LOM Weekly Perspectives

One more victory for the matador, last week, as the snorting bull charged fearlessly, right into the sword. Some people think that the bull may also have been snorting illegal substances. Cisco’s modestly upbeat announcement, hedged by a lot of covering statements, was hardly a clear declaration of the long-expected turnaround in tech spending. Remember -- we need to see firm indications of sales growth, not just another spate of cost cutting. But creeping greed may be edging out fear. More, suicidal bovines are sure to charge into the ring soon to meet their fate. The herd instinct is natural among fund managers, including the hedge crowd. And, it will be a little while before they gore the matador. Still, in swinging times accomplished traders can make good money, betting the right way.

Did we hear fervent shouts of "Ol¾ ! Ol¾ !" from the bears? Not so last week, as they rushed to cover their short positions and added to the upward momentum, before the market swung down again. Hedge funds are exacerbating volatility, and there are increasing worries that the inexperienced among them may be exposing themselves to excessive risk in the race to achieve high returns. Many of these funds may not have adequate risk management systems in place. There will undoubtedly be more blowups, hopefully only among the smaller ones. This may avert scaring a significant number of investors and prevent large-scale redemptions that could provoke even bigger market swings.

The substantial money flows into hedge funds reflects the relentless search for the sort of high returns that were once the province of the tech sector. Mind you, there is still residual hope among many investors that technology will once again provide exceptionally high returns. Unfortunately, this is likely to be the case for only a selected number of tech stocks, among the beaten-down sector. It will not apply broadly to the whole gamut of technology stocks. Meanwhile, previously shunned equities in the "old economy" sectors have long since been re-valued upward. Clearly, this has also been the case with formerly undervalued REITs and small-caps, and the latter have had a very strong run as money has poured into such funds.

Small capitalisation companies were neglected during the technology frenzy but came into fashion mainly last year. Their predominant characteristics are well known. They tend to have greater volatility than big-caps and liquidity can be a problem. However, their market sector is relatively inefficient, allowing good returns to be made from diligent analysis and stock picking. Given the flood of money that has already flowed in, the broad sector can no longer be considered as under-valued. Currently, some of the upward valuation can be attributed primarily to large inflows rather than a judicious assessment of intrinsic worth. One notable sign is that many small-cap funds have closed themselves to new investors. This does not mean that it is no longer possible to find undervalued stocks among small caps. It is just going to be harder to do. Earnings growth potential in this sector is boosted by low interest rates, and will be helped if the economy puts in a decent performance while labour costs are contained. For some sub-sectors a depreciated currency is beneficial. Such firms produce mainly for the domestic economy, and a lower dollar means less severe competition from foreign imports. Meanwhile, those big-caps with substantial foreign earnings will obviously gain from foreign exchange translation, and the market is already zeroing in on the chief beneficiaries.

Moving from the small to the very large, the travails of some super-sized firms have been a bit disconcerting for investors. This includes big names such as General Electric. Now, it was never clear that such conglomerates could provide a convincing explanation, in terms of efficiency gains, for having a number of diverse activities managed as part of a large organisation. Normally, there are both economies and diseconomies that ensue from large size and from having a multiplicity of activities. A lot of the diseconomies have to do with problems associated with adequate information flows, rapid market responsiveness, and flexibility. In an age when the internet makes interaction of independent units easier and more efficient, questions must inevitably be raised about the efficiency of large aggregated conglomerates. If there are, indeed, ‘synergies’ available then they must be clearly identified rather than referred to in a vague manner.

By the term 'conglomerate' we are not referring to those firms, which are in the business of finding and acquiring distressed or undervalued companies in different fields, rebuilding them and ultimately reselling them at a higher price. This is true value investing. In passing, let us refocus on Cisco (not a conglomerate, either), which at the height of the tech boom was acquiring companies at a rapid pace. Many analysts praised the insightful knowledge of Cisco management. The argument was that individual investors, in buying the stock, were also purchasing a whole portfolio of technology stocks via Cisco's knowledgeable insiders. Well, that theory has since been firmly debunked, as Cisco has drastically written down the value of its acquisitions.

Firms generally have a life cycle in terms of their principal activity, going from a start-up phase, to growth, to maturity. At maturity they try to rejuvenate themselves by expanding into alternative lines of activity. This does not always work well and does not necessarily transform them into a growth company. The penchant in recent years for complex organisational structures (were they really necessary for more efficient operation?) and accounting flimflam raises suspicion about the real earning power of assets under management. One good reason to try for bigness is, of course, to attain a measure of monopoly power, and we will have to look at that issue in a future column.