October 24, 2002
Dow Jones Average: 8,494
S&P 500 Index :896
Pricing Power
Economic theory holds that in a capitalist system the lure of profitable
growth will attract capital and new competitors. Unfettered competition
is supposed to bring a larger quantity of better products and services
to consumers at lower prices. The irony is that higher prices benefit
the owners (shareholders) of companies. The very system that benefits
owners of capital over the long term, can destroy enterprise values
in the short term through over capacity and relentless competition.
The current economic environment clearly favors consumers over company
shareholders.
With few exceptions, industries worldwide are experiencing over capacity
and sluggish demand. Price cutting is the result as too many competitors
compete for customers. Statistics show that for the first time in decades
there is general deflation in the price of goods sold, a fact confirmed
by the bleak earnings reports issued by companies everyday. The communications
industry is in the worst shape, as carrying capacity has far outstripped
the demand for traditional phone service, wireless, and internet access.
The strongest companies in the industry are struggling while the weaker
ones such as Worldcom and Global Crossing are in bankruptcy. Even the
pharmaceutical industry, that bastion of predictable profits, is witnessing
a fall in drug prices due to patent expirations and generic competition.
The auto companies are mired in a never ending price war, with GM now
offering zero percent loans, zero upfront payment, and zero payments
until 2003. Outside of the housing industry, investors are hard pressed
to find any companies that have pricing power.
Companies have pricing power when they are the first to market a product
that people want. When product cycles mature competition and production
capacity grow. This reduces the pricing power of all companies in the
industry. At that stage greater market share and superior distribution
networks give certain companies an edge over the competition. In the
late 1990's the two main growth drivers in the economy and stock market,
i.e., technology and medical companies, reached product plateaus. While
production capacity and competition increased, few new breakthrough
products were developed. There was some hope that new energy technologies
such as fuel cells would provide the next wave of growth for the economy,
but that has not happened yet. While investors wait for the next big
innovations, companies are reacting to current conditions by closing
plants, laying off workers, and merging with competitors.
Current Strategy
In the most recent quarter the Dow Jones Industrial Index dropped by
a whopping 18 percent. It was the largest quarterly decline for the
index since the crash of 1987 and one of the largest quarterly declines
in U.S. stock market history. The duration and severity of the current
bear market has financial commentators and strategists referring more
frequently
to the Great Crash of 1929-1932. While this market has not reached the
depth of decline seen in the 1930¹s, it has extinguished any remaining
bullish enthusiasm.
After the drubbing of last quarter stocks have stabilized and recovered
some lost ground in recent weeks. The combination of lower stock prices
and interest rates at a 40 year low has been enough to spark some buying.
The challenge for investors is making specific stock selections. The
median price earnings ratio for stocks is higher than it was at the
market peak over two years ago. Companies with the best business prospects
are selling at historically high price earnings ratios, while the ³cheaper²
stocks are losing money or have poor prospects. There are not that many
obviously undervalued stocks. The stock market is in more of a trading
range marked by rolling declines and recovery attempts. We have adapted
to the new market environment, buying after steep declines and taking
some profits on rallies.
The bond positions in our clients¹ accounts gained value in the
third quarter. The gain was rather large in the treasury inflation indexed
bonds. Although it was tempting to take this gain, we elected to hold
the bonds as the rate they pay is still better than money market funds.
