The importance of a proper sell discipline

We have written extensively about what we believe investors should look for in a business before they commit their own capital to that business.

In posts such as "Beautiful Growth Companies" parts I, II, and III we explained some of the criteria we look for in determining whether a business fits our definition of a "Taylor Frigon growth company."

Today we will discuss a subject that is equally as important to investors: how to determine when a company that you own is no longer a growth company. In other words, we will examine the proper sell discipline for a business in which you have invested.

Not only is the sell decision a difficult decision, but it is -- in our experience -- one that is fraught with pitfalls. It is perhaps easier to make an investment error around the decision to sell than it is around the decision to buy.

This is because a company you sell is -- unless you are shorting the company -- by definition a business you have already bought, which means that you have determined through extensive due diligence that it is a business that you would like to own. It is important not to be "hasty" in reversing that decision and thereby robbing yourself of participation in future growth based on an event or condition that turns out to be short-term in nature.

On the other hand, if that company no longer meets the definition of a growth company, it is critical that you identify that as soon as possible, so that you can deploy your capital somewhere else with greater business prospects.

While we have written extensively on the matter of not selling a growth company because of temporary market-driven events (for example in this previous post), our investment process is not a "buy and hold" strategy. It is very easy for those who speak out against the folly of trying to time market cycles to be falsely categorized as someone who believes in "buy and hold forever."

However, the distinction is that we believe that a sell decision should be made based on business indicators, rather than market indicators. We have written about this distinction in a post from January, 2008 entitled "Remaining calm without being blind or obstinate." In that post, we made several important points that bear on the current discussion.

First, we noted that companies have life cycles just as people do, and that owning a company in its growth phase is not only more profitable than owning it during its mature phase, but can be less dangerous as well -- something many investors do not realize. This understanding of the life cycles of companies shows that "buy and hold" is a flawed strategy, because it is simply not realistic. A look back at history and at the record of companies that were once thought to be "bulletproof" proves that point.

Second, we noted that research seems to indicate that the "lifespans" of companies may be growing shorter in recent decades. Thus, while "buy and hold forever" was never a sound strategy, it might have been possible to safely own some companies in the past for two or three decades (a fact which may have contributed to the concept of "buy and hold"). Today, that time period may be much shorter, and the necessity for vigilance even greater than in previous generations.

For all of these reasons, the sell decision requires great judgment and diligence. It is perhaps an area in which extensive experience is most helpful, in order to build the kind of judgment that only comes from years of observation, as well as from reflection on past mistakes. We will briefly outline some the principles underlying our own sell strategy.

We have often used the expression "a well-run business positioned in front of a fertile field of future growth" to describe a company that may meet the definition of a growth company. We would state right at the outset our belief that a good sell discipline is the product of a good buy discipline: when a company no longer meets the buy criteria, it is important to revisit your thesis and determine if it is time to deploy your capital elsewhere.

We can characterize the reasons a company might no longer be a growth company into three areas:

1. It gives an indication that it is no longer a well-run company.
2. Something happens to close off its field of growth.
3. The company pursues its field of growth to the extent that it fills it up.

A change in company leadership requires a re-examination of the situation to determine whether the business still fits the definition of a "well-run company," as would any serious leadership missteps. Likewise, a new paradigm shift might arise that suddenly alters the business landscape and replaces the paradigm shift the business was pursuing. Both of the first two categories require that the investor remain aware of what is taking place at the business itself, and within the business landscape of the company.

Barring one of those two changes, however, the company will eventually fall into the third category. Determining when it begins to do so requires a clear picture of two factors: the size of the field of growth, and the size of the company.

At some point, even a well-run company that has been exploiting a wide field for business growth will grow to the point that it has run out of open field. At this point, it can be called a mature company rather than a growth company. It may certainly continue to be a well-run business, and it may continue to achieve incremental growth, but barring the development of a new paradigm shift which creates a new field for above-average growth, its growth rate will be more in line with the rest of the economy.

The point at which a growth company rolls over and becomes a more mature company will vary from company to company and from one field of growth to another.

We will illustrate using a company that we owned for much of the decade of the 1990s, and sold in the year 2001 because we determined that it no longer fit the definition of a growth company, payroll processing company Automatic Data Processing, or ADP.*

During the 1990s, ADP was taking advantage of a tremendous field of growth, which was created by their innovative application of new technological capabilities (brought about by the proliferation of computing power) to solving business needs that had previously been solved using time-clocks, punch-cards, manual payroll processing, and other systems that had developed when computers were still nonexistent, or so expensive that they could not be used for such mundane tasks.

The company had strong and steady earnings growth throughout the 1990s. In fact, by 1999 the company had amassed over 150 consecutive quarters of double-digit earnings growth -- a feat unmatched by any other firm!

However, by 2001 there were some signs that the payroll process outsourcing business, which ADP had helped to create, was becoming more mature. There were now over 1,000 outsourcing companies, including formidable opponents such as Paychex, Ceridian, and Intuit.** While the technological developments of the 1990s had created a fertile field of growth for the offloading of routine business tasks, resulting in an outsourcing paradigm shift that benefited ADP's business, our research indicated that this era of rapid outsourcing growth could be maturing to a degree that made ADP less immune to business cycles (a feature that previously made the company extremely attractive).

Further, after creating and exploiting this paradigm shift, ADP was no longer a small company. It now sported a market capitalization north of $35 billion, up from just $24 billion only two years before. We have previously discussed the idea that, as companies grow to dominate their field, there is a tendancy for them to switch from "disruptive innovation" to "sustaining innovation," in the words of noted business scholar and author Clayton Christensen.

Some of the fundamentals we have mentioned in previous posts as important business measurements helped confirm our suspicions that ADP might be transitioning from a classic Taylor Frigon growth company into a mature company that had pursued an open field of growth to the point that the field was now full and future growth would be more moderate. One of these indicators was their earnings growth, which in 2001 began to slow notably from the pace of previous years.

It is important to emphasize that these quantitative measures, while important, are only one part of the overall decision. Too often, investors look for an easy quantitative litmus test that will tell them definitively the right moment to sell. The above discussion is meant to emphasize the complexity of the sell decision and the importance for serious judgment and diligence, and the importance of not being "hasty."

We decided that, although still a well-run business, ADP was no longer operating in front of a "fertile field for future growth" and made the decision to sell all shares in the company during the month of August, 2001. It is notable that the company's earnings continued to level off and then decline in 2002, and that ADP has not resumed the kind of growth rate it had during its true "growth phase." The stock has generally been "treading water" since then.

It is important to understand that the sell decision involves an analysis of many different vital signs within a company and the industry in which it operates. It is also important to understand that the sell decision is not driven by the ever-changing winds of Wall Street (the market-related forces) but by fundamental business issues.

In the modern era of increasingly rapid innovation and indications of an increased "topple rate," it is especially important to understand that the "buy and hold" mentality is not realistic, and to develop a robust sell discipline for the companies in which you decide to allocate your capital.

* The principals of Taylor Frigon Capital Management do not own securities issued by Automatic Data Processing, Inc. (current ticker symbol ADP, formerly AUD).

** The principals of Taylor Frigon Capital Management do not own securities issued by Ceridian (private), or Intuit (INTU). They own shares of Paychex (PAYX).

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For later posts on this same subject, see also:
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Don't be hasty, young Jim Cramer (more on the dangers of chasing cycles and short-term performance)

On Wednesday, the frenetic CNBC host Jim Cramer suggested an investment strategy for his viewers -- buy shares of stocks held by a mutual fund whose performance is likely to attract new money, causing it to invest more money in its existing holdings and thus drive up their prices.

In the video above, he says:

"What should you be thinking of doing, when you have a bizarre, mechanical selloff at the end of a strong day as we just had? [. . .] If you know where the money's flowin' [cash register sound effect], you know which stocks are going higher -- and sometimes it's downright simple to figure out where all that cash is headed. Right now, for example, there's one mutual fund that is pantsing everybody else: the redundantly-named American Growth Fund of America, which is up a miraculous 9.5% year-to-date. That is fantastic performance, relative to everyone else, and that's how you have to think about it, relative. The fund is run by James Rothenberg and Gordon Crawford -- Gordie Crawford, to everybody who knows him in the business -- and it already manages 126 billion dollars. The symbol, if you want to look it up, play along at home, is AGTHX. Whenever one fund is beating all the others so soundly -- and this is just, I mean, an amazing, amazing outperformance [boxing speed-bag sound effect] -- the guys running it will get gobs of money [cash register sound effect], from regular people who want to ride the hottest mutual fund. Believe me, the guy'll be on the cover of all these different publications, there'll be interviews, there'll be articles, and it's gonna send money to the American Growth Fund of America, which will be rolling in dough -- a lot of dough, as in April equity mutual funds experienced the largest monthly inflow of dollars [. . .] in twelve months, receiving twenty billion smackers. Overall, mutual funds that invest in stocks are still down for the year, but the money is coming back, and because of the outperformance of this fund, we know where a decent chunk of it is gonna go."

Mr. Cramer then argues that investors should use that logic to invest in the individual stocks owned by the American Growth Fund of America.*

While we applaud Mr. Cramer's emphasis on owning companies rather than mutual funds, we would caution investors that we believe they would be far better served by an investment philosophy of owning great companies through market cycles, rather than an investment philosophy based on timing this or that market cycle, the way Mr. Cramer does.

In this episode, Mr. Cramer is using his redoubtable creative imagination to come up with yet another market cycle -- in this case, a market cycle based on the year-to-date performance of a single mutual fund -- although in other places he has recommended catching stocks that are ready to go up based on all kinds of other market cycles, from the activities of the Fed to the approach of the Super Bowl.

We would warn investors that, while these kinds of cycles may indeed move stocks temporarily in one direction or another, the difficulty of timing these kinds of short-term moves makes such a strategy very difficult to follow successfully for thirty or forty years in a row (a length of time that is not unrealistic for an investor's lifetime, and may in fact be a couple decades too short for investors who are in their twenties or thirties, or for investors who are considering the investment of assets by their descendants from successive generations).

The problem with investment disciplines that are based on trying to time this or that cycle -- as we have explained previously in posts such as "Gambling, Speculation, and Investment" and "Drawbacks of sector rotation" -- is that you are basically in the same position as a gambler in Las Vegas who is playing against the house: you have to pay to play (in this case, via trade commissions and other Wall Street fees every time you jump in or jump out), and one bad call can wipe out all your previous hard work.

We would also point out that, while Mr. Cramer is not specifically encouraging the flow of investment dollars to mutual funds based on their short-term performance, his exuberant praise of the performance of the American Growth Fund of America year-to-date is an example of the kind of short-term focus on performance that has directly contributed to the miserable long-term returns earned by the average mutual fund investor as chronicled by Dalbar, Inc. year after year.

In this segment, Mr. Cramer practically grants the fund's managers "rock-star status," calling their returns "miraculous" and "amazing, amazing," and he bases his investment thesis on the prediction that the media will anoint them with the same sort of adulation as well.

We would advise readers that making such judgments based on short-term numbers covering a few months -- when you are trying to measure the investment value of a business, which may not realize the rewards of its business model for a few years -- is not wise.

As we pointed out long ago in a piece entitled "What hasty investors could learn from an Ent," businesses live and move over a different time-frame than our hectic, individual lives. We note in that article that a Morningstar study of investment managers who beat their benchmark for a period of ten years found that "almost every outperforming manager (greater than 90% for large-cap equity managers) trailed his benchmark for a period of at least three years, often by significant amounts."

Lest someone try to diminish the force of this logic by saying that the only managers who use such arguments are those who have been doing poorly in the short-term, we would offer that our own Taylor Frigon Core Growth Strategy, in which we own the kinds of companies that we occasionally discuss in this blog, has performed even better year-to-date (after fees) than the fund highlighted on CNBC through May 20, 2009.

Nevertheless, we will be the first to emphasize that short-term market returns are not the way that individuals and families build and maintain multi-generational wealth, but that such wealth must be built and preserved on the sure foundation of a sound investment philosophy focused on well-run, growing businesses over a long period of years.

Investors would do well to consider these important issues.

* The principals of Taylor Frigon Capital Management do not own shares in the American Growth Fund of America (AGTHX).

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Invest like Mr. Howell

The television series Gilligan's Island ran for three seasons from 1964 through 1967 -- and for decades ever after in reruns.

One thing that strikes us as money managers is the way the show's producers chose to characterize "The Millionaire" -- Thurston Howell the Third, played by the late Jim Backus.

Among the many devices they used in order to set "The Millionaire" apart from the other castaways, along with having him talk about yachting and golfing, was to have him refer regularly to the stock market. Occasionally, the transistor radio on the island would announce some piece of stock market news, which would send Mr. Howell into fits of despair, while the only response from the rest of the castaways would be varying levels of sympathy for his plight. To them, the stock market was as foreign as most of the other fixtures of the lifestyle of the mega-wealthy.

In this way, Gilligan's Island is a kind of window back in time, to a period not so long ago, when a far smaller percentage of the American population owned shares in businesses or paid attention to what was taking place on Wall Street. If you were very wealthy, you probably had a stock broker, who recommended individual companies and individual bonds to you, who lived in your city and whom you knew personally.

A small percentage of the population may have owned some shares in the companies that they worked for, if they worked for a public company, but otherwise their entire exposure to stocks would probably be only indirectly, through their participation in some sort of a pension arrangement at their company. In those days, the average retirement age for men was 65, and their average life expectancy was just over 67, one of the big changes that accounts for the difference between our era of investing and the situation depicted in Gilligan's Island.

Since then, there has been a dramatic increase in life expectancy, primarily brought about by the increase in wealth and standards of living that resulted from the explosion in business growth in all parts of the economy after the malaise of the 1970s. There has also been a tremendous increase in wealth and in the ownership of investment securities -- so much so that if Gilligan's Island had been filmed today, every one of the castaways would probably be huddled around the radio along with Mr. Howell, and when he moaned about the performance of his stocks, Mary Ann would have asked him, "What will this mean for my 401(k)?" and the Professor would probably calculate in his head the exact percentage decline in his own 403(b).

This dramatic increase in the percentage of the population with investable wealth during the 1980s and 1990s led to the rise of an entirely new kind of money management from the individual stocks and bonds that Mr. Howell would have owned, a sort of "money management for the masses." With so many investing it was no longer possible for everyone to know the portfolio manager who was investing their assets the way the wealthy had in the past. The primary vehicle that would facilitate money management for thousands of investors would be the mutual fund.

In 1965, there were only 170 mutual funds in the US, with total assets of only $35 billion. By 2008, there were 8,889 mutual funds in the US, with total assets of $9.6 trillion (statistics on mutual fund investment are available from the Investment Company Institute).

We have written about what we believe are significant drawbacks to the mutual fund investment structure before, such as in this previous post.

In addition to taxation issues, "deworsification" issues, and "style drift" issues, mutual funds have an even more serious drawback: they tend to divorce their investors from the truth that investment should be about providing capital to businesses.

It is perhaps easiest to understand this pernicious effect through our mental exercise of thinking back to the days of Thurston Howell, III. The ultra-wealthy Mr. Howell was very aware that he was an owner in various business interests -- news of those business interests were often featured in the radio broadcasts that caused him such anxiety.

But owners of mutual funds do not typically have personal contact with the managers of those funds, and therefore do not typically have the opportunity to understand the businesses that they own indirectly through the fund, nor have explained to them the investment thesis behind the ownership of those particular companies.

As a result, they tend to become more focused on the market performance of those funds, rather than on the business performance of those companies. Numerous studies show clearly that the masses who invest in these forms of "mass-managed money" consistently buy into them when their prices are highest, and sell out of them when their prices plummet. The second graph in this post from January 2008 clearly shows massive amounts of money flowing into equity mutual funds in 1999 and 2000 and flowing out of them at the very bottom of the 2000-2002 bear market, in 2002. A story in today's Wall Street Journal chronicles several individual investors who sold equities near the market's most recent bottom in March, and notes that $70 billion flowed out of equity funds in February and March alone.

Mr. Howell, who had no qualms about expressing elitist opinions, might have said that this is exactly what one might expect when you come up with a way to distribute the stock market to the masses.

In fact, while there never was such an episode, we can almost imagine a Gilligan's Island in which everyone on the island decides that they want to participate in the stock market too. There would be general euphoria as the market goes up, and Mr. Howell obligingly sells some of his shares to Ginger, Mary Ann, the Skipper, and Gilligan, who eagerly buy more and more as the market reaches new highs.

Soon enough, however, the market would turn around, and the other castaways would become increasingly angry, fearful, and frustrated. They would decide that -- just like the actual episode in which the Howells adopted Gilligan as the new "G. Thurston Howell, IV" -- what seemed wonderful at first quickly became totally distasteful and ultimately something they all wanted no part in.

The episode would no doubt end with a gleeful Mr. Howell buying back everybody's stock at prices far lower than he originally sold them for, while telling his wife what a wonderful thing it is to be a Howell.

This is in fact something very close to what just happened in the markets over the past several months. It is definitely what just happened to those retail investors described in the Wall Street Journal article, who sold their equity index funds and mutual funds on or about March 9th of this year. Thinking about it in terms of Gilligan's Island might help some aspiring investors to take a more "Howell-like" approach.

In fact, there are many important investment lessons that can be learned from a reflection on Gilligan's Island. We personally believe that the tremendous growth in wealth that has taken place since the first season aired in 1964-1965 is a good thing, as is the greatly increased percentage of the American public who can participate in providing capital to businesses, and can participate in the rewards of the growth or those businesses.

But in order to really benefit, investors should remember what owning stocks or bonds is really all about. To do that, they might want to think a little more like Mr. Howell (without adopting the arrogant mindset that frequently got him into trouble of his own).

For later posts on this same subject, see also:

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Beautiful Growth Companies, part III

We have previously published many posts which attempt to convey to readers the Taylor Frigon philosophy of classic growth investment.

In an effort to help readers understand what is meant by a "Taylor Frigon growth company," we have from time to time offered examples of specific companies which we own in the portfolios that we manage.

For example, in previous posts "Beautiful Growth Companies" and "Beautiful Growth Companies, part II" we explained some of the fundamental criteria which we believe are important in the analysis of a company's performance, illustrating them with a company which we would classify as a "Taylor Frigon growth company," medical waste disposal company Stericycle.*

Today, we will examine another company which fits our criteria, in an effort to illustrate some other important insights into the question, "What is a growth company?"

We have often cited the concise definition used by Thomas Rowe Price, from whom our growth stock investment philosophy is descended through the late Richard C. Taylor. Mr. Price emphasized "the simplicity and soundness of the growth stock theory" as an investment philosophy, in which "the most important requirement is dynamic, capable management operating in a fertile field of future growth."

He further elaborated on this definition by saying that a growth stock is "a share in a business enterprise which has demonstrated long-term growth of earnings, reaching a new high level per share at the peak of each succeeding major business cycle and which gives indications of reaching new high earnings at the peaks of future business cycles. Earnings growth per share should be at a faster rate than the rise in the cost of living, to offset the expected erosion in the purchasing power of the dollar." He specified a goal of 10% average annual earnings growth, or 7.2% compounded annually, for a ten-year period.

The importance of the above definition is in its emphasis on owning specially-selected businesses through cycles rather than trying to guess which businesses will be best for one cycle or another, the way many investors (both professional investors and individual investors) try to do. We have written about this concept previously (for example, in this post).

One indicator of a company that may meet the definition of a growth company is growth of earnings even in a cycle that appears to be very unfavorable to its industry. This may be an indication that the company is positioned in front of a rich vein of growth, which it can expand even as competitors are forced to contract. Such growth may indicate that the company is adding some new value to clients, creating a paradigm shift or disruption of some kind in its field, as we have discussed in previous posts such as this one.

While high-tech companies seem to be the most natural examples of companies in front of these paradigm-shifting fields of growth, and while we have written extensively about some important tech-related paradigm shifts, there can be growth companies in any business or industry.

To illustrate, we have selected an example from perhaps the most counter-intuitive industry we could find in the current markets -- the financial sector.

During 2008, as the financial industry cratered, shares of FactSet Data were initially hit hard, as investors applied a kind of "guilt by association" to companies having anything to do with the financial sector.**

FactSet sells detailed financial data services to professional investors, competing with other financial data providers such as Thomson Financial, Reuters, and Bloomberg. A significant percentage of their revenues comes from "buy side" investment firms, which manage money for institutions or run mutual funds and other investment vehicles. Investment bankers who need detailed information and analysis during mergers and acquisitions are also among their client base. It would seem that 2008 would be a terrible environment for FactSet.

On the contrary, FactSet grew their earnings per share by 17% during 2008, and grew their revenues by 21%. In fact, 2008 was the company's twenty-eighth straight year of revenue growth.

To apply the ten-year growth standard specified by Mr. Price above, FactSet has grown their net income at a compound annual growth rate of 25.78% (Mr. Price recommended at least a 7.2% compound rate for ten years). In all of the past ten years they grew net income by more than 10% each year over the prior year's total, and in all but three years of the past ten the net income growth was over 20%. In three of those years growth was over 30% and in one of them it was over 40%.

Even in their most recently-reported quarter, net income was up 17% over the same quarter in the previous year.

The reasons for this continued growth -- which surprised the consensus of Wall Street analysts in the most recent quarter -- are several, but they can be summarized by saying that FactSet is a classic growth company that is executing strongly in pursuit of a fertile field of growth. The company is taking market share from their competitors, due to certain ways in which they add value that are unique to their operation.

For one thing, FactSet has always allowed customers to drop their subscription at any time, rather than forcing them to sign up for one-year, three-year, or even longer subscriptions the way their competitors do. FactSet is also unique in that they enable clients to purchase data from a wide variety of sources, rather than one selected source for each type of data, the way many competitors do.

FactSet is also making strong inroads into foreign subscriptions for their service, from money managers in Europe and Asia. Revenues from outside the US continue to grow faster than revenues within the US (16% and 10% for the most recent quarter, respectively). Even during a global slowdown, money managers in India (for example) need a source of data, where more open government economic policy has created a growing need for professional wealth management, just as the economic growth in the 1980s and 1990s did here in the United States.

FactSet is still a small company, relative to their competitors, which is also something we have discussed previously in regards to a company's ability to grow at a faster rate than the rest of their industry or the overall market.

All these characteristics should be well understood by investors, and should help them to understand what we mean when we say that a company is a classic Taylor Frigon growth company.

* The principals of Taylor Frigon Capital Management own shares of Stericycle (SRCL).

** The principals of Taylor Frigon Capital Management own shares of FactSet Data (FDS).

For later discussions of this same topic, see also:
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An illuminating interview

We have mentioned the excellent economic analysis of professional economist Brian Wesbury many times before on the pages of this blog.

Today, Mr. Wesbury had an illuminating interview with Fox Business anchor Stuart Varney in which he lays out some of the arguments he has been making -- going all the way back to 2008 -- that the recession was the result of a financial panic, which resulted in a sudden halt in the velocity of money (the turnover of money in the system as it passes from one individual or business to another), and his prediction that the economy would see an equally sharp and rapid recovery once velocity returned to normal.

There have been many economic signs lately that indicate that this diagnosis was very accurate.

In the interview above, Mr. Wesbury makes another noteworthy point, beginning with interviewer Stuart Varney's question at about 2:13 into the video. Wesbury says:

"We have a window here of twelve to eighteen months. The Federal Reserve is very easy, it's accommodative, it's printing lots of money. The market-to-market accounting rules were changed, and velocity is coming back, and that means the stock market and the economy, I think, are going to outperform the consensus expectations. But when we get down the road -- twelve, eighteen, twenty-four months from now -- we're going to pay a price for this growth in government. It's going to hurt this economy later, but right now we have a window -- a calm in the middle of the storm, if you will -- where I think people who can stay optimistic can make lots of money."

Mr. Wesbury's identification of a near-term cause for optimism (the twelve- to eighteen-month "window" or "calm in the middle of the storm"), as well as his warning note about the dangers from "growth in government," are noteworthy for investors.

We have also sounded a note of warning about some of the same issues, such as in our February post entitled "First, do no harm." We would argue that investors should be carefully considering the correct path for the landscape that may lie ahead. Recent posts we have published have given some advice on what we believe will be important going forward:

  • We believe that there will very likely be a divergence between companies that are smaller and more innovative, and companies that are larger and whose fortunes are more tied to the overall economy and business cycle. We discussed this idea in some detail in "Return of the 1970s, part 2" and "Look for paradigm shifts, part 2."
  • We believe investors may do well to reconsider the much-maligned concept of "New Economy" versus "Old Economy," as we mentioned in a recent post entitled "Revisiting the 'New Economy.'"
  • We would also caution investors to be very focused on owning securities issued by companies that don't have a lot of debt. We hinted at this before, such as in our December post entitled, "The best perspective comes from a business focus."
We have emphasized many times that we do not believe in trying to time cycles, or predict the next moves of the economy, and we are not saying that the current conditions require investors to do so.

On the contrary, we believe that the current environment, and the environment that may lie ahead, only emphasizes even more strongly the fundamental importance of focusing on the ownership of good businesses. That should be the absolute touchstone for all investors -- both in promising times, and in times when respected economists are sounding notes of caution.

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Revisiting the "New Economy"

In just eight or ten short months -- on January 14th of next year for the Dow and on March 10th and 24th for the Nasdaq Composite and S&P 500, respectively -- we will reach the tenth anniversary of the peak of the "dot-com" stock market bubble and the beginning of the spectacular collapse that followed (for a chart showing the beginning and end dates of that bear market, and other bear markets in history, see this previous blog post).

While those "innocent" days may seem like ancient history to investors who have just been through an even more ferocious bear market than that one, they are actually part of a continuity that investors should be sure that they understand.

After that bear market, those who had been critical of the optimism surrounding the talk of a "New Economy" in the 1990s felt vindicated, as Wired magazine's James Surowiecki pointed out in "The New Economy was a Myth, Right?"

That article, written in October 2002, at the very bottom of the dot-com bear market, cited a December 2001 essay by Harvard professor Jeff Madrick saying, "The new economy of the late 1990s was an invention of media and Wall Street [. . .]. By 2000, new economy rhetoric became a frenzy of half-truths, bad history, and wishful thinking."

While the 2000-2002 bear market seemed to vindicate such critics, Surowiecki argued that things had changed fundamentally over the past ten years, and he gave clear explanations of what had changed and how. Specifically, productivity had increased dramatically, due primarily to the impact of increased globalization and a revolution in information technology.

Almost eight years later, however, we can look back and wonder where the continuation of the promise of the 1990s went. Markets are roughly where they were in 2002 and in 1997 before that, and the stocks of technology companies that actually had legitimate business models and survived the crash are still well below their previous trajectories.

For example, the stock chart for network equipment maker Cisco Systems* clearly shows the tremendous runup of the stock into the year 2000**. Cisco was one of the darlings of the 1990s, and briefly became the world's largest company by market capitalization in March of 2000.

The chart also shows the earnings per share of Cisco, which is the solid line connecting dots for each earnings release, directly below the stock price in the chart. While there is clearly a severe "V-shaped" drop in the company's earnings during the period from the start of 2001 to the start of 2002, earnings growth resumed in 2002 and eventually surpassed their previous highs, even though the stock price never did (it continues on in a sideways direction and today is roughly at the same point that it ends up in the 2006 chart**).

In fact, if you look at the company's fundamentals from the year 2000 and compare them to the company today, a very interesting picture emerges.

At the end of July, 2000, Cisco's market capitalization was almost $454 billion. Today, it is just below $114 billion.

Then, the company's trailing twelve months of sales were $16.7 billion. Today, the trailing twelve months of sales amount to about $39.6 billion.

Then, Cisco's net profit margins were 16.4%. Today, they have risen to 19.4%.

In 2000, the company's trailing twelve months of operating earnings amounted to $0.47 per share. Today, the company's trailing twelve months of operating earnings amount to $1.40 per share.

Clearly, there has been a profound change in the way value is being assigned. Back then, the company was trading at a price-to-earnings multiple of 181.8. Today, the P/E is 15.6.

What is the lesson in all of this?

We would argue that investors should consider the following analysis. Clearly, a P/E ratio of almost 182 is a ridiculous valuation. We would argue that it is quite obvious in retrospect that part of the run-up of 1999 to 2000 should never have happened, not only for Cisco but for the stocks of many other companies as well.

In the chart above, for example, we have drawn one possible trend line in red and would argue that some portion of the stock advance above and to the left of that line should probably never have taken place (the portion marked with a red "X" for example).

We have written in the past about some of the factors that led to this misallocation of capital or malinvestment, such as in "The long shadow of the Y2K bug," written in August 2008.

Unfortunately, as we describe in that previous post, after 2002 there was a similar bout of misallocation of capital, this time into real estate, the financial sector, and briefly into commodities. Just as the tech bubble before it, the post-2002 housing bubble was caused by misguided attempts to "steer" the economy by the Federal Reserve, using inflationary monetary policy.

The misallocation of capital into housing, financials, and commodities sucked capital away from technology companies which have continued building on the promise of technology. Additionally, investors who had been through the tech bubble's collapse were "once bitten, twice shy" and had no confidence in the promise of broadband and connected computing that had been hyped so exuberantly during the late 1990s.

However, some of those companies -- and some new ones as well -- continue to create exceptional value, even if the market now assigns valuation far below what it is actually worth (just as before it had assigned value that was far too high).

In the chart above, for instance, you can see the trajectory of Cisco's earnings line marked with the blue curve. Today, their earnings are another 25% higher than where they were then, even though their price is at the same level.

We believe that the egregious mistakes that culminated in the wreckage of 2008 delayed the arrival of some of the technologies that are now reaching a real turning point. We have written previously about some of these promising technologies and the ways that they will change the landscape both for individual consumers and for businesses, such as in "The Unstoppable Wave," "Big Changes Coming part I and part II" and "Video is clearly the killer app here . . ."

This time, however, the companies producing revolutionary changes are available at much more reasonable valuations! We have used Cisco as an example, and it is a company with an important role in network technology, but there are many other companies that investors can find which are adding value and paving the way for revolutionary changes.

We believe that investors should carefully consider this much-overlooked lesson of the past ten years.

* The principals of Taylor Frigon Capital Management own shares of Cisco Systems (CSCO).

** The chart above, from the
Securities Research Company, is a semi-log chart, which is the best type of chart for seeing relative market moves because it depicts percentage moves on a constant scale, rather than depicting dollar moves on a constant scale (thus a 10% move would be the same size on the chart whether the stock went from $2.50 to $2.75 or from $50 to $55, while an arithmetic scale chart would show the second move as being twenty times larger). We have depicted a chart from 2006 because SRC makes their business selling these charts, so that investors who want one that is up-to-date rather than three years old can purchase one if they desire from their website.

For later blog posts dealing with this same subject, see also:

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The bond market rules the world, revisited

The most recent issue of the Journal of Indexes (May/June 2009) contains an article entitled "Bonds: Why Bother?" by Robert Arnott.

In it, the author compares the performance of the S&P 500 total return index over the past forty years to the return of a portfolio of a constant 20-year maturity Treasury bond. Based on the results of his comparison, he concludes that the "Stocks for the Long Run" argument famously put forward by Professor Jeremy Siegel (which we have discussed in previous posts, such as this one) is fatally flawed and categorizes it as a "false dogma" and that 2008 should teach investors the "folly of relying on false dogma."

"For the long-term investor," Arnott writes, "stocks are supposed to add 5 percent per year over bonds. They don't. Indeed, for 10 years, 20 years, even 40 years, ordinary long-term Treasury bonds have outpaced the broad stock market." He goes on to say, "For the long-term investor, stock markets are supposed to give us steady gains, interrupted by bear markets and occasional jolts like 1987 or 2008. The opposite -- long periods of disappointment, interrupted by some wonderful gains -- appears to be more accurate."

We disagree with Mr. Arnott's conclusion, and would caution investors that while it is true that many false dogmas that some investors relied on should be re-examined in the aftermath of 2008, there is a real danger of running off again in an equally wrong direction. We have recently written about some evidence that many investment professionals are doing just that.

In fact, we have noted earlier that after the 1973-1974 bear market, the entire investment industry went off in what we believe was a dangerously wrong direction (see for example our previous discussions in "Beware of the witch doctors of modern finance" and "Professor Amar Bhide and his praise of more primitive finance").

Investors should be cautioned that arguments for rejecting the ownership of equity shares in good businesses as the foundation of long-term wealth creation and long-term wealth preservation are equally wrong-headed.

Robert Huebscher has published a good reply to Mr. Arnott's piece entitled "Bonds for the long run? Not quite yet." In it, he notes that, although for the two 40-year periods ending in February 2009 and March 2009 the Treasury bonds Arnott used did outperform the S&P 500 total return index, those were the only two 40-year periods since 1926 in which they did so. "For all other 40-year spans, stocks beat bonds," Huebscher writes.

Huebscher notes that for the 40-year period in question, stocks have returned an average of 10.95% per year, and that until 1980 bonds returned "a stodgy 2% to 4%." Since that time, however, "bond performance has marched steadily upwards, returning a remarkable 8.79% over the 40-year period ending in March."

We would add that bond performance truly did enter a remarkable period after 1980, because the runaway inflation of the late 1970s had brought interest rates to levels investors of today can hardly imagine, and then they began to drop steadily after the Fed adopted the monetarist arguments of Milton Friedman and Anna Schwartz. That period was truly an historic period for bond owners, one that will probably never take place again (see chart above). Indeed, the fact that the 40-year bond outperformance that Arnott cites is not found for any of the other 40-year intervals in recent history underscores the conclusion that this was truly an anomalous period in financial history.

We believe that investment in bonds and other income-producing investment vehicles can be a very important part of an investor's long-term wealth building and wealth preservation strategy. We have written about this topic previously in a post entitled "The bond market rules the world." In that post, however, we noted that "ownership-based investment [such as the ownership of equity shares in growing businesses -- i.e. stocks] should form the foundation of an investor's long-term strategy" and that "income strategies can be built on top of that foundation, rather than ever being the foundation itself."

Investors should be wary of arguments that seek to invert this architecture and replace an ownership-based foundation with a debt-based one.

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For later posts on the same subject, see also:

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