Posts tagged ‘Peter Lynch’

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.

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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

Twinkie Investing – Sweet but Unhealthy

Source: Photobucket

It’s a sad day indeed in our history when the architect of the Twinkies masterpiece cream-filled sponge cakes (Hostess Brands) has been forced to close operations and begin bankruptcy liquidation proceedings. Food snobs may question the nutritional value of the artery-clogging delights, but there is no mistaking the instant pleasure provided to millions of stomachs over the 80+ years of the Twinkies dynasty. Most consumers understand that a healthy version of an organic Twinkie will not be found on the shelves of a local Whole Foods Market (WFM) store anytime soon. The reason people choose to consume these 150-calorie packages of baker bliss is due to the short-term ingestion joy, not the vitamin content (see Nutritional Facts below). Most people agree the sugar high gained from devouring half a box of Twinkies outweighs the long-term nourishing benefits reaped by eating a steamed serving of alfalfa sprouts.

Much like dieting, investing involves the trade-offs between short-term impulses and long-term choices. Unfortunately, the majority of investors choose to react to and consume short-term news stories, very much like the impulse Twinkie gorging, rather than objectively deciphering durable trends that can lead to outsized gains. Day trading and speculating on the headline du jour are often more exciting than investing, but these emotional decisions usually end up being costlier to investors over the long-run.  Politically, we face the same challenges as Washington weighs the simple, short-term decisions of kicking the fiscal debt and deficits down the road, versus facing the more demanding, long-term path of dealing with these challenges.

With controversial subjects like the fiscal cliff, entitlement reform, taxation, defense spending, and gay marriage blasting over our airwaves and blanketing newspapers, no wonder individuals are defaulting to reactionary moves. As you can see from the chart below, the desire for a knee jerk investment response has only increased over the last 70 years. The average holding period for equity mutual funds has gone from about 5 years (20% turnover) in the mid 1960s to significantly less than 1 year (> 100% turnover) in the recent decade. Advancements in technology have lowered the damaging costs of transacting, but the increased frequency, coupled with other costs (impact, spread, emotional, etc.), have been shown to be detrimental over time, according to John Bogle at the Vanguard Group.

Source: John Bogle (Vanguard Group)

During volatile periods, like this post-election period, it is always helpful to turn to the advice of sage investors, who have successfully managed through all types of unpredictable periods. Rather than listening to the talking heads on TV and radio, or reading the headline of the day, investors would be better served by following the advice of great long-term investors like these:

 “In the short run the market is a voting machine. In the long run it’s a weighing machine.” -Benjamin Graham (Famed value investor)

“Excessive short-termism results in permanent destruction of wealth, or at least permanent transfer of wealth.” -Jack Gray (Grantham, Mayo, Van Otterloo)

“The stock market serves as a relocation center at which money is moved from the active to the patient.” - Warren Buffett (Berkshire Hathaway)

 “It was never my thinking that made big money for me. It always was my sitting.” – Jesse Livermore (Famed trader)

“The farther you can lengthen your time horizon in the investment process, the better off you will be.”- David Nelson (Legg Mason)

 “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.” T. Rowe Price (Famed Growth Investor)

 “Time arbitrage just means exploiting the fact that most investors…tend to have very short-term time horizons.” -Bill Miller (Famed value investor)

“Long term is not a popular time-horizon for today’s hedge fund short-term mentality. Every wiggle is interpreted as a new secular trend.” -Don Hays (Hays Advisory – Investor/Strategist)

A legendary growth investor who had a major impact on how I shaped my investment philosophy is Peter Lynch. Mr. Lynch averaged a +29% return per year from 1977-1990. If you would have invested $10,000 in his Magellan fund on the first day he took the helm, you would have earned $280,000 by the day he retired 13 years later. Here’s what he has to say on the topic of long-term investing:

 “Your ultimate success or failure will depend on your ability to ignore the worries of the world long enough to allow your investments to succeed.”

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”

 “My best stocks performed in the 3rd year, 4th year, 5th year, not in the 3rd week or 4th week.”

 “The key to making money in stocks is not to get scared out of them.” 

“Worrying about the stock market 14 minutes per year is 12 minutes too many.”

It is important to remember that we have been through wars, assassinations, banking crises, currency crises, terrorist attacks, mad-cow disease, swine flu, recessions, and more. Through it all, our country and financial markets most have managed to survive in decent shape. Hostess and its iconic Twinkies brand may be gone for now, but removing these indulgent impulse items from your diet may be as beneficial as eliminating detrimental short-term investing urges.

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), but at the time of publishing SCM had no direct positions in WFM, BRKA/B, LM, TROW or 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.

November 18, 2012 at 9:38 pm 1 comment

Sifting Through the Earnings Rubble

An earthquake of second quarter earnings results have rocked the markets (better than expected earnings but sluggish revenues), and now investors are left to sift through the rubble. With thousands of these earnings reports rolling in (and many more in the coming weeks), identifying the key investment trends across sectors, industries, and geographies can be a challenging responsibility. If this was an easy duty, I wouldn’t have a job! Fortunately, having a disciplined process to sort through the avalanche of quarterly results can assist you in discovering both potential threats and opportunities.

But first things first: You will need some type of reliable screening tool in order to filter find exceptional stocks. According to Reuters, there are currently more than 46,000 stocks in existence globally. Manually going through this universe one stock at a time is not physically or mentally feasible for any human to accomplish, over any reasonable amount of time. I use several paid-service screening tools, but there are plenty of adequate free services available online as well.

Investing with the 2-Sided Coin

 

As Warren Buffett says, “Value and growth are two sides of the same coin.” Having a disciplined screening process in place is the first step in finding those companies that reflect the optimal mix between growth and value. I am willing to pay an elevated price (i.e., higher P/E ratio) for a company with a superior growth profile, but I want a more attractive value (i.e., cheaper price) for slower growth companies. I am fairly agnostic between the mix of the growth/value weighting dynamics, as long as the risk-reward ratio is in my favor.

Since I firmly believe that stock prices follow the long-term trajectory of earnings and cash flows, I fully understand the outsized appreciation opportunities that can arise from the “earnings elite” – the cream of the crop companies that are able to sustain abnormally high earnings growth. Or put in baseball terms, you can realize plenty of singles and doubles by finding attractively priced growth companies, but as Hall of Fame manager Earl Weaver says, “You win many more games by hitting a three-run homer than you do with sacrifice bunts.” The same principles apply in stock picking. Legendary growth investor Peter Lynch (see also Inside the Brain of an Investing Genius) is famous for saying, “You don’t need a lot of good hits every day. All you need is two to three goods stocks a decade.”

Some past successful Sidoxia Capital Management examples that highlight the tradeoff between growth and value include Wal-Mart stores (WMT) and Amazon.com (AMZN). Significant returns can be achieved from slower, mature growth companies like Wal-Mart if purchased at the right prices, but multi-bagger home-run returns (i.e., more than doubling) require high octane growth from the likes of global internet platform companies. Multi-bagger returns from companies like Amazon, Apple Inc. (AAPL), and others are difficult to find and hold in a portfolio for years, but if you can find a few, these winners can cure a lot of your underperforming sins.

Defining Growth

Fancy software may allow you to isolate those companies registering superior growth in sales, earnings, and cash flows, but finding the fastest growing companies can be the most straightforward part. The analytical heavy-lifting goes into effect once an investor is forced to determine how sustainable that growth actually is, while simultaneously determining which valuation metrics are most appropriate in determining fair value. Some companies will experience short-term bursts of growth from a single large contract; from acquisitions; and/or from one-time asset sale gains. Generally speaking, this type of growth is less valuable than growth achieved by innovative products, service, and marketing.

The sustainability of growth will also be shaped by the type of industry a company operates in along with the level of financial leverage carried. For instance, in certain volatile, cyclical industries, sequential growth (e.g. the change in results over the last three months) is the more relevant metric. However for most companies that I screen, I am looking to spot the unique companies that are growing at the healthiest clip on a year-over-year basis. These recent three month results are weighed against the comparable numbers a year ago. This approach to analyzing growth removes seasonality from the equation and helps identify those unique companies capable of growing irrespective of economic cycles.

Given that we are a little more than half way through Q2 earnings results, there is still plenty of time to find those companies reporting upside fundamental earnings surprises, while also locating those quality companies unfairly punished for transitory events. Now’s the time to sift through the earnings rubble to find the remaining buried stock gems.

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, AMZN, AAPL, 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.

July 29, 2012 at 12:32 am Leave a comment

Sidoxia’s Investor Hall of Fame

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.

April 16, 2012 at 11:12 am 1 comment

Box Wine, Facebook and PEG Ratios

I’m no wine connoisseur, but I do know I would pay more for a bottle of Dom Pérignon champagne than I would pay for a container of Franzia box wine. In the world of stocks, the quality disparity is massive too. In order to navigate the virtually infinite number of stocks, we need to have an instrument in our toolbox that can assist us in accurately comparing stocks across the quality spectrum. Thank goodness we have the handy PEG ratio (Price/Earnings to Growth) that elegantly marries the price paid for a stock (as measured by the P/E ratio) with the relative quality of the stock (as measured by its future earnings growth rate).

Famed investor Peter Lynch (see Inside the Brain of an Investing Genius) understood the PEG concept all too well as he used this tool religiously in valuing and analyzing different companies. Given that Lynch earned a +29% annual return from 1977-1990, I’ll take his word for it that the PEG ratio is a useful tool. As highlighted by Lynch (and others), the key factor in using the PEG ratio is to identify companies that trade with a PEG ratio of less than 1. All else equal, the lower the ratio, the better potential for future price appreciation. Facebook Vs. Eastman Kodak

To illustrate the concept of how a PEG ratio can be used to compare stocks with two completely different profiles, let’s start by answering a few questions. Would a rational investor pay the same price (i.e., Price-Earnings [P/E] ratio) for a company with skyrocketing profits as they would for a company going into bankruptcy? Look no further than the lofty expected P/E multiple to be afforded to the shares of the widely anticipated Facebook (FB) initial public offering (IPO). That same rational investor is unlikely to pay the same P/E multiple for a money losing company like Eastman Kodak Co. (EKDKQ.PK) that faces product obsolescence. The contrasting values for these two companies are stark. Some pundits are projecting that Facebook shares could fetch upwards of a 100x P/E ratio, while not too long ago, Kodak was trading at a P/E ratio of 4x. Plenty of low priced stocks have outperformed expensive ones, but remember, just because a “value” stock may have a lower absolute P/E ratio in the recent past, does not mean it will be a better investment than a “growth” stock sporting a higher P/E ratio (see Fallacy of High P/Es).

Price, Earnings, and Dividends

As I’ve written in the past, a key determinant of future stock prices is future earnings growth (see It’s the Earnings Stupid). The higher the P/E multiple, the more important future earnings growth becomes. The lower the future growth, the more important valuation and dividends become.

We can look at various money-making scenarios that incorporate these factors. If my goal were to double my money in 5 years (i.e., earn a 100% return), there are numerous ways to skin the profit-making cat. Here are four examples:

1) Buy a non-dividend paying stock of a company that achieves earnings growth of 15%/year and maintains its current P/E ratio over time.

2) Buy a stock of a company that has a 5% dividend and achieves earnings growth of 11%/year and maintains its current P/E ratio over time.

3) Buy a value stock with a 5% dividend that achieves earnings growth of 5%/year and increase its P/E ratio by 10% each year.

4) Buy a non-dividend paying growth stock that achieves earnings growth of 20%/year and decreases its P/E ratio by about 5% each year.

I think you get the idea, but as you can see, in addition to earnings growth, dividends and valuation do play a significant role in how an investor can earn excess returns.

Lynch’s Adjusted PEG

Peter Lynch added a slight twist to the traditional PEG analysis by accounting for the role of dividends in the denominator of the PEG equation:

PEG (adjusted by Lynch) = PE Ratio/(Earnings Growth Rate + Dividend Yield)

This “adjusted PEG” ratio makes intuitive sense under various perspectives. For starters, if two different companies both had a PEG ratio of 0.8, but one of the two stocks paid a 3% dividend, Lynch’s adjusted PEG would register in at a more attractive level of 0.6 for the dividend paying stock.

Looked at under a different lens, let’s suppose there are two lemonade stands that IPO their stocks at the same time, and both companies use the exact same business model. Moreover, let us assume the following:

• Lemonade stand #1 has a P/E of 14x and growth rate of 15%.

• Lemonade stand #2 has a P/E of 12x and growth rate of 8%, but it also pays a dividend of 3%.

Given this information, which one of the two lemonade stands would you invest in? Many investors see the lower P/E of Lemonade stand #2, coupled with a nice dividend, as the more attractive opportunity of the two. But as we can see from Lynch’s “adjusted PEG” ratio, Lemonade stand #1 actually has the lower, more attractive value (.9 or 14/15 vs 1.1 or 12/(8+3)).

This analysis may be delving into the weeds a bit, but this framework is critical nonetheless. Valuation and earnings projections should be essential components of any investment decision, and with record low interest rates, dividend yields are playing a much more important role in the investment selection process. Regardless of your purchase decision thought process, whether deciding between Dom Perignon and box wine, or Facebook and Kodak shares, having the PEG ratio at your disposal should help you make wise and lucrative decisions.

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 FB, EKDKQ.PK, 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.

February 18, 2012 at 9:39 pm 8 comments

Sweating Your Way to Investment Success

Source: StopSweatyArmpits.com

There are many ways to make money in the financial markets, but if this was such an easy endeavor, then everybody would be trading while drinking umbrella drinks on their private islands. I mean with all the bright blinking lights, talking baby day traders, and software bells and whistles, how difficult could it actually be? 

Unfortunately, financial markets have a way of driving grown men (and women) to tears, usually when confidence is at or near a peak. The best investors leave their emotions at the door and follow a systematic disciplined process. Investing can be a meat grinder, but the good news is one does not need to have a 90% success rate to make it lucrative. Take it from Peter Lynch, who averaged a +29% return per year while managing the Magellan Fund at Fidelity Investments from 1977-1990. “If you’re terrific in this business you’re right six times out of 10,” says Lynch. 

Sweating Way to Success

If investing is so tough, then what is the recipe for investment success? As the saying goes, money management requires 10% inspiration and 90% perspiration. Or as strategist and long-time investor Don Hays notes, “You are only right on your stock purchases and sales when you are sweating.” Buying what’s working and selling what’s not, doesn’t require a lot of thinking or sweating (see Riding the Wave), just basic pattern recognition. Universally loved stocks may enjoy the inertia of upward momentum, but when the music stops for the Wall Street darlings, investors rarely can hit the escape button fast enough. Cutting corners and taking short-cuts may work in the short-run, but usually ends badly.

Real profits are made through unique insights that have not been fully discovered by market participants, or in other words, distancing oneself from the herd. Typically this means investing in reasonably priced companies with significant growth prospects, or cheap out-of-favor investments. Like dieting, this is easy to understand, but difficult to execute. Pulling the trigger on unanimously hated investments or purchasing seemingly expensive growth stocks requires a lot of blood, sweat, and tears. Eating doughnuts won’t generate the conviction necessary to justify the valuation and excess expected return for analyzed securities.

Times Have Changed

Investing in stocks is difficult enough with equity fund flows hemorrhaging out of investor accounts like the asset class is going out of style (See ICI data via The Reformed Broker). Stocks’ popularity haven’t been helped by the heightened volatility, as evidenced by the multi-year trend in the schizophrenic  volatility index (VIX) -  escalated by the “Flash Crash,” U.S. debt ceiling debate, and European financial crisis. Globalization, which has been accelerated by technology, has only increased correlations between domestic market and international markets. As we have recently experienced, the European tail can wag the U.S. dog for long periods of time. In decades past,  concerns over economic activity in Iceland, Dubai, and Greece may not even make the back pages of The Wall Street Journal. Today, news travels at the speed of a “Tweet” for every Angela Merkel  – Nicolas Sarkozy breakfast meeting or Chinese currency adjustment, and eventually results in a sprawling front page headline.   

The equity investing game may be more difficult today, but investing for retirement has never been more important. Stuffing money under the mattress in Treasuries, money market accounts, CDs, or other conservative investments may feel good in the short run, but will likely not cover inflation associated with rising fuel, food, healthcare, and leisure costs. Regardless of your investment strategy, if your goal is to earn excess returns, you may want to check the moistness of your armpits – successful long-term investing requires a lot of sweat.

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 ETFC, 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.

January 15, 2012 at 5:08 pm 3 comments

10 Ways to Destroy Your Portfolio

With the rise and frequency of heightened volatility in recent years, investing has never been as difficult as it is today. However, the importance of investing has never been more crucial either, thanks to the rising, corrosive effects of inflation, and the uncertainty surrounding the sustainability of Social Security, pensions, and other retirement accounts.

If you are not losing enough money from our structurally flawed and loosely regulated financial industry that is inundated with conflicts of interest, here are 10 additional ways to destroy your investment portfolio:

#1. Watch and React to Sensationalist News Stories: Typically, strategists and pundits do a wonderful job of parroting the consensus du jour. With the advent of the internet, and 24/7 news cycles, it is difficult to not get caught up in the daily vicissitudes. However, the accuracy of the so-called media experts is no better than weather forecasters’ accuracy in predicting the weather three Saturdays from now at 10:23 a.m. Investors would be better served by listening to and learning from successful, seasoned veterans (see Investing Caffeine Profiles).

#2. Invest for the Short-Term and Attempt Market Timing: Investing is a marathon, and not a sprint, yet countless investors have the arrogance to believe they can time the market. A few get lucky and time the proper entry point, but the same investors often fail to time the appropriate exit point. The process works similarly in reverse, which hammers home the idea that you can be 200% wrong when you are constantly switching your portfolio positions.

#3. Blindly Invest Without Knowing Fees: Like a dripping faucet, fees, transaction costs, taxes, and other charges may not be noticeable in the short-run, but combined, these portfolio expenses can be devastating in the long-run. Whether you or your broker/advisor knowingly or unknowingly is churning your account, the practice should be immediately halted. Passive investment products and strategies like ETFs (Exchange Traded Funds), index funds, and low turnover (long time horizon / tax-efficient) investing strategies are the way to go for investors.

#4. Use Technical Analysis as a Primary Strategy: Warren Buffett openly recognizes the problem with technical analysis as evidenced by his statement, “I realized technical analysis didn’t work when I turned the charts upside down and didn’t get a different answer.” Legendary fund manager Peter Lynch adds, “Charts are great for predicting the past.” Most indicators are about as helpful as astrology, but in rare instances some facets can serve as a useful device (like a Lob Wedge in golf).

#5. Panic-Sell out of Fear & Panic-Buy out of Greed: Emotions can devastate portfolio returns when investors’ trading activity follows the herd in good times and bad. As the old saying goes, “The herd is lead to the slaughterhouse.” Gary Helms rightly identifies the role that overconfidence plays when ininvesting when he states,”If you have a great thought and write it down, it will look stupid 10 hours later.” The best investment returns are earned by traveling down the less followed path. Or as Rob Arnott describes, “In investing, what is comfortable is rarely profitable.” Get a broad range of opinions and continually test your investment thesis to make sure peer pressure is not driving key investment decisions.

#6. Ignore Valuation and Yield: Valuation is like good pitching in baseball…very important. Successful investors think about valuation similarly to skilled sports handicappers. Steven Crist summed it up beautifully when he said, “There are no ‘good’ or ‘bad’ horses, just correctly or incorrectly priced ones.” The same principle applies to investments. Dividends and yields should not be overlooked – these elements are an essential part of an investor’s long-run total return.

#7. Buy and Forget: “Buy-and-hold” is good for stocks that go up in price, and bad for stocks that go flat or decline in value. Wow, how deeply profound. As I have written in the past, there are always reasons of why you should not invest for the long-term and instead sell your position, such as: 1) new competition; 2) cost pressures; 3) slowing growth; 4) management change; 5) excessive valuation; 6) change in industry regulation; 7) slowing economy; 8 ) loss of market share; 9) product obsolescence; 10) etc, etc, etc. You get the idea.

#8. Over-Concentrate Your Portfolio: If you own a top-heavy portfolio with large weightings, sleeping at night can be challenging, and also force average investors to make bad decisions at the wrong times (i.e., buy high and sell low). While over-concentration can be risky, over-diversification can eat away at performance as well – owning a 100 different mutual funds is costly and inefficient.

#9. Stuff Money Under Your Mattress: With interest rates at the lowest levels in more than half a century, stuffing money under the mattress in the form of CDs (Certificates of Deposit), money market accounts, and low-yielding Treasuries that are earning next to nothing is counter-productive for many investors. Compounding this problem is inflation, a silent killer that will quietly disintegrate your hard earned investment portfolio. In other words, a penny saved inefficiently will depreciate rapidly.

#10. Forget Your Mistakes: Investing is a very challenging game, and it is not getting any easier. As Albert Einstein said, “Insanity is doing the same thing, over and over again, but expecting different results.” Mistakes will be made and it behooves investors to document them and learn from them. Brushing your mistakes under the carpet may make you temporarily feel better emotionally, but does nothing to help your returns.

As the year approaches a close, do yourself a favor and evaluate whether you are committing any of these damaging habits. Investing is tough enough already, without adding further ways of destroying your portfolio.

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.

November 5, 2011 at 10:36 pm 11 comments

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