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Red alert

By D Mark Harrison

Thursday 1st May 2003

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I was stabbed twice the other day - and by a doctor of all people. The first stab was an innocent inoculation against a deadly disease. The second was a verbal stab at an opinion I hold on blue-chip stocks. To cut a long story short, the needle-wielding doctor asked me what my racket was, I said US securities analyst and she asked my opinion on US blue chips. I ventured that blue chips are, by and large, poor investments, even over the long term. She begged to differ and the verbal assault began.

My defence? Basically I told her to look at the performance of stocks in the Dow Jones Industrial Average, perhaps the best-known measure of blue-chip stocks in the US. The Dow is an unmanaged index of 30 of the most solid and respected businesses in the US, with stocks picked based on excellent past performance and the expectation of solid future growth. The Dow contains such stalwarts as AT&T, Coca-Cola, Disney, Philip Morris and Microsoft. But does it provide great returns?

My argument to the fair medic was "not necessarily". Invest in good US stocks, certainly, even a wider portfolio using an index like the Standard and Poor's 500. But if you are investing in individual US stocks, once a company hits the blue-chip heights of the Dow, drop it like a hot potato.

For example, compare the performance of two companies - steel behemoth Bethlehem Steel, and everyone's favourite band-aid maker, Johnson & Johnson - between 1974 and 1997. During that period, Bethlehem was on the Dow, Johnson and Johnson was not (they swapped in 1997). A $US10,000 investment in Bethlehem on 1 January 1974 was worth $2700 in 1997, inclusive of all dividends. Over the same period, $10,000 invested in J&J multiplied more than tenfold to $106,133. This rather interesting comparison begs the question: why was Bethlehem part of the Dow from 1974-1997 and J&J excluded?

Similarly, look at Coca-Cola and IBM, both of which were dropped from the Dow in 1932 and reinstated in 1987. During their time in the wilderness, IBM and Coke enjoyed explosive growth and had they remained as part of the index the Dow would likely be sitting at 30,000+ today instead of being at just over 8000 as it was as Unlimited went to press. When NCR was added to the Dow in 1929 it was trading at over 100 times earnings. By the time it was removed just three years later, it had lost 95% of its value. Beware the fad.

Need more proof? From 1974 to 1997, a $10,000 investment in what is today the world's largest retailer, Wal-Mart, would have grown to a mind-blowing $3.46 million. Close on a 30% compounding rate of return. Despite this, Wal-Mart was only added to the Dow in 1997. In other words, Wal-Mart delivered a 364-fold return in the 23 years preceding its inclusion in the Dow. In the next 23-year period (1997-2020) I would hazard a guess that Wal-Mart's return to shareholders will be nowhere near 300 times their money; not even 30 times their money. To increase just 30-fold, Wal-Mart would need to be generating about $6 trillion in annual revenues in 2020 - about $2000 a year from every household on the planet.

To the intelligent investor, such data may conceivably arouse one's curiosity. To be considered for the Dow, a company must be the dominant force in its industry. It also needs to have demonstrated consistent growth and profitability over many decades. But do favourable past results have any bearing on future results? After all, the investor of today does not profit from the growth of yesterday. As Charles Munger, vice-chairman of Warren Buffett's holding company Berkshire Hathaway, said at that company's annual meeting in 2001: "The way people extrapolate the past is stupid. Not just slightly stupid but massively stupid."

While Munger was not referring to the good people at Dow Jones & Company who select the Dow Jones Industrial Average constituents, he may as well have been. In his 1997 book, The Living Company, Arie de Gous analysed the life expectancy of companies of all sizes and determined the average Fortune 500 company had a life expectancy of just 40 or 50 years. One third of the companies on the Fortune 500 in 1970 no longer existed in 1983. In the typical instance it would take a blue-chip company 25-30 years from inception to make it into the Fortune 500, and less than 20 years after that to cease to exist.

Harvard professor Clay Christensen also came to some interesting conclusions in his book The Innovator's Dilemma. His theory was that the success and scale of many blue-chip companies are the precise reasons for their eventual demise. Size forges its own anchor.

The bluest chip of them all, telephone carrier AT&T, is a typical victim of what Christensen refers to as the disruptive innovation thesis. Back in the good ol' days of 1974, AT&T was the ultimate blue chip, a monopoly with strong and growing revenues. To many, it was as risk-free as US Treasury stock with all the upside of a share. It was a stock for widows and orphans and even today it is one of the most widely held stocks in the world. Back in 1974, there was no evidence to suggest that in just 25 years the business would be struggling to survive. Indeed, there were 50 years of outstanding performance to gaze back upon and project into the future. Yet over time its core business of long-distance voice traffic has become practically free to all in the US, resulting in the deterioration of AT&T's core revenues. A $10,000 investment in AT&T in 1974 would be worth around $5000 today (including all dividends and spinoffs).

So if the traditional wisdom of blue-chip stocks being good, safe investments is wrong, how should one invest for safety of principal and a decent return? You could do worse than follow the advice of the late Ben Graham, the so-called dean of Wall Street, who amassed a fortune following principles such as "invest in low-priced, solidly run companies with good dividends, diversify, and think for yourself".
In other words, take blue chips with a pinch of salt.

D Mark Harrison is the principal of Largo Capital Management, an Auckland-based manager of private investment funds. Declaration of interest: nil

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