Dennis C. Butler, President
Centre Street Cambridge Corporation
Private Investment Counsel
of all guest columns written by Dennis C. Butler, CFA
Everyone by now has seen the newspaper advert run by a national brokerage firm that begins with the admonition: "In todayís market doing nothing could be risky." Since we are sometimes guilty of "doing nothing" for months on end, the classic Three Stooges line "I resemble that remark!" immediately came to mind when the piece first came to our attention. Curiously, though, we donít feel that we are going out on any kind of limb through our sloth. Be that as it may, letís continue our look at the advertisement. The firmís chief executive writes (of the market "correction"): "I donít believe it will go on forever." Well, isnít this insightful. We are reminded of the story of one of the "stock operators" of old who, when asked if he thought the market would go up, said: "It always has." Trying to reassure customers during a trying period (and, no doubt, stimulate a little trading), the CEOís commentary continues with the usual drivel about "diversification" and asset allocation to help construct a portfolio "better prepared to weather market changes." We hate to be unkind, but isnít it a little too late for that? Furthermore, whoís to say the new portfolio will be any better prepared to meet the next market change than the old portfolio was for the last? The business of investing is by its very nature volatile and unpredictable. Those who are unmindful of this fact and fail to approach the pursuit in the consistent and systematic fashion it requires will be doomed to fighting the last war and, sadly, not being able to take advantage of the opportunities generally introduced by the same "market changes" responsible for the kind of confusion and disarray that, apparently, has terrorized some market participants during the last eighteen months or so.
Most market indexes showed negative returns of 3 to13% through the end of the yearís first half, so itís not particularly surprising that Wall Street firms are trying to be comforting. Yet those are headline numbers; in reality things arenít so bad. The Wall Street Journal reported at the end of May that most of the $3 trillion loss in equity market value since early last year was due to a few big technology stocks (the mirror image, by the way, of what was happening during the big index gains of the late 1990s). The rest of the market isnít in bad shape; on the contrary, ex the techs the remaining issues in the Standard and Poorís 500 index actually rose almost 6% in 2000 (versus a reported 9.1% decline for the entire index) and were up slightly through May, 2001.
The Sluice Gate
"Internet Time": a term used in the late 1990s to describe the accelerated pace of business decision-making and transactions brought about by modern communications technology. The term was also used to describe the rush by venture capitalists to fund new technology companies and shepard them to the public marketplace as quickly as possible. Heady were the days when the colossal appetite, among stock market participants, for anything having to do with technology meant spectacular returns for venture funds and their promoters. As we know, that game came to an end a little over a year ago and since then over 550 of the flimsier start-ups, the "dot-coms," have closed their doors and websites forever. Venture capital firms are now hurting, their funds stuffed with premature companies hungry for cash. Unfortunately for the companies, the V.C. guys are back to doing old-fashioned "due diligence," meaning they are actually giving business plans, prospects and managements a good, hard look. This makes them less likely to fund just any old start-up at the extravagant levels seen a couple of years ago. Entrepreneurs now have to accept lower valuations for their companies. All of this is, of course, small comfort to those who bought these stocks in the days when possibilities seemed boundless, who are now poorer for the experience.
This -- the latest in Wall Streetís recurring boom/bust cycles -- raises interesting questions about the important economic role played by the stock market in capital allocation. According to textbook theory, securities markets serve to distribute a societyís aggregate savings into the most promising channels where they will earn the highest returns. If that is the case, why is it that so many of the people who participate in the public markets -- savers and investors, individual and institutional -- seem to lose so much money in the process while a relatively small number of insiders and bankers make out like bandits? Are there capital providers who benefit from this system? For the investor in the public markets, these are obviously issues of some importance. To answer these questions we must first know something about how the system works.
The mechanism through which markets operate to apportion resources is the "price signal." Strong price action (i.e. high and rising prices) attracts the interest of economic actors eager to invest capital in sectors where it will earn the greatest return. Weak prices are a signal for these players to avoid an area. It is a straight-forward process and occurs in all kinds of markets. By way of example, the Financial Times reported recently that jute growers in India and Bangladesh are producing bumper crops in 2001. Scarce supply drove prices of the commodity to ten-year record highs in 2000. Farmers reacted by increasing acreage by over 20% in the expectation that ample demand would absorb their larger output at prices more than sufficient to cover their additional investments in labor, land, and other agricultural inputs. That and favorable growing conditions have increased the prospective supply and prices have already begun to fall back. Thus are societyís needs met by market action involving price signals stimulating an appropriate response.
Financial markets are no different: high and rising prices attract money seeking the highest return and stimulate a greater supply of securitiesóthe stock and bond issues which provide funds for expanding enterprise. The most significant role of the public market for securities (The New York Stock Exchange, NASDAQ, etc.) in this scheme is one of price discovery -- creating the price signals sought by providers of capital. With the assistance of Wall Street firms and encouraged by companies themselves, market participants seek to purchase shares in the most promising businesses, thereby driving up their prices. High and rising prices in themselves tend to attract even more buyers, resulting in still higher prices, and so on. This action draws the attention of players such as our venture capitalist, who may use the opportunity to float shares of a new company in the same industry as one favored by the public markets. An established corporation, noting the positive attitude toward its prospects that is reflected in the market for its stock, may jump at the chance to raise additional capital by selling newly-issued shares at favorable prices.
The role of the markets in price discovery carries important implications for investors, especially if they are participating in initial public offerings (the sale of shares in new companies) or in "secondaries" (the sale of newly issued shares by an existing public company). Very seldom are the public markets the source of direct investment in enterprises. These are so-called "secondary markets" where shareholders trade amongst themselves and typically not with the corporations whose shares they own. Corporations raising capital actually sell their securities through intermediaries. Established corporations contract to sell shares to an underwriter (investment bank) which in turn sells the stock to the public at a modest markup. New enterprises often follow the venture capital route for financing.
The situation with venture capital is based on the same principle, but operates somewhat differently. Venture capitalists provide funds and other types of business assistance to start-up companies which they view as having promising prospects. Here the allocation of capital is a private operation. But this private process is in many if not most cases predicated upon a so-called "exit strategy" reliant on selling shares in the public markets. (It is important to note that because of the risks they are taking, venture capitalists expect to sell their interests in companies at a very large mark-up over their entry prices) Here again, the ability to sell shares in these relatively new enterprises depends on a strong market -- high and rising prices -- for similar companies. Now presumably the venture capitalist brings companies through a maturation process which ensures that the firms which do become publicly traded stand a reasonable chance of continued success. Nevertheless, the failure rate is high even during normal times (for every Microsoft there are literally hundreds of failures or, ultimately, mediocre companies). In the midst of the technology initial public offering boom of the late 1990s, start-ups came to market very quickly (without benefit of maturation in many cases), taking advantage of the strong public market demand for dot-coms and the like. As noted above, such firms have failed at an unusually high rate.
The public markets, therefore, are an indirect source of the capital that funds enterprise -- participants purchase securities from the direct providers (venture funds and underwriters, in our examples) thereby permitting the direct providers to earn their desired return on capital. In these transactions we see another important role for the public markets in the capital allocation process which is to facilitate the distribution of securities by interested sellers. Herein lies the problem for the public investor and the cause of so much disappointment. Interested sellers (as distinguished from "distressed sellers") almost by definition are those seeking to take advantage of elevated prices to dispose of their inventory of securities. For those of us who have observed such operations over a period of time, the marketís role as a "cashing-out" mechanism is all too clear.
When all is said and done, this system probably allocates our societyís capital better than most, even with the built-in inefficiencies and waste. Inefficiencies and waste are, afer all, part of life itself -- you try many things and hope that one or two work. The lesson for investors with limited capital for such experiments is that it behooves them to exercise special care, understand how the game works and learn to take advantage of it. They should learn to play their own role in the distribution system for securities. Like venture capitalists, investors should be seeking "entry points" at low valuations in situations with reasonable, if not brilliant, prospects going forward. Unlike venture capitalists, investors rarely can have an influence on the operations of their companies, so they should plan their "exit strategies" accordingly.
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. 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:
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Revised: October 24, 2001 TAF
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