Efficient Stock Market

Investment Manager's Letter October 2000

The third Quarter of 2000 has been an interesting period for the stock market. The Dow Jones ended with a gain of 1.94%, while the NASDQA was down 7.39%, and the S&P Average lost 1.30%.

While it was a bad period for overvalued tech stocks. It was a good period for Berkshire Hathaway and other old economy stocks. While this may indicate that market is moving into a new mind set, the most interesting thing about this period as people look back from future years may be that it was the time when reality finally drove a stake thought the heart of the efficient market theory. It has been a period when the world has finally learned what Warren Buffett has been telling us for years. Markets are Not rational they are over-reactive.

From this point forward I, as investment manager, see no way a intelligent person will be able to claim that the Markets are efficient (rational). In March the market was saying that dot COM companies where worth 100 – 200 times revenues. On Monday the Oracle of the Internet James Cramer said that as far as business on the Internet was concerned the end was near. It is very good medium for the public. It provides tons of information at very attractive prices. The only problem being that there is no way that a dot company can make money posting this information. Six months ago the market was pricing new economy stocks for perfection. Today the value of the dot coms is rapidly approaching zero. Warren Buffett says the market is not efficient it is manic-depressive. Never has there been a period that so clearly demonstrated the accuracy of this contention.

A Rebirth of Value

The good news is that there are a lot of old economy stocks that are selling at discounts to their intrinsic value. It is my hope that there will be, at the end of this correction a period of capitulation where prices give you a margin of safety on a purchase. While there is no guarantee that this will happen, the capitulation is beginning to appear in the tech stocks, for example Intel down 30% last week. But the panic does not appear to be spreading to the rest of the market, which is generally holding the lows that they made earlier in the year. The danger is that we will get a rolling bottom, and today’s prices are the best that we are going to get as far as old economy stocks are concerned. It still seems too early to commit cash reserves because there is at least a better than 50% 50% chance that the economy will get worse than most people are now predicting.

Small Cap Leads

Interestingly enough the best performing average since the first of the year has been the Russell 2000 which tracks the performance of small cap stocks. The pundits have been calling the revival of small caps forever. Logic tells us that sooner or later they are going to be right. If indeed we are to see a more mundane economy in the years ahead small cap may be the place to go if you what to outperform. History tells us that small caps do better than large caps over the long term. In an international economy that is growing at a slower rate than the recent past it is going to be much more difficult for the giant companies to show double digit revenue growth. This was taken of granted in to go-go nineties, and we may return to long period where the best money will be made in the smaller companies.

While the macro factors may favor smaller companies in the near future the market currently is actively ignoring the old economy segment of this market. The mutual funds have largely abandoned this group. Most funds have too much money to bother with a really small company, and because the sector has been lagging for so long, they have dropped off all the radar screens.

Cheap Capital = Dead Money

Conventional wisdom still seems to favor Tech stocks. TV pundits will their eyes firmly affixed to the rear view mirror assume that last years favorites will rise again. My, as investment manager, experience tells me that last year’s stories very seldom repeat their previous glory. My, as investment manager, hunch is that Tech stocks are going to be dead money for a long time. Investors have been throwing money at this group at a rate that has never been seen before. Cheap capital is a lovely high but it rarely leads to good return on investment. It destroys the discipline that managers need to build a survivable franchise. Easy money means you never learn Rule Number One. Who needs moats when money is free?

You give the average CEO $100 million in excess cash he will be convinced that God wants him to spend it. It is his sacred duty to use that money. Pump up the revenues, spend the option money, its the American way. For a new economy CEO capital spending is addictive. ROE what the hell is that? In the past this has led to large areas of over-capacity that takes years to burn off.

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