Playing with the Wrapping instead of the Gift
I am writing this newsletter on Friday, April 14, 2000, which was the day the Dow dropped over 600 points
and was the biggest point drop in history for all major indexes. Friday concluded a week in which the NASDAQ dropped
25% as investors fled technology stocks.
Ever watch a one-year old open presents at his first birthday party? Inevitably, they are much more impressed
with what their presents come wrapped in than the actual gift itself. The toddler could care less about the present
and prefers the attention-grabbing wrapping because they don't understand which is the actual gift and which becomes
trash about five minutes after it is opened. Over the past year, many investors have followed a similar philosophy,
enraptured with the "wrapping paper" of the stock market; young, unproven companies with huge losses
and market capitalizations hundreds of times larger than their actual revenues. These are the "New Economy"
stocks that propelled the NASDAQ to an unheard of 80%+ run-up in 1999 while the rest of the market including the
Dow did nothing over the past 12 months.
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For awhile, it didn't seem to matter what kind of economic news came out - it was all good for wrapping paper stocks.
Rising interest rates and commodity prices cutting into corporate profits? No problem for the "New Economy"
- there are no profits!
Concerned that a six-month old company with ten employees selling hardware over the internet is valued higher than
Sears? Don't be - they will drive their "bricks and mortar" Old Economy competition out of business
shortly through the magic of the internet.
And my favorite example: Were you confused when 3com (the networking company) spun off 5% of it's Palm
unit (which manufactures hand held computers) in an IPO? I sure was, that 5% IPO was valued more highly on it's
first day public than the parent company, 3com |
- which retained a 95% ownership in Palm. That's right - investors were willing to pay more for a 5% ownership
in Palm than in a 95% ownership in Palm plus the other divisions of 3com! It must be new math.
Don't get me wrong - I think the internet is great - but it is also a distribution, sales and communication tool
that can be used by anyone and any corporation, New Economy or Old. I also think technology and biotechnology
are great - but why do they suddenly deserve a valuation 20 times higher than they ever have before? Are they
going to be 20 times more profitable?
These are the same kinds of questions fundamental investors were asking last year at this time about the slow growing,
very highly-valued giant consumer products companies like Coke and Proctor & Gamble. Why is a company growing
at 3% a year worth 50 times earnings? Because "this time it's different", we were told at the time.
The real answer: because it was last year's wrapping paper - and is this year's trash.
At least last year's wrapping paper stocks were good companies - just too expensively valued given historical measures
of valuation. This year's crop of wrapping paper stocks, with their absolutely ridiculous prices pushed higher
and higher by the "One-year old" investors, would be better described as old newspaper used to wrap fish
rather than a gift.
Value Investing: The purchase of companies, through the stock market,
for less than their economic value due to temporary unpopularity (lack of investor demand). This is the opposite
of growth investing, which is buying companies at a premium in hopes that other investors continue to push their
prices higher and higher regardless of what the business is actually worth
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Much of the blame for the strong demand for "wrapping paper" stocks rests squarely on the new small investor.
After several years of atypical returns much higher than normal from many large growth stocks, investors felt
a 30+% return had become their birthright. It was felt that the risks of common stock were overblown, and new
investors that know nothing about what they own other than it "always goes up" switched from large growth
stocks to much more speculative technology and biotechnology stocks.
Why is a company growing at 3% a year worth 50 times earnings? The answer: because it was last
year's wrapping paper - and is this year's trash.
Wall Street's job is to give their customers what they want, and they have. Many bogus mathematical formulas have
been invented to justify stratospheric stock prices in order to continue to feed the seemingly inexhaustible appetite
of small investors for internet business that are little more than concepts dressed up as companies.
The widespread involvement of ordinary Americans has made this bubble more volatile and hazardous than it's predecessors
of the late 20's and early 70's, which were mostly created by professionals.
Short-term returns over the past year
have been inversely related to investor experience; the less experienced have had no fear of holding positions
in stocks that experienced investors and professionals wouldn't touch with a ten
foot pole.
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While this has been a discouraging environment for those that believe that their stock should represent an underlying
strong business, for long-term investors the last six months has presented an incredible gift as the newer investors
have been fixated on the wrapping paper.
The Gift
While most investors have been concentrating their buying demand on a very few stocks, a few investors have had
an incredible fire sale of all sorts of companies, industries, and sectors of the market that are selling at prices
not seen since the early nineties. Health and drug stocks were cheaper in February and March than in 1993 when
nationalized healthcare threatened their profits. Retailers and Financial stocks are cheaper than during 1994
when interest rates were raised 6 times and the economy wasn't running nearly as smoothly as today. Consumer stocks
trade lower than in 1993 when the threat of generics taking their business drove their stock prices down by over
30%. The list goes on and on, real estate, insurance, transports, etc., all are as cheap by historical standards
as the dot-com's and biotechs are expensive on a historical basis.
So when are the Haves and the Have Nots going to switch places? The gap between most of the market and the few
popular stocks has never been greater, and it has gone on for what seems like a very long time.
I believe we have already seen the start of the sector rotation. A 36% correction in the NASDAQ in three weeks
time is a good start. But much more important is the |
massive capitulation among investors, businesses, and professionals.
Capitulation among investors
Even among the more experienced investors that understand more about the economic value of the stocks they own,
a mass exodus to the technology arena at the exact wrong time has given them a double dose of poor returns. Having
sat on companies with strong business results but flat or declining stock prices over the past 18 months, many
have abandoned their long-term strategies to chase what is hot. This reached a peak during the first quarter of
2000 and these Johnnie-come-latelies have likely suffered greater losses during the recent correction than those
lucky enough to cashed in on the irrational prices.
I am very tired of hearing about how jealous people are of their neighbor, relative, or boy that cuts the yard
that has gotten rich on internet stocks. Many have given in to their feeling of jealousy and bought their internetIPO.com
from their lawnboy and been handed their head over the past couple of weeks.
Capitulation among Professionals
Technology stocks, which are less than 10% of the U.S. economy, represent over 40% of the holdings of the average
mutual fund. Doesn't matter whether the fund has a name like "International", "Balanced",
"Growth", or in many cases "Growth & Income", as a group they are way way overweighted
in technology. On the reverse side, out of over 6000 mutual funds, only 121 are labeled "small Value"
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by Morningstar. Of those, only 10 have maintained an exposure of at least 85% to smallcap value stocks over the
past three years. Less than 10% of the managers hired to invest in the historically highest returning sector of
the market have actually done so over a stretch when the sector has obviously been ignored by investors. Didn't
they teach these guys to "buy low" at investing school?
In the first quarter of 2000 three very successful, well known, long-time value investors have announced they are
closing their shops, retiring, and have sold billions and billions of dollars worth of "Old Economy"
companies during the first quarter. In January, George Vaderheiden, one of Fidelity Investment's value gurus stepped
down. Last month Robert Sanborn announced he is leaving Oakmark Funds, and recently Julian Robertson announced
he is shutting down his giant hedge fund family Tiger Management.
Capitulation among businesses
If you think investing in Old Economy stocks has been frustrating, think about how you would feel if you were running
a successful, profitable company, setting quarter after quarter of record earnings and revenues only to see your
stock price ignored.
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Management has responded to this in two ways. While most companies are now using the internet as a tool in their
business, many of these companies have tried to reinvent themselves as an internet company - going dot.com to boost
shareholder value. Of course, this strategy is backfiring as investors have cooled on the dot-coms for the time
being.
Much more impressive is the number of announcements of management-led
leveraged buyouts (LBO's) - or announcements that management is exploring possibilities of putting themselves up
for sale on the private market in order to enhance shareholder value.
The timing couldn't be better, more and more "Old Economy" companies are being taken off the market by
LBO's, takeovers, and share buyback programs, decreasing the supply of available investment at the same time that
demand is perceptibly picking up for investing in companies with real sales and earnings. The best companies in
a diverse group of industries are available for purchase, many at pre-1995 prices.
The gift is there for the taking for those investors that are able to avoid focusing
on the wrapping paper. I firmly believe that March 2000 will be looked back at as the point where most investors
grew tired of the wrapping paper and started to open the gift.
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