Centre Street Cambridge Corporation

Private Investment Counsel

Commentary

January 1994

Well, here we are at the beginning of another year and in the investment world all the gurus are trying to convince everyone that they know where dollars will grow the fastest in 1994.  About the only thing your cynical and thoroughly disgusted investment counselor can say is "we'll see what happens".

Now that we've thoroughly discussed our strategy for the next twelve months, I thought we'd spend some time talking about the past year and the current financial environment.  At the risk of sounding monotonous it has to be emphasized that it is critical to put these things in perspective if one wants to be a serious investor and do more than simply buy securities because "their prices are going up".

During 1993 corporations raised more money in the securities markets than ever before. Wall Street firms' earnings were at record levels and hiring was up.  Individuals poured incredible amounts of cash into stock and bond mutual funds, including many new funds that invest abroad: in fact, Americans invested more in foreign securities markets than ever before. With few exceptions securities markets around the world rose - some at rates of 50-60% or higher. The general view is that interest rates will stay low (and fall overseas), corporate earnings will rise and that the economy will grow at a moderate, non-inflationary pace.  Foreign economies such as Europe and Japan will begin to pick up after a couple of years of recession. Stock prices will continue to benefit.

In the school of investing where we studied it was taught that one should invest "with an eye to calamity". What, pray tell, is so calamitous about the picture painted above? After all, don't we have the best of all possible worlds: slow growth, low inflation and low interest rates? What could go wrong? A fact sometimes lost upon the non financial historians who people the investment world today is that it is precisely during these periods when there is a high level of comfort and optimism with regard to the future of business and investment returns that the risk to buyers of securities is greatest. Conversely, for those who own securities or the corporations which issue them it is a time of milk and honey as witnessed by the hordes of newly public companies and corporate insiders that have unloaded shares onto the financial markets during the past couple of years.

For those who care to look there are numerous danger signals in the marketplace which prompt us to take the care in making our commitments that we have exhibited over the past year and continue to recommend at the present time. The high level of stock issuance and insider selling alluded to above is an obvious sign that the buyer should beware.  While buying from willing sellers is not necessarily a bad thing, buying from panicky sellers at low prices is a far different thing than buying from gleeful sellers at high prices as is now the case. This brings us to our next caution signal:  valuations. We are convinced that it would take a great deal of luck to justify current optimistic valuations of businesses in the stock market.  It is important to note at this point that the financial markets are forward-looking; that is, they reflect market participants' views on future prospects (some have referred to markets as "voting mechanisms".).  Our view for quite some time has been that the future reflected in the securities markets is a very robust one, indeed. Not only that, it must come to pass in order for current valuations to be maintained. Now, we freely admit that business and stock prognosticators may be correct this time; nevertheless, placing bets based on such predictions is not what we call investing. We prefer to defer to a wise investor who once remarked that paying a high price can turn the best of businesses into a lousy investment.

As you know, this issue of valuation carries a great deal of weight in our thinking and, in our view, makes the difference between good and poor results. The remaining "danger signals" which we will note below belong to the realm of observations of behaviors which seem to indicate an ignorance of or a willingness to overlook the risks of paying high prices. It is important to be cognizant of such behaviors because the awareness helps to prevent one from becoming seduced by the prevailing "easy money" atmosphere.  The level of complacency among market participants today is very worrisome, for example. Events of the past several years have taught people that markets that fall tend to rebound -- quickly. Look at 1987, 1989, 1990.  It's gotten to the point where every little drop in stock prices is viewed as a chance to commit more funds.  Brokers will even say that a decline in a stock's price from, say, $32 to $30 represents a "buying opportunity" instead of a relatively inconsequential fluctuation. To us, overpriced stocks that decline a little to a slightly less overpriced level are not very interesting. As historians we also observe that markets don't always bounce back so quickly. Buyers of the average stock in August of 1929 had to wait about two decades to get their money back. Those who bought in 1971-72 fared better: it took them only 10-12 years to recoup their losses.

Also indicative of a tendency to throw caution to the wind is the tremendous boom in mutual funds mentioned above. These days, low rates on certificates of deposit and money market funds and a prevailing "cash is trash" mentality have driven many individuals to seek higher returns in stock and bond funds. It is interesting to contrast this environment with that prevailing during the 1981-82 period. In the early 1980s short term rates were at 15-20% and stocks were "trash". As we all know, stocks were dirt cheap in the early 1980s. Now, when stocks are expensive, everyone wants them. Make sense? Oh, and let's not forget the stories about the large percentages of first-time mutual fund buyers who mistakenly believe that mutual funds are federally insured. This development is very disturbing to those of us who see mutual funds as almost ponzi-scheme-like pumping up security valuations.

These are some of the more obvious and public signs of complacency. Within the Wall Street community itself the euphoric atmosphere is also a telltale indicator. The focus is on what can be done, not what could go wrong. Wall Street, always a creative place, is very adept at inventing justifications for ever higher valuations. However, when denizens of that special world start to claim that valuations don't matter, that's when we feel a strong urge to leave the room. By way of example, one highly educated and computer literate analyst recently argued that valuations were beside the point since "earnings momentum" drives stock prices. Would that we could predict such "momentum" with confidence! In the Spring of 1993 the stock of a company called Policy Management Systems (stock symbol "PMS") dropped from about $87 to $25 because its earnings momentum turned out to be a fiction. We could also point out that in the late 1970s-early 80s earnings momentum did not do much of anything for prices.

More ominous to us are developments in the financial world about which the public hears little and the implications of which, in some cases, are not understood even among the professionals involved. Margin debt (purchasing stock with borrowed money), for example, is at record levels. Certain types of investment organizations are using leverage (borrowing) of as high as 50:1 ($50 debt to $1 of equity) to speculate in marketable securities. New types of securities are being created which react in totally unexpected ways to events which impact the financial markets: so-called interest-only and principal-only "strips" have been among the latest disasters mentioned in the press. Finally, some of the biggest banks and securities firms have created and expanded an unregulated (so far) industry based on "derivatives". Derivatives, simply stated, are artificial securities that are based upon an underlying instrument, hence the term "derivative". Such financial devices permit corporations to hedge currencies, change fixed-rate debt to floating-rate obligations and a variety of other things. The amount of derivatives outstanding is huge and they create enormous potential obligations for the guarantor institution (bank, brokerage firm), none of which appear on their balance sheets. Just what impact such "high-tech" instruments could have in some future financial crisis is not entirely understood.

This long-winded discussion has attempted to show why we should not be quite so comfortable with the financial environment as some would have us be since the very phenomena supporting the current mania may be the ones which eventually pull the rug out from under it. For example, how comfortable will recent mutual fund buyers be if the value of their shares, instead of rebounding after a decline, continued to drop? Will cash be trash if people suddenly find themselves with 20% losses in equities? The fact is that no one knows what will shatter the widespread complacency. It could be something totally unexpected or something entirely obvious. At any rate we will continue to pay as much attention to risk as to return, seek out reasonably priced businesses and hope, Micawber-like, that "something will turn up".

PS:
For those of you who may be wondering what your advisor does with his own money, he "eats his own cooking".

Note that our forecasts of a year ago were right on the mark: the stock market rose, interest rates fell and the economy grew!

 

Dennis Butler, MBA, CFA