Centre Street Cambridge Corporation

Private Investment Counsel

Commentary

October 1995

Despite some nervousness in the technology sector, the financial markets remained exuberant during the last quarter and, in a move reminiscent of the 1980s, security prices climbed ever higher, helped by a continuing torrent of money flooding into mutual funds and a widespread belief that we are in the best of all possible worlds in terms of the investment climate: low inflation and interest rates, favorable political trends and lean and mean corporations with stronger managements and lower cost structures. One thing is for certain: this is definitely the best of all possible worlds for every business owner or investor who ever wanted to sell anything from an entire company to a few shares of stock. The depth and breadth of buying power in the marketplace is seemingly endless.

Mergers, Acquisitions and Spin-offs

Eagerness to buy was also reflected in the continued pace of large transactions during the last three months: Westinghouse went after CBS, Turner Broadcasting is attempting to combine with Time Warner, and the New York banks Chase Manhattan and Chemical (as well as a host of smaller banking institutions throughout the country) are merging. And these are but a few of the deals under way. It is interesting to note that many of the transactions are being accomplished using the acquiring company's shares as consideration, indicating that current share prices make stock more valuable than cash. Also interesting is the case of AT&T which has taken the opposite tack by announcing its intention to split into three different businesses. Not that the long distance telephone giant is averse to making acquisitions, but after having wasted billions of dollars in corporate assets by buying NCR in 1991, perhaps the company's executives decided that smaller is better. The idea seems to have support on Wall Street since the management team is now receiving accolades there for their bold move to engineer a split-up of the company, eliminate thousands of jobs, etc. Perhaps it has some merit: separate businesses will have incentivized managements more sharply focused on their particular operations. Well, at least the new arrangement may open up room at the top for new blood.

Some of the combinations mentioned above do make sense. U.S. banks, for example, are undergoing rapid transformation as economic changes and the internationalization of business have basically forced the country to rethink banking regulations dating to the Depression era. Looked at objectively, there are far too many banks in the U.S. and the industry will probably continue its consolidation, despite the high prices agreed to in some of the deals recently concluded. The motivations behind some of the other transactions are, quite frankly, lost on us. Some of them seem to be driven by little more than the egos of corporate chieftains who feel they have to rush to do deals before someone else gets there first. Egos and haste can lead to waste, as the AT&T experience shows. The Time Warner/Turner deal, in attempting to combine some of the biggest egos in the business world, makes for a very uncertain enterprise when viewed in this light. What is certain is that many of these companies, especially those in the telecommunications and entertainment fields, are doomed to spending huge sums in the future, mostly on unproven technologies and products. Who knows what will happen with these businesses?

The End Is Near -- Again

We were initially amused at an advertisement for an investment newsletter that ran on CNBC -- the financial news channel -- which opened with the following statement: “Each day brings us closer to the next 'market event'.” (Wisely, the advertiser left out the exact date.) Subscribing to the letter, of course, would help the investor avoid calamitous damage to his or her portfolio. As we said, we were amused -- the first time. After seeing it several times a day, every business day for over 1½ years, it has gotten rather tiresome.

There's one prediction of impending doom which we won't have to put up with for long, however. Barron's recently published an article entitled “Apocalypse Soon” written by Joseph E. Granville. For those of you not familiar with the name, Joe Granville gained notoriety in the 1980s by predicting a long, deep decline in stock prices. Investors taking heed of such advice missed out on one of the greatest bull markets in financial history. By drawing certain parallels between 1929 and current market conditions, Mr. Granville now predicts a cataclysmic decline in prices matched only by the Great Crash. Luckily for us the approaching “market event” is supposed to happen within a few weeks, so we will be spared a lengthy period of nail biting. For readers who are inclined to take such doomsayers seriously (something we are not prepared to do), Granville has recently published a book entitled Granville's Last Stand.

Investing With An Eye To Calamity

Sounding a more serious note regarding these so-called “market risks”: we do consider the possibility of severe market “breaks” in our work, perhaps more so than many in our business. (In fact, we have been accused of being “too risk averse”, as if that were possible when dealing with someone else's money.) We are responsible for the investment of some very conservative funds and clients, potential clients and others sometimes ask how we would react in the event of a serious decline in security prices. There are probably as many approaches to dealing with such an eventuality as there are investors, but many of these schemes seem to rely on instinct or the advice of individuals such as Mr. Granville to get the investor out of harm's way in time. Our oft-stated view is that such attempts to predict markets are a waste of time. Instead, in our investment operations we are very attuned to valuation levels of securities and keep the possibility of market declines in mind at all times in order to prepare for and take advantage of them, as opposed to just reacting to events. There are three elements to our approach: exposure, selection and flexibility.

Exposure

One of the most important issues facing any investor concerns the allocation of their funds between types of investments (for simplicity we will assume our only choices are equities and debt securities.). While neither class of investment is immune from loss of value, equities are generally perceived as “riskier” while bonds are viewed as “safer.” Market prices of equities tend to fluctuate to a much greater degree than those of bonds and equities lack the contractual arrangements inherent in bond ownership. Importantly, however, equities offer higher potential returns due to the fact that they represent ownership of businesses, which can grow or otherwise become more valuable, and that they are volatile, sometimes permitting purchase at advantageous prices. By buying bonds you are really lending money, and that only entitles you to a fixed return.

Although equities offer superior returns, they also entail the risk of substantial price declines which, even if temporary, could occur at an inconvenient time, so it is not wise for anyone to put all their eggs in this basket. So, our first way of dealing with the potential for large market reversals is to protect ourselves against them in the first place by limiting our allocation to this volatile sector. The extent to which the investor should commit funds to equities depends on a number of things, including age, wealth and personal risk tolerance, and is a matter involving experience and judgement, not precise formulas.

Selection

We strongly feel that the individual securities one buys and how one buys them has a lot to do with the ability to weather a market downturn. Our insistence on paying reasonable prices for businesses we understand helps keep us away from owning companies whose share prices have risen sharply due to speculative juices and which probably reflect unrealistic expectations about prospects. It also prompts us to avoid businesses whose prospects are inherently speculative, in our view, such as those involving high technology, or which don't make sense to us. Our patience and willingness to view inactivity (holding money market funds, for example) as a viable option is a further factor limiting our exposure to risk.

Flexibility

If the investor does the homework necessary to understand the businesses that he or she owns through the medium of common stocks, then market declines take on a radically different meaning than when viewed from the perspective of the speculator who sees stock ownership as essentially a gamble. Good businesses don't disappear because their stock prices go down. Lower prices may mean an opportunity to add to positions. And if a market downturn is severe enough to reduce the percentage of our stock holdings to below what we would normally allocate to this class of assets, we can even move funds from other assets -- bonds or cash -- and either add to current holdings or further diversify our portfolio by purchasing additional companies at the newly prevailing lower prices. Since lower prices imply a lower risk level in general, it may even make sense to increase our total allocation to equities -- further taking advantage of the opportunities that are presented to us.

The strategy for dealing with market declines that we have outlined is based on certain underlying assumptions such as that the economy will continue to gradually grow over time and that private ownership of businesses will not be outlawed. (These were very real concerns during the time of the devastating market collapse of the early 1930s.) It also requires investors to take a very long term perspective, to have a realistic view of their financial needs, to understand how an investment portfolio can help them meet those needs and, above all, to have discipline in the face of potentially nerve-rattling events. Individual investors, by the way, seem most suited for this approach since they can plan long term and not be concerned with what others are doing or with short term “underperformance”. For those who are inclined to view the financial markets as a kind of rollercoaster ride, we suspect they will either enjoy the thrills or end up nauseated but, in any case, will be none the wiser or wealthier for the experience.

Apocalypse Aftermath? —Just in Case.

You never know. By the time this humble newsletter arrives Mr. Granville's Great Crash of 1995 may already be history. If you followed the Seer's advice and sold aggressively near the market's top, you now have the cash to buy with abandon. Remember, investors who had money to invest in 1931 saw their holdings quintuple in value within a few years.

 

Dennis Butler, MBA, CFA