SOME OTHER DEFINITIONS

In this section we'll look at some other definitions.  For example, it's important to know the fiscal year for the company; it may not coincide with the calendar year that we all know and love.  An introduction will be given to the business cycle; understanding the business cycle is important to learning about the main characteristic of a growth company: it ignores the cycle.  We'll take about recessions and who in the US decides if one has hit.  We'll touch on the life cycle of a company and finally discuss mutual funds and professional money managers.

Fiscal Year versus Calendar Year

Sometimes companies have a New Year’s Day that differs from January 1!  For reasons that may be related to their business activity, the company has a financial or fiscal year that does not coincide with a calendar year.  For example, if you are retailer, you might want the fiscal year to end on June 30.  The period leading up to December 31, can be very hectic.  Trying to manage sales and close out all accounts for the year could be a daunting task.  Further, if sales are slow in December, you could try discounting in the spring to get revenue numbers up for the fiscal year!  The major impact that this issue has is when it comes to the Value Line Investment Survey—see appendix 3 for details.  In Value Line, stock prices are reported on a calendar year basis, while financial results are reported on the company fiscal year.

What’s the business cycle?

I’ll start off by talking about another term—the GDP or gross domestic product.  The GDP is the sum of all goods and services, that is, a measure of economic activity over a period of time—normally a year.  Items that make up something else—production of doors that become part of cars—aren’t counted towards GDP, just the final items.  Most of the time, the GDP grows steadily—usually due to increases in productivity.  However, on occasion the GDP declines.  If the GDP declines for two or three consecutive quarters, the economy is said by many to have entered a recession.  (Some people say two quarters, while others prefer three—imagine: economists disagreeing—well I never!) More on this topic in a moment. The business cycle is the cycle of change in economic activity (as measured by the GDP) over time.  This cycle—from low-point to low-point—is irregular.  Currently (August 2000) we’re in the longest period of expansion (growth after a recession) ever measured.

If a recession is very severe, the GDP declines extremely sharply and many people are put out of work, this recession is referred to as a depression.  The last depression occurred in the 1930s.  Economies in the western world are now structured such that depressions are very unlikely to occur.  In fact, there has been no major depression or serious hint of a depression in western countries since the recovery after World War II.

Who really decides if the economy is in a recession?

In the US, a decision as to whether the economy is in a recession is made by the National Bureau of Economic Research.  The Bureau defines a recession as

The Bureau is a private, non-profit organization dedicated to the study of economics.  The Bureau is "committed to undertaking and disseminating unbiased economic research among public policymakers, business professionals, and the academic community."  Most economists use the Bureau's definition was to whether the economy has entered into a recession.   It is possible that the economy could sustain two consecutive quarters of economic downturn without a definition of a recession being called.

What’s a growth company

As is often the case, opinions can differ on what constitutes a growth company.  This definition is probably the only time that I don’t care about earnings!  I define a growth company as a company with revenues that are impervious to the business cycle.  A growth company has steadily increasing sales even when there is a down turn in the business cycle.  Growth companies can have erratic earnings, but the growth in the top line on their income statement is not affected by the business cycle.

What’s the business life cycle?

Think about the Roman Empire.  It had an introductory phase—Romulus and Remus founded the thing.  I had an early growth phase.  Rome was a small city state surrounded by others.  The Etruscans had a much larger nation and could have conquered the Romans.  It had a rapid growth phase—growth through “acquisition.”  The Romans went around conquering peoples.  Actually, it had a few distinct growth spurts.  The early empire had competitors—Carthage—but Rome proved more adroit and eventually neutralized competitors.  The empire had a long mature phase when nothing much happened.  They experimented with different management styles, republic, temporary dictators, eventually settling on monarchy.  There were frequent internal struggles for the top job.  Although the empire was successful and profitable, it decided to have a spin off.  The empire split in two: east and west.  The Western Empire went into a decline phase (AT&T ); competitors entered once safe markets, eventually the empire collapsed.  The Eastern Empire flourished (Lucent ) and outlasted its parent by a thousand years.  You’ve just learned about the business life cycle for the Roman Empire.

Every business goes through such a cycle.  There’s the early phase when the company has a new idea.  The company is small and vulnerable.  However, being small, the company is not on the radar screens of competitors.  There’s a growth phase.  The market is now becoming established.  Dozens of companies form as people sense great opportunity.  There are sufficient customers that there is not too much competition among companies.  Growth is rapid and sustained by expanding the market.  The companies then enter a phase, still a growth phase, where competition among companies starts.  Margins start to shrink and consolidation within the industry occurs.  As the rate of growth slows down further, the remaining companies enter a mature phase.  They generate cash; however, the market is close to saturation, so companies pay this cash out as dividends.  Every industry reaches this mature phase where the rate of consolidation slows down, but doesn’t stop.  Eventually, 90% of the market is held by three or four companies.  Finally, new technology kicks in and the big, well-established behemoths don’t respond fast enough and start an inexorable decline.  Sales collapse, margins shrink, the industry folds.

The figure that follows traces out the business life cycle.  You can think of any industry and follow its progress along the curve.  The rail industry is in the decline phase, while the Internet is in the early growth area.  The auto industry is in the mature phase; the biotech sector is probably in the mid growth area.

What’s a mutual fund?

A mutual fund is an investment vehicle that offers shares to the public.  The mutual fund uses the cash obtained in selling these shares to invest in financial instruments.  Mutual funds have professional managers.  The funds usually have a defined investment style: exclusively common stock, specific industries or sectors of the economy.  Unlike public companies, there is no secondary market—“stock exchange”—for mutual fund shares.  The shares are bought from and sold to the fund.

What’s the deal with professional money mangers?

Professional money managers are all grouped together as if they’re one thing—which they’re not.  We most often think of a money manager as someone who is in charge of one of the thousands of mutual funds.  That person makes decision as to what stocks should be bought and sold.  Peter Lynch is perhaps the most famous of all mutual fund managers—he’s a bench mark!

Money managers often compete with one another for the investing public’s dollars.  Since the investing public looks for past performance, companies often put pressure on their managers to perform well on a quarter-by-quarter basis.

Over the long term, the vast majority of actively managed funds (over 90% by some reckoning) under-perform the overall market.  Often, fund managers cannot risk buying out-of-favor companies—like the pharmaceutical industry in 1993/4.  Such companies might put a short term drag on the overall performance of the fund.  Individual investors often do not have this restraint.  They can buy companies when they’re selling at a cheap price.