Wednesday, October 12, 2005

Relax... It’s Not Just Chaos...It’s Schumpeterian Dynamics

As I sat composing this post in my mind this morning over a cup of coffee, I was gratified to learn I am in good company. Before I could reduce my thoughts to writing, I heard both Alan Greenspan and Mario Gabelli refer to recent events in the US business world using Joseph Schumpeter’s famous phrase, “creative destruction.” I guess that puts me in good company regarding the framework with which I observe and interpret the current foment in US economic activity of many types these days.

This week, we see the markets digesting:
Delphi’s Chapter 11 filing
-GM’s fallout from the Delphi filing
-Fed rate increases affecting home building
-Energy prices affecting retail spending and inflation
-Conventional telephony providers being potentially upended within a few years by VOIP from cable providers using wifi distribution
-Cable providers being potentially upended within a few years by dsl-based video services from telephony providers
-Airlines continuing to struggle with mismatches of cost structures and customer demand
-Yahoo, Google, eBay, TimeWarner and Microsoft all reaching outside of their main lines of business to either form alliances or enter new business lines

Is this unbridled chaos we see in both the US equity markets and corporate operating environment? Yes, and that’s a good thing. This is what full-on Schumpterian dynamics, of which creative destruction is only an initial part, are about.

My own equity portfolio strategy is based in part upon Schumpeter’s theories. In particular, he expressed some valuable insights in several papers which he wrote during the 1920s. These views shaped much of my approach to large-cap equity portfolio selection and management. Creative destruction is actually a very small part of his overall theory, despite it being the best-known part.

First, this “gale of creative destruction,” to use Schumpeter’s own phrase, is a good thing for large-cap equity strategists like me. In change there is growth. The ‘90s, a period of sustained low inflation and favorable economic policies for change, and thus, growth, enabled my strategy to perform up to its potential, both absolutely and relative to the market index I watch, the S&P500. Rather than worry about ailing giants, my strategy’s focus is purely on sustained superior business performance. I have never been invested in GM or Delphi. Microsoft has been out of the portfolio for all of this decade. eBay is no longer in it, either.

Second, the existence of such strong gales of economic creative destruction mean, ironically, that focusing on each immediate event is a mistake. When there is great variability and foment on the economic landscape, that is precisely when it’s better to take longer-term positions, then batten down and ride out the daily storms. No doubt brokerage firms are making a bundle amidst the uncertainty over GM, the airlines, and energy prices. Meanwhile, my own portfolio has remained well-performing, without trading since mid-summer. An earlier post addressed the “addiction” to trading some managers and their customers have, and my thoughts about that addiction.

Seeing the looming demise of one or two airlines, an auto maker or two, and at least one of their parts suppliers, gives me hope for new business models. For growth to be sprouting in other areas which is currently overshadowed by all the hand-wringing over these antiquated companies and their now-outdated approaches to markets and suppliers.

What lessons may be gleaned from all this recent chaotic activity? First, you can’t control these events, so don’t worry about them. Second, look on the bright side- for every “problem,” someone sees an opportunity, and there’s a potential for investment in that opportunity. Don’t confuse the two, and focus on the second lesson.

Tuesday, October 11, 2005

In Further Praise of Sell-Side Analysts

How could I overlook this week’s gyrations in GM’s stock price as a result of the Delphi Chapter 11 filing on Saturday? A great topic for today’s musings. I won't even belabor my own comments within the past week regarding how long Detroit would be without one less free-standing auto manufacturer.

I guess I don’t understand our brilliant Wall Street analyst corps.

GM and Delphi are two of the largest US firms in a very prominent economic sector. Delphi’s spinoff from GM is recent and very public. Both companies’ economic woes have been well-covered in the press, never mind by analysts, for months.

So how can it be that Delphi’s filing could cause a 10% drop on the open of GM’s stock by today’s market close? Isn’t the analyst’s job to divine these things a priori, by dint of her/his superior knowledge, skill and familiarity with the companies and situation at hand? Could the bankruptcy filing really have been that much of a surprise? Even CNBC’s “Squawk Box” reported that Steve Miller, head of Delphi, had explicitly warned of filing for Chapter 11 protection several times recently. This, they noted, was not something he had ever done when leading the turnaround at Waste Management.

It seems to me that this situation, the linked and troubled fortunes of GM and its one-time subsidiary, Delphi, illustrates how poorly the analyst community typically performs. I don’t see analysts as any better at covering this developing situation than the business media, such as CNBC or the Wall Street Journal. It reminds me of the oft-repeated quote attributed to Thomas Jefferson regarding a choice between government with no free press, or a free press with no government.

Give me the media every time.

Sunday, October 09, 2005

Mediocrity Isn’t What It Used To Be

I’ve been reflecting on the immense volatility in the equity markets of late. Volatility of this magnitude suggests that the market isn’t totally efficient. For instance, last week didn’t seem to provide that much “news” on which to base the large moves in the major indices. And throughout these last few months, our portfolio strategy has enjoyed significant out-performance of the S&P500, suggesting market inefficiency.

Why isn’t the market totally efficient? The topic, and the related, “is the market efficient,” have been the subject of numerous written opinions.

I’ve come to a tentative conclusion this week that one major reason for market inefficiency, contrary to longstanding theory, is that all market participants are not equal in their ability to use, or process, information. Some are simply mediocre, and they generate so much ill-conceived action that it swamps the volumes generated by their more-skilled colleagues.

While I’ve studied statistics for roughly 30 years, it is only recently that this aspect of efficient markets theory occurred to me. It’s as if the theory’s developers forgot one important assumption: not only must information be available to all in order to be correctly and rapidly priced into the market, it must be used with equivalent skill by all participants.

I suspect that much market activity is dominated by the broad class of average, that is to say, mediocre, analysts, money managers and fund allocators. Thus the apparent reason why some investors out-perform the market over time, while most cannot.

The same idea, of course, applies to the companies whose equities many of us trade. It has much to do with why my own approach works.

And, as educational standards in the US have slipped during my own lifetime, it’s reasonable to assume that mediocrity isn’t what it used to be. It’s probably getting even, well, more mediocre.

To be continued……………