COMMENTARY - 2nd QUARTER 2009

We have watched with interest in recent months the dilemmas of some high-profile university endowment funds, including those at Yale and Harvard. Leaders in higher education, these institutions were also considered investment trailblazers, allocating large portions of their endowments toward alternative asset classes such as private equity, real estate and commodities, while deemphasizing traditional investments in stocks and bonds. As the financial crisis unfolded during the past 18 months, these endowments have suffered mightily, forcing the universities to lay off staff, reduce student aid, halt construction on new buildings, and issue debt to meet their obligations.

The hallmark of these endowments’ initial success – and the source of their current woes – was an asset allocation strategy that placed capital in seemingly diverse, or uncorrelated, asset classes. On the surface, the varied asset classes appear to be quite unrelated, and their returns in theory should be uncorrelated. However, the theory behind most asset allocation models assume correlations never change. As we’ve seen, in a crisis, all asset classes tend to move together; that is, they aren’t uncorrelated at all. Many investors assume that greater diversification is accomplished by merely adding a greater number of pieces to their investment pie chart – and letting that mix ride. But if your apple-cherry-blueberry pie turns out to taste entirely like apples, then all you have is an apple pie. The ostensibly diverse assets were far more correlated than initially thought, and as these universities have so painfully demonstrated, diversification for diversification’s sake just doesn’t work.

Even as these endowment funds realized their allocation mistakes – and remember, they were seen as master allocators of capital – they were unable to undo their errors. Their capital crunch comes because, as opposed to stocks and bonds, there is virtually no liquidity in these alternative asset classes. The endowments’ holdings in timberlands and commercial real estate, to name just two examples, are effectively non-saleable at this time. And if, as we often hear these days, cash is king, then liquidity is the kingmaker. The time these endowments need access to capital is precisely the time they cannot sell assets to raise that capital. So while the endowments claim to be posting 30 – 35% annual declines, to our minds, their losses are likely far greater because those holdings have essentially no current value. This predicament has already caused many endowments to reassess their investment disciplines and return to the more traditional approach of common stock and bond investing.

These reasons help explain the crunch facing the likes of Harvard and Yale, but we believe their style of investing may not work for yet another reason – we are now living in a new era of reduced expectations for economic growth and investment returns. During 2008, an array of asset price bubbles, fueled by excessive institutional and consumer leverage, violently and simultaneously burst. Fear, credit contraction and the resulting need for liquidity reinforced the market declines. Institutional de-leveraging was swift and fierce, and, in our opinion, fortunately is largely completed. But as Warren Buffett noted in a recent interview, consumer de-leveraging is a slow process. As the consumer constitutes roughly 70% of our economy, and as the U.S. constitutes nearly a quarter of global output, we expect a lengthy process of global economic healing, spanning at least several years.

Among the hallmarks of the coming period will be consumer and corporate thrift, signs of which we are already seeing. For example, the U.S. savings rate will likely return to 1950-1990 levels of roughly 9% of personal income, and perhaps reach 10-11% of personal income.



The softening of global aggregate demand, amid a world awash with idle productive capacity and underemployment, suggests a slow-growth future with relatively mild inflation. Of course, there will be winners and losers from the vigorous competition for a share of a limited economic pie. Whereas the rising tides of leverage-driven global growth floated nearly all boats, we believe the next leg in the global economy will reward only the very best – the best run, the strongest financed, and the most competitive in global markets.

If cash is indeed king – as we argue is the case – then dividends are the crown prince. While it is true that dividends have always been an essential contributor to overall stock returns, we believe that in a slow-growth world, they will prove to be more important than ever. Current yields on cash and cash-equivalent investments simply do not provide enough return to deliver the income (or income growth) necessary to sustain oneself in retirement in the same manner that growing dividend income will.

In an environment such as this, we believe a premium will be placed on those investments that provide increased certainty of cash flow and income production. This holds true not only for income-producing investments such as high quality corporate and municipal bonds, but we believe this is especially true for high quality, dividend-paying stocks that can provide certainty of cash flows and dividend income. As a consequence, we will continue to populate your portfolios with shares of those companies that are unencumbered by excessive debt, have a history of producing sustainable cash flows, possess a proven track record of paying and growing dividends, and – most importantly – trade at attractive valuations.

Interestingly, the stock market of late has actually reflected a world not where cash is king but where trash is king. While we welcome the roughly 40% move in the S&P 500 since its March 9th low, the chart below demonstrates that the lowest quality companies (represented by credit rating) have initially enjoyed the highest returns since that time.




It is not atypical for those stocks that fall the most during a stock market decline to rise the most during the initial “snap-back” phase of a market rebound. This is especially the case following short and sharp declines on the order of those we have witnessed in the fourth quarter of last year and early this year. As one would expect, the early leaders also tend to be found in those sectors which also suffered the steepest declines; among them, the financial, consumer discretionary, and real estate sectors – sectors in which we remain largely underrepresented for now. As the market advances, the initial outperformance of those sectors tends to wane as the rest of the market “catches up,” a phenomenon we have already begun to witness over the past several weeks. To borrow a metaphor, while the “crud” initially floats to the top, the cream ultimately rises to the surface. We believe we hold “the cream” in your portfolios.

As we’ve pointed out recently many times to our clients, we do not worry for those of us who remain invested in high-quality, cash-rich, large-cap, blue-chip, dividend-paying companies. Our concern instead lies with those who remain on the sidelines in cash, still caught between a rock and a hard place: on one hand, too fearful to invest; on the other hand, earning meager yields and foregoing the opportunity of earning significantly higher yields in the form of stock dividends and ultimately benefiting from the growth in value of these businesses over the long term.

With best regards,

The Golub Group

Disclaimer: All opinions presented in this commentary are strictly those of the Golub Group.  You should not construe any implied or expressed conclusions presented as a promise of future returns.