Pricing Power – October 2002
October 24, 2002
Dow Jones Average: 8,494
S&P 500 Index :896
Economic theory holds that in a capitalist system the lure of profitable growth will attract capital and new competitors. Unfettered competition is supposed to bring a larger quantity of better products and services to consumers at lower prices. The irony is that higher prices benefit the owners (shareholders) of companies. The very system that benefits owners of capital over the long term, can destroy enterprise values in the short term through over capacity and relentless competition. The current economic environment clearly favors consumers over company shareholders.
With few exceptions, industries worldwide are experiencing over capacity and sluggish demand. Price cutting is the result as too many competitors compete for customers. Statistics show that for the first time in decades there is general deflation in the price of goods sold, a fact confirmed by the bleak earnings reports issued by companies everyday. The communications industry is in the worst shape, as carrying capacity has far outstripped the demand for traditional phone service, wireless, and internet access. The strongest companies in the industry are struggling while the weaker ones such as Worldcom and Global Crossing are in bankruptcy. Even the pharmaceutical industry, that bastion of predictable profits, is witnessing a fall in drug prices due to patent expirations and generic competition. The auto companies are mired in a never ending price war, with GM now offering zero percent loans, zero upfront payment, and zero payments until 2003. Outside of the housing industry, investors are hard pressed to find any companies that have pricing power.
Companies have pricing power when they are the first to market a product that people want. When product cycles mature competition and production capacity grow. This reduces the pricing power of all companies in the industry. At that stage greater market share and superior distribution networks give certain companies an edge over the competition. In the late 1990’s the two main growth drivers in the economy and stock market, i.e., technology and medical companies, reached product plateaus. While production capacity and competition increased, few new breakthrough products were developed. There was some hope that new energy technologies such as fuel cells would provide the next wave of growth for the economy, but that has not happened yet. While investors wait for the next big innovations, companies are reacting to current conditions by closing plants, laying off workers, and merging with competitors.
In the most recent quarter the Dow Jones Industrial Index dropped by a whopping 18 percent. It was the largest quarterly decline for the index since the crash of 1987 and one of the largest quarterly declines in U.S. stock market history. The duration and severity of the current bear market has financial commentators and strategists referring more frequently
to the Great Crash of 1929-1932. While this market has not reached the depth of decline seen in the 1930¹s, it has extinguished any remaining bullish enthusiasm.
After the drubbing of last quarter stocks have stabilized and recovered some lost ground in recent weeks. The combination of lower stock prices and interest rates at a 40 year low has been enough to spark some buying. The challenge for investors is making specific stock selections. The median price earnings ratio for stocks is higher than it was at the market peak over two years ago. Companies with the best business prospects are selling at historically high price earnings ratios, while the ³cheaper² stocks are losing money or have poor prospects. There are not that many obviously undervalued stocks. The stock market is in more of a trading range marked by rolling declines and recovery attempts. We have adapted to the new market environment, buying after steep declines and taking some profits on rallies.
The bond positions in our clients¹ accounts gained value in the third quarter. The gain was rather large in the treasury inflation indexed bonds. Although it was tempting to take this gain, we elected to hold the bonds as the rate they pay is still better than money market funds.