provided a boost to the markets with the capture of Saddam Hussein. With financial markets largely dependent on investor confidence, this event helped the gains of prior months continue. Another trend, one with perhaps more long-term implications, has been the shift of investors security preferences to favoring larger-cap old-economy stalwarts, indicating a winding down of the focus on speculative plays and an increase in economically driven investing. We believe such an environment favors investors like ourselves, who focus on bottom-up, balance-sheet driven company analysis, coupled with top-down, risk managed portfolio construction.
Among High Yield Bonds
Given our investment approach that uses one team, one process to identify opportunities in an array security types, it should be no surprise that the positioning of our high-yield strategies was guided by the same thinking applied in our equity and convertible strategies. Once again the pessimism surrounding the prospects for economic recovery created ample opportunity for investors who saw beyond the media accounts and market sentiment. This was especially true in the high-yield arena, where entering 2003, the differential between the current yields of corporate debt and the yields on Treasuries (known as the credit spread) had widened significantly from historic norms. Over the course of the year as the economy and markets rebounded, high-yield debt rose in value as more and more investors viewed such firms as economically viable, and poised for growth.
As in other arenas, however, we spurned the truly distressed debt of companies whose actual survival was in question, opting for stronger companies with more visible means of financial support. This meant that we trailed the broad high-yield market when the dead-cat bounce rally enabled the truly beaten-down companies to post strong returns as their stocks doubled or tripled in value. Our bias for stronger companies within the high-yield realm still enabled us to participate in the market rally in 2003, and leaves us poised to participate going forward, as we believe that the speculative rally is winding down, leaving the market to focus more squarely on specific company's prospects.
Focusing on companies and their balance sheet strength in our research, we believe that much of the potential for high-yield returns in 2004 will stem from special situations that have an impact on individual holdings. For example, credit upgrades, mergers and acquisitions, and equity IPOs all have the potential to improve a company's financial outlook for the better, and typically results in positive market recognition. This type of environment tends to favor investors over speculators, and we believe our investment process, guided by intense scrutiny of all aspects of a company's financial condition, should have an advantage if our economic outlook unfolds.
Among Convertibles
The convertible market appears to be returning to a more normal state of affairs, following a period where abnormalities reigned. Entering 2003, the markets unprecedented proportion of busted issues with little or no equity sensitivity, dearth of new issuance, and a string of negative annual returns all contributed to the uncharacteristic environment. With the continued rise in the equity markets and issuance during the final quarter of 2003, the convertible markets enjoyed one of their best annual returns, while seeing an increase in equity sensitivity as well as investment opportunities.
With the trend moving to a more normal balance between upside potential and downside protection (as measured by conversion and investment premiums, respectively), we believe that another outlier trend of 2003 is abating as well. As the economy recovered, many distressed, purely speculative holdings from downtrodden sectors such as Telecom, Utilities, and Technology enjoyed tremendous gains, as their stock prices doubled or tripled from cents per share to dollars per share. Although we entered the year positioned for economic recovery, we refrained from investing in companies whose actual survival was on the brink, as such investments run counter to our discipline of maintaining the proper balance between risk and reward throughout the market cycle. We adhere to this approach even during the first phase of a recovery, when dead cat bounces and speculative activity prevails over other investments.
During the fourth quarter, however, the field appears to be leveling between speculative and stronger companies, with investment grade holdings actually outpacing non-investment grade issues for the month of December. Our focus on sectors that will benefit from an overall economic recovery, especially more business spending, aided the convertible strategy during the quarter, particularly due to Technology holdings and a resurgence of many large-cap cyclicals. We are pleased with the strategies participation in the 2003 rally and look forward to 2004, where we believe our focus on factors such as balance sheet strength will gain even more market recognition.