Originally published in The Papyrus, Fall 2000. A Publication of Hermes Econometrics

One Wall Street Truth You Can’t Trust

When investing in today’s market, this conventional wisdom has been true for over two decades. What we forget is that conventional wisdom is, by definition, grounded in the experience and customs/ conventions of a particular time and place. At each point in time, such truths seem self-evident.

An example is found in the late ’60s when inflation began to rise. Everyone “knew” that stocks were the best hedge against rising prices. Unfortunately, the opposite proved true—corporate expenses outstripped earnings, leading to the worst bear market since 1929.

As fickle as fashion, conventional wisdom masquerades as eternal truth. And we accept it as such. But, while the popular wisdom of any era is true to the reality of its recent past, when you test it against empirical data over a longer period of time, it often falls apart. Conventional wisdom seldom stands the test of time because no rule works in all markets.

Long-term investment success isn’t that simple. In the early ’70s, people clung to the belief that if you bought the premier growth companies, they would hold up well, even in a market decline. These were “one-decision” stocks to just “buy and hold”. The rise of companies likeXerox, Polaroid, and Digital Equipment marked the beginning of a new era, or so it was believed.

Today’s portfolio managers seem to have again staked hopes for future performance on the creme de la creme of growth stocks. But, anyone who is seasonedin the business knows that no one has ever been able to estimate earnings ten years out—and these stocks are priced as if you can.

Although experience leads us to question the popular wisdom, historydoesn’t have to repeat itself. Rather, history should serve as a “vast earlywarning system”. This is why it’s worth taking a closer look at the parallels between the “one-decision” stocks of the ’70s and the “one-decision” stocks of today. Today’s list of “one-decision” stocks is the top companies with the highest price-to-earnings ratio (P/E). The roster includes America Online, Cisco, Dell, Disney, Medtronic, and Yahoo! Set along side the top companies with the highest P/Es from the pool of Forbes’ “Nifty 50” of the ’70s; a group of growth stocks that was loved by institutional investors; the similarities are striking. Technology stocks dominate; median P/Es are double the average of those on the S&P 500; yields are measly; and nearly all of the companies on both lists flaunt a 10-year history of double-digit annual earnings growth.

History should serve as a “vast early- warning system”.

In the ’70s, institutional investors bought hot companies because future superior earnings growth seemed all but a certainty. The high P/Es were a sign of their blind faith. Today, names like Oracle and Cisco inspire equal loyalty. The events of recent months may have shaken confidence in the Nasdaq- 100 index and even the Dow Jones Industrial Average. Despite this, many investors blindly hold fast to the belief that “if you buy and hold the best, over time, you’ll prosper.” On the surface, the idea of focusing on the strongest companies seems logical. In reality, this type of thinking has several flaws over longer periods of time. Why? It ignores the advent of new competitors, further technical and product innovations and changes in financial and competitive environments.

Everything depends on when you buy, or sell, not just what you buy.

The impact can be clearly seen by again looking back to the “Nifty 50” of the 1970s and comparing their performance to that of average stocks. This could be accomplished by simply using the S&P 500 index performance as representative of general stock performance. A $25,000 investment made in 1972’s “Nifty 50” would have grown to $445,148 by June 2000 with dividends reinvested. Not bad, but the S&P 500 performance for the same period was $752,603. A stunning 70% more return than achieved by sticking with the best. In the long run, won’t companies like Cisco and AOL outperform the stars of yesteryear? After all, these are the engines of the New Economy. The investor of the ’70s could easily have argued the same about Xerox, Eastman Kodak, or Polaroid—and he would have been right. These companies had profits and products that were changing the world.

Xerox made it possible to reproduce documents or pages from a book. In classrooms nationwide, teachers began to use photocopied “handouts” to supplement outdated textbooks. If the Internet ushered in the Information Age, Xerox opened the door. But that didn’t mean Xerox would be immortal. What the “buy the best and hold” theory ignored then—and ignores now—is that companies have lifecycles. Your ultimate results depend on when you buy, or sell, not just what you buy. This is why Hermes Econometrics Fund Enhancement Program combines the merits of mutual funds and variable annuities utilizing active portfolio management with proprietary models to identify periods of opportunity and risk in the market.

“Conventional wisdom seldom stands the test of time because no rule works in all markets.”