The EPS House of Cards: Tricks of the Trade

House of cards and money

 

As we enter the quarterly ritual of the tsunami of earnings reports, investors will be combing through the financial reports. Due to the flood of information, and increasingly shorter and shorter investment time horizons, much of investors’ focus will center on a few quarterly report metrics – primarily earnings per share (EPS), revenues, and forecasts/guidance (if provided).

Many lessons have been learned from the financial crisis over the last few years, and one of the major ones is to do your homework thoroughly. Relying on a AAA ratings from Moody’s (MCO) and S&P (when ratings should have been more appropriately graded D or F) or blindly following a “Buy” rating from a conflicted investment banking firm just does not make sense.

FINANCIAL SECTOR COLLAPSE

Given the severity of the losses, investors need to be more demanding and comprehensive in their earnings analysis. In many instances the reported earnings numbers resemble a deceptive house of cards on a weak foundation, merely overlooked by distracted investors. Case in point is the Financial sector, which before the financial collapse saw distorted multi-year growth, propelled by phantom earnings due to artificial asset inflation and excessive leverage. One need look no further than the weighting of Financial stocks, which ballooned from 5% of the total S&P 500 Index market capitalization in 1980 to a peak of 23% in 2007. Once the credit and real estate bubble burst, the sector subsequently imploded to around 9% of the index value around the March 2009 lows. Let’s be honest, and ask ourselves how much faith can we put in the Financial sector earnings figures that moved from +$22.79 in 2007 to a loss of -$21.24 in 2008? Since that time regulation and reform has put the sector on a more solid footing.  Luckily, the opacity and black box nature of many of these Financials largely kept me out of the 2009 sector implosion.

WHAT TO WATCH FOR

But the Financial sector is not the only fuzzy areas of accounting manipulation. Thanks to our friends at the FASB (Financial Accounting Standards Board), company management teams have discretion in how they apply different GAAP (Generally Accepted Accounting Principles) rules. Saj Karsan, a contributing writer at Morningstar.com, also writes about the “Fallacy of Earnings Per Share.”

“EPS can fluctuate wildly from year to year. Writedowns, abnormal business conditions, asset sale gains/losses and other unusual factors find their way into EPS quite often. Investors are urged to average EPS over a business cycle, as stressed in Security Analysis Chapter 37, in order to get a true picture of a company’s earnings power.”

 

These gray areas of interpretation can lead to a range of distorted EPS outcomes. Here are a few ways companies can manipulate their EPS:

Distorted Expenses: If a $10 million manufacturing plant is expected to last 10 years, then the depreciation expense should be $1 million per year. If for some reason the Chief Financial Officer (CFO) suddenly decided the building would last 40 years rather than 10 years, then the expense would only be $250,000 per year. Voila, an instant $750,000 annual gain was created out of thin air due to management’s change in estimates.

Magical Revenues: Some companies have been known to do what’s called “stuffing the channel.” Or in other words, companies sometimes will ship product to a distributor or customer even if there is no immediate demand for that product. This practice can potentially increase the revenue of the reporting company, while providing the customer with more inventory on-hand. The major problem with the strategy is cash collection, which can be pushed way off in the future or become uncollectible.

Accounting Shifts: Under certain circumstances, specific expenses can be converted to an asset on the balance sheet, leading to inflated EPS numbers. A common example of this phenomenon occurs in the software industry, where software engineering expenses on the income statement get converted to capitalized software assets on the balance sheet. Again, like other schemes, this practice delays the negative expense effects on reported earnings.

Artificial Income: Not only did many of the trouble banks make imprudent loans to borrowers that were unlikely to repay, but the loans were made based on assumptions that asset prices would go up indefinitely and credit costs would remain freakishly low. Based on the overly optimistic repayment and loss assumptions, banks recognized massive amounts of gains which propelled even more imprudent loans. Needless to say, investors are now more tightly questioning these assumptions. That said, recent relaxation of mark-to-market accounting makes it even more difficult to estimate the true values of assets on the bank’s balance sheets.

Like dieting, there are no easy solutions. Tearing through the financial statements is tough work and requires a lot of diligence. My process of identifying winning stocks is heavily cash flow based (see my article on cash flow investing) analysis, which although lumpier and more volatile than basic EPS analysis, provides a deeper understanding of a company’s value-creating capabilities and true cash generation powers.

As earnings season kicks into full gear, do yourself a favor and not only take a more critical” eye towards company earnings, but follow the cash to a firmer conviction in your stock picks. Otherwise, those shaky EPS numbers may lead to a tumbling house of cards.

Read Saj Karsan’s Full Article

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management has no direct position in MCO or MHP at the time this article was originally posted. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

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April 18, 2014 at 1:02 pm Leave a comment

Lewis Sells Flash Boys Snake Oil

Snake Oil

I know what you’re saying, “Please, not another article on Michael Lewis’s Flash Boys book and high frequency trading (HFT),” but I can’t resist putting in my two cents after the well-known author emphatically proclaimed the stock market as “rigged.” Lewis is not alone with his outrageous claims… Clark Stanley (“The Rattlesnake King”) made equally outlandish claims in the early 1900s when he sold lucrative Snake Oil Liniment to heal the ailments of the masses. Ultimately Stanley’s assets were seized by the government and the healing assertions of his snake oil were proven fraudulent. Like Stanley, Lewis’s over-the-top comments about HFT traders are now being scrutinized under a microscope by more thoughtful critics than Steve Kroft from 60 Minutes (see television profile). For a more detailed counterpoint, see the Reuters interview with Manoj Narang (Tradeworx) and Haim Bodek (Decimus Capital Markets).

While Lewis may not be selling snake oil, the cash register is still ringing with book sales until the real truth is disseminated. In the meantime, Lewis continues to laugh to the bank as he makes misleading and deceptive claims, just like his snake oil selling predecessors.

The Inside Perspective

Regardless of what side of the fence you fall on, the debate created by Lewis’s book has created deafening controversy. Joining the jihad against HFT is industry veteran Charles Schwab, who distributed a press release calling HFT a “growing cancer” and stating the following:

“High-frequency trading has run amok and is corrupting our capital market system by creating an unleveled playing field for individual investors and driving the wrong incentives for our commodity and equities exchanges.”

 

What Charles Schwab doesn’t admit is that their firm is receiving about $100 million in annual revenues to direct Schwab client orders to the same HFT traders at exchanges in so called “payment-for-order-flow” contracts. Another term to describe this practice would be “kick-backs”.

While Michael Lewis screams bloody murder over investors getting fraudulently skimmed, some other industry legends, including the godfather of index funds, Vanguard founder Jack Bogle, argue that Lewis’s views are too extreme. Bogle reasons, “Main Street is the great beneficiary…We are better off with high-frequency trading than we are without it.”

Like Jack Bogle, other investors who should be pointing the finger at HFT traders are instead patting them on the back. Cliff Asness, managing and founding principal of AQR Capital Management, an institutional investment firm managing about $100 billion in assets, had this to say about HFT in his Wall Street Journal Op-Ed:

“How do we feel about high-frequency trading? We think it helps us. It seems to have reduced our costs and may enable us to manage more investment dollars… on the whole high-frequency traders have lowered costs.”

 

Is HFT Good for Main Street?

Many investors today have already forgotten, or were too young to remember, that stocks used to be priced in fractions before technology narrowed spreads to decimal points in the 1990s. Who has benefited from all this technology? You guessed it…everyone.

Lewis makes the case that the case that all investors are negatively impacted by HFT, including Main Street (individual) investors. Asness maintains costs have been significantly lowered for individual investors:

“For the first time in history, Main Street might have it rigged against Wall Street.”

 

In Flash Boys, Lewis claims HFT traders unscrupulously scalp pennies per share from retail investor pockets by using privileged information to jump in front of ordinary investors (“front-run”). The reality, even if you believe Lewis’s contentions are true, is that technology has turned any perceived detrimental penny-sized skimming scheme into beneficial bucks for ordinary investors. For example, trades that used to cost $40, $50, $100, or more per transaction at the large wirehouse brokerage firms can today be purchased at discount brokerage firms for $7 or less. What’s more, the spread (i.e., the profits available for middlemen) used to be measured in increments of  1/8, 1/4, and 1/2 , when today the spreads are measured in pennies or fractions of pennies. Without any rational explanation, Lewis also dismisses the fact that HFT traders add valuable liquidity to the market. His argument of adding “volume and not liquidity” would make sense if HFT traders only transacted solely with other HFT traders, but that is obviously not the case.

Regardless, as you can see from the chart below, the trend in spreads over the last decade or so has been on a steady, downward, investor-friendly slope.

How Did We Get Here? And What’s Wrong with HFT?

Similarly to our country’s 73,954 page I.R.S. tax code,  the complexity of our financial market trading structure rivals that of our government’s money collection system. The painting of all HFT traders as villains by Lewis is no truer than painting all taxpayers as crooks. Just as there are plenty of crooked and deceitful individuals that push the boundaries of our income tax system, so too are there traders that try to take advantage of an inefficient, Byzantine exchange system. The mere presence of some tax dodgers doesn’t mean that all taxpayers should go to jail, nor should all HFT traders be crucified by the SEC (Securities and Exchange Commission) police.

The heightened convoluted nature to our country’s exchange-based financial system can be traced back to the establishment of Regulation NMS, which was passed by the SEC in 2005 and implemented in 2007. The aim of this regulatory structure was designed to level the playing field through fairer trade execution and the creation of equal access to transparent price quotations.  However, rather than leveling the playing field, the government destroyed the playing field and fragmented it into many convoluted pieces (i.e., exchanges) – see Wall Street Journal article  and chart below.

The new Reg NMS competition came in the form of exchanges like BATS and Direct Edge (now merging), but the new multi-faceted structures introduced fresh loopholes for HFT traders to exploit – for both themselves and investors. More specifically, HFT traders used expensive, lightning-fast fiber optic cables; privileged access to data centers physically located adjacent to trading exchanges; and then they integrated algorithmic software code to efficiently route orders for best execution.

Are many of these HFT traders and software programs attempting to anticipate market direction? Certainly. As the WSJ excerpt below explains, these traders are shrewdly putting their capitalist genes to the profit-making test:

Computerized firms called high-frequency traders try to pick up clues about what the big players are doing through techniques such as repeatedly placing and instantly canceling thousands of stock orders to detect demand. If such a firm’s algorithm detects that a mutual fund is loading up on a certain stock, the firm’s computers may decide the stock is worth more and can rush to buy it first. That process can make the purchase costlier for the mutual fund.

 

Like any highly profitable business, success eventually attracts competition, and that is exactly what has happened with high frequency trading. To appreciate this fact, all one need to do is look at Goldman Sachs’s actions, which is to leave the NYSE (New York Stock Exchange), shutter its HFT dark pool trading platform (Sigma X), and join IEX, the dark pool created by Brad Katsuyama, the hero placed on a pedestal by Lewis in Flash Boys. Goldman is putting on their “we’re doing what’s best for investors” face on, but more experienced veterans understand that Goldman and all the other HFT traders are mostly just greedy S.O.B.s looking out for their best interests. The calculus is straightforward: As costs of implementing HFT have plummeted, the profit potential has dried up, and the remaining competitors have been left to fend for their Darwinian survival. The TABB Group, a  financial markets’ research and consulting firm, estimates that US equity HFT revenues have declined from approximately $7.2 billion in 2009 to about $1.3 billion in 2014.  As costs for co-locating HFT hardware next to an exchange have plummeted from millions of dollars to as low as $1,000 per month, the HFT market has opened their doors to anyone with a checkbook, programmer, and a pulse. That wasn’t the case a handful of years ago.

The Fixes

Admittedly, not everything is hearts and flowers in HFT land. The Flash Crash of 2010 highlighted how fragmented, convoluted, and opaque our market system has become since Reg NMS was implemented. And although “circuit breaker” remedies have helped prevent a replicated occurrence, there is still room for improvement.

What are some of the solutions? Here are a few ideas:

  • Reform complicated Reg NMS rules – competition is good, complexity is not.
  • Overhaul disclosure around “payment-for-order-flow” contracts (rebates), so potential conflicts of interest can be exposed.
  • Stop inefficient wasteful “quote stuffing” practices by HFT traders.
  • Speed up and improve the quality of the SIP (Security Information Processor), so the gaps between SIP and the direct feed data from exchanges are minimized.
  • Improve tracking and transparency, which can weed out shady players and lower probabilities of another Flash Crash-like event.

These shortcomings of HFT trading do not mean the market is “rigged”, but like our overwhelmingly complex tax system, there is plenty of room for improvement. Another pet peeve of mine is Lewis’s infatuation with stocks. If he really thinks the stock market is rigged, then he should write his next book on the less efficient markets of bonds, futures, and other over-the-counter derivatives. This is much more fertile ground for corruption.

As a former manager of a $20 billion fund, I understand the complications firsthand faced by large institutional investors. In an ever-changing game of cat and mouse, investors of all sizes will continue looking to  execute trades at the best prices (lowest possible purchase and highest possible sales price), while middlemen traders will persist with their ambition to exploit the spread (generate profits between the bid and ask prices). Improvements in technology will always afford a temporary advantage for a few, but in the long-run the benefits for all investors have been undeniable. The same undeniable benefits can’t be said for reading Michael Lewis’s Flash Boys. Like Clark Stanley and other snake oil salesmen before him, it will only take time for the real truth to come out about Lewis’s “rigged” stock market claims.

 

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold long positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in GS, SCHW, ICE, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

April 11, 2014 at 1:04 pm 1 comment

The Treadmill Market – Jogging in Place

Treadmill

This article is an excerpt from a previously released Sidoxia Capital Management complementary newsletter (April 1, 2014). Subscribe on the right side of the page for the complete text.

After the stock market raced ahead to about a +30% gain last year, it became clear this meteoric trend was not sustainable into perpetuity. Correct investing should be treated more like a marathon than a sprint. After dashing ahead by more than +100% over the last handful of years, 2014 stock prices took a breather by spending the first quarter jogging in place. Like a runner on the treadmill, year-to-date returns equated to a -0.7% for the Dow Jones Industrial Average index, and +1.3% for the S&P index. Digesting the large gains from previous years, despite making no discernable forward progress this quarter, is a healthy exercise that builds long-term portfolio endurance. As far as I’m concerned, nothing in life worthwhile comes easy, and the first three months of the year have demonstrated this principle.

As I’ve written in the past (see Series of Unfortunate Events), there is never a shortage of issues to worry about. The first few months of 2014 have been no exception. Vladimir Putin’s strong armed military backed takeover of Crimea, coupled with the Federal Reserve’s unwinding $30 billion of the $85 billion of its “Quantitative Easing” bond buying program (i.e. tapering) have contributed to investors’ nervousness. When the “Fairy Godmother of the Bull Market,” Federal Reserve Chair Janet Yellen, hinted at potentially raising interest rates in about 12 months, the mood soured further.

The unseasonably cold winter back east (a.k.a., Polar Vortex) has caused some additional jitters due to the dampening effects on economic conditions. More specifically, economic growth as measured by GDP (Gross Domestic Product) is expected to come in around a meager +2.0% rate during the first quarter of 2014, before picking up later in the year.

And if that isn’t enough, best-selling author Michael Lewis, whose books include Money Ball, The Blind Side, and Liar’s Poker, just came out on national television and sparked a debate with his controversial statement that the “stock market is rigged.” (read and listen more here)

Runners High

But as always, not everything is gloom and doom. Offsetting the temporary price fatigue, resilient record corporate profits have supported the surprising market stamina. Like a runner’s high, corporations are feeling elated about historically elevated profit margins. As you can see from the chart below, the reason it’s prudent for most to have some U.S. equity exposure is due to the clear, upward multi-decade trend of U.S. corporate earnings.

Source: Calafia Beach Pundit (gray areas are recessions)  

Source: Calafia Beach Plundit (gray areas are recessions)

While the skeptics wait for these game-ending dynamics to take root, core economic fundamentals in areas like these remain strong:I didn’t invent the idea of profits impacting the stock market, but the concept is simple: stock prices generally follow earnings over long periods of time (see It’s the Earnings, Stupid). In other words, as profits accelerate, so do stock prices – and the opposite holds true (decelerating earnings leads to price declines). This direct relationship normally holds over the long-run as long as the following conditions are not in place: 1) valuations are stretched; 2) a recession is imminent; and/or 3) interest rates are spiking.  Fortunately for long-term investors, there is no compelling evidence of these factors currently in place.

Employment Adrenaline

The employment outlook received a boost of adrenaline last month. Despite the slight upward nudge in the unemployment rate to 6.7%, total nonfarm payroll jobs increased by +175,000 in February versus a +129,000 gain in January and an +84,000 gain in December. Not only was last month’s increase better than expectations, but the net figures calculated over the previous two months were also revised higher by +25,000 jobs. As you can see below, the improvement since 2009 has been fairly steady, but as the current rate flirts with the Fed’s 6.5% target, Chair Yellen has decided to remove the quantitative objective. The rising number of discouraged workers (i.e., voluntarily opt-out of job searching) and part-timers has distorted the numbers, rendering arbitrary numeric targets less useful.

Housing Holding Strong

In the face of the severe winter weather, the feisty housing market remains near multi-year highs as shown in the 5-month moving average housing start figure below. With the spring selling season upon us, we should be able to better gauge the impact of cold weather and higher mortgage rates on the housing market.

Even though stock market investors found themselves jogging in place during the first quarter of the year, long-term investors are building up endurance as corporate profits and the economy continue to consistently grow in the background. Successful investors must realize stock prices cannot sustainably sprint for long periods of time without eventually hitting a wall and collapsing. Those who recognize investing as a marathon sport, rather than a mad dash, will be able to jump off the treadmill and ultimately reach their financial finish line.

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold long positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

April 5, 2014 at 12:02 am Leave a comment

Passive vs. Active Investing: Darts, Monkeys & Pros

Bob Turner is founder of Turner Investments and a manager of several funds at the investment company. In a recent article he reintroduces the all-important, longstanding debate of active management (“hands-on”) versus passive management (“hands off”) approaches to investing. Mr. Turner makes some good arguments for the active management camp, however some feel differently – take for example Burton Malkiel. The Princeton professor theorizes in his book A Random Walk Down Wall Street that “a blindfolded monkey throwing darts at a newspaper’s stock page could select a portfolio that would do just as well as one carefully selected by experts.” In fact, The Wall Street Journal manages an Investment Dartboard contest that stacks up amateur investors’ picks against the pros’ and random stock picks selected by randomly thrown darts. In many instances, the dartboard picks outperform the professionals. Given the controversy, who’s right…the darts, monkeys, or pros? Distinguishing between the different categorizations can be difficult, but we will take a stab nevertheless.

Arguments for Active Management

Turner contends, active management outperforms in periods of high volatility and he believes the industry will be entering such a phase:

“Active managers historically have tended to perform best in a market in which the performance of individual stocks varies widely.”

He also acknowledges that not all active managers outperform and admits there are periods where passive management will do better:

“The reason why most active investors fail to outperform is because they in fact constitute most of the market. Even in the best of times, not all active managers can hope to outperform…The business of picking stocks is to some degree a zero-sum game; the results achieved by the best managers will be offset at least somewhat by the subpar performance of other managers.”

Buttressing his argument for active management, Turner references data from Advisor Perspectives showing an inconclusive percentage (40.5%-67.8%) of the actively managed funds trailing the passively managed indexes from 2000 to 2008.

The Case for Passive Management

Turner cites one specific study to support his active management cause. However, my experience gleaned from the vast amounts of academic and industry data point to approximately 75% of active managers underperforming their passively managed indexes, over longer periods of time. Notably, a recent study conducted by Standard & Poor’s SPIVA division (S&P Indices Versus Active Funds) discovered the following conclusions over the five year market cycle from 2004 to 2008:

  • S&P 500 outperformed 71.9% of actively managed large cap funds;
  • S&P MidCap 400 outperformed 79.1% of mid cap funds;
  • S&P SmallCap 600 outperformed 85.5% of small cap funds.

Read more about  the dirty secrets shrinking your portfolio. According to the Vanguard Group and the Investment Company Institute, about 25% of institutional assets and about 12% of individual investors’ assets are currently indexed (passive strategies).  If you doubt the popularity of passive investment strategies, then look no further than the growth of Exchange Traded Funds (ETFs – see chart), index funds, or Vanguard Groups more than $1 trillion dollars in assets under management.

Although I am a firm believer in passive investing, one of its shortcomings is mean reversion. This is the idea that upward or downward moving trends tend to revert back to an average or normal level over time. Active investing can take advantage of mean reversion, conversely passive investing cannot. Indexes can get very top-heavy in weightings of outperforming sectors or industries, meaning theoretically you could be buying larger and larger shares of an index in overpriced glamour stocks on the verge of collapse.  We experienced these lopsided index weightings through the technology bubbles in the late 1990s and financials in 2008. Some strategies may be better than other over the long run, but every strategy, even passive investing, has its own unique set of deficiencies and risks.

Professional Sports and Investing

As I discuss in my book, there are similarities that can be drawn between professional sports and investing with respect to active vs. passive management. Like the scarce number of .300 hitters in baseball, I believe there are a select few investment managers who can consistently outperform the market. In 2007, AssociatedContent.com did a study that showed there were only 22 active career .300 hitters in Major League Baseball. I recognize in the investing world there can be a larger role for “luck,” which is difficult, if not impossible, to measure (luck won’t help me much in hitting a 100 mile per hour fastball thrown by Nolan Ryan). Nonetheless, in the professional sports arena, there are some Hall of Famers (prospects) that have proved they could (can) consistently outperform their peers for extended durations of time. Experience is another distinction I would highlight in comparing sports and investing. Unlike sports, in the investment world I believe there is a positive correlation between age and ability. The more experience an investor gains, generally the better long-term return achieved. Like many professions, the more experience you gain, the more valuable you become. Unfortunately, in many sports, ability deteriorates and muscles atrophy over time.

Size Matters

Experience alone will not make you a better investor. Some investors are born with an innate gift or intellect that propels them ahead of the pack. However, most great investors eventually get cursed by their own success thanks to accumulating assets. Warren Buffet knows the consequences of managing large amounts of dollars, “gravity always wins.”  Having managed a $20 billion fund, I fully appreciate the challenges of investing larger sums of money. Managing a smaller fund is similar to navigating a speed boat – not too difficult to maneuver and fairly easy to dodge obstacles. Managing heftier pools of money can be like captaining a supertanker, but unfortunately the same rapid u-turn expectations of the speedboat remain. Managing large amounts of capital can be crippling, and that’s why captaining a supertanker requires the proper foresight and experience.

Room for All

As I’ve stated before, I believe the market is efficient in the long run, but can be terribly inefficient in the short-run, especially when the behavioral aspects of emotion (fear and greed) take over. The “wait for me, I want to play too” greed from the late 1990s technology craze and the credit-based economic collapse of 2008-2009 are further examples of inefficient situations that can be exploited by active managers. However, due to multiple fees, transaction costs, taxes, not to mention the short-term performance/compensation pressures to perform, I believe the odds are stacked against the active managers. For those experienced managers that have played the game for a long period and have a track record of success, I feel active management can play a role. At Sidoxia Capital Management, I choose to create investment portfolios that blend a mixture of passive and active investment strategies. Although my hedge fund has outperformed the S&P 500 in 4 of the last 5 years, that fact does not necessarily mean it’s the appropriate sole approach for all clients. As Warren Buffet states, investors should stick to their “circle of competence” so they can confidently invest in what they know.  That’s why I generally stick to the areas of my expertise when I’m actively investing in stocks, and fill in the remainder of client portfolios with transparent, low-cost, tax-efficient equity and fixed income products (i.e., Exchange Traded Funds). Even though the actively managed Turner Funds appear to have a mixed-bag of performance numbers relative to passively managed strategies, I appreciate Bob Turner’s article for addressing this important issue.  I’m sure the debate will never fully be resolved. In the meantime, my client portfolios will aim to mix the best of both worlds within active and passive management strategies in the eternal quest of outwitting the darts, monkeys, and other pros.

Read the full Bob Turner article on Morningstar.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds but had no direct position in stocks mentioned in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

March 29, 2014 at 3:19 pm 4 comments

The Buyback Bonanza Boost

Trampoline 2

With the S&P 500 off -1% from its all-time record high, many bears have continued to wait for and talk about a looming crash. For the naysayers, the main focus has been on the distorted monetary policies instituted by the Federal Reserve, but as I pointed out in Fed Fatigue is Setting In, QE and tapering talk are not the end-all, be-all of global financial markets. One need not look further than the dozen or so countries listed in the FT that have bond yields below the abnormally low yields we are experiencing in the U.S. (10-Year Treasury +2.75%).

Although there are many who believe a freefall is coming, much like a trampoline, a naturally occurring financial mechanism has provided a relentless bid to boost stock prices higher…a buyback bonanza! How significant have corporate stock repurchases been to spring prices higher? Jason Zweig, in his Intelligent Investor column, wrote the following:

In the Russell 3000, a broad U.S. stock index, repurchased $567.6 billion worth of their own shares—a 21% increase over 2012, calculates Rob Leiphart, an analyst at Birinyi Associates, a research firm in Westport, Conn. That brings total buybacks since the beginning of 2005 to $4.21 trillion—or nearly one-fifth of the total value of all U.S. stocks today.

 

To further put this gargantuan buyback bonanza into perspective, a recent Fox Business article described it this way:

Companies spent an estimated $477 billion on share buybacks last year. That’s enough to buy every NFL team 12 times over, run the federal government for 50 days or host the next nine Olympic Games with several billion left to spare. This year, companies are expected to ramp up buybacks by 35%, according to Goldman Sachs.

 

The bears continue to scream, while purple in the face, that the Fed’s QE and zero interest rate program (ZIRP) shenanigans are artificially propping up stock prices. The narrative then states the tapering and inevitable Fed Funds rate reversal will cause the market to come crashing down. While there is some truth behind this commentary, history reminds us that not all rate rising cycles end in bloodshed (see 1994 Bond Repeat or Stock Defeat?). Even if you believe in Armageddon, this rate reversal scenario is unlikely to happen until mid-2015 or beyond.

And for those worshipping the actions of Ms. Yellen at the Fed altar, believe it or not, there are other factors besides monetary policy that cause stock prices to go up or down. In addition to stock buybacks, there are dynamics such as record corporate profits, rising dividends, expanding earnings, reasonable valuations, improving international economies, and other factors that have contributed to this robust bull market.

At the end of the day, as I have continued to argue for some time, money goes where it is treated best – and generally that is not in savings accounts earning 0.003%. There is no reason to be a perma-bull, and I have freely acknowledged the expansion of froth in areas such as social media, biotech, Bitcoin and other areas. Regardless, there is, and will always be areas of speculation, in bull and bear markets (e.g., gold in the 2008-2009 period).

Magical Math

Investing involves a mixture of art and science, but with a few exceptions (i.e., fraud), numbers do not lie, and using math when investing is a good place to start. A simple but powerful mathematical formula instituted at Sidoxia Capital Management is the “Free Cash Flow Yield”, which is a metric we integrate into our proprietary SHGR (a.k.a.,“Sugar”) quantitative model (see Investing Holy Grail).

Free Cash Flow Graphic

Quite simply, Free Cash Flow (FCF) is computed by taking the excess cash generated by a company after ALL expenses/expenditures (marketing, payroll, R&D, CAPEX, etc.) over a trailing twelve month period (TTM), then dividing that figure by the total equity value of a company (Market Capitalization). Mechanically, FCF is calculated by taking “Cash Flow from Operations” and subtracting “Capital Expenditures” – both figures can be found on the Cash Flow Statement.  The Free Cash Flow ratio may sound complicated, but straightforwardly this is the leftover cash generated by a business that can be used for share buybacks, dividends, acquisitions, investments, debt pay-down, and/or placed in a banking account to pile up.

The great thing about FCF yields is that this ratio (%) can be compared across asset classes. For example, I can compare the FCF yield of Apple Inc – AAPL (+9.5%) versus a 10-Year Treasury (+2.75%), 1-year CD (+0.85%), Tesla Motors – TSLA (0.0%), Netflix, Inc – NFLX (-0.001%), or Twitter, Inc – TWTR (-0.003%). For growth and capital intensive companies, I can make adjustments to this calculation. However, what you quickly realize is that even if you assume massive growth in the coming years (i.e., $100s of millions in FCF), the prices for many of these momentum stocks are still astronomical.

An important insight about the current corporate buyback bonanza is that much of this price boost is being fueled by the colossal free cash flow generation of corporate America. Sure, some companies are borrowing through the debt markets to buy back stock, but if you were the Apple CFO sitting on $159,000,000,000 in cash earning 1%, it doesn’t make a lot of sense to sit on the cash earning nothing. It also doesn’t take a genius (or Carl Icahn) to figure out borrowing at record low rates (2.75% 10-year) while earning +10% on a stock buyback will increase shareholder value and earnings per share (EPS). More specifically, when Apple borrowed $17 billion  at interest rates ranging from 0.5% – 3.9%, a shrewd, rational human being would borrow to the max all day long at those rates, if you could earn +10% on that investment. It is true that Apple’s profitability could drop and the numerator in our FCF ratio could decrease, but with $45 billion smackers coming in every year on top of $142 billion in net cash on the balance sheet, Apple has a healthy margin of safety to make the math work.

Where the math doesn’t compute is in insanely priced deals. For example, the recent merger in which Facebook Inc (FB) paid $19 billion (1,000 x’s the estimated 2013 annual revenues) for a 50-person, money-losing company (WhatsApp) that is offering a free service, makes zero financial sense to me. Suffice it to say, the FCF yield on WhatsApp could cause Warren Buffett to have a coronary event. Yes, diamond covered countertops would be nice to have in my kitchen, but I probably wouldn’t get much of a return on that investment.

Share buybacks are not a magical elixir to endless prosperity (see Share Buybacks & Bathroom Violators), but given the record profits and record low interest rates, basic math shows that even if stock prices correct (as should be expected), the trampolining effect of this buyback bonanza will provide support to the market.

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold long positions in certain exchange traded funds (ETFs), AAPL and a short position in NFLX, but at the time of publishing SCM had no direct position in TSLA, TWTR, FB, Bitcoin, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

March 22, 2014 at 1:17 pm 1 comment

Investing, Housing, and Speculating

House Dollar Sign

We all know there was a lot of speculation going on in the housing market during 2005-2007 as risk-loving adventurists loaded up on NINJA loans (No Income, No Job, and No Assets) and subprime CDS (Credit Default Swap) securities. But there is a different kind of speculation going on now, and it isn’t tied directly to housing. Instead of buying a house with no down payment and a no interest loan, speculators are leaping into other hazardous areas of danger. Like a frog jumping from lily pad to lily pad, speculators are now hopping around onto money-chasing industries, including biotech, social media, Bitcoin, and alternative energy.

As French novelist Jean-Baptise Alphonse Karr noted, “The more things change, the more they stay the same.” Irrespective of the painful consequences of the bubble-bursting aftermaths, human behavior and psychology addictively succumb to the ever-seductive emotion of greed. Over the last 15 years, massive fortunes have been gained and lost while chasing frothy financial dreams in areas like technology, housing, and gold.

Most get-rich-quick dream chasers have no idea of how to invest in or value a stock, but they sure know a good story when they hear one. Chasing top performing stocks is lot like jumping off a bridge – anyone can do it, and it feels exhilarating until you hit the ground. However, there is a better way to create wealth. Despite rampant speculation, most individuals understand the principles behind buying a house, which if applied to stocks, can make you a superior investor, and assist you in avoiding dangerous, speculative investments.

Here are some valuable housing insights to improve your stock buying:

#1.) Price is the Almighty Variable: Successful real estate investors don’t make their fortunes by chasing properties that double or triple in value. Buying a rusty tool shed for $1 million makes about as much sense as Facebook paying $19 billion (1,000 x’s the estimated 2013 annual revenues) for a money-losing company, WhatsApp. Better to buy real estate when there is blood in the street. Like the stock market, housing is cyclical. Many traders believe that price patterns are more important than the actual price. If squiggly, technical price moving averages (see Technical Analysis article) make so much money for stock-renting speculators, then how come day traders haven’t used their same crossing-lines and Point & Figure software in the housing market? Yes, it’s true that the real estate transactions costs and illiquidity can be costly for real estate buyers, but 6% load fees, lockup periods, 20% hedge fund fees, and 9% margin rates haven’t stopped stock speculators either.

#2). Cash is King: It doesn’t take a genius to purchase a rental property – I know because practically half the people I know in Southern California own rental properties. For example, if I buy a rental property for $1 million cash, is it a good purchase? Well, it depends on how much after-tax cash I can collect by renting it out? If I can only net $3,000 per month (3.6% annualized return), and be responsible for replacing roofs, fixing toilets, and evicting tenants, then perhaps I would be better off by collecting 6.5% from a low-cost, tax-efficient exchange traded real estate fund, without having to suffer from all the headaches that physical real estate investing brings. Forecasting future asset price appreciation is tougher, but the point is, understanding the underlying cash flow dynamics of a company is just as important as it is for housing purchases.

#3). Debt/Leverage Cuts in Both Directions: Adding debt (or leverage) to a housing or stock investment can be fantastic if prices go up, and disastrous if prices go down. Putting a 20% down payment on a $1 million house works out wonderfully, if the price of the house increases to $1.2 million. My $200,000 down payment is now worth $400,000, or up +100%. The same math works in reverse. If the price of the home drops to $800,000, then my $200,000 down payment is now worth $0, or down -100% (ouch). Margin debt on an equity brokerage account works in a similar fashion, but usually a 50% down payment is needed (less risky than real estate). That’s why I always chuckle when many real estate investors tell me they steer clear of stocks because they are “too risky”.

#4). Growth Matters: If you buy a home for $1 million, is it likely to be worth more if you add a kitchen, tennis court, swimming pull, third floor, and putting green? In short, the answer is yes. The same principle applies to stocks. All else equal, if a company based in Los Angeles, establishes new offices in New York, London, Beijing, and Rio de Janeiro, and then acquires a profitable competitor at a discounted price, chances are the company will be much more valuable after the additions. The key concept here is that asset values are not static. Asset valuations are impacted in both directions, whether we are talking about positive growth opportunities or negative disruptions.

Overall, speculatively chasing performance is tempting, but if you don’t want your financial foundation to crumble, then build your successful investment future by sticking to the fundamentals and financial basics.

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold long positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct discretionary position in FB, Bitcoin, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

March 15, 2014 at 10:00 am 1 comment

Speculative Animal (Hamster) Spirits on the Rise

Hamster Wheel

“Winning is a habit. Unfortunately, so is losing.”

- Vince Lombardi

And one thing is for sure…day traders have a habit of losing. Like a hamster on a spinning wheel, day traders use a lot of energy in creating loads of activity, but end up getting nowhere in the process. This subject is important because the animal (hamster) spirits are on the rise as evidenced by the 22% and 17% increase in average client trades per day reported last month by TD Ameritrade (TD) and Charles Schwab (SCHW), respectively.

The statistics speak for themselves, and the numbers are not pretty. An often cited study by Terrence Odeon (U.C. Berkely) and Brad Barber (U.C. Davis) showed that 80% of active traders lose money. The duo came to this conclusion over six years of research by studying 66,465 accounts. More importantly, they “found that if you were to look at the past performance of these traders, only 1 percent of them could be called predictably profitable.” Uggh!

How can this horrendous performance be? Especially when we are continually bombarded with the endless commercials of talking babies and perpetual software bells & whistles that shamelessly promote and pledge a simple path to prosperity. The answer to why active trading fails for the overwhelming masses is the following:

  • Taxes/Capital Gains
  • Transactions costs/commissions
  • Research costs/software
  • Lack of institutional advantages (speed, beneficial rates, I.T./automation, execution, etc.)
  • Impact costs (buying handicaps returns by pushing purchase prices higher, and selling handicaps returns by pushing sale prices lower)
  • Absence from participation in long-term upward drift in equity prices

After considering the horrible odds stacked against the active trader, the atrocious results are not surprising.

The Blemished Investing Brain

So far, we’ve discussed the mechanics behind the money-losing results of active trading, but the underlying reasons can be further explained by the three-pound, 100,000,000,000 amalgamation of cells located between our ears. Evolution has formed our brains to seek pleasure and avoid pain, and trading stocks can create a rush like no other activity. Similar to the orgasmic emotions triggered by making a quick buck at the blackjack table in Las Vegas or scratching off a winning number on a lottery ticket, buying and selling stocks creates comparable effects.

Through the use of high-powered, multi-million imaging technology (i.e., functional-MRI), Brian Knutson, a professor of neuroscience and psychology at Stanford University discovered that active trading for money impacts the brain in a similar fashion as do sex and drugs. The data is pretty compelling because you can see the pleasure center images of the brain light up dynamically in real time.

To put the results of his human trading experiments in context, Knutson noted:

“We very quickly found out that nothing had an effect on people like money — not naked bodies, not corpses. It got people riled up. Like food provides motivation for dogs, money provides it for people.”

Brokerage firms and casinos have figured out the greed-seeking weakness in human brains and exploited this vulnerability to the maximum. By rigging the system in their favor, mega-billion dollar financial institutions and gaming empires continue to sprawl around the globe.

The emotional high experienced by day traders is one explanation for the excessive trading, but there is another contributing factor. The inherent human cognitive bias that behavioral finance academics call overconfidence (or illusory superiority) helps fuel the destructive behavior. Surveys that ask people if they are above-average drivers highlight the overconfidence phenomenon by showing the mathematical impossibility of having 93% of a population as above-average drivers. Similarly, a study of Stanford MBA students showed 87% of the respondents rating their academic performance above median.

Even, arguably the greatest trader of all-time, Jesse Livermore realized the negative impacts of emotions and active trading when he said, “It was never my thinking that made big money for me. It always was my sitting.” As I’ve written in the past, active trading is hazardous to your long-term wealth. Rather than succumbing to the endless pitfalls of day trading and getting nowhere like a hamster on a spinning wheel, it’s better to use a long-term, objective and unemotional investing process to achieve investment success.

See also: Brain Scans Show Link Between Lust for Sex and Money

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold long positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct discretionary position in TD, SCHW, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

March 8, 2014 at 1:28 pm Leave a comment

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