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Thursday, March 18, 1999

An Investment Opinion
by Dale Wettlaufer

The Mutant Index

Having heard so much about Dow 10,000 over the last week and having had the chance to muse over it, today I'll offer a couple of thoughts on it. Then I want to direct you to some excellent thinking on the subject of securities analysis and the current state of the market.

One thing I would emphasize to an audience with background knowledge is the breadth of the market. Certain theories say that breadth is key and a "confirmation" of new highs. It would be hard to dismiss the signaling functions of markets, but I would like to know why the market is supposed to be different in the distribution of outcomes than all other facets of human existence. Not every child in school is going to be a perfect student, and not every one is going to fail. Most are average -- that's the normal distribution in life. Just as it's unfortunately not true when every parent believes his or her child is a genius, not every stock in the market is going to hit new highs at the same time and perform the same.

The bell curve is almost like the circle in nature -- normal distributions are everywhere, if you look. Most mallards, flies, mice, and humans are going to exhibit certain traits that are pretty well distributed around a mean with some freakish stuff around the edges. For instance, Charles Manson was more than a few standard deviations away from the mean in his personal comport, and Einstein was a few clicks over from the mean on intelligence. But as the part of the story line goes in Good Will Hunting or Trading Places, intelligence is distributed by powers beyond our control.

Now, as for the stock market, occurrences of certain characteristics aren't that tough to observe. Get out a stock chart and take a look. In most years, the general rise in stock prices is clustered around a mean. The farther you get away from the center, the greater the deviation from that mean, up or down. Some years stocks crash. Some years they soar.

What has confounded some is the performance of the S&P 500 over the last four years. But let's throw out 1995 since the market was coming out of a credit crash-induced funk. Over the last three years, the market is up 28.3% compounded annually with dividends reinvested. That rarely happens -- it's the freakish tail of a distribution of simultaneous events -- so people twist themselves into all sort of explanations as to why it has happened. Evergreen Funds has a great commercial out right now. Set to the Bee Gees' "Jive Talkin'" (way to go, Evergreen!), the spot portrays a bunch of talking heads on a financial news network giving their predictions as to where the market is going to go, how you should allocate your assets (don't forget the 5% in commodities, institutional people and private banking clients, it's very important that you support your broker's trading division), and what the Fed will do next. Total jive.

I'll get to the point here. Last week, I looked at the performance of the Russell 2000 over the last three years. The Russell 2000 has actually underperformed historical equity market returns over this time period, returning 8.8% compounded annually with dividends reinvested. You have to feel good about this, as it keeps some strategists off the unemployment line. They wouldn't have a job trying to convince you investors' biases are the boot on the neck of the small caps. Maybe I'm enjoying this lush job at the Fool because I'm just another talking head giving a different theory. Call me a Fool, but I think it actually has something to do with the performances of the companies underlying the indices that explain their advances.

Luckily, some investment thinkers and doers up at CS First Boston share this view. In a recent edition of that firm's excellent "Frontiers of Finance" series, Michael Mauboussin, Bob Hiler, and Patrick McCarthy explain how The (Fat Tail) Wags the Dog. The divergence of the S&P 500 and smaller capitalization indices is due to excellent economics of the companies in the larger indices. The report details the quantum difference in the productivity of a few larger companies in the S&P 500 and how that is driving the performance of the index.

The report also details how the market capitalization-weighted return on capital for the S&P 500 companies has advanced more than 10 percentage points since 1995. That's not 10% -- that's a 67% increase. Just as a very short primer, return on capital is like return on equity, but it's not colored by the use of financial leverage. It's cash flow per dollar of capital, whether that capital is debt, equity, or equity equivalents such as insurance claims and expense reserves. Return on invested capital is just the unleveraged after-tax return on all capital employed by a business and can be increased by two things, broadly speaking: margins and asset productivity.

When you have a company with 40% net margin and very little fixed assets, as Microsoft does, you get high asset turnover on a fat margin base. You'd have to assume some pretty bad results in the very near future to price Microsoft at anything approaching the historical market P/E. In fact, it's hard to believe some people can't give the company's valuation a little latitude when it creates $1.88 in cash flow for every dollar of capital invested in the business.

American corporations, by way of comparison, have generated returns on capital of about 11-13% ($0.11 to $0.13 per dollar of invested capital) over the course of the century. Let's express this by way of bond math. If you bought Microsoft at a P/E of 100 (I assume here that cash flow is equal to earnings), that means it's like a bond currently yielding 1%. But imagine, when you buy this special bond, that you get the right to invest your coupon income in new bonds that are priced to a current yield of 188%. It doesn't take long for you to make up the difference paying up for this business -- assuming it doesn't fall apart tomorrow or the next year, that the West Coast isn't swallowed up by an angry earth, or that a meteor doesn't cast us into a new ice age.

You have incredibly good asset productivity at the leading S&P 500 companies. Look at the best gainers over the last 30 years and 10 years in American markets. There's Wal-Mart and Dell, both lower margin, high asset turnover businesses. When you return 25% on capital as Wal-Mart did in the early years, and your working capital is largely supported by your vendors, you've just got a ton of money coming in every year to reinvest and push the formula into new markets. And when you're Dell and you measure your inventory in hours (ending inventory last quarter was 168 hours or less) while your competitors sometime deal with 1-2% weekly depreciation of the CPU (the largest single item in the cost of the inventory) and DRAM in their boxes that are in inventory for 4-6 weeks, you're going to take market share and you're going to grow faster.

It's pretty simple to figure out that a company that needs 1/10 the assets per dollar in sales of its largest competitor (expressed another way, has 10 times the asset turnover), and can scale the business at that same ratio, is going to be successful. When you can do that at a better margin, well, that's pretty tough to compete with. For every dollar in capital that Dell has invested in the business, it has generated an after-tax return of around $1.70 to $2.20, or even more, over the last year. Dell isn't priced at 10 times the market, but it's 10 times more productive, which compounds geometrically. The market is saying that that competitive advantage won't last. People generally don't think of the market's outlook on Dell as being anything resembling pessimistic, but there you have it.

Here's a table of the market-cap weighted return on invested capital (ROIC) performance of the S&P 500 (Expand window, please):

YearMedian ROIC Mean ROIC Market-Cap Weighted ROIC
1995 11.0% 13.1% 15.3%
1996 10.1 12.5 16.4
1997 10.0 12.4 18.9
1998E 10.0 12.5 25.5
1999E 10.0 12.5 26.8
Average 10.2% 12.6% 20.6%

Source: Company published data, CS First Boston estimates.

Analyst Michael Mauboussin goes on to write: "It is first important to note that over one-half of the S&P Industrial's market-capitalization-weighted ROIC is derived from four companies: Microsoft, Dell, Coca-Cola, and GE. These four companies, which comprised 12.3% of the index weighting at year-end 1998, had an average ROIC of 119%."

Contribution to Market-Capitalization-Weighted ROIC
S&P Industrials, year-end 1998

CompanyMarket-capitalization weighted ROIC contribution

Subtotal of top 4: 13.0%
All others (358 companies): 12.5%
Total 25.5%
Source: Company published data, CSFB estimates.

If you look at the broad market, as expressed by the Russell 3000, then you're going to see a normal distribution with little bumps on both tails. But when you zero in on the distribution of the S&P 500, you've got a mutant right tail created by these companies. It's as if one team in the NFL has five offensive lineman, each weighing 500 pounds with 7% body fat who can run a 4.0-40 yard dash. Think they'd win the Super Bowl? These are mutant companies and the cream of the crop of global businesses. Of course they're going to outperform and make all the other companies out there look like pikers. As the CS First Boston report notes:

"One key implication of this analysis is that the warranted P/E for the market -- even without consideration of lower interest rates -- is justifiably much higher today than it was earlier this decade. Further, these data suggest that P/E comparisons relative to the market are suspect. In fact, the use of relative multiples is a de facto comparison to market-dominant companies generating extraordinary returns and growth."

I'd love to throw price/sales ratios in there, too. The report concludes: "Beating the S&P 500 Index is always challenging for a money manager. The task is even more daunting without an appreciation of the key performance drivers of the indices. This report provides some insights about the market's past performance -- and why it may continue in the future." I'll add in there that it's dangerous being a stock market strategist, prognosticator, and soothsayer without an appreciation of these dynamics, too. I highly recommend the report and pretty much everything else at the Cap@Columbia site to which I linked above.

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