The Market Sheds a Tier

Institutional money managers have created a separate set of stocks with inflated price-earnings ratios. That bubble may be about to burst.

ON OCTOBER 9, FEDERAL JUDGE A. Sherman Christensen dropped the second shoe in the Telex- IBM case, and the thud confused Wall Street more than the deadline for negotiated commissions.

Judge Christensen, sitting in Tulsa, Oklahoma, announced that he had erred in his original decision to award Telex $352 million from IBM, which had been accused of unfair competition and restraint of trade. He said there were substantial errors in the computation of damages in the case, prompting one wag to remark:

“The biggest case in the history of computers, and they can’t even compute the damages correctly.”

At this writing the decision is still up in the air, and that indecision has given Wall Street apoplexy. For a decade money managers have enjoyed an IBM security blanket. The giant computer company represented the epitome of the top tier of a two-tiered stock market. The presence of IBM and the other stocks on that top tier made investment decisions rather simple.

Controlling 70 per cent of the burgeoning computer mainframe business, IBM has compounded its earnings at a 15 to 20 per cent pace for as long as anyone can remember. Compared to its competition, IBM was a head, shoulders, and navel standout. That’s why the cast for the computer industry is called: “ IBM and the seven dwarfs.”

The company was doing well, but not as well as the price of its stock. A number of fortunes are based on the continual ascent of IBM’s price. The stock would go up 25 per cent and split. Up another 25 per cent the next year, then another split. At that rate, a few years produced 1000 per cent profits. Sell it? “Don’t be silly. I’d rather sell my wife!”

Such action was tailored for money managers, and they learned to use IBM as monopolistically as Standard Oil carved up the country in pre-Sherman Anti-Trust days. Rudimentary investment philosophy tells us that stock prices are directly related to demand and supply. When insatiable demand overwhelms existing supply, prices inevitably work higher. When Judge Christensen rendered his initial decision against IBM, the company had 145 million shares outstanding. More than half of those shares were owned by institutions. The “to whom” implications are staggering.

There was a real two-tier system in computer stocks. IBM was worth 40 times earnings while the rest of the computer companies were worth, collectively, maybe 10 times earnings.

“Buy the dominant company in a rapidly expanding industry and ignore all the rest.”

That was the professional investment philosophy, adhered to with such uniform fealty by money managers that a roll call at an institutional investors conference was answered with a series of “baaaaaas.”

The two-tiered market was tangible. Not only could investors see it, they could feel it, right in the portfolio. Most investors don’t buy stocks selling over $100 per share, and that put IBM, Polaroid, Xerox, Eastman Kodak, and a number of other top-tier stocks out of their reach. The institutions had that thin field to themselves, and they took blood oaths not to sell those stocks, only buy them.

The Standard and Poor’s 500 stock index was up more than 15 per cent in 1972. Most investors didn’t benefit, however, because more than two-thirds of that advance was in 25 issues. Five per cent of the list accounted for almost 70 per cent of the gain. The bursting point of that bubble was lowered somewhat by Judge Christensen’s original decision against IBM. Suddenly, the very domination of an industry that is so important to top-tier stocks began to carry with it some rather dismaying anti-trust implications. At first, the weakness was confined to IBM and that other hoary growth number, Xerox, but it quickly spread to the other

More Texas Monthly

Loading, please wait...