The InvestMentor

June 16, 1997

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I read the Wall Street Journal like a coupon clipper. I cut out the best articles, read and underline them, and then file them away for future reference. Rather impractical in the age of computers (but so is clinging to my Day Timer). Occasionally, The Journal yields a real face-slapper. On May 7, there appeared an article entitled "Waiting to Explode." It discussed what I believe is the greatest threat to global economic bliss—a major credit crunch.

In particular, the "emerging" countries are in a fragile state as a result of their banking situations. If you read my stuff, you know I’m silly-bullish about the current opportunities for many global stocks, so this topic is a sensitive one to me. For the purpose of creating a picture of the global credit mess, allow me to borrow liberally from the article. The IMF (International Monetary Fund) says 133 of its 181 member countries have "significant" financial problems. A number of countries have spent as much as 10% of GDP on cleaning up bank messes (by comparison, our "savings-and-loan crises" cost 3% of GDP). Transitioning communist banks has cost $250 billion. Moody’s Investor/Rating service lists 58 banks in need of rescuing (nine in Japan).

Several factors have combined to create this scenario. At the top of the list is the lack of international banking standards. A U.S.-led group has recently put together a series of recommendations for achieving financial stability--but that seems a bit like closing the gate after the horses have gotten out. Another reason for the mess results from years of forced lending to state-run businesses. In China, 20% of all loans are non-performing. The tremendous flow of international capital has also played a role. Banks have aggressively over-lent to projects, often to fund real estate development without regard to repayment prospect.

So how does this ultimately come home to roost? Several ugly scenarios could evolve. First, as a result of still-to-come bank shut-downs, several countries could see a "run" on their banks. Bulgaria did, and investors are still awaiting repayment. Secondly, economic growth (and thus world-wide living standards) could be crippled. In most developing countries, the bank is the primary source of capital (in lieu of tiny stock markets). Third, unrestrained lending leads to speculative excess. Hong Kong’s stock market lost 3.5% in one day last week as Chinese banks, who invested in speculative stocks to offset lending losses, were forced to liquidate by the Chinese government. Most countries don’t even have an SEC-like regulatory body. Finally, in its worst form, a financial crisis leads to civil unrest (remember Albania?). Keep your eyes open about this topic (and fingers crossed).

Stock of the Week : Zeneca Group PLC (U.K.)

"If you buy a stock just off this letter, God help you. Don’t mistake ideas for instructions."

Ask people for the name of the successful British pharmaceutical giant, and nine times out of ten, you’re going to hear: "Glaxo." If you were to judge by stock performance, the correct answer would be: "Zeneca." Never heard of it? Neither had I until I went looking for great U.K. stock opportunities. Zeneca Group is an international bioscience company that was spun off of giant Imperial Chemical Industries in 1993. The company is made up of three core divisions: 1) Pharmaceuticals; 2) Agrochemicals; and 3) Specialty Chemicals. The company does about $10 billion in annual sales (by comparison, Glaxo does $14 billion). Their primary therapeutic focus in on cancer. Zeneca is number two in world-wide anti-cancer medicine sales. They manufacture ‘Nolvadex’, the largest selling breast cancer medication, ‘Casodex’ for prostate cancer, and several other related drugs. ‘Zoladex’, a leading cancer therapy, was recognized in 1991 by the Queen’s Award for Technological Achievement. Other biopharmaceutical products treat migraine headaches and asthma.

Overall, Zeneca has above average annual sales and earnings growth, below industry average valuations, and very little debt. The stock has been one of the best performing U.K. stocks in the last two years and clearly isn’t "cheap" by anyone’s definition. On the other hand, this is an industry (and company) that should experience intermediate-to-long-term outperformance. It’s not uncommon for drug stocks to have several successive years of strong performance. The U.K. market is, in my opinion, somewhere in the middle of their bull market cycle. They have decent economic fundamentals and a (liberal) Prime Minister who seems to be surprisingly business-friendly. The stock trades for $93 on the NYSE (as an ADR) under ticker symbol: ZEN—as in "Zen and the Art of Making Money."

Investment Lesson of the Week : Investment Industry Myth #5

"Investment research data has very little value…but tremendous utility."

Over the years I’ve compiled a list of "Investment Industry Myths." They are a series of widely-accepted "truths" that, in reality, are nothing more than B.S. Often, they are perpetuated because they help to keep margins fat in this industry. Myth #5 states: "Small Cap stocks outperform Big Cap stocks." Not true. There is no long term performance benefit of small cap over big cap. It’s a prevailing fallacy of investment theory and accepted widely.

The field work on the subject was done by Ibbotson and Sinquefield, and the Ibbotson data is the most widely-quoted, in support of the argument that small caps have beat big caps over the last 70 years. But if you study the data, you'll notice two flaws.

First, prior to the 1970's, there was no small cap outperformance. While small caps appear to "beat" big caps, it has all happened since 1974.

Secondly--and here’s the real kicker--the numbers don’t account for transaction costs. Historical analysis of transactions show that small caps have higher expenses in the three-part-equation that is "trading cost." The first part of trading cost, but often the area of smallest difference between large and small cap, is good old fashioned "commission"--the cost you pay the executing brokerage firm to buy or sell the stock. The commission on small cap trades generally exceeds that on large cap. Secondly, the "impact" or "friction" cost of small cap trades nearly always exceeds the impact of large cap. Impact is the cost that results from a change in stock price that results from the actual purchase or sale. This is a liquidity phenomenon. If you try and buy 100,000 shares of a small cap stock, you will cause the price to rise. If you try and buy 100,000 shares of IBM, it’s unlikely to budge. Finally, the "spread" costs of small cap stocks exceed large cap. The spread is the difference between bid and ask price. The bigger the spread, the greater the cost. A study by Frank Russell & Co. demonstrated that small cap spreads are usually three times larger than big caps. The effect of higher transaction cost is a reduction in total return on investment. If you take the Ibbotson numbers, and back out a transaction cost, small caps have no outperformance over big caps.

I've observed (and experienced) this reality while working at a billion dollar small cap firm. In several years, the fallacy of "small over big" will be much less accepted. Small caps are a great investment, and are underrepresented in the reported returns of our markets (due to funky index construction). But you should own them because you like the company, not for the "superior returns" of the asset class—it’s an illusion.