September 30, 2005

Market Summary – 3rd Quarter, 2005

Word on The Street, according to many of our brokerage friends, is that growth stocks are about to rebound. The logic here is that value has had a run of outperforming growth over the past five years, and the times are bound to change.

Naturally, we disagree with that. Not only do we think the times aren’t tailor-made for growth, but we also suspect that other recently popular investment strategies – asset allocation, market timing and sector rotation, will disappoint investors. More on that later. First, let’s explore a few questions about the idea that growth stocks are back in vogue:

1. Just because growth stocks have been out of favor, does it mean that they are any more likely to do better now?
When you play at the craps table, the fact that you haven’t rolled a 7 in any of the last ten throws doesn’t mean you are more likely to do so on the next roll. The odds remain the same for each number. So it is with growth stocks. Just because they have been lagging value stocks since 2000 doesn’t mean things will turn around now or in 2006. The odds don’t improve just because of the past record.

2. Which growth stocks are primed to do so well anyway?
Growth stocks come in many shapes and sizes. Are investors supposed to put money back into technology stocks, the darlings of the 1990s? How about the big retailers that grew so fast in the past (Wal-Mart, Home Depot)? Or is it telecommunications stocks? Growth is a pretty broad category. We’re just wondering what analysts have surmised to give them a clue that this sector of the market is ready to take off. We are skeptical of the evidence.

3. If growth stocks are ready to dominate the market, does that imply that value stocks are overpriced?
Of course, this question creates a bit of a conundrum. Stocks, by our definition at least, no longer qualify as a value if they are overpriced. Yes, there certainly are stocks that fit the “value” mold a few years back that wouldn’t make the cut today. Are the “pro-growth” market analysts suggesting that growth stocks suddenly offer attractive prices? Because when it comes down to it, the success of a stock has much more to do with the price you buy it at.
Investors often pay any price for growth stocks and then rely on rapidly rising earnings or the expansion of market multiples (P/E ratios) to continue to achieve the desired profit. Growth advocates appear to suggest that the right environment for such a development exists today. But does it?

4. Is up the only possible direction for growth stocks?
We wouldn’t pretend to imply that there is a huge bear market ahead for growth stocks. But frankly, many of the shining stars of the 1990s don’t yet qualify as a real value. Growth kicked into an extended run of market dominance beginning in 1984. But the P/E ratio for the Standard & Poor’s 500 at this time in 1984 (excluding firms with negative earnings) was 9.32. It rose steadily into double-digits from there. The ratio today is 17.32, down a bit even from a couple of years ago, due in part to the fact that we’re coming off a strong earnings year. But is it really cheap? It is interesting to note that the P/E ratio of the S&P 500 was nearly the same on September 30, 2005 as it was on September 30, 1987, just before the October surprise occurred that year. Not that we’re predicting another Black Monday, but it shows that in our minds, the market isn’t particularly cheap at the moment.

5. Is today’s investment environment conducive to a big run for growth stocks?
If you are hoping that the pump is primed for another run for growth stocks, just look at the economic environment. We seem about as far away from the 1990s now as you can be. Oil prices aren’t under control, but up dramatically. Inflation isn’t stabilizing or moving lower, it is rising. Government deficits aren’t disappearing, but expanding. The job market, while improved, isn’t anything like the 1990s, where employers couldn’t find enough qualified people for work. In fact, right now, it feels more like the 1970s, another period where growth stocks struggled in the face of high inflation, rising interest rates and all sorts of economic woes. Growth stocks, in our judgment, need multiple expansion (rising P/E ratios) to flourish. Given the economic trends we’re seeing, this isn’t the kind of environment where that can happen.
A Morgan Stanley report tells us that in the three best decades for equities, the 1950s, 1980s and 1990s, multiple expansion was responsible for almost 40% of the total return in equities. By contrast, in the 1970s, a rugged decade for stocks, multiples actually declined by a 7.6% annualized rate. If the economic environment today is closer to what a recent Wall Street Journal headline termed “That 70’s Show,” what does that say for the prospect of multiple expansion being a contributing factor in the next few years?

To carry that thought further, the lack of multiple expansion doesn’t do much to help growth stocks, which are very dependent on that factor to thrive. The record of the high-inflation era of the late 70s and early 80s tells the story.

6. Is this the time to be investing in “categories”?
The media and some market analysts love to talk in terms of investment categories – growth stocks, value stocks, technology, large-cap, small-cap, etc. We admit to our own, built-in bias against category investing. Index funds, for example, have not been the place to be in the past few years. It has been much better to use a selective approach, and buy stocks based on underlying fundamentals – price being a big one. Our record shows the benefits of this
style. Buying stocks at the right price is not rolling the dice. But buying a category, like growth stocks, on the theory that they’ve been down so long the only way to go is up, is not much different from putting all your chips on the coldest number at the craps table, and figuring it has to turn up some time. That’s not investing – it’s betting on the market.

We’re buying stocks, not bets
Investing, in our book, comes down to the benefit of owning a piece of an individual company. While we may be referred to, in the general sense, as value investors, we don’t compare our performance to any particular value index. Nor do we restrict ourselves to stocks that may be categorized as “value” in today’s terms.

In fact, it is very possible that some of the stocks we select will be considered, in every traditional sense of the word, a growth stock. What it is called doesn’t matter. What it costs does.

This is no secret, but it seems funny to us that many investors want to find something else to hang their hat on rather than solid, gumshoe research and investment judgment. Our current judgment is growth stocks still have an uphill climb. But it doesn’t matter. Within any category, there are good stocks and bad stocks, and we keep working on finding the good ones.

The appearance of comfort can be hazardous to your financial health
Now let’s talk about a solution that has been offered to many investors – asset allocation (or what we like to call “comfort investing”).

There’s a good chance that you’ve either been pitched the virtues of asset allocation or actually made investment decisions based on some form of it. It might have been a “personalized” asset allocation strategy where some numbers were plugged into a computer and out came the portfolio mix that is “just right for you.” Or it could have been as simple as a “recipe card” model portfolio, a cookie cutter approach, such as picking out a portfolio mix depending upon whether you are a low-risk or high-risk investor.

Asset allocation really became popular in the 1990s as many financial marketers and institutional investors used a study of pension fund management to make the case that investing was all about asset allocation. The study, led by Gary Brinson (named one of the four most influential people in institutional investing), purported to tell that, in effect, 93.6% of investment performance can be attributed to a portfolio’s asset allocation mix. The conclusion drawn by some was that if you simply find the right way to diversify for your level of risk, issues like which security you buy and when you decide to invest, much less the price you pay for a stock and bond, have little to do with your result.

There have been a number of papers written about the Brinson study in recent years, questioning not so much the findings, but more importantly, how the results are misinterpreted and applied in inappropriate ways. The Brinson study was based on the performance of specific large corporate pension plans ranging from $100 million to $3 billion over a ten-year period of time. In other words, there may not have been a direct correlation between Brinson’s findings and the way individuals like you would actually use asset allocation.

Second, according to two veteran market number crunchers, Roger Ibbotson (Professor of Finance at the Yale School of Management) and Paul Kaplan (Director of Morningstar Center for Quantitative Research), depending on how you measure things, asset allocation may only be responsible for determining 40% of your investment result (a far cry from 93.6%). When comparing one individual portfolio to another, these two researchers say that asset allocation only explains “about 40 percent of the variation of returns” among different portfolios. The remaining 60% is explained by other factors, such as security selection, investment timing and fees. So when comparing how your portfolio performs compared to your neighbor’s, asset allocation strategy is only part of the equation.

In the 1990s, it was easy to justify a focus on asset allocation. That’s because asset allocation strategies were based on index performance, and in the 1990s, most major indices were hard to beat. Who could question the benefits of asset allocation?

A whole new world
Today’s market seems a far cry from those halcyon days when you could throw money at an index and earn double-digit returns. But if asset allocation was so foolproof, such a perfect way to capitalize on good times and protect yourself from the bad, what has happened since 1999?

The answer is, the market happened…the same thing that’s been happening since those enterprising folks met under the buttonwood tree on the corners of Wall and Broad Streets in New York. Stocks rise and fall in part on “macro” issues like the strength of the economy, market trends or political events. But in the final analysis, an individual stock is measured on its own merits.

If what the marketers say is true, and asset allocation is responsible for more than 90% of portfolio performance, then what happened to the infallibility of owning an “asset allocated” portfolio so far in the new millennium? Will asset allocators take 90% of the blame for the fact that many investors have lost money, or basically gained nothing in the past few years? And if they do, what does that say for the benefits of asset allocation?

Diversification oversimplification
OK, so you don’t want to have to decide between growth and value or how to mix stocks, bonds and cash investments. You just want protection from down markets. So why not diversify LIKE CRAZY? After all, doesn’t more diversification mean more protection for your portfolio?

Some diversification? Yes. But there is a limit, and it may be smaller than you think. A long-appreciated study that ran in the Journal of Finance back in 1987, called “How Many Stocks Make a Diversified Portfolio,” tried to determine the diversification value of owning a different number of stocks. For instance, putting all of your eggs in one basket and buying one stock, would give you no diversification value (a score of 1.0 on this scale). Owning ten stocks brings that diversification value to 0.49. Owning 20 stocks makes it 0.44. While there is a big difference between owning one stock or 10, there is not much difference between owning 15 stocks or 50.

So it goes to show that diversification has its limits. We’re a firm believer in not putting all of your eggs into one basket. But there is limited value in spreading your assets out too much.

Let us be clear
If our view is correct, and we are in a period of rising inflation and rising interest rates, stock returns will have to compete with higher bond yields. So does that mean this is a time to avoid stocks?

In a nutshell, the answer is an unequivocal “no!” When prices are rising and purchasing power is being lost, it makes sense to OWN an asset, and stocks are no exception. But it is important to be selective – choosing companies that can control costs and successfully pass on their higher expenses to customers while still growing their business. Many will succeed in this endeavor (as many did during the high inflation days of the 1970s and early 1980s). Those companies that can do this will be excellent assets to own. What the new environment tells us is that there’s more to managing an investment portfolio than choosing a category. You must be selective, and above all, pay the right price for the company.

~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.