ITA Wealth Management

Back in the mid 1990s, I heard about a company named Cisco Systems. At that time I knew little about routers, but I had a sense they were going to be big as the Internet grew. With very little information and analysis, I purchased shares, only to watch them rise in price almost daily. A relative was working in the bay area so I called him and asked him about Cisco. Yes, he was very aware of the company. In fact they were in the process of expanding their campus and expected to double their workforce within a short period. With no more analysis, I added shares to my holdings despite the higher price.

The price of CSCO continued to climb. This stock did so well it was soon the stock of choice for charitable contributions. With that background, let me shift to a long quote from Rob Arnott’s book, “The Fundamental Index.”

“Having a clear and informed belief regarding price efficiency is one of the most critical elements to fomulating an investment strategy. Consider this: $500 billion lost in only 30 months. It is a staggering amount of money–more than 50 times the collective annual casino takings from Las Vegas tourists and two-and-a-half times the estimated losses domestic airlines and associated travel industries suffered after September 11, 2001. Shockingly, it’s more than 100 times the losses incurred in the collapse of Long-Term Capital Management (the most spectacular hedge fund collapse in history) that many knowledgeable people–including former Federal Reserve Board chairman Alan Greenspan–thought could potentially bring down the entire global economy.”

“This massive wealth destruction wasn’t the result of rogue traders with leveraged balance sheets. It occurred in the stock market–in the 30 months following the collapse of the technology bubble in March 2000. The $500 billion figure isn’t even the total stock market loss over this dreadful stretch. This astronomical loss resulted from one stock: Cisco Systems, the largest stock in the world based on market capitalization at the peak of the tech bubble. This stock was valued at nearly $600 billion at a time when its sales were less than $20 billion, its trailing 12-month operating earnings were less than $3 billion, its cumulative profits since inception were well under $8 billion, and it had never paid a dividend. Additionally, Cisco’s workforce numbered fewer than 30,000 people.”

“Index fund investors as a group–people who believe in market efficiency and who do not believe in betting on single stocks–lost nearly $100 billion in Cisco. An average 401(k) participant with $100,000 invested in a Standard & Poor’s (S&P) 500 Index fund lost more than $45,000 in those 30 bleak months, almost $4,000 of which was lost on Cisco alone.”

Why go into such detail about this single stock? Arnott is making a strong case that price alone is a dangerous metric and that even index fund investors, who embrace diversity, can be hurt when funds are built around cap-weighted stocks. He is making the point one would not be hurt the same way if the funds are constructed around fundamentals such as sales, cash flow, book value, and dividends.

Just to complete the story, I still hold shares of Cisco with a rather nice IRR value since the shares purchased many years ago were bought at very low prices.

Lowell Herr

Photograph: Image by Dennis Dean