The simultaneous collapse of so many emerging markets . . . demonstrates that the destructive forces at work are mostly psychological. The IMF, the World Bank and other multilateral lenders, and wealthy nations probably don't have enough reserves to prop up all these markets—even if they wanted to do so. However, eventually the selling will stop and bargain-hunters will return to markets with P/E ratios measured in single digits. . . . This is more like a fever that has to run its course than a fatal illness.
— Stuart J. Sweet, Laffer Associates

The first few days of January ushered in a bone-chilling gale of economic havoc from the East. The numbing impact of the imploding Asian economies and markets, buffeted by sweeping crises of confidence and collapsing currencies, swirled across US markets, forcing investors to check their economic thermostats. With teeth chattering, many began to experience double vision. Their view of a Goldilocks economy with low inflation, low interest rates, and improving earnings was becoming blurred by an icy haze clouding the outlook for corporate earnings.

Having first stalled in Thailand last summer, the overheated Asian economies have joined Japan in a cold sweat. It is often said that when the US economy sneezes, the world economy catches a cold; now, fears of irrational exuberance among US investors are being supplanted by exaggerated concerns that the Asian contagion will infect the US economy with the deflationary flu.

Whether the worst fears of investors are realized only time will tell. Ironically in a year in which Titanic is both a blockbuster movie and a Broadway hit, it is becoming increasingly apparent that the chilling effect on global economic activity stemming from the roiling Asian markets has placed much of the economic world in uncharted waters amidst treacherous icebergs.

What launched the Asian economy on this tumultuous voyage will be debated by economists and politicians for some time. What is clear is that the events in Asia are the culmination of rapid economic growth fostered by massive government and corporate expenditures floated with foreign loans and supported by a surfeit of currency ginned out by central banks. Joining the feast were the closely held banks and large corporations with interlocking economic and political ties to the governing elite. Fueled by easy money and expanding world markets no longer fettered by the political and economic hamstrings of the Cold War, economic Nirvana swept over the region. Credit was readily available for almost all who wanted to board the economic ship. With each passing year, growing demand fueled further economic expansion. Public-works projects and factories spitting out a host of capital and consumer goods for domestic and international consumption sprung up like dandelions. Real-estate speculation flourished in the wake of ever-rising demand facilitated by easy credit and controlled currencies. The proliferation of debt fueled an explosion of industrial capacity. Unfortunately, the drive to capture world markets resulted in a profitless prosperity. Too much unprofitable investment resulted in the inevitable failure to earn an adequate return on the borrowed capital. Many Asian companies have not had any earnings for some time. The failure to generate real profits exposed the fragile framework of the Asian economies. The heat of the economic expansion faded in the face of global financial market pressures and the exhaustion of any residual government artifice to prop up their overleveraged corporate and government structures. Corporations throughout Asia could no longer be supported by their friends in banking and the government. Banks could no longer sustain the economic charade as their own capital structures were in peril. The artificially inflated currencies were exposed to strains from leaders and speculators alike. Investors around the world began to dump Asian currencies and securities. In ignominious fashion, when the money spigot dried up, the erstwhile investors bid their adieux.

The International Monetary Fund's attempts to shore up the embattled economies are rather like the boy with his finger in the dike. The IMF and other international agencies cannot eliminate the painful bankruptcies which will follow in the wake of cascading currencies. On the other hand, the silver lining in the Asia debacle is that the byzantine structure of the relationships among banks, corporations, and the government elite has been exposed. They will no longer be able to engage in the cronyism and nepotism which accompanied their mushrooming economies, superimposed on an inflated structure of easy credit, continued currency manipulation, and systemic government and corporate corruption.

The restructuring of Asian markets to function in a more open and sound economic fashion will be a positive long-term development. The potential for healthy Asian economic growth is enormous. However, in the short term, the impact of the unraveling of the Asian economies is fraught with major economic and political risk. Growing nationalism will be apparent in resentment of the West and the IMF for imposing draconian measures for painful economic reform. Political destabilization growing out of economic turmoil could result in heightened political and military tension.

Even if political and military calm were to prevail in the region, the immediate economic consequences are troublesome. Faced with the need to generate foreign currency to restore and maintain their stability and to forestall further political turmoil, the Asian economies will seek to flood the world with their products and raw materials at bargain prices. The Toyota car, the Sony TV, the Korean steel, and the Aiwa sound system are cheaper today than they were a month ago. The dollar, having recovered dramatically against foreign currencies over the past few years, can buy more goods and services from abroad. But for every Toyota sold, a Big Three product goes begging, and the trade deficit worsens. And not only will Americans buy more foreign products, American corporations will find it even more difficult to export overseas. It will take more yen, won, rupiahs, bhat, marks, and pounds to buy American goods. And so we come to one of the reasons US investors are having second thoughts about the seriousness of the world turmoil.

Faced with increasing competition at home and declining sales overseas, revenues and profit margins will be under pressure. Whether it is a Caterpillar tractor, a curtailed order for a Boeing aircraft, a case of Coke, a Microsoft software program, or a Citicorp loan to a Korean manufacturer gone bad, the squeeze is on. Thus, despite low inflation and interest rates at home, low unemployment, and another year of record profits, investors are starting to question their previously rosy scenario for corporate profits, particularly for companies with significant overseas exposure, especially in Asia.

Nations eager to build up their monetary reserves and pay off debt will engage in aggressive dumping of goods and services, resulting in a possible deflationary destabilization of some prices. Among other things, deflation can result in the destruction of economic value, particularly of real estate, plant and equipment, raw materials, and other tangible assets. Price wars erode profit margins. Eroding profit margins spell lower earnings. Lower earnings spell lower stock prices. The investor who rejoices over the deal he got on a new Toyota may be dejected when a CNBC anchorman he sees on his Panasonic TV tells him how much his index fund has declined. And when he drives to work in Peoria, he gets a pink slip because Caterpillar is cutting back production due to weak demand from overseas.

Beyond the obvious concerns for corporate profits, there is also the underlying if yet unarticulated fear that events can sometimes take on a life of their own. Political leaders under economic stress at home can resort to trade barriers in an attempt to shore up political support. Trade wars could erupt which would accelerate and exacerbate economic problems. Trade wars can often precipitate military tension.

Can it really get this bad? Yes. Will it? Who knows? But anyone who pretends to predict with any degree of certainty the outcome for the next few quarters is a charlatan or a blind optimist. Lest the reader think we are too negative, we hasten to add that for a myriad of reasons, we think the worst fears are overblown. We doubt that our economy will go into a tailspin. Only 9% of US corporate foreign revenues come from non-Japan Asia. Further, a resurgent Europe could help to offset the weakness in Asia. Overall corporate profits are still expected to be up between 5% and 8%. Nevertheless, the Asian turbulence has changed the dynamics such that many corporations will report 1998 profits below those of 1997. And for many of them, stock prices will slide downward.

An offer you can't refuse.

The uproar has contributed to a lowering of prices for materials, goods, and services, thus sustaining the trend to lower inflation and interest rates. Lower rates have in turn resulted in higher bond prices. If inflation remains subdued, and if economic activity stagnates, it is certainly plausible that 30-year US Treasury bonds will continue to decline in yield. However, despite the lip service given to the possibility of deflation, for reasons beyond the scope of this paper, we think it is unlikely that deflation for the economy as a whole will visit the United States. Rather, a low level of inflation should continue. Therefore, while yields may decline some more, the total 1998 return from bonds (the coupon plus price appreciation resulting from lower yields) will be less than 10%, and probably closer to 7% or 8%.

If the total return on bonds is probably going to be lower than 10%, and profits are less likely to be robust, where might an investor seek an above-average return? We thought you would never ask! Why, common stocks, of course, particularly those stocks which offer intrinsic value significantly higher than their publicly traded prices. Importantly, in the next few quarters, the stocks of companies benefiting from merger-and-acquisition activity may offer especially superior risk/reward characteristics. Acquisitions can be quite profitable for sellers. Between 1986 and 1995, the average corporate acquisition premium was 35% to 40% above the previous public price of the acquired company.

The impetus for accelerated merger-and-acquisition activity is fairly straightforward. Faced with a slowdown in business activity and with difficulty raising prices in a deflationary or disinflationary environment, acquisitions provide a convenient vehicle for sales growth. M&A activity will also be spurred by firms hopeful of diverting attention from their own less-than-stellar performance and by directors and managers who, unable to grow their sales and/or whose stocks are languishing, view selling out as the perfect solution for maximizing shareholder and stock-option value—including their own.

Facilitating a high level of merger and takeover transactions will be strong corporate cash flows. Even though profit growth will likely be moderating, cash flows remain high in a number of industries. Typically, cash flows are used for dividend hikes, debt reduction, share buybacks, or acquisitions. Today, dividends are viewed as less important than in past years, due in part to the double taxation they incur for taxable investors. Debt repayment is less critical as corporate balance sheets have improved dramatically in the past several years. The repurchase of stock through share buybacks is often overrated, as many companies issue a large number of offsetting shares for option grants. Thus, acquisitions have become a more viable option for corporations confronted with slowing top-line growth.

In addition to strong cash flows, acquisitions can also be financed with the stock of the acquirer. With stock valuations generally higher as a result of the prolonged bull market, stock transactions serve as a valuable currency to finance deals and provide additional incentive to sellers as they generally defer capital gains on the market value of the proffered stock.

After a long period of corporate restructuring in an effort to achieve efficiency and economies of scale in core product and service lines, corporate America is well positioned to benefit from acquisitions. With profit margins high after the rationalizations of their businesses and sales growth more difficult to achieve, acquisitions become a logical strategy for growth. And, in a global economy with excess industrial capacity, corporate cash flow is less likely to be directed at plant expansion. Finally, faced with intense competitive pressures at home and abroad, for many companies it becomes a case of "acquire or be acquired." Thus, conditions are ripe for not only a continuation, but probably an acceleration, of acquisition activity. And companies whose stocks falter become easy and appealing prey for the other fish in the global corporate ocean.

Beyond the broad imperative of increasing sales growth, the motivation for pursuing acquisitions in various industries will be driven by the dynamics of each industry. Edward Kerschner of PaineWebber recently outlined eight drivers of consolidation activity:

• To gain economies of scale in buying materials, building brands, and spreading administrative costs over more customers in cutting-edge technology.
• To gain economies of scope. Many customers prefer "one-stop shopping," so the large company which provides a broad range of products and/or services has a competitive advantage.
• To integrate vertically into higher-margin businesses.
• To acquire new technology.
• To acquire strategic assets or workers that would be impossible to duplicate or recruit in a timely manner.
• To keep competitors out of your geographic territory.
• To respond to the deregulation which is transforming the landscape in some of America's biggest industries.
• To expand internationally.

A number of companies in industries such as health care, telecommunications, financial services, technology, and energy will probably undergo a high level of merger-and-acquisition activity. The urge to merge on the part of corporations can serve as a powerful force for positive stock-price performance. With the prospect of a volatile market ahead for the foreseeable future, a focus on the beneficiaries of the long wave of consolidation should serve investors well. In essence, such an approach is one of the key tenets which JKA has followed since its formation. As one of the three legs of the Business Valuation Approach, it seems particularly well suited for today's uncertain environment.

Wanna buy a dollar for fifty cents?

We are a bottom-up value manager adhering to what we call the Business Valuation Approach, which seeks to identify attractive investment opportunities using a broad definition of value, uncovering securities often overlooked by other investors. We think value can be found in different types of securities at different points in the economic cycle. We practice a disciplined philosophy of investing focused on uncovering value in whatever form the markets present it, as opposed to sticking with a rigid style narrowly defined. After all, we think our clients want the best value, not a sophistic style and overly mechanical methodology. We try to make our clients money, not produce cute little sausage links.

Our buy criteria consist of three elements. Essentially, we will buy a stock which trades at a discount to:

• its five-year projected earnings growth rate;
• its historical valuation based on financial benchmarks such as its price-to-earnings, price/book, price/cash flow, or price/sales ratios; or
• its private-market value.

Occasionally, a stock will clear more than one of these hurdles.

Unlike many typical value managers who practice only a Graham-and-Dodd approach (buying only low P/E or price/book stocks), our buy criteria allow us to purchase growth stocks, but at a reasonable price. Earnings growth is certainly a positive attribute of a company, but an attribute for which investors often pay too much. But if purchased at a value price, a growth stock can be an excellent investment. One criterion we examine when purchasing a stock is whether it is trading at a discount to its growth rate of earnings or demonstrable cash flow. Our focus in 1996 and 1997 on cellular telecommunications and cable-TV stocks was motivated partly by the fact that their prices were extremely low based on reasonably predictable and growing cash flows. This at a time when these stocks were considered pariahs by Wall Street.

Another criterion we employ when considering a stock is whether it trades at a discount to its historical valuation on such measures as price/earnings, price/cash flow, price/book, or even price/sales basis (a measurement rarely applied today because of the run-up in financial assets over the last several years). Today, even when most stocks decline in price, they rarely trade at a discount to their historical valuation parameters. Again, in the summer and fall of 1996, securities like Lehman Brothers and oil-services stocks provided excellent entry points for purchase at very low prices in relation to these financial yardsticks, and the results have been quite rewarding.

But what makes us (if not unique) certainly one of a distinctive minority is our emphasis on private-market value, the amount an outside party would be willing to pay for an entire publicly traded company. The target price takes into account such characteristics as cash flow, assets, management team, and goodwill, plus debt (if any). In addition, a premium is usually paid to take sole control of a company. Such considerations as a company's strategic value to a potential buyer may also play a key role in its valuation. Our highly successful investments in the financial-services industry are due largely to the application of the discipline of private-market valuation. Our focus on this type of analysis over the past seventeen years has successfully identified undervalued companies for our managed accounts, and now we are exploiting its strengths for the benefit of our mutual fund, the Fountainhead Special Value Fund. We buy a stock when its perceived value (the price at which the market values it via its publicly traded price) is at a significant discount to its private-market value; the wider the gap, the better. Quite simply, we try to buy a dollar for fifty cents. This spread can be closed through price appreciation arising from many factors, including a takeover, a restructuring, a spin-off to shareholders, or other catalysts. Often the board of directors will seek to "create or enhance shareholder value" because they recognize that the publicly-traded price does not reflect the company's private-market value, and they may be motivated by the fact that if they do not enhance shareholder value, someone else will.

Even Wall Street may eventually recognize a company's hidden value vis-à-vis its stock price, but the Street (which gravitates toward the safe and comfortable, and which has very short-term time horizons) displays a general unwillingness to dedicate significant resources to private-market value. By exploiting inefficient segments of the market—what we often call the "unwanted and unloved"—we can buy low and sell high most of the time.

One of the salutary benefits of focusing on the value of a business (as opposed to trying to outguess Wall Street) arises from the inevitable swings in stock price which create opportunity. Far from dreading volatility, the Business Valuation Approach welcomes it. If someone in a state of panic and fear is willing to part with some stock at a bargain price, we will gladly oblige, and if we have the conviction to wait until the market price catches up to the private-market value, we can better resist the temptation to sell. Furthermore, when someone is willing to pay a fair (or a premium) price, we will be more than happy to sell.

We have often said that our clients own pieces of businesses, not "the market." In today's environment, in which commoditized stocks and bonds are used as vehicles for speculation in the short run, it is easy to fall prey to the urge to "do something." We think it is impossible to time the market; we know of no one who has made a fortune doing so consistently. On the other hand, the patient investor can do quite well over long periods of time by buying a piece of a business at an opportunistic price.

Often wrong, but rarely in doubt.

At the beginning of a year, economists and securities analysts typically provide a brief retrospective of the recent past and an overview and prediction of the markets and corporate prospects for the coming year. While usually interesting, very few will hit the nail on the head, and some will prove to be embarrassingly off the mark. Of course we do have opinions about the outlook for the financial markets and such determining factors as inflation, interest rates, earnings, and other ingredients of the economic casserole. But we leave it to others, armed with whizzing computers gorged with endless bits of statistical data, to predict the unpredictable with conviction and alacrity.

In that regard, further confirmation of our emphasis on private-market value is the glaring failure of another widely followed practice, namely buying stocks based on estimated earnings. Securities analysts appear to offer greater odds of pinning the tail on the donkey than of predicting corporate earnings.

As an example of the fallacies of forecasting (and further reinforcing our skepticism in regard to consensus thinking), the questionable predictive abilities of the financial gurus of Wall Street were highlighted in yet another study of their feet of clay. David Dreman and Eric Lufkin examined the quarterly earnings forecasts of investment analysts for 1,115 NYSE, NASDAQ, and AMEX stocks for the period of 1990 through 1996. The gap between reported earnings and estimates was staggering: the average analysts' consensus forecast was off 48.7%! This figure was even higher than demonstrated by other studies, including the 44% gap which Dreman and Lufkin found in a similar study spanning the period between 1973 and 1996. Dreman succinctly concludes that

The inaccuracy of these forecasts shows how dangerous it is to buy or hold stocks on the basis of what analysts predict for earnings. . . . there are just too many unknowables for such pretended precision.

Which is one reason value or low-P/E strategies work: they do not depend on spuriously scientific earnings estimates. A value stock is unlikely to collapse if its quarterly earnings fall short of expectations; skepticism is already built into the price. But when earnings come in above expectations, these stocks shoot out the lights. In short, surprises are often good for value stocks. Rarely are surprises good for growth or momentum stocks. With these, it's look-out-below if there is a shortfall, and a shrug of the shoulders if earnings come in on the upside.

If you like the thrill of staying glued to your favorite business channel, ready to call your broker when the newsreader drops a bit of good or bad news, then maybe momentum and aggressive-growth stocks are right for you. But if you are more interested in having your money grow with minimal exposure to nasty setbacks, stick with [value stocks].

Dreman's enlightening studies confirm our historical real-world experience. This firm is concluding its seventeenth successful year. This writer has been engaged in professional investing for well over a quarter of a century. Value investing does work, and it is inherently less risky in the real world than are other approaches to investing. Our definition of value investing is somewhat more expansive than Dreman's, yet it is based on the very simple concept of buying stocks which are cheap as businesses and not the hype of relative value and earnings guesstimate fantasy churned out by Wall Street.

Straw hats in the winter.

The outstanding returns of the major US stock-market averages for the past three years will not likely be matched in 1998. The fallout from the implosion of key Asian economies will probably have a more negative impact on a number of US industries than many analysts have heretofore acknowledged. Earnings gains will be more difficult to achieve and sustain. Investors betting on growth should stay close to the exits and keep the Rolaids handy. Yet, while painful, the impact of an Asian slowdown on the United States will be far from catastrophic. As mentioned, European recovery could be a surprising plus for our economy. Also offsetting the economic flu from the East will be generally lower interest rates, which should somewhat limit any erosion in stock prices. A number of companies whose futures are less dependent on overseas activity should stand out as attractive alternatives to the former icons of growth, which are being decimated one by one.

Over the longer term, we remain optimistic about international economic growth. A Dow Jones Industrial Average of 10,000 in the next two to three years should be a stepping-stone toward a Dow 12,000, and then 15,000, in the first decade of the next century. Thus, while there is no need to follow the ostrich into its hole over the likelihood of a more restrained environment in coming quarters, there is certainly a need to be realistic regarding investment expectations. It has been a grand party for some time. But now, the world markets must digest some of the inevitable excesses arising from a worldwide liquidity boom showing obvious signs of overindulgence.

Despite flagging economic fortunes abroad and high valuation levels among domestic companies, there exist many opportunities for profitable investing. By focusing on our three value criteria, we should be able to capitalize on the inevitable agitation of markets traversing rough waters. When conditions warrant, we may sell some securities whose prices already reflect the gain we anticipated, or whose fundamentals are no longer as promising as we had expected. Should we not find compelling value, we will wait patiently for it to appear. Fortunately, amid the din of numerous (and probably erroneous) earnings estimates for 1998 which reflect extremes of blind optimism or the cacophonous Cassandras of doom, opportunity still abounds. After all, who can resist the annual inventory clearance sales held by Wall Street? We are in the midst of winter, and we see quite a few straw hats.