On the eve of the Beijing Olympics it seems appropriate to mention the passing of legendary broadcaster Jim McKay, who left an indelible mark on this generation. Many of us came of age watching McKay broadcast major sporting events all over the world. “The thrill of victory and the agony of defeat” are words that still give me goose bumps. We will all miss his unique commentary at the Olympics later this year.
Olympic drama all over the place… Beginning in August the eyes of the world will be watching athletes from around the globe go for gold, with heroic achievement or catastrophic defeat hanging in the balance. Before this human drama of athletic competition unfolds the equity market is giving us a preview, sort of. We might call this the human drama of economic competition, and there is no shortage of marquee events. We have long-respected CEOs being canned like Ken Thompson at Wachovia and Stanley O’Neal at Merrill Lynch. There have been century old firms grasping for survival like Bear Stearns, and corporate icons struggling to stay independent, like Anheuser Busch.
All of this is an indication that the performance gap between winners and losers across multiple industries is widening in dramatic fashion. Indeed, the best example of this trend is in the financial sector as the market struggles to identify which banks will be forced to cut their dividend or worse yet become takeover targets, and which are in stronger position to ride out the credit tightening cycle. To date, bottom fishing in bank stocks has not added much value to portfolios.
Timing is everything… I’ve been repeatedly asked lately if now is the time to buy bank stocks. I wish it were that easy. It really depends on which bank stocks you are thinking of purchasing. Doesn’t selection always matter? Well sort of, but sometimes the consequences of being right or wrong on stock selection are more dramatic than at other times. And now, I believe, is one of those times when selection not only matters, it is critical.
Selection matters most… Not just in financial services but across all industries. For example, the performance gap between drug companies with exciting new pipelines is widening in relation to competitors struggling to replace lost sales as the bulk of their existing drugs come off patent. Similarly, retailers with a reputation for excellent customer service are performing much better than those that consistently deliver poor customer service and in-store experience. Not surprisingly, innovative technology companies are outpacing those burdened with outdated business models.
My key point here is that the consequences of these competitive battles will be more dramatic than normal going forward. This is primarily a function of the macro environment. In essence, increasing inflationary pressures, a global economic slowdown, uncertain Fed policy, and persistent geopolitical tensions are raising the stakes creating a “winner take all” competitive landscape. All this uncertainty makes investors nervous, if not fearful, which translates into increased market volatility. In this context, avoiding disasters is critical to portfolio performance. In other words, what stocks you don’t own might be more important than what stocks you do own. We have witnessed a recent example of this at one of the biggest large-cap mutual funds that we compete against. The struggling Legg Mason Value Trust portfolio, managed by Bill Miller, took a big hit from its holding in Bear Stearns, as well as other financial stocks. For the record, Miller’s fund has fallen 28.1% over the last 12 months, precipitating a decline in assets under management from $18 billion to $12 billion during the first quarter of 2008. In comparison, the Willingdon large-cap quality growth portfolio is up 7.0% over the same time frame, while the S&P 500 is down 6.7%*. Pension funds and hedge fund managers have also taken hits from their holdings in credit default swaps and other creative debt instruments, some of which were purchased with questionable knowledge of the credit quality of the underlying securities.
Meanwhile, sound bite prognosticators and even some experienced analysts love to be the first to call a major bottom in a sector, as some analysts did after the bail out of Bear Stearns. I suspect that some degree of analytical laziness has infiltrated the investment community and that is not a good thing. Analytical laziness will eventually lead to financial pain for somebody, whether it is the CEO or unfortunate shareholders.
There has to be a certain amount of disciplined, systematic due diligence in the stock selection process. There are important differences lurking below the surface between the major players in most industries, but these can only be detected by thorough, consistently applied analysis. These differences, be it product, price, cost, service, innovation, technology, management, cash flow, strategic vision, or execution, will ultimately determine relative performance.
It would not surprise me if the overall market made little progress for the remainder of the year as it works its way through the mountain of uncertainty. Yet, this difficult environment will give portfolio managers an opportunity to differentiate themselves and the performance of their portfolios. The thrill of victory… and the agony of defeat, sort of.
* WWM returns are total composite returns from 5/31/07 through 5/31/08. Returns are net of all management fees and transaction costs. All fully discretionary equity portfolios invested in the Willingdon Wealth Management core portfolio are included in the composite. The Legg Mason Value Trust returns represent the primary share class (LMVTX). Both the WWM core equity portfolio and the Legg Mason Value Trust invest primarily in large-capitalization stocks. The S&P 500 is a proxy for the US equity market. Past performance is not a guarantee of future results.
