11 Jan 2002 Trees Are As Important As The Forest
The tug-of-war between the Bulls and the Bears continues as analysts and investors fret over half-full or half-empty scenarios. There is little argument that the economic numbers suggest a bottoming in the economy. The rise in unemployment is slowing, consumer confidence is improving, commodities’ prices are rising from their lows, and bond prices are declining. The big question centers on the speed of the recovery and the vitality of corporate earnings. The stock indexes, historically the best leading indicators, are signaling recovery sooner, rather than later. The NASDAQ Composite index reached a six-month high on Wednesday.
All of the important averages are at or above their 200-day moving averages. The 200dma has acted like a ceiling for the markets in recent weeks, but all have recently punched through. The NASDAQ is well above (6%) its 200 dma while the S&P and DOW continue to have some difficulty punching through. Why all the technical talk? – because this is a very technical market. Much of the money coming into the market now is going into indexes and sector funds. The big-name favorites continue to go up beyond reasonable levels because of their inclusion in the most popular indexes.
The Dow Jones Index, for example contains 30 of the largest and most respected companies in America. IBM for instance trades at a Price to Earnings ratio of 27 times, a level close to its high of 29, reached during the Internet Bubble. Intel trades at 45 times earnings, considerably higher than its Bubble levels of 27 times. Coca Cola trades at 28 times its earnings, while analysts expect the company to grow at only 12% annually. Granted, the ‘E’ or earnings part of the equation is drastically down for most companies due to the recession, resulting in higher ratios. But these companies are also pricey on other measures such as price to sales, price to cash flow and price to book value. The relatively high valuations of these leading companies provide rich fodder for the Bears who say that stocks may be ahead of themselves. The stock averages may, with a big emphasis on may be ahead of themselves, but deeper analysis of individual stocks reveals there some values still out there.
The Quantitative team of Credit Suisse First Boston did an analysis based on consumer sentiment troughs and peaks. They found that risk to equity investors was considerably lower and return potential considerably higher in the months following troughs in consumer sentiment. They analyzed 3, 6, and 12-month periods of market performance before and after six consumer sentiment troughs in the American economy on the dates 2/71, 12/74, 5/80, 4/82, 10/86, and 1/91. As you can see in the graph that follows, market performance on average did very well after the bottoms in consumer sentiment.
Now, you may be thinking that the market has already accomplished much of this move. Indeed the S&P 500 is up 11% from September 17th (first trading day following the 9/11 attacks) and 20% from September 21st (the S&P’s low). Many investors thought that the economy and the markets were bottoming in August and September, before the attacks. If indeed that was the case the S&P has a considerable amount to go beyond its 11% rally so far. The market bottom reached on the 21st may be unusually low due to the trauma and panic that enveloped the markets in the days following the markets’ re-opening. For that reason it is likely not a good starting place for analysis.
Now for the Trees
Since September 17th the best performing industries in the S&P 500 have been the Internet Software & Services companies (up 90%), Computers and Electronics (up 68%), Casinos and Gaming (up 57%), and Homebuilding (up 48%). Other technology industries, Specialty Department stores, and Airlines round out the top ten. The worst performing industries were those that traditionally attract money in uncertain times such as Utilities (down 56%), Food Retail (down 13%), Oil & Gas (down 10%), and Soft Drinks (down 5%). Utilities were double whammied as Congress and regulatory agencies seemed to move away from deregulation trends. Investors left these stocks in favor of companies that do well in an expanding economy.
There have been some other significant issues adding to volatility during the latter weeks of 2001. The collapse of Enron forced employees to take a hard look at their allocations of company stock to their total net worth. I suspect there was a great deal of selling pressure on the stock of companies that use their own shares in their retirement programs. Tax-selling also played a large role in the waning weeks of 2001. Big name companies, down 50%, 60%, and 70% from their highs experienced selling pressures on their stocks right up until the end of the year. Tax-sellers took advantage of the liquidity that appeared when companies announced good news to unload more of their shares. And, of course, the index effect that we discussed above, played a role in the sometimes illogical moves of stocks relative to their peers.
What’s ahead? – probably more of the same we are seeing now. There remains a huge supply of cash on the sidelines (3 to 5 trillion dollars, depending upon the classifications you use) earning 1% to 3%. As the market volatility settles down, and it is settling down, sidelined investors will return. Many will likely not come roaring back, but their steady buying pressure will act as a support under the equities markets. With the big-name index stocks now fully valued, we are entering a ‘stock-picker’s market’. The coming months will likely be a grind for the averages, but individual companies will do well on their merits. The challenge will be to find and own those companies that are best positioned to grow in the recovering economy.
Companies most likely to thrive in the quarters ahead, in my opinion, are those that help their customers improve their productivity by allowing them to concentrate on what they do best, while outsourcing those functions that are not critical to their core competencies. Companies like EDS, Affiliated Computer Services, and Amdocs provide business process outsourcing for their customers more efficiently and economically than they can provide for themselves. Valuable resources are freed up for the execution of their mission critical functions. In a similar vein, contract manufacturers such as Flextronics, Celestica, and Jabil Circuits provide manufacturing services for companies such as Nokia, Cisco, IBM, and Hewlett-Packard. Companies are increasingly outsourcing their manufacturing functions for a number of reasons made even more apparent by the recession. By outsourcing they can reduce inventory costs as well as workforce resizing, plant obsolescence, and capacity issues. In addition to the macro business trends moving in their favor, contract manufacturers also thrive during recessions.
Software companies are expected to do very well as companies begin to employ all that hardware from Y2K and the Internet buildup. Now that they have the hardware, IT (Information Technology) managers will want to employ it as effectively as possible to contribute to the productive management of their businesses. Software companies like Siebel Systems, Intuit, Symantec, SpeechWorks International, and Microsoft should do very well in the early stages of the recovery. EDS, Affiliated Computer Services, and Amdocs have seen their consulting services rise dramatically since September 11th as companies have learned how critical offsite backup and recovery systems are to avoiding costly business interruptions. They will no doubt benefit as well as the same companies press the new hardware into service. It is also likely, but not as widely accepted, that the Y2K desktops and laptops are getting a bit dated. The introduction of Windows XP by Microsoft offers IT managers a compelling case for upgrading systems, particularly from Windows 98. Dell should benefit significantly from the XP upgrade cycle, both in desktops and servers.
Another major trend for the next several years will be in the medical and health fields. The most exciting investment opportunities lie in the area of biotechnology. The confluence of demand from the largest demographic segment of the population, the baby boomers, combined with the incredible possibilities for cures being made possible through technology and the eventual mapping of the human genome, serve to create exciting investment opportunities. Along with the high opportunity comes equal risk. Most often, the innovation and discoveries are generated by the smallest of drug companies. These companies bring extra layers of risk in that their products affect the very health of people. Therefore, there are many more hoops for them to jump through before they can bring products to market to generate profits. In other words, investing in individual biotechnology companies requires specific expertise to single out the best prospects and diversification to reduce the risk to a manageable level. For these reasons I have elected to use a passively managed Exchange Traded Fund (ETF) known as Ishares NASDAQ Biotech Index which represents the leading biotech firms and many smaller promising ones. There are over 70 companies represented in the fund.
Finally, I expect specific retailers to do well as the economy recovers. Those specialty retailers such as Lowe’s, Best Buy, WalMart (fully valued), have done very well over the past traumatic months and should continue to do so as the economy recovers.
Our game plan is to be invested in those companies that lead their industry, that are in industries that we believe will lead our economy, and to watch valuations very closely. For example, Lowe’s trades at 35 times earnings and is expected to grow 25% annually, while Home Depot trades at 43 times earnings and is expected to grow at 20% per year. Ex-GE guru Robert Nardelli is an incredible manager and may do great things at Home Depot, but Lowe’ has a proven strategy that works very well – and we can own the stock at a considerable discount to HD.
I’m afraid we will continue to see difficult days ahead and we will be forced to endure the negative comments of the Bears who still get the CNBC and CNN airtime, but recovery is coming. I believe there is significant appreciation potential for the companies we own, in spite of what the Bears say about the major stock averages.