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SEVEN CRITICAL LESSONS
1. WALL STREET TENDS TO TAKE CURRENT TRENDS AND EXTRAPOLATE THEM OUT TO INFINITY.
“If you are going bankrupt, be sure you bankrupt on a big scale.”
—Paul A. Samuelson In the mid-to-late 1970s, when the U.S. economy was mired in a prolonged recession and stocks languished, it seemed to many that the country would never have prosperity again. In the 1990s, when the so-called “new economy” was exploding and the stock market was roaring, the rallying cry was that recessions and bear markets were a thing of the past. Both times, analysts, economists, media pundits, and investors alike were guilty of straight-line extrapolation, and both times, they were wrong.
I believe this behavior was primarily driven by two factors:
❙ It is human nature to think things will continue as they are at any point in time. The herd mentality tends to have people crying “the sky is the limit” or screaming “the sky is falling.”
❙ Wall Street analysts are measured on their ability to be accurate over the short term. This causes them to focus on the most recent data, and assume that today’s trends will continue indefinitely. This short-term focus makes it impossible for them to spot market turning points. Disci- pline, therefore, is critical.
2. IT IS RARELY “DIFFERENT THIS TIME.”
“Business will be better or worse.”
—Calvin Coolidge In this world of accelerated change, it seems that the more things change, the more they stay the same. One of the biggest challenges investors face is to resist believing the popular
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assumption that in any given situation “it is different this time.” We saw this in the late 1990s as earnings became a non- issue in the valuation of companies. At the time we did not jump on the bandwagon of buying the high-flying Internet stocks, but we occasionally questioned ourselves. Of course, those stocks have declined precipitously from their peaks, and we have our investment discipline to thank for keeping us on the sideline.
Over time, however, certain businesses do change signif- icantly and investors have to be prepared to understand and respond to these changes. The utilities industry is a good example. Deregulation in the 1990s dramatically altered the nature of the utilities industry. What was once a safe, secure, guaranteed rate-of-return business became a competitive free-for-all. In 1994, while buying utilities using the RDY discipline, the discipline began failing to identify periods of over- and undervaluation. RDY was not working because, in the increasingly competitive environment, utilities companies were raising or cutting their dividends without regard to underlying earnings. The typical negative correlation of RDY versus relative price was not holding (see Chapter 3). In response we sold all of our utility holdings. Then, in 1999 and 2000, the utilities appeared to get cheap again. We considered buying again—thinking maybe things were changing—but not enough data was available and we therefore took no action.
Secular change does occur from time to time, but not as often as investors assume. It did occur with electric utilities, how- ever. Below is a discussion of a group that was accused of sec- ular change but was merely experiencing a cyclical downturn.
In the early 1990s, the market decided that banks were no longer attractive stocks and valuations declined significantly.
The market’s rationale was that banks were in a commodity business—the buying and selling of money—and that in a low interest rate environment, they could not hope to grow earn- ings without offering other services. Thus, the era of the
“financial supermarket” was born. Citigroup, for example,
acquired insurance companies, sub-prime (high interest) credit card firms, and brokerage houses, and at the same time began emphasizing international lending, all in an effort to boost the value of the company. In the recent economic downturn, however, all of these higher earning assets became liabilities, and those banks still tied directly to traditional spread businesses (mortgage and commercial lending) outper- formed the financial supermarkets.
The most recent and dramatic illustration of “it is rarely different this time” was Internet stock valuations in the late 1990s. As dotcom valuations soared to mind-boggling highs, the market assumed that it was different this time. We saw the dotcoms simply as retailers with a new distribution channel—
similar to traditional retailers with catalog businesses. We asked ourselves why these companies should have such lofty valuations. In hindsight we now know it wasn’t different this time, and those stocks that soared into the stratosphere fell to earth with a loud thud.
Change can take place over time; for example, witness the electric utilities (previously discussed). Generally, though, the sentiment that “it is different this time” creates a buy or sell opportunity for the disciplined, astute investor.
3. MARKET WORKOUTS ARE OFTEN GREAT INVESTMENT OPPORTUNITIES.
“Listening to the economics wizards talk about the reces- sion, you can get the feeling that things are going to get bet- ter as soon as they get worse.”
—Russell Baker Beginning with a technology-led market decline and followed by a general slowdown of the economy exacerbated by the events of September 11, 2001, the markets are in a workout phase.
Different industry groups are also subject to workouts.
There have been many examples of workout opportunities over the years, but a good example of this phenomenon would
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be pharmaceutical stocks during the early 1990s, following Hillary Clinton’s failed attempt at managed care reform. At that time, with potential government regulation looming, the pharma- ceutical stocks took a valuation dive. The health care debate centered on cost containment, with high-priced drugs considered by some the major contributors to the explosion in health costs. As a result, drug stocks languished, and an era of consolidation in the industry began with a wave of mergers.
However, when health care industry analysts did some real research, they found that drug therapies were often cheaper than the alternatives, such as surgical procedures. The push to centralized health care failed, and investors focused again on the underlying fundamentals. A newly consolidated drug in- dustry rebounded, providing renewed investment opportuni- ties. These are the times when value investors are challenged to keep the faith and are often rewarded with outstanding re- turns as the market goes back to a more normal state of af- fairs—remember, it is rarely “different this time.”