Market Review

Item 12-31-99 12-31-00 Change
S7P 500 1469.25 1320.28 -10.1%
DJIA 11497.12 10786.85 -6.2%
NASDAQ 4069.31 2470.52 -39.3%
IBD MF Index 712.24 587.49 -17.5%
CRB Commodity Index 205.14 228.2 11.2%
3-Month Bill Rate 5.08% 5.70% 12.2%
Long Bond Rate 6.48% 5.46% -15.7%

Merry Christmas And Happy New Year From Mr Market:

Tax-loss selling, which we thought might have come early (see last quarter’s letter) turned into a bonafide rout for the remainder of the quarter, with margin liquidation and mutual fund redemptions adding to the pressure. New economy and old economy alike, prices were marked down to bargain basement levels. Mr Market, who at this time last year could see only limitless opportunity in the likes of Internet stocks and the stocks of companies building the Internet, today is so depressed he wants to sell everything, at any price. Remember the rule: it’s OK to have transactions with Mr Market (we can sell him things when he’s excited and pays too much; and we buy things from him when he’s depressed), but we never take advice from Mr Market.

It’s been a year since we wrote our “technology apology” letter, stating that the market was a voting machine in the short run. And what a difference that year has made! The market turned into a weighing machine, and some companies just didn’t measure up. We won’t bore you with a long list of stocks that went down and with companies no longer in business. A recent issue of Barron’s summed up the landscape pretty well with the headline: “180 Casualties In The Tech Wreck On The Information Highway.” The question is now whether or not the market is becoming a voting machine again on the giveaway side of the equation. Should we be buyers from Mr Market? As most of you know from our communication with you describing portfolio changes on an individual basis, we have indeed been doing some selective shopping. This bear market has created some superb long-term opportunities.

As markets go, however, we aren’t ready to proclaim this bear is done. One of the strong features of the bull market that went up year after year was that as it rose, investors, as measured by Investors’ Intelligence and reported in Investors’ Business Daily, remained stubbornly bearish. This attitude supplied the fuel for more market increases, as investors piled up money on the sidelines waiting for a break that never came. Today’s situation is reversed. According to the same sources, bulls now remain stubbornly high as the market declines. Incredibly, given the 50% plunge in the NASDAQ and even greater losses in individual issues, we apparently have not been able to scare anybody yet. Fifty plus percent bulls in the Investors’ Intelligence survey is more consistent with a market top than a bottom.

Our Utility Stocks Are Having A Good Year (Remember Global Warming?):

Wish we owned more. Last year at this time–after four winters of above-normal temperatures–investors were convinced that global warming was going to change the investment landscape for energy. Later in the year, an article in the New York Times reporting a mile-wide body of ocean at the North Pole, which was supposed to be ice, provided further confirmation of this theory. We don’t want to discount the possible damage to the atmosphere we are doing with all our pollution; but as we said last year, one thing we can do as a result of our advances in technology is determine that it’s been getting cold and snowing on parts of this continent for the past several million years. We’ll bet on a few more cold winters. Here’s a thought for you. If we’re experiencing a reversion to the mean that will eventually turn that body of water up at the North Pole back into ice, how many below-normal-temperature winters will it take, and how cold will it get? BRRRRRRRRRRRRRRR!

Also doing well last year were our old friends, the Real Estate Investment Trusts, discussed several times in past letters. The following charts (courtesy of YAHOO!) lend perspective to the dramatic differences in fortunes created by last year’s return to earth. TECO, the Florida utility for Tampa, rose over 60% during the year, while popular Worldcom peaked at $55 and sank to $14. Meanwhile, the Vanguard REIT Index Fund rose 20% while high flyer Lucent crashed from $75 to $13.


Anyone even remotely familiar with today’s investment scene knows the Fed is expected to lower interest rates at its next meeting latter this month. Unfortunately, most participants believe this action, if carried out, will be for the purpose of messaging the markets. Granted, one of the Fed’s duties is “lender of last resort,” but this responsibility stops far short of institutionalizing a rising stock market. If the Fed performs its primary responsibilities correctly, in conjunction with a consistent fiscal policy, then the markets should be able to take care of themselves. In other words, the Fed should act based on economic conditions, but its job is not to eliminate risk from the stock market.

Markets In Capitalism:

As they pertain to the economy, our markets are important sources of capital for the tasks of our various governments, and for entrepreneurs seeking to increase their accumulation of private property, or wealth. Both of these functions allow the economy to create jobs and thereby maintain full employment. When this relationship between the markets and the economy becomes dysfunctional, as it did in the third quarter of 1998, our job creators lose their access to capital which eventually leads to economic contraction. In the 1998 liquidity crises, “eventually” was actually instantly, as the mortgage markets became so risk averse that our banking system’s inventory of housing loans ballooned to the point of having to shut down. When the Fed intervened, the banks were once again able to sell their inventory of loans into the mortgage markets, thereby renewing their capacity to make new ones. This was a clear case of the Fed becoming the “lender of last resort,” as it re-established the relationship between the markets and those with legitimate capital needs. (Unfortunately, because the rescue of one particular, abusive private enterprise was involved in this process, the Fed undeservedly was accused of protecting the markets for their own sake.)

The Federal Reserve:

In 1999, as the NASDAQ soared 85%, our markets clearly became dysfunctional on the other extreme: anyone could raise capital regardless of the reason. Investing stopped being an activity which matches risk with potential reward. As we learned in 2000, through the collective, rational action of the markets, 1999 was a year when any fool was granted access to capital, and any fool could get rich. In 2000, these excesses were corrected; the markets took care of themselves. We were glad the Fed didn’t lower interest rates at its last meeting. We hope the Fed responds in the future to economic conditions. The worst thing the Fed could do, in our opinion, is attempt to eliminate risk from our markets. With no risk in the markets, prudent enterprises lose their access to capital as investors seek only the highest returns, and the markets again become dysfunctional. We don’t ascribe to the theory that economic reward has an unconditional, positive correlation with risk taken. As we learned in 2000, risk can also result in negative economic return. Benjamin Graham, in The Intelligent Investor, said it this way: “…there has developed the general notion that the rate of return which the investor should aim for is more or less proportionate to the degree of risk he is ready to run. Our view is different. The rate of return sought should be dependent, rather, on the amount of intelligent effort the investor is willing and able to bring to bear on his task.”

The Real Gift:

So whether Mr Market’s depression of the past year has presented us with values, or just reality checks, remains to be seen. The real gift of the past year is to re-establishment the concept of risk. In the long run, our markets are healthier as a result.

100 TIMES EARNINGS = 100 MPH (Dangerous):

Moore’s Law: The Theory:

Forgive the layman’s interpretation of Moore’s Law, namely: technology advances will double approximately every 18 months. As described in The Road Ahead, by Bill Gates, Gordon Moore, cofounder of Intel, predicted that the capacity of computer chips would double every two years. This has been true for 20 years, and the Law is likely to hold up for another 20 years, given that laboratories are already working on microprocessors that are 10 million times faster than the ones we’re using today. The book continues, “No experience in our everyday life prepares us for the implications of a number that doubles a great many times–exponential increases.” As an example, double one penny everyday for a month. The unbelievable result exceeds $10,000,000 (try it).

The Application–Linear Doesn’t Work:

Viewed from such a perspective, it is easy to justify paying 100 times earnings for earnings that are compounding at 50% annually; or 60, 70 or 80 times for earnings growing 30 to 40% annually. Given our recent entrance to the information age, or New Economy, it is even credible to expect many selections of companies expanding at such phenomenal rates; opportunity is everywhere. Certainly one of the most compelling examples of this logic is Cisco Systems ($38.25), which reinforced the theory by rewarding stockholders who held the shares worth $0.40 in 1992 by growing in value to $82 in early 2000. Earnings per share for the same period grew from $0.02 to $.53 estimated for 2000–a 26.5 fold increase. According to Value Line, earnings compounded at 49% annually for the past five years (beating the Street estimates by one cent every quarter). Hence, an earnings multiple of 154.7 times expected earnings when the stock peaked at $82 per share in February, 2000.

And what a peak it was. With 7.3 billion shares outstanding, Cisco’s market capitalization totaled $598.6 billion, enough to rank it as the largest company in the world. Second place belonged to General Electric ( $47.93), whose market capitalization amounted to $540 billion. In contrast to Cisco’s 49% earnings growth, GE’s growth for the past five years amounted to a more modest 13.5%. Because of its growth, Cisco was valued by investors at $598 billion, but its revenues of $18.9 billion estimated for 2000 amounted to only 30% of GE’s $63.5 billion. And Cisco’s earnings of $3.9 billion amounted to only 32% of GE’s $12.3 billion. Thus, even though by some measures Cisco was less than a third the size of GE, its market capitalization exceeded GE’s by over $58 billion. Such was the power and value of expectations. (On a qualifying basis, it is only fair to recognize the apparent superiority of Cisco’s financial condition. With no long-term debt, the company has positive working capital of $5.9 billion, including cash exceeding $5 billion. This compares with GE’s negative working capital of $3 billion albeit long-term debt is relatively insignificant at $692 million.)

The logic of paying 154 times earnings for Cisco was impeccable, as long as earnings continued to double every couple of years. What appears to have happened to Cisco’s stock is also described in Bill Gates’ book. Yes, Moore’s Law works because technology does advance at a very rapid pace. The application of this information, however, is not as straightforward as investors would like it to be. This is because such rapid advances are accompanied by change, sometimes change which is disruptive. Gates depicts An Wang, whose Wang Laboratories became the dominant supplier of electronic calculators in the 1960’s. “In the 1970’s, Wang ignored the advice of everyone around him and left the calculator market just before the arrival of low-cost competition that would have ruined him.” In other words, Wang avoided a very disruptive change.

“Wang reinvented his company to be the leading supplier of word processing machines. During the 1970’s, in offices around the world, Wang word processing terminals began to replace typewriters. The machines contained a microprocessor, but they weren’t true personal computers because they were designed to do only one thing–handle text. The kind of insight that had led Wang to abandon calculators could have led his company to success in personal computer software in the 1980’s, but he didn’t spot the next industry turn…Once general-purpose personal computers appeared, Wang’s software and his single-purpose machine were doomed.”

Although he navigated the first turn, Wang failed to see the second turn and drove off the road. (The life cycle of a growth stock was complete.) In Gates’ own words, “If Wang had recognized the importance of widely compatible software applications and general-purpose computers, there might not be a Microsoft today. I might be a mathematician or an attorney somewhere, and my adolescent foray into personal computing might be little more than a distant personal memory.” When Wang missed the turn, in other words, the opportunity was created for a Microsoft. The point is that staying in the path of Moore’s Law is difficult. Investors can’t just pay 150 times earnings for one company’s stock and expect the company to deliver consistent 50% annual growth forever. Staying in front of that disruptive change is like driving a car at high speed, like 100 MPH.

One hundred times earnings requires a lot of certainty. Little changes in expectations, which reduce the earnings multiple, can have drastic financial consequences for stockholders. If you’re driving a car at 100 MPH, instead of, say, 50 MPH, the importance of ordinary turns is magnified; driving off the road can be a terminal experience. Likewise, 100 times earnings leaves no room for the unexpected–such as slower demand from end users, competition, the bankruptcy of some customers, questions about accounting procedures, a little visit from the Justice Department. Yet all of these dangers exist in the path of Moore’s Law. Some of them have effected Cisco. We’re not saying that Cisco has gone off the road or missed the turn; but we do think the market is finally recognizing the possibility, as remote as it may be. Our purpose is to illustrate that it may not be possible to apply Moore’s Law in linear fashion by paying 100 times earnings for growth, especially over a long time horizon.

Of course, we may be wrong. Cisco’s earnings may keep compounding and investors may levitate the stock back to its old heights of 150 times earnings. (If there’s any company that could be the exception, it would very likely be Cisco.) However, I think we’ve demonstrated the risk of high earnings’ multiples, especially as a sustained way of life. Sooner or later, the small margin for error implied in the price will result in a disappointment. Remember, at high multiples, even small changes can be disruptive; just like a car traveling at 100 MPH whose driver misjudges a corner.

To Belabor The Point:

Indulge us. Remember, at this time last year, advisors such as ourselves were derided by so-called investors because we didn’t understand and believe that “in the New Economy, the only investments worth their while were companies whose stocks sold for huge multiples of earnings.” In fact, most companies back then didn’t even have earnings. Their multiples of sales, in some cases, were even higher than Cisco’s multiple of earnings. Even if we haven’t demonstrated that it’s hard to find even one company that can justify 100 times, surely we could lead even the biggest skeptic of these ideas to understand that all companies in any universe can’t justify 100 times earnings for their stocks. Yet, as many investors have become painfully aware during most of 2000, that is precisely where the NASDAQ ended up 1999: overvalued.

This year’s experience on the NASDAQ (see table on front page) has gone a long way toward carving out the excess valuations of the past two years. Based on its 39% decline, one might conclude that its worst drop on record has created nothing but buying opportunities. We would caution that the rule to remember in this case is that a stock isn’t cheap, or a good value, simply because it has declined 50% or 75%. Depending on fundamentals, such a stock could still be overvalued. Each company needs to be analyzed on a case-by-case basis. The following chart, courtesy of Barron’s, illustrates the point: although the index fell precipitously from its peak in March through November, the NASDAQ as a whole was still selling at 100 times earnings (a further decline in December may have reduced this multiple). Our interpretation? Many values have been created; but we are buying only companies we are willing to hold in the face of adversity, because the market could easily resume its downtrend. (None of our selections are based on expectations which accompany those of stocks selling at 100 times earnings.)


Compaq (NYSE/$15.05):

We’re going to cheat a little. Although a more realistic valuation of Compaq’s cash flow, combined with its investment portfolio, could result in substantial price appreciation by themselves, the investment community will need to see some evidence of growth before the stock price reflects the company’s true potential. As we said when we bought the shares at $25, and again at $19, Compaq is the nation’s third largest computer company. As such, the company serves both retail and enterprise markets; its products include mainframes, servers, workstations, commercial desktops and PC’s and storage. Its iPaq–a Microsoft-programmed Palm competitor–has been sold out for a month. The company has no debt in its capital structure. Yes, the business is cyclical. When it turns up, Compaq is so woven into the fabric of our economy that the company will prosper. If the stock isn’t worth $40 per share sometime during the next few years, we will be facing problems much worse than we have now. Thus, even though growth is not supposed to be a selection factor for inclusion in the SAFH portfolio, we can’t help but include this one. The shares are classified Level III, Conservative Growth.

Lucent (NYSE/$13.50):

Ditto. We haven’t started buying yet, but Lucent is definitely on our radar screen: for most of the same reasons we like Compaq. With modest debt in the capital structure, Lucent’s position in telecommunications leads us to believe the company’s turnaround efforts will succeed. We think the company’s problems are reflected in its stock price; but its potential a few years out could result in much higher valuations. The shares are classified Level III, Conservative Growth.

CNA Financial (NYSE/$36.56–November 28):

We eliminated our positions in CNA. It was becoming increasingly obvious that our ability to determine the company’s value by analyzing its financial statements was declining.


The following table shows the complete history of SAFH. I am sure you understand that no representation is being made regarding the portfolio’s future investment results. The portfolio is maintained to describe investment decisions made in a narrow investment arena, so it is not representative of the diverse investment universe used by Dreher Capital Management. It is not updated regularly, and you will not be notified on a timely basis of any changes.

Buy Date Description Risk Level Buy Price Curr Yield Sell Date Sell Price Change DJIA Change
3-21-95 Seagate Tech IV $26.00 0.0% 11-7-96 $76.00 192.3% 51.7%
3-22-95 Sun Microsystems IV $33.88 0.0% 10-19-95 $72.63 114.4% 17.0%
3-23-95 Varlen Corp(1) IV $11.84 0.9% 10-29-98 $28.00 136.5% 107.8%
7-22-97 General Motors* III $56.00 3.3% CurrPrice $60.66 8.3% 33.8%
12-04-98 Budget Group III $12.25 0.0% 9-20-00 $3.56 -70.9% 19.7%
12-09-98 Alexander & Baldwin III $21.00 3.4% CurrPrice $26.25 25.0% 19.7%
12-09-98 Heilig-Meyers IV $7.50 0.0% CurrPrice $0.04 -99.5% 19.7%
3-31-99 Ameron Intl III $35.50 3.4% CurrPrice $37.25 4.9% 10.2%
3-27-00 CNA Financial III 30.625 0.0% 11-28-00 $36.56 19.4% -4.4%
3-27-00 TECO II $18.75 4.0% CurrPrice $32.37 72.6% -2.2%
3-28-00 Berkshire Class B III $1,1667.00 0.0% CurrPrice $2,354.00 41.2% -1.4%
5-25-00 Alleghany Corp III $164.00 0.0% CurrPrice $205.50 25.3% 4.5
12-29-00 Compaq III $15.05 0.9% CurrPrice $15.05 0.0%0.0% 0.0%
12-29-00 Lucent III $13.50 0.6% CurrPrice $13.50 0.0% -0.0%
* Recent price adjusted upward for special dividends-.06 Raytheon, .7 Delphi.

Sam Dreher       Tom Velevis
President           Investment Associate


This letter is for the information of clients of Dreher Capital Management: 275 SE Broad St, Southern Pines, NC 28387, #910-692-4330. Information contained herein is taken from sources believed to be reliable, but is not represented to be complete, is not guaranteed for accuracy by Dreher Capital Management and is subject to change without notice. More information on specific companies mentioned in this report is available upon request. Prices as of end of quarter unless otherwise noted.