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Cicadas have awakened. Will the market’s Sleeping Giants follow suit?

Market Summary – 2nd Quarter, 2007

The insect known as the cicada has emerged from its underground existence in many parts of the country. You may know these bugs by their noisy song that can often be heard on summer evenings. One common form of cicada spends 17 years underground before coming into the light, singing incessantly in search of a mate. This has been a banner year for cicadas in the U.S.

Spending 17 years underground might seem extreme. But the practice isn’t limited to this noisy bug. This pattern has happened with popular stocks from time to time throughout history. Ironically, we know of many cases where stocks that are among the most popular in the market for a period of time also are susceptible to spending extended periods “underground,” becoming unproductive investments in an individual’s portfolio.

We thought it was a good idea to review a study we initially published in our first quarter, 2005 newsletter. At that time, our research showed that the 25 stocks with the largest capitalization at the end of 1999 had, as a group, been underwater so far in the new millennium. In particular, we highlighted the plight of 16 stocks out of the 25, the “Sorry 16” as we called them that were still in negative territory even though the market had enjoyed positive growth from 2003 to 2005. In fact, this group of 16 stocks was down, on average, nearly 40% for the first half of the decade.

The Big Cap Sleep
Remember, these were among the biggest companies – the most prominent names – considered by many to be “reliable” investments as the stock market goes. Some even thought you should own and hold these stocks for the long run regardless of price. In days gone by, these were considered “one decision” stocks – that is, you did not have to weigh any factors other than the company’s name and reputation to decide that it was right for your portfolio.

Our findings, more than two years after our initial study and at a time when the S&P 500 and Dow Jones Industrial Average have reached record levels, are amazing. Of the 25 largest stocks in the S&P 500 at the turn of the millennium, 16 are still “underground.” 15 of the stocks in our original “Sorry 16” remain down for the period. One change has been made to the Sorry 16, as Wells Fargo has joined the group of stocks in negative territory, and UPS has managed to gain enough value to move into positive ground for the period.

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Although 7-1/2 years have passed (close to half of your adult life for those age 35, 15% of your adult life for those age 65, assuming in both cases that adulthood starts at age 18), you would still be in a losing position in any of these 16 stocks if you invested just prior to the market’s peak in March 2000. In an individual’s investment life that is a REALLY long time. Not only have these 16 stocks failed to keep pace with the cost of living and but they are still losing money (from a total return perspective) PERIOD!

Stocks in the current Sorry 16 are down, on average, 30% from their value at the beginning of 2000. In April 2005, the Sorry 16 was down an average of 39%. In other words, very little ground has been made up in that time. By contrast, the S&P 500 Index, which started the decade in a deep hole, is up 2.3% as of the end of June 2007 – though it just managed to finally overcome negative territory in the last two months.

Some of the stories within the Sorry 16 are astounding. For instance, Microsoft is still down 49.5% from the beginning of 2000. Intel has dropped 48%. Home Depot is still 42.8% below its value 7-1/2 years ago. The standout disaster remains Time Warner, a shocking 72.3% below its price at the start of 2000.

Every one of these companies would have seemed like a “no brainer” for investors. This is also true for Modern Portfolio pundits – those who suggest a division of your investment dollars among a variety of asset categories based on formulations derived from historical market trends. They care little about what you pay for a stock, or even what particular stock you own, as long as the company is representative of a specific asset category.

The plight of the Sorry 16 demonstrates just how limiting this approach can be. After all, any large-cap stock portfolio could easily have included names like Home Depot and Microsoft, at the beginning of 2000, in 2005 or even today. But clearly, investors would have been better off to pay attention to the price they paid for a stock and not its size or popularity, before diving in.

Situations like these – where stocks become excessively expensive with a high price/earnings (P/E) ratio – are not unusual. Investors can easily fall prey to the popularity contest that exists from time-to-time in the market. One of the most notable occurrences in recent times took place in the 1970s, with the so-called “Nifty Fifty” stocks – those too were considered “one decision stocks” for any portfolio. Even though some of the stocks were trading as high as 90 times earnings (Polaroid, for example, which went bankrupt in 2001), the conventional wisdom held that these companies were appropriate for any portfolio at any price.

A closer look shows things were even worse
While long time investors are well aware of the “Nifty Fifty,” the truth is that there was not one set list of 50 stocks included in this group. A 2002 study by two professors of economics at Pomona College points out that two of the most notable “Nifty Fifty” lists were created by Morgan Guaranty and Kidder Peabody. Of those two lists, 24 stocks appeared in both groups.

long term overpriced stocks

The Nifty Fifty stocks were notable for having lofty P/E ratios. For instance, on the Morgan list of 50 stocks, more than half had P/Es above 40. At the time, the P/E ratio for the S&P 500 was 19.2. On the Kidder Peabody list, all stocks had P/Es above 40.

The Pomona study found that between 1973 and 2001, the 24 stocks that appeared on both the Morgan and Kidder lists generated an average annual return of just 9.69% (using the most favorable method of measuring performance). Not bad, but the S&P 500, in that same time period, returned 12.02% per year. So during a very bullish 29-year period for equities, this group of 24 stocks could not even generate an average annual return of 10%, the historic average for the stock market. When translated to dollars, an investment in the S&P 500 grew at almost double the rate of a comparable investment in the select group of 24 stocks that appeared on both the Morgan and Kidder Nifty Fifty lists.

Have investors learned lessons from the Nifty Fifty period and the more recent saga of the Sorry 16? Time will tell. If history is any guide, investors will be fooled time and again, ignoring the valuation of a stock and buying it based on its reputation or recent record of rapid price growth.

GE and Altria – a study in contrasts
Consider what was happening at the start of 2000. There may be no better example of a solid, well-run American company than General Electric. It set the example of how a corporation in America should be run, and many executives graduated from GE to head other major American companies. The right kind of investment for any portfolio, right? Yet its stock ended June 2007 down more than 25% for the 2000s.

To be clear, this doesn’t necessarily mean there is anything wrong with GE. It remains a great company. The problem was that at its peak in popularity, GE represented a great company that was not (at the time) a good investment. The numbers bear that out. Investors who put their hard-earned money into GE stock, focusing only on the company’s good reputation and ignoring the price of the stock, continue to pay for their mistake.

An interesting contrast is Altria (formerly Philip Morris). In the 1990s and early 2000s, no big company may have been as reviled. Its tobacco business was the target of legal and government sanctions. Domestically speaking, its main area of business appeared to be the antithesis of a growth industry. The price, however, was one of the most attractive among the 25 biggest stocks at the time. The truth was Altria’s business prospects, including its diversified markets and global growth potential were strong. Altria’s stock is up more than 200% so far in the 2000s, the main driver of positive growth for the group of 25 big stocks we’ve discussed in this newsletter.

Another caution – big returns with little risk
Most portfolio managers can look like a genius when times are good. At the end of the 1990s, virtually all managers seemed invincible. After all, there were few stocks that offered any resistance to the raging bull of the previous 17 years. Most important, growth was in its prime, and it seemed no price was too high to pay for a stock.
Since the end of 2002, the last negative year for the stock market, the S&P 500 Index has risen in value by 70.9%. In that environment, we have again returned to a period where most stock pickers (fund managers) will be able to generate solid returns without appearing to put investor’s money at risk.

In fact, many investors may be getting the impression, as they did in the late 1990s, that risk is not a major concern. The stock market has demonstrated only minimal volatility in recent years, a trend that can result in unwarranted contentment with the risk profile of the stock market. Be mindful of the fact that market volatility is a fact of life, even if it hasn’t been in recent times.

While we refer to the S&P 500 Index for comparison purposes in this newsletter, we also want to reiterate something we’ve indicated many times before – we believe investing in the Index is not in your best interests. Index investing, a favorite approach of Modern Portfolio Theorists again ignores valuation measures that should matter.

Every stock has a price. Some prices are too high. This is not unlike the housing market, where homes that are overpriced take a long time to sell. In the stock market, if the price is too high, it is subject to substantial correction. There are plenty of reasons for investors to show patience and hold off buying even popular, big name stocks if the numbers aren’t agreeable from a value perspective.

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Reputation does not a good investment make
The simple lesson is that you can’t get carried away with a company’s good name. There is no such thing as a “one-decision” stock.

Instead, the key is to identify good companies that are currently being overlooked by the market. In an investment environment where stock values are climbing while economic growth is extremely modest, the potential for risk may be on the rise. The less predictable the markets, the more important it is to focus on price.

This is a banner year for many cicadas, their 17-year hibernation underground having come to an end. Will stocks like Microsoft, GE and Cisco take that long to wake up? The next decade will tell the tale, but the first seven-and-a-half years have not been promising.

In the meantime, we’ll keep looking for companies that have something else to offer – the potential for appreciation, based in large part on an attractive current value, and avoid stocks that face a significant risk of joining the cicadas underground.

It’s Almost Stein Time
He used to give game show contestants a chance to take money out of his pocket on the cable TV program “Win Ben Stein’s Money.” While some might have questioned the wisdom of putting money up for grabs, the very intelligent and articulate Stein was rarely defeated by his opponents, and managed to keep most of what was at stake.

q207 cartoonMr. Stein is much more generous about sharing his financial acumen, and we’re excited for our clients to hear directly from the former Presidential speechwriter, current New York Times columnist, CBS News commentator and best selling financial author.

We’re honored to have Mr. Stein headline our second annual MPMG Speaker Series on Thursday, July 26th at the Golden Valley Country Club. The event kicks off with hors d’oeuvres at 6:00 p.m., with Mr. Stein’s presentation running from 7:00 to 8:30 p.m. We hope you reserved seats, as all of the tickets we have available for the event have been claimed. Be sure to bring your ticket with you in order to be seated.

Look for us to provide a summary event on our website (www.MPMGLLC.com) shortly after it occurs. We are excited to share Mr. Stein’s wisdom with as many of you as possible, whether you can make it in person or view the summary on our website.

~MPMG

Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.

The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.