April 18, 1998
Dow Jones Average: 9167
S & P 500 Index: 1123
Lower Standards
The report card on corporate profitability was dismal for the most
recent marking period. In rapid succession Compaq, Intel, IBM, 3Com,
Oracle, Seagate, and a host of other technology companies announced
declining earnings. Profits in the energy sector were squeezed by low
oil prices. Consumer product companies, such as Coke, were hurt by the
weakness in foreign economies. While there were a few bright sectors,
earnings growth was slow to non-existent for much of corporate America.
A decline in stock prices would have seemed logical, given the disappointing
corporate news and a deepening economic crisis in Asia. But after a
shaky start in January 1998 the market soared to new heights. An essential
characteristic of bull markets is the relentless climb of stock prices
in the face of bad news. When investors are in a bullish, buying mood
they shrug off bad news and assume that things will get better for companies.
In bear markets the reverse is true, good news is discounted because
investors are fearful that it won't last.
When investors make large investment returns the tendency is to expect
and desire more of the same. Rising account sizes create a sense of
satisfaction and well-being, instilling a passion for stock buying.
Eventually the desire to buy clashes with the reality of generally overvalued
stocks, not worth buying by any historical, mathematical, or logical
measure. The only way investors can justify continued stock purchases
is by sharply lowering their standards and expectations of company performance.
Companies that were once considered average are currently receiving
an outstanding grade from investors. Companies that are clearly failing
are now passed along to higher levels by lenient investors. The urge
to admit new companies to portfolios is so strong that almost all companies
regardless of results are accepted.
The much maligned standards and expectations in our education system
look high when compared to standards currently applied to stocks. Investors
are receiving a one percent dividend return from the average stock.
This is a paltry return compared to any period in the past, but obviously
satisfies today's investors. Stocks priced at 40 times earnings used
to be rare, the top of the corporate class. Only a handful of companies
able to achieve rapid consistent growth of about 40 percent annually
would sell for such a price/earnings multiple. In the current market
environment companies growing at a mere 10 percent per year are now
receiving a top price/earnings ratio from investors. When investment
standards go up again, many stocks that are currently passing will become
failures as investments.
Current Strategy
Every stock we have bought for clients has gone higher than we thought
possible. While we expected a good return from our carefully chosen
group of stocks, the actual returns have grown to unexpected and somewhat
unwarranted proportions.
Our key holdings continue to benefit from a relative valuation advantage.
In the technology sector IBM is still relatively cheap when compared
to other technology companies. The NY Times is somewhat less pricey
than the newspaper group. Helmerich & Payne is a relatively inexpensive
choice in natural gas exploration, and Intuit is one of the less expensive
electronic commerce companies. In an up market, stocks that are relatively
undervalued attract investors. In a down market, relative valuation
is a shaky prop at best.
While we like the prices of our holdings relative to the overall market,
we are much more focused on the absolute progress at the companies we
have chosen. It is real, tangible improvements, earnings power, and
cash that over time provide a solid floor under stock prices. So far
we are very pleased with the progress at almost all the companies we
have purchased.
Buying new positions is our toughest challenge in this high market.
We are determined to keep our standards high for new stock selections
even as most investors are lowering their standards. It takes far more
research to find anything that meets our standards in the current market.
We have increased our buying of bonds, both as a defensive and income
producing measure. After taking huge gains on positions such as Bankers
Trust and IBM it seems prudent to secure some of that progress.
