The Painful Market and Company Updates and Visits
At the end of September, the average NASDAQ issue priced over $5 had declined 42% from its high and the average NYSE issue priced over $5 had declined 35% from its high. Fortunately, our accounts did not see this degree of depreciation, although it is always painful to experience any decline in value. We personally invest in the same companies you do, and therefore share your feelings. We are always available to talk and commiserate. However, due to the excellent quality of the companies we own, the damage to our net worths should be temporary. Indeed, as of the date of this writing, all of our accounts have experienced significant appreciation from September 30 values.
The rapid reversal of emotion from confident optimism to scared pessimism is not a shining example of human rationality. The best description of this behavior, and what to do about it, continues to be Benjamin Graham’s story about Mr. Market. Warren Buffett retells this story better than Ben Graham himself, in the Berkshire Hathaway 1987 annual report.
"Ben Graham said that you should imagine market quotations as coming from a remarkable accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.
Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.
Mr. Market has another endearing characteristic: He doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.
But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence." (emphasis added).
Ben Graham’s infamous "Mister Market" has, in one quarter, made a turn from exceptionally manic to exceptionally depressive. Mr. Market, greedily paying $85 for Coke and $57 for Gillette at the end of June, was scared to scrape up $56 and $38 for the same two companies at the end of September! Today, Mr. Market’s mood has improved, and he has repriced these two enterprises at $69 and $45. As I look back at similar declines in the last twenty years, such periods have consistently been wonderful opportunities to buy the best businesses. In fact, we did add and/or initiate positions in Coke, Gillette, Monsanto and Disney. In most cases, we did not get the low, but we sure missed the highs. In the past several market declines, these companies led the recovery and were making new highs within a year or two.
Company Visits
The Walt Disney Co.
"Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return." The acquisition of Capital Cities ABC and the building of Disney California Experience provide welcome opportunities to reinvest the prodigious amounts of cash the company generates. Long term corporate growth occurs because cash flow is reinvested at a high rate of return. We are not worried about Disney’s ability to continue this.Lately, the movie and television show production business has experienced poor margins. The cost of hiring talent has inflated along with the cost of distribution and marketing. It is Disney’s intention to be much more selective in which movies to invest in, thereby reducing the number of pictures it makes by half. Disney is the only major studio that also owns its own product distribution network: ABC. It is extremely important to be aware of the substantial competitive advantage this gives Disney over both other producers of creative content and other broadcasters.
Disney expects flat to down earnings over the next three quarters, followed by a gradual improvement towards management’s five year growth target of 20% annualized. Average compounded growth in the 15-20% per year range is likely to be a reality. Disney’s compounded earnings growth over the past three decades was 16.3% per annum. The slowdown in earnings growth has catalyzed a decline in the stock from recent highs of $43 to the current $25 price. This is a very attractive price for Disney, although we think the stock is likely to mark time during this mediocre earnings period.
Boeing and Airbus Industries
The single most important issue for Boeing and Airbus is profit margin. In September of 1998, Boeing and Airbus declared a truce in their price war. As Ian Massey, Airbus’ Chief Financial Officer pointed out at the financial analysts meeting I attended in London, "we are the only duopoly in the world that prices to put each other out of business." In 1994, the war started in earnest when a former Boeing executive said Boeing would put Airbus out of business. Now, with both sides stinging from their battle for market share, conciliatory talk and just announced catalog price increases indicate improvement in prices and margins.Airbus has increased its share of order volume to 50% over the past several years with hard work and government support. They feel this level is necessary to manage their production in the cyclical commercial aircraft production business. Because Boeing’s order volumes are in larger, more expensive airplanes, Boeing still does about $26 billion in aircraft revenues versus Airbus’ $12 billion. For comparison purposes, Boeing had aircraft revenues of $17.5 billion in 1995 compared to Airbus’ $8.6 billion. Airbus should continue to grow revenues the next couple years, while Boeing’s revenue should be flat.
The price war damaged profit margins severely at these two companies. Since it will take years to work through billions of dollars of low-priced airplane orders, profitability depends on success in expense cutting. It is our belief that Boeing will improve its operating margin from the current 1%, and herein lies its investment story. If Boeing can take this to 6%, as they have in recent boom years, earnings per share will balloon and the stock price should follow. Airbus is not a public company and is taking steps to go public in the future.
We will be visiting Monsanto and Capital One Financial on October 19th and 20th.
Steven L. Re¢ , CFA
October 16, 1998
The above is for information purposes only and is not to be construed as a recommendation to purchase or sell securities. The above information is from sources deemed reliable but is not guaranteed. It should not be assumed that investments in any of the above mentioned securities will be profitable, and past performance is not a guarantee of future results. Earnings projections often miss, and markets don’t always go up. The employees and families of Quality Growth Management, Inc. may own the above mentioned securities in their own accounts, and may trade them at any time without notice.