Boring Portfolio

Retrospective, Part III
... with the RUT in a rut

by Greg Markus
(TMF Boring)

ANN ARBOR, Mich. (Aug. 26, 1998) -- Weakness in international markets spilled over onto U.S. stocks Wednesday, sending the S&P 500 down 0.79% and the Nasdaq lower by 1.67%. To no one's surprise, small-cap stocks were particularly hard hit, with the Russell 2000 index tumbling 2.40%. For those keeping score, the aptly-acronymed RUT is now off a stunning 23% since April 22.

Twenty-three percent.

Not even Cisco Systems (Nasdaq: CSCO) avoided the slaughter in the Boring Portfolio today. It slipped $5/16 to $103 5/8. The real mess is over at Borders Group (NYSE: BGP). Borders stock fell $1 7/8 to establish a new 52-week low at $22 1/8. I guess that will teach those folks at Borders to dare post a profit in the off-season!

The sell-off in small-caps (and to a lesser degree in medium- and large-caps, too) has generally not been accompanied by huge trading volume. Instead, it's been a steady if fruitless search for a bottom at a time when buyers on Wall Street are scarcer than windsurfers at Nag's Head. And about as comfortable.

With that recap of a day better left unrecapped out of the way, I turn to Part III of the Boring Retrospective.

In Part I and Part II I reviewed how I first stumbled into The Motley Fool, received the nom-de-screen "TMF Boring," and eventually commenced the online, real-time learning experience known as the Boring Portfolio -- or Borefolio, for short. The objective is to sum up where we've been over the past three years or so and where things are heading from here.

Given the nature of the stock market in the last half of the 1990s, the Borefolio has been oriented primarily toward the lower end of the market capitalization continuum, because that is generally where the better values were to be found.

Alas, despite their compelling valuations, small-cap stocks have underperformed large-cap issues significantly over the past few years. As a consequence, the Boring Portfolio's returns have often badly lagged "the market" -- i.e., the S&P 500 and the Nasdaq Composite Index, the latter of which is dominated by a handful of very large technology companies. (The Borefolio has outperformed the Russell 2000 Index of small-cap stocks, however.)

Financial analysts have puzzled over what's ailing the small-caps. They've concluded that two factors probably account for most of the story.

The first factor is an increasing predilection among investors for Index funds. Investors have concluded, not unreasonably, that there's not much point in paying high fees to buy into actively managed mutual funds when roughly nine out of ten of those funds have underperformed the no-brainer, low-cost funds that simply "buy the S&P." Ergo, cash has flowed into Index funds, and far less so into funds that buy smaller stocks.

Closely related is a preference -- and now almost a necessity -- for managers of large funds to seek stocks in which they may invest substantial sums of money (and, later, uninvest them) without pushing the share prices too far out of whack. What these managers seek is called "liquidity," and in the world of equities that means mega-cap stocks -- the General Electrics (NYSE: GE), Coca Colas (NYSE: KO), Wal-Marts (NYSE: WMT), and so forth.

The result has been a positive feedback loop in which cash flows into big-cap stocks, which drives up their prices, which boosts the relative performance of big-cap and Index funds, which in turn attracts new money to those funds, thereby refueling the cycle.

Such cycles can continue for quite some time, pushing prices beyond intrinsic value. Eventually, however, reality intrudes and the market gets its prices "right." Whether or not this is occurring in the summer of 1998 is something that no one can know until after the fact -- and probably not until well after the fact.

For that matter, by no means does everyone agree that the prices of large-cap stocks were out of whack even at their recent peaks. After all, someone was on the "buy" side of every one of those transactions while the Dow was zooming beyond the 9000 mark.

So if you don't subscribe to the claim that big-cap stocks are expensive, you have plenty of company. Moreover, if you don't expect to be cashing out for another 20 or 30 or 40 years, it should matter to you hardly at all whether stocks are overpriced or not right now. Buy the Foolish Four, or use the Cash-King approach, or DRIP into high-quality large-caps regardless of price, and you've got an excellent shot at doing very, very well over the long haul.

All I can tell you is that, as a guy who's been searching for attractively valued stocks over the past couple of years, I have had an awfully tough time finding many among large-caps. Moreover, the attractively valued, high-quality small- and midcap stocks I've bought -- Carlisle Companies (NYSE: CSL), Borders Group (NYSE: BGP), and FelCor (NYSE: FCH), to name three -- have suffered mightily in the recent market downturn.

Will bargain-priced smaller stocks eventually recover and once again display the market-beating performances that they have in the past? No one knows.

[The conclusion to the Boring Retrospective will appear on Friday.]

FoolWatch -- It's what's going on at the Fool today.

08/26/98 Close

Stock  Change    Bid 
 ANDW  -  3/16  15.63 
 CGO   -1 3/8   31.38 
 BGP   -1 7/8   22.13 
 CSL   -1 3/16  43.06 
 CSCO  -  5/16  103.63 
 FCH   -  1/2   24.13 
 PNR   -1 7/16  34.88 
 TBY   -  1/16  6.88 
                   Day   Month    Year  History 
         BORING   -2.62%  -8.64%  -8.47%  15.17% 
         S&P:     -0.79%  -3.26%  11.72%  74.41% 
         NASDAQ:  -1.66%  -5.57%  12.59%  69.85% 
     Rec'd   #  Security     In At       Now    Change 
   6/26/96  150 Cisco Syst    35.93    103.63   188.38% 
   2/28/96  400 Borders Gr    11.26     22.13    96.56% 
   8/13/96  200 Carlisle C    26.32     43.06    63.58% 
    3/5/97  150 Atlas Air     23.06     31.38    36.07% 
   4/14/98  100 Pentair       43.74     34.88   -20.27% 
   5/20/98  400 TCBY Enter    10.05      6.88   -31.56% 
   11/6/97  200 FelCor Sui    37.59     24.13   -35.82% 
   1/21/98  200 Andrew Cor    26.09     15.63   -40.11% 
     Rec'd   #  Security     In At     Value    Change 
   6/26/96  150 Cisco Syst  5389.99  15543.75 $10153.76 
   2/28/96  400 Borders Gr  4502.49   8850.00  $4347.51 
   8/13/96  200 Carlisle C  5264.99   8612.50  $3347.51 
    3/5/97  150 Atlas Air   3458.74   4706.25  $1247.51 
   4/14/98  100 Pentair     4374.25   3487.50  -$886.75 
   5/20/98  400 TCBY Enter  4018.00   2750.00 -$1268.00 
   1/21/98  200 Andrew Cor  5218.00   3125.00 -$2093.00 
   11/6/97  200 FelCor Sui  7518.00   4825.00 -$2693.00 
                              CASH   $5686.93 
                             TOTAL  $57586.93