Giverny 2008 - The opportunity of a generation

To Giverny Capital’s partners,
2008 was a difficult year in the stock market, to say the least. We believe that the market drop – and
the high level of pessimism – have created great investment opportunities to a degree we have seldom
seen in the modern history of financial markets.
From these depressed levels, we believe that the potential rewards for stocks are very high. We
believe that the potential returns for stocks in general have not been this promising since 1979:
• Valuation for stocks in general are very low. The price-earnings ratio to normalized profits is
around 9 times for the S&P 500.
• Consumer confidence in the US is at an all-time low of 25 (1985=100). The lowest it had
reached before was 42 in 1974.
• Just in the US, there is around $7000 billion in cash (waiting to get back in the market). This is
an amount sufficient to acquire all of the companies in the S&P 500.
• Interest rates on Treasury bills are almost zero. The bond alternative is far from attractive.
• Most investors are pessimistic. Institutions have a very low asset allocation for stocks.
Historically, these were signs of future great returns for stocks.
• We can purchase shares of outstanding companies at a third of their intrinsic values, a situation
we have rarely seen.
• Finally, the legendary investor Warren Buffett is very optimistic toward stocks: he urged
investors to invest for the first time since 1979. He wrote: “A simple rule dictates my buying:
Be fearful when others are greedy, and be greedy when others are fearful. And most certainly,
fear is now widespread, gripping even seasoned investors.”

The year 2008 in review
Last year, we ended our letter with these words: “If there is a recession in 2008, we are ready.” We
entered into a recession last year. Here is a review of some of the main news of a year that was far
from ordinary:
􀂃 From their peak, world markets were down by more than 50%. Even those that were
considered (wrongly it seems) “decoupled” from the US economy went down. Markets in
China, Brasil, Russia and India were down from 50 to 75%.
􀂃 Most industrialised countries went into recessions.
􀂃 Housing prices were down by 20% in most industrialised countries.
􀂃 Three of the top five stock brokers in the US vanished or were forced to merge into a new
entity (Bear Stearns, Lehman Brothers and Merrill Lynch).
􀂃 The three financial titans AIG, Freddie Mac and Fannie Mae collapsed.
􀂃 Short-term interest rates in Canada and US are almost zero.
􀂃 The S&P 500 dividend yield is higher than 10 year Treasury bonds by more than 1%,
something that last happened in the mid 1950s.
􀂃 It is estimated that around one of three hedge funds could close because of the crisis.
􀂃 Oil prices went from a peak of US$147 in July to a low of US$35 in December.
􀂃 The Canadian dollar dropped 23% compared to its US countepart.
􀂃 The Canadian stock market was not immune: from its peak, the S&P/TSX dropped 50%, the
small-cap index by 60% and the TSX Venture by 75%.
We are always psychologically ready for recessions or market corrections. At the same time, we share
the same agnosticism as Warren Buffett’s as for the capacity to predict them (we leave that to
astrologists, market strategist and other fortune-tellers). We have accepted since the start that market
and economic cycles are parts of our capitalist systems and manage our assets accordingly.
Since 1945, there have been 11 recessions. Four times, the stock market dropped by more than 40%.
And crises have one thing in common: they all ended!
The recent economic crisis originated from the drop in real-estate prices and in the huge consequences
on the financial institutions, worldwide. Afterward, the crisis spread to all industries. The market
correction was then amplified by the huge number of speculators that crowded the investment world in
the years 2006-2007. For example, we wrote to you last year that at some point, there were $200
billion of oil contracts owned by investors. These were not destined to utilisation. Speculators were
hoping to find “other” buyers to purchase their contracts before the delivery date. Forced to sell, losses
were tremendous for most of them. There was also, the private equity firms (a new name for LBOs)
that acquired companies by leveraging them to dangerous levels. Many of them were forced to sell
securities to improve their balance sheet. All this deleveraging process is still hurting the economy.
And as always, market drops created by the selling of speculators have created more fears for many
other investors (even those that don’t need to sell). It is hard for many investors to keep a long-term
view during market corrections, especially when it lasts many months. But they have to. While it is
impossible to know when, we are certain that this crisis will pass. Our civilization has gone through
tougher times! A wise man once said that history doesn’t repeat itself but it rimes!
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Our portfolio did pretty well given the circumstances. We have always focussed our capital in solid
companies with great balance sheets and good profit margins. They also share an important ingredient:
honest and accountable people at the helm. Our companies are not immune to recessions. But we
believe that they have what it takes to pass through them. Some of them will emerge even stronger!
Finally, we are prudent in the price we pay for stocks. That helps in bear markets.
Some of our companies were hurt quite a bit by the recession but, for the most part, our investment
philosophy helped us beat the market this year, the same way we have done it since 1993. And we are
also taking advantage of the market crash to purchase great bargains. As Warren Buffett would say:
“be greedy when others are fearful.”
The level of undervaluation of stocks in general
Although we’re stock pickers (not investors in the market per se), we do closely follow the general
valuation level of the S&P 500 (in our opinion, the most important index in the world).
To value the S&P 500, we take into consideration three parameters: operating earnings, normalized
earnings to smooth out the economical ups and downs and long term interest rates in the US. The last
parameter is used to compare price-earnings ratio (P/E) to bond alternatives. Over a long period of
time, the market P/E tends to follow the inverted yield of interest rates. Of course, in periods of
optimism, the normalized P/E of the S&P 500 can be way higher than interest rates would justify. And
in periods of pessimism (like right now!), P/Es can be way lower than their intrinsic value.
If we look at the following chart, the S&P 500 seems to us undervalued by more than 50%, a discount
rarely seen (note: in 2008 we use a 4% level for the 10 years bond although it was 2.5% at year end).

In 2008, the rolling 10 years average returns of the S&P 500 was less than -1%. It was only the second
time in the last 200 years that this return was below 0% (the other time was for the 1929-1939 period).
In 10 years, the market has gone from overvalued to undervalued.
But in the end, the only way to lose money in the stock market over the long run is to sell during
corrections or recessions. So the emotional goal of the typical investor is not to fall into the “trap” of
bear markets. This “trap” awaits those that can not be impervious to stock market fluctuations.
Although it is far from easy, the key to attain such wisdom is to consider stocks as parts of businesses.
And – big news! – that’s what they are. Nothing else!