Voting Machine or Weighing Machine?
March 31, 2005
Market Summary – 1st Quarter, 2005
Back in the 1930s, when the stock market was struggling, legendary value investor, Benjamin Graham coined a phrase that still holds water today – “In the short run the stock market is a voting machine. In the long run, it is a weighing machine.” Graham, Warren Buffet’s mentor, meant that the crowd will often buy (vote for) the popular stocks just because they are popular. Of course, choosing the crowd favorite has a particular downside – the buyer usually pays a premium price for it. This reflects a much more time-tested piece of conventional wisdom, the law of supply and demand.
The “weighing machine” metaphor has to do with what a stock is actually worth. If you put it on a scale and determine its true value, and you pay a fair (or maybe even a bargain) price for it, you can expect to see a solid return over time. While the stock may not win any popularity contests in the short run, investors will eventually recognize its inherent value.
Popular stocks gone awry
As the blazing 90’s came to an end, money was pouring into the biggest of the big stocks. Index funds were all the rage. What happened since that time is quite instructive.
Based on price from the start of 2000 through April 15, 2005 (a period of 5 years, 3 months and 11 additional business days), only nine of the 25 biggest stocks in the S&P 500 gained ground. The other 16 lost money, and most of them lost a lot. All but two of the 16 super-big stocks that lost money are down more than 20% so far in the new millennium. These “Sorry 16” stocks, as a group (we’re talking big names here, like GE, Microsoft, Wal-Mart, Intel and Coca Cola) are down an average of 39.59%. In that same span, the S&P 500 Index itself has also declined, but by only about half as much.
The plight of the passive-ists
So who is paying the price? Mainly the passive investors who were sold on the idea that index investing solved all of their problems. If you are a “passive-ist,” chances are your portfolio has yet to recover from the bear market of the early 2000s. If you were a NASDAQ passive-ist, you are really hurting (the NASDAQ composite index is off 50% since the start of 2000).
Passive-ists and those focused on buying the popular, large-cap companies tend not to focus on price. Even if a stock is going up at an unrealistic rate, they will feel obligated to vote for the popular stock.
As the record of the past few years shows, this can be costly. Over these 5+ years, many of what are considered the finest companies in America have not delivered positive returns for investors. This doesn’t mean GE and Microsoft are in trouble. These stocks simply became TOO expensive during the market’s peak (and sadly, some of them in our opinion are still too pricey).
Voting machine investors will pay any price for a stock provided it meets a certain popularity threshold. In the short run, stock prices don’t particularly reflect the true worth of many companies. In the long run, the real value comes to the forefront. We don’t mean to demean truly
great companies. It is just that great companies can be overpriced and therefore make poor investments (see the charts).
It doesn’t always matter whether you own the best company in its industry. What matters is that the stock is priced right given the company’s fundamentals. Circuit City may be the second banana to Best Buy in the retail electronics sector, but we didn’t buy Circuit City expecting it to overtake Best Buy.
We bought it because the price was attractive given the
underlying value of the company, even though, from a business perspective, Circuit City will probably continue to trail Best Buy.
Big Stock Blues
The laws of gravity apply to stocks just as they do to physics. The force of gravity in the market is something called valuation. As the charts indicate, financial gravity (valuation) will regress over time to realistic levels.
The market has been hard on most stocks, but the evidence of the past few years shows that you can’t count on the so-called quality companies as a refuge from the realities of the marketplace. At times like these, valuation really matters more than the market capitalization of the stock. Investors need to look at companies of all sizes and assess a stock’s valuation on an individual basis.
Narcissism, Nihilism, but is it Capitalism?
In this post-Enron, Sarbanes-Oxley era you’d think that corporate CEOs and their boards of directors would act differently. Maybe they’d be sensitive to the fact that it doesn’t look so good when CEOs “earn” an outrageous compensation package. Perhaps they would exercise more caution regarding their own largesse given the fact that the stock market (as detailed in our previous story) hasn’t done any favors for a large number of investors since the 1990s.
Mercer Human Resource Consulting released a study a few weeks back showing that CEO bonuses among 350 large public companies rose by an average of 46%. The average compensation for these executives totaled more than $7 million for the year. In fact, despite the mundane state of the stock market, CEO compensation has generally been rising more than 10% annually going back to 1998 (with the exception of 2003).
It isn’t just the amount of money that has us dumbfounded, but the fact that so many CEOs just don’t deserve rewards at these levels. There are too many cases today where company executives are being paid regardless of performance. The Wall Street Journal recently ran a story titled “Goodbye to Pay for no Performance.” But is that really happening?
Our own voting machine
In our fiduciary role we have the ability to vote our own conscience on these matters. We’re all for rewarding executives who deliver results for their shareholders and the good of their companies. But too many executives have lost their sense of proportion, and too many corporate boards have ignored the problem. A study by Pearl Meyer (executive compensation consultants) found that annual compensation for the average large company CEO was 240 times the average worker’s wage. Not long ago, the difference was just 20 times.
Capitalism is based on the idea of competition and producing the best product at the cheapest price. The reason we are sensitive to companies that allow what appears to be an excessive compensation package is that it seems they have lost sight of what’s the most important part of the equation; rewarding shareholders, the true owners of the company. Executives act like they are more absorbed by how much they can feather their own nest rather than the good of the shareholders or those who work for the company.
How CEOs stack up
In 2001, Steve Jobs, the co-founder and born-again savior of Apple Computer pulled down a total compensation package of $90,000,000. But since that time, Apple’s stock has risen by 223%, and the company has enjoyed some significant successes such as the I-Pod and its Apple retail stores, and its market capitalization has increased from $6 billion to $30 billion. While Jobs’ compensation for a single year was clearly extravagant, he only ranked 10th in 2001.
Some of the other big dogs of CEO compensation in 2001 were Sanford Weill of Citigroup, Gerald Levin of AOL Time Warner, Louis Gerstner of IBM and Joseph Nacchio of Qwest Communications. It reads like a Who’s Who of overpaid executives. Even if their performance up to that point was used as justification, the record demonstrates that paying astronomical compensation in one year is no assurance that good things will follow. Just look at the track record of those four stocks since the end of 2001.
Or how about companies that “negotiate” sweetheart contracts that will generously reward failure? One egregious example involves the recently pink-slipped Carly Fiorina of Hewlett-Packard. After playing a losing hand as head of HP, she was extended a lovely parting gift in the form of a $42 million exit package. Of course, this was pre-ordained from the time she started at the company, regardless of the results she delivered. One wonders if Shakespeare could have ever dreamed up the phrase “parting is such sweet sorrow,” had he lived in these times.
Enough is enough
There really isn’t an argument about whether these CEOs are worth every penny. The real question is whether shareholder value is increased by such highly compensated executives. In occasional cases, it happens, but most likely due to other circumstances. And you can’t necessarily draw a clear link between excessive CEO compensation and poor-performing stocks. But the trend is enough to give us pause.
We aren’t so naïve as to think the tide of ridiculous compensation packages for top executives is going away. But as investors, we retain the right to shy away from investing in those companies.
The opportunities ahead
We’ve been talking about the trend of higher energy prices for some time. While we certainly expect short-term swings that could temporarily send oil prices lower, the secular long-term trend is that oil demand is on the rise and oil supplies are leveling off.
In the first quarter, oil prices rose, as did the costs of other products and services. As we have stated before we agree with those investors who are nervous about the possibility that inflation is ready to make a comeback. Accordingly, we have avoided fixed income investments, which we see as a casualty of potentially higher interest rates that tend to result from inflationary pressures. We have positioned our portfolio in energy, gold and commodity-related holdings as a way of capitalizing most effectively on the current environment.
One of the great advantages of investing in the marketplace is liquidity. One of the great disadvantages is liquidity. This allows investors to vote continuously on individual stocks, constantly overvaluing and undervaluing different issues. These swings are a reality in today’s stock markets. This is especially true in the era of hedge funds, where money moves into and out of stocks more quickly than ever before, based almost entirely on a trading methodology. The investors who prefer “voting” on stocks can sometimes create opportunities for those of us who “weigh” our options instead.
In general, our value approach can help in this uncertain market. Risk is usually reduced when we believe a stock is priced closer to a company’s real valuation rather than when it is considered a popular (and overpriced) favorite. As of late, a lot of stocks aren’t as popular as they used to be. Those types of stocks now have more appeal to us. Going forward, the slow start for the stock market in 2005 may lay the groundwork for the next phase of solid investment opportunities for our portfolios.
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.