Quarterly Letter to Clients October 1999

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Quarterly Letter to Clients

January, 1999

Indices at quarter-end (December 31, 1998):

Dow Jones Industrials: 9,181.43 4thQ'98: +17.07% YTD: +16.10%

Standard & Poor's 500: 1,229.23 4thQ'98: +20.86% YTD: +26.66%

Jules Feiffer says that optimism depends on short-term memory loss. This certainly proved true in 1998.

The first quarter of the year was terrific; the second was basically flat; the third quarter was devastating. The problems ranged from impeachment of the President to the collapse of the Asian economies to hedge fund failures. Many stocks declined 40-50%. Deflation became the buzzword. The third quarter saw the Dow Jones and the S&P 500 make their second largest single-quarter percentage drop since the crash of 1987.

Then the market suffered a bout of short-term memory loss, spurred in part by three interest rate cuts in short succession. The result was a tremendous move upward. The fourth quarter brought the averages their largest single-quarter percentage gain since 1987.

But not all stocks participated: the top ten stocks accounted for more than 40% of the gain in the S&P 500. The other 490 issues turned in a still handsome, but much more muted gain in the range of 15%. The cause of this disparity is an anomaly known as "capitalization weighting". In short, each issue in the index is weighted according to its total market value. The bigger the company, the larger its pull on the average.

In contrast, the Dow Jones is price-weighted, which means that a higher-priced stock has more impact on the average than a lower-priced issue, even if its capitalization is larger. This is part of the cause of the divergence of the two averages.

But individuals, and most money managers, buy an equal dollar amount of an issue, an action known as "equal-weighting". If the S&P had been equal weighted, rather than capitalization-weighted, it's gain for '98 would have been in the mid-single digits. If we need more evidence of this effect, note that there were more losing stocks on the NYSE in 1998 than winners. And as Merrill Lynch's Bob Farrell points out, on the NASDAQ, 1,690 stocks were higher in '98 while 3,351 fell. Thus we have another year in which the vast majority of fund managers, yours truly included, trailed the averages.

Merger was the word in 1998, and "mega" was the word in mergers. Among the highlights: Travelers came home to the Citi; AT&T subscribed to cable, buying TeleCommunications; Exxon/Mobil and British Petroleum/Amoco depleted the world's supply of oil companies; Polygram danced into the arms of Seagrams (which promptly froze out Tropicana); Chrysler found a German garage in Daimler; GTE got a call from Bell Atlantic; AOL made an E-Trade and bought Netscape; and finally, several European currencies folded into the Euro.

Of course, the other big word in the market in 1998 was "Internet". A friend, and client, recently asked me why I did not buy the Internet stocks, such as America Online and Yahoo. My response was that I am an investor, not a gambler. These stocks command P/E multiples of 300 to 600 (when there is an E) and sell at multiples of sales that boggle the mind. Once you have something to lose, you no longer have the desire to wager it on such dicey propositions. My friend persisted, saying that there has never been anything like the 'net. I countered that I remembered several such manias, that I remembered (this is not a joke) when fried chicken was a big stock market craze. In the 60's and 70's companies were tagging "compu-" or "-tronics" to their names and experiencing the same sort of moves that ".com" is creating today. Many of those companies are no longer in existence.

While I do not doubt the viability of the 'net as a medium of communication, advertising and commerce, I am not comfortable paying such multiples in the hope that several years in the future these companies will attain the revenues and income that might justify today's prices. Several other of my clients have voiced agreement.

Slow and sure wins the race. My methods may not always produce flash, but they are not likely to blow up, either. In 1999, as always, I will continue to seek out investments that are reasonably priced, that hold promise of future growth, and that exhibit sound balance sheets. I remain confident that this strategy will produce attractive returns over time.

Jim Pappas