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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Never mind that dot-com stocks have nothing to do with the new dominant investment systemIndependent consultants have polled focus groups of nonprofessional investors in an effort to determine what kinds of securities they thought would represent the financial markets of the twenty-first century.13 That the overwhelming choice was the kinds of companies that trade on NASDAQ proves again that the general public is perfectly capable of recognizing progress and opportunity when they see it. For At this point we reach a chasm between fantasy and reality so wide that it defies logic: Notwithstanding the fact that the countrys foremost economists, business executives, marketing and management experts, and even the general public all recognize that science has brought us innovations that have structurally altered how productivity and profits are achieved, we still look at the Dow Jones Industrial Average, and the investment principles that accompany it, as the essence of finance and the last word in wealth creation. It boggles the mind that we give any weight at all to the importance of 30 industrial stocks. The disconnect between the new facts of business and the old fancies about investing is brought to us by those vested in the old dominant investment system. They put forth the bursting of the dot-com bubble in 2000 as evidence that investing in technology is risky and futile. Never mind that dot-com stocks have nothing to do with the new dominant investment system. What that was about was mass marketers simply using the Internet to enhance mass marketing. Money was thrown into computers and networks by many executives who had no idea about, or intention of, changing their basic business model. As Larry Downes and Chunka Mui concluded in Unleashing the Killer App, technology is not merely a tool to implement an existing strategy it increases productivity only when it is allowed to eliminate current operating models and underlying assumptions. Many of us within the investment industry have understood for years that those underlying assumptions have changed and must in turn change the nature of investing. When it is argued that sound investment principles do not change, we point out that for over half of the twentieth century Dow stocks and other blue chips were analyzed within the same framework as were bonds. Those old commandments of analysis were destroyed in the middle of the twentieth century, and the markets survived just fine. Here are some facts: Even after Dow stocks and those like them became dominant, they were expected to fit into the old analytical structure of bonds. Stocks had to pay high and regular cash flow to investors in the form of dividends. Paying a high dividend was more important than putting that cash into the future growth of the company. Only after 60 years into the Dows term as the dominant investment did the investment establishment get over this obsession with dividends. Even then it was changes in tax laws that instigated the new view, not the importance of investing for growth.15 Not until 1958 was it acceptable for the yields of stock dividends to fall below the yields of interest payments from bonds.16 We have not heard an analyst recommend a stock solely because it paid a high dividend since 1988. Markets evolve, the investment establishment eventually adapts to the new environment, and the rules change. How high NASDAQ will be and how many opportunities will be lost by the time that happens in this century are anyones guess. Sometimes when we look at things one way long enough, it becomes difficult to see the misguided impressions, the fudged facts, and the beliefs we hold only because we have always held them. An artist friend tells us that she will turn her work upside down to get a fresh perspective. She says that this short-circuits the minds anticipated connections and that the gaps in logic jump out at her. Upending the ideology of the stock market is equally enlightening. Here are two examples. THEMARKET A couple approaches us at a party and asks us to help resolve a disagreement: What did themarket do in 1998? We replied, Large-cap value stocks rose about 11%; large-cap growth stocks rose about 42%; small-cap growth stocks fell about 3%; and a small-cap value stocks fell about 5%.17 With some irritation they said, Thats nice, but what did themarket do? They probably thought we were being difficult, but the fact is that there has not been a themarket for over 20 years. There are thousands of companies of different sizes and growth rates that cause them to react differently to economic conditions and perform differently at any given point in time. They can be segregated into style sets. The major ones are defined in the following box. The data are from July Leading biotech company created in the late twentieth century. Few tangible assets compared to Exxon-Mobil. Its wealth is in its patents, revenues from product sales, and research and development. Second largest consumer goods company behind Philip Morris. Based in the Netherlands, it markets foods, home, and personal care products. That these styles had become distinct by the 1970s coincides with the Dows passing its peak years as the dominant investment. The course of this event is explored in Part II, which supplies the historical data and context for each investment culture. The significance of these style sets for an investor today is illustrated in Figures 1.9, 1.10, and 1.11. A style will be the top performer for a while, but inevitably the stocks it represents will fall in value, and stocks of a different style will take their place as the best performers. The data used to construct the graphs were provided courtesy of Wilshire. ANALYZE THIS The magazines of pop finance have been filled with articles such as these: 1999: The New Way to Value Stock Prices: Old Rules Are Broken 2000: Mystery of Stock Values: Will the New Rules Keep Working? The truth is that there have been distinctly different ways of analyzing stocks for over 20 years. Because large-cap value, large-cap growth, small-cap value, and small-cap growth stocks have so little in common that they react differently to economic conditions, a financial ratio that is appropriate for evaluating one company may be irrelevant for another. The distinctions between stock styles are so extreme that a professional money manager is required to specialize in one style or another. If a large-cap value manager should suddenly begin to buy small-cap growth stocks, we would view that in the same way as you would if your gynecologist hung out a shingle professing to be qualified to do brain surgery. Yet, every day we hear people from within and outside our business reject one NASDAQ stock or another as a poor investment because its characteristics do not fit some misconception of what is normal. Their conclusions are often a dead giveaway that they filter their facts through a prism of investment clichs built around the stock model of the Dow Jones Industrial Average. That brings us to that thing about P/E ratios.18 Because this is one of the simplest financial ratios used to evaluate stocks, it has undergone a number of new applications over the last few years. At dinner parties, for instance, when the conversation turns to themarket, it can be used like this to impress your friends: I only buy stocks for my portfolio if the P/E is The P/E ratio can be an excellent tool when you want to prove to your teenager that in fact you do know something about buying stocks online, as in, Of course I know how to set up the online trading account. I just dont want to do it right now because the markets P/E is too high (too low, or whatever). Best of all (and we have used this one ourselves), the P/E ratios value as a topic for magazine articles or newsletters cannot be overstated: What to Buy Now? 20 Stocks with the Lowest P/Es Why the New Economy Stocks Should/Should Not (whatever) Have High P/E Ratios The Right P/E for the Market Evaluating either the market or an individual stock by its P/E ratio is like judging someones character by his or her shoe size it can be one thing to consider in concert with other factors, but by itself it doesnt mean a lot. We can be left feeling unmoored when a new investment culture ma terializes and an old one slips away. If blue-chip companies will no longer be the best place to invest for the long term, what does one do? When the Dow has a significant decline, we used to be able to say, Be patient, it will bounce back, it always does. What happens when we cant say that anymore? We looked to history for the answer. After two years of searching, bells started ringing when we discovered that dominant investment systems begin and end in similar patterns (see Figure 1.12). The next chapter lays out how closely the path of the NASDAQ since it came to represent the new dominant investment system in 1998 correlates with the pattern the Dow followed when it became the new investment force of the 1900s. This discovery has helped us to anticipate the direction of stocks and has been a guide in making investment decisions for our clients and ourselves. It raises the mind out of the rut of the day-to-day market gyrations and sends it down the road of fruitful possibilities. NOTES 1. Janet Lowe, Benjamin Graham on Value Investing (Chicago: Dearborn Financial Publishing, 1994). Benjamin Grahams pioneering work came to be known as the Graham-Dodd theory of analysis, required reading for any financial analyst today. 2. IBM per share earnings: 1984, $2.930; 1985, $2.680; 1986, $1.952. 3. Prices are adjusted for stock splits. 4. Sidney Homer, A History of Interest Rates (New Brunswick, NJ: Rutgers University Press, 1963), p. 309. 5. Jeremy Atack and Peter Passell, A New Economic View of American History (New York: W.W. Norton, 1994). 6. Initial bursts of spending create secondary and tertiary bursts. For example, a new construction project means that money is spent on materials. Suppliers will engage in additional spending of their own. The annual effect of the multiplier is about two. 7. A New Economic View of American History, p. 8. 8. Richard Pascale, Mark Milleman, and Linda Gioja, Surfing the Edge of Chaos (New York: Crown, 2000). 9. Bureau of Economic Analysis, National Income and Productivity Tables. 10. Larry Downes and Chunka Mui, Unleashing the Killer App (Boston, MA: Harvard Business School Press, 1998), p. 63. 11. Elliott Ettenburg, The Next Economy (New York: McGraw Hill, 2002), p. 4. 12. The Regional Economist, Federal Reserve Board of St. Louis, July, 2001. 13. Source: U.S. investor surveys conducted by Roper Starch Worldwide. 14. The NASDAQ composite is an index that includes all domestic and non-U.S. stocks listed on the National Association of Securities Dealers Automated Quotation System. It contains over 5000 stocks. 15. Jeremy Siegel, Stocks for the Long Run (Chicago: McGraw Hill, 1994), p. 62. 16. Ibid., p. 26. 17. In 1998 these indexes represented the sectors mentioned and performed as follows: Wilshire Target Large Growth +42.21%, Wilshire Target Large Value +11.25%, Wilshire Target Small-Cap Growth (2.46%), Wilshire Target Small-Cap Value (4.87%). 18. P/E stands for the stock price divided by the companys per-share earnings; for example, a stock price of 100 divided by earnings of $20 per share = P/E of 50. |
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