STOCKS, TIME HORIZONS AND EXECUTIVE ETHICS

Editors Note:

At Stockupticks, we'll be the first to admit that no one can predict where the rough waters are going to be in the stock market. So once again, we asked analyst Doug Rogers of ManageSource.com to throw us an oar and share his knowledge on recent events that have affected our portfolios and our economy. 

Doug's insight and experience really come through in the following piece where he discusses both the mechanics of the markets and the ethical dilemma facing corporate America. 

Why are the valuations of some Small Cap stocks growing so quickly in a bear market? 

How can corporations return a profit in a sluggish economy?

Is Alan Greenspan's observation about "infectious greed" really true? 

What are the investment lessons from the first two calendar-quarters of 2002? 
 

Searching for Value & Values in Today’s Market

That’s it.  Shut down the stock markets and start investing in mink farms and selling ice to Eskimos!  Not so fast Chicken Little, the sky isn’t falling and there might be some value left in this vicious market! 

I am separating this installment into two sections, a market summary and a look at corporate America.  In the first I will present some technical and fundamental data to help you find some value in the market, give some guidance on where we think it may be heading and, hopefully help regain some composure with respect to the market’s most recent results.  I am dedicating the second section to evaluating the state of corporate America and the recent accounting scandals in relation to the nature of today’s corporate culture.

 

Market Summary

Investors should have already increased their investment time horizon and should now be hunting for exceptional equity values.  We are currently in the midst of a small-cap cycle that has seen significantly more resilience in the small-cap arena and indicates that small-cap equities still hold a valuation advantage to their large cap brethren as compared to mean historical valuation trends.  We are using macro data from the Russell 2000 for small-caps and S&P 500 results for our large cap universe.  Small-cap cycles usually occur concurrently with overall market deterioration as investors rotate funds out of overvalued and under-performing mid- and large-cap stocks, and can last anywhere from 3 to 5 years, according to Merrill Lynch’s small cap strategist, Satya Pradhuman. 

Currently, we are approximately 2 years into a cycle that has seen small cap mean valuation levels move from an approximate 75% - 85% discount to the large-cap mean to current levels around 50%-60% discount, suggesting that the small cap market still presents opportunity for investors seeking value in today’s market.  Recent studies demonstrate that mean valuation trends in Price/Sales, Price/Cash Flow, Price/Book and Price/Earnings remain near historical highs for large cap stocks, but still offer upside potential in the small-cap arena. 

Many analysts, however, suggest that this disparity represents opportunity for small cap valuations to attain similar mean valuation levels as their large-cap counterparts.  The percentage difference would then represent the upside potential to a given investor.  Although I somewhat agree to this sentiment, I feel that the data also supports my opinion that, historically, small caps stay within a smaller valuation variance to their statistical mean, than do large caps.  In other words, the pendulum swings further in the large cap markets due to program trading, enhanced access, greater visibility, and significantly larger investor bases, among other things.  The small cap market generally trades slower and possibly more deliberately due to the lower levels of volume, visibility and access involved. 
 

The Upshot Is This

S&P 500 equities still demonstrate historically above average valuation levels and you could expect to see more near-term selling, especially in relation to the market’s incredible downward momentum.  Small caps, on the other hand, still present value and upside potential to investors when compared to both historical data and current valuation trends. Don’t miss the boat!  Re-read some of my previous articles and start to put some of your savvy to work seeking out bargains and value in small caps.  Consumer resiliency should continue to boost the “Consumer Staples” and “Consumer Cyclicals” sectors, and we also think that “Healthcare” will continue to offer selective upside potential.  Investors have an excellent opportunity to redevelop their core holdings and establish a solid equity foundation for the impending recovery.  Stocks are an investment and your time horizon shouldn’t be less than 12 – 18 months in a market as volatile as we’ve recently seen.
 
 

Corporate America

I would like to switch gears at this point and discuss the current eco-political environment that has gripped the markets, our courts and our executive suites.  I would like to stress two critical points, before jumping up on my proverbial soapbox:  1. It is my opinion that any individual that knowingly defrauds investors in any way should be dealt with harshly and swiftly to help ensure the integrity of and faith in, American business, and 2. The “infectious greed” that Mr. Greenspan talked about last week applies to all of us, not just key corporate executives.  It applies to board members, salesmen, executives, assistants, venture capitalists, investment managers, and most importantly……investors.  We as individuals and participants in the greatest market on the planet must all accept some of the blame for precipitating the events that we all purport to be so shocked about. 

The market boom of the mid and late 1990s substantially altered investor expectations at both the individual and institutional levels.  It’s important to understand that the primary responsibility of public company executives is to increase shareholder value.  Some of you may disagree and point to your MBA reference on Corporate Finance and how their responsibility is planning, negotiation, oversight, etc., etc., etc.  However, the fact is that the board, the employees, the I-banks and the entire investment community only care about the value of the equity in their portfolios.  Results are the primary driver to increasing wealth, attracting business and improving perception. 

This is the infectious greed Mr. Greenspan was talking about.  Now, consider this in relation to the late 1990’s environment where companies with unproven business plans, outrageous spending and no revenues are generating shareholder value to the tune of triple digit valuations and quadruple digit growth projections.  The perspective of the entire market was so distorted that the only way that many executives saw to keep their jobs, increase shareholder value and maintain their investor base was to somehow generate similar results.  Unfortunately, it is impossible for a mature company to achieve results similar to exceptional start-ups, let alone the ridiculous anomalies that were writing the headlines during the past decade.
 
 

Develop A Strategy Based On Quantitative And Qualitative Metrics

Executives became increasingly more aggressive with their accounting (AOL/Time Warner) and, in some cases, crossed the line from aggressive to just plain fraudulent.  However, just like the cumulative hole that high interest loans bury consumers in, the only way to keep one accounting indiscretion hidden is to perpetrate another one until the hole is too large to ignore.  It’s important to recognize that the hole was there. The hole was there for a long time.  When everyone was making the returns they demanded, however, no one second-guessed the results, did we? 

Executives, for the most part, have no intention of perpetrating fraud to enrich themselves.  The system is too big, and there are too many eyes to think that a handful of individuals at the top will be able to get away with something so obviously illegal.  They would have to be incredibly arrogant (M.S.) or incredibly stupid. 

It is critical to reevaluate our responsibilities as investors and stop viewing stocks as a means of getting rich quickly and as executives as the means for making that happen.  Stocks are an investment, and companies need good management, good policies and good product to generate value for investors over time.  This is a statement that many have lost sight of.  Over time, stocks generate significantly higher returns than any other investment vehicle.  Thus, investors have to learn from the past decade and reestablish their portfolios in a way that acknowledges stocks as an investment that will provide them superior returns over time and not as quick way to buy a new Mercedes-Benz. 
 

And Finally ...

You cannot compete against the professionals on a moment-to-moment or day-to-day basis (the reason for this will be a topic in my forthcoming book on investing), and you should not attempt to.  Develop a strategy based on quantitative and qualitative metrics, analyze the companies that you understand and that meet all of your criteria, and then make a well-informed decision that will result in building a solid financial future.

I hope that I have presented these two topics in a more pragmatic way than most have seen lately.  It is not as comprehensive as I would have liked (I’ll save that for the book), since space is limited, but I hope that what I’ve said will help some of you gain a more calm, focused and clear perspective on the events that have transpired during the past quarter. 

Stockupticks Safe Harbor Statement: Statements contained in this document, including those pertaining to estimates and related plans other than statements of istorical fact, are forward-looking statements subject to a number of uncertainties that could cause actual results to differ materially from statements made.

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