Final part of interview:
Goldilocks exists, and that
their mutual funds can consistently produce 25%-35% annual returns. The
[accompanying] chart of the S&P 500 Performance Percentile Ranking puts
the market's performance in its true historical context and shows that we've
recently enjoyed a level of price performance we've seen in only three prior
periods since the 1920s -- two of which turned out to be very bad times to be
buying stocks.
Q: What exactly are you charting?
A: We calculated the one-year rolling returns for each month from January
1927 through March 1998, for a total of 855 observations. We then assigned
a percentile rank from zero to 100% to each month based on its 12-month
return. And we further applied that approach to the two- through 10-year
periods. Then we took all the percentile rankings that this process produced
for each month and averaged them to calculate the specific month's return
ranking. When you do that, lo and behold, this chart just stands out as an
eye-opener. What it shows is that the market has been at this level of excess
performance only four times in the last 73 years: In that whole period
surrounding August and September of '29. At the end of 1955 into early '56,
in July-August of 1987 -- and now. So for many managing money now, this is
a first-time event. For most of the rest of us, it's a second-time event. I
remember '87 very clearly. But I don't remember '55 too clearly and I don't
think a lot of money managers do.
Q: What does this tell you?
A: The statistics say that March's market returns were in the top 1.2% of all
returns since 1925. By definition, that's a very rare performance. What does
that portend for the future? The short and easy answer is "nothing very good."
The market has performed this spectacularly in a total of only 10 months --
and eight out of 10 times, over the next 12 months, it has fallen, by an average
of 13.54%. And the median decline was 9.2%.
Q: But what about those other two great months? We don't remember
the mid-1950s either. But the history books tell us that was a good time
to buy stocks.
A: Yes, depending on whether you measure from August or November of
'55, the market was up 8%-12% over the following year. But there were
substantial differences between '55 and now. Interest rates were at half the
current level of ours. Inflation was actually negative. The economy was in the
early stages of an expansion, as opposed to 85-86 months into one. And
valuations were substantially lower, with P/Es in the 10-14 range. The yield
curve spread looked good. So performance in that stretch was exceptional,
but you didn't have a lot of negative economic factors lining up against the
market. Clearly, the economic landscape was different then, so it's difficult to
say what these observations mean. But it's easy to say that if we had interest
rates and P/Es lower by half, and negative inflation, the market would have a
lot more room for error than it has now. I'm not predicting a '29 crash
Q: That's a relief.
A: It's impossible to easily compare today's market and economy to 1929's,
due to lack of data. Nonetheless, it's interesting that some events incredibly
similar to today happened in the late 1920s.
Q: Such as?
A: How about the world's second-largest economy -- which was Germany
back then -- never fully recovering from the '20-'21 recession, struggling for
the rest of the decade and then just falling apart? It was the precursor to the
Crash. Today, Japan has never recovered from the slowdown of '89-'90. It
has had its market go from 40,000 to 15,000. It's still struggling. The
comparison is a little eerie. So while we're not predicting a rerun of 1929, we
do feel that today's circumstances are more parallel to '29 and '87 than to '55.
And if so, defensiveness is clearly in order.
Q: So you've gone to cash? Or you're digging a bunker?
A: People ask me, "Are you going to tell me I want to own T-bills at 5%?
Are you nuts?" My answer is that if you study history you find that just before
the market has turned negative, cash was always perceived as a terrible
investment -- until after the fact.
Q: Cash is trash until it's not.
A: Right. And it will be king again. I can't point to the exact trigger. But the
risks are high enough here that the market is extremely susceptible to the
downside.
Q: You see the bottom just dropping out of the market?
A: My gut says, for a bunch of different reasons, no. I suspect it will be more
like the classic bear markets of the 'Seventies, which are more corrosive than
dramatic. Particularly because we are structurally set up to prevent a sharp
decline, with all the recurring funding of IRAs, 401(k)s, etc. It may take longer
than I think to happen. Maybe six to nine months. We could get a decent rally
from here. But unless the underlying evidence of a change in the
macroeconomic trend evaporates, the market will have to start discounting a
downturn over the next year and a half.
Q: Surely your hedge fund isn't 100% in cash -- how would you justify
your fees?
A: No. But I tend to be a more aggressive investor than most. So I want to
be short a number of stocks. Particularly, companies that have a large global
presence they can't hide, that are capital intensive and don't have good pricing
structures. That's going to be a tough row to hoe. I'm not one to just take all
my money out of stocks, either. But if I'm a buyer of stocks, which I am,
those stocks have good domestic franchises, niche markets where they don't
have a lot of competition, good growth rates. And I buy them at a discount to
those growth rates. If we do get a corrosive bear market, you will find
analysts looking for new ideas for people who have exposure to stocks when
the bad news hits.
Q: Something they can sell as "recession-proof."
A: Even though very few things truly are. Anyway, I think the key will be to
avoid the big-cap, flat-revenue companies.
Q: Small-caps usually get killed in a recession, too.
A: You're right. But I'm not sure it's going to be that bad yet. It may be that
our economy merely stalls, we end up growing at a half-percent and never
have a recession. The market would still adjust to that pretty significantly. But
small-caps, you might recall, did pretty darn well in late '90, after the
recession ended, through '91 -- even though the economy barely grew. And
there are some small-caps that have been beaten up pretty much over the last
six months, so you can buy them at reasonable valuations, and their growth
rates aren't likely to disappear in a big hurry.
Q: But your portfolio is more short than long?
A: I'm actually pretty heavily net short in the hedge fund. I'm about 30% long,
about 70% short. For the people for whom I manage money in a more
conservative fashion, I have a much more conservative allocation. Only about
30% stocks, about 30% bonds, with the balance in cash.
Q: How about a specific example of what you're short?
A: On the negative side, I don't like stocks like United Technologies.
Q: You have something against old conglomerates?
A: I have a hard time seeing, in a slowing economy, how elevators, air
conditioners and aircraft engines carry it substantially higher. The stock has
had a tremendous run. Pratt & Whitney is a great business. I have no problem
with the company or the management. I want to make that clear. But I do
think that when the wind is in the face of a business model, no matter how
good they are, they can't escape that fact. And the stock price will reflect that.
So, when you are looking at a company selling at approximately 21 times
earnings, with revenue growth in single digits, essentially, and with two of its
units starting to show signs of slowdown -- and I think the aircraft business
will slow, too -- it's hard to see how you sustain a 21-times earnings multiple.
I think it trades more reasonably at 14 times earnings. And future earnings
may be lower.
Q: So the catalyst will be what? An earnings disappointment?
A: I know Wall Street is big on "catalysts," but my view is that there are
always some stocks advancing, some declining. I've always felt that picking
shorts is not an issue of looking at a specific stock and saying, "Here is the
thing that's wrong with this company." Rather, it's an issue of looking at the
business model and how it fits into the macroeconomic environment. You can
see my point in Citicorp. John Reed, in October of 1990, was seen as an
idiot. Now he's seen as the hero of banking. What has changed? I would
argue that what changed was the environment for banking. It became
extremely positive. In that environment, John Reed may be wiser today --
Q: But he's certainly richer.
A: A lot. But is he fundamentally a hugely different guy than he was at the
bottom of '90? I would say no. It's just that the wind has been at the back of
his business model. He did what was necessary to carry the ball forward, and
the result was a valuation expansion. But I think we're again moving into an
environment where banking is going to be a tough business, so I don't like the
bank stocks here. And while John Reed is a very capable manager, I don't
think he can make progress in a truly tougher environment for banking.
So the kinds of companies I'm short aren't these concept stocks or story
stocks, because gosh knows what they're worth. I look for stocks at all-time
highs, with rich valuations, in businesses where I think the macro environment
is turning against them. In a case like Citicorp, you probably won't get hurt a
lot in a short and you probably will make some money. Or if you already own
it and sell it, I think you'll be able to buy it back at much lower prices.
Q: So Citi and Travelers are ringing a bell?
A: Let me put it this way: Almost no one remembers anymore, but when was
the last time Citibank made a merger announcement that attracted worldwide
attention? The answer is in 1929, when it was the First National City Bank
and announced its deal with the Corn Exchange. I think it was on September
19, 1929, amid a big wave of bank mergers that all came crashing to the
ground. So I personally see the merging of Citi and Travelers at the top of the
cycle as a very negative sign. A flat yield curve spread is not good for banks.
Nor is a slowing economy. Or debt problems in the Third World. So I'm very
negative on banks selling at 20 times earnings.
Q: What's a small-cap that's caught your eye?
A: I'll mention a couple of ideas. A company that I think has very interesting
potential is Dset Corp. It provides telecommunications network-management
stuff, software. With the explosion in the telecommunications industry, with all
the new services, new companies and new combinations of companies, not
surprisingly, how you integrate all this has become an issue. Dset is a leader in
providing communications software designed to work carrier-to-carrier, or
equipment maker-to-carrier. Designed, in essence, to create some sense in
the software around it. The IPO was actually at $16 or $17, the stock ran up
to $22, then all the way back down to $13. I think the company has clear
growth capability in excess of 50%. People need their software for
productivity, to understand what they have. They can't afford to just put all
these pieces together and hope that it works. So this company has inherently
high gross margins. Historically, 85%-90% gross margins. It's a money
machine with a high growth rate, and regardless of how quickly the economy
declines, I don't expect any lack of demand for the product. Now, the
valuation on the stock is still high, but so is the growth rate, and I don't think
there's huge downside in the stock.
Q: What's your other example?
A: Another stock that has run up a bit, so I liked it better -- like everything in
life -- at lower levels, is ICU Medical. They manufacture and sell disposable
medical connection systems used for IVs that are designed to prevent
accidental disconnection of the IV. They have a needle-less, disposable
product that prevents blood from splattering or backing up into the IV.
Patented products, a tiny market. But it could dominate that market with these
very innovative new products. They are reasonably priced, they've got good
distributors.
Q: Isn't it tough to compete with the commodity-priced old standards in
today's cost-conscious medical markets?
A: Except that they offer superior features that address real contamination
issues. Their products, relative to the competition, are priced better and work
better. And they are actually cheaper for the hospitals to use, they've found,
because they keep other pieces of equipment from being contaminated. The
company has been growing its revenues at about 30%; its earnings, at about
25%. The stock sells today at about 20 times earnings. On dips, I would
argue, you could buy this thing at 16 times trailing earnings. And they don't
have any really good product competition. It's a small enough market that
none of the big guys want to build these things. They've got a new factory
they're not running at 100% of capacity. They've got to increase their sales
and marketing spending some. So there are some issues, but you're buying it
at less than its growth rate.
Q: Thanks, Joe. |
