It’s the style, stupid
September 30, 2004
Market Summary – 3rd Quarter, 2004
Investors gained a false sense of security during the booming 1990s. A red-hot stock market had a lot to do with that, but so did an investment concept that became increasingly popular during that decade – asset allocation.
The fireworks flew on New Year’s Eve 1999, celebrating the new millennium. Has it really only been less than five years since those glory days, when making money in the market was a snap? To those who bought into the “passive” investment philosophy espoused by the gurus of asset allocation, there was nothing to worry about. As long as you owned a properly diversified portfolio, all was well. Who cares what specific asset you owned? Better yet, just put your money into INDEX FUNDS! Own the market, don’t worry about what you pay for it. All will be well.
So investors went for the cookie cutter approach, putting the idea of individual thought or careful research on the back burner. Many of them decided that experienced money managers weren’t earning their keep.
And what happened? The market turned on passive investors. They found out that cutting the cookies is only one step. You have to bake them too, and in the process, most of them got burned.
The times they are-a-changin’
The market from early 2000 forward has pretty much been a stinker. Blaming the market for poor portfolio performance is easy; however, it misses the essential truth that asset allocation is not all that it was cracked up to be.
Asset allocation was derived from a concept known as Modern Portfolio Theory (let’s make it easy and call it MPT). The theory boils down to this – the performance of a portfolio can be attributed primarily to the general mix of asset classes held by the investor. Applied to the level of individual investors’ risk tolerance, MPT assured many that by simply identifying the right mix of asset classes to own, they could earn a competitive return. Diversification was the key.
All that matters, according to this approach, is the asset class and how much to put in it. Who cares what specific investment you stick in the asset class, or what you pay for it? Just invest and forget. And why not? MPT is based on a Nobel Prize winning economic concept. Is there anything that could go wrong with something as academically sound as that? It can if the hypothesis is wrong, like it has been for most of this decade.
We don’t mean to dismiss the benefits of owning a diversified portfolio. Nor do we wish to denigrate those who make it part of their practice to promote asset allocation as a beneficial approach to investing. And far be it from us to question the judgment of the Nobel Prize committee. But we offer one simple question. How could you ignore what you are paying for a stock, particularly one that you choose for your portfolio? It’s like buying a car without checking out the sticker or even knowing what model it is.
Check the best sellers
If you look through the stacks of investment tomes at your local library, you won’t find a lot of biographies on the great asset allocators. What you will find are books about master investors of all time – Benjamin Graham, Warren Buffet, Peter Lynch, and John Templeton. These legends knew something that escapes the passive money folks – individual thought and proper respect for the price of an investment.
In any economic or market environment, there are stocks that perform well and there are some that turn out to be real dogs.
But in the kind of environment we’re in now, and likely to be in for the foreseeable future, selectivity is more critical than ever.
Consider the most popular asset class for long-term investors – “large-cap stocks.” From the time the stock market hit its peak in March 2000 until the bear market finally hit its low in March 2003, every $100,000 an index investor put into the S&P 500 would have lost about $41,000. Diversifying into another asset class, small-cap stocks, wouldn’t have been much help. During the same period, $100,000 invested in the best index measuring small-cap stock performance, the Russell 2000, dropped to a value of $62,700.
Back to the future
But won’t the market eventually return to normal someday? For starters, keep in mind that the S&P index investor who lost $41,000 on a $100,000 investment during the bear market will need a return of almost 70% just to get back to even. That requires a lot of “normal” to get back to even. Unfortunately, the markets may not act all that normal (in other words, by 1980s and 1990s standards) in the coming years, making life tougher for the indexers.
When the bull market began in the early 1980s, conditions were ripe for a rebound by stocks after the debacle of the 1970s. Energy costs declined. The economy grew at a solid and steady pace and interest rates were just beginning to come down from double-digit levels. At this time, stock valuations were historically attractive. In such an economic environment, the multiples of stocks (their price/earnings ratio) expanded significantly. This made sense given the economic conditions. In fact, by some measures, 40% of the stock market’s gain during that golden age could be attributed to the expansion of market multiples.
Today, energy costs are rising, our economy is growing but at a slower pace, and interest rates are hovering around their lowest level in four decades, which means the most likely direction in the future is up. On top of that, the dollar has weakened in comparison to other currencies. Given this environment, we believe it will be difficult for market multiples to continue to expand. More likely, we’ll see a contraction in price/earnings ratio for the market as a whole. That’s not good news for index investors. If market multiples contract, it will be the S&P and other key indices that will be left behind.
At MPMG, we’ve almost completely avoided the top 25 stocks in the S&P 500. The one recent exception is Altria (see more on page four). Our style doesn’t lean toward large-cap stocks that appear to be overpriced. With our focus on finding the right stocks at the right price, general market trends become a secondary issue. More important, our approach is focused on earning solid, long-term returns on a consistent basis. By contrast, the asset allocators and indexers are very dependent on market multiples going higher. When the time is right, their fortunes can look appealing, but consistency is hard to achieve. And if the fans of asset allocation thought the last four years were lousy, their disappointment may continue.
We wish we were wrong, but…
In our previous two newsletters, we’ve made the case that oil prices were heading higher. Like you, we’d prefer that our refueling trips to the corner mini-mart were a less painful exercise this year. But so far, our expectation has proven to be correct, with flying colors.
The price of a barrel of crude oil wasn’t that unreasonable when the year began, flowing at about $30. The increase since then has been nearly unimpeded, and the question now is whether there is an end in sight.
Certainly in the short run, oil prices will fluctuate. But we’re convinced that over time, the trend we’ve seen this year will be more the norm than the exception. Not that oil prices will rise by 50% or more each year, but simply that it will be harder to quench the world’s growing thirst for oil. As they say, it is simply a matter of supply and demand.
The result is that you’ll continue to notice a number of energy-related stocks in your portfolio to capitalize on this trend. We’ve talked about a number of our holdings in the past (which are benefiting from the energy price spike). Here’s another that we recently added:
Marathon Oil Corporation (MRO – $41.28) – A major player in the oil and gas business, Marathon Oil is in a strong competitive position in its field. We’re particularly attracted to Marathon’s refining business, which it is in the process of
buying out from its refining partner, Ashland Oil. Finding enough oil in the ground is one issue, but the lack of new refineries is another. They aren’t being built anymore, at least in the U.S. That makes Marathon’s strength in this business a major asset to the company’s future.
3rd Quarter Review
Still a struggle
The U.S. economy is still growing, if not exactly blazing. Most companies are reporting decent profit margins. For the time being at least, inflation hasn’t become a serious issue across the economic spectrum, despite the spike in oil prices. So on the face of it, all should be well in the market, right?
Of course, investors don’t work in a vacuum. There have been plenty of external factors that have taken a toll in the last three months. The war in Iraq remains the biggest headline-making, headache-inducing issue. But there were plenty of other distractions as well, ranging from a string of hurricanes to more terrorist attacks.
That’s a lot of distractions for investors to deal with, and it showed in the performance of stocks over the past three months. As we mentioned last time around, dealing with times of difficulty is nothing new for the market.
But if you need a reminder of just how fickle stocks can be, think back to how even longer-term returns have changed over the past ten years. This chart shows the current direction of 10-year average annual returns on the S&P 500, beginning in September 1994 and continuing through September 2004. In September 2000, index investing looked tremendous, with a 10-year annualized return of almost 20%. It didn’t take long for that picture to change.
While any number of financial scribes and other market seers will tell you that index investing (such as an S&P 500 fund) is the way to go, we beg to differ. Good stocks at good prices can succeed in any environment. In a time like this, such stocks may represent only a small minority of the equity universe. But they are there, and our objective continues to be to identify and invest in these value-priced securities.
Other stocks of note
Xerox (XRX – $14.08) – The newsletter you are reading may appear to be a professionally published piece. But we didn’t send it out to a printing firm. Instead, the finished product is
courtesy of our own Xerox printer. No, this isn’t a paid advertisement for Xerox, but an example of how using our own observations and experience, we recognize an opportunity when we see it. Xerox isn’t exactly a hot name in the technology arena. In fact, the company admittedly lost much of its luster over the years. But for every dollar the company makes by selling a piece of its hardware, it makes an additional $3 in revenue, providing follow-on services to the buyer. In an extremely competitive business, Xerox truly has its act together. As is our custom, we found the stock attractively priced, and have benefited from that move.
Costco (COST – $41.51) – It takes a special company to earn the title as “the only company Wal Mart fears.” That was the title of a recent Fortune magazine piece on Costco. The warehouse club powerhouse has a certain cache not typically connected to this end of the retail market. Costco counts among its customers even the well-to-do. Who would have guessed that this warehouse market is also the biggest seller of fine wines in the world? While Wal-Mart’s own warehouse concept, Sam’s Club, has many more stores than Costco, Costco has more revenue. It all comes down to Costco’s ability to attract a more profitable demographic. Good deals are still in style for virtually all shoppers, and Costco remains a viable growth opportunity in our portfolios.
Circuit City (CC – $15.34) – Circuit City may never be mistaken as the company that Best Buy fears. The Twin Cities-based Best Buy has been one of the darlings of the retail marketplace in recent years. At the same time, Circuit City struggled, went through some management changes and was forced to relocate some of its stores. Those problems added up to an appealing stock price for Circuit City when it was added to our portfolios. We hold out no false hopes that this company will be able to match Best Buy from a business standpoint, but it certainly is a better investment right now. Circuit City still has $10 billion in revenues, no debt and cash in the bank. The company is clearly moving in the right direction, and home entertainment is still a big piece of the retail market.
Altria Group (MO – $47.04) – This is the parent company of Phillip Morris, the troubled tobacco firm. It could also be referred to a “litigation ‘r us.” Tobacco-related lawsuits are still in high gear. It is impossible to know how successfully the company will fight off those challenges, or how large the judgments could be against it. But the stock has sold off in recent months to a level that makes it worth holding. Even some modestly favorable news on the legal front could translate into a recovery for the stock.
The opportunities ahead
A phrase you may hear repeated, especially in our own communications, is that this is a stock pickers market. What that means in a nutshell is that we look for more of the same in the months ahead compared to what we’ve already experienced in 2004.
With interest rates likely to move up and energy prices continuing to be a concern this may not be the “rising tide that lifts all boats” kind of market. Experienced money management can make a real difference in this kind of environment. Why? Because there are always opportunities to find good companies with good earnings available at good prices. Casual investors (or passive index investors) may not find this type of market very appealing. From our perspective, we see potential in many areas. In fact, what often happens is that bad news can quickly drive down stock prices (especially with large hedge funds dumping “disappointing” stocks on a moment’s notice). This creates a bigger pool of attractively-priced stocks that may find a home in our portfolio and potentially generate the kinds of consistent, long-term returns we try to achieve.
We’re confident that our investment style is well-suited for the current environment. While the fans of asset allocation and passive investing still rely on broad market indexes to generate returns, we continue to pursue a value-oriented, selective (and thought-based) strategy that offers solid investment potential even in a stubborn market.
Congratulations are in order for Sarah Schroeder, our Director of Client Relations. She recently married Christopher Rude, so those of you who talk with Sarah will have to get used to her new surname.
Hats off as well to Harrison Grodnick, who has achieved the necessary requirements to obtain the CFA (Chartered Financial Analyst) designation. This is a grueling process requiring that a thorough exam on very involved securities concepts be passed in each of three years. Harrison’s success and dedication means a lot to our investment family.
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.