Posts tagged ‘Peter Lynch’

Scrapes on the Sidewalk

Scraped Knees

Baron Rothschild, an 18th century British nobleman and member of the Rothschild banking family, is credited with the investment advice to “buy when there’s blood in the streets.” Well, with the Russell 2000 correcting about -14% and the S&P 500 -8% from their 2014 highs, you may not be witnessing drenched, bloody streets, but you could say there has been some “scrapes on the sidewalk.”

Although the Volatility Index (VIX – a.k.a., “Fear Gauge”) reached the highest level since 2011 last week (31.06), the S&P 500 index still hasn’t hit the proverbial “correction” level yet. Even with some blood being shed, the clock is still running since the last -10% correction experienced during the summer of 2011 when the Arab Spring sprung and fears of a Greek exit from the EU was blanketing the airwaves. If investors follow the effective 5-year investment playbook, this recent market dip, like previous ones, should be purchased. Following this “buy-the-dip” mentality since the lows experienced in 2011 would have resulted in stock advancing about +75% in three years.

If you have a more pessimistic view of the equity markets and you think Ebola and European economic weakness will lead to a U.S. recession, then history would indicate investors have suffered about 50% of the pain. Your ordinary, garden-variety recession has historically resulted in about a -20% hit to stock prices. However, if you’re in the camp that we’re headed into another debilitating “Great Recession” as we experienced in 2008-2009, then you should brace for more pain and grab some syringes of Novocaine.

If you’re seriously considering some of these downside scenarios, wouldn’t it make sense to analyze objective data to bolster evidence of an impending recession? If the U.S. truly was on the verge of recession, wouldn’t the following dynamics likely be in place?

  • Two quarters of consecutive, negative GDP (Gross Domestic Property) data
  • Inverted yield curve
  • Rising unemployment and mass layoff announcements
  • Declining corporate profits
  • Hawkish Federal Reserve

The reality of the situation is the U.S. economy continues to expand; the yield curve remains relatively steep and positive; unemployment declined to 5.9% in the most recent month; corporate profits are at record levels and continue to grow; and the Fed has communicated no urgency to raise short-term interest rates in the near future. While the current headlines may not be so rosy, and the Ebola, eurozone, and Chinese markets may be giving you heartburn, nevertheless, the stock market has steadily climbed a wall of market worry over the last five years.

As the great Peter Lynch stated (see also Inside the Brain of an Investing Genius), “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” Stated differently, Value investor Seth Klarman noted, “We can predict 10 of the next two recessions,” which highlights pundits’ inabilities of accurately predicting the next downturn (see also 100-Year Flood ≠ 100-Day Flood). As Lynch also adds, rather than trying to time the market, it is better to “assume the market is going nowhere and invest accordingly.”

Now may not be the time to dive into stocks headfirst, but many stocks have fallen -10%, -20%, and -30%, so it behooves long-term investors to take advantage of the correction. It’s true that buying when there is “blood in the streets” is an optimal strategy, but facts show this is a difficult strategy to execute. Rather than get greedy, long-term investors may be better served by opportunistically buying when there are “scrapes on the sidewalk.”

Investment Questions Border

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold 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.

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October 18, 2014 at 8:50 pm Leave a comment

Investing with Crayons

Child's Drawing of Family

At one level, investing can be extremely challenging if you consider the plethora of diverse and unpredictable factors such as monetary policy, fiscal policy, wars, banking crises, natural disasters, currency crises, geopolitical turmoil, Ebola, Scottish referendums, etc. On the other hand, investing (not trading or speculating) should be quite simple…like drawing stick figures with a crayon. However, simplicity does not mean laziness. Successful stock research requires rigorous due diligence without cutting corners. Once the heavy research lifting is completed, concise communication is always preferred.

In order to be succinct, investors need to understand the key drivers of stock performance. In the short run, investors may not be able to draw the directional path of stock prices, but over the long run, Peter Lynch described stock predictions best (see Inside the Investing Genius) when he stated:

“People may bet on hourly wiggles of the market but it’s the earnings that waggle the wiggle long term.”

 

In other words, if revenues, earnings, and most importantly cash flows go up over the long-term, then it is highly likely that stock prices will follow. Besides profits, interest rates and sentiment are other key contributing factors affecting the trajectory of future stock prices.

In high school and college, students often cram as much information into a paper with the goal of layering pages as high as possible. Typically, the heaviest papers got A’s and the lightest papers got C’s or D’s. However, as it relates to stock analysis, the opposite holds true – brevity reigns supreme.

American psychologist and philosopher William James noted, “The art of being wise is the art of knowing what to overlook.”

In our digital world of informational overload, knowing what to overlook is quite a challenge. I experienced this dynamic firsthand early on in my professional career when I was an investment analyst. When asked to research a new stock by my portfolio manager, often my inclination was to throw in the data kitchen sink into my report. Rather than boil down the report to three or four critical stock-driving factors, I defaulted to a plan of including every possible risk factor, competitor, and valuation metric. This strategy was designed primarily as a defense mechanism to hedge against a wide range of possible outcomes, whether those outcomes were probable or very unlikely. Often, stuffing irrelevant information into reports resulted in ineffectual, non-committal opinions, which could provide cosmetic wiggle room for me to rationalize any future upward or downward movement in the stock price.

Lynch understood as well as anyone that stock investing does not have to be complex rocket science:

“Everyone has the brainpower to follow the stock market. If you made it through fifth-grade math, you can do it.”

 

In fact, when Lynch worked with investment analysts, he ran a three-minute timer and forced the analysts to pitch stock ideas in basic terms before the timer expired.

If you went back further in time, legendary Value guru Benjamin Graham also understood brain surgery is not required to conduct successful equity analysis:

“People don’t need extraordinary insight or intelligence. What they need most is the character to adopt simple rules and stick to them.”

 

Similarly, Warren Buffett hammers home the idea that a gargantuan report or extravagant explanation isn’t required in equity research:

“You should be able to explain why you bought a stock in a paragraph.”

 

Hedge fund veteran manager Michael Steinhardt held the belief that a stock recommendation should be elegant in its simplicity as well. In his book No Bull – My Life In and Out of Markets he states that an analyst “should be able to tell me in two minutes, four things: 1) the idea; 2) the consensus view; 3) his variant perception; and 4) a trigger event.

All these previously mentioned exceptional investors highlight the basic truth of equity investing. A long, type-written report inundated with confusing charts and irrelevant data is counterproductive to the investment and portfolio management process. Outlining a stock investment thesis is much more powerful when succinctly written with a crayon.

Investment Questions Border

 

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own a range of positions in certain exchange traded fund positions, 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.

September 20, 2014 at 3:15 pm 2 comments

Got Growth?

Slide1

Investing in the stock market can be quite stressful, especially during periods of volatility…but investing doesn’t have to be nerve-racking. Investing legend T. Rowe price captured the beneficial sentiments of growth investing beautifully when he stated the following:

“The growth stock theory of investing requires patience, but is less stressful than trading, generally has less risk, and reduces brokerage commissions and income taxes.”

 

What I’ve learned over my investing career is that fretting over such things as downgrades, management changes, macroeconomic data, earnings misses, geopolitical headlines, and other irrelevant transitory factors leads to more heartache than gains. If you listen to a dozen so-called pundits, talking heads, journalists, or bloggers, what you quickly realize is that all you are often left with are a dozen different opinions. Opinions don’t matter…the facts do.

Finding Multi-Baggers: The Power of Compounding

Rather than succumbing to knee-jerk reactions from the worries of the day, great long-term investors realize the benefits of compounding. We know T. Rowe Price appreciated this principle because he agreed with Nobel Prize winning physicist Albert Einstein’s view that “compounding interest” should be considered the “8th wonder of the world” – see also how Christopher Columbus can turn a penny into $121 billion (Compounding: A Penny Saved is Billions Earned).

People generally refer to Warren Buffett as a “Value” investor, but in fact, despite the Ben Graham moniker, Buffett has owned some of the greatest growth stocks of all-time. For example, Coca Cola Co (KO) achieved roughly a 20x return from 1988 – 1998, as shown below:

Source: Yahoo! Finance

Source: Yahoo! Finance

If you look at other charts of Buffett’s long-term holdings, such as Wells Fargo & Company (WFC), American Express Co (AXP), and Procter & Gamble – Gillette (PG), the incredible compounded gains are just as astounding.

In recent decades, there is no question that stocks have benefited from P/E expansion. P/E ratios, or the average price paid for stocks, has increased from the early 1980s as long-term interest rates have declined from the high-teens to the low single-digits, but the real lifeblood for any stock is earnings growth (see also It’s the Earnings, Stupid). As growth investor extraordinaire Peter Lynch once said:

“People may bet on hourly wiggles of the market but it’s the earnings that waggle the wiggle long term.”

 

As Lynch also pointed out, it only takes the identification of a few great multi-bagger stocks every decade to compile a tremendous track record, while simultaneously hiding many sins:

“Fortunately the long-range profits earned from really good common stocks should more than balance the losses from a normal percentage of such mistakes.”

 

The Scarcity of Growth

Ever since the technology bubble burst in 2000, Growth stocks have felt the pain. Since that period, the Russell 1000 Value index – R1KV (Ticker: IWD) has almost doubled in value and outperformed the Russell 1000 Growth index – R1KG (Ticker: IWF) by more than +60% (see chart below):

Source: Yahoo! Finance

Source: Yahoo! Finance

Although the R1KG index has yet to breach its previous year 2000 highs, ever since the onset of the Great Financial Crisis (end of 2007), the R1KG index has been on the comeback trail. Now, the Russell 1000 Growth index has outperformed its Value sister index by an impressive +25% (see chart below):

Source: Yahoo! Finance

Source: Yahoo! Finance

Why such a disparity? Well, in a PIMCO “New Normal & New Neutral” world where global growth forecasts are being cut by the IMF  and a paltry advance of 1.7% in U.S. GDP is expected, investors are on a feverish hunt for growth. U.S. investors are myopically focused on our 2.34% 10-Year Treasury yield, but if you look around the rest of the globe, many yields are at multi-hundred year lows. Consider 10-year yields in Germany sit at 0.96%; Japan at 0.50%; Ireland at 1.98%; and Hong Kong at 1.94% as a few examples. This scarcity of growth has led to outperformance in Growth stocks and this trend should continue until we see a clear sustainable acceleration in global growth.

If we dig a little deeper, you can see the 25% premium in the R1KG P/E ratio of 20.8x vs. 16.7x for the R1KV is well deserved. Historical 5-year earnings growth for the R1KG has been +52% higher than R1KV (17.8% vs. 11.7%, respectively). Going forward, the superior earnings performance is expected to continue. Long-term growth for the R1KG index is expected to be around 55% higher than the R1KV index (14% vs 9%).

In this 24/7, Facebook, Twitter society we live in, investing has never been more challenging with the avalanche of daily news. The ultra-low interest rates and lethargic global recovery hasn’t made my life at Sidoxia any easier. But one thing that is clear is that the investment tide is not lifting all Growth and Value stocks at the same pace. The benefits of long-term Growth investing are clear, and in an environment plagued by a scarcity of growth, it is becoming more important than ever when reviewing your investment portfolios to ask yourself, “Got Growth?”

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 KO/PG (non-discretionary accounts) and certain exchange traded fund positions, but at the time of publishing SCM had no direct position in TWTR, FB, WFC, AXP, IWF, IWD 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.

August 16, 2014 at 6:18 pm 1 comment

Searching for the Market Boogeyman

Ghost

With the stock market reaching all-time record highs (S&P 500: 1900), you would think there would be a lot of cheers, high-fiving, and back slapping. Instead, investors are ignoring the sunny, blue skies and taking off their rose-colored glasses. Rather than securely sleeping like a baby (or relaxing during a three-day weekend) with their investment accounts, people are biting their fingernails with clenched teeth, while searching for a market boogeyman in their closets or under their beds.

If you don’t believe me, all you have to do is pick up the paper, turn on the TV, or walk over to the office water cooler. An avalanche of scary headlines that are spooking investors include geopolitical concerns in Ukraine & Thailand, slowing housing statistics, bearish hedge fund managers (i.e., Tepper Einhorn, Cooperman), declining interest rates, and collapsing internet stocks. In other words, investors are looking for things to worry about, despite record corporate profits and stock prices. Peter Lynch, the manager of the Magellan Fund that posted +2,700% in gains from 1977-1990, put short-term stock price volatility into perspective:

“You shouldn’t worry about it. You should worry what are stocks going to be 10 years from now, 20 years from now, 30 years from now.”

 

Rather than focusing on immediate stock market volatility and other factors out of your control, why not prioritize your time on things you can control. What investors can control is their asset allocation and spending levels (budget), subject to their personal time horizons and risk tolerances. Circumstances always change, but if people spent half the time on investing that they devoted to planning holiday vacations, purchasing a car, or choosing a school for their child, then retirement would be a lot less stressful. After realizing 99% of all the short-term news is nonsensical noise, the next important realization is stocks are volatile securities, which frequently go down -10 to -20%. As much as amateurs and professionals say or think they can profitably predict these corrections, they very rarely can. If your stomach can’t handle the roller-coaster swings, then you shouldn’t be investing in the stock market.

Bear-markets generally coincide with recessions, and since World War II, Americans experience about two economic contractions every decade. And as I pointed out earlier in A Series of Unfortunate Events, even during the current massive bull market, a recession has not been required to suffer significant short-term losses (e.g., Flash Crash, Greece, Arab Spring, Obamacare, Cyprus, etc.). Seasoned veterans understand these volatile periods provide incredible investment opportunities. As Warren Buffett states, “Be fearful when others are greedy, and be greedy when others are fearful.” Fear and panic may be behind us, but skepticism is still firmly in place. Buying during current skepticism is still not a bad thing, as long as greed hasn’t permeated the masses, which remains the case today.

Overly emotional people that make investment decisions with their gut do more damage to their savings accounts than conservative, emotional investors who understand their emotional shortcomings. On the other hand, the problem with investing too conservatively, for those that have longer-term time horizons (10+ years), is multi-pronged. For starters, overly conservative investments made while interest rate levels hover near historical lows lead to inflationary pressures gobbling up savings accounts. Secondly, the low total returns associated with excessively conservative investments will result in a later retirement (e.g., part-time Wal-Mart greeter in your 80s), or lower quality standard of living (e.g., macaroni & cheese dinners vs. filet mignon).

Most people say they understand the trade-offs of risk and return. Over the long-run, low-risk investments result in lower returns than high risk investments (i.e., bonds vs. stocks). If you look at the following chart and ask anyone what their preferred path would be over the long-run, almost everyone would select the steep, upward-sloping equity return line.

Source: Betterment.com / Stocks for the Long Run

Source: Betterment.com / Stocks for the Long Run

Yet, stock ownership and attitudes towards stocks remain at relatively low and skeptical levels (see Gallup survey in Markets Soar and Investors Snore). It’s true that attitudes are changing at a glacial pace and bond outflows accelerated in 2013, but more recently stock inflows remain sporadic and scared money is returning to bonds. Even though it has been over five years, the emotional scars from 2008-2009 apparently still need some time to heal.

Investing in stocks can be very scary and hazardous to your health. For those millions of investors who realize they do not hold the emotional fortitude to withstand the ups and downs, leave the worrying responsibilities to the experienced advisors and investment managers like me. That way you can focus on your job and retirement, while the pros can remain responsible for hunting and slaying the boogeyman.

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 and WMT, 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.

May 24, 2014 at 4:26 pm 1 comment

Controlling the Investment Lizard Brain

Brain

“Normal fear protects us; abnormal fear paralyses us.”

- Martin Luther King, Jr.

 

Investing is challenging enough without bringing emotions into the equation. Unfortunately, humans are emotional, and as a result investors often place too much reliance on their feelings, rather than using objective information to drive rational decision making.

What causes investors to make irrational decisions? The short answer: our “amygdala.” Author and marketer Seth Godin calls this almond-shaped tissue in the middle of our head, at the end of the brain stem, the “lizard brain” (video below). Evolution created the amygdala’s instinctual survival flight response for lizards to avoid hungry hawks and humans to flee ferocious lions.

 

Over time, the threat of  lions eating people in our modern lives has dramatically declined, but the human’s “lizard brain” is still running in full gear, worrying about  other fear-inducing warnings like Iran, Syria, Obamacare, government shutdowns, taxes, Cyprus, sequestration, etc. (see Series of Unfortunate Events)

When the brain in functioning properly, the prefrontal cortex (the front part of the brain in charge of reasoning) is actively communicating with the amygdala. Sadly, for many people, and investors, the emotional response from the amygdala dominates the rational reasoning portion of the prefrontal cortex. The best investors and traders have developed the ability of separating emotions from rational decision making, by keeping the amygdala in check.

With this genetically programmed tendency of constantly fearing the next lion or stock market crash, how does one control their lizard brain from making sub-optimal, rash investment decisions? Well, the first thing you should do is turn off the TV. And by turning off the TV, I mean stop listening to talking head commentators, economists, strategists, analysts, neighbors, co-workers, blogger hacks, newsletter writers, journalists, and other investing “wannabes”. Sure, you could throw my name into the list of people to ignore if you wanted to, but the difference is, at least I have actually invested real money for over 20 years (see How I Managed $20,000,000,000.00), whereas the vast majority of those I listed have not. But don’t take my word for it…listen or read the words of other experienced investors Warren Buffett, Peter Lynch, Ron Baron,  John Bogle, Phil Fisher, and other investment titans (see also Sidoxia Hall of Fame). These investment legends have successful long-term investment track records and they lived through wars, recessions, financial crises, and other calamities…and still managed to generate incredible returns.

Another famed investor, William O’Neil, summed this idea nicely by adding the following:

“Since the market tends to go in the opposite direction of what the majority of people think, I would say 95% of all these people you hear on TV shows are giving you their personal opinion. And personal opinions are almost always worthless … facts and markets are far more reliable.”

 

The Harmful Consequence of Brain on Pain

Besides forcing damaging decisions, another consequence of our lizard brain is its ability to distort reality. Behavioral economists Daniel Kahneman (Nobel Prize winner) and Amos Tversky through their research demonstrated the pain of $50 loss is more than twice as painful as the pleasure from $50 gain (see Pleasure/Pain Principle). Common sense would dictate our brains would treat equivalent scenarios in a proportional manner, but as the chart below shows, that is not the case:

Source: Investopedia

Source: Investopedia

Kahneman adds to the decision-making relationship of the amygdala and prefrontal cortex by describing the concepts of instinctual and deliberative choices in his most recent book, Thinking Fast and Slow  (see Decision Making on Freeways).

Optimizing Risk

Taking excessive risks in technology stocks in the 1990s or in housing in the mid-2000s was very damaging to many investors, but as we have seen, our lizard brains can cause investors to become overly risk averse. Over the last five years, many people have personally experienced the ill effects of unwarranted conservatism. Investment great Sir John Templeton summed up this risk by stating, “The only way to avoid mistakes is not to invest – which is the biggest mistake of all.”

Every person has a different perception and appetite for risk. The optimal amount of risk taken by any one investor should be driven by their unique liquidity needs and time horizon…not a perceived risk appetite. Typically risk appetites go up as markets peak, and conservatism reaches a fearful apex near market bottoms – the opposite tendency of rational decision making. Besides liquidity and time horizon, a focus on valuation coupled with diversification across asset class (stocks/bonds), geography (domestic/international), size (small/large), style (value/growth) is critical in controlling risk. If you can’t determine your personal, optimal risk profile, then find an experienced and knowledgeable investment advisor to assist you.

With the advent of the internet and mobile communication, our brains and amygdala continually get bombarded with fearful stimuli, leading to disastrous decision-making and damaging portfolio outcomes. Turning off the TV and selectively choosing the proper investment advice is paramount in keeping your amygdala in check. Your lizard brain may protect you from getting eaten by a lion, but falling prey to this structural brain flaw may eat your investment portfolio alive.

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold 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.

January 11, 2014 at 4:39 pm 6 comments

Bernanke: Santa Claus or Grinch?

Santa - Grinch

I’ve written plenty about my thoughts on the Fed (see Fed Fatigue) and all the blathering from the media talking heads. Debates about the timing and probability of a Fed “taper” decision came to a crescendo in the recent week. As is often the case, the exact opposite of what the pundits expected actually happened. It was not a huge surprise the Federal Reserve initiated a $10 billion tapering of its $85 billion monthly bond buying program, but going into this week’s announcement, the betting money was putting their dollars on the status quo.

With the holiday season upon us, investors must determine whether the tapered QE1/QE2/QE3 gifts delivered by Bernanke are a cause for concern. So the key question is, will this Santa Claus rally prance into 2014, or will the Grinch use the taper as an excuse to steal this multi-year bull market gift away?

Regardless of your viewpoint, what we did learn from this week’s Fed announcement is that this initial move by the Fed will be a baby step, reducing mortgage-backed and Treasury security purchases by a measly $5 billion each. I say that tongue in cheek because the total global bond market has been estimated at about $80,000,000,000,000 (that’s $80 trillion).

As I’ve pointed out in the past, the Fed gets way too much credit (blame) for their impact on interest rates (see Interest Rates: Perception vs Reality). Interest rates even before this announcement were as high/higher than when QE1 was instituted. What’s more, if the Fed has such artificial influence over interest rates, then why do Austria, Belgium, Canada, Denmark, Finland, France, Germany, Japan, Netherlands, Sweden, and Switzerland all have lower 10-year yields than the U.S.? Maybe their central banks are just more powerful than our Fed? Unlikely.

Dow 128,000 in 2053

Readers of Investing Caffeine know I have followed the lead of investing greats like Warren Buffett and Peter Lynch, who believe trying to time the markets is a waste of your time. In a recent Lynch interview, earlier this month, Charlie Rose asked for Lynch’s opinion regarding the stock market, given the current record high levels. Here’s what he had to say:

“I think the market is fairly priced on what is happening right now. You have to say to yourself, is five years from now, 10 years from now, corporate profits are growing about 7 or 8% a year. That means they double, including dividends, about every 10 years, quadruple every 20, go up 8-fold every 40. That’s the kind of numbers you are interested in. The 10-year bond today is a little over 2%. So I think the stock market is the best place to be for the next 10, 20, 30 years. The next two years? No idea. I’ve never known what the next two years are going to bring.”

READ MORE ABOUT PETER LYNCH HERE

Guessing is Fun but Fruitless

I freely admit it. I’m a stock-a-holic and member of S.A. (Stock-a-holic’s Anonymous). I enjoy debating the future direction of the economy and financial markets, not only because it is fun, but also because without these topics my blog would likely go extinct. The reality of the situation is that my hobby of thinking and writing about the financial markets has no direct impact on my investment decisions for me or my clients.

There is no question that stocks go down during recessions, and an average investor will likely live through at least another half-dozen recessions in their lifetime. Unfortunately, speculators have learned firsthand about the dangers of trading based on economic and/or political headlines during volatile cycles. That doesn’t mean everyone should buy and do nothing. If done properly, it can be quite advantageous to periodically rebalance your portfolio through the use of various valuation and macro metrics as a means to objectively protect/enhance your portfolio’s performance. For example, cutting exposure to cyclical and debt-laden companies going into an economic downturn is probably wise. Reducing long-term Treasury positions during a period of near-record low interest rates (see Confessions of a Bond Hater) as the economy strengthens is also likely a shrewd move.

As we have seen over the last five years, the net result of investor portfolio shuffling has been a lot of pain. The acts of panic-selling caused damaging losses for numerous reasons, including a combination of agonizing transactions costs; increased inflation-decaying cash positions; burdensome taxes; and a mass migration into low-yielding bonds. After major indexes have virtually tripled from the 2009 lows, many investors are now left with the gut-wrenching decision of whether to get back into stocks as the markets reach new highs.

As the bulls continue to point to the scores of gifts still lying under the Christmas tree, the bears are left hoping that new Fed Grinch Yellen will come and steal all the presents, trees, and food from the planned 2014 economic feast. There are still six trading days left in the year, so Santa Bernanke cannot finish wrapping up his +30% S&P 500 total return gift quite yet. Nevertheless, ever since the initial taper announcement, stocks have moved higher and Bernanke has equity investors singing “Joy to the World!

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold 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.

December 22, 2013 at 1:45 am Leave a comment

Organizing Your Investment Basket

basket

With the Easter bunny relaxing after a busy holiday, kids from all over are given the task of organizing the candy and money collected during their hunts. Investors are also constantly reminded that their portfolio eggs should not be solely placed in one basket either. Instead, investors are told to diversify their investments across a whole host of asset classes, geographies, styles, and sizes. In other words, this means investors should be spreading their money across commodity, real estate, international, emerging market, value, growth, small-cap, and large-cap investments. As Jason Zweig, journalist from a the Wall Street Journal points out, much of the diversification benefits can be achieved with relatively small change in the position count of a portfolio:

“As many studies have shown, at least 40% of the variability in returns can be reduced by moving from a single company to 20. Once a portfolio contains 20 or 30 stocks, adding more does little to damp the fluctuations in wealth over time.”

 

But wait. Going from one banking stock to 20 banking stocks is not going to provide you with the proper diversification you want or need. Rather, what is as important as investing across asset class, geography, style, and size, is to follow the individual stock strategies of guru Peter Lynch. In order to put his performance into perspective, Lynch’s Fidelity Magellan fund averaged +29% per year from 1977 – 1990 – almost doubling the return of the S&P 500 index for that period.

More specifically, to achieve these heroic returns, Lynch divided the stocks in his fund into the following categories:

Slow Growers: This group of stocks wasn’t Lynch’s favorite because these companies typically operate in mature industries with limited expansion opportunities. For these single-digit EPS growers, Lynch focused more on identifying high dividend-paying stocks that were trading at attractive valuations. In particular, he paid attention to a dividend-adjusted PEG ratio (Price-to-Earnings Growth). A utility company would be an example of a “Slow Grower.”

Stalwarts: These are large established companies that still have the ability to achieve +10% to +12% annual earnings growth regardless of the economic cycle. Lynch liked these stocks especially during recessions and downturns. Valuations are still very important for Stalwarts, and many of them pay dividends. An investor may not realize a “home run” with respect to returns, but a +30% to 50% return over a few years is not out of the question, if selected correctly. Former examples of “Stalwarts” include Coca Cola (KO) and Procter & Gamble (PG).

Fast Growers: This categorization applies to small aggressive firms averaging about +20% to +25% annual earnings growth. While “Fast Growers” offer the most price appreciation potential, these stocks also offer the most risk, especially once growth/momentum slows. If timed correctly, as Lynch adeptly achieved, these stocks can increase multi-fold in value. The great thing about these “Fast Growers” is they don’t have to reside in fast growth industries. Lynch actually preferred market share gainers in legacy industries.

Cyclicals: These companies tend to see their sales and profits rise and fall with the overall economic cycle. The hyper-sensitivity to economic fluctuations makes the timing on these stocks extremely tricky, leading to losses and tears – especially if you get in too late or get out too late. To emphasize his point, Lynch states, “Cyclicals are like blackjack: stay in the game too long and it’s bound to take all your profit.” The other mistake inexperienced investors make is mistaking a “Cyclical” company as a “Stalwart” at the peak of a cycle. Examples of cyclical industries include airline, auto, steel, travel, and chemical industries.

Turnarounds: Lynch calls these stocks, “No Growers,” and they primarily of consist of situations like bail-outs, spin-offs, and restructurings. Unlike cyclical stocks, “Turnarounds” are usually least sensitive to the overall market. Even though these stocks are beaten down or depressed, they are enormously risky. Chyrysler, during the 1980s, was an example of a favorable Lynch turnaround.

Asset Plays: Overlooked or underappreciated assets such as real estate, oil reserves, patented drugs, and/or cash on the balance sheet are all examples of “Asset Plays” that Lynch would consider. Patience is paramount with these types of investments because it may take considerable time for the market to recognize such concealed assets.

Worth noting is that not all stocks remain in the same Lynch category. Apple Inc. (AAPL) is an example of a “Fast Grower” that has migrated to “Stalwart” or “Slow Grower” status, therefore items such as valuation and capital deployment (dividends and share buyback) become more important.

Peter Lynch’s heroic track record speaks for itself. Traditional diversification methods of spreading your eggs across various asset class baskets is useful, but this approach can be enhanced by identifying worthy candidates across Lynch’s six specific stock categories. Hunting for these winners is something Lynch and the Easter bunny could both agree upon.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) and AAPL, but at the time of publishing SCM had no direct position in KO, PG, Chrysler, Fidelity Magellan, 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 7, 2013 at 12:24 am Leave a comment

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