Fundamentals vs. Emotions

A week ago, my wife Robyn and I joined our son Carter at his school’s Title 1: Math Night event. This event has been happening for years. Parents of elementary school kids are invited to participate along with their children in various math challenges. It gives the opportunity for the kids to show off what math skills they have been acquiring to their parents, but it’s also a chance for parents and children to learn and work together. Most importantly, children get to see their parents become a visible and collaborative part of their educational experience.

The event was a lot of fun. The night started off with everyone meeting in the cafeteria. While eating Papa John’s pizza and cookies, the audience was entertained by a song from the fourth and fifth graders’ production of Winnie-the-Pooh. After that, families wandered the school, shoulder to shoulder, crowding into classrooms where the various math challenges were broken up by grade-level. I am proud to report to you all that I was able to understand most of the fundamental elementary math… however it took Carter’s not so patient instruction for his mom and dad to understand what was being asked from the problems.

The event, however, was also exhausting. It was late in the day. Many of the parents were in work attire, having rushed directly to the school from their jobs. The longer everyone was there, the hotter it got. But I think the real reason for the exhaustion was the level of emotions involved. Most of the kids were beaming, but they were running on empty at the start of the event, so there were occasional outbursts peppered here and there. Parents and grandparents, although out of their normal routine and tired, were still smiling ear to ear chasing their kids, and in many cases also juggling younger children and babies. The most emotionally exhausted of everyone, however, were the teachers. They couldn’t believe how many people showed up. Even though there was not enough space, enough supplies, or enough teacher-power to serve all the demands, the teachers were overjoyed at the level of participation from their students’ families, and it was delightful to witness.

The battle between fundamentals and emotions is something we all must learn to regulate throughout life. It’s hard to focus on a division problem when you are joking with your friends. It’s easy to forget to put one foot in front of the other in a basketball game if you’re busy searching the crowd for your significant other. And it is hard to not get swept away in the most recent investment trend of the day when everyone on the news, at the office, or at poker night is buying the same thing.

The major U.S. stock markets have been on a tear since the end of October last year, which was also the first breakout since the previous market highs of October 2021, but I am starting to see and read an increasing number of negative opinions creep into the headlines. The term “bubble” is being used more frequently, while mentions are being made of the “fear of new market highs,” since they should sensibly only be met with another market crash. This Artificial Intelligence driven bull market rush continues to be compared more and more to the Dot-com bubble during the turn of the century.

You all know that we here at Anderson Griggs Investments are not in the prophecy industry. We do not try to predict the beginning or ending of bull markets, bear markets, economic expansions, or recessions. But what we do try to do is invest your savings based on the fundamentals, while controlling for the emotional influences of society. One of those pertinent fundamentals presently tells us that bull markets can last well beyond common expectation, 6.6 years on average vs. the average bear market duration of 1.3 years.

In studying the current “expensiveness” or “over-boughtedness” of the S&P 500 index, the usual watermark for stock market returns, the composition of the index, cannot be overlooked. The “Magnificent 7” companies, which only account for 1.6% of the total companies in the index, account for 31% of the index’s total returns due to their very massive size. While those companies have done well, they are also the companies that have received the most investor attention for many years in a row. This is important because it offers what I believe to be a plausible way for the market to shake off its frothiness and settle its bubbled temperament, without a catastrophic bear market outcome. Those huge companies everyone has bought up to high prices can continue to shed investors, who end up putting those funds into the recently less favorable (and undervalued) participants of the “Mediocre 493,” which some clever pundits are using to describe everything else in the S&P 500 index.

I know some of you follow your accounts more closely than others, and you may have noticed this happening in your own portfolios. Over the past couple of weeks, there have been many days where our average stock holdings have either out-performed the average indexes, been down significantly less on negative days, or even offered positive returns on days the indexes were negative. I would assume this is due to investor selection, probably more so from institutional investors than from individual investors, who are switching from the momentum focused Magnificent 7 to the Mediocre 493, where value can still be identified.

Based on our research, the current 12-month forward expected return of the S&P 500 index, purchased at today’s prices, is 4.28%, which includes dividends. The current yield on a 10-year Treasury is 4.31%.  In other words, the price of the current market has the earnings potential for today’s buyers set equal to the risk-free rate of return. So, you are theoretically earning the same thing on a risky investment as you are on a risk-free investment. Once investors’ emotions run their full cycle, this investment fundamental will affect investor behavior the most.

I am going to leave you with a quote by Warren Buffet from his recent 2023 Letter to Shareholders of Berkshire Hathaway. As many of you may have seen, Buffet’s long-term business partner, Charlie Munger, who was honorably given the title of “The Architect of Berkshire Hathaway” by Mr. Buffet, passed away last November. Buffet’s letter in its entirety offers a rewarding experience for any of you who may be interested, but these two small sections taken from the “What We Do” section, which describes how Berkshire Hathaway invests their shareholders’ money, is a good summary of our own investment beliefs.

Our goal at Berkshire is simple: We want to own either all or a portion of businesses that enjoy good economics that are fundamental and enduring. Within capitalism, some businesses will flourish for a very long time while others will prove to be sinkholes. It’s harder than you would think to predict which will be the winners and losers. And those who tell you they know the answer are usually either self-delusional or snake-oil salesmen.

At Berkshire, we particularly favor the rare enterprise that can deploy additional capital at high returns in the future. Owning only one of these companies – and simply sitting tight – can deliver wealth almost beyond measure. Even heirs to such a holding can – ugh! – sometimes live a lifetime of leisure.

Happy Spring to you all. We wish you the best,

Justin Anderson