August 27, 1998

The Task at Hand
By Dale Wettlaufer (TMF Ralegh)

In case you don't own any smaller companies in your portfolio, you may not have noticed that the market has been declining almost all year in 1998. That's right. As depicted by the Russell 2000 (an index of stocks with the 2000 highest market capitalizations), the market was down 15.8% (reinvesting dividends) coming into Thursday. So why is the drop in the S&P 500 from a 1998 high of 1186.7 to Thursday's open at 1084.2 a big surprise?

A big part of it is in the way indexes are constructed. The typical stock in the S&P 500 accounts for a couple of tenths of one percent of the index. However, larger companies in a capitalization-weighted index account for larger parts of the index's movements. Microsoft, for example, accounts for 3.27% of the S&P 500's value. Therefore, if Microsoft goes up 50% in a year, 50 other companies could decline and we would still not be in a bear market if you are judging the health of the market just on the basis of the S&P 500.

Many investors know, however, that we've been sliding for a while. While Dell is up 190% and Microsoft is up 68% for the year, a raft of smaller companies is down by more 20% to 50%. A viable explanation for this is that the S&P 500 is made up of the most successful companies traded in the U.S. The best companies with the best profit profiles are a heck of a lot more resistant to a decline in their value. Some think there's a "Nifty-Fifty" syndrome going on the U.S. right now, but it makes a lot more sense to value something like a Coke at 70 times earnings when it can earn a 50% return on equity and invested capital than to value another company at 20 times earnings when it can only earn 12% on its shareholders' equity or invested capital.

There is not a sickness among investors these days, charges by the financial press and "value proponents" notwithstanding. Value is not value just because you can buy it at book value. Not when the company earns 10% on its book value. With the larger capitalization companies coming down, things are suddenly beginning to look gloomy on the evening news shows, but if you've been paying attention, you know prices have been coming down all year long.

But all of this may be missing the point. In the U.S., we have a market of stocks, not a stock market, as Peter Lynch astutely pointed out. Worrying about "the market" is at best an interesting intellectual exercise and at worst a total distraction from the main pursuit of investing, which is to find companies with superior economics at fair prices. Worrying what the market will do tomorrow adds little value to the main task at hand. The main task is to be an investor. Look at what opportunities are out there. You don't always have to be in motion, buying or selling something. Thinking and evaluating are the main pursuits of the investor. You can't change what the market will hand you, and you don't have to rush out and buy something because it's down a point or two. However, you do have to think and evaluate clearly and honestly to be a good investor.

We hope you enjoy the articles listed to the right and that they will help you in that main pursuit.

First Stop: Significance, Schmignificance