When the fund managers bale out, that’s the time to pile in, says Brett Arends
Remember the cull of the “value managers” near the end of the dotcom bubble? In early 2000, prominent fund managers who refused to jump on the bandwagon finally paid the price. Among them were Tony Dye, the Phillips & Drew chief investment officer in London, locally known as “Dr Doom” for his gloomy philippics, and George Vanderheiden at Fidelity in Boston.
Their departures were one of the market’s final acts of capitulation. The bubble burst soon afterwards.
Is something similar about to happen again? There is some reason to think it might. On October 31, 2005, after months of speculation, Bob Stansky resigned as the manager of Magellan, Fidelity’s flagship mutual fund.
This was no ordinary resignation. Until recently, Magellan was the world’s biggest equity mutual fund: assets peaked six years ago at well over $100 billion. Previous Magellan managers included Fidelity heir Edward Johnson III, now the company chairman, and the legendary Peter Lynch.
A rare financial sin
By the time of his departure, Stansky had run Magellan for a decade and for most of that time had posted impressive returns. But he ultimately paid the price for what has only rarely been a financial sin: betting too heavily on the growth prospects of America’s leading companies.
America’s blue chips are having a poor millennium. Between New Year’s Eve 1999 and mid-December 2005, the Dow Jones Industrial Average fell by 6%, while the broader Standard & Poor’s 500 index was a chunky 12% lower. That compares badly not only with certain overseas markets, most notably in Asia, but even with the smaller stocks at home. The Russell 2000 index of smaller-capitalization US companies rose by 41% over that same period. Since the market lows three years ago, shortly before the launch of the Iraq war, the average American small cap has doubled in value.
It is surprising how badly many of America’s flagship stocks have fared in recent years. From the dawn of the new millennium to the end of last year, Wal-Mart, GE, Pfizer and Intel each declined by around a third. Viacom, a giant media conglomerate, was down by more than 40% and mighty Microsoft had halved in value. These were the stocks that you “couldn’t go wrong” owning in the late 1990s. What has happened since is, of course, exactly what those who follow markets would expect.
It was no wonder, therefore, that Magellan underperformed the market so badly. Stocks such as these made up the core of the fund. As Magellan foundered, disgruntled investors withdrew funds at a rate exceeding $1 billion a month by 2004. Redemptions forced stock sales that depressed prices still further, leading to further underperformance and further withdrawals.
Cycles of fashion
Of course, there is an inevitable cyclical nature to all this. Such stocks were so heavily in fashion in the late 1990s that you would expect a reaction, while the armies of unknowns were due their moment in the sun. The question follows: at what point does the cycle start moving back again?
Some leading fund managers, such as Bill Nygren at Chicago’s Oakmark, broke cover early in 2004. Nygren, traditionally seen as a “value” manager, argued in the spring that some of the best values to be found were in top-quality growth companies, including Wal-Mart. In Boston, a number of his competitors privately agreed, but were holding out for the market’s final act of capitulation, Stansky’s departure.
On October 31, as Fidelity regretfully announced that Stansky would be spending more time with… well, with someone else, we at the Boston Herald whimsically decided to launch the Stansky Index. The stock market’s newest index would track the ex-manager’s top 25 holdings, as disclosed in his last regulatory filing at Magellan.
What began as a bit of a joke quickly became about as creepy as a Twilight Zone episode.
Abrupt price turnarounds
We looked at Citigroup, Stansky’s fourth biggest holding. In his last 18 months, the stock fell by 13%, edging below $45 by the end of October. After that: pop! It suddenly jumped by 9%. Then there was Intel, another top 10 holding. From January 2004 until the end of October it slumped by nearly 40%, culminating in a grisly and uninterrupted three-month slide. After November 1, 2005, however, it suddenly rocketed by almost a fifth. Viacom? Shares in Sumner Redstone’s media conglomerate had slumped by late October to a fresh seven-year low. They rallied 10% by mid-December. The list goes on. Look at Dell Computer, Bank of America, Tyco and Wal-Mart. After months or years of heading south, the shares abruptly changed course at, or around, the end of October. They were all in Stansky’s core portfolio.
The bottom line is that the Stansky Index rose by more than 6% in the six weeks following his resignation. That isn’t just better than the US market overall. It also beats Magellan’s returns during three of the past five years.
Growth or value?
It is easy to joke about this. And there were outside, temporary influences. In October, tax-loss selling by institutions pushed these stocks especially low. Similar sales by private investors in late December also reined in some of the subsequent gains. What is intriguing, however, is the question of whether there is something deeper at work.
These US blue chip “growth” stocks no longer look expensive. Those bubble valuations appear to have unwound. At the end of last year, Microsoft was trading at 21 times forecast earnings. This is by no means cheap for, say, a brewer, but it is this company’s lowest rating since the 1980s.
Citigroup, at 2.2 times book value, is no pricier than British rival HSBC, even though American companies have traditionally traded at a premium to British rivals. Pfizer, the world’s largest pharmaceutical company, is valued at less than 12 times forward earnings. That is the lowest since the 1980s, and even lower than during the 1994 panic over government plans to regulate US healthcare. At the same time, Intel had fallen from an admittedly absurd price-to-earnings ratio of 60 a few years ago to 19 times, or 10 times cashflow. Wal-Mart, which traded on a laughable 55 times earnings in the late 1990s, was down to 19 times by the end of last year.
If you want to travel back in time to the summer of madness in 1999, reflect that back then Cisco Systems was on a price-to-earnings ratio of 200. Today the ratio is a mere 17. Dell Computer is in the enviable position of earning a return on equity of nearly 50%. Twenty-one times forward earnings might be too much to pay, but it is not obviously so. There are, at last, dividends you can see with the naked eye. Bank of America pays out 4.1%, Citigroup 3.6%, Pfizer 3.4% and GE 2.5%.
That is only half the story. After the spending binge of the late 1990s, institutional investors pressured boardrooms at blue chip companies to claw back investment. The belt-tightening has worked. About the same time that Stansky was throwing out his Dilbert desk calendar, Barron’s, the Wall Street weekly, published a list of major American companies now sitting on mountains of cash. They included Cisco, Intel, Dell, Exxon and Microsoft. They even included Gap, the clothing retailer whose bonds hit junk status a few years before.
Stripping out net cash leaves enterprise valuation multiples even lower. Whether or not the companies return the cash to investors is a development that remains to be seen. Ominously, fund managers now tell the monthly Merrill Lynch survey that they want boardrooms to invest the cash, rather than returning it to investors. History is very clear on which group tends to spend money more wisely. Either way, the Stansky Index is one to watch for 2006.
CV Brett Arends
Brett Arends is a columnist on the Boston Herald. He is a former management consultant with McKinsey and financial journalist on the London Daily Mail. He has written a book on sports betting.