Market Review

Item 12-31-2000 12-31-2001 Change
S&P 500 1320.28 1148.08 -13.04%
DJIA 10786.85 10021.5 -7.10%
NASDAQ 2470.52 1950.4 -21.05%
IBD MF Index 587.49 469.67 -20.05%
CRB Commodity Index 228.2 190.61 -16.47%
3-Month Bill Rate 5.70% 1.71% -70.00%
Long Bond Rate 5.46% 5.36% -1.83%


Let’s use the Vanguard 500 Index Fund, which replicates the Standard & Poor’s 500 Index, including dividends, to take a look back at the decade of the 1990’s specifically 1990-1999. An amazing period of time: one year (1990) was negative (-1.8%), two other years saw increases of less than double digits (1992 +7.4%, 1994 +1.2%). The fund’s average rate of return for the period was 18.9% including dividends. Speaking of dividends, the fund’s current yield declined during the period from 3.5% at the beginning to 1.3% at the end. Three years during the decade saw total returns exceed 30%, with another three years experiencing returns in excess of 20%. For the years 1995-1999, the decade’s second half, the fund’s average total return soared to 28.6% annually.

Bonds were for chumps. As depicted by Vanguard’s Total Bond Market Index Fund, bonds returned only 7.7% on average, beginning the period with an 8.8% current yield and ending with 7.0%. With the help of hindsight, it was clear that investments in stocks during the period were much more likely to result in a superior rate of return. As for risk, bonds experienced two years of negative returns (-2.7% in 1994 and (0.8% in 1999) versus only one negative year for stocks. They were thereby riskier than stocks and returned less for the period.

Going forward with this empirical evidence, it was easy to reach a conclusion favoring stocks over most other asset classes. Rate of return became the primary focus; risk was basically removed from the equation. With little or no evidence of risk in stocks, even relative to bonds, chasing returns became the norm. Thus was spawned a financial press giving investors naive advice to unload mutual funds returning “only” 15% to buy the funds making 20% and more, such as Fidelity Aggressive Growth, which at the end of March 2000 had a year-to-date return of 14.4%, a one-year return of 94.4%, a three-year return of 61.2% and a five-year return of 42.6% (figures courtesy of The Chartist Mutual Fund Letter, November 1, 2001 edition). During this short 10-year period in history, pimply-faced, 16-year olds making out in the back seats of cars grew up to be 26-year-old masters of the universe managing billions of dollars. Some 30-year olds I met only casually at dinner parties spoke sincerely about their plans to retire in six years with their stock options on Microsoft or Cisco. Their logic was impeccable: everybody knows money doubles every 2.5 years when it’s growing at 31%!

But the investment landscape changed quickly. The Vanguard 500 Index Fund dropped 28.1% from the beginning of 2000 through the first three quarters of 2001, falling a full 43.8% behind bonds, which returned 15.7% for the period. By the end of October 2001, the Fidelity Aggressive Growth Fund was sporting a year-to-date return of minus 52.4%, a one-year return of minus 61.3%, a three-year return of minus 5.0% and a rather pedestrian five-year return of plus 4.2%.

What happened?

The Pendulum-Direction:

Sir John Templeton, 88-year-old founder of the Templeton Funds (sold to Franklin Resources), was interviewed on TV back in September. Set forth in his remarks was the idea that the investment pendulum reached a peak in early 2000, during the dot-com mania we have mentioned often in past communications, and it is now moving in the other direction. A primary characteristic of the pendulum, according to Sir John, is that its momentum always carries it too far: to unsustainable levels of ecstasy and pessimism. Unsustainable levels of ecstasy may be what are described above for the decade of the 1990’s. If so, the pendulum, as Sir John says, is moving toward lower prices and valuations for equities.

The Pendulum-Distance:

If this is true about the pendulum changing directions, the next question is how far has it come? Have we reached a bottom? Having seen the NASDAQ decline over 70%, and with this ugly bear two years old by some measures, it’s possible the pendulum has already swung a fair piece. Some indicators have shown signs of a bottom, whether temporary or permanent of course remains to be seen. At the end of last September and the beginning of October, Investors Intelligence, as reported in Investor’s Business Daily, actually displayed a three-week period when bears outnumbered bulls a bullish contrary indicator. For another example, a Value Line formula that allocates assets between stocks and bonds is so bullish the company is warning investors about extenuating circumstances mainly included by the worlds widely known economic problems.

As for the economy’s role in the matter, it seems to be a double-edged sword. Unprecedented weakness in employment, sales and manufacturing numbers can be used to make a strong case for lower corporate earnings accompanied by declining stock prices. These same figures, however, are sited by the bulls who argue that the deepness of the recession will be the source of a powerful V-shaped recovery. Their case is supported by the Government’s aggressive response to the weakness, including some of the lowest interest rates ever recorded and a very stimulative fiscal policy.

The Pendulum-Perspective:

As stated, only the future can tell us if we’ve seen the bottom in stock prices. To develop some perspective on how far the pendulum could swing if it isn’t finished with its downward cycle, it might be helpful to consider the distance we traveled to reach that unsustainable state of ecstasy at the end of the last decade. An article by John Bogle, founder of Vanguard, does just that. Reprinted in the December 4, 2000 edition of InvestmentNews, Mr Bogle analyzes the return on stocks for the past fifty years (1950-1999) in order to develop some estimates of what the next ten-year period may hold in store for investors.

To paraphrase, the article describes the beginning of the period as one in which bonds yielded 2.6% and stocks had current dividends of 8.7%. During the trip to 1999, dividends declined to just over 1.0%, earnings per share increased by 6.0% annually, and the price investors paid for the earnings rose at an annual rate of 3.3% (from 7 times to 30 times). The average stock dividend for the period was 4%. These numbers are based on data for the S&P 500 Stock Index. Thus, Bogle describes the experience as an investment return of 10% (4% dividends and 6% growth), plus a speculative return of 3.3% (the increase in what investors paid for the results), for a total return of 13.3%. As the article notes, these returns are purely theoretical, since they don’t take into account income taxes and investment management expenses such as commissions and management fees.

Using this analysis to give him some perspective on return possibilities for the 2000 to 2009 decade, Bogle concludes the period may be a difficult one for investors. Just to equal the same investment return of 10%, earnings growth would have to accelerate from 6% to 9%, since we’re starting with only a 1% dividend yield compared to the 4% average of the past half-century. Further, Bogle notes, it seems more likely that price-to-earnings ratios will decline rather than increase again. “to add another 3 percentage points of speculative return to reach the 13% annual total return of the past would require a rise of another 33%–to 40, from 30 in today’s p/e ratio over the next decade. Possible? Certainly. In the stock market, anything can happen. Likely? I don’t think so. Consider that prior to 1995, the p/e ratio had never exceeded 24 times.”

Thus, although the pendulum already may have retraced much of its rise, a return to some levels in the past would not bode well for investors anxious to nail the bottom of this market. As for Sir John’s (Templeton) view, he said the pendulum has further to go. Remember, it has momentum, so it doesn’t stop where price levels are reasonable; it continues on its path until prices are so unreasonable they are not sustainable. Are we there?


On Conflicts of Interest:

The NASDAQ’s return flight to earth from its dot-com rocket ride into the 5,000’s ended in a rough landing, to say the least. (Remember the old television show, Queen for A Day? NASDAQ investors could start a new one: Rich for a Year.) So it isn’t surprising that many passengers are crying foul, claiming they got bad advice from analysts with conflicting interests. Do we think analysts have conflicting interests? Can a fat dog bark? The brokerage community is riddled with conflicts of interests, many of which we’ve tried to articulate in past letters. So are most other walks of life when we take the time to look for them. What’s really important about conflicts of interest is their disclosure. Investors should be informed of possible conflicts of interest, and many times they are not, at least in our opinion.

But blaming the collapse of the new economy on these poor analysts isn’t fair. Investors need to take responsibility for their own actions at some point. Ron Baron put it nicely in his June 30, 2001 Quarterly Report: “The recent spate of criticism of brokerage firms” research recommendations by regulators, the press and investors should be categorized, in our opinion, as looking for scapegoats for poor investment decisions in many cases by those who should have known better.” Those who should have known better include professionals as well as individuals. Marty Whitman wasn’t as nice in his July 31, 2001 Quarterly Report: “The main point is that many, if not most, analysts, by and large, were incompetent. It was like they were in Jonestown drinking the Kool-Aid. Put otherwise I bet the same trillion dollars would have been lost by the investing public even if there had been no conflicts of interest.”

The point is that brokerage firms don’t exist to think up ways for you to make money. Brokerage firms are merchandisers. They are marketing machines that exist to make a profit based on what they can sell us. In many instances “research” is simply a product. Write reports on what isn’t popular (regardless of its investment merits) and it won’t sell. In other instances, “research” is merely a way to support underwriting departments, which profit from selling us the securities of large corporate and government issuers, as well as Initial Public Offerings. It’s only natural; a large corporation isn’t likely to ask a brokerage firm to underwrite its next stock offering if the brokerage firm’s “research” recommends selling the stock. Research is propaganda. This isn’t new information and it’s not going to change.

On The Value of Research:

Given the above, this will be a short reflection. Nevertheless, it seems important to address a certain school of thought purported by the investment community that stocks can’t realize their true potential unless the underlying company is written up by Wall Street analysts. As stated in the July 23, 2001 issue of InvestmentNews, “For instance, pharmaceutical giant Merck & Co, Inc., with a market cap of $155 billion, has roughly 30 analysts covering it. In contrast, J.M. Smucker Co., with a market cap of $644 million, has just one analyst covering it”

What these two companies have in common, in addition to being mentioned in the same article, is the fact that Dreher Capital Management has a position in both of them. For the record, it didn’t make any difference to us which, or how many, Wall Street analysts were writing on either company: we made our decisions by ourselves, without analyst counsel as it were. Our clients and others who have suffered through these pages over the years certainly have been exposed to Marty Whitman’s concept of Resource Conversion; whereby stock prices tend toward their private values via stock buy backs, spin-offs, mergers, leveraged buyouts and takeovers. The investment community may not want you to believe it, but these events do occur even without the benefits of Wall Street analysts. Companies that really do make cash don’t stay undervalued for long (Smuckers, which we purchased for only a few of you “sorry” has risen from $17 to over $35 in 19 months).

As for being written up by Wall Street analysts, our favorite example of this value (or lack of value) was described in last April’s edition of Forbes, ASAP. The article tracks the recommendations of some very prominent Wall Street Analysts on Rhythms NetCommunications. We won’t get personal by identifying the analysts and their houses, but here are their recommendations for this stock.

$71.00: BUY, “will sustain strong top-line revenue growth we see the company as undervalued.” (The stock rose in price following this recommendation to $93.13, its ultimate peak.)

$30.62: BUY, “superior product offering national footprint.”

$11.94: BUY, “company produced a very solid quarter price target $55.”

$10.88: BUY, “Rhythms strategic value has been enhanced.”

$ 3.94: BUY, “Its national network gives it strategic value.”

$ 0.88: “downgraded to neutral.”

On The Related Topic of Mutual Funds:

If brokerages are merchandising machines, what are mutual funds? Do mutual funds have conflicts of interest? Oh my, where do we begin? Someplace obscure might be interesting. Remember underwriting from above? Yes, mutual funds have been known to be in the business of underwriting as an alternative to scouring the investment landscape looking for bargains for shareholders. Now that Fidelity, for example, has added stock brokerage to its rapidly growing list of non-core financial services, some of the firm’s practices have been questionable: if you’re an underwriter of new stock issues, and you just happen to own a mutual fund, where do you think you might sell some of that stock especially the stock that gets kind of hard to sell? An August 2001 issue of Barron’s, quoting Mercer Bullard, a former assistant chief counsel for the SEC and president of Fund Democracy, a consumer-advocacy group based in Washington, made the following comments.

“Bullard referred to a little-known 1997 rule change that allows a money manager affiliated with an investment bank to purchase up to 25% of an IPO underwritten by the bank…the more stringent rules had been in force to prevent abuses, such as dumping brokerages selling unmarketable securities they’ve underwritten to kindred public funds that had plagued the business in the Twenties and Thirties. This time around, the lure of IPO profits drew Boston-based Fidelity Investments, sponsor of the Fidelity Magellan Fund, into the underwriting business. Over the past two years Fidelity has amassed one of the worst records among the co-managers who have completed 20 offerings or more From January 1999 through August 22, its deals have lost, on average, 46%, versus an average loss of 25% for the group.

“For example, Magellan and Fidelity Contrafund bought AT&T Wireless from a syndicate in which Fidelity Capital Markets participated at the original offering price of $30 on April 26, 2000. Since then the share price has dropped to $15.73.”

Then, of course, there are the more obvious cases wherein mutual funds use (more accurately, misuse) their investment clout in the IPO markets to create illusions of superior returns to attract unsuspecting investors. The venerable Dreyfus outfit was noted in the same Barron’s article for this infraction.

“Some fund groups used IPO allocations to salt the performance of new funds. Michael L Schonberg used IPO gains to boost the performance of Dreyfus Aggressive Growth until it ranked as a top-performing fund of its class. Improprieties in that operation resulted in Dreyfus paying an SEC fine of $950,000 last year, while Schonberg paid a $50,000 fine and suffered a suspension.

“Scott Cooley, senior analyst for Morningstar, the Chicago-based fund tracker, hopes that the SEC will require fund groups to disclose in detail what they do with their IPO profits. These gains have represented an extraordinary windfall that can’t be repeated and they certainly don’t represent the acumen of the investment manager, says Cooley. I think there should be more regular disclosure to help investors determine the contributing factors to return.”

Then there are the real obvious cases of front running. Front running happens when your mutual fund manager buys stock for his own account before he buys it with your money. From another financial magazine, same company, same manager: “The Dreyfus Corporation has tentatively agreed to pay $20.5 million to settle a federal class action lawsuit and a state lawsuit brought in 1998 by investors in two Dreyfus mutual funds. The investors charged former Dreyfus portfolio manager Michael Schonberg of front running securities he subsequently purchased for the Dreyfus Aggressive Growth Fund and the Premier Aggressive Growth Fund. The suits further charged Dreyfus with willfully concealing Schonberg’s actions.”

Mutual funds get paid fees on the money they have under management. In an ideal world, their money under management would depend on their performance (measured fairly), so their fees would depend in turn on how well the managers managed the money. Like the rest of the world, however, conflicts of interest develop: some structural, some artificial, some which need to be outlawed, all of which need to be disclosed. These issues are usually covered up during prosperous bull markets. Bear markets are notorious for, as Warren Buffett has wont to say, seeing who is swimming naked when the tide goes out.

On 1973-1974:

Unfortunately for you, our clients (at least during 1998 and 1999), and fortunately for you (at least during 2000 and 2001), these were my formative years. They could be described as gloomy. John Bogle didn’t have to go back to 1950 to find an era of cheap stocks. The 1973-1974 bear demonstrated how low can you go. Value Line’s median price-to-earnings ratio for the week ended December 23, 1974 was 4.8 times; its median dividend yield stood at 7.8%. If the pendulum goes this far this time, IBM ($121) goes to $20  on an earnings basis and $7 1/8 on a dividend basis; Merck ($58.80) goes to $15 1/2 based on earnings and $18  based on dividends. Here’s a few more: Microsoft ($66.25), $8 7/8-$0; EMC ($13.44), 5 cents-$0; Exxon ($39.30), $11-$11 7/8; General Electric ($40.08), $6 7/8-$8 : General Motors ($48.60), $23 -$25 5/8.

That’s enough. These aren’t predictions. First, many of these stocks are above average and thereby wouldn’t suffer the median experience of the equity universe in the event of a 1973-1974 bear. Second, present conditions as lousy as they may be don’t seem nearly as dire as they did during that period. While there was a war, the country was torn apart by it rather than united as we are now (at least for the present). Oil prices now aren’t on the way up to $50 per barrel (at least for the present). Our government isn’t coming apart at the seams the way it was during the Watergate years. (Feel lucky? How would we like to have Bill Clinton or Dan Quale leading us now?) After the September 11 attack, some might say the country’s crowning achievement was to reopen the NYSE within a week. Looking back at the 1973-1974 era, some might say the country’s defining accomplishment was to hold another election. They were truly dark days. While we aren’t using them to predict what’s in store for us in coming years, they are a good reminder of how far the pendulum could go if things get worse. Meanwhile, let it just suffice never to say a stock is too cheap to go any lower!

Fortunately, this period represented a bargain as far as stock prices were concerned. The pendulum had swung too far. Curiously, while I remember low stock prices, numbers that seemed low, I don’t remember any panic. Probably despair or despondency would be better words to characterize the period. The rest of the world may have been going about its business, but from my ivory tower, I remember thinking every time the stock market rallied that the next day it would give it all back just like all the times before, week after week, month after month.

On Panic:

Speaking of panic, Webster says it is “a sudden, unreasoning, hysterical fear, often spreading quickly.” This happened in 1970, pretty much like Webster describes except for the “unreasoning” portion of his definition. Back in those days a recession had resulted in a few bankruptcies. Commercial paper was relatively new, just starting to trade in the secondary market. It seems that several companies were abusing their use of commercial paper by not backing it up fully with lines of bank credit. One of the largest of these abusers was Chrysler, and there was a run on the market. The company’s maturing paper couldn’t be rolled over; there were no buyers, only sellers. There was a conference of banks, which met, I believe, in New York. The president of our bank went to this conference.

We had a policy at the bank that trust people (analysts like yours truly) and banking people (like the president) would write notes to share with each other after calling on companies the trust side looking for stocks to buy, the banking side looking for loan business. Being the young smart-ass that I was back in those days, with just enough information to get into trouble, I sent a memo to the president asking him for his notes on Chrysler. I didn’t expect a response. The next day when I was called down to his office I thought it might be over for me (this might be another form of panic, but that’s a different story). However, what he told me was amazing. The Federal Reserve, functioning in its capacity of lender of last resort, had instructed all Chrysler bankers to double their credit lines to the company, so the company could pay off all of its paper if necessary with bank debt. “Now,” he said, “you’re an insider, so don’t buy or sell any stock in Chrysler until further notice.”

When I related this story to my fellow analysts (conspiring young smart-asses, mainly), the mood became sober, because we wondered what company would be next, and which would the Feds save and which would they let perish. Back in those days analysts actually studied balance sheets in conjunction with income statements, so we could figure out which companies didn’t belong in the commercial paper market without supporting bank lines. Fortunately, and sort of remarkably, the run stopped at Chrysler, the markets became orderly, and a magnificent stock rally ensued and lasted for two years. (International Harvester would have to wait for another day.) Thus, except for the fact that some reason existed for the run, this panic unfolded just like Webster describes it was sudden and spread quickly. For more details on this panic, and a discussion of the possible responsibility of brokerages, see the January 1, 1995 edition of The Strategy Adviser: “Clear and Present Danger.”

Then there was 1987. That was a legitimate panic that most of us remember. It was the culmination of a severe-but-short bear market, setting the stage for the fabulous decade of the 1990’s, though it would take a couple of years for the indices to reach their old peaks.

Truly an archetype panic occurred during the third quarter of 1998. Without a single bankruptcy or missed payment on a credit instrument, the markets went into a free fall. Complacency changed to fear overnight, the spread between Government and corporate bonds soared to near record levels and the banking system of the United States was temporarily unable to finance housing construction, as there was no secondary market for the paper. This panic hit every cord of Webster’s definition: sudden, unreasonable, hysterical, spread quickly. This too was brief, however, and represented a buying opportunity for the last frenzied days of the decade. A discussion of this panic can be found in our Letter of January 1, 2001: “The Roles Of Risk And The Federal Reserve.”

Many brokerages and others making prognostications of late have suggested that the market decline following the terrorist attacks of last September 11 was a panic comparable to those of 1970, 1987 and 1998. My purpose in describing these panics is to state emphatically that there was no panic in the market decline after last September 11. Yes, the airlines got crushed, but not unreasonably so; they were on the way down before, and their price levels at this point could be considered quite rational. The same could be said for the lodging stocks. There was one incident that resulted in a buying opportunity. The Bass brothers got into some financial difficulty and had to unload over a billion dollars of Disney stock (we tried to buy some of this for all of you, but unfortunately our efforts were not successful). Thus, whether the market decline following last September 11 turns out to be a bottom or not, characterizing the period as one of panic in the financial markets is simply wrong.

The last true panic I remember occurred in March of 2000. This panic was another classic. It was sudden, hysterical and fast spreading. It embodied the fear of investors that they were missing out on the opportunity to get rich in the new economy stocks. As history has documented, nothing could have been further from reality. This fear was epitomized by a Wall Street Journal “Heard On The Street” column wherein a high-profile mutual fund manager explained his recent sells of old economy blue chips Bristol-Myers and Procter & Gamble, for examples to buy new economy stocks. His timing was unwittingly perfect. It marked the end of a long decline with a bottom-forming capitulation for the likes of Procter & Gamble, Eli Lilly, Johnson & Johnson and Clorox. All of these stocks are higher now, while the new economy stocks whose purchases their liquidations funded have been decimated. Affymetrix is an example. Cited in the article as a leading genomics company and pillar of the new economy, the stock traded that month for $163.50 per share. Via an index mutual fund, we purchased shares in Affymetrix this past October, paying $22.41 each (though we didn’t liquidate any of our positions in Bristol-Myers, Clorox or Johnson & Johnson to do so). Similarly, Cisco, whose shares changed hands at $80 that infamous March, and whose praise also was sung in the article, didn’t stop declining until it reached $11.

As Peter Bernstein, writing in the July 1998 edition of Worth, remarks, “Panic does represent opportunity to investors who are stout of heart and have resisted the temptation to believe that trees grow to the sky. That is why I have never indulged in an investment strategy that involves a100 percent commitment to any single asset class not cash, not high-fliers, not anything in between. Long-run success depends far more on understanding risk, preparing for risk, and managing risk than on picking the right stock or fund or asset class. Panic will be your greatest enemy or your greatest friend, depending on how well you manage it when it occurs.” The ability to capitalize on the opportunities brought about by panic means being diversified enough so that you are not one of the opportunities. This is how we try to manage your money.

On Outlook Versus Price:

Last quarter’s Letter quoted Marty Whitman as saying that “investors who are strictly outlook conscious, rather than price conscious, in the selection of securities to buy, own or sell” could get into trouble when the market becomes a weighing machine rather than a voting machine. What was this supposed to mean?

Often times we establish positions in the stocks of companies whose short-term outlooks are marred by some difficulty, such as a decline in quarterly earnings, a production problem or external factors. The very fact that these problems exist often leads to low prices for the stocks that represent opportunities, at least in our view. In these cases, we can overlook the immediate outlook because we are getting an opportunity to buy cash flows or assets at a price that might be lower than what a private buyer would pay. Of course, we would want to buy in a business we like, not one that’s simply cheap, so we can’t take our eye off the long-term outlook. But price becomes the determining factor, not the outlook. Put another way, it is possible to pay too much for a good outlook.

We hope Affymetrix is an example. It may or may not be, and its price in relation to its resources is still hard for us to measure, given our non-technical backgrounds. That is why we used an index fund to gain exposure. But consider the outlook for this company as a leading genomics enterprise. The outlook really hasn’t changed. Genomics continues to represent an exciting new field with huge and growing potential. People (a lot smarter than we) said this in March of 2000 and they are saying it today. We agree, but using strictly an outlook context in which to select stocks, someone’s cost is $163.50 per share, which is where the stock traded in March of 2000. Without reference to price, buyers, in effect, valued the company at $9.3 billion, or 46.5 times what turned out to be $200 million in revenues for the year. Estimated revenues for next year of $270 million, on the other hand, are being valued by the market at 5.0 times more in line with established medical companies such as Abbott Labs ($51), 4.4 times; Johnson & Johnson ($53), 4.5 times; Medtronic ($47), 7.4 times and Bristol-Myers ($59), 5.0 times (prices as of October 26, 2001).

To review, same outlook, different price. This may not be the bottom, but if you don’t think the pendulum has traveled a good distance, explain why the outlook for this company is valued today at $1.3 billion versus $9 billion two years ago this coming March.

On Dividends:

Barron’s, October 2001: “Susan Byrne, founder and president of $3.7 billion Westwood Management, emphasized the need to focus on stocks whose dividend yield and earnings growth combined would deliver market-beating returns” “Recent experience suggests investors should have lower long-term-return expectations for stocks in general, and looking ahead, we see dividends comprising a higher percentage of realized returns, notes Christopher Wolfe, equity strategist for J.P. Morgan’s private clients. For equity investors, this means a spotlight on stocks with a strong dividend component.” Financial Planning, October 2001: “Many clients rely on dividend-paying assets. A small allocation of real estate investment trusts can boost income while reducing risk.” InvestmentNews, October 2001: “Last week, Standard & Poor’s put six Reits into its stock indexes one in the S&P 500, three in the MidCap 400 and two in the SmallCap 600.” A table in Forbes, November 2001: “Not only do these stocks have low risk ratings, they sell for no more than ten times 2002 estimated earnings and have a record of paying dividends.”

Comes forth now an army of analysts, strategists, commentators and assortment of folks extolling the virtues of dividends. We have two words for all of them: welcome, welcome! Welcome back to the fold those who were trained better but lost their way in the new economy, and welcome to the young Turks just discovering the virtues of dividends; for all of them are a little closer now to the theory of compounding, or interest on interest. Having said for many years that a complete investment experience requires a portion of one’s portfolio to be in fixed-income securities and securities paying high dividends, we are happy to see the crowd embrace the merits of these investments.

Have you seen Chuck lately? The setting for the advertisement is a few investors sitting around looking very serious (now they know there’s risk in the stock market). Charles Schwab, himself, comes out dressed in a three-piece suit and tells everyone to be calm; it’s just a bear market. Everyone sighs a nervous little laugh of relief, and Chuck goes on to say all you need is some cash and a few bonds and you can weather the storm. Man, if you don’t think the pendulum has moved, just think back a year or so. Remember the full-page advertisements in the financial press where a cell phone took up the whole page? The ads offered to give you this phone FREE if only you would deposit $10,000 in you account and use the phone to trade, trade, trade. I wonder what Chuck did with all those phones?

Inevitably, this newfound enthusiasm for the income component of investment return has the potential to become overdone and end badly. First of all, bigger isn’t better. With the linear thinking of the investment community, high current yields could have a tendency to be emphasized over lower yields that expose the investor to less risk. Second, if the amount of cash an investor can realize from a company over the long-run, discounted at the investor’s cost of capital, represents the worth of a company, dividends may not be as important as they once were. This sounds contradictory, but think about the shortening of cycles over the past five decades.

At the beginning of John Bogle’s investment study, 1950, companies especially large companies such as AT&T remained intact for hundreds of years, or at least that was the expectation of investors, including those who bought 100-year railroad bonds. So it was very likely that the only cash an investor could reasonably expect to realize from owning stock in a corporation was the dividends received over the years. Perhaps this was a contributing factor to stocks having the high current return of 8.7% at the time. With the advent of the Information Age, however, this time horizon changed. It became shorter. Ushered in on the wings of the computer, the Information Age allows investors to determine the value of companies and their individual components. As a result, the time company managers now spend on allocating resources deciding when to raise capital and whether to do it using retained earnings, debt, equity or sale of non-core assets is just as important as the time they spend developing and marketing their products and services. Investors in a truly undervalued company can expect to realize cash from their positions over a short time horizon via takeovers by private buyers (such as other companies), leveraged buyouts, spin-offs and stock buy-backs. Throw in the taxability of dividends to many investors, and it becomes clear that dividends in many ways represent an inefficient way of realizing a gain from investment.

It is not our intent at this juncture to fade the crowd and sell the comfortable income streams you purchased at much lower levels. In fact, we believe there remain many current yield opportunities. In addition to real estate investment trusts, which we have owned for several years, we continue to find intriguing total-return opportunities in non-nuclear, electric utilities and natural gas distribution companies. Many of these ideas pay double and even triple the small money market yields available today. Nevertheless, the sudden popularity of dividends makes us nervous. Consider our antennae up, especially with REIT’s going into the S&P 500 and other indices. When we begin reading in popular financial publications statements like “it’s OK for investors to own REIT’s that yield less than bonds, because REIT’s raise their dividends and bonds are fixed,” then it will be time to look elsewhere for opportunity.

On Bonds Versus Stocks:

Another reason we would be cautious about scooping up current yield in this market is the distance bonds have traveled just over the past two years. This is another sign of how far the pendulum has swung. As measured by the Vanguard 500 Index Fund, stocks, beginning in 2000, declined 28.1% through September 2001. In contrast, the Vanguard Total Bond Index Fund delivered a total return of 15.7% for the period. In less than two years, therefore, bonds outstripped stocks by an amazing 43.8%. Using the NASDAQ as a proxy for stocks, the story becomes almost unbelievable. This index declined 63% during the same 18-month period, placing it over 78% behind bonds! We don’t know how low a reasonable person would expect interest rates to go, but we certainly wouldn’t be reaching for yield now by extending maturities. It’s possible that this is the worst time to buy bonds since 1993. Consequently, we have confined our purchases of bonds to investment grade issues maturing in five to seven years.

On Financial Publications:

This reflection could be under “Conflicts of Interest,” because (you guessed it) magazines have to sell magazines. So excuse us for overstating the obvious: namely, that article you read recently in your favorite financial publication, depicting an amazing new product or service that will make shareholders wealthy, wasn’t written for your benefit; it was written to sell the publication. As for the new product or service, by the time you read the article its affects are more than likely fully discounted by the stock price. We all know this, yet we are all guilty of running to our brokers with checkbook in one hand and article in the other.

The tragedy of September 11 brought this conflict-of-interest problem to light in a very surrealistic sort of way. We are saving the October 1, 2001 issue of Forbes for perpetuity. Dated three weeks AFTER the attacks, there is no mention of them in this issue, and there is a book review on Fear of Flying, described as “A gripping new tale of a commuter plane crash may give frequent fliers pause.” Obviously, in light of the circumstances, this headline and review were in very poor taste. They probably would have been omitted had the magazine not already been on the newsstands or at least too far along in the publication process to change.

The point is that the financial press is so out of date by the time we receive their issues it is just plain silly to believe we can extract anything even remotely resembling timely information information that we can use in our investments because other investors, who by implication don’t have the information when we do, will come along and pay us more for the investment when they get the information. At the risk of opening up the broad subject of “what is information,” we would suggest that if you can’t use it two years from now, it might not be very valuable. Descriptions of how companies operate, what their products are, investment principles: these are examples of subjects that hold the possibility of standing the test of time and providing some value. Just in this letter, for example, consider how applicable to this time are the comments of John Bogle, made a year ago, or the remarks of Peter Bernstein that appeared two-and-a-half years ago in Worth.

The financial publication business is structurally programmed to present popular ideas on an untimely basis. Our job as consumers is to recognize this flaw: resist the temptation to think we can get something for nothing by reading an article in a magazine and running to our brokers before the crowd; instead, incorporate the information into our thinking process so it will help us recognize an opportunity we might encounter in the future.

On Retirement Investment Strategies:

We couldn’t resist. In our local newspaper, The Pilot, appeared the invitation to attend a seminar (maybe some of you did) to learn “if you will outlive your retirement income.” This seminar was put on by two individuals who, between them, had enough degrees to use up most of the alphabet: MBA, CPA, CFP, and JD. A full-color, 20-page workbook was provided to all who attended.

Balancing an adequate rate of return with stability of principal is what Dreher Capital Management has been doing for retiree’s since our inception in 1994. This is our specialty. We were doing it during the dot-com bubble days, when the concept was unpopular. Now that the market declines have re-established the concept of risk, investment tenets designed to make your money last and provide income during retirement are being purported by individuals selling the same old investment products and schemes, from mutual funds to annuities. Rest assured that when these scary times are replaced by another stock market fad, and these individuals have moved on to the next scheme, Dreher Capital will remain in the same business of trying to balance an adequate return with safety of principal for our clients.

On Enron:

This reflection is not our own, but we are grateful to its source (anonymous); for it makes us realize that although our work is serious, we shouldn’t take ourselves too seriously. Investors may or may not learn from Enron and diversify their investments; perhaps they will even be able to identify similar symptoms earlier in the future. But one thing is certain: as always happens in the stock market, Enron will happen again.

FEUDALISM: You have two cows. Your lord takes some of the milk.

FASCISM: You have two cows. The government takes both, hires you to take care of them and sells you the milk.

PURE COMMUNISM: You have two cows. Your neighbors help take care of them and you all share the milk.

APPLIED COMMUNISM: You have two cows. You must take care of them, but the government takes the milk.

TOTALITARIANISM: You have two cows. The government takes them both and denies they ever existed. Milk is banned.

MEXICAN DEMOCRACY: You have two cows. The government takes both and drafts you into the army.

EUROPEAN DEMOCRACY: You have two cows. The EU Commission decides which regulations for feeding and milking apply. If there aren’t any, they invent some. They pay you not to milk the cows. They take both cows, shoot one, milk the other and pour the milk down the drain. They then require you to fill out forms accounting for the missing cows.

CAPITALISM: You have two cows. You sell one and buy a bull. Your herd multiplies and the economy grows. You sell them and retire on the income.

ENRON VENTURE CAPITALISM: You have two cows. You sell three of them to your publicly listed company, using letters of credit opened by your brother-in-law at the bank, then execute a debt/equity swap with an associated general offer so you get all four cows back, with a tax exemption for five cows. The milk rights of the six cows are transferred via an intermediary to a Cayman Island company secretly owned by the majority shareholders who sell the rights to all seven cows back to your listed company. The annual report says the company owns eight cows, with an option on one more.


Both Templeton and Bogle have suggested that the 2000-2009 decade will be difficult for investors compared to the fabulous 1990’s. Warren Buffett has made similar observations. The world of academia has stated over the years that stocks return between 9% and 10%, on average, when viewed over the past 100 years. If the twenty-year period from 1990 to 2009 has an average experience, therefore, the implications for this decade could be grim. Using each decade as one observation, it would take a 0% return in the current decade to balance out the 18.9% return of the 1990’s (18.9% + 0%/ 2 = 9.45%). While this is not a prediction on our part, the idea of a 0% return in stocks over a 10-year period is not as far-fetched as it may appear.

First of all, such a return would be the complete opposite of what we are being told by the investment community, which is encouraging investors and the financial press to invest at the “bottom” of this market. And doing the opposite of what some of these characters want us to do is at times very profitable.

Second, there is precedence. Our calculations indicate the DJIA hit the 1,000 mark in 1966 and didn’t get past this level until 1983, marking a 17-year period of 0% return in stocks. Then, of course, there is the more recent, sad story of Japan.

Third, we hate to call it to your attention because time is flying (hope we’re having fun!), but only four months after this New Year we have just entered, the decade will be a third gone. And so far, we’re not even back to even. As for the NASDAQ, which has risen nearly 43% from its bottom, it could double and still not be within 1000 points of a 0% return for the new decade.

Given the record of stocks to date for this decade, we are inclined to recognize the wisdom of Templeton and Bogle. While it is possible we saw the bottom of this bear following the terrorist attacks on September 11, it seems unlikely that we’ll be going back to the business as usual (unusual might be more apt) of the 1990’s.


Warts And All:

Speaking of incompetence, people who live in glass houses shouldn’t throw stones! We have a selection on the SAFH list that lost all the money. The company declared bankruptcy and its stock went for that long dirt nap. The SAFH portfolio attempts to identify stocks of companies that have a chance to double because of their cash generating abilities, before growth is taken into consideration. In the case of Heilig-Myers, my judgment (Tom wasn’t here) was incompetent because I didn’t recognize the danger of the company’s debt, which ultimately proved too large even for the cash that was being generated. A large debt load also played a part in the miserable performance of Budget Car Rental, which we removed from the portfolio after a 70% loss.

So, ask some readers, why do we persist on showing these results when they’re so bad? The answer is integrity. If we just showed the successes, the SAFH portfolio wouldn’t mean anything. We think it’s important to show the complete record so we can see how the idea works. The magazine commentators who recommend all sorts of investments and then review them when it’s convenient amuse us. “Oh yes,” they say. “We recommended XYZ two years ago at $50; today, it’s $75.” They don’t mention that in the meantime XYZ might have dropped to $25. And if it doesn’t come back, they conveniently forget to report on its progress. We show the complete history of the SAFH portfolio, warts and all. (As stated, this portfolio is not a complete summary of the investments we select for clients, and it does not represent a complete investment experience. Some of its positions may not be appropriate investments for all investors.)

NiSource ($24.25):

NiSource is another Level II, Aggressive Income idea that we believe has a chance for substantial price appreciation once its impressive cash flow is recognized by the investment community. Its current dividend yield is 4.5%. The company serves 430,000 electric customers in Indiana and 3.2 million natural gas customers in Indiana, Ohio, Pennsylvania, Kentucky, Virginia, Maryland, Massachusetts, New Hampshire and Maine. All of its electric power comes from coal. The shares (and pricing for SAFE) were purchased in October.

Ameron International ($61.125):

We believe the September 11 terrorist attacks may have diminished the outlook for Ameron International. We adjusted our model accordingly and decided to sell the shares on September 19.

Heilig-Myers ($0):

We held on to this one hoping for some negotiated value for equity holders, but, as described above, the company’s debt load seems to be eliminating even this possibility. Ouch.


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 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 $60.10 7.3% 24.3%
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 $26.70 27.1% 11.2%
12-09-98 Heilig-Myers IV $7.50 0.0% 12-31-01 $0.00 -100.00% 19.9%
3-3199 Ameron Intl III $35.50 2.1% 9-19-01 $61.13 72.2% -9.0%
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 5.0% CurrPrice $26.24 39.9% -9.1%
3-28-00 Berkshire Class B III $1,667.00 0.0% CurrPrice $2,512.00 50.7% -8.4%
5-25-00 Alleghany Corp III $164.00 0.0% CurrPrice $192.50 17.4% -2.9%
12-29-00 Compaq III $15.05 1.3% CurrPrice $9.76 -35.1% -7.1%
12-29-00 Lucent III $13.50 0.7% 5-21-01 $11.41 -15.5% 1.0%
10-8-01 NiSourse II $24.25 5.4% CurrPrice $23.06 -4.9% 9.9%

*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, and #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.