The End of the Blue Chip Bargains
by Graham Summers
September 29, 2006
For once, the mutual fund industry did us a favor.
I don’t mean to be brash, but generally I am not a fan of mutual funds. They rarely produce the excellent returns they promise and typically charge too much in fees and other expenses.
According to a study in Jeremy J. Siegel’s book Stocks For the Long Run, there were only three years between 1982 and 1992 when more than 50% of mutual funds beat the market. In fact, The Wall Street Journal reports that the average return for all mutual funds during this period was 16.3%. And the S&P 500? 17.5%.
However, in 2006, mutual funds created the rarest of opportunities for us: incredible market-leading businesses trading at bargain basement prices. It was enough to make you want to write a thank you note to Morgan Stanley, Fidelity, and Merrill Lynch.
Investor panic following the market corrections of May, June and July resulted in large quantities of capital leaving the U.S. marketplace. Nowhere is this more obvious than in U.S. stock-based mutual funds.
In June 2006, more than $8.4 billion flowed out of these funds. It was the first time money has left these investments in over three years. The last time was February 2003 when the market bottomed out following the tech bubble crash.
The result of this outflow of capital was that mutual funds had to diminish their positions in the stock market. Consequently, their investments of choice, blue chip stocks, hit their cheapest levels in years. These are the only companies liquid enough for large mutual funds to safely invest in. And they also happen to be the most profitable, stable companies in the world.
I’m talking about the Cokes, the Intels, the Johnson & Johnsons, even the General Electrics: the brand and market leaders of the world. I’m not simply picking these companies at random either. All of them were incredibly cheap this year. And all experienced significant insider buying.
50 years from now, people will still be drinking Coke, typing on their computers, wearing Band-Aids, and buying home appliances. And in the meantime those who invested in these companies this year will see their investments return anywhere from 10% to 20% a year.
If this doesn’t seem too impressive, consider that a 10% return compounded over a 20-year period comes to nearly a six-fold increase in your initial capital. A 20% return compounded over the same period comes to 37-fold increase.
This is how Warren Buffett became the second richest man in the world. As much as most financial writers like to write about Buffett’s inspiration from the Benjamin Graham School of value investing, in actuality Buffett made his fortune simply by investing in the best brands at the best possible prices.
As he put it, “I’d much rather buy a great company at a fair price than a fair company at a great price.” To that end, Buffett bought Coke in 1987 while it was trading around 40 times earnings and $4.00 a share. Today, 20 years later, Coke is above $40 and Buffett is a billionaire many times over.
We’ve discussed the mega-soft drink company in these pages before. So far Coke is up 11% for the year. It’s hardly budged in the face of several serious market corrections. The market has swung in favor of blue chip stocks… and this opportunity will not last forever.
As I write this, the mainstream financial media has begun to unveil its “Buy Blue Chip Stocks” banners. In other words, the end of the blue chip bargains is in sight and it’s time to look for the next big idea.
Good investing,
Graham
