Posts tagged ‘Warren Buffett’
There has been a lot of hyper-taper sensitivity of late, ever since Fed Chairman Ben Bernanke broached the subject of reducing the monthly $85 billion bond buying stimulus program during the spring. With a better than expected ADP jobs report on Wednesday and a weekly jobless claims figure on Thursday, everyone (myself) included was nervously bracing for hot November jobs number on Friday. Why fret about potentially good economic numbers? Firstly, as a money manager my primary job is to fret, and secondarily, stronger than forecasted job additions in November would likely feed the fear monster with inflation and taper alarm, thus resulting in a triple digit Dow decline and a 20 basis point spike in 10-year Treasury rates. Right?
Well, the triple digit Dow move indeed came to fruition…but in the wrong direction. Rather than cratering, the Dow exploded higher by +200 points above 16,000 once again. Any worry of a potential bond market thrashing fizzled out to a flattish whimper in the 10-year Treasury yield (to approximately 2.86%). You certainly should not extrapolate one data point or one day of trading as a guaranteed indicator of future price directions. But, in the coming weeks and months, if the economic recovery gains steam I will be paying attention to how the market reacts to an inevitable Fed tapering and likely rise in interest rates.
The Expectations Game
Interpreting the correlation between the tone of news and stock direction is a challenging endeavor for most (see Circular Conversations & Tweet), but stock prices going up on bad news has not a been a new phenomenon. Many will argue the economy has been limp and the news flow extremely weak since stock prices bottomed in early 2009 (i.e., Europe, Iran, Syria, deficits, debt downgrade, unemployment, government shutdown, sequestration, taxes, etc.), yet actual stock prices have chugged higher, nearly tripling in value. There is one word that reconciles the counterintuitive link between ugly news and handsome gains…EXPECTATIONS. When expectations in 2009 were rapidly shifting towards a Great Depression and/or Armageddon scenario, it didn’t take much to move stock prices higher. In fact, sluggish growth coupled with historically low interest rates were enough to catapult equity indices upwards – even after factoring in a dysfunctional, ineffectual political backdrop.
From a longer term economic cycle perspective, this recovery, as measured by job creation, has been the slowest since World War II (see Calculated Risk chart below). However, if you consider other major garden variety historical global banking crises, our crisis is not much different (see Oregon economic study).
While it’s true that stock prices can go up on bad news (and go down on good news), it is also possible for prices to go up on good news. Friday’s trading action after the jobs report is the proof of concept. As I’ve stated before, with the meteoric rise in stock prices, it’s my view the low hanging profitable fruit has been plucked, but there is still plenty of fruit on the trees (see Missing the Pre-Party). I am not the only person who shares this view.
Recently, legendary investor Warren Buffett had this to say about stocks (Source: Louis Navellier):
“I don’t have concerns about this market.” Buffet said stocks are “in a zone of reasonableness. Five years ago,” Buffett said, “I wrote an article for The New York Times that said they were very cheap. And every now and then, you can see that that they’re very overpriced or very underpriced.” Today, “they’re definitely not way overpriced. They’re definitely not underpriced.” “If you live long enough,” Buffett said, “you’ll see a lot higher prices. I don’t know what stocks will do next week or next month or next year, but five or 10 years from now, they are very likely to be higher.”
However, up cycles eventually run their course. As stocks continue to go up on good news, ultimately they begin to go down on good news. Expectations in time tend to get too lofty, and the market begins to anticipate a downturn. Stock prices are continually incorporating information that reflects the direction of future earnings and cash flow prospects. Looking into the rearview mirror at historical results may have some value, but gazing through the windshield and anticipating what’s around the corner is more important.
Rather than getting caught up with the daily mental somersault exercises of interpreting what the tone of news headlines means to the stock market (see Sentiment Pendulum), it’s better to take a longer-term cyclical sentiment gauge. As you can see from the chart below, waiting for the bad news to end can mean missing half of the upward cycle. And the same principle applies to good news.
Bad news can be good news for stock prices, and good news can be bad for stock prices. With the spate of recent positive results (i.e., accelerating purchasing manager data, robust auto sales, improving GDP, better job growth, and more new-home sales), perhaps good news will be good news for stock prices?
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.
Life has been challenging for the bears over the last four years. For the first few years of the recovery (2009-2010) when stocks vaulted +50%, supposedly we were still in a secular bear market. Back then the rally was merely dismissed as a dead-cat bounce or a short-term cyclical rally, within a longer-term secular bear market. Then, after an additional +50% move the commentary switched to, “Well, we’re just in a long-term trading range. The stock market hasn’t done a thing in a decade.” With major indexes now hitting all-time record highs, the pessimists are backpedaling in full gear. Watching the gargantuan returns has made it more difficult for the bears to rationalize a tripling +225% move in the S&P 600 index (Small-Cap); a +214% move in the S&P 400 index (Mid-Cap); and a +154% in the S&P 500 index (Large-Cap) from the 2009 lows.
For the unfortunate souls who bunkered themselves into cash for an extended period, the return-destroying carnage has been crippling. Making matters worse, some of these same individuals chased a frothy over-priced gold market, which has recently plunged -30% from the peak.
Bonds have generally been an OK place to be as Europe imploded and domestic political gridlock both helped push interest rates to record-lows (e.g., tough to go lower than 0% on the Fed-Funds rate). But now, those fears have subsided, and the recent rate spike from Ben Bernanke’s “taper tantrum” has caused bond bulls to reassess their portfolios (see Fed Fatigue). Staring at the greater than -90% underperformance of bonds, relative to stocks over the last four years, has been a bitter pill to swallow for fervent bond believers. The record -$9.9 billion outflow from Mr. New Normal’s (Bill Gross) Pimco Total Return Fund in June (a 26-year record) is proof of this anxiety. But rather than chase an unrelenting stock market rally, stock haters and skeptics remain stubborn, choosing to place their bond sale proceeds into their favorite inflation-depreciating asset…cash.
Crash Diet at the Buffet
I’ve seen and studied many markets in my career, but the behavioral reactions to this most-hated bull market in my lifetime have been fascinating to watch. In many respects this reminds me of an investing buffet, where those participating in the nourishing market are enjoying the spoils of healthy returns, while the skeptical observers on the sidelines are on a crash diet, selecting from a stingy menu of bread and water. Sure, there is some over-eating, heartburn, and food coma experienced by those at the stock market table, but one can only live on bread and water for so long. The fear of losses has caused many to lose their investing appetite, especially with news of sequestration, slowing China, Middle East turmoil, rising interest rates, etc. Nevertheless, investors must realize a successful financial future is much more like an eating marathon than an eating sprint. Too many retirees, or those approaching retirement, are not responsibly handling their savings. As legendary basketball player and coach John Wooden stated, “Failing to prepare is preparing to fail.”
20 Years…NOT 20 Days
I will be the first to admit the market is ripe for a correction. You don’t have to believe me, just take a look at the S&P 500 index over the last four years. Despite the explosion to record-high stock prices, investors have had to endure two corrections averaging -20% and two other drops approximating -10%. Hindsight is 20-20, but at each of those fall-off periods, there were plenty of credible arguments being made on why we should go much lower. That didn’t happen – it actually was the opposite outcome.
For the vast majority of investing Americans, your investing time horizon should be closer to 20 years…not 20 days. People that understand this reality realize they are not smart enough to consistently outwit the market (see Market Timing Treadmill). If you were that successful at this endeavor, you would be sitting on your private, personal island with a coconut, umbrella drink.
Successful long-term investors like Warren Buffett recognize investors should “buy fear, and sell greed.” So while this most hated bull market remains fully in place, I will follow Buffett’s advice comfortably sit at the stock market buffet, enjoying the superior long-term returns put on my plate. Crash dieters are welcome to join the buffet, but by the time they finally sit down at the stock market table, I will probably have left to the restroom.
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), including IJR, and IJH, but at the time of publishing, SCM had no direct position in BRKA/B, Pimco Total Return Fund, 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.
“A challenge only becomes an obstacle when you bow to it.”
― Ray Davis (Famous General in the Marines)
In the investing world, one major challenge is defining the differences between “growth” vs. “value”. Warren Buffett said it best when he described growth and value as two separate sides of the same coin. In general, low or declining growth will be valued less than a comparable company with faster growth. Often, most companies go through a life cycle just like a human would (see Equity Life Cycle). In other words, companies frequently start small, grow larger, mature, and then die. Of course, some companies never grow, or because of lack of funding or outsized losses, end up suffering an early death. It’s tough to generalize with companies, because some businesses are more cat-like than human. For example, Apple Inc. (AAPL) may not have had nine lives, but the stock has been left for dead several times during its lifespan, before managing to resurrect itself from value status to growth darling (with a little assistance from Steve Jobs). Whether Tim Cook can lead Apple back to the Promised Land of growth remains to be seen, but many investors still see value.
Fluctuating price and earnings trends over a company’s life cycle frequently create confusion surrounding the proper categorization of a stock as growth or value. The other frustrating aspect to this debate is the absence of a universally accepted definition of growth and value. A few specialty companies have chosen to address this challenge. Russell Investments in Seattle, Washington is a leader in the benchmark/index creation field. Russell tackles the definitional issue by creating quantitatively based definitions, tediously explained in a thrilling 44-page paper titled, “Construction and Methodology.” Here is an exhilarating excerpt:
“Russell Investments uses a ‘non-linear probability’ method to assign stocks to the growth and value style valuation indexes. Russell uses three variables in the determination of growth and value. On the value side, book-to-price is used, while on the growth side, the I/B/E/S long-term growth variable was replaced by two variables- I/B/E/S forecast medium-term growth (2 yr) and sales per share historical growth (5 yr).”
As I bite my tongue in sarcasm, I like to point out that these methodologies constantly change – Russell most recently changed their methodology in 2011. What’s more, there are numerous other indexing companies that define growth and value quite differently (e.g., Standard & Poor’s, Lipper, MSCI, etc.).
Like religious beliefs that are viewed quite differently and are prone to passionate arguments, so too can be the debates over growth vs. value categorization. I’ve been brainwashed by numerous great investors (see Investor Hall Fame), and underpinning my philosophy is the belief that price follows earnings (see It’s the Earnings Stupid). As a result, I am constantly on the lookout for attractively priced stocks that have strong growth prospects. If Russell or S&P looked under the hood of my client portfolios, I’m certain they would find a healthy mix of growth and value stocks, as they define it. If they looked in Warren Buffett’s portfolio, arguably similar conclusions could be made. Most observers call Buffett a value investor, but over Buffett’s career, he has owned some of the greatest growth stocks of all-time (e.g., Coca Cola (KO), American Express Co (AXP), and Procter & Gamble (PG)).
At the end of the day, expectations embedded in the value of share prices determine future appreciation or depreciation, depending on how actual results register relative to those expectations. If stock prices are too high (as measured by the P/E, Price/Free-Cash-Flow, or other valuation metrics), slowing growth can lead to sharp and painful price declines. On the flip side, cheap or reasonably priced stocks can experience significant price appreciation if earnings and cash flows sustainably improve or accelerate.
In my view, the greatest stock pickers think about investing like sports handicapping (see What Happens in Vegas, Stays in Las Vegas). The key isn’t buying fast growth (high P/E) or slow growth (low P/E) companies, but rather discovering which stocks are mispriced. Finding heavily shorted stocks that are poised for growth, or discovering unloved stocks with underappreciated potential are both ways to make money.
While defining growth vs. value is certainly difficult, the more important challenge is calibrating a company’s future growth expectations and determining the fair price to pay for a stock based on those prospects. Investing entails many difficulties, but categorizing investors or stocks as growth or value is a less important challenge than honing forecasting and valuation skills. Investing is challenging enough without worrying about superfluous growth vs. value definitions.
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), and AAPL, but at the time of publishing SCM had no direct position in KO, AXP, PG, MHP, 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.
With trillions in cash sitting in CEO and private equity wallets, investment bankers have been chasing mergers & acquisitions with a vengeance. Unfortunately for the bankers, investor skittishness has slowed merger activity in the boardroom. Rather than aggressively stalk corporate prey, bidders look more like deer in headlights. However, animal spirits are not completely dead. Some board members have seen the light and realize the value-destroying characteristics of idle cash in a near-zero interest rate environment, so they have decided to go elephant hunting. During a nine day period alone in the first quarter of 2013, a total of $87.7 billion in elephant deals were announced:
- HJ Heinz Company (HNZ – $27.4 billion) – February 14, 2013 – Bidder: Berkshire Hathaway (BRKA)/ 3G Capital Partners.
- Virgin Media Inc. (VMED – $21.9 billion) – February 6, 2013 – Bidder: Liberty Global Inc. (LBTYA).
- Dell Inc. (DELL – $21.8 billion) – February 5, 2013 – Bidder: Silver Lake Partners LP, Michael Dell, Carl Icahn.
- NBCUniversal Media LLC 49% Stake (GE- $17.6 billion) – February 12, 2013 – Bidder: Comcast Corp. (CMCSA).
These elephant deals helped the overall M&A deal values in the United States increase by +34% in Q1 from a year ago to $167 billion (see Mergermarket report). Unfortunately, the picture doesn’t look so good on a global basis. The overall value for global M&A deals in Q1 registered $418 billion, down -7% from the first quarter of 2012. On a transaction basis, there were a total of 2,621 deals during the first three months of the year, down -20% from 3,262 deals in the comparable period last year.
With central banks across the globe pumping liquidity into the financial system and the U.S. stock market near record highs, one would think buyers would be writing big M&A checks as they wrote poems about rainbows, puppy dogs, and flowers. This is obviously not the case, so why such the sour mood?
The biggest scapegoat right now is Europe. While the U.S. economy appears to be slowly-but-surely plodding along on its economic recovery, Europe continues to dig a deeper recessionary hole. Austerity-driven fiscal policies are hindering growth, and concerns surrounding a Cypriot contagion continue to grab headlines. Although the U.S. dollar value of deals was up substantially in Q1, the number of transactions was down significantly to 703 deals from 925 in Q1-2012 (-24%). Besides buyer nervousness, unfriendly tax policy could have accelerated deals into 2012, and stole business from 2013.
Besides lackluster global M&A volume, the record low EBITDA multiples on private equity exit prices is proof that skepticism on the sustainability of the economic recovery remains uninspired. With exit multiples at a meager level of 8.2x globally, many investors are holding onto their companies longer than they would like.
While merger activity has been a mixed bag, a bright spot in the M&A world has been the action in emerging markets. In 2012, the value of global transactions was essentially flat, yet emerging market deal values were up approximately +9% to $524 billion. This value exceeded the pre-crisis M&A activity level in 2007 by $73 billion, a feat not achieved in the other regions around the globe. Although emerging markets also pulled back in Q1, this region now account for 23% of total global M&A deal values.
Elephant buyout deals in the private equity space (skewed heavily by the Heinz & Dell deals) caused results to surge in this segment during the first quarter. Private equity related buyouts accounted for the highest share of global M&A activity (~21%) since 2007. However, like the overall U.S. M&A market, the number of Q1 transactions in the buyout space (372 transactions) declined to the lowest count in about four years.
Until skepticism turns into confidence, elephant deals will continue to distort results in the M&A sector (Echostar’s [DISH] play for Sprint [S] is further evidence). However, the existence of these giant transactions could be a leading indicator for more activity in the coming quarters. If bankers want to generate more fees, they may consider giving Warren Buffett a call. Here’s what he had to say after the announcement of the Heinz deal:
“I’m ready for another elephant. Please, if you see any walking by, just call me.”
Despite the weak overall M&A activity, the hunters are out there and they have plenty of ammunition (cash).
See also: Mergermarket Monthly M&A Insider Report (April 2013)
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) and CMCSA, but at the time of publishing SCM had no direct position in HNZ, BRKA, VMED, LBTYA, DELL, GE, DISH, S or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
As Warren Buffett correctly states, “If you are in a poker game and after 20 minutes, you don’t know who the patsy is, then you are the patsy.” The same principle applies to investing and financial analysis. If you are unable to determine who is cooking (or warming) the books via deceptive practices, then you will be left holding a bag of losses as tears of regret pour down your face. The name of the stock investing game (not speculation game) is to accurately gauge the financial condition of a company and then to correctly forecast the trajectory of future earnings and cash flows.
Unfortunately for investors, many companies work quite diligently to obscure, hide, and distort the accuracy of their current financial condition. Without the ability of making a proper assessment of a company’s financials, an investor by definition will be unable to value stocks.
There are scores of accounting tricks that companies hide up their sleeves to mislead investors. Many people consider GAAP (Generally Accepted Accounting Principles) as the laws or rules governing financial reporting, but GAAP parameters actually provide companies with extensive latitude in the way accounting reports are implemented. Here are a few of the ways companies exercise their wiggle room in disclosing financial results:
Depreciation Schedules: Related to GAAP accounting, adjustments to longevity estimates by a company’s management team can tremendously impact a company’s reported earnings. For example, if a $10 million manufacturing plant is expected to last 10 years, then the depreciation expense should be $1 million per year ($10m ÷ 10 years). If for some reason the Chief Financial Officer (CFO) suddenly changes his/her mind and decides the building should last 40 years rather than 10 years, then the company’s annual expense would miraculously decrease -75% to $250,000. Voila, an instant $750,000 annual gain created out of thin air! Other depreciation tricks include the choice of accelerated or straight-line depreciation.
Capitalizing Expenses: If you were a management team member with a goal of maximizing current reported profitability, would you be excited to learn that you are not required to report expenses on your income statement? For many the answer is absolutely “yes”. A common example of this phenomenon occurs with companies in the software industry (or other companies with heavy research and development), where research expenses normally recognized on the income statement get converted instead to capitalized assets on the balance sheet. Eventually these capitalized assets get amortized (recognized as expenses) on the income statement. Proponents argue capitalizing expenses better matches future revenues to future expenses, but regardless, this scheme boosts current reported earnings, and delays expense recognition.
Stuffing the Channel: No, this is not a personal problem, but rather occurs when companies force their goods on a distributor or customer – even if the goods (or service) are not requested. This deceitful practice is performed to drive up short-term revenue, even if the reporting company receives no cash for the “stuffing”. Ballooning receivables and substandard cash flow generation can be a sign of this cunning, corporate custom.
Accounts Receivable/Loans: Ballooning receivables is a potential sign of juiced reported revenues and profits, but there are more nuanced ways of manipulating income. For instance, if management temporarily lowers warranty expenses and product return assumptions, short-term profits can be artificially boosted. In addition, when discussing financial figures for banks, loans can also be considered receivables. As we experienced in the last financial crisis, many banks under-provisioned for future bad loans (i.e. didn’t create enough cash reserves for misled/deadbeat borrowers), thereby overstating the true, underlying, fundamental earnings power of the banks.
Inventories: As it relates to inventories, GAAP accounting allows for FIFO (First-In, First-Out) or LIFO (Last-In, Last-Out) recognition of expenses. Depending on whether prices of inventories are rising or falling, the choice of accounting method could boost reported results.
Pension Assumptions: Most companies like their employees…but not the expenses they have to pay in order to keep them. Employee expenses can become excessively burdensome, especially for those companies offering their employees a defined benefit pension plan. GAAP rules mandate employers to contribute cash to the pension plan (i.e., retirement fund) if the returns earned on the assets (i.e., stocks & bonds) are below previous company assumptions. One temporary fix to an underfunded pension is for companies to assume higher plan returns in the future. For example, if companies raise their return assumptions on plan assets from 5% to a higher rate of 10%, then profits for the company are likely to rise, all else equal.
Non-GAAP (or Pro Forma): Why would companies report Non-GAAP numbers on their financial reports rather than GAAP earnings? The simple answer is that Non-GAAP numbers appear cosmetically higher than GAAP figures, and therefore preferred by companies for investor dissemination purposes.
Merger Magic: Typically when a merger or acquisition takes place, the acquiring company announces a bunch of one-time expenses that they want investors to ignore. Since there are so many moving pieces in a merger, that means there is also more opportunities to use smoke and mirrors. The recent $8.8 billion write-off of Hewlett-Packard’s (HPQ) acquisition of Autonomy is evidence of merger magic performed.
EBITDA (Earnings Before Interest Taxes Depreciation & Amortization): Skeptics, like myself, call this metric “earnings before all expenses.” Or as Charlie Munger says, Warren Buffett’s right-hand man, “Every time you see the word EBITDA, substitute it with the words ‘bulls*it earnings’!”
This is only a short-list of corporate accounting gimmicks used to distort financial results, so for the sake of your investment portfolio, please check for any potential tricks up a company’s sleeve before making an investment.
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 HPQ/Autonomy, 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.
Uncertainty is like a fin you see cutting through the water – many people are uncertain whether the fin sticking out of the water is a great white shark or a dolphin? Uncertainty generates fear, and fear often produces paralysis. This financially unproductive phenomenon has also reared its ugly fin in the investment world, which has led to low-yield apathy, and desensitization to both interest rate and inflation risks.
The mass exodus out of stocks into bonds worked well for the very few that timed an early 2008 exit out of equities, but since early 2009, the performance of stocks has handily trounced bonds (the S&P has outperformed the bond market (BND) by almost 100% since the beginning of March 2009, if you exclude dividends and interest). While the cozy comfort of bonds has suited investors over the last five years, a rude awakening awaits the bond-heavy masses when the uncertain economic clouds surrounding us eventually lift.
The Certainty of Uncertainty
What do we know about uncertainty? Well for starters, we know that uncertainty cannot be avoided. Or as former Secretary of the Treasury Robert Rubin stated so aptly, “Nothing is certain – except uncertainty.”
Why in the world would one of the world’s richest and most successful investors like Warren Buffett embrace uncertainty by imploring investors to “buy fear, and sell greed?” How can Buffett’s statement be valid when the mantra we continually hear spewed over the airwaves is that “investors hate uncertainty and love clarity?” The short answer is that clarity is costly (i.e., investors are forced to pay a cherry price for certainty). Dean Witter, the founder of his namesake brokerage firm in 1924, addressed the issue of certainty in these shrewd comments he made some 78 years ago, right before the end of worst bear market in history:
“Some people say they want to wait for a clearer view of the future. But when the future is again clear, the present bargains will have vanished.”
Undoubtedly, some investors hate uncertainty, but I think there needs to be a distinction between good investors and bad investors. Don Hays, the strategist at Hays Advisory, straightforwardly notes, “Good investors love uncertainty.”
When everything is clear to everyone, including the novice investing cab driver and hairdresser, like in the late 1990s technology bubble, the actual risk is in fact far greater than the perceived risk. Or as Morgan Housel from Motley Fool sarcastically points out, “Someone remind me when economic uncertainty didn’t exist. 2000? 2007?”
What’s There to Worry About?
I’ve heard financial bears argue a lot of things, but I haven’t heard any make the case there is little uncertainty currently. I’ll let you be the judge by listing these following issues I read and listen to on a daily basis:
- Fiscal cliff induced recession risks
- Syria’s potential use of chemical weapons
- Iran’s destabilizing nuclear program
- North Korean missile tests by questionable new regime
- Potential Greek debt default and exit from the eurozone
- QE3 (Quantitative Easing) and looming inflation and asset bubble(s)
- Higher taxes
- Lower entitlements
- Fear of the collapse in the U.S. dollar’s value
- Rigged Wall Street game
- Excessive Dodd-Frank financial regulation
- High Frequency Trading / Flash Crash
- Unsustainably growing healthcare costs
- Exploding college tuition rates
- Global warming and superstorms
I could go on for another page or two, but I think you get the gist. While I freely admit there is much less uncertainty than we experienced in the 2008-2009 timeframe, investors’ still remain very cautious. The trillions of dollars hemorrhaging out of stocks into bonds helps make my case fairly clear.
As investors plan for a future entitlement-light world, nobody can confidently count on Social Security and Medicare to help fund our umbrella-drink-filled vacations and senior tour golf outings. Today, the risk of parking your life savings in low-rate wealth destroying investment vehicles should be a major concern for all long-term investors. As I continually remind Investing Caffeine readers, bonds have a place in all portfolios, especially for income dependent retirees. However, any truly diversified portfolio will have exposure to equities, as long as the allocation in the investment plan meshes with the individual’s risk tolerance and liquidity needs.
Given all the uncertain floating fins lurking in the economic background, what would I tell investors to do with their hard-earned money? I simply defer to my pal (figuratively speaking), Warren Buffett, who recently said in a Charlie Rose interview, “Overwhelmingly, for people that can invest over time, equities are the best place to put their money.” For the vast majority of investors who should have an investment time horizon of more than 10 years, that is a question I can answer with certainty.
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) including BND, but at the time of publishing SCM had no direct positions 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.
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.
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.
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.
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.
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.
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.
Simon had Garfunkel, Batman had Robin, Hall had Oates, Dr. Evil had Mini Me, Sonny had Cher, and Malone had Stockton. In the investing world, Buffett has Munger. Charlie Munger is one of the most successful and famous wingmen of all-time - evidenced by Berkshire Hathaway Corporation’s (BRKA/B) outperformance of the S&P 500 index by approximately +624% from 1977 – 2009, according to MarketWatch. Munger not only provides critical insights to his legendary billionaire boss, Warren Buffett, but he also is Chairman of Berkshire’s insurance subsidiary, Wesco Financial Corporation. The magic of this dynamic duo began when they met at a dinner party during 1959.
In an article he published in 2006, the magnificent Munger describes the “Art of Stock Picking” in a thorough review about the secrets of equity investing. We’ll now explore some of the 88-year-old’s sage advice and wisdom.
Charlie Munger believes an individual needs a solid general education before becoming a successful investor, and in order to do that one needs to study and understand multiple “models.”
“You’ve got to have models in your head. And you’ve got to array your experience both vicarious and direct on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and in life. You’ve got to hang experience on a latticework of models in your head.”
Although Munger indicates there are 80 or 90 important models, the examples he provides include mathematics, accounting, biology, physiology, psychology, and microeconomics.
Advantages of Scale
Great businesses in many cases enjoy the benefits of scale, and Munger devotes a good amount of time to this subject. Scale advantages can be realized through advertising, information, psychological “social proofing,” and structural factors.
The newspaper industry is an example of a structural scale business in which a “winner takes all” phenomenon applies. Munger aptly points out, “There’s practically no city left in the U.S., aside from a few very big ones, where there’s more than one daily newspaper.”
General Electric Co. (GE) is another example of a company that uses scale to its advantage. Jack Welch, the former General Electric CEO, learned an early lesson. If the GE division is not large enough to be a leader in a particular industry, then they should exit. Or as Welch put it, “To hell with it. We’re either going to be # 1 or #2 in every field we’re in or we’re going to be out. I don’t care how many people I have to fire and what I have to sell. We’re going to be #I or #2 or out.”
Bigger Not Always Better
Scale comes with its advantages, but if not managed correctly, size can weigh on a company like an anchor. Munger highlights the tendency of large corporations to become “big, fat, dumb, unmotivated bureaucracies.” An implicit corruption also leads to “layers of management and associated costs that nobody needs. Then, while people are justifying all these layers, it takes forever to get anything done. They’re too slow to make decisions and nimbler people run circles around them.”
Becoming too large can also create group-think, or what Munger calls “Pavlovian Association.” Munger goes onto add, “If people tell you what you really don’t want to hear what’s unpleasant there’s an almost automatic reaction of antipathy…You can get severe malfunction in the high ranks of business. And of course, if you’re investing, it can make a lot of difference.”
Technology: Benefit or Burden?
Munger recognizes that technology lowers costs for companies, but the important question that many managers fail to ask themselves is whether the benefits from technology investments accrue to the company or to the customer? Munger summed it up here:
“There are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that’s still going to be lousy. The money still won’t come to you. All of the advantages from great improvements are going to flow through to the customers.”
Buffett and Munger realized this lesson early on when productivity improvements gained from technology investments in the textile business all went to the buyers.
Surfing the Wave
When looking for good businesses, Munger and Buffett are looking to “surf” waves or trends that will generate healthy returns for an extended period of time. “When a surfer gets up and catches the wave and just stays there, he can go a long, long time. But if he gets off the wave, he becomes mired in shallows,” states Munger. He notes that it’s the “early bird,” or company that identifies a big trend before others that enjoys the spoils. Examples Munger uses to illustrate this point are Microsoft Corp. (MSFT), Intel Corp. (INTC), and National Cash Register from the old days.
Large profits will be collected by those investors that can identify and surf those rare large waves. Unfortunately, taking advantage of these rare circumstances becomes tougher and tougher for larger investors like Berkshire. If you’re an elephant trying to surf a wave, you need to find larger and larger waves, and even then, due to your size, you will be unable to surf as long as small investors.
Circle of Competence
Circle of competence is not a new subject discussed by Buffett and Munger, but it is always worth reviewing. Here’s how Munger describes the concept:
“You have to figure out what your own aptitudes are. If you play games where other people have the aptitudes and you don’t, you’re going to lose. And that’s as close to certain as any prediction that you can make. You have to figure out where you’ve got an edge. And you’ve got to play within your own circle of competence.”
For Munger and Buffett, sticking to their circle of competence means staying away from high-technology companies, although more recently they have expanded this view to include International Business Machines (IBM), which they invested in late last year.
Market Efficiency or Lack Thereof
Munger acknowledges that financial markets are quite difficult to beat. Since the markets are “partly efficient and partly inefficient,” he believes there is a minority of individuals who can outperform the markets. To expand on this idea, he compares stock investing to the pari-mutuel system at the racetrack, which despite the odds stacked against the bettor (17% in fees going to the racetrack), there are a few individuals who can still make decent money.
The transactional costs are much lower for stocks, but success for an investor still requires discipline and patience. As Munger declares, “The way to win is to work, work, work, work and hope to have a few insights.”
Winning the Game – 10 Insights / 20 Punches
As the previous section implies, outperformance requires patience and a discriminating eye, which has allowed Berkshire to create the bulk of its wealth from a relatively small number of investment insights. Here’s Munger’s explanation on this matter:
“How many insights do you need? Well, I’d argue: that you don’t need many in a lifetime. If you look at Berkshire Hathaway and all of its accumulated billions, the top ten insights account for most of it….I don’t mean to say that [Warren] only had ten insights. I’m just saying, that most of the money came from ten insights.”
Chasing performance, trading too much, being too timid, and paying too high a price are not recipes for success. Independent thought accompanied with selective, bold decisions is the way to go. Munger’s solution to these problems is to provide investors with a Buffett 20-punch ticket:
“I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches ‑ representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all.”
The great thing about Munger and Buffett’s advice is that it is digestible by the masses. Like dieting, investing can be very simple to understand, but difficult to execute, and legends like these always remind us of the important investing basics. Even though Charlie Munger may be slowing down a tad at 88-years-old, Warren Buffett and investors everywhere are blessed to have this wingman around spreading his knowledge about investing and the art of stock picking.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
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 BRKA/B, GE, MSFT, INTC, National Cash Register, IBM, 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.