Investors better read the footnotes James Grant Wednesday, March 6, 2002
Money management as art form
NEW YORK In 1962, the late Sam Walton opened the first Wal-Mart store in Rogers, Arkansas. Forty years later - just the other day - Wal-Mart overtook Exxon Mobil Corp. to become the world's biggest corporation as measured by sales. A Wal-Mart spokesman attributed this triumph to an "emphasis on value shopping."
Reaching into their wallets, consumers demand value. Investing other people's money, professional money managers are less discriminating. The great anomaly of American capitalism is the detachment of individual investors from their investment dollars.
The stock market peaked two years ago, yet the investment merchandise remains prohibitively expensive.
Is the price of a share reasonable in relation to the earnings of the underlying enterprise? In relation to its dividend? In relation to the corporation's net assets? In relation to interest rates? By none of these measures are the prices quoted for the biggest companies anything but stupendously high.
The Leuthold Group, a Minneapolis-based research firm, computes a valuation measure that weighs share prices against earnings, both historical and estimated. What it finds is that the Standard Poor's 500 index changes hands at about 25 times earnings. If Wal-Mart sold common stocks, it would not be selling Yahoo! (at 277 times earnings), nor would it be selling its own (at 42 times earnings).
The mantra that common stocks are the best investment is neither true nor false. Unless modified by three little words - "at a price" - it is meaningless. In general, when purchased at Wal-Mart prices, common stocks deliver excellent returns over time. At Tiffany prices they tend to disappoint. Fifty years ago the business of professional money management hardly existed. According to Federal Reserve data, American individuals owned 97 percent of their shares outright. Today they directly hold a little less than half. The proportion of investment decisions made by mutual funds, pension funds and the like has drastically increased.
No doubt, many fiduciaries care deeply about the funds entrusted to them. They feel almost as if the money were their own. However, their interests are not the same as those of their clients. As a successful investor once told me, the primary objective of most money managers is not to make money for the client. It is to keep the client. And the way to do that, of course, is to look good. Thus has professional investing become a kind of performance art.
A mutual fund manager looks good by outperforming his or her relevant "benchmark" - for instance, the S&P 500. To compete, a contestant must run with the market wherever it goes, even over a cliff. Are stocks overvalued? In professional circles, the question is not so much inadmissible as irrelevant. On Wall Street, simply avoiding loss is not success. What makes a career in a time like this is losing a little less than the competition.
Concluding his inquest into the crash of 1929, Ferdinand Pecora, counsel to the Senate Banking Committee, prescribed the remedy of full disclosure. Give investors the facts, he reasoned, and they would make informed decisions. What he did not anticipate was that investors would not bother to read the annual reports.
The great bull market of the 1990s, preceded by the great bull market of the 1980s, annihilated skepticism on Wall Street. In keeping with the letter of the Depression-era securities laws, companies disclosed the facts (or at any rate most of them). However, Wall Street didn't want the facts so much as the earnings, insubstantial and revision-prone as they might be. Corporate America obligingly produced them.
It is understandable that amateurs would fail to notice the alarming divergence between the fundamental value of American businesses and the prices assigned to the pieces of paper conferring ownership of those businesses. What is reprehensible is that the professionals did not. Alfred Harrison, vice chairman of Alliance Capital Management and manager of the $11 billion Alliance Premier Growth Fund, speaks for many when he confesses that "nobody really dug into footnotes" of the Enron financial statements. Harrison's firm, as of Sept. 30, owned 43 million Enron shares, which raises a question. If a 43-million share investment wasn't enough to command the attention of leading fiduciaries, what would have been?
There is one way to succeed on Wall Street. It is the way Warren Buffett got rich. Pay low prices for the shares of good businesses. Buy them when the rest of the world wants to sell them. Keep your wits about you. Have the courage of your convictions. The writer, editor of Grant's Interest Rate Observer, contributed this comment to The New York Times.