The Quantum View

Third Quarter 2010

Which Way Does the Demand Curve for Stocks Slope?

By Mat Johnson

In economics it is conventional wisdom that as the price of something falls, the demand will go up, leading to the typical downward sloping demand curve, i.e., lower price begets higher demand. This is a pretty elementary rule of economy (the verb). If there is something that someone likes, and the price goes down, we typically buy more of it; when the price goes up, we tend to buy less.

One instance where this doesn't always appear to hold true however is with stocks. In fact there has been a great deal of research trying to explain this anomaly. Doing a Google search on my exact title, yields 62,300 results, many of which are links to research papers conducted by Ivy League scholars who have published multiple papers on the subject spanning the decades of their careers. Many of these papers are even boldly entitled something like, "Why does the demand for stocks slope upward."

Alas, there is no conclusion as to "why," and for good reason. It doesn't. What most see with low or falling stock prices, AND low and falling demand, has little to do with the simple price of the stock. Rather, the observed phenomenon is driven by what the shares of stock represent, ownership in the underlying company; where the company is a business focused on investing in profitable endeavors.

The implication is that the price reflects a perception that the underlying company isn't worth the value represented by the share price, and explicitly reflects the view that its investments will be less profitable, and therefore worth less to own. Accordingly, if the company's value (return on investment) is perceived to be lower then the demand for its investments will be less, resulting in the price of the shares falling. This continues until a 'fair' price for the company encourages investors to demand its shares in anticipation of the company seeing better future returns on its investments.

This may seem an esoteric way to look at investing to many, but it is an all-important one, in my opinion, as it is the very definition of investing, though one that has somehow become forgotten. A great number of investors, inclusive of many professional money managers, have grown up in an era where investing is deemed little different than gambling. The likely cause of this is the pervasive view that stock price changes are random, and that investing is an activity that one tries to 'win.' The result is the often observed rampant selling when prices are low (fear of losing), and frenzied buying when prices are high (fear of not winning), and a multitude of strategies that virtually guarantee failure, or at best mediocrity.

On a higher level, it also suggests that much of the investment community lacks well-defined investment objectives, with the default goals being to "beat the market" and "to not lose money." An understanding of what a company does often factors little into investment decisions. Instead investment decisions are motivated by a stock's price, and what they think is generally more concerned with which direction the price will move. Unfortunately, stocks don't know what we think.

When it comes to true investing, and understanding how an investment creates value for shareholders, as in the case of stocks, too little effort is expended. The reality is, and this too is basic economics, value is always and everywhere a derived phenomenon. A good example is with 'value investing.' The perception is that value investing is successful largely because stocks are acquired at a low price. The reality is that without growth, i.e., the ability of a company to invest in high return activities, the value stock will simply remain at a low price — the 'value trap.' Ultimately, there can be no successful value investment without successful growth of investment.

With this as a background for assessing the current outlook, there are a number of reasons to anticipate increased value, i.e., prices, in the equity market ahead.

Over the last several months, several events have triggered fears of a falling stock market, most notably concerns of the U.S. relapsing into recession. While these fears were most pronounced after Greece's troubles began, and again following the August market swoon, the economic data never tilted toward decline. Admittedly, it didn't indicate a quicker improvement either. However, across the most recent earnings season, companies continued to report record levels of profitability and profits. If there was anything lacking, it was that companies were not investing more heavily in those areas responsible for generating those record profits.

To this latter point, it's not entirely surprising that companies would hold back. The 'rules' for many businesses are in a state of flux, perhaps leading to a higher degree of caution with respect to investing in an unclear future. This uncertainty is likely only being compounded with the upcoming elections ushering in a new set of 'rule makers' and yet another new set of rules. Companies are not sitting completely idle however. Within recent GDP reports, business investment has grown at an annual rate of better than 20% for the past two quarters, with much of this focused on business equipment investment.

In lieu of investing even more heavily, companies seem to be looking for returns elsewhere, namely by acquiring equities through acquisitions or even their own shares. To this latter point, companies are on pace to acquire more than $300 billion worth of their own shares in 2010, a fairly overt indication of their view toward their current share price.

We are equally optimistic about company prospects. While there remain ample challenges, including economic, regulatory and general uncertainty, the fact that companies have attained the level of profitability that they have during the recession positions them well for investing in highly profitable activities as we continue to transition to economic expansion. In the process, we shareholders stand poised to benefit from these investments, having acquired our stakes at attractive values — and fully expect to see their success translate into higher share prices.

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By Stephen Bradley

Today, many Americans are mired down by a sense of pessimism about the economy. This is largely driven by all the daunting headlines about housing prices, unemployment, deficits and political discord in Washington. This pessimism is amplified by the media coverage given to these voices of gloom.

It seems appropriate to view some offsetting perspectives on the mid and long-term positives for the United States from three of the country's top business executives. Warren Buffet, Steve Ballmer of Microsoft and GE's Jeff Immelt talked about good news at their companies and their positive outlook for the future at the recent Economic Development Summit. They told the nearly 2,000 business leaders, government officials, aspiring entrepreneurs and others at the summit that things are getting better. They also offered some ideas for what needs to be done.

The famed investor Warren Buffett declared the country and world will not fall back into the grips of the recession. "I am a huge bull on this country. We are not going to have a double-dip recession at all," said Buffet, chairman of Omaha, Neb. based Berkshire Hathaway Inc. "I see our businesses coming back across the board. He said the same things that worked for the country through a century of two world wars, a depression and more, all while increasing the standard of living, will work again. He stated banks are lending money again, businesses are hiring employees and he expects the economy to come back stronger than ever. "This country works," Buffett declared during a question-and-answer session. "The best is yet to come."

Ballmer conveyed there soon will be more technological advancement and invention than there was during the Internet era. That will help drive business growth, he said. "I am very enthusiastic what the future holds for our industry and what our industry will mean for growth in other industries."

He envisions new technologies that move beyond the Internet to tie together computers, phones, televisions and data centers to create amazing new products. And the pace of innovation will increase as technology makes workers more productive. "All areas of science today are moving forward more quickly," Ballmer related. "The speed of scientific breakthrough is accelerating."

Immelt explained that angry political rhetoric is not helpful and headlines are too focused on finding negative indicators. He said business at GE, one of the world's largest companies, is improving. Immelt remarked the country is going to need to adjust, though. The economy since the 1970s has been driven by consumer credit and a misguided notion in building a "lazy" service economy, he added, and manufacturing, with an aim to reduce the trade deficit, is the key. "It was just wrong. It was stupid. It was insane," Immelt declared of the push for a service-based economy. "The future of the economy has to be as an exporter." He said GE is now finding it profitable to build manufacturing and service centers in the United States rather than overseas, because it is more competitive to do so. More investment is needed in technology innovation, exports need to be rejuvenated, and clean energy and affordable health care need to be given top billing for policymakers. But the corporate leader stated he recognizes a polarizing environment in Washington makes it unlikely a national energy policy and other helpful guidance will ever take hold. Instead, he urged local business leaders and government officials to come up with their own local solutions. "Anger is not a strategy. Anger does not create growth. Only optimism creates growth," he remarked. "Be the contrarian. Everyone is mad today. Be happy."

Most individuals are moving money from stocks or equities into fixed income or bond type investments. One universal investment principle that wise investors keep in mind is that the crowd is almost always wrong. We think these great business leaders have a better vision of the future than those in the media.

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By Brett Meyer, CFA

Most investors are familiar with Large Cap stocks as measured by indexes like the S&P 500 or Dow Jones Industrial Average and Small Cap stocks as measured by the Russell 2000 Index. However, many investors are unaware of another category of stocks referred to by market professionals as Mid Cap stocks. Mid Cap is typically defined as companies with market capitalizations between $1 and $10 billion. Major index providers Frank Russell Company and Standard and Poor's recognize this subset of companies with benchmarks like the Russell Midcap Index and the S&P 400 Midcap Index.

The performance of Mid Cap stocks over the long-term has been quite compelling. The following chart highlights the annualized return and risk over the past 30 years for a handful of widely recognized Frank Russell capitalization specific benchmarks.

The outperformance of Mid Cap stocks is intuitive when one looks at the business cycle of most firms. The smallest companies (sub $1 billion in market cap) are often in the start-up phase and are subject to higher failure rates than larger companies. Moving up to the Large Cap space, these companies have grown to a point where their businesses have matured and stabilized, which diminishes explosive future growth opportunities. In contrast to these two extremes, Mid Cap companies have demonstrated the ability to succeed and expand beyond the start-up phase, yet still have plenty of room left to grow substantially for investors.

Investors often have exposure to Mid Cap stocks perhaps without recognizing it. Many Large Cap portfolios invest a portion of their assets in Mid Cap stocks and some Small Cap portfolios invest in a handful of Mid Cap names. Quantum Capital Management has a dedicated Mid Cap Growth portfolio for those investors seeking a dedicated exposure. We welcome the opportunity to discuss whether this portfolio may be appropriate for your asset allocation. Keep in mind that higher return products are often accompanied with higher risk levels.

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By Howard Aschwald, CFA

How do you know if an investment is at a good price? This fundamental question is the basis for all professional stock market analysis. Investors use many gauges to determine the fair value of a company. Many analysts look at the trailing 12 month earnings or 12 month predicted future earnings to see if a company is cheap or expensive in relation to the stock price. This Price to Earnings ratio (PE) is then compared to a company's PE history to see if it is higher or lower than average. A more sophisticated way of valuation is to look at a long term total projection of company earnings, add that up and then divide by a factor that adjusts for the risk level of the company. If a company is selling for less than this "intrinsic value", then it is a buy. These techniques are OK, but earnings are difficult to predict for most companies and big changes in the economy tend to magnify (up and down) changes to earnings. This makes this type of value calculation very unstable.

At Quantum, we think a more accurate and stable measure of company's value is to look at its Market Value to Invested Capital (MVIC) ratio. The denominator of this indicator looks at all of the capital that has been put into a company since it started, subtracts all of the money that has been removed from the company, and then adjusts that figure for inflation. The numerator adds together the current total stock market value plus all the outstanding debt value. The advantage of this indicator is that it does not rely on forecasts and it does not use inconsistent accounting techniques to determine its value. We like to see the level of this indicator in relation to its past history to determine if a stock is cheap or expensive.

In addition to looking at a stock's individual value, we can use the MVIC measure to determine whether the entire market is cheap, fair or overvalued. The chart below looks at the stock market's MVIC ratio as of September 30, 2010 and compares that to its past eight year history. As one can see, the MVIC is about 13% below its average value. This is just below its "normal range" of plus or minus 12%. While this does not guarantee profits or an up market, it does show that US Stocks are not expensive and that there is still plenty of room for appreciation in the coming year.

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