© January 2013 Nick Murray. All rights reserved. Reprinted by permission.

The election. The fiscal cliff. The national debt. The federal deficit. Slow (to nonexistent) economic growth. Chronically high unemployment. Superstorm Sandy, the east coast’s Katrina. Impending tax increases. The euro plague, leapfrogging from Greece to Spain, next perhaps to Italy and even France. The weak dollar. The Federal Reserve continuing to push on a string. The China slowdown. The LIBOR scandal. The Facebook IPO fiasco. Yet another new strain of flu virus. The end of the world foretold by the Mayan calendar. Two thousand twelve was certainly a banner year for catastrophe, was it not?

How very odd, then, that the broad equity market—which started the year at 1277 on the S&P 500 and has flirted with 1450 as I write on the winter solstice—so signally failed to get the message. With dividends, it seems to be on track to have returned something like fourteen percent in this seemingly most relentlessly dismal of years. How shall we account to ourselves for this dichotomy, which seems on its face not merely inexplicable but downright weird? Well, I can think of two possible explanations.

The first and most obvious is that the stock market is just dead wrong: that it has recklessly ignored the plethora of real and impending disasters that are bearing down on us with each passing day, and which will surely swamp our economy and precipitate a market meltdown…any day now. For simplicity’s sake, let’s call this Door Number One: Pessimists Right, Market Wrong.

But then there’s that other possibility. Which is, of course, that the pessimists have not just been momentarily wrong: they’ve been fundamentally—and perhaps fatally—wrong about the whole equation. They have, in short, been focusing entirely on the fiscal, monetary and economic mistakes of countries. But the equity market—as is its wont—has been much more narrowly focused on the variables which always ultimately drive it: the healthy, growing (and by some measures record-breaking) earnings, cash flows, dividends and cash positions of companies. We’ll call this, as I’m sure you’ve already anticipated, Door Number Two: Market Right, Pessimists Wrong.

This is just one armchair observer’s opinion, you understand, but—as I have all along—I’m going with Door Number Two. And thereby hangs a tale.

It is fashionable in pessimist circles to note that the equity market as denominated in the Standard & Poor’s 500-Stock Index is closing out 2012 just about exactly where it ended 1999, in the mid 1400s—having all these years “done nothing.” This observation, narrowly correct as it clearly is, misses a couple of important things.

The first of these is, of course, that at the close of 1999 the market was within weeks of the bitter end of its greatest two-decade run of all time, during which the Index had gone up quite a bit more than ten times. It was at that point, by any and perhaps every measure, way ahead of itself.

The second and to me even more telling point is that while the Index has been, on net, treading water for these unlucky thirteen years, the earnings and dividends of its five hundred component companies have essentially doubled. (As the late American philosopher Charles Dillon Stengel always said: “You could look it up.”) OK, technically the earnings have a tad more than doubled, and the dividends a tad less, but the point is made: the prices of the great companies in America and the world relative to their earnings and dividends have to all intents and purposes halved, lo these thirteen years past.

One may therefore suggest, not unreasonably, the possibility that the market may in these thirteen years have gotten almost as far behind itself as it was ahead of itself in 1999. And that what it has been doing in 2012 is playing catch-up.

And there is perhaps more to this thesis than most investors may suspect. At the end of 1999, the S&P 500 was completing a year in which it earned about $50. Dividing those earnings by 1450, the Index’s earnings yield stood at 3.5%—at a moment when the yield on the 10-year U.S. Treasury bond (though falling rapidly) was still around 5%. It could have been argued (and in fact this thesis turned out to be the correct one) that the bond was a better value, or at least a very competitive safe haven.

Today near 1450, with earnings in excess of $100, the S&P 500′s earnings yield is about 6.7%, while the 10-year Treasury’s is 1.8%, suggesting that the relative values of stocks and bonds have very sharply reversed since 1999. And that’s not all.

Dig a little deeper, and we discover a couple of very intriguing facts about dividends. The more obvious of these is that—for only the second time since 1958—the current dividend yield of the S&P 500, at slightly higher than 2%, is greater than that of the 10-year Treasury. (The only other time this has happened was during the Great Panic of 2008-09.)

More obscurely but perhaps more importantly in the longer run, since 1871 the average dividend payout ratio—the percentage of their earnings that companies paid to shareholders as dividends—has been 53%. It’s currently 29%. This certainly doesn’t insure that companies will be significantly raising their dividends anytime soon. But it tells us that, at least historically, they have a lot of room to do so—or to buy back stock, which is simply enhancing shareholder value by another means.

Set aside the staggering economic progress of the developing world—China, India, Brazil and the like—in these thirteen years. Set aside the fact that the cost of computing has fallen by something like 98% since 1999, thereby empowering the rise of a billion global smartphone users. Set aside the stunning reality that the United States has gone from the most abject dependence on foreign oil to a point where it will emerge as the world’s leading oil producer by 2020.

And set aside, if you can, the inarguable fact that the fiscal conditions of the West’s democracies are an unholy mess. Tocque­ville said it 170 years ago, and it’s never been truer than it is today: “A democracy will always vote itself more benefits than it is prepared to produce.” Set this aside, I say, because as they become almost daily more genuinely global, the great companies become progressively less dependent on the economies of the older democracies on both sides of the Atlantic. At his confirmation hearings in 1953, President Eisenhower’s nominee for secretary of defense could opine (if not in so many words) that what was good for General Motors was good for this country. In 2013, General Motors will sell as many cars in China as it does in the United States. This is not your father’s Oldsmobile, and it isn’t his stock market, either.

Especially if you have a personal predilection to pessimism, the turn of the year might be a good time to ask yourself—or, even better, to ask your financial advisor—whether, in fact, it might be the market that’s right and the pessimists who are wrong. In terms of your own financial planning, and especially of your retirement income planning, this could turn out to be the single most important financial question you ask in 2013.

Stock prices rallied sharply around the world in the third quarter, with 42 out of 45 countries tracked by MSCI showing positive returns in US dollar terms. Total return exceeded 10% in 19 different markets, while Ireland, Japan, and Morocco registered minor losses.

For the twelve-month period ending September 30, 2012, 40 markets had positive returns, with six countries—including the US—delivering a total return in excess of 30%, according to MSCI.

Investors have been confronted with a steady drumbeat of discouraging news over the past year—a feeble economic recovery here and abroad, staggering budget deficits with no solution in sight, the prospect of a Eurozone breakup, an acrimonious presidential election campaign, banking scandals, and a punishing drought across the US. Considering all the uncertainty, it’s not difficult to explain why mutual fund investors have generally favored fixed income strategies rather than equities over this past twelve-month period.

Many investors are easily persuaded that successful investing requires constant attention to current events and frequent adjustment of their equity exposure. The news excerpts below represent just a small sample of the issues investors might have dwelled on. We suspect that many investors not only failed to achieve their respective market rate of return over the past twelve months but would be surprised to learn how well stock prices have done in many markets over that period.

• “Unless politicians act more boldly, the world economy will keep heading toward a black hole… At a time of enormous problems, the politicians seem Lilliputian. That’s the real reason to be afraid.”

“The World Economy: Be Afraid,” Economist, October 1, 2011.

• “Investors also are nervous because October historically has been one of the more volatile months for stocks.”

E.S. Browning. “Market Nears Bear Territory,” Wall Street Journal, October 4, 2011.

• “The Dow Jones Industrial Average turned in its worst Thanksgiving-week performance since markets began to observe the holiday in 1942.”

Steven Russolillo. “Investors Go Shopping—Just Not for Stocks,” Wall Street Journal, November 26, 2011.

• “Over the past three months, investor uncertainty about the soundness of bank balance sheets, manifested in the daily volatility of stock prices, is back up to levels seen historically only in advance of two great crises… This dynamic has played out twice before in the past 85 years—in the Great Depression and the panic of 2008-09—with devastating consequences for the broader economy.”

Andrew Atkeson and William E. Simon, Jr. “The Rising Fear in Bank Stock Prices,” Wall Street Journal, November 28, 2011.

• “The managing director of the International Monetary Fund has raised fears that the world faces the risk of economic retraction, rising protectionism, isolation, and… what happened in the ’30s (Depression).”

Hugh Carnegy and George Parker. “IMF Chief Warns over 1930s-Style Threats,” Financial Times, December 16, 2011.

• “It is hard to avoid the conclusion that stock prices are levitating at over-inflated values, thanks to the herd-like behavior and collective fear of investment institutions.”

Financial Times, December 30, 2011.

• “An escalation of the crisis would spare no one. Developed and developing country growth rates could fall by as much or more than in 2008-09.”

Quotation attributed to Andrew Burns, head of macroeconomics, World Bank. Chris Giles. “World Bank Warns on the Risk of Global Economic Meltdown,” Financial Times, January 18, 2012.

• “This may be the unhappiest bull market ever. We love to hate it, but that may be just egging it on.”

Tom Petruno. “The Unhappiest Bull Market Ever,” Los Angeles Times, February 12, 2012.

• “US companies are more uncertain about the future than at any point since the financial crisis, with just one in five of the biggest corporations making any predictions as they published quarterly results.”

Ajay Makan. “Doubt Haunts US Company Results,” Financial Times, February 21, 2012.

• “For nearly a decade, it turns out, the most accurate forecasts have come from the fringe. So it’s upsetting to learn that many of these Cassandras now believe, for different reasons, that we are on the brink of another catastrophe that may be far worse.”

Adam Davidson. “Sorry to Break It to You,” New York Times, February 5, 2012.

• “It remains clear that this almost uninterrupted equity market lacks substance and conviction. The rally’s volume has been very weak, and institutional operators have been absent from the market. There has been very little participation from the retail investor, based on data from Lipper, a provider of information and ratings on mutual funds. Corporate insiders have been big sellers of stock, exceeding $6 billion last month (with the ratio of selling to buying hitting the astronomical 13-to-1 mark).”

David Rosenberg, chief economist and strategist, Gluskin Sheff. “The World is Not Fixed and This Equity Rally Lacks Conviction,” Financial Times, March 15, 2012.

• “No one sees a growth rate fast enough for the American economy to return to full employment any time soon.”

Joseph Stiglitz, Nobel laureate 2001. “The American Labour Market Remains a Shambles,” Financial Times, March 13, 2012.

• “We think that most of the US market is just not worth investing in… And it’s our belief that profitability will have to come down and the market isn’t priced for it.”

Quotation attributed to Ben Inker, head of asset-allocation group, Grantham, Mayo, Van Otterloo. Jonathan Cheng. “Two Pros Weigh In on US Stocks,” Wall Street Journal, April 2, 2012.

• “It’s simple arithmetic and it leads to a simple yet alarming conclusion that unless current law is amended before year-end, the stock market has to fall by at least 30%.”

Donald J. Luskin. “The 2013 Fiscal Cliff Could Crush Stocks,” Wall Street Journal, May 4, 2012.

• “Stocks have not been so far out of favor for half a century. Many declare the ‘cult of the equity’ dead.”

John Authers and Kate Burgess. “Out of Stock,” Financial Times, May 24, 2012.

• “The US economy is continuing to lose momentum just as global events that could derail the recovery gather steam… The downshift couldn’t come at a worse time. Experts warn that a breakup of the euro zone could spark the worst credit freeze since the collapse of Lehman Brothers in 2008.”

Ben Casselmann and Phil Izzo. “Recovery Slows as Global Risks Rise,” Wall Street Journal, June 16, 2012.

• “‘Dr. Doom’, Nouriel Roubini, says the ‘perfect storm’ scenario he forecast for the global economy earlier this year is unfolding right now as growth slows in the US, Europe, as well as China.”

Ansuya Harjani. “Roubini: My ‘Perfect Storm’ Is Unfolding Now,” CNBC, July 9, 2012.

• “Bill Gross, co-founder and co-chief investment officer of Pacific Investment Management Co., says stock investors should rethink the age-old investing mantra of buying and holding stocks for the long run… Stocks, he says, operate much like a Ponzi scheme, showing returns that have no real bearing on reality.”

Steven Russolillo and Kirsten Grind. “Bill Gross: Stocks Are Dead and Operate Like a Ponzi Scheme,” Wall Street Journal, August 1, 2012.

Author Weston Wellington is a Vice President with Dimensional Fund Advisors

Bill Miller is one of the most closely watched money managers in the industry, so it was big news when he announced his decision last week to step down as portfolio manager of Legg Mason Capital Management Value Trust (LMVTX) early next year. His departure also adds an intriguing chapter to the long-running debate regarding the value of active stock selection.

Miller’s most frequently cited accomplishment is the fifteen-year period from 1991 through 2005, during which Value Trust outperformed the S&P 500 each calendar year, the only US equity fund manager to have ever done so. His success attracted a wide and enthusiastic following: Morningstar named him Portfolio Manager of the Decade in 1999, Barron’s included him in its All-Century Investment Team that same year, and a Fortune profile in 2006 described him as “one of the greatest investors of our time.” A former US Army intelligence officer and philosophy student, his formidable intellect covered a wide range of interests, and he believed that conventional investment analysis could be enhanced with insights drawn from literature, logic, biology, neurology, physics, and other fields not obviously related to finance. His expressed desire to “think about thinking” suggested an unusual ability to assess information differently from other market participants and arrive at a more profitable conclusion.

Miller’s bold and concentrated investment style would never be confused with a “closet index” approach. Big bets on Fannie Mae, Dell, and America Online, for example, were rewarded with handsome gains (as much as fifty times original cost in the case of Fannie Mae). Unfortunately, similar bets in recent years revealed the dangers of a concentrated strategy as heavy losses in stocks such as Bear Stearns and Eastman Kodak penalized results. For the five-year period ending December 31, 2010, LMVTX finished last among 1,187 US large cap equity funds tracked by Morningstar. Considering the enormous variation in outcomes among these carefully researched ideas, Miller’s overall investment record presents an interesting puzzle: How can we disentangle the contribution of good luck or bad luck, of skill or lack of skill?

Over the May 1982–October 2011 period, annualized return was 11.28% for the S&P 500 Index and 11.76% for the Russell 1000 Value Index. Value Trust slightly outperformed the S&P and underperformed the Russell index by over 0.40% per year. A three-factor regression analysis over the same period shows the fund underperformed its benchmark by 0.08% per month.

Do these results offer conclusive evidence of the failure of active management? Not necessarily. The fund’s expenses are above average at over 1.75% and provide a stiff headwind for any stock picker to overcome. Gross of fees, the fund’s performance over and above its benchmark goes from –0.08% to 0.07% per month. This swing from negative to positive raises an interesting point that Ken French speaks to at every Dimensional conference. There are almost certainly some mistakes in market prices and almost certainly some skillful managers who can exploit them. But who is likely to get the benefit of this knowledge—the investor with his capital or the clever money manager? If stock-picking talent is the scarce resource, economic theory suggests the lion’s share of benefits will accrue to the provider of the scarce resource—just what we see in this instance.

To cloud the discussion even further, both of these results, positive and negative, flunk the test for statistical significance; in neither case can they be attributed to anything more than chance. So even with twenty-nine years of data, we cannot find conclusive evidence of manager skill—or lack thereof. This is the inconvenient truth that every investor must confront: The time required to distinguish luck from skill is usually measured in decades, and often far exceeds the span of an entire investment career.

Miller is well aware of the challenge of distinguishing luck from skill and has conspicuously declined to boast about his results, even when they were unusually fruitful. He has acknowledged that topping the S&P 500 each year for fifteen years was an accident of the calendar and that using other twelve-month periods produced a less headline-worthy result.

Commentators have said that Miller has “lost his touch” or that his investment style is no longer suitable in the current market environment. These arguments strike us as the last refuge for those who find the idea of market equilibrium so unpalatable that they search for any explanation of his change in fortune other than the most plausible one—prices are fair enough that even the smartest students of the market cannot consistently identify mispriced securities.

Where does this leave investors seeking the best strategy to grow their savings?

When asked by a New York Times reporter in 1999 to sum up his legacy, Miller replied, “As William James would say, we can’t really draw any final conclusions about anything.” Twelve years later, this observation seems more useful than ever. And investors would be wise to treat even the most impressive claims of financial success with a healthy degree of skepticism.

Author Weston Wellington is a Vice President with Dimensional Fund Advisors

REFERENCES

Andy Serwer, “Will the Streak Be Unbroken,” Fortune, November 27, 2006.

Edward Wyatt, “To Beat the Market, Hire a Philosopher,” New York Times, January 10, 1999.

Tom Sullivan, “It’s Miller Time,” Barron’s, October 12, 2009.

Diana B. Henriques, “Legg Mason Luminary Shifts Role,” New York Times, November 18, 2011.

Standard & Poor’s

Morningstar Inc.

“I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.”

–Warren Buffett

“In investing, what is comfortable is rarely profitable.”

–Robert Arnott

“Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.”

–Sir John Templeton

“Your success in investing will depend in part on your character and guts, and in part on your ability to realize at the height of the ebullience and the depth of despair alike that this too shall pass.”

–John Bogle

“You make most of your money in a bear market, you just don’t realize it at the time.”

–Shelby Cullom Davis

“To achieve long-term success over many financial market and economic cycles, observing a few rules is not enough. Too many things change too quickly in the investment world for that approach to succeed. It is necessary instead to understand the rationale behind the rules in order to appreciate why they work when they do and don’t when they don’t.”

–Seth Klarman

Looking back at the decade of the 1930′s, which includes the Great Depression, it’s hard to imagine that it may have been, “the most technologically progressive decade of the century,” according to economic historian Alexander Field. And, those advancements — in the midst of our country’s worst economic slump — may have set the stage for our post-World War II boom.

Like our Great Depression experience, could the current economic downturn be laying the seeds for a new American renaissance in the coming years?

In his recent book, A Great Leap Forward, Field argues that technological advancement and innovation flourished during the Great Depression. In a New York Times interview he said, “There is evidence that for some organizations and industries, just as for some individuals, adversity summons reservoirs of initiative and creativity that have long-term positive consequences. And, based on Depression experience, we can be optimistic that when exciting technological paradigms are ripe for exploitation, work will continue on them, slump or no slump.”

If necessity is indeed the mother of invention, then right now there may be exciting new technologies and innovation growing under the radar that will bear fruit in the years to come. As David Leonhardt wrote in The New York Times, the U.S. has several advantages over other countries including, “The world’s best venture-capital network, a well-established rule of law, a culture that celebrates risk taking, (and) an unmatched appeal to immigrants.” Those advantages may be working overtime now creating the next “big thing.”

Don’t forget that 20 years ago, the internet was only known to scientists and academics. Today, it’s ubiquitous and would be hard to live without. Twenty years from now we could be writing about something entirely new that changes the way we work and live — and employs millions of people.

It’s easy to throw up your arms in frustration about the challenges our world faces. And, yes, we do have challenges and many people are experiencing economic hardship. Yet, there is reason for hope. Seeds were sown during the adversity of the Great Depression that bore fruit in the decades to follow. It could be happening again.

It’s never wise to bet against the United States.

With the passing of Steve Jobs, we wanted to share three of his ideas that you may find helpful.

Steve Jobs’ business career is remarkable by any standard. His ability to go from boy wonder co-founder of Apple Computer, to Chairman and CEO of Pixar, to the largest individual shareholder of The Walt Disney Company, to ousted executive who returned to save Apple and turn it into a seemingly unbeatable brand, is simply amazing. While he made plenty of mistakes in his youth, he matured into a very successful businessman with some insightful thoughts on success. Here are three of his ideas worth sharing:

“Connect the dots.”

Over time, all of us have incredible life experiences – some positive, and some not. Regardless of the outcome, they ultimately shaped the person you are today. Everything that has happened to you in your past has the ability to positively affect you in the present – if you connect the dots.

At a 2005 Commencement address at Stanford University, Jobs told a story about how on a whim, he dropped in on a calligraphy class while attending Reed College back in the early 1970s. At the time, he found the class utterly fascinating, but totally useless. It wasn’t until 10 years later, when he was designing the Macintosh computer, that he was able to connect the dots. The result: the Macintosh became the first computer with beautiful typography and it became a huge hit in the desktop publishing industry.

Think for a moment about some of your life experiences. What lessons have you learned? What stories can you create from these lessons that you can share with your family, friends, or business associates? Stories are one of the best ways to connect with people so consider connecting the dots of your life experiences and turn them into a meaningful message.

“Say no.”

There is no shortage of opportunities in life. However, there is often a shortage of conviction. Rather than trying a little bit of everything and successfully completing nothing, Jobs did the opposite. He was an obsessive focuser on a small number of things that were truly important to him.

Apple sells essentially just four products: the Macintosh computer, the iPod, the iPhone, and the iPad. With just four main product lines, Jobs led Apple to the world’s most valuable company with a $350 billion market value, according to The Wall Street Journal. Despite the temptation, Jobs resisted the call to offer a multitude of lower-end products and milk the company’s great brand. He said, “It’s only by saying no that you can concentrate on the things that are really important.”

Ask yourself, what can you say “no” to in your personal or business life so you have room to say “yes” with complete conviction to something else that’s more important?

“Quality, not quantity.”

At Pixar, where Jobs built the firm from peanuts into a company that he sold to The Walt Disney Company for $7.4 billion, there is no 80/20 rule. It’s more like the rule of 100—every effort gets 100 percent support. Accordingly, Pixar delivered an average of only one movie every 18 months; a weak pace by major movie studio standards. However, the result was anything but weak. Pixar has generated more than $7.0 billion in worldwide box office receipts since 1995 – and they’ve had no bombs, according to The Numbers.

Like Pixar, life is not about quantity. It’s about quality. When you spend more time focusing on quality – such as in relationships – life satisfaction will multiply.

In a 2004 BusinessWeek interview, Jobs reflected on his personal growth that resulted from him successfully bouncing back from cancer. He said, “I realized that I loved my life. I really do. I’ve got the greatest family in the world, and I’ve got my work. I love my family, and I love running Apple, and I love Pixar. And I get to do that. I’m very lucky.”

By following these simple ideas – connecting the dots, saying no to the unimportant and focusing on quality, not quantity – you, too, can end up with a life you love. Do that and you’ll be one of the lucky few in this life who can look back at the end of their days and say with great conviction, “It was a life well lived.” RIP.

Anyone studying the long-run history of American business cannot help but observe how many of the prominent firms of one era fail to make it to the next. Free-market economies are characterized not only by intense competition but also by disruptive change. Sometimes a company’s toughest competitor turns out to be a firm it has never heard of selling a product or service that didn’t exist until recently. The list of companies that once dominated their industry but have fallen on hard times is lengthy enough to give every thoughtful investor reason for sober reflection.

Among many possible examples, a number of firms come to mind that were once highly regarded but later encountered serious or even fatal problems.

• Bethlehem Steel pioneered the steel I-beam, which launched a skyscraper boom in cities across the country. Its engineering expertise supplied the steel sections for the Golden Gate Bridge. But growing competition and a changing marketplace eventually took their toll, and the firm filed for bankruptcy in 2001.
• In 1973, Eastman Kodak held a seemingly impregnable position in the lucrative market for photo film and chemicals, enjoyed a reputation for innovation and astute marketing, and boasted a market value even greater than oil giant Exxon. Kodak shareholders had been favored with an uninterrupted stream of dividends dating back to 1902. Today the company is struggling to reinvent itself as the film business shrivels, the dividend has been suspended, and the share price is limping along under $3.
• A Fortune article profiling Pfizer in mid-1998 praised it for having “one of the richest product pipelines in the Fortune 500.” A Wall Street analyst enthused that “some of my clients refer to Pfizer as the best company in the S&P 500.” In early 1999, a Forbes cover story sounded a similar note, crowning Pfizer “Company of the Year” and observing that “the people who brought us Viagra have more blockbusters on the way.” Thirteen years later, the Viagra boom has subsided, patents are expiring on highly profitable products, and the gusher investors expected from the research pipeline has slowed to a trickle. The share price has slumped over 50% since year-end 1998 compared to a 3% loss for the S&P 500 Index.

Some companies almost single-handedly create new industries but still find it difficult to turn innovation into a permanent advantage. Pan Am (air travel), Kmart (discount retailing), Polaroid (instant photography), and Wang Laboratories (word processing) all had impressive initial success and provided handsome rewards for their investors. Alas, neither Pan Am nor Polaroid survives today, and Kmart shareholders were wiped out when the firm emerged from bankruptcy in 2003. (Kmart, Polaroid, and Wang Laboratories were all cited as examples of “excellent” companies in the 1982 bestseller In Search of Excellence.)

Evidence of this “creative destruction” appears all around us. For example, the Wall Street Journal reported that shares of Minnesota-based Best Buy Co. slumped Wednesday to their lowest level since 2008 after reporting a 30% drop in quarterly profits. For most of its life, Best Buy has been the toughest kid on the block, vanquishing rivals such as Highland Superstores and Circuit City on its way to becoming the nation’s leading electronics retailer.

Will Best Buy fall victim to even tougher competitors such as Amazon.com or Walmart? Or is this current downturn just a speed bump on the road to even greater success? No one can say. For every riches-to-rags story, we can find another tale of decline followed by dramatic recovery. According to some accounts, for example, Apple was only a few months from bankruptcy when Steve Jobs returned to the company in 1997. Now it vies with ExxonMobil for the number one spot in a ranking by market cap. And who would have imagined that a floundering New England textile firm with a low-margin business that sells suit-lining fabric would one day become a financial colossus known as Berkshire Hathaway?

The thrill of owning a great growth company during its most lucrative phase is a powerful incentive to search for the Next Big Thing. But almost every company with a highly profitable position is under constant attack from competitors seeking to garner a portion of those hefty profits for themselves.

As a result, the search for firms destined to generate greater-than-expected profits for many years into the future is fraught with peril and likely to end in frustration. Most investors will be far better off harnessing the forces of competitive markets and putting them to work on their behalf by holding a diversified portfolio. As Nobel laureate Merton Miller once observed, “Above-normal profits always carry with them the seeds of their own decay.”

Author Weston Wellington is a Vice President with Dimensional Fund Advisors

Miguel Bustillo and Matt Jarzemsky, “Best Buy Gets Squeezed” Wall Street Journal, September 14, 2011.

David Stipp, “Why Pfizer Is So Hot,” Fortune, May 11, 1998.

“Pfizer: Company of the Year,” Forbes, January 11, 1999.

Standard & Poor’s Stock Guide, 1974.

Thomas Peters and Robert Waterman, In Search of Excellence (HarperCollins, 1982).

Merton Miller, “Is American Corporate Governance Fatally Flawed?” Journal of Applied Corporate Finance, Vol. 6, No. 4, Winter 1994.

Last week we came across an “Economic and Policy Watch” update prepared by a major investment bank that reviewed recent government proposals to address the nation’s funding crisis. Titled “It Just Gets Worse,” the report chided policymakers for actions that “look like a poor cover for loose money, rising inflation, and fiscal problems,” and warned that “government financing needs are corrupting monetary policy.” As a result of these ill-advised tactics, the bank had turned “more negative” on the outlook for financial stability and saw “little hope of improvement in the inflation/currency mix.”

Amidst the barrage of news coverage from dozens of sources probing the US debt/default/downgrade issue, such a conclusion might seem unremarkable. We found it of interest because the focus of the report was not the US Treasury but the government of Indonesia, and it appeared over a decade ago, on July 16, 2001.

Indonesia’s sovereign debt rating at that time placed it firmly in the “junk” (non-investment grade) category: B3 from Moody’s and single-B from Standard & Poor’s. Although Moody’s upgraded Indonesia to a B2 rating in 2003 and to Ba1 in early 2011, at no time over the past decade was Indonesia deemed to merit an investment grade rating.

What has been the experience of equity investors in Indonesia since this report was published? The Jakarta Composite Index closed at 415.09 on January 16, 2001, while the Dow Jones Industrial Average finished that day at 10,652.66. On Wednesday, the Jakarta Composite closed at 4,087.09 and the Dow at 12,592.80. If the Dow Jones Average had kept pace with Indonesian stocks over the past decade, it would be over 104,000 today.

Investors in Indonesia have had their share of ups and downs over the years, and markets fell even harder than the US during the financial crisis, with a peak-to-trough loss of nearly 60%. But the recovery was sharper as well: The Jakarta Composite recouped all of its losses by April 2010, and the all-time high on July 22 this year was 45% above the high-water mark of early 2008.

For the ten-year period ending June 30, 2011, total return as computed by MSCI was 29% per year in local currency and 33% in US dollar terms. At no point throughout this period did Indonesia have an investment grade rating for its sovereign debt, and outside observers continue to find fault with the country’s troublesome level of corruption, primitive infrastructure, and unpredictable regulatory apparatus.

We are not suggesting that investors should dismiss the effects of a US government credit downgrade. US Treasury securities are so widely held around the world that any potentially destabilizing event is worrisome. Nor are we suggesting that investors focus solely on countries with low credit ratings. Just as a broadly diversified portfolio includes companies with high and low credit quality, investing in countries with both high and low ratings is equally sensible.

Some might say the strong performance of Indonesian stocks over the past decade was at least partly attributable to the nation’s improving credit profile, even if it remained at a relatively low level. The US, in contrast, appears to be deteriorating. Our point is that a low credit rating in and of itself is not necessarily a death sentence for equity investors. Citizens of triple-A countries behave much like those living in single-B territory—they eat, drink, shop, get stuck in traffic jams, chatter on mobile phones, and check their Facebook pages. (Indonesia claims the second-largest number of members in the world.) Companies doing business in either location generate cash flows, and investors do their best to evaluate what those cash flows are worth. A triple-A sovereign debt rating is no guarantee of superior equity market returns, and a “junk” rating is no assurance of failure. A diversified strategy will have exposure to both.

Author Weston Wellington is a Vice President with Dimensional Fund Advisors

Research assistance by Victoria Choi.

Ray Farris, “It Just Gets Worse,” ING Barings Economic and Policy Watch, July 16, 2001.

“Global Credit Research,” Moody’s Investors Service, March 2004.

“Missing BRIC in the Wall,” Economist, July 21, 2011.

Securities data provided by Bloomberg.

MSCI data copyright MSCI 2011, all rights reserved.

Yahoo! Finance, finance.yahoo.com (accessed July 25, 2011).

Stock prices slumped around the world yesterday [Monday, July 18], but shares of Apple Inc. shrugged off worries about a Greek government bond default and record gold prices and surged to an all-time high of $373.80. With a market value of over $344 billion, Apple has already shouldered aside Microsoft to become the world’s largest technology firm measured by market capitalization and is now second only to energy giant ExxonMobil among US stocks. It has all happened so quickly that despite its heavyweight stature in the US stock market, Apple shares are still conspicuously absent from the Dow Jones Industrial Average.

Apple’s innovative products are the gold standard for personal communication and entertainment gadgets, and the company’s fresh approach to store design generates sales-per-square-foot numbers other retailers can only dream about. As the company goes from strength to strength and the billions pile up on the balance sheet, it’s worth recalling how uninspiring the future for the company looked not so long ago.

One hundred shares purchased at the initial offering price of $22 in December 1980 have multiplied to 800 shares after four stock splits with a current market value in excess of $299,000.

Apple historical share price adjusted for splits to faciliate comparison with current $373 price.

• $39: “Lately hitting a new high above 77, stock in Apple is not just high-priced—37 times this year’s estimated profit—but high-fashion. … Apple doesn’t tempt me.” Robert Barker, “Apple: It May Be Too Late to Take a Bite,” BusinessWeek, February 14, 2005.
• $12: “But behind the hype and buzz surrounding the iPod and Jobs, there are problems stewing at Apple. Its core computer business, which still accounts for 70 percent of the company’s sales, is withering. … What’s more, despite their soaring sales, iPods are depressing profitability because of their lower profit margin.” Stephen Gandel, “Why iPod Can’t Save Apple,” Money, March 24, 2004.
• $12: “I give them two years before they’re turning out the lights on a very painful and expensive mistake.” Quotation attributed to David Goldstein, Channel Marketing Corp. Cliff Edwards, “Sorry, Steve: Here’s Why Apple Stores Won’t Work,” BusinessWeek, May 21, 2001.
• $11: “Our conclusion is that Apple has started down a path that will lead to its demise as a serious player in the PC market. … Further, we do not believe Apple will survive its next downturn, which will presage the company spiraling into insignificance as it loses any advantage of scale.” Excerpt from Dataquest company report. “Dataquest Sounds Death Knell for Apple,” Reuters, September 23, 1997.
• $4 “Apple has attracted a growing crowd of short-sellers, professional speculators who bet against a company by selling borrowed shares they hope to replace later at a profit if the stock falls. The short-sellers, in fact, now hold the equivalent of 10 percent of Apple’s shares.” Steve Lohr and John Markoff. “The Incredible Shrinking Apple Computer” New York Times, January 26, 1997.
• $6: “Apple may have few options other than to shrink the company or to eventually sell out to a deep-pocketed partner.” E.S Browning and Jim Carlton, “Apple Still Hobbled Despite Write-Down,” Wall Street Journal, March 29, 1996.

Over its thirty-plus years as a public company, Apple has turned out to be a very rewarding investment. One hundred shares purchased at the initial offering price of $22 in December 1980 have multiplied to 800 shares after four stock splits with a current market value in excess of $299,000. Over the same period, $2,200 invested in the S&P 500 with dividends reinvested grew to approximately $49,000. But how many investors would have had the patience to wait nearly three decades for their investment to bear such abundant fruit? At year-end 1985, for example, Apple shares were still stuck at $22, and by year-end 2002, they had appreciated at an annual rate of only 4.4%—well below one-month Treasury bills for a twenty-two-year period. How many of us could have stuck it out, especially with industry “experts” telling us at the time that Apple’s best days were behind it?

Some will study the ups and downs of Apple over the years and conclude that the roller coaster aspect of its business and its share price illustrates why clever timing is essential to successful investing. Our conclusion is that predicting the future is difficult and forecasting success or failure in the fast-changing world of technology is harder still. A tiny number of stocks available for trading today will produce sensational results in the years ahead. Owning a broadly diversified strategy can provide exposure to the market’s most spectacular—and unexpected—winners.

Author Weston Wellington is a Vice President with Dimensional Fund Advisors