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Gal^Stad
Investments Inc.

Year in Review

1999 in Perspective,
from the January 2000 issue

At the end of a century, one expects a bit of gaudy fin de siècle craziness -- that last orgy of decadent excess to top off a hundred years of wrenching change and extreme contrasts. Who would have guessed that instead of 1899's optimism, we faced Y2K pessimism? Fortunately the financial markets provided us with our full quota of extravagance and excitement.

With new highs of market participation, media coverage has swelled to the point where it is nearly impossible to go through a day without several updates of the market indexes and the latest hot IPO. But what has received less emphasis from the financial talking heads is the bizarre contrasts which have been the hallmark of this stage of the bull market.

Nineteen ninety-nine started out calmly enough, and with great promise for the Contra portfolio. As interest in the top tier of Internet stocks was slaked last winter, there was a promising revival of value stocks.

Even small caps showed a bit of strength, and with the help of the Royal LePage and UniHost takeovers and some nice moves in more heavily weighted stocks, it was shaping up to be a banner year. But then things started to go awry. A few mistakes came home to roost and many of our small caps went south while a few key stocks powered ahead.

When the dust settled the overall return on the portfolio of 9.2% made for a modest year, but this figure masks a schizoid story. Never before has Contra had such a yawning gap between our U.S. and Canadian stocks.

Fortunately, we were weighted about two-thirds to the American side which helped us, although we were dinged for about 4% in currency translation costs which lowered our returns substantially. Even where we were more successful, the gains were very narrow. In over 20 years of investing, never before have our returns been so inconsistent as 1999. A strange year indeed.

Returns on the key indexes were also all over the map. The S&P gained a healthy 19.5% on the year, but as in our own case, the gains came from a few big stocks. In fact, well over half of those big stocks decreased over the year, the first time that the index had a double-digit gain when this happened.

This may seem counterintuitive, but you must remember that unlike the Dow -- which is an arithmetical average -- the S&P is weighted by the member's market cap. Just eight out of 500 stocks were responsible for over 50% of the index's gains.

The fact that a one-dollar rise in Microsoft and General Electric is equivalent to the combined weight of the 250 bottom stocks, speaks volumes about what index funds are actually holding.

There were also plenty of examples of the growing clout of index funds. Adding insult to injury, Contra stalwart Laidlaw was dropped in favour of Yahoo. While our guy drifted into the ditch, Yahoo accelerated an unbelievable 64% in the five trading days between the time it was named to the S&P 500 and the time it actually joined -- an increase of some $35.6 billion in market cap.

For the Dow, a little high-tech injection of Intel and Microsoft gave a nice boost to bring the annual return to about 25%. This was surpassed by the Nasdaq which, like the S&P, is weighted to market cap and was up a sizzling 85%.

Since that scary day in October 1998 when global markets teetered on the precipice, setting off a T-bill buying frenzy, the Nasdaq has nearly tripled. Yet two-thirds of the exchange's stocks were down 30% or more.

Meanwhile, north of the border, the TSE 300 was up almost 32% and savvy foreign investors had the additional boost of currency gains. The majority of this was fuelled by BCE and Nortel and for those who went with the crowd and purchased the big guys, great gains were their just rewards.

This year we look up at other people's results and dream along with Warren Buffet. His Berkshire Hathaway A was scalded with a loss of 19.8%. But fortunately, few can touch our five-and ten-year numbers.

So what happened to the Y2K scare? A complex topic which defies succinct explanation, but the key point is the hysteria peaked quite early -- became discredited due to incorrect predictions and links to survivalist tin-foil heads -- and by the time of the actual rollover the people pulling money out of the market were swamped by a tide of optimism.

Wall Street alone doled out $13 billion in bonuses for 1999, more than enough to completely overwhelm gold bugs in their millennial bunkers. As for the lack of any significant computer problems after the rollover, only someone who missed our October 1998 commentary would be surprised.

Yes, stock values are still dependent on the big picture, interest rates (now at their highest levels in over two years), and both earnings and total sales remain critical parameters. One element of this picture is quite out of the ordinary and a lot more unpredictable.

Though a certain degree of sector rotation is a normal aspect of a cyclical market, what is happening now is quite different in terms of scale. The simple reason for the wide divergence in stocks is that people are selling iboringi stocks and buying iexcitingi ones. The confluence of a number of disparate factors have consorted to make this an incredibly liquid market.

So where does this leave us as a new century dawns? The few remaining bears point darkly to parallels with 1929 and 1973. Maybe. But when people talk about the "inevitable" popping of the bubble with such certainty, they are blowing smoke.

Sure, many of the Internet IPO darlings will do an ignominious crash and burn -- that's a given -- but what about the genuine leaders of the tech pack? Companies like Nortel, Lucent (its recent dip notwithstanding), Cisco and JDS Uniphase, who are building the infrastructure of this glorious electronic age are modern-day Carnegies who will remain key players regardless of which Internet retailer scores and which is scuppered.

This may not justify the sky-high valuations put on these companies -- but they will all work hard to grow their earnings.

Looking strictly at the indexes, we could see a significant pull back, but again, this is not inevitable strictly based on a good run. The Dow started 1947 at 176 points, and closed out 1961 at 731, a 315% increase. Did this set the scene for a blowout? So it seemed for a while, and by late May of 1962 the index had shed 21%.

But if the experience of the 60s were repeated this would be a temporary setback, for in less than four years, a tech-powered growing economy pushed the Dow for the first time to the 1,000 mark -- in February 1966.

The point is that periods of massive and fundamental technological change are able to bend the rules of gravity -- at least for a while...

Where are we heading now with the portfolio? Well, there have been a few noticeable changes over the past couple of years. In 1997, we started the year with 37 positions, last year 31 and the new decade (thought we'd say millennium, didn't you?) with 29.

Our goal mentioned earlier this year is to get the portfolio under 25 stocks as this will be more manageable.

We only have about half as much money in the market as at our peak in 1997, our posture remains more conservative than usual. This is simply because a few years ago stock levels were far more justified than today. Fortunately, our best years were being posted when our investment level was higher.

A couple of things that weire proud of. It has been a decade since the portfolio has lost money over the course of a year. To our way of thinking, 365 days is a short period of time and the briefer the duration, the easier it is to lose money. Of course, this year we do have the advantage of February 29th.

Also, last year was the eighth in a row where there has been at least one takeover. 1999 was a record with six. The previous record was two years prior with four. As the number of firms in the portfolio shrinks, the possibility of this happening of course is reduced. But given that not so long ago there were only 16 companies in the portfolio, we trust our "luck" in this direction will continue to hold.

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