Luster has faded from high-flying favorites of 'index' investors

By DAVID MOON, Moon Capital Management
February 18, 2001


Let's see who comes out of the closet in this difficult market. In mid 1999, the three largest and most heavily weighted stocks in the S&P 500 were Microsoft, GE and Intel. Since then, those stocks declined an average of 30 percent. The S&P 500 is down almost 10 percent. My how the mighty have fallen.

But wait a minute. Over 70 percent of the stocks on the New York Stock Exchange are actually up over the last 12 months. How can this be if 'the market' is down? If you live by the indexing sword, you die by it.

In 1999 and much of 1998, a small number of very large stocks drove the S&P 500 to new heights, while almost every other sector of the stock market was in a bear decline. (Except tech-related issues, which seem to exist in an alternate, parallel reality, where price movements are completely unrelated to earnings and assets.) In 1999, the S&P 500 increased 21 percent, while over half of the stocks on the New York Stock Exchange declined 30 percent or more. Because the S&P 500 is weighted based on the size of the companies in the index, a handful of very large companies accounted for all of the S&P 500 return. In fact, the smallest 450 of the 500 stocks in the S&P 500 actually declined in 1999.

The 50 large stocks in that index were priced at an astronomical 70 times earnings, but investors did not care. As long as these were the largest stocks in the index, people had to keep buying them, right? Many institutional charge fees for actively managing portfolios, but really only mimic the S&P 500 - buying the 50 or so largest stocks in the index. These 'closet indexers' enjoyed the 1998-1999 irrational run-up in prices. And they expected it to continue as long as investors kept pouring money into their 401(k)s.

But someone forgot the lesson about valuation.

Just as the discrepancy between the prices of the new 'Nifty Fifty' and the rest of the market rapidly grew during 1999, it is rapidly diminishing now. There are two distinct groups of stock market performance in the last year (excluding the 'dot.com' market, which is its own roller coaster market, driven alternatively by greed and fear.) One very large group of investors, who relied on closet indexing to build their portfolios, are having trouble getting out of that shrinking closet.

Seventy percent of the stocks on the New York Stock are Exchange increased in the last 12 months. But the NASDAQ Composite and the S&P 500 are down 48 and 3' percent, respectively. And if an investor has historically merely bought the largest companies in those indexes, it is difficult to make the shift to the lesser known, more cheaply valued stocks. Think about it, if your entire investment strategy has been based on how large a company is or the indexes in which a stock is included, trying to think about actually earnings and the value of those earnings is a pretty major shift in style and philosophy.

In the last 3 weeks, Cisco Systems, one of Wall Street's former darlings, has fallen from 42 to 28. At its peak, Cisco was one of the largest companies in the S&P 500. Last week they announced weak sales, precipitating the first instance of Cisco earnings falling short of estimates in over six years. The company expects flat revenue for the rest of the year. It must be time for the bargain hunters to come in and snatch up shares.

But even after this decline in price, Cisco still sells at 66 times earnings. So what is a closet indexer to do - buy more of a stock that was once one of the largest companies in the world, but has fallen more than 33 percent in price? Or pass on a stock that still sells at an astronomical price relative to its logical value?

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

Add me to your commentary distribution list.

MCM website