November 1999
As a reflection of our “New Economy”, the thirty companies of the Dow Jones Industrial Average (DJIA) have been adjusted. The new average includes ten non-industrial companies as compared to just two when the index was formed in 1928.
The companies dropped include Sears, Goodyear, Union Carbide and Chevron. Their replacements are Microsoft, Intel, Home Depot and SBC Communications. With the exception of the Home Depot/Sears trade, the clear trend is the substitution of technology companies for manufacturers of products such as tires, chemicals and oil.
The total market value of the four stocks added to the DJIA is nearly $1.0 Trillion or nine times the value of the stocks being dropped. More importantly, the earnings of the new companies are less than three times the amount of the old companies. In other words, roughly nine times the price for three times the earnings!
Allow us to elaborate on the “New Economy” with numbers and an illustration. Our clients and friends may recall our October 1996 newsletter when we introduced the concept of the “Victor Kiam Test”. This simplified valuation method is our Wall Street version of Mr. Kiam’s advertisement about razors and reads, “I liked the stock so much, I bought the whole company”.
Applying the “Victor Kiam Test” to the additions and deletions to the DJIA yields interesting cash flow differences. If we assume we use money borrowed at 10% to purchase every share of each set of companies, we are faced with the following:
Basically, for the privilege of owning the “new” stocks, we would have to borrow another $57 Billion in the first year of ownership just to cover interest expenses. Were we to be so “old fashioned” as to buy the old stocks of the Dow, we would earn $2 Billion the first year. This illustration gives us approximately 60 Billion reasons to wonder about the “New Economy”.
Some argue that the higher growth rates of the “New Economy” stocks justify their outsized valuations. However, upon closer examination, even a 30% growth in earnings of these companies would leave an annual borrowing gap of $50 Billion in the second year. Moreover, as technology companies, their ”New Economy” business plans are subject to overnight competition from new entrants. Said another way, the assets and capacity of an aluminum company are a bit harder to replicate than those of a software provider.
What are we to conclude about all of this? For one, we are reminded that numbers don’t lie and it appears that some of today’s largest stocks are overvalued. As these companies are added to various indices (S&P 500 and DJIA), these benchmarks become more difficult to gauge, especially when compared to historical numbers.
Our focus on reasonably valued, well-managed companies has produced solid, overall appreciation in client portfolios. One of the 25 stocks on our Buy List has been unusually disappointing (Xerox). However, its poor performance has been more than offset by excellent returns on stocks such as Alcoa and J. P. Morgan. While performance can never be guaranteed, we are optimistic that our portfolio companies are positioned to grow their earnings and dividends in the corning years.
Given the fact that interest rates have risen 1% this year, we admit to being pleasantly surprised that the stock market has appreciated so nicely. Alan Greenspan has done an admirable job of talking the market down and pushing interest rates up, but we wonder where stock prices would be if he were not dampening investor enthusiasm on a regular basis. Thankfully, the world is growing at a steady and mostly peaceful rate. We do, however, encourage investors to remember our “Victor Kiam Test” when they consider buying stock in companies simply because they like their products.