First Quarter, 2000
During the past calendar quarter, we devised an approach to
broaden your portfolio’s exposure to the various areas of technology that are
having such a profound effect on our lives now and for the foreseeable future.
Technology is understandably the fastest growing area of the
economy, and the one most likely to continue as such. The main drawbacks to
technology stocks have been their lofty valuation and their extreme
volatility. In order to participate in this area but reduce the downside risk,
we have taken a diversified approach to technology investing. Part of our
approach has been to acquire a small number of different technology-oriented
funds, many of which own one hundred or more underlying companies in their
portfolios. This strategy gives your portfolio exposure to an exceptionally
broad cross-section of companies ranging from venture capital start-up
situations to the largest, most firmly established "core technology"
companies in the world.
This broad-brush approach has been augmented by the selection
of a small number of individual technology stocks in your portfolio many of
which you have owned for some time. These individual stock purchases are made
when we believe a stock’s valuation has become attractive, based upon a
combination of current price and future growth prospects. The process is never
complete; as the dynamics of the stock markets change, so too does your
portfolio.
Let us be very clear regarding one consequence of increased
exposure to these technology holdings: the volatility of your portfolio will be
greater now than it has been in the past. This point is easily observed from the
severe drubbing taken by the tech-heavy NASDAQ market during the past four
weeks. Many high-growth companies have now experienced 30-50% price declines in
spite of no perceived change in their business fundamentals. The stocks of other
technology companies with unproven products or business plans have declined even
more.
As you may recall from our previous quarterly reports, we
have long been concerned about the danger to the stock market of rising interest
rates. During the past 12 months, we gradually reduced your exposure to the
stock market. For more than fifteen months, however, investors have chosen to
ignore the mathematical relationship which postulates that rising interest rates
eventually cause stock prices to decline. Now that lesson appears to be sinking
into the collective mind of the investment community.
How much of a correction is possible? Let us illustrate,
again using Cisco’s common stock as a representative core technology holding.
In our last quarterly letter, we noted that Cisco’s P/E averaged around 40
times earnings during 1994-98, a period when the company’s earnings growth
rate was considerably higher than it is today. Were Cisco to return to a 40 P/E
multiple on this year’s projected earnings, the stock price could decline to
$20 a share from its March 27 peak of $82. A price decline of this magnitude is
possible for a number of reasons including:
- Cisco’s annualized earnings growth rate today is approximately half of
what it was 3-4 years ago.
- Rising interest rates have reversed the P/E multiple expansion of the
past decade.
- Cisco faces substantially greater competition from many other giant
corporations, relative to the early 1990s.
- Cisco’s profitability, as measured by its cash return on invested
capital, is approximately ½ of what it was in 1994 and earlier.
Cisco is, of course, the cream of the crop; the consummate
core technology company. If, as we believe, there is sound logic behind a
possible price decline to $20 from $82 for this stock, one can imagine the
potential market declines facing other technology stocks that today are hoping
for earnings at some ill-defined future point in time.
Performance
For most of this year’s first quarter, it was the same
story as all of last year. Most of the largest growth stocks continued to become
more overpriced. Value stocks, now nicknamed "old economy" stocks,
continued to languish or decline in price. This pattern, however, appears to
have begun reversing course in mid-March. With another sharp drop in April, the
recent pullback in technology stocks, although painful, should be healthy for
attracting new investor capital to the area. This pullback also provided the
opportunity for us to add a number of additional good tech stocks at more
reasonable prices.
Corporate bond interest rates exhibited a dual personality
with shorter-term bonds (i.e., those maturing in up to 5-7 years) experiencing a
modest increase in interest rates with commensurate price declines, while
longer-term bonds saw their prices rise modestly as their interest rates
declined somewhat.
We are reluctant to increase the percentage of your assets in
stocks because evidence of increasing inflation is now mounting. Increasing
inflation (should the new economic data so confirm) eventually leads to higher
interest rates, which in turn are bad for stocks as well as bonds.