Brookside "SEP" News

 

 

Let me tell you about a conversation I had in the Grill Room of our yacht club a few months ago.  As I walked into the room, my friend George asked, “Hey, Jim, what did the market do today?’  I replied that it was up about 3 ½ points.  Then Bruce, who had overheard the conversation, said, “No, it was actually down about 6 points.”  Frank then chimed in with, “That’s strange.  I just heard on the radio in the car on the way over here that it was up about 8 points.”

 

George, Bruce and I are all in the investment business and quickly realized that as strange as our conversation may have sounded to others, all three of us were right.  The “market” truly was up 3 ½ points, down 6 points and up 8 points.  The problem, of course, was that each of us was using a different index to measure the same market.

 

The “market” we were referring to was the stock market, and specifically, the U.S. stock market.  However, in discussing the market, one should keep in mind that there are in reality many liquid markets that get measured each day.  There is the stock market (and many variations of the stock market), the bond market (with all its variations), the options markets, the futures markets, and even a fine art market.  Moreover, these are just to mention a few.  But clearly, when most people talk about “the market,” they are referring to the stock market.

 

In addition, it would seem at first glance that to measure the activity of one market would be a pretty straightforward task.  Yet, as is true in so many things, perceptions are not always the same as reality.  As markets developed, people have created a profusion of ways to measure them, some quite good and many of them dreadful.  As it turns out, the fellow that Frank heard on the radio was probably using the least accurate measure of the market -- the Dow Jones Industrial Average (DJIA).

 

Many years ago, the “Dow” was devised to be a representative measure of stock direction.  The need to have some measure of the market grew as stock ownership became more widespread.  People naturally wanted to know how their own investments were doing in comparison to the market.

 

Charles Dow created the venerable Dow index in 1896 by selecting 12 companies that he thought were the largest and best representatives of the market and the economy.  Some of the companies he selected still exist, like General Electric, while many of the originals long ago vanished, such as LaClede Gas and Tennessee Coal & Iron.  The index expanded to its current number of 30 companies in 1928.  There is now a committee at Dow Jones that selects the index’s components and occasionally makes some substitutions.  The most recent changes were made in April 8, 2004, when American International Group, Pfizer, and Verizon replaced AT&T, Eastman Kodak, and International Paper.  So, what we have is a small group of large companies that is arbitrarily adjusted by a committee from time to time.  There is clearly no way that a group of 30 changing stocks can represent the entire market of more than 11,000 public companies of all sizes.  However, that is only part of the problem with the Dow.

 

The real Achilles' heel of the Dow is how it is calculated.  I guess Mr. Dow wanted an index that was simple enough to calculate on the back of an envelope.  To get his index, all he did was to add up the prices of his stocks and divide that number by the number of stocks in the index.  This methodology is known as a price-weighted approach to calculating an index.  It ignores the differences in size of the companies, and over weights the impact of high priced stocks.  As an example, because IBM sells for about $82 per share, it makes up much more of the index than Exxon that sells at about $58 per share.  However, Exxon is almost 3 times the size of IBM in total market value.  It also disregards the fact that a $1 change in a $10 stock is much more significant than a $1 change in a $50 stock.

 

Such distortions render the Dow almost pointless to professional investors as a benchmark by which to compare stock performance.  About the only value of the Dow is its long history and ease of calculation.  However, with the availability of alternative indices and the everyday use of computers, even those virtues don’t rescue the Grand Daddy of indices.  If it were not for the fact that the index is owned by Dow Jones, the publisher of the Wall Street Journal, it surely would have gone the way of Woolworth Department Stores by now.  Selling the index for royalties brings in a great deal of money to Dow Jones every year, and a strong incentive to keep it alive.

 

The index that Bruce was referring to is the Standard & Poor’s 500 Index (S&P 500), introduced in 1957.  It is quite an improvement over the DJIA in a number of ways.  First, it has a much broader representation of the total market having 500 rather than 30 stocks in its index.  The 500 stocks represent the largest companies in each of the major U.S. industries.

 

It also is not sensitive to the price per share of the stocks in the index as the Dow is.  Instead of being price-weighted, it is market capitalization-weighted.  The market capitalization of a company is simply its share price multiplied by the number of shares outstanding.  In other words, it is the total market value of the company’s publicly traded stock.  This is a much better weighting approach since the share price of a stock is actually a fairly meaningless figure unless it is combined with the number of shares issued.  As an example, a company that has a share price of $40 with 500,000 shares issued can cut its price to $20 per share just by issuing another 500,000 shares.  Either way, it is still the same size company. ($40 x 500,000 shares= $20,000,000 market cap, as does $20 x 1,000,000 shares)  In the Dow, the $40 stock would get twice as much weight as the $20 stock, even though the companies are the same size.  In the S&P 500, both stocks would be weighted equally.

 

However, this market cap weighting has problems of its own if one is using the index to compare performance.  Because of the gigantic size of some of the companies in the index, the largest companies overpower the remainder of the index.  In the case of the S&P 500, the top 10 companies (representing only 2% of the full 500 group) account for 20.17% of the total index.  If you add in the next 30 largest companies, you find that these 40 stocks account for over 50% of the total index! The next 460 stocks make up the remaining 50%. 

 

Because the index so heavily weights the largest stocks, it might be a good barometer of the overall economy, but it becomes rather ineffective as a benchmark to compare to a portfolio’s performance.  When we buy positions in a portfolio, we do not invest twice as much money in a company that is twice the size of another company in which we invest.  We may, and frequently do, invest as much money in a smaller company as a large one.  So comparing a portfolio’s return to a market cap weighted index can lead to very misleading conclusions.  Put another way, if you are racing horses or cars, do you really care what the average speed is of a sailboat race?

 

There are many other market cap weighted indices such as the NASDAQ, the Russell Indices, and the Wilshire 5000 Index.  But they all suffer from the same flaw of being very top heavy.  Small and medium size companies (which are still major companies) just do not get much representation in the index.  If these small and medium size companies are available to you to invest in, then you want to compare your performance with an index that gives them appropriate weighting.

 

So now we come to the index that we have found most useful as a benchmark of stock returns, and the one we use in your reports.  It is called the Value Line Geometric Index (VLG), and is the one I was referring to in answering George’s question.  As you probably know, Value Line is a very well respected independent research firm that publishes the Value Line Investment Survey.  I have subscribed to it and worked with it for many years. 

 

In 1961, they introduced the Value Line Index.  The index includes every stock in their 1700 company universe, which means that there are small, medium, and large companies represented in every industry, including many foreign stocks.  Moreover, every stock, regardless of share price or market capitalization, gets an equal weighting.  They assume the same amount of money goes into every stock every day, and then compute the percentage change of each investment.  It is the equivalent of having $1.00 invested in all 1700 stocks every day.  While not perfect, we have found the VLG to be the best representation of a very broad selection of U.S. stocks including foreign stocks traded in the U.S.

 

Well, the obvious question now is, “Does all this really make any difference?”  And my answer is, “Oh my, you bet it does!”  Look at the following table for a comparison of the three indices over the past 10 years.

 

As you can see, there are years when the indices are fairly close; last year is a good example.  Yet there are times when the VLG hugely diverges from the other two indices.  Take a look at 1998 and 1999.  In both of those years, the broader and equally weighted VLG showed a negative stock market while the other two were indicating a roaring bull market!  What happened is that in those two years, we had a stock market where the largest companies appreciated a great deal, while the rest of the market (which is the vast majority of most stocks) just sat on their tails or declined.  If you had a portfolio composed of a broad mixture of stocks, you would have had a tough time beating “the market” because “the market” as reported in the press was booming.  However, the press was reporting the market as represented by a couple of indices that were over weighted by just a few stocks.  In addition, notice the effect those years have on the longer term 10-year rates of return.  Using the more accurate VLG, one can much more readily understand why the 1995-2005 decade was a lot more difficult to make money in than was the common impression.

 

This may be more than you ever wanted to know about market indices, but I wanted to explain why we use the Value Line Index on our performance reports rather than the indices that you hear about more often on the radio or on CNBC.  While the VLG is beginning to get a bit more mention in the press, it’s going to be a long time before it is even a glint in the eye of the fashionable Dow.  And please keep in mind that the Value Line Index should only be used to compare against the performance of stocks, and not a portfolio that has any other non-stock investments such as bonds or cash.