In the world of modern finance, there has always been the search for the Holy Grail. Ever since the advent of computers, practitioners have looked to harness the power of computing and direct it towards the goal of producing endless profits. Regrettably, nobody has found the silver bullet, but that hasn’t slowed down people from trying. Wall Street has an innate desire to try to turn the ultra-complex field of finance into a science, just as they do in the field of physics. Even JPMorgan Chase (JPM) and its CEO Jamie Dimon are already on their way to suffering more than $2 billion in losses in the quest for infinite income, due in large part to their over-reliance on pseudo-science trading models.

James Montier of Grantham Mayo van Otterloo’s asset allocation team was recently a keynote speaker at the CFA Institute Annual Conference in Chicago. His prescient talk, which preceded JP Morgan’s recent speculative trading loss announcement, explained why bad models were the root cause of the financial crisis. Essentially these computer algorithms under-appreciate the number and severity of Black Swans (low probability negative outcomes) and the models’ inability to accurately identify predictable surprises.

What are predictable surprises? Here’s what Montier had to say on the topic:

“Predictable surprises are really about situations where some people are aware of the problem. The problem gets worse over time and eventually explodes into crisis.”

Just a month ago, when Dimon was made aware of the rogue trading activities, the CEO strenuously denied the problem before reversing course and admitting the dilemma last week. Unfortunately, many of these Wall Street firms and financial institutions use value-at-risk (VaR) models that are falsely based on the belief that past results will repeat themselves, and financial market returns are normally distributed. Those suppositions are not always true.

Another perfect example of a Black Swan created by a bad financial model is Long Term Capital Management (LTCM). Robert Merton and Myron Scholes were world renowned Nobel Prize winners who single handedly brought the global financial market to its knees in 1998 when LTCM lost $500 million in one day and required a $3.6 billion bailout from a consortium of banks. Their mathematical models worked for a while but did not fully account for trading environments with low liquidity (i.e., traders fleeing in panic) and outcomes that defied the historical correlations embedded in their computer algorithms. The “Flash Crash” of 2010, in which liquidity evaporated due to high frequency traders temporarily jumping ship, is another illustration of computers wreaking havoc on the financial markets.

The problem with many of these models, even for the ones that work in the short-run, is that behavior and correlations are constantly changing. Therefore any strategy successfully reaping outsized profits in the near-term will eventually be discovered by other financial vultures and exploited away.

Another pundit with a firm hold on Wall Street financial models is David Leinweber, author of Nerds on Wall Street.  As Leinweber points out, financial models become meaningless if the data is sliced and diced to form manipulated and nonsensical relationships. The data coming out can only be as good as the data going in – “garbage in, garbage out.”

In searching for the most absurd data possible to explain the returns of the S&P 500 index, Leinweiber discovered that butter production in Bangladesh was an excellent predictor of stock market returns, explaining 75% of the variation of historical returns. By tossing in U.S. cheese production and the total population of sheep in Bangladesh, Leinweber was able to mathematically “predict” past U.S. stock returns with 99% accuracy. To read more about other financial modeling absurdities, check out a previous Investing Caffeine article, Butter in Bangladesh.

Generally, investors want precision through math, but as famed investor Benjamin Graham noted more than 50 years ago, “Mathematics is ordinarily considered as producing precise, dependable results. But in the stock market, the more elaborate and obtuse the mathematics, the more uncertain and speculative the conclusions we draw therefrom. Whenever calculus is brought in, or higher algebra, you can take it as a warning signal that the operator is trying to substitute theory for experience.”

If these models are so bad, then why do so many people use them? Montier points to “intentional blindness,” the tendency to see what one expects to see, and “distorted incentives” (i.e., compensation structures rewarding improper or risky behavior).

Montier’s solution to dealing with these models is not to completely eradicate them, but rather recognize the numerous shortcomings of them and instead focus on the robustness of these models. Or in other words, be skeptical, know the limits of the models, and build portfolios to survive multiple different environments.

Investors seem to be discovering more financial Black Swans over the last few years in the form of events like the Lehman Brothers bankruptcy, Flash Crash, and Greek sovereign debt default. Rather than putting too much faith or dependence on bad financial models to identify or exploit Black Swan events, the over-reliance on these models may turn this rare breed of swans into a large bevy.

See Full Article on Montier: Failures of Modern Finance

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in JPM, Lehman Brothers, 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.

The financial crisis of 2008-2009 was painful, not to mention the Flash Crash of 2010; the Debt Ceiling / Credit Downgrade of 2011; and the never-ending European saga. Needless to say, these and other events have caused pain akin to burning one’s hand on the stove. This unpleasant effect has rubbed off on investors.

Admitting one has a problem is half the battle of conquering a challenge.  A key challenge for many investors is understanding the crippling effects fear can have on personal investment decisions. While there are certainly investors who constantly see financial markets through rose-colored glasses (my glasses I argue are only slightly tinted), Nobel Prize winner Daniel Kahneman and his partner Amos Tversky understand the pain of losses can be twice as painful as the pleasure experienced through gains (see diagram below).

Source: Investopedia

Said a little differently, faced with sure gain, most investors are risk-averse, but faced with sure loss, investors prefer risk-taking. Don’t believe me? Well, let’s take a look at some of Kahneman and Tversky’s behavioral finance work on what they called “Prospect Theory” (1979) – the analysis of decisions made under various risk scenarios.

In one specific experiment, Kahneman and Tversky presented groups of subjects with a number of problems. One group of subjects was presented with this problem:

Problem #1: In addition to whatever you own, you have been given $1,000. You are now asked to choose between:

A. A sure gain of $500

B. A 50% change to gain $1,000 and a 50% chance to gain nothing.

Another group of subjects was presented with this problem:

Problem #2:  In addition to whatever you own, you have been given $2,000. You are now asked to choose between:

A. A sure loss of $500

B. A 50% chance to lose $1,000 and a 50% chance to lose nothing.

In the first group, 84% of the respondents chose A and in the second group, 69% of the respondents chose B. Both problems are identical in terms of the net cash outcomes ($1,500 for Answer A, and 50% chance of $1,000 or $2,000 for Answer B). Nonetheless, due the different “loss phrasing” in each question, Answer A sounds more appealing in Question #1, and Answer B sounds more appealing in Question #2. The results are irrational, but investors have been known to be illogical too.

In practical trading terms, the application of “Prospect Theory” often manifests itself via the pain principle. Due to loss aversion, investors tend to cash in gains too early and fail to allow their winning stocks to run higher for a long enough period.

The framing of the Kahneman and Tversky’s questions is no different than the framing of political and economic issues by the various media outlets (see Pessimism Porn). Fear can generate advertising revenue and fear can also push investors into paralysis (see the equity fund flow data in Fund Flows Paradox).

Greed can sell in the financial markets too. The main sources of financial market greed have been primarily limited to bonds, cash, and gold. If you caught those trends early enough, you are happy as a clam, but like most things in life, nothing lasts forever. The same principle applies to financial markets, and over time, capital in today’s winners will slowly transition into today’s losers (i.e., tomorrow’s winners).

A healthy amount of fear is healthy, but correctly understanding the dynamics of the “Pleasure/Pain Principle” can turn those fearful tears into profitable pleasure.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including fixed income ETFs), but at the time of publishing SCM had no direct position in GLD, 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.

The recently reported lackluster, monthly employment report made stockholders grumpy (as measured by the recent -168 point decline in the Dow Jones Industrial index) and bondholders ecstatic (as measured by the surge in the 10-year Treasury note price and plunge in yield to a meager 1.88% annual rate). Stocks on the other hand are yielding a much more attractive rate of approximately 7.70% based on 2012 earnings estimates (see chart below) and are also offering a dividend yield of about 2.25%. 

S&P 500 earnings yields trouncing bond yields despite historical correlation.

In my view, either stock prices go higher and drive equity yields lower; bonds sell off and Treasury yields spike higher; or a combination of the two. Either way, there are not many compelling reasons to pile into Treasuries, although I fully understand some Treasuries are needed in many investors’ portfolios for income, diversification, and risk tolerance reasons.

Not only are equity earnings yields beating Treasury yields, but so are dividend yields. It has been a generation, or more than 50 years, since the last time stock dividends were yielding more than 10-year Treasuries (see chart below). If you invested in stocks back when dividend yields outpaced bond yields, and held onto your shares, you did pretty well in stocks (the Dow Jones Industrial index traded around 600 in 1960 and over 13,000 today). 

Source: The Financial Times

The Dynamic Dividend Payers

The problem with bond payments (coupons), in most cases, is that they are static. I have never heard of a bond issuer sending a notice to a bond holder stating they wanted to increase the size of interest payments to their investors. On the flip side, stocks can and do increase payments to investors all the time. In fact here is a list of some of the longest paying dividend dynamos that have incredible dividend hike streaks:

• Procter & Gamble (PG – 55 consecutive years)

• Emerson Electric (EMR – 54 years)

• 3M Company (MMM – 53 years)

• The Coca-Cola Company (KO – 49 years)

• Johnson & Johnson (JNJ – 49 years)

• Colgate-Palmolive Company (CL – 48 years)

• Target Corporation (TGT – 43 years)

• PepsiCo Inc. (PEP – 39 years)

• Wal-Mart Stores Inc. (WMT – 38 years)

• McDonald’s Corporation (MCD – 35 years)

This is obviously a small number of the long-term consecutive dividend hikers, but on a shorter term basis, more and more players are joining the dividend paying team. So far, in 2012 alone through April, there have been 152 companies in the S&P 500 index that have raised their dividend (a +11% increase over the same period a year ago). Of those 152 companies that increased the dividend this year, the average boost was more than +23%. Some notable names that have had significant dividend increases in 2012 include the following companies:

• Macy’s Inc. (M: +100% dividend increase)

• Mastercard Inc. (MA: +100%)

• Wells Fargo & Company (WFC: +83%)

• Comcast Corp. (CMCSA: +44%)

• Cisco Systems Inc. (CSCO: +33%)

• Goldman Sachs Group Inc. (GS: +31%)

• Freeport McMoran (FCX: +25%)

• Harley Davidson Inc. (HOG: +24%)

• Exxon Mobil Corp. (XOM: +21%)

• JP Morgan Chase & Co. (JPM: +20%)

Lots of Dividend Headroom

The nervous mood of investors is not much different from the temperament of uneasy business executives, so companies have been slow to hire; unhurried to acquire; and deliberate with their expansion plans. Rather than aggressively spend, corporations have chosen to cut costs, hoard cash, grow earnings, buy back shares, and pay out ever increasing dividends from the trillions in cash piling up.

When a company on average is earning an 8% yield on their stock price, there is plenty of headroom to increase the dividend. As a matter of fact, a company paying a 2% yield could increase its dividend by 10% for about 15 consecutive years and still pay a quadrupling dividend with NO earnings growth. Simply put, there is a lot of room for companies to increase dividends further despite the floodgate of dividend increases we have experienced over the last few years. If you look at the chart below, the dividend yield is the lowest it has been in more than a century (1900).   

Source: The Financial Times

Perhaps we will experience another “Summer Swoon” this year, but for those selective and patient investors that sniff out high-quality, dividend paying stocks, you will be getting “paid to wait” while the dividend floodgates continue to widen.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including Treasury bond ETFs), CMCSA and WMT, but at the time of publishing SCM had no direct position in PG, EMR, MMM, KO, JNJ, CL, TGT, PEP, MCD, M, MA, WFC, CSCO, GS, FCX, HOG, XOM, JPM, 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.

Article is an excerpt from Sidoxia Capital Management’s complementary May 2012 newsletter. Subscribe on right side of page.

The last five years have been historic in many respects. Not only have governments and central banks around the world undertaken unprecedented actions in response to the global financial crisis, but investors have ridden an emotional rollercoaster in response to historically unparalleled uncertainties.

While the nature of this past crisis has been unique, experienced investors know these fears continually manifest themselves in different forms over various cycles in time. Despite the more than doubling in equity market values over the last few years, as measured by the S&P 500 index, the emotional pendulum of investor sentiment has only partially corrected. Investor temperament has thankfully swung away from “Panic,” but has only moved closer to “Fear” and “Skepticism.” Here are some of the issues contributing to investors’ current sour mood:

The Next European Domino: The fear of the Greek domino toppling the larger Spanish and Italian economies has investors nervously chewing their finger-nails, and political turmoil in France and the Netherlands isn’t creating any additional warm and fuzzies.

Job Additions Losing Steam: New job creation here in the U.S. weakened to a lethargic monthly rate of +120,000 new jobs in March, while the unemployment rate remains stubbornly high at an 8.2% level.

Domestic Growth Losing Mojo: GDP (Gross Domestic Product) growth of +2.2% during the first quarter of 2012 also opened the door for the pessimists. Consumers are still spending (+2.9% growth), but government spending, business investment, and housing are taking wind out of the economy’s sails.

Emerging Markets Submerging: Unspectacular growth in the U.S. is not receiving any favors from slowing emerging markets like China and Brazil, which took fiscal and monetary actions to slow inflation and housing speculation in 2011.

Humpty Dumpty Politics: Presidential elections, tax policy, and deficit reduction are all concerns that carry the possibility of pushing the economic Humpty Dumpty off the wall, and as a result potentially lead to a great fall. The determination of Humpty Dumpty’s fate will likely have to wait until year-end or 2013.

Any student of history knows these fears and other concerns never go away – they simply change. But like supply and demand, gravitational forces eventually swing the emotional pendulum in the opposite direction. As Sir John Templeton so aptly stated, “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” Or in other words, escalating bull markets must climb the proverbial “Wall of Worry” in order to sustain upward momentum. If there was nothing to worry about, then all the buyers would already be in the markets. We are nowhere close to experiencing “Euphoria” like we saw in stocks during the late-1990s or in the housing market around 2005.

Positively Climbing the “Wall of Worry”

With all this bad news out there, surprisingly there are some glimmers of hope chipping away at the “Wall of Worry.” Here are some of the positive factors helping turn pessimist frowns upside down:

Slow & Steady Wins the Race: The economic recovery has been weaker than hoped, but I can think of worse scenarios than 11 consecutive quarters of GDP growth and 25 straight months of private job creation, which has reduced the unemployment rate from 10.0% in October 2009 to 8.2% last month.

Earnings Machine Keeps Chugging Along: With the majority of S&P 500 companies having reported their quarterly results for the first quarter, three-fourths of the companies are beating forecasted earnings, which are currently registering in at a respectable +7.1% rate (Thomson Reuters). One company epitomizing this trend is Apple Inc. (AAPL). The near doubling in Apple’s profits during the quarter, thanks to explosive iPhone sales, pushed Apple’s shares over $600 and helped drive the NASDAQ index to its best day of the year.

Super Ben to the Rescue: The Federal Reserve has already stated their intention of keeping interest rates near 0% until 2014. The potential of additional monetary stimulus spearheaded by Federal Reserve Chairman Ben Bernanke, in the form of QE3 (Quantitative Easing Part III), may provide further needed support to the stock market (a.k.a., the “Bernanke Put”).

Return of the IPO: Initial Public Offerings (IPOs) have gained steam versus last year with more than 53 already coming to market in the first four months of 2012. This is no 1999, but a good number of deals have done quite well over the last month. For example, data analysis company Splunk Inc. (SPLK) share price is already up around 100% and the value of leisure luggage company TUMI Holdings (TUMI) has climbed over +40%. In a few weeks, the highly anticipated blockbuster Facebook (FB) IPO is expected to begin trading its shares, so we can see if the chronicled deal can live up to all the hype.

Dividends Galore: Dividend payments to stockholders are flowing at an extraordinary rate so far in 2012. Companies like IBM (increased its dividend by +13%), Exxon Mobil – (XOM +21%); Goldman Sachs – (GS +31%) are but just a few of the dividend raisers this year. Through the first three months of the year, the number of companies increasing their dividend payments was up +45% as compared to the comparable number for all of 2011.

Emerging Growth Not Dead: While worriers fret over slowing growth in China, companies like Apple grew by more than +100% in this region and collected nearly 20% of its revenues from this Asian country (~$8 billion). Coincidentally, China is expected to surpass an incredible one billion mobile connections in May – many of those iPhones. In other related news, Starbucks Corp. (SBUX) plans to triple its workforce and number of stores in China over the next three years. China has also helped fuel a backlog of Caterpillar Inc. (CAT) that is more than triple the level of 2009. Emerging markets may have slowed down in 2011, but with inflation beginning to stabilize, emerging market central banks and governments are now beginning to ease policies and reduce red-tape. For example, Brazil and India have started to lower key benchmark interest rates, and China has started to reverse capital flow restrictions.

Stay Off the Trampled Path

The mantra of “Sell in May and go away” always gets a lot of playtime around this period of the year. Over the last few years, the temporary spring/summer sell-offs have only been followed by stronger price appreciation. Individuals attempting to time the market (see also Getting Off the Treadmill) generally end up in tears. And for those traders who boast about their excellent timing (like those suspicious friends who brag about always winning in Las Vegas), we all know the truth – nobody buys at the lows and sells at the highs…except for liars.

With all the noise and cross-currents flooding the airwaves, investing for individuals without assistance has never been so difficult. But before hiding in your cave or reacting to the next scary headline about Europe, the economy, or politics, do yourself a favor by reminding yourself these chilling news items are nothing new and are often great contrarian indicators (see also Back to the Future). The emotional pendulum is constantly swinging from fear to greed and investors stand to prosper by adjusting sentiment and actions in the opposite direction. To survive in the investing wild, it is best to realize that the grass is greener and the eating more abundant when you stay off the trampled path of the herd.    

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and AAPL, but at the time of publishing SCM had no direct position in SPLK, TUMI, IBM, XOM, GS, SBUX, CAT, FB, 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.

As I sift through the flood of quarterly corporate profit reports and finish up my quarterly client responsibilities, I’ve now carved out some to time to focus on writing. For anyone waiting in line for the next Investing Caffeine piece, please come back late Monday or early Tuesday for my monthly review (or sign up for my complementary newsletter on the right side of page). Stay tuned…

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, 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.

How is it that the stock market has more than doubled over the last three years, when investors have been dumping stocks like they are going out of style? If you don’t believe me, and you think jovial investors are jacking stocks higher, then please explain to me why billions of dollars are hemorrhaging out of equity funds on a monthly basis over the last five years (see Fund Flow data chart below)?

Source: Calafia Beach Pundit

If by small chance you buy my argument that skeptical investors continue to doubt the sustainability of the three-year doubling in the stock market, then why is the Volatility Index (VIX) trading like investors are sunbathing at the beach while licking lollipops? For those not keeping score on the VIX (see also The VIX and the Rule of 16), typically a reading below 20 is interpreted as investor overconfidence and/or complacency. On the flip side, readings above 20 usually indicate pessimism or fear.

As you can see from the chart below, we have spent a good portion of the last few years on both sides of the 20 mph VIX speed limit, and currently at a reading of about 17, investors have slowed down to enjoy the scenery.

Source: Yahoo! Finance

So with massive selling and a cheery reading on the VIX, how can these bipolar data-points be reconciled? Therein lies the “Fund Flows Paradox.”

Take Me Out to the Ballgame

If you equate equity investors to fans at a baseball stadium, the fund flow data clearly shows investors are tired of losing money and have been leaving the game in droves. Instead of staying at the equity baseball stadium, those fatigued stock investors have decided to head over to the adjacent bond arena. The equity stadium will never completely be empty because financial markets always have speculative traders. In baseball terms you can think of these short-term traders as the emotionally volatile die-hard fanatics, who will stick around regardless of whether the home team wins or loses.

So while sentiment gauges like the VIX, or sentiment surveys conducted by AAII (American Association of Individual Investors) may be temporarily flashing contrarian bearish signals, one should be cognizant that these data points do not include the petrified opinions of investors who have raced out of the stadium. Eventually when the home team’s winning streak is long enough, investors will return back to the stadium from the bond arena. While there is no sign of individual investors coming back to the stock game anytime soon, in the meantime patient and disciplined investors have had plenty of opportunities to take advantage of. With massive numbers of individual investors and sellers sitting on the sidelines, the markets require relatively little buying to push prices higher.

Over the last few years, not only have equity valuations been broadly reasonable, volatility spikes during the last few summers have  also created amplified opportunities. With the wall of worries currently blanketing traditional and new media headlines (i.e., European crisis, U.S. election uncertainty, unsustainable and slowing profits, pending tax cut expirations, Mideast turmoil, etc.) there is no sense of urgency to pile back in to the equity markets.

The doubling in stock prices have occurred on low volumes, largely on the backs of a smaller institutional investor base, not to mention high frequency traders and speculators. While sentiment surveys may currently provide some insight into short-term equity trader attitudes, don’t let these volatile and unreliable data cloud the true underlying pessimism of the masses who have left the stock stadium in large numbers. Trillions of dollars remain on the sidelines as potential fuel for future equity appreciation, once confidence returns.

Opinions are interesting, but actions speak louder than words. Spend more time looking at the actions of the fund flow data, rather than the opinions of various short-term sentiment surveys or short-term options trader statistics. Adjusting your focus to investor actions and behavior will provide a truer gauge of overall investor sentiment and assist you in solving the “Fund Flows Paradox.”

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in VXX, 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.

Investing Caffeine has profiled many great investors over the months and years, so I thought now would be a great time to compile a “Hall of Fame” summarizing some of the greatest of all-time. Nothing can replace experience, but learning from the greats can only improve your investing results – I’ve benefitted firsthand and so have Sidoxia’s clients. Here is a partial list from the Pantheon of investing greats along with links to the complete articles (special thanks to Kevin Weaver for helping compile):

Phillip Fisher –  Author of the must-read classic Common Stocks and Uncommon Profits, he enrolled in college at age 15 and started graduate school at Stanford a few years later, before he dropped out and started his own investment firm in 1931. “If the job has been correctly done when a common stock is purchased, the time to sell it is – almost never.” Not every investment idea made the cut, however he is known to have bought Motorola (MOT) stock in 1955 and held it until his death in 2004 for a massive gain. (READ COMPLETE ARTICLE)

Peter Lynch – Lynch graduated from Boston College in 1965 and earned a Master of Business Administration from the Wharton School of the University of Pennsylvania in 1968.   Lynch’s Magellan fund averaged +29% per year from 1977 – 1990 (almost doubling the return of the S&P 500). In 1977, the obscure Magellan Fund started with about $20 million, and by his retirement the fund grew to approximately $14 billion (700x’s larger). Magellan  outperformed 99.5% of all other funds, according to Barron’s. (READ COMPLETE ARTICLE)

William O’Neil –  After graduating from Southern Methodist University, O’Neil started his career as a stock broker. Soon thereafter, at the ripe young age of 30, O’Neil purchased a seat on the New York Stock Exchange and started his own company, William O’Neil + Co. Incorporated. Following the creation of his firm, O’Neil went on to pioneer the field of computerized investment databases. He used his unique proprietary data as a foundation to unveil his next entrepreneurial baby, Investor’s Business Daily, in 1984. (READ COMPLETE ARTICLE)

Sir John Templeton - After Yale and Oxford, Templeton moved onto Wall Street, borrowed $10,000 to purchase more than 100 stocks trading at less than $1 per share (34 of the companies were in bankruptcy). Only four of the investments became worthless and Templeton made a boatload of money. Templeton bought an investment firm in 1940, leading to the Templeton Growth Fund in 1954. A $10,000 investment made at the fund’s 1954 inception would have compounded into $2 million in 1992 (translating into a +14.5% annual return). (READ COMPLETE ARTICLE)

Charles Ellis –  He has authored 12 books, founded institutional consulting firm Greenwich Associates, a degree from Yale, an MBA from Harvard, and a PhD from New York University. A director at the Vanguard Group and Investment Committee chair at Yale, Ellis details that many more investors and speculators lose than win. Following his philosophy will not only help increase the odds of your portfolio winning, but will also limit your losses in sleep hours. (READ COMPLETE ARTICLE)

Seth Klarman – President of The Baupost Group, which manages about $22 billion, he worked for famed value investors Max Heine and Michael Price of the Mutual Shares. Klarman published a classic book on investing, Margin of Safety, Risk Averse Investing Strategies for the Thoughtful Investor, which is now out of print and has fetched upwards of $1,000-2,000 per copy in used markets. From it’s 1983 inception through 2008 his Limited partnership averaged 16.5% net annually, vs. 10.1% for the S&P 500. During the “lost decade” he crushed the S&P, returning 14.8% and 15.9% for the 5 and 10-year periods vs. -2.2% and -1.4%. (READ COMPLETE ARTICLE)

George Soros – Escaping Hungary in 1947, Soros immigrated to the U.S. in 1956 and held analyst and management positions for the next 20 years.  Known as the “The man who broke the Bank of England,” he risked $10 billion against the British pound in 1992 in a risky trade and won. Soros also gained notoriety for running the Quantum Fund, which generated an average annual return of more than 30%. (READ COMPLETE ARTICLE)

Bruce Berkowitz -Bruce Berkowitz has not exactly been a household name. With his boyish looks, nasally voice, and slicked-back hair, one might mistake him for a grad student. However, his results are more than academic, which explains why this invisible giant was recently named the equity fund manager of the decade by Morningstar. The Fairholme Fund (FAIRX) fund earned a 13% annualized return over the ten-year period ending in 2009, beating the S&P 500 by an impressive 14%. (READ COMPLETE ARTICLE)

Thomas Rowe Price, Jr. – Known as the “Father of Growth Investing,” in 1937 he founded T. Rowe Price Associates (TROW) and successfully ramped up the company before the launch of the T. Rowe Price Growth Stock Fund in 1950. Expansion ensued until he made a timely sale of his company in the late 1960s. His Buy and Hold strategy proved successful. For example, in the early 1970s, Price had accumulated gains of +6,184% in Xerox (XRX), which he held for 12 years, and gains of +23,666% in Merck (MRK), which he held for 31 years. (READ COMPLETE ARTICLE)

There you have it. Keep investing and continue reading about investing legends at Investing Caffeine, and who knows, maybe you too can join Sidoxia’s Hall of Fame?!

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and WMT, but at the time of publishing SCM had no direct position in MOT, TROW, XRX, MRK, FAIRX, 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.

Source: Photobucket

When it comes to Lent, most Christian denomination followers give up a vice, such as food, alcohol, or now in more modern times…Facebook (FB). Since Lent began on Ash Wednesday this year (February 22, 2012), investors have given up something else – gold (GLD). As a matter of fact, the shiny metal has declined by about -8% since Lent began. Stocks, on the other hand, as measured by the S&P 500, have outperformed gold by more than 10% over this period (the Lent period damage is even worse, if you look at the NASDAQ).

If you go back further in time, the underperformance is more extreme, once you account for dividends, which gold of course does not provide. For example, since the peak of the financial crisis panic in March of 2009, S&P 400, S&P 600, and NASDAQ stocks have outperformed gold by more than +40%. Yet, I am still waiting for the sign-spinning guy at the corner of First St. & Main St. to advertise stock trade-in opportunities. Contrarians may also get a kick out of the top investment CNBC survey too.

Source: Orlando Sentinel

Last Friday’s jobs data was nothing to write home about, so gold cheerleaders might wait for more fiat currency debasement to come in the form of QE3 (i.e., quantitative easing or printing press). But once again, while this potential added monetary stimulus may not be bad for gold, let’s not forget that stocks still outperformed gold under QE1 & QE2.

As I have always stated, I can’t disagree with the inflationary pressures that are brewing. Stimulative monetary and fiscal policies, coupled with emerging market expansion and undisciplined government spending don’t paint a pretty inflationary picture. So if that’s the case, why not focus on other commodities that provide real utility besides just shininess (e.g., agricultural goods, copper, aluminum, oil, and even silver).

The gold bugs may still have a little post-Lent party, until rates start going up and panic insurance premiums go down, but once the Fed’s easing policy stance changes (see Paul Volcker Fed Chairman era) and fiscal sanity eventually returns to Washington, investors may look to another vice to gorge on.

See also some other items to gorge on: CLICK HERE

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including small cap ETFs, mid cap ETFs, energy ETFs, commodity ETFs) , but at the time of publishing SCM had no direct position in GLD, FB, 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.

Article is an excerpt from Sidoxia Capital Management’s April 2012 newsletter. Subscribe on right side of page.

That warm safety blanket of cash that millions of Americans have clutched on to during the 2008-09 financial crisis; the 2010 “Flash Crash”; and the 2011 U.S. credit downgrade felt cozy during the bumpy ride we experienced over the last three years. Now with domestic stocks (S&P 500) up +12% in the first quarter of 2012, that same comfy blanket of CDs, money market, and checking accounts is switching into a painful tourniquet, cutting off the lucrative blood and oxygen supply to millions of Americans’ future retirement plans.

Earning next to nothing by stuffing your money under the mattress (0.7% average CD rate – Bankrate.com) isn’t going to make many financial dreams a reality. The truth of the matter is that due to inflation (running +2% to +3% per year), blanket holders are losing about -2% per year in the true value of their savings.

Your Choice: 3 Years or 107 years?

If you like to accumulate money, would you prefer doubling your money in 3 years or 107 years? Although the S&P 500 has more than doubled over the last three years, based on fund flows data and cash balances at the banks, apparently more individuals prefer waiting until the year 2119 (107 years from now) for their money to double – SEE CHART BELOW.

Obviously the massive underperformance of CDs cherry picks the time-period a bit, given the superb performance of stocks from 2009 – 2012 year-to-date. Over 1999-2012 stock performance hasn’t been as spectacular, but what we do know is that despite the lackluster performance of stocks over the last 12 years, corporate profits have about doubled in a similar timeframe, making equity prices that much more attractive relative to 1999.

With the economy and employment picture improving, some doomsday scenarios have temporarily been put on the backburner. As the recovery has gained some steam, many people are opening their bank statements with the painful realization, “I just made $31.49 on my checking maximizer account last year! Wow, how incredible…I can now go out and buy a half-tank of gas.” Never mind that healthcare premiums are exploding, food costs are skyrocketing, and that vacation you were planning is now out of reach. If you’re a mega-millionaire, perhaps you can make these stingy rates work for you, but for most of the other people, successful retirements will require more efficient use of their investment dollars. Or of course you can always work at Wal-Mart (WMT) as a greeter in your 80s.

Rationalizing with a Teen

Some people get it and some don’t. Trying to time the market, by getting in and out at the right times is a losing battle (see Getting Off the Market Timing Treadmill). Even the smartest professionals in the industry have little accuracy and cannot consistently predict the direction of the markets. Rationalizing the ups and downs of the financial markets is equivalent to rationalizing the actions of a teenager. Sometimes the outcomes are explainable, but most of the times they are not.

What an astute investor does know is that higher long-term returns come with higher volatility. So while the last four years have been a bumpy ride for investors, this is nothing new for an experienced investor who has studied the history of financial markets. There have been a dozen or so recessions since World War II, and we’ll have a dozen or so more over the next 50-60 years. Wars, banking crises, currency crises, and political turmoil have been a constant over history. Despite all these setbacks, the equity markets have climbed over +1,300% over the last 30 years or so. The smartest financial minds on the planet (e.g., the Ben Bernankes and Alan Greenspans of the world) haven’t been able to figure it out, so if they couldn’t do it, how is an average Joe supposed to be able to time the market? The answer is nobody can predict the direction of the market reliably.

As my clients and Investing Caffeine followers know, for those individuals with adequate savings and shorter time horizons, much of this conversation is irrelevant. However, based on our country’s low savings rate and the demographics of longer Baby Boomer life expectancies, most individuals can’t afford to stuff all their money under the mattress. As famous investor Sir John Templeton stated, “The only way to avoid mistakes is not to invest – which is the biggest mistake of all.” Earning 0.7% on your nest egg is difficult to call investing.

Ignoring the Experts

Why is the investing game so difficult? For starters, individuals are constantly bombarded by so-called experts through television, radio, and newspapers. Not only did Federal Reserve Chairmen Alan Greenspan and Ben Bernanke get the economy, financial markets, and housing markets wrong, the most powerful and smart financial institution CEOs were dead wrong as well. Look no further than Lehman Brothers (Dick Fuld), Citigroup Inc. (Chuck Prince), and American International Group (Martin Sullivan), which were believed to house some of the shrewdest executives – they too completely missed the financial crisis.

Rather than listening to shoddy predictions from pundits who have little to no investing experience, it makes more sense to listen to successful long-term investors who have survived multiple investment cycles and lived to tell the tale. Those people include the great fund manager Peter Lynch who said it is better to “assume the market is going nowhere and invest accordingly,” rather than try to time the market.

What You Hear

As the market has more than doubled over the last 37 months, here are some clouds of pessimism that these same shoddy economists, strategists, and analysts have described for investors:

* Europe and Greece’s impending fiscal domino collapse

* Excessive money printing at the Federal Reserve through quantitative easing and other programs

* Imminent government disintegration due to unresolved structural debts and deficits

* Elevated unemployment rates and pathetic job creation statistics

* Rigged high frequency trading and “Flash Crash”

* Credit downgrade and political turmoil in Washington

* Looming Chinese real estate bubble and subsequent hard economic landing

Unfortunately, many investors got sucked up in these ominous warnings and missed most, if not all, of the recent doubling in equity markets.

What You Don’t Hear

What you haven’t heard from the popular press are the following headlines:

* 10 consecutive quarters of GDP growth

* Record corporate profits and profit margins

* Equity valuations attractively priced below 50-year average (14.4 < 16.6 via Calafia Beach Pundit)

* Rising dividends with yields approaching 3%, if you consider recent bank announcements

* Record low interest rates and moderate inflation make earnings streams and dividends that much more valuable

* Four million new jobs created over the last three years

* S&P Smallcap near all-time highs (21 years); S&P Midcap index near all-time highs (20 years); NASDAQ is at 11-year highs; Dow Jones Industrials and S&P 500 near 4-year-highs.

* Record retail sales with a consumer that has reduced household debt

Source: Calafia Beach Pundit

Given the massive upward run in the stock market over the last few years (and a complacent short-term VIX reading of 15), stocks are ripe for a breather. With that said, I would advise any blanket holders to not get too comfy with that money decaying away in a CD, money market, or savings account. Waiting too long may turn that security blanket into a tourniquet – forcing investors to amputate a portion of their future retirement savings.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and WMT, but at the time of publishing SCM had no direct position in C, AIG, RATE, Lehman Brothers, 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.

The clock is ticking, and for many investors that makes the allure of short-term speculation more appealing than long-term investing. Of course the definition of “long-term” is open for interpretation. For some traders, long-term can mean a week, a day, or an hour.  Fortunately, for those that understand the benefits of time arbitrage, the existence of short-term speculators creates volatility, and with volatility comes opportunity for long-term investors.

What is time arbitrage? The concept is not new and has been addressed by the likes of Louis Lowenstein, Ralph Wanger, Bill Miller, and Christopher Mayer. Essentially, time arbitrage is exploiting the benefits of moving against the herd and buying assets that are temporarily out of favor because of short-term fears, despite healthy long-term fundamentals. The reverse holds true as well. Short-term euphoria never lasts forever, and experienced investors understand that continually following the herd will eventually lead you to the slaughterhouse. Thinking independently, and going against the grain is ultimately what leads to long-term profits.

Successfully executing time arbitrage is easier said than done, but if you have a systematic, disciplined process in place that assists you in identifying panic and euphoria points, then you are well on your way to a lucrative investment career.

Winning via Long-Term Investing

Legg Mason has a great graphical representation of time arbitrage:

Source: Legg Mason Funds Management

The first key point to realize from the chart is that in the short-run it is very difficult to distinguish between gambling/speculating and true investing. In the short-run, speculators can make money just as well as anybody, and in some cases, even make more profits than long-term investors. As famed long-term investor Benjamin Graham so astutely states, “In the short run the market is a voting machine. In the long run it’s a weighing machine.” Or in other words, speculative strategies can periodically outperform in the short run (above the horizontal mean return line), while thoughtful long-term investing can underperform. 

Financial Institutions are notorious for throwing up strategies on the wall like strands of spaghetti. If some short-term outperforming products spontaneously stick, then the financial institutions often market the bejesus out of them to unsuspecting investors, until the strategies eventually fall off the wall.

Beware o’ Short-Termism

I believe Jack Gray of Grantham, Mayo, Van Otterloo got it right when he said, “Excessive short-termism results in permanent destruction of wealth, or at least permanent transfer of wealth.” What’s led to the excessive short-termism in the financial markets (see Short-Termism article)? For starters, technology and information are spreading faster than ever with the proliferation of the internet, creating a sense of urgency (often a false sense) to react or trade on that information. With more than 2 billion people online and 5 billion people operating mobile phones, no wonder investors are getting overwhelmed with a massive amount of short-term data. Next, trading costs have declined dramatically in recent decades, to the point that brokerage firms are offering free trades on various products. Lower trading costs mean less friction, which often leads to excessive and pointless, profit-reducing trading in reaction to meaningless news (i.e., “noise”).  Lastly, the genesis of ETFs (exchange traded funds) has induced a speculative fervor, among those investors dreaming to participate in the latest hot trend. Usually, by the time an ETF has been created, the cat is already out of the bag, and the low hanging profit fruits have already been picked, making long-term excess returns tougher to achieve.

There is never a shortage of short-term fears, and today the 2008-09 financial crisis; “Flash Crash”; debt downgrade; European calamity; upcoming presidential elections; expiring tax cuts; and structural debts/deficits are but a few of the fear issues du jour in investors’ minds. Markets may be overbought in the short-run, and a current or unforeseen issue may derail the massive bounce from early 2009. For investors who can put on their long-term thinking caps and understand the concept of time arbitrage, buying oversold ideas and selling over-hyped ones will lead to profitable usage of investment time.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any 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.