Lower Standards – April 1998

April 18, 1998

Dow Jones Average: 9167
S & P 500 Index: 1123


Lower Standards

The report card on corporate profitability was dismal for the most recent marking period. In rapid succession Compaq, Intel, IBM, 3Com, Oracle, Seagate, and a host of other technology companies announced declining earnings. Profits in the energy sector were squeezed by low oil prices. Consumer product companies, such as Coke, were hurt by the weakness in foreign economies. While there were a few bright sectors, earnings growth was slow to non-existent for much of corporate America.

A decline in stock prices would have seemed logical, given the disappointing corporate news and a deepening economic crisis in Asia. But after a shaky start in January 1998 the market soared to new heights. An essential characteristic of bull markets is the relentless climb of stock prices in the face of bad news. When investors are in a bullish, buying mood they shrug off bad news and assume that things will get better for companies. In bear markets the reverse is true, good news is discounted because investors are fearful that it won’t last.

When investors make large investment returns the tendency is to expect and desire more of the same. Rising account sizes create a sense of satisfaction and well-being, instilling a passion for stock buying. Eventually the desire to buy clashes with the reality of generally overvalued stocks, not worth buying by any historical, mathematical, or logical measure. The only way investors can justify continued stock purchases is by sharply lowering their standards and expectations of company performance.

Companies that were once considered average are currently receiving an outstanding grade from investors. Companies that are clearly failing are now passed along to higher levels by lenient investors. The urge to admit new companies to portfolios is so strong that almost all companies regardless of results are accepted.

The much maligned standards and expectations in our education system look high when compared to standards currently applied to stocks. Investors are receiving a one percent dividend return from the average stock. This is a paltry return compared to any period in the past, but obviously satisfies today’s investors. Stocks priced at 40 times earnings used to be rare, the top of the corporate class. Only a handful of companies able to achieve rapid consistent growth of about 40 percent annually would sell for such a price/earnings multiple. In the current market environment companies growing at a mere 10 percent per year are now receiving a top price/earnings ratio from investors. When investment standards go up again, many stocks that are currently passing will become failures as investments.


Current Strategy
Every stock we have bought for clients has gone higher than we thought possible. While we expected a good return from our carefully chosen group of stocks, the actual returns have grown to unexpected and somewhat unwarranted proportions.

Our key holdings continue to benefit from a relative valuation advantage. In the technology sector IBM is still relatively cheap when compared to other technology companies. The NY Times is somewhat less pricey than the newspaper group. Helmerich & Payne is a relatively inexpensive choice in natural gas exploration, and Intuit is one of the less expensive electronic commerce companies. In an up market, stocks that are relatively undervalued attract investors. In a down market, relative valuation is a shaky prop at best.

While we like the prices of our holdings relative to the overall market, we are much more focused on the absolute progress at the companies we have chosen. It is real, tangible improvements, earnings power, and cash that over time provide a solid floor under stock prices. So far we are very pleased with the progress at almost all the companies we have purchased.

Buying new positions is our toughest challenge in this high market. We are determined to keep our standards high for new stock selections even as most investors are lowering their standards. It takes far more research to find anything that meets our standards in the current market. We have increased our buying of bonds, both as a defensive and income producing measure. After taking huge gains on positions such as Bankers Trust and IBM it seems prudent to secure some of that progress.

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