November 25, 2003The sequel is never as good as the original – remember Rocky II? What we always learn is that you should never try to remake a classic. You would think investors would remember this and would avoid trying to create a sequel of The Great Stock Market Bubble of the 90s. However, judging by the performance of the stock market this year, it appears that some investors have very short memories (or never get to the theater.) Consider the following: Through 10/31/03, the S&P 500 had appreciated an impressive 21% for the year. Yet, the best performers have been low quality, volatile “growth” companies that do not pay dividends and are not currently earning a profit. In addition, the best performing sectors are those with arguably the worst fundamentals. Sound familiar? It should, because this is the same phenomenon that occurred in the late 1990s. We all know how that story ended. Is this sequel doomed to end the same way, or will Rocky beat Apollo Creed this time?
First, it’s constructive to cite the differences between Bubble I and Bubble II (i.e. today). During Bubble I the trailing 12-month price to earnings (P/E) ratio for the S&P 500 reached a peak level of 30x, vs. a P/E ratio of only 20x today. Put another way, at the zenith of Bubble I investors were paying 50% more for a dollar of earnings than they are today. In addition, at the peak of Bubble I the U.S. economy was at the tail end of an 8-year expansion and the Federal Reserve had raised the Fed Funds rate to 6.5% in order to slow down the overheating economy. Today, the U.S. economy is just beginning to show legitimate confirmation of the long-awaited recovery from the 2001 recession. The generous 1% Fed Funds rate has been instrumental in getting the economy back on track. Also, tax cuts have resulted in much lower tax rates on income, capital gains, and dividends than those in place during Bubble I. Finally, the stock market was coming off an unprecedented 5th straight year of 20%+ gains when Bubble I burst, while today we are in the early stages of a rebound from the worst bear market in 30 years. As a result, it’s clear that the broad market today is much healthier than it was at the peak of Bubble I. Long-term investors should feel confident in dedicating a significant portion of their investment portfolio to stocks. However, not all stocks are created equal.
This leads us to a discussion of the similarities between Bubble I and today. During 1999, the technology sector gained 77%, vs. only 21% for the entire S&P 500, while the P/E ratio for the tech sector reached an astronomical 63x. Technology stocks have had a similar run during 2003, gaining 41% through October 31st, vs. only 21% for the S&P 500, while carrying a P/E ratio of 40x. Another characteristic of Bubble I was that investors aggressively overestimated corporate earnings prospects and paid ridiculous prices for companies that were not earning a profit. As illustrated in the graph above, the same mad rush to buy unprofitable companies is occurring today. Solid, well-managed, and profitable companies in the energy, consumer staples, and basic materials sectors were shunned in 1999 because they lacked sizzle. In stunningly similar fashion, investors are ignoring these same companies today. The key similarity between the two periods is the extremely large appetite for risk displayed by investors. When sentiment turns sharply positive, investors often discard normal risk management techniques and gravitate toward stocks with the greatest upside potential. However, such stocks generally offer the most downside risk as well.
Following the bursting of Bubble I in March 2000, “old economy” stocks in boring industries such as energy, consumer staples and basic materials came back into favor while “new economy” tech stocks crashed. Investors finally realized the folly of their ways and began to pay attention to valuation and earnings, resulting in significant relative outperformance for “old economy” companies over the next 3 years. We believe a similar transition in performance is likely to occur following Bubble II. The best performers this year have been low quality, high beta, small market cap stocks. The surge of capital into such names has been driven by the huge amounts of liquidity provided to investors courtesy of low mortgage rates and tax cuts. Now that this rush of liquidity has subsided and valuations have reached excessive levels in certain parts of the market, we believe investors will return their focus to companies with solid fundamentals, strong earnings prospects, and reasonable valuations. In addition, we expect investors to finally recognize the value in the new 15% dividend tax rate, thereby bringing high dividend yielding stocks back into favor. These anticipated trends play directly into Westwood’s strategy.
As an example of the disparity in the market today, let’s compare technology to energy. We can see that investors have fallen in love again with the technology sector, driving tech stock prices up 41% this year (indicated by red line in graph above.) On the other hand, energy has become the ugly stepchild, rising only 8% (blue line above) – much less than both the tech sector and the S&P 500 (green line above.) Does this variance in performance make sense? Not when you consider that technology is a sector where there is excess capacity, with more on the way, and where companies burn through cash. In contrast, energy is a sector with under capacity, extremely high barriers to entry, and companies return free cash flow to shareholders in the form of dividends. Furthermore, energy sector earnings have grown a whopping 72% in the past 12 months, have accounted for almost 1/3 of total S&P 500 earnings during 2003, and the stocks trade at an attractive P/E ratio of 13x. Just as they did following Bubble I, we believe investors will recognize discrepancies such as this and begin to seek out undervalued companies in “old economy” industries.
Now let’s look toward the future. During 2003, economic growth finally recovered from the 2001 recession. So far, this recovery has been accompanied by rising stock prices, a declining dollar, benign inflation, and increased investor optimism. As the year draws to a close, it’s commonly believed that the Fed will raise interest rates next year, the Bush administration will maintain its weak dollar policy in order to stimulate economic growth in an election year, and continued excess capacity across the economy will keep a lid on inflationary pressures. Which stocks will perform best under this scenario? The best bet historically in this type of environment has been to own companies with competitive advantages, some degree of foreign exposure, and healthy balance sheets. Such firms have the ability to grow earnings in the absence of pricing power, to benefit from the weaker dollar via revenues denominated in foreign currencies, and aren’t likely to have margins squeezed by higher debt costs. Westwood has not strayed from its focus on companies with these high quality attributes. Our disciplined process, which emphasizes healthy balance sheets, solid earnings growth & cash flow, and above market dividend yields, has historically given our clients the opportunity to prosper over the long term.
Bubble I ended in a bear market of epic proportions. We do not expect the same to happen in today’s market. In fact, we believe equities currently offer the best risk/reward trade-off of all major asset classes. However, certain segments of the market are due for a pullback. Investors who have forgotten lessons learned from a few years back and have loaded up on the stocks of low quality companies with no earnings will likely be disappointed if they fail to see the light soon enough. Just like in the movie sequel, Rocky will win this fight, but a lot of folks are still betting on Apollo Creed.
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ã 2003 Westwood Holdings Group, Inc. This information is provided for clients and prospective clients of Westwood Management and Westwood Trust, hereinafter "Westwood" and their employees. It is not an offer or solicitation to sell securities. The information provided here is copyrighted by Westwood and may not be used without its permission.
