Dennis C. Butler, President
of all guest columns written by Dennis C. Butler, CFA
In the classic 1950s science-fiction film Forbidden Planet, space travellers from Earth discover that an ancient, but extinct, race of supremely intelligent aliens built a machine capable of instantly producing anything they desired, merely by their thinking of it. Unfortunately for the aliens, the machine also brought into existence beings from their subconscious ids. These creatures -- embodiments of long-suppressed hatreds and animal instincts -- completely devoured the machine's creators. Likewise, our Wall Street dynamo seems to hold out the promise of producing almost anything out of thin air -- companies with no revenues or earnings, new economies with no economics and vast wealth by the age of 23. One can only hope that the monsters that could be spawned by this rampant speculation stay suppressed for a while longer.
We fear our hopes may be in vain. In an interview on the evening business news, a Silicon Valley consultant said, "If you are not investing in the Internet today, you are not investing in tomorrow's economy. Internet stocks are not technology -- they are their own economy." Our initial reaction to hyperventilation of this sort is to dismiss it as cheerleading by someone with gobs of stock to sell. But how different is this, really, from the seductive hype that so often accompanies inventions or new processes that somehow promise to bring significant change to the economy and society? One could point to the development of automotive transportation about a century ago: excited entrepreneurs established numerous auto-making concerns. However, the investor in those companies very likely would have participated to a greater extent in the new automotive economy simply by buying a car, as most of the manufacturers eventually disappeared from the scene. The same could be said for radio, television, air transport and a host of et ceteras -- not very favorable precedents for those enthralled by today's cyber promoters.
We have often looked back in amazement on historical periods of market over-enthusiasm, wondering how people got carried away with it all; couldn't they recognize the danger staring them in the face? Our observations of the present speculative binge make clear to us just how difficult it is, especially for investment professionals, to (1) recognize and acknowledge such a period when you are in its midst and (2) take the necessary, unpopular steps to avoid the eventual consequences. Pressure to conform to the accepted wisdom of the times is real and enormous. Conformity has its rewards: propelled by technology issues, the stock market averages had another outstanding year in 1999, with the NASDAQ Composite achieving a gain of over 85%. Outstanding, that is, as long as you blissfully ignore little things like the 65% of New York Stock Exchange issues that declined last year. Or the fact that only FIVE issues -- out of almost 5000 -- accounted for over half of the NASDAQ's rise.
Despite the excitement surrounding technology and a select few companies in other industries, a majority of stocks have been declining for nearly two years, crimping the "performance" of investors who choose to go elsewhere and let speculators have their party. There is a positive side to the general decline in stocks: an increasing number of nicely-run companies are selling at reasonable prices. All the investor has to do is accumulate them and wait patiently. But patience is not a virtue in the "new economy" of the twenty-first century.
Lack of patience was evident in the media attention given two investment non-conformists recently. One, Warren Buffett, has had a couple of bad years as his holdings of "old economy" companies such as Gillette and Coca-Cola declined in value while the market averages rose sharply. The other, a prominent mutual fund manager, also experienced poor results last year as he stuck to his guns and refused to embrace the new parameters pushed by Wall Street to justify inflated stock valuations. The consequences of such heresy for each were negative, although in different ways. Shares of Buffett's holding company, Berkshire Hathaway, declined 20% in 1999 -- a temporary inconvenience that Buffett probably doesn't worry too much about. In spite of an unmatched long-term record, there was also some talk about the Old Man losing his touch. In contrast, the mutual fund manager saw the assets in his fund decline by half in just over a year, seriously jeopardizing his economic well-being, if not his career.
Both investors are alike in their refusal to join in the frenzy for technology stocks. At a time when technology dominates the markets and is responsible for almost all of market index results, their policies virtually guarantee poor results relative to the indexes. In light of their mediocre showings in a booming stock market, the wisdom of this adherence to established procedures, in particular their avoidance of technology, has been called into question.
Why not buy technology shares? Theoretically speaking, nothing prevents it; but the current mania makes technology a risky proposition. It is important to understand that for Buffett and investors of his type, this question is equivalent to asking, "Why not own what is going up?" or "Why not invest in what has been successful?" In the absence of sound investment reasons for doing so, one is really asking, "Why not speculate? Everyone else is." Most of the activity in the technology sector amounts to just that: speculation. There is no sound reason to pay absurd prices for shares in companies often having scant revenues and no earnings. It is very unlikely that such businesses (if they can be called that) are worth tens of billions of dollars -- more than many well-established, household-name companies. Sooner or later, speculators lose money.
That such questions arise is, in reality, a sign of the times. It is difficult for the average observer to have patience with successful, conservative long-term-oriented methodologies when Internet stocks quintuple in a single day. It is also difficult, though understandable, for participants to gain a proper respect for the markets after several years of unusually large advances have made the markets seem "safe" when just the opposite is really the case. Thus, the entire investment process is corrupted, as people come to have unrealistic expectations about what they can achieve, financially, with their securities portfolios. This explains why most people do not do well in investing, at least over time: they are attracted to the markets in times like these when nearly everything they do seems to work well, unaware that most things work well only in times like these. In a speculative market, speculators win. Successful long term operators are aware of this fact and act accordingly. Hence, there are times when it pays to observe experienced players like Buffett, who, by all accounts, appears to be patiently awaiting conditions that are more advantageous for the investor and not the speculator.
One of the most interesting phenomena of the last several years has been the dominance of market activity by large-capitalization issues -- especially those in the technology sector. Early last year we undertook a study aimed at gaining some perspective on the phenomenon: Has it occurred before? How does this episode compare with others? The resulting paper, Index Distortions, Return Expectations and the Investment Business, was published last month by our friends at Sullivan & Serwitz, an investment advisory firm in California, in their monthly newsletter. Marshall Serwitz and Robert Sullivan may be reached at 779 Altos Oaks Drive, Los Altos, CA 94024, Phone: (650) 949-2221.
Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 23 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html.
"Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28). "Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Dennis C. Butler
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
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© Copyright 2000 Dennis C. Butler, All Rights Reserved
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© Copyright 2000 Dennis C. Butler, All Rights Reserved