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Cash, Stock and 1965 Lincoln Continentals

July 2001

The investment public has been treated to quite a lesson over the last fifteen months. By most estimates, U.S. stocks are down some $3.0 trillion since March of 2000. Many previously highflying companies have witnessed billion dollar drops in their market value. With all these billions and trillions bandied about, it is time to draw an important distinction between “cash” and “stock”.

As a reminder, “cash” is the legal tender that teller machines spew and that children accept as weekly allowance. “Stock” on the other hand, is a printed piece of paper representing partial ownership in a company. As usual, we will use an analogy to contrast the two and their relevance to investing.

Suppose you were a collector of old cars or, like me, you inherited your grandfather’s 1965 Lincoln Continental. Curious as to its value, you flipped through a specialty car valuation magazine (Whitewall Street Journal) and learned that 500 Lincolns still existed and that recent sales occurred at around $10,000 each. Treating the old car market like the stock market, the “market value” of the Lincoln 500 (i.e., S&P 500) would be $5.0 million (500 cars x $10,000 each). For fun, let’s further assume that one could order old parts and assemble another 1965 Lincoln for $50,000 (can you see the “buy” versus “build” analysis coming?).

Indulge us further and pretend that Jack Nicholson stars in a new movie entitled “Honeywell Jack”. The Hollywood set crew buys one of the 1965 Lincolns as Jack’s cool car in the movie. The movie is a success and now everyone wants to own a Lincoln just like Jack’s. In fact, one Lincoln is sold to an exuberant investor during the movie’s first week for $20,000. Accordingly, the market value of the entire “Lincoln 500” doubles to $10 million (500 Lincolns x $20,000 each). Lincoln owners see the transaction reported in the Whitewall Street Journal and conclude that their investment is up 100% in one week.

Yes, that’s the way it works on Wall Street. The market value of the Lincoln 500 went up $5.0 million while only $20,000 in cash traded hands with the sale of one car! Similarly, when the stock market lost $3.0 trillion in “stock” value over the last 15 months, it is important to note that far less cash changed hands.

If the Lincoln scenario mirrored the Internet stock bubble last year, Lincolns would eventually trade at $200,000, despite the fact that they could be built for $50,000. In fact, at $200,000 each, you would see people swapping their Lincolns for oceanfront lots. This is what happened when big companies acquired little ones for billions of dollars of “stock” during the heady days. No cash traded hands in most of those famous mergers and, likewise, no cash is lost due to recent “write-downs”.

The investment moral to the Lincoln 500 story is that cash is a different animal than stock. Our equity valuation methods compare the actual cash return from company earnings to the market value of stocks we are buying or selling. We also complete a “buy versus build” analysis when evaluating a company’s underlying worth. Finally, when learning that a company is acquired for “billions of dollars” we determine whether the offer was for “cash” or “stock” before giving the valuation any serious credence.

Enough about Lincolns and onto our current market view. Put simply, we are bullish about investing in the right companies now. We predict that one or more of the following will work together to produce excellent stock returns over the coming years.

Inventory Recession Ends
Last year, raw material scarcity had become a serious business risk to manufacturers. Given the long-running economic expansion, purchasing agents overbought inventories to protect against shortages. The bursting of the Tech Bubble (560 Internet companies have failed in the last year) and higher energy prices slowed the overall economy and now manufacturers are “working down” their inventory levels. The good news is that the consumer remains somewhat perky (housing, etc.) and it is likely that inventories will bottom and manufacturing growth resume.

Energy Supplies
Demand for energy has slowed due to tepid global growth and conservation, while gasoline and natural gas supplies have risen. On the margin, we feel energy prices will be lower in the future. (Good for corporate earnings and consumer spending). In fact, we recently reduced our energy exposure.

Cash has piled up on the sidelines during this period of market malaise. Moreover, a $30-$40 billion “pop” is coming in the form of government tax refunds. When cash returns to the stock market (and it will), we expect it to be in torrents.

Interest Rates
It is an old Wall Street maxim. “Don’t Fight the Fed”. Greenspan is dropping interest rates and eventually the market should respond positively.

We have used the weak stock market to add a number of terrific Quality Core (Blue Chip) names to our Buy List. These are all large capitalization ($2.0 billion minimum) companies with great management, predictable businesses, strong balance sheets and reasonable “cash on cash” valuations. These companies are trading well off their highs and operate in transportation, software, photonics, investment banking and the medical device industries. As always, a series of global risks exist (i.e. Japan) and while future investment performance can never be guaranteed, we remain excited about our current holdings.

As for those tax return checks that should be mailed this summer, I plan to use mine to fill my Lincoln’s gas tank.

Your comments and questions are always welcomed.


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