04 Oct 2002 Valleys and Mountaintops
Having just been in the mountains of West Virginia I was reminded of some very interesting parallels to today’s stock market. From the mountaintop it seems one can see forever. The view is spectacular, the air is fresh and clear, and problems seem miles away. But down in the valleys everything is close and problems seem omnipresent. Travel can be treacherous on the tight sharp switchbacks. Just yards ahead around the next curve there may be a ten-ton coal truck barreling down the hill pushing the limits of control.
During the stock market boom of the late 90’s, it seemed the economy was perfect. Capitalism was reaching its true potential where innovators and entrepreneurs were funded with capital with speed and efficiency. Business was humming at capacity. Newly issued stocks of brand new companies quickly blasted to huge multiples on only the promise of profits to come, sometimes five or ten years in the future. The air was fresh and we thought we could see forever.
Today, problems seem omnipresent. Even the stocks of consistently profitable companies are driven down with little regard for their potential in the coming years. Stocks suffer because investors cannot see signs of growth, even if it is around the next switchback. Worse still, many fear the coal truck in their lane around the next curve. Are there more Enrons, or Worldcoms, or Tycos lurking out there? The chances are greatly diminished now that the vast majority of large-company CEO’s and CFO’s have certified their company’s results under requirements of the SEC. But investors are not so easily convinced.
From the mountaintop we saw that technology’s demand for power would outstrip our ability to generate it. Companies like Enron and Williams offered solutions to our problems and were afforded high tech multiples accordingly. Even more conservative companies like Duke Energy saw its price to book multiple swell to three times what it is today. The stock trades at book value today at a price not seen since 1997.
Just yesterday, Veritas, the leading data storage management company in the US, who’s name means truth in Latin, announced that its CFO lied on his resume about his getting an MBA from Stanford. The stock fell 20% on the news, losing one BILLION dollars in market cap. So far this morning at least three major Wall Street firms have downgraded the company on the ‘shocking’ news – AFTER the coal truck’s collision. Why wait until the stock was down an additional 20% to make their downgrade? Their justifications for downgrade were just as true before the announcement. Too many Wall Street analysts pile on a downtrodden company, lacking the courage to take the contrary or longer-term view if there is one. When Veritas disclosed their CFO’s resume lies, they also announced his resignation. Credit Suisse’ George Gilbert points out that the company’s CEO Gary Bloom can now appoint a CFO more in line with his own more conservative outlook for financial reporting. Additionally, the company’s multiple is now in line with its industry multiple for the first time in Veritas’ history. The company grows earnings over 25% a year, is making money, and has an excellent financial position. Sure sounds like a good long-term investment.
Cisco, the world’s leading supplier of data networking products to the Internet (supplying 85% by many estimates), now trades at a price to sales multiple of one tenth of where it was during the market boom and one third of it levels pre-bubble. Cisco has over $12 billion in cash and marketable securities. The company continues to operate profitably and to grow earnings in a very difficult economic climate. Consider this – is the Internet more or less important than it was two or three years ago? If it were gone tomorrow what impact would it have on the global economy? According to George Gilder, Internet traffic rose 5500 fold from 1994 through 2001. He further calculates that to sustain the traffic of 2001 using the technology of 1994 would have cost $39 trillion, or four full years of GDP. I have seen studies that indicate that at the current rate of growth, the Internet could be swamped by traffic within five years. Don’t think for one nanosecond that Cisco and communications companies like it are irrelevant in today’s economy.
There are countless examples of stocks in many industries that are mispriced in today’s market because of investors’ fears and unusual short-term bias. While there are numerous reasons to be frightened, the market presents rare pricing opportunities to long-term investors who are willing to chance the next curve. Many have pulled off the road, some for good. Some say they will get back on when conditions improve, but experience says that they miss much of the opportunity ahead.
We warned that October could be severe in its volatility. Early indications are that it will be. While the news on the economy continues to be surprisingly good on most fronts (service economy expanding, unemployment better than expected, and personal income rising) individual stocks continue to get pounded on earnings shortfalls, sometimes bringing the entire market down with them. But, if the economy continues to improve, the market will reflect it at some point and long-term investors will be rewarded for driving through the valley.