August 2005 Letter
Our April letter to you discussed the expectation for a trading range environment for common stocks in 2005. The second quarter was trendless and our views on the economy and the markets have not changed. Rather than rehash old ground, we believe you will find of interest the investing insights we learned from a favorite widowed client who is now deceased. She provided a practical education in investment management that is still appreciated.
She was a long-term investor who did not pay much attention to the inevitable ups and downs of the stock market. As long as her income stayed intact and grew over time, she was content. Client meetings were focused on income change from a prior period, not percentage account performance relative to some benchmark. This simple philosophy focuses on income growth, promotes a long view, a bias towards stocks, and psychological calm during periods of market decline. It forced investment in companies that were financially strong that could grow earnings and dividends. Finally, since not every company can increase dividends every year, diversification of holdings was important.
Our widow would have been chagrined at the time horizon of today’s typical investor. Richard Band, editor of the “Profitable Investing” newsletter recently wrote that the average holding period for a NYSE-listed stock is now around eleven months compared to over eight years in 1960. Stock turnover has gotten faster and faster—much to the delight of stock brokers and tax collectors. Thanks to CNBC, the Internet, frenetic Wall Street “experts”, program trading, etc., long-term is now the time between lunch and dinner.
We believe the ability of our clients to take the long view is a huge advantage. It avoids the costs of high turnover and allows us to take advantage of under/over valuations caused by a short-term focus on quarterly earnings, the latest report from the Federal Reserve, etc. It creates the opportunity to buy good companies at cheap prices. The widow’s ground rules push us toward reasonably priced companies that have the ability to consistently grow earnings and to bring a reasonable share of those profits to the bottom line. This free cash flow can be shared with stockholders in the form of dividends. The enclosed chart on Johnson & Johnson is an example of this widow’s delight.
There is also a thirty-year chart of the Standard & Poor’s 500 stock index that illustrates the widow’s strategy. One million dollars invested in the index at the end of 1974 would have compounded annually over 10% through December 2004. The one million dollars would have grown to just under $18 million. In addition to this market value appreciation, the widow would have particularly liked the fact that the original $42,000 of annual income grew to $276,215 in 2004 (a yield on the original $1 million investment of 27.6%).
A thirty-year U.S. Treasury bond could have been bought at the end of 1974 to yield 8%. One million dollars invested in this issue would have provided annual interest income of $80,000. This translates into total income for the term of the bond of $2.4 million. Total income for the same amount invested in the S&P 500 would have been approximately $4.5 million. The widow’s emphasis on income growth, not just the level of income, to keep up with inflation and the decline in the purchasing power of the dollar, also represents good sense.
The widow got it right. Her investment philosophy gave her the confidence to hold on to stocks in periods of decline. It avoided the transaction and tax costs inflicted on the frequent traders. Her focus on rising income led her to a diversified portfolio of financially strong companies that could increase earnings and dividends over the years. Her long-term holdings appreciated and income grew steadily.
With over 176 years of investment experience, the portfolio management team at Covington strongly adheres to the widow’s approach to managing money. Although we continue to experience volatile financial markets, our outlook continues to be positive.
On a more personal note, we are pleased to update you on the progress of Covington Capital Management. Since opening our doors for business in September 2004, our current client commitments exceed $500 million of assets under management. This includes both individual families as well as non-profit institutions. Because of our growth, we plan to add to our professional staff in the fall in order to add further investment expertise and ensure that we continue to provide personalized, in-depth service to our clients.
In these difficult times we are experiencing around the world, we hope you will enjoy a safe and peaceful summer with family and friends.
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