Equity Market Strategy - Deja Vu All Over Again?

Yogi Berra, the famous New York Yankee catcher and man-ager, once remarked “It seems like deja vu all over again.” The formula for big gains in stocks so far this year has been simple, straightforward and very scary. The big gains have come from owning stocks in companies with uncertain futures. These companies have low or negative cash flows, low returns on equity, low dividend yields, excessive capital spending, high price-to-earnings ratios (P/E ratios) and high betas. These struggling companies so far this year have included technology companies such as Corning (+172%), Nortel Networks (+154%), PMC-Sierra (+131%), Juniper Networks (+120%), EMC (+103%), Network Appliance (+97%), Lucent Technologies (+78%) and airlines such as American Airlines (+70%), to name just a few. Not long ago, all of these companies were trading below $5.00 per share, a mere fraction of their lofty highs in the era of the tech bubble.

Looking at the characteristics of these year-to-date market leaders, one cannot help but draw comparisons to the late 1990’s. All of the companies mentioned above either have extremely high P/E ratios, such as Nortel and EMC at 136 and 78 times 2003 earnings estimates, respectively; or have no P/E ratio, such as PMC-Sierra, Lucent Technologies and American Airlines, because of negative earnings per share. They all have very low or, in most cases, negative free cash flows, with very low or negative returns on capital. “Seems like deja vu all over again.”

Historically, companies that provide superior investment returns over the long term exhibit attractive returns on capital, discipline in capital spending and research and development, positive cash flows, strong earnings growth prospects and attractive valuations. Companies that have these positive characteristics have not been the market leaders this year. This situation is not likely to last. Market strategist Steve Galbraith put it best: “We somehow suspect Ben Graham never started his class with: ‘Folks, the way you make money in stocks is by buying the garbage’.”

Certainly, there are a number of reasons to be positive on the outlook for stocks. However, there are a few areas of concern. The current environment for investing in stocks can be outlined as follows:

• The US economy should continue to gradually and modestly improve. Consensus estimates for real GDP growth in the second half of 2003 are approximately 4.5% at an annual rate.
  
  
• With the improvement in the economy, coupled with cost cutting and productivity gains, we are seeing improvement in corporate earnings. Earnings on the S&P 500 are on track to be up 9% this year with consensus estimates of a 10% increase in 2004.
  
  
• We’re not likely to get clarity on the job front until late Spring 2004. The risk is that this recovery, should it remain essentially jobless, could become stalled resulting in a more reticent consumer, which, in turn, could hurt corporate earnings growth and stock valuations.
  
  
• Business inventories have been falling during the summer months. While giving a temporary boost to firms’ returns on equity, if the economy continues to improve, rebuilding inventories would result in the need to expand hiring, thus accelerating the recovery.
  
  
• The current low interest rate environment reflects an absence of inflation and has allowed consumers to restructure their balance sheets and lower their borrowing costs. This is a positive for further growth in consumer spending. The Federal Reserve continues its deliberate policy of growing the money supply at high single digit rates demonstrating its commitment to fight deflation, which is a positive for stocks.
  
  
• The net effect of the Federal tax cuts will be a positive for the consumer and, ultimately, for corporate earnings.
  
  
• A fair amount of good news has been priced into stocks. Although valuations are relatively high, with the P/E ratio on S&P 500 earnings at 19 times 2003 earnings and 17 times 2004 earnings, these valuations are not untenable given the improvement in corporate earnings, the economy and the low interest rate environment.

Our focus is on staying away from the “garbage” by pursuing companies with positive fundamentals and attractive valuations. While there are risks in the current market, we believe that on balance the outlook for stocks in the year ahead is more positive than negative. We believe the difference in the next 12 months is that the higher quality companies, as measured by positive cash flows, strong returns on capital, increasing dividends and healthy earnings growth rates, will begin to dominate some of the “garbage” that has lead the market recovery so far this year. For us, “deja vu all over again” means a focus on what has worked over the past 20 years, not the past 20 weeks.

The run-up in the market has provided us with an opportunity to take profits in certain holdings. At the same time, we have identified new opportunities and have made timely additions to the portfolios. While market valuations are currently somewhat stretched, we continue to follow our discipline, look for opportunities to put cash to work, and to improve the structure of our clients’ portfolios. Our focus continues to be on identifying attractively priced companies with high returns on capital, positive cash flows and solid earnings prospects, with shareholder-oriented management.