by David B. Anderson
David B. Anderson is president of Gold Investment Advisors. He can be reached by phone at 913.396.0305 or by e-mail at daveanderson@goldcap-kc.com.
Most investors prefer to use price-of-earnings ratio (P/E) as the appropriate yardstick of value. At last year's crest of enthusiasm for new-economy stocks, the unweighted average of 300 technology companies soared to a P/E of 115x. As of June 30, they had fallen to slightly above a still lofty 40x. In 1968, the "scientific" stocks spiraled upward to 66x, and plummeted to 25x by 1970. After a partial recovery, the old new-age stocks ultimately retreated to 10x in 1975 and remained subdued until 1990. These cycles of excess have consequences. So far, 555 dot-coms have failed. The premium valuation ascribed to any company with a business model and an "e" or "i" in front of its name 18 months ago was not dissimilar to "ix" or "ics" in 1968.
The P/E for the S&P is currently 22x, but this figure is skewed by overcommitment of capital to the 100 largest companies (most of which are techs). If we calculate the P/E for the "average" of all index stocks, it is only 17x. Most interesting is the fact that neglected, small-cap stocks are trading at less than 15x. In "normal" times, the largest three percent of stocks commands less than half of free-market capital. However, in February 2000, the "nifties" represented two-thirds of total worth and today still account for over 60 percent of the $14.6 trillion universe.
We remember vividly how glamorous new-economy stocks rocketed higher, but ultimately the laws of the capital market prevail. Investors are still hoping to get even. Many of the "over-owned" and "heavily-hyped" cocktail-circuit stocks will have difficulty doing more than a partial rebound (like 1970 scientific stocks). These new-paradigm dandies will be redistributed and capital will flow to the under-appreciated small caps that are valuation deprived.
Investing is not easy, but it can be simple. We believe that five rules, if followed, will provide a discipline to avoid mistakes and earn a reasonable return:
1. Select an appropriate asset mix. As a general rule, clients should put their age in bonds and the difference from 100 percent in stocks.
2. Broadly diversify. Most mistakes are made in the passion of seeking gains. No stock group should exceed 25-30 percent of a portfolio, as they can do when excessively valued.
3. Make changes deliberately. When you have decided to make a shift, dollar-cost averaging techniques should be used to minimize the impact of poorly timed, zig-when-you-should-zag decisions.
4. Fade the headlines. Headlines are created to sell newspapers and appeal to psychology, not to provide unresearched revelations.
5. Minimize all friction. In the voracious years of the late '90s, fee income of banks and funds became excessive.
There are always opportunities in the market. Doing your homework gives you confidence when times are tumultuous. An objective investor, like the efficient cook, doesn't wait for "a watched pot that never boils."