What About The Mediocre Companies?

My friend S, a consultant, was discussing corporate performance with me recently. While debating the recent fortunes of tech companies such as Google, Intel, and Microsoft, she challenged me to articulate what I would to fix what ails the last one. I had opined that Microsoft is, essentially, finished as a company capable of generating consistently superior returns, in part, as I have written recently, because of its chairman's excessive wealth. By the way, according to S, my estimate of Gates' net worth may have been light by as much as 50% or so. He apparently was worth some $50B as recently as 6 months ago, not the $25B I thought.

In any case, I said that the first, and, for a while, only thing I would do at Microsoft would be to essentially execute the threatened anti-trust remedy of the Netscape case- split the company into three: an applications software company, an operating systems company, and an internet-related company.

I'd like to explore my friend's next major remark. She assailed me, in a friendly way, for essentially ignoring the existence of less-than-consistently-superior return-generating companies, as if they should all perish. As a consultant, I believe her tendencies and motivations lean toward fixing mediocre companies, rather than simply tossing in the towel on them. It's a laudable goal, and no doubt a profitable one for the consulting sector.

However, I approach these issues as, I believe, most of my readers do- a passive investor. Mind you, I do opine on situations which I believe can be rescued. I say whether or not I believe a company can be put back on a path to consistently superior returns, or not. For example, GM, Intel, Dell and Microsoft- almost certainly not. HP and AMD- quite possibly.

But, what is a passive investor to do now? What does a passive investor desire now?

The obvious answer to these questions is that a passive investor desires to earn total returns which exceed the market average. S/he wants, ideally, consistently superior returns, on some risk-adjusted basis. Therefore, owning the stocks of mediocre firms is probably not high on such an investor's list of things to do.

Furthermore, the investor does not have to "settle" for shares of a mediocre, below-average-return company. Because of inexpensively-marketed, passively-managed index funds from complexes such as Vanguard, an investor may easily and cheaply buy an index which represents the S&P500, or virtually any sector. There are many ways an investor may take positions in companies through these vehicles, with expectations of returns that benefit from diversification, without ever needing to actively select a single company, much less voluntarily buy a lackluster one.

However, an investor may wish to attempt to outperform the market with part of her/his funds. It so happens that my large-cap investment strategy is based upon proprietary research which has shown that the best way to increase the odds of owning consistently superior total return-generating companies is to select those who have already been doing so. Then hold them a little longer, to reap the benefits of their continuing ability to surprise other investors with their consistently superior fundamental performance. That's why I have no interest in mediocre companies.

Mediocre companies have shareholders, and employees, and produce things. They exist in our economy, and no doubt provide valuable products and services, without which you and I would probably have lives which are different as a result. These opinions of my friend S are all true.

However, that doesn't mean you, or I, should want to own stock in these mediocre purveyors of economic necessities. But someone does. And, frankly, unless they decide to take a loss, these owners may not be able to sell their shares. Of course, it's easy to see that, should they believe they have better return expectations with some other investment, they should sell. But people are not always rational about these things, by any means. For more evidence of this, just Google "behavioral finance" and sample some of the literature from this field.

So, what happens to them- the underperforming, mediocre companies? There are several possible outcomes for these companies.

For some, their stock price declines, as a result of their increasing ineptitude, until it is so low that someone actively buys up a lot of it, believing that they can modestly improve the firm, and reap the attendant total returns. An example of this in the market now is Kirk Kerkorian's long-running bet on GM's return from near-death to just "pretty sick." Eddie Lampert has gone one better at Sears, buying a controling interest in the firm, and betting on wringing some excess returns out of it, one way or another.

However, both of these are active solutions unavailable to the typical investor- even most institutional ones.

Another path for a mediocre firm is for the CEO and senior management to take the firm private, using private equity backing, in order to reap the rewards of significant restructuring away from prying eyes and quarterly demands of the investing public. In these cases, the inside management takes advantage of their better knowledge of possible outcomes for the firm, and buys it cheaply, relative to potential returns, from a lesser-informed group of shareholders. However, this removes the firm from the public markets, so, again, a passive investor won't be seeing this option until later, after the anticipated turnaround.

This leaves mediocre firms who attempt turnarounds on their own. Firms whose stock price has sunk so low that, with a modicum of better-than-average performance, their share prices may spurt up in surprised response to the unexpected results. However, by definition, this is essentially betting on aberrant behavior. It requires a lot of in-depth analysis of just the "right" opportunities. It is an exlicit timing play. The investor has to get it just right, and that usually means taking significant risks.

I actually explored these situations in my proprietary research, as one type of strategy to pursue in the equity markets. My findings were, essentially, that the likelihood of turnarounds, among all possible situations of declining performance, multiplied by the average resultant total return, provided an unfavorable expected return. It simply is not a statistically viable approach for those on the "outside" of such situations, having no special knowledge of the ensuing turnaround.

Finally, let's consider why one invests in equities. Ideally, you are in equities for their growth potential. That means valuing them for their future growth, rather than fixed-income-like steadiness of cashflows. Thus, discounted cash flow valuations are inappropriate for equities which are bought and held for, well, the potential that equities uniquely offer. This being the case, and, again, my research has supported this analytically, one would not want to buy the equities of mediocre, low-growth, or low-earnings-growth firms. It just makes no sense, when there are plenty of better alternatives out there.

So, in the final analysis, this is my reply to my friend S, as to why I ignore mediocre companies, or those formerly superior companies now lapsing into their dotage. I ignore them because, relative to currently consistently superior total return firms with the fundamental performances to sustain those returns, the mediocre companies are simply not attractive for providing the passive investor with consistently market-beating total returns.

I know someone will continue to hold the equity of mediocre companies. Some may be turned around. Others may be acquired, merged, or simply stripped and closed. But for passive investors, getting involved in mediocre firms is a high risk, low return proposition. I don't see that changing anytime soon.