COMMENTARY ARCHIVE

Market Conditions: Summer 2002 

 

I wanted to take a few minutes and comment on current market conditions. I will begin with a summary of key points / opinions. You may read the rest of this correspondence as your time and interest permit. These key points / opinions are:

(a) The stock market, in general, has declined over the past two years primarily because most stocks were over-priced the first place.

(b) Panic selling has taken over in recent weeks, as it did shortly after 9/11, and is beginning to drive the prices of some stocks to under-valued levels.

(c) The intrinsic value of Alpine portfolios remains sound, regardless of how low prices go in the short run.

(d) The stock prices of companies with sound intrinsic values will rebound and a satisfactory return will be realized.


We are in the middle of a historically severe bear market. (A bear market is defined as a period of declining stock prices – usually 20% or more from previous market highs.) Over the past 27 months, the bell-weather S&P 500 Index has declined over 35% in price. Why?

5 factors could be cited: (1) Stock prices were too high in the first place; (2) 9/11 changed the world and economy forever; (3) The 2001 Recession; (4) Bad ethics / bad accounting; (5) Panic selling. I believe the first factor is by far the most significant in this bear market thus far. Alpine stock performance is my best argument in this regard.

The inception of Alpine-selected stock performance was March of 2000. Coincidentally, this is the exact same month that the bear market started. During most of the year 2000, we paid approximately $10 for each $1 of earnings purchased, while it cost $30 to buy $1 of earnings in the S&P 500. Alpine stocks were therefore a good barometer of reasonably priced stocks, and the S&P 500 was a good barometer of high-priced stocks. The Alpine-selected stocks went up over 70%; the S&P 500 stocks went down over 35%. During this bear market, it is a fact that the stocks highest in price relative to their earnings went down the most.

9/11, recession, and bad ethics are factors which add significantly to the prevailing mood. However, recession and bad ethics are not significant economically. 9/11 is significant, but must be put in context.

A stock market decline commensurate with the economic costs of terrorism is warranted. The problem is that many of these costs are nearly impossible to quantify. For example, one must assume there will be more to come. But how much more? We take what we believe is a somewhat pessimistic view and estimate a total economic cost of $1 trillion in present value. (See http://www.house.gov/jec/terrorism/costs.pdf for a summary discussion of such costs.) While a very large figure on its own, $1 trillion is less than 10% of current US equity market value, and is not commensurate with a multi-trillion dollar bear market. As a footnote, Israel has experienced significant economic loss from terrorist activity. Yet, Israel continues to hold its position among the world’s wealthy nations as measured by gross domestic product per capita.

Recessions and bad ethics have been permanent fixtures in the history of capitalism from day one. As for recessions, the intrinsic value of a business, and thus the true underlying value of a stock, is hardly impaired because it has several years of sub-normal earnings during a down economic cycle. As for bad ethics, avoiding companies with tricky accounting, complex business models, and excessive debt loads will go a long way toward keeping one out of trouble. There is not a single major story in the news – Enron, Tyco, Worldcom, or Xerox – which wasn’t accompanied by a big red flag.

Nevertheless, the combination of these factors, irrespective of their true economic consequences, and the self-fulfilling cycle of continuing price declines has created a panic. Stock price declines have accelerated in recent weeks, not unlike the way in which they declined after 9/11, and there is no predicting where or when they will hit bottom.

A passive observer could only look on with bemused curiosity as the herd stampeded into the market in the late 90’s and as it stampedes out today. The intelligent investor, not unlike the passive observer, views crowd behavior with detachment. The intelligent investor focuses on intrinsic value – the value of the business underlying the stock price – and buys, holds, or sells accordingly.

Since intrinsic value is such an important concept, it is appropriate to take a moment to define it. Intrinsic value is the cash that can be taken out of a business over its business life. In a simplified example, let us assume a company pays out all of its cash income in dividends each year. The investor who wants a 10% return would pay $10 for each $1 in dividends. The complicating factor is that companies generally retain and reinvest some or all of their net income rather than paying it out in dividends. Therefore, it is critically important to understand exactly how a company invests its retained earnings. The key point is that, regardless of whether or not a company pays a dividend, intrinsic value can be calculated based on three measurable figures: total cash income, retained cash income, and potential re-investment rates. Our focus is on these numbers and the qualitative business characteristics – products, markets, management, and competition – that produce them.

While focusing on intrinsic value provides the most sound and practical foundation for knowing what a stock is worth, it does not protect against irrational panic selling. There is no guarantee that Alpine stock accounts will not decline in price. In fact, the guarantee is that, at some point, they will decline significantly. The key is to distinguish between irrational market fluctuations and real economic losses. Our observations on this point are as follows: (a) We are seeing irrational declines in some Alpine-selected stocks; (b) The intrinsic value of Alpine-managed stock portfolios remains sound and undiminished.

You may be wondering: How long does it take for stock prices of companies with stable intrinsic values to rebound? The all-important answer is: By the time such stocks have to be sold in order to fund spending needs. The reason we ascertain client needs, circumstances, and objectives is to properly structure a portfolio so that we don’t have to sell stocks low to raise money. Portfolio cash needs are matched with portfolio cash flows.

 

 Nick Tompras

July 2002

 


 

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