Centre Street Cambridge Corporation

Private Investment Counsel


January 1993

At Boston's First Night celebration a few years ago, one of the entertainments was THE ORACLE.  Set up in the plaza at City Hall, people from the crowd would pose questions over a PA system and after a minute or so of weird noises and music a booming voice sounding something like Darth Vader would announce the "prophecy".  At one point a kid from Southie came up to the microphone and said:  "OK Oracle, you've been pretty wishy-washy tonight and for once I'd like to see you give a simple Yes or No answer.  I want to know if the Celtics are going to win the pennant this year--yes or no."  After the usual rumblings the Oracle said:  "The answer to your question is as simple as the question itself:  yes or no!"

With this in mind let's go on to the Outlook for 1993:

1.) Economy: The economy will grow at a positive or negative
2.) Interest rates: Rates will increase or decrease.
3.) Stock market: Stock prices will rise or fall.

As investors we are faced with a disconcerting task since the success of our operations depends heavily upon future circumstances that are not predictable with any degree of assurance and which are usually beyond our control.  There are many ways to deal with this uncertainty.  One method (favored by the usual Wall Street types) involves the expenditure of enormous amounts of intellectual and financial capital in an effort to predict future economic growth rates, levels of interest rates, stock market movements and company earnings--usually over a short time horizon and with results that are less than satisfactory.  One can also do things like buy treasury bills, thereby removing much of the uncertainty (if you don't count inflation): it's less exciting, but "safer".

The method we prefer is based on the notion that the investor should make commitments in such a way as to protect against potential adversity while at the same time putting him/herself in a position to benefit from favorable developments that may occur.  The key to this approach is the PRICE PAID.  An investment priced at a deep enough discount to its intrinsic value offers improved odds of a successful outcome and less risk of permanent loss.  Fortunately for this type of investor it is in the nature of financial markets to occasionally provide such opportunities and the intellectual endeavor required to detect them lends itself to disciplined, yet common-sensical analytical techniques which do not need the services of soothsayers.  Rather than try to accurately predict future developments--a virtually impossible task--the objective here is to assess values using current circumstances and conservatively drawn scenarios of the future.  The result is less dependency on future events unfolding according to plan.

To get some idea of how this works, refer to Table I.  The assessment of value can also be applied to the stock market as a whole.  This is an interesting exercise since it provides some insight into the general level of prices and market-related risk.  The concept here is quite simple:  earnings for these companies have grown at a rate of about 7.5% over time.  The current earnings figure of about $30.60 is thus a trendline or "normalized" figure, which may or may not correspond to the earnings actually reported for the companies in the index (For example, for the years 1989-1993, earnings were/are expected to be $26.83, $24.77, $16.72, $24.00 and $28.50 respectively.).  A "multiplier" taking into account different interest rate and equity risk scenarios capitalizes the earnings to produce a range of fair values for the market as represented by this index.  These values are then compared with the current market level.  As you can see, even under optimistic assumptions prices--on average--appear to exceed fair value.  Not that this fact would stop us from investing:  good values can be found under almost any circumstances.  However, current conditions make the search much more difficult.

A final comment before concluding. Just because stocks appear expensive does not mean they won't rise in price. We have witnessed this phenomenon this past year. The risk factor is heightened, however.

Regardless of the excitement which may prevail in the investment world, we prefer not to take undue risks with other people's money.  We will wait until such opportunities appear where sizable commitments can be made at levels of risk we deem appropriate and where the odds for a favorable outcome are weighted in our favor.


Dennis Butler, MBA, CFA