By DAVID MOON, Moon Capital Management
January 6, 2002

Warren Buffett once said, "it is only when the tide goes out do we learn who has been swimming naked." After two years during which the first became last and the last became first, Buffett's analogy is swimmingly clear: throwing investment caution to the wind is a great strategy when it works. When it doesn't, the intensity of the pain can significantly outweigh the enjoyment of the pleasure.

During 1998 and 1999, the S&P 500 and NASDAQ Composite increased 54 and 160 percent, respectively. The S&P 500 performance driver was, primarily, a handful of large, well-run companies selling at astronomical prices. When these few over-weighted stocks began the inevitable return toward normalcy, the index (and closet indexers) began to give back their gains. In the last two years, the S&P 500 declined 22 percent, resulting in a four-year annualized return of about four percent a year. The four-year NASDAQ annualized return was little better, only 5.6 percent.

Returns in the NASDAQ were even more volatile. Astronomical is too timid of a word to describe the valuation of the NASDAQ Composite in 1999. Comical is more appropriate. Stocks no longer traded as a multiple of earnings; too few of them had earnings. Then came the price-to-revenue measure, which only worked as long as the company actually had revenues. Many stocks were trading at multiples of expected (hoped for?) revenues. The NASDAQ Composite is now down 57 percent from its March 2000 high, with many mutual funds down even more.

With carnage like that, even the conservative folks must be losing money, right? Not necessarily. When the tide receded, we learned that several Wall Street swimmers were wearing bathing suits. (Figuratively speaking, from an investment standpoint. Personally, I would rather not imagine Buffett, Peter Lynch or Abby Cohen in even a modest literal bathing suit, much less without one.) While the Russell 2000 squeaked out a modest one percent gain in 2001, more focused value-oriented active managers did much better. For example, the Oakmark Fund (down 7.2 percent in 1998-99) increased 39 percent in the last two years. The Third Avenue Value Fund (up only 16.7 percent in 1998-99) increased 24 percent in 2000-01. These are only examples of some of the managers considered dinosaurs in 1999 (presumably on the brink of extinction) who roared in the last couple of years. Scores of managers and funds did well in 200-01, but most of them were among the laggards in the end of the growth fund/dot.com heydays in 1999.

What, if any conclusions should you draw? Admittedly, one of the worst investment strategies is to simply and blindly assume that last year's winners will repeat this year. Or vice-versa. (This popularity of this folly contributed to the speculative level of stock prices in 1999.) The performance difference between most growth funds and value funds in 1999-98 was more pronounced than ever before. In the last two years, the pendulum has swung in the opposite direction. Normally, these different styles move somewhat in tandem, differing by degrees - not usually direction. If we are return to a more "normal" market (a market with more historical precedence), then old mundane factors like earnings and balance sheets will continue to affect stock prices.

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

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