Down 55 to 54 with three seconds to play, Coach Dale called his team into the huddle before Ollie McClellan’s two free throws……. “Alright, listen. After Ollie makes his second shot”….. The coach then turned to Ollie, “And you will make your second shot.” That was an unforgettable moment in the movie “Hoosiers.” What made this line particularly memorable was that Ollie was the weakest player on the team. But the coach’s confidence gave Ollie, as well as his teammates, a sense of self-belief that carried the mythical Hickory Huskers to the 1952 Indiana state high school basketball championship. The instinct of Coach Dale at that critical time was the defining moment of the game. The entire outcome, or what I call the pulse of the game, hinged on that moment.
In a similar sense, portfolio managers are in constant search for the pulse of the market. The pulse is the dominant theme or investor mindset that drives the market. Often it is described by the proverbial question – Is the glass half empty or half full? In a market environment where positive news is largely ignored, while negative news causes stocks to crater, one would say that the glass is half empty. Conversely, if positive news sparks a market rally, while negative news is quickly ignored, one would say the glass is half full.
The pulse matters because it sets the tone for how the market and stock prices will process fundamental developments. The reaction in the market following the recent 4th quarter earnings announcements has revealed what could be the pulse of the market for 2006. At this stage the market is neither half full nor half empty. A more accurate description is that it is directionless, or perhaps even weightless.
Think of it this way… With no clear conviction regarding the direction of the economy and with geopolitical uncertainty a way of life, the market sentiment remains suspended in air like a ping-pong match played on the moon. It takes very little to move the ball back and forth in a big way. Translated, exaggerated stock price movements occur as over reactions to both positive and negative news. These gyrations can be painful, but can also create valuable buying opportunities. The key is to differentiate broken stories from short-term hiccups in otherwise fundamentally solid situations. And that, in a nutshell, is what might just be the pulse of the market for 2006.
Looking back to last year… The pulse of the market in 2005 was to have patience in most sectors, except energy, which rallied through out the year. Generally speaking most stocks were stuck in trading ranges, offering multiple buy and sell opportunities during the year. Patience and disciplined valuation were the keys to performance in 2005.
The pulse has changed for 2006… My gut feel is that we will have a more narrow market compared to last year. Theoretically, in this type of environment, strong stocks will stay strong and stocks that struggle will struggle for the duration. Unfortunately, the market is anything but theoretical. Nevertheless, some stocks with strong fundamental momentum may in fact lead the market through out the year. In these situations, focusing on trading ranges will negatively affect stock selection. In essence, a stock with sustainable fundamental momentum, bought at the top of its trading range, might out perform a struggling stock bought at the bottom of its trading range.
Our strategy is to pay close attention to the competitive battles within industries in order to identify which companies have sustainable business momentum and which companies can turn around short term problems. One intriguing example of this is the ongoing battle in the semiconductor industry between Intel (INTC) and Advanced Micro Devices (AMD). Intel is far and away the leader in the industry in terms of market share, financial strength, and manufacturing leverage. Despite this, AMD has gained significant share in recent years and appears to have the technological edge in several important product areas, including desktops and servers. Intel has vowed to regain share in 2006 through aggressive pricing and a strengthened product portfolio. The stock price performance between INTC and AMD will reflect the outcome of this intense competitive battle.
Back to the court… Sometimes in basketball the coach may call a set play for a player who has been struggling with his shot in order to build his confidence. Other times the coach will call the same set play for the hot shooter. Great coaches have a knack for knowing which of these players to go to. I think this is the challenge for portfolio managers today - When to stick with the strong stocks and when to switch to the struggling stocks in anticipation of a turn around. A great illustration of this is the battle between Coca Cola (KO) and PepsiCo (PEP) in the soft drink industry. KO has underperformed PEP due to poor product innovation, inconsistent marketing strategies and management turnover. The ability of Coca Cola to reverse this fundamental deterioration will largely determine whether it can improve its performance versus PepsiCo.
We’ll have more to say about these, and other, all important competitive battles as the year unfolds.
