A Recipe for Disaster

Justice does not always get served in the stock market because financial markets are not always efficient in the short-run (see Black-Eyes to Classic Economists). However, over the long-run, financial markets usually get it right. And when the laws of economics and physics are functioning properly, I must admit it, I do find it especially refreshing.

There can be numerous reasons for stocks to plummet in price, but common attributes to stock price declines often include profit losses and/or disproportionately high valuations (a.k.a. “bubbles”). Normally, your garden variety, recipe for disaster consists of one part highly valued company and one part money-losing operation (or deteriorating financials). The reverse holds true for a winning stock recipe. Flavorful results usually involve cheaply valued stocks paired with improving financial results.

Unfortunately, just because you have the proper recipe of investment ingredients, doesn’t mean you will immediately get to enjoy a satisfying feast. In other words, there isn’t a dinner bell rung to signal the timing of a crash or spike – sometimes there is a conspicuous catalyst and sometimes there is not. Frequently, investments require a longer expected bake time before the anticipated output is produced.

As I alluded to at the beginning of my post, justice is not always served immediately, but for some high profile IPOs, low-quality ingredients have indeed produced low-quality results.

Snap Inc. (SNAP): Let’s first start with the high-flying social media darling Snap, which priced its IPO at $17 per share in March, earlier this year. How can a beloved social media company that generates $515 million in annual revenue (up +286% in the recent quarter) see its stock plummet -48% from its high of $29.44 to $15.27 in just four short months? Well, one way of achieving these dismal results is to burn through more cash than you’re generating in revenue. Snap actually scorched through more than -$745 million dollars over the last year, as the company reported accounting losses of -$618 million (excluding -$2 billion of stock-based compensation expenses). We’ll find out if the financial bleeding will eventually stop, but even after this year’s stock price crash, investors are still giving the company the benefit of the doubt by valuing the company at $18 billion today.

Source: Barchart.com

Blue Apron Holdings Inc. (APRN): Online meal delivery favorite, Blue Apron, is another company suffering from the post-IPO blues. After initially targeting an opening IPO price of $15-$17 per share a few weeks ago, tepid demand forced Blue Apron executives to cut the price to $10. Fast forward to today, and the stock closed at $7.36, down -26% from the IPO price, and -57% below the high-end of the originally planned range. Although the company isn’t hemorrhaging losses at the same absolute level of Snap, it’s not a pretty picture. Blue Apron has still managed to burn -$83 million of cash on $795 million in annual sales. Unlike Snap (high margin advertising revenues), Blue Apron will become a low-profit margin business, even if the company has the fortune of reaching high volume scale. Even after considering Blue Apron’s $1 billion annual revenue run rate, which is 50% greater than Snap’s $600 million run-rate, Blue Apron’s $1.4 billion market value is sadly less than 10% of Snap’s market value.

Source: Barchart.com

Groupon Inc. (GRPN): Unlike Snap and Blue Apron, Groupon also has the flattering distinction of reporting an accounting profit, albeit a small one. However, on a cash-based analysis, Groupon looks a little better than the previous two companies mentioned, if you consider an annual -$7 million cash burn “better”. Competition in the online discounting space has been fierce, and as such, Groupon has experienced a competitive haircut in its share price. Groupon’s original IPO price was $20 in January 2011 before briefly spiking to $31. Today, the stock has languished to $4 (-87% from the 2011 peak).

Source: Barchart.com

Stock Market Recipe?

Similar ingredients (i.e., valuations and profit trajectory) that apply to stock performance also apply to stock market performance. Despite record corporate profits (growing double digits), low unemployment, low inflation, low-interest rates, and a recovering global economy, bears and even rational observers have been worried about a looming market crash. Not only have the broader masses been worried today, yesterday, last week, last month, and last year, but they have also been worried for the last nine years. As I have documented repeatedly (see also Market Champagne Sits on Ice), the market has more than tripled to new record highs since early 2009, despite the strong under-current of endless cynicism.

Historically market tops have been marked by a period of excesses, including excessive emotions (i.e., euphoria). It has been a long time since the last recession, but economic downturns are also often marked with excessive leverage (e.g., housing in the mid-2000s), excessive capital (e.g., technology IPOs [Initial Public Offerings] in the late-1990s), and excessive investment (e.g., construction / manufacturing in early-1990s).

To date, we have seen little evidence of these markers. Certainly there have been pockets of excesses, including overpriced billion dollar tech unicorns (see Dying Unicorns), exorbitant commercial real estate prices, and a bubble in global sovereign debt, but on a broad basis, I have consistently said stocks are reasonably priced in light of record-low interest rates, a view also held by Warren Buffett.

The key lessons to learn, whether you are investing in individual stocks or the stock market more broadly, are that prices will follow the direction of earnings over the long-run. This helps explain why stock prices always go down in recessions (and are volatile in anticipation of recessions).

If you are looking for a recipe for disaster, just find an overpriced investment with money-losing (or deteriorating) characteristics. Avoiding these investments and identifying investments with cheap growth qualities is much easier said than done. However, by mixing an objective, quantitative framework with more artistic fundamental analysis, you will be in a position of enjoying tastier returns.

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 SNAP, APRN, GRPN, 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 the information to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

 

July 14, 2017 at 11:54 pm 3 comments

Keeping the Economy Afloat

There have been plenty of concerns about rising interest rates, flattening yield curves, and potential recessions, but we all know that consumer spending accounts for roughly two-thirds of our country’s economy. Well, I certainly met my personal economic duty this summer by putting my consumer spending responsibilities to work. Not only did my family vacation involve approximately 5,700 miles of cross-country flying, but also 1,400 miles of driving all over the East Coast. By placing my credit card charging limits to the test on hotels, Airbnb, restaurants, gasoline, and overpriced tourist activities, I may have single-handedly kept the economy afloat for the rest of 2017.

Here’s a synopsis of the Slome family adventure and my spending spree binge.

Bon Jour Montreal!

View of the city from Mount Royal.

Montréal is the cultural, French-speaking crown jewel of Canada. Unbeknownst to me, the largest city in Canada’s province of Québec is actually a floating island on the Saint Lawrence River. The city name, Montreal, is actually derived from the prominent and picturesque hill at the heart of the city, Mount Royal.

Port of Montreal – Cirque de Soleil tents in the background.

Finger Lakes Fun

Ithaca, New York is located at the base of the Finger Lakes (Cayuga Lake) in upstate New York. With a population of around 30,000, this college town is home to my business school alma mater (Cornell University), which was founded in 1865 and home to a total of more than 20,000 students.

 

Taughannock Falls, which is Native American for “great fall in the woods,” is a 215-foot waterfall making it the highest single-drop waterfall east of the Rocky Mountains.

 

My drone shot of Cayuga Lake and a small portion of the Cornell University campus.

Niagara Falls

We chose to check out the 176-foot Niagara Falls from the Canadian side of the U.S.-Canada border. About 34 million gallons per minute flows during the summer time, and our drenched extremities were proof positive of this fact.

 

Panoramic view of Niagara Falls from Journey Behind the Falls.

 

View of Horseshoe Falls from 520 feet in the air while on the rotating restaurant in the Skylon Tower.

Rockin’ It in Cleveland

Cleveland is the second-largest city in Ohio, located on Lake Eerie. Even though the Cleveland Cavaliers may have lost in the NBA Finals to the Golden State Warriors, the city still rocks. The “Forest City” is home to the famous Rock and Roll Hall of Fame designed by renowned architect I. M. Pei and the well-known West Side Market.

The iconic pyramid-shaped Rock and Roll Hall of Fame located on the beautiful Lake Eerie waterfront.

 

It’s a little known fact that Cleveland is home to the original Christmas Story movie house. The movie was set in the early-1940s but released in 1983. Nostalgic items such as the infamous leg lamp, Red Ryder Carbine Action 200-shot Range Model BB gun, and photos of Ralphie can be found in the adjacent museum.

Slomes Seize Steel City

We discovered the vibrant city of Pittsburgh, also known as the “Steel City” and “City of Bridges” (446 bridges), at the intersection of the Allegheny, Monongahela, and Ohio Rivers “Three Rivers”. This sports-driven city is home to the World Champion Penguins (hockey), Steelers (football), and Pirates (baseball) professional teams. My dad grew up here and attended the University of Pittsburgh (“Pitt”) for both his undergraduate and medical school degrees. The rolling hills landscape provides some breathtaking views of the city, especially from Mount Washington.

 

Downtown Pittsburgh from Mount Washington.

 

The 42-story Gothic Cathedral of Learning located at the center of the Pitt campus – the second tallest university building in the world.

Gettysburg – Civil War Galore

As we began our eastward trek, Gettysburg, Pennsylvania offered a beneficial dual purpose in providing both a valuable history lesson and also a pit-stop on the way to our next vacation location. It was dumb luck rather than strategic planning that landed us at Gettysburg on the 154th anniversary of the greatest but bloodiest Civil War battle in July 1863 (half way through the Civil War 1861 – 1865). The United States of America may look a lot different if the 75,000 Confederate troops led by General Robert E. Lee would have defeated the 97,000 Union troops commanded by General George Meade. However, when all was said and done, the anti-slavery Union troops defeated the Confederates over a three-day battle, which resulted in more than 6,000 deaths and greater than 50,000 casualties. President Abraham Lincoln honored the fallen Union soldiers in his famous two-minute Gettysburg address four months after the battle (November 1963). In the speech, Lincoln provided an important historical context of the battle, which ultimately turned the tide of the Civil War in the Union’s favor as they fought for human equality.

A view from the Gettysburg battlefield on the 154thanniversary of the famous Confederate-Union clash.

 

Looking for enlightenment as I sit next to Abe outside the Gettysburg Museum.

Wade Watches Washington

Stopping at the nation’s capital was a logical progression, as we continued our East Coast adventure. Whether you are a political junky or not, it’s difficult to not get sucked into the grandeur of this majestic city of roughly one million (including commuters) on the Potomac River. The District of Columbia borders the states of Virginia and Maryland and is named after President George Washington, a man who shares the same birthday with me. Between the memorials, monuments, museums, entertainment options, and restaurants, there is no shortage of activities to choose from in this spectacular city.

The Lincoln Memorial had new meaning after our Gettysburg visit.

 

We stopped to say hello to President Trump, then the president and I both decided to send out a tweet.

Beach Blast

Completing our journey at Virginia Beach was no accident. All of our speed vacationing required a little R&R, and turned out to be a blast in more than one way. Not only did we enjoy soaking in the miles of beaches and hundreds of hotels and restaurants along the oceanfront, but we also appreciated the 4th of July fireworks blasting right outside our beach resort.

Nice view outside our oceanfront room.

 

A little relaxing cruise time down the strand.

Like any vacation, the 2017 summer family adventure eventually came to an end. No matter what I believe or say, the debate about the timing of the next recession and/or bear market will rage on for eternity. But the fact remains, despite an unemployment rate of 4.4% near cyclically low levels, there is still a record high of six million job openings available, which means there is still plenty of slack in the economy to sustain economic expansion. Although I will continue to save and strive to maintain positive investment performance figures, I will also do my best to keep the economy afloat with my consumer spending and travel binging habits.

P.S. If you spend more time vacation planning than investment planning, give us a call…we can help!

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 the information to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

 

 

July 9, 2017 at 12:19 am 3 comments

Hot Dogs, Political Fireworks, and Our Nation’s Birthday

This article is an excerpt from a previously released Sidoxia Capital Management complimentary newsletter (July 3, 2017). Subscribe on the right side of the page for the complete text.

The 4th of July has arrived once again as we celebrate our country’s 241st birthday of independence. Besides being a time to binge on hot dogs, apple pie, fireworks, and baseball, this national holiday allows Americans to also reflect on the greatness created by our nation’s separation from the British Empire.

As our Founding Fathers fought for freedom and believed in a more prosperous future, I’m not sure if the signers of our Declaration of Independence (Below [left to right]: Roger Sherman, Benjamin Franklin, Thomas Jefferson, John Adams, and Robert Livingston) envisioned a world with tweeting Presidents, driverless Uber taxis, internet dating, biotechnology medical breakthroughs, cloud storage, and countless other innovations that have raised the standard of living for billions of people around the world.

(These Founding Fathers may use different pictures for their Facebook profile, if they were alive today.)

I tend to agree with the wealthiest billionaire investor on the planet, Warren Buffett, that being born in the United States is the equivalent of winning the “Ovarian Lottery.” The opportunities for finding success are exponentially higher, if you were born in America vs. Bangladesh, for example. Surprisingly, the U.S. only accounts for about 4% of the global population (325 million out of 7.5 billion world total). However, even though we Americans make up such a small portion of the of the people on the planet, we still manage to generate over $18 trillion in goods and services, which makes us the world’s largest economy. As the #1 economy, we account for almost 25% of the world’s total economic output (see table & graphic below).

Rank Country GDP (Nominal, 2015) Share of Global Economy (%)
#1 United States $18.0 trillion 24.3%
#2 China $11.0 trillion 14.8%
#3 Japan $4.4 trillion 5.9%
#4 Germany $3.4 trillion 4.5%
#5 United Kingdom $2.9 trillion 3.9%

Source: Visual Capitalist

How do we create six times the output of our population (i.e., 4% of world’s population producing 25% of the world’s output)? Despite the nasty, imperfect, mudslinging politics we live through daily, the U.S. has perfected the art of capitalism, which has landed us on top of the economic Mt. Everest. Although, there is always room for improvement, culturally, the winning “entrepreneurial” strain is born into our American DNA. The recent merger announcement between Amazon.com Inc. (AMZN) and Whole Foods (WFM), the leading natural and organic foods supermarket, is evidence of this entrepreneurial strain. Amazon has come a long way and gained significant steam since its founding in July 1994 by CEO Jeff Bezos. Consequently, the momentum of this internet giant has it steamrolling the entire retail industry, which has led to a flood of store closings, including department store chains, Macy’s, J.C. Penney, Sears and Kmart. The Amazon-Whole Foods merger announcement was not a huge surprise to my family because we actually order more than half of our groceries from AmazonFresh (Amazon’s food delivery program). What’s more, since I despise shopping, I continually find myself taking advantage of Amazon’s “Prime Now” 2-hour delivery option to my office, which is free to all Prime subscribers. It won’t be long before Amazon’s multi-channel strategy will allow me to make same-day orders for groceries, electronics, and general merchandise from my office, then pick up those items on my way home from work at the local Whole Foods store.

Leading the Pack

Replicating this competitive advantage around the world is a challenge for competing countries, and our nation remains leap years ahead of others, regardless of their efforts. However, the United States does not have a monopoly on capitalism. We are slowly exporting our entrepreneurial secret sauce abroad with the help of technology and globalization. Just consider these three Chinese companies alone are valued at almost $1 trillion (Alibaba Group $360B [BABA]; Tencent Holdings $340B [TCEHY]; and China Mobile $220B [CHL]), and the largest expected IPO (Initial Public Offering) in the world could be a Saudi Arabian company valued at $2 trillion (Saudi Aramco). When 96% of the world’s population lies outside of the U.S., this reality helps explain why exporting our advancements should not be considered a bad thing. In fact, a growing international pie means more American jobs and more dollars will flow back to the U.S., as we export more value-added products and services abroad.

Even if other countries are narrowing the entrepreneurial competitive gap with the United States, we still remain a beacon of light for others to follow. Despite what you may read in the newspaper or hear on the TV, Americans are dramatically better off financially over the last 20 years. Not only has net worth increased spectacularly, but consumers have also responsibly reduced debt leverage ratios (see chart below).

Source: Calafia Beach Pundit

If you were a bright CEO working for an innovative new start-up company, would you choose to launch your company in a closed, censored society like China? How about a fractured Britain that is pushing to break away from the European Union? Better yet, how about Japan with its exploding debt levels, a declining population, and a stock market that is about half the level it peaked at 28 years ago? Do emerging markets like Brazil with widespread corruption scandals blanketing a new president (after a recently impeached president) seem like the best location for a hot new venture? The answer to all these questions is a resounding “no”, even when compared to the warts and flaws that come with our durable democracy.

Political Pyrotechnics

Besides the bombs bursting in air during the 4th of July celebration, there were plenty of political fireworks blasting in our nation’s capital last month. No matter what side of the political fence you stand on, last month was explosive. Consider ousted FBI Director Jim Comey’s impassioned testimony relating to his firing by President Donald Trump; the contentious Attorney General Jeff Sessions Senate Intelligence Committee interview; the politically driven Republican baseball shooting; and the Special Counsel leader Robert Mueller’s investigation into Russian interference and potential Trump administration collusion into the 2016 elections.

Despite the combative atmosphere in Washington D.C., the stock market managed to notch another record high last month, with the Dow Jones Industrial Average index advancing another 340.98 points (+1.6%) for the month, and +8.0% for the first half of 2017. As I have written numerous times, the scary headlines accumulating since 2009 have prevented investors, strategists, economists, and even professionals from adequately participating in the almost quadrupling in stock prices since early 2009. Unfortunately, to the detriment of many, large swaths of investors who were burned by the 2008-2009 Financial Crisis have been scarred to almost permanent risk aversion. The fact of the matter is stock prices care more about economic factors than political / news headlines (see Moving on Beyond Politics).

The bitter, vitriolic political discourse is unlikely to disappear anytime soon, so do yourself a favor, and focus on the more important factors driving financial markets to new record highs – mainly corporate profits, interest rates, valuations, and sentiment (see Don’t Be a Fool). During this year’s 4th of July, partaking in hot dogs, apple pie, fireworks, and baseball are wholly encouraged, but please also take the time to celebrate and acknowledge the magnitude of our country’s greatness. That’s a birthday wish, I think we can all 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 AMZN and certain exchange traded funds (ETFs), but at the time of publishing had no direct position in WFM, BABA, TCEHY, CHL, 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.

July 3, 2017 at 12:24 pm Leave a comment

Sports, Stocks, & the Magic Quadrants

Vegas Betting

Picking stocks is a tricky game and so is sports betting. With the NFL and NCAA football seasons only a few months away, we can analyze the professional sports-betting industry to better understand the complexities behind making money in the stock market. Anybody who has traveled to Las Vegas, and bet on a sporting event, understands that simply choosing a game winner is not enough for a casino to pay you winnings. You also need to forecast how many points you think a certain team will win or lose by (i.e., the so-called “spread”) – see also What Happens in Vegas, Stays on Wall Street. In the world of stocks, winning/losing is not measured by spreads but rather equities are measured by valuation (e.g., Price/Earnings or P/E ratios).

To make my point, here is a sports betting example from some years back:

Florida Gators vs. Charleston Southern Buccaneers: Without knowing a lot about the powerhouse Southern Buccaneers squad from South Carolina, 99% of respondents polled before the game are likely to unanimously select the winner as Florida – a consistently dominant, nationally ranked powerhouse program. The tougher question becomes trickier if football observers are asked, “Will the Florida Gators win by more than 63 points?”(see picture below). Needless to say, although the Buccs kept it close in the first half, and only trailed by 42-3 at halftime, the Gators still managed to squeak by with a 62-3 victory. Importantly, if you had bet on this game and placed money on the Florida Gators, the overwhelming pre-game favorite, the 59 point margin of victory would have resulted in a losing wager. In order for Gator fans to win money, they would have needed Florida to win by 64 points. 

Point Spread

If investing and sports betting were easy, everybody would do it. The reason sports betting is so challenging is due to very intelligent statisticians and odds-makers that create very accurate point spreads. In the investing world, a broad swath of traders, market makers, speculators, investment bankers, and institutional/individual investors set equally efficient valuations over the long-term.

The goal in investing is very similar to sports betting. Successful professionals in both industries are able to consistently identify inefficiencies and then exploit them. Inefficiencies occur for a bettor when point spreads are too high or low, while investors identify inefficient prices in the marketplace by shorting expensive stocks and buying cheap stocks (i.e., undervalued or overvalued).

To illustrate my point, let’s take a look at Sidoxia’sMagic Quadrant“:

Magic Quadrants A-B-Cs & 1-2-3s

What Sidoxia’s “Magic Quadrant” demonstrates is a framework for evaluating stocks. By devoting a short period of time reviewing the quadrants, it becomes apparent fairly quickly that Stock A is preferred over Stock B, which is preferred over Stock C, which is preferred over Stock D. In each comparison, the former is preferred over the latter because the earlier letters all have higher growth, and lower (cheaper) valuations. The same relative attractive relationships cannot be applied to stocks #1, #2, #3, and #4. Each successive numbered stock has higher growth, but in order to obtain that higher growth, investors must pay a higher valuation. In other words, Stock #1 has an extremely low valuation with low growth, while Stock #4 has high growth, but an investor must pay an extremely high valuation to own it.

While debating the efficiency of the stock market can escalate into a religious argument, I would argue the majority of stocks fall in the camp of #1, #2, #3, or #4. Or stated differently, you get what you pay for. For example, investors are paying a much higher valuation (high P/E) for Tesla Motors, Inc (TSLA) for its rapid electric car growth vs. paying a much lower valuation (low P/E) for Pitney Bowes Inc (PBI) for its more mature mail equipment business.

The real opportunities occur for those investors capable of identifying companies in the upper-left quadrant (i.e., Stock A) and lower-right quadrant (i.e., Stock D). If the analysis is done correctly, investors will load up on the undervalued Stock A and aggressively short the expensive Stock D. Sidoxia has its own proprietary valuation model (Sidoxia Holy Grail Ranking – SHGR or a.k.a. “SUGAR”) designed specifically to identify these profitable opportunities.

The professions of investing and sports betting are extremely challenging, however establishing a framework like Sidoxia’s “Magic Quadrants” can help guide you to find inefficient and profitable investment opportunities.

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) and TSLA, but at the time of publishing, SCM had no direct position in PBI, 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 the information to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

June 24, 2017 at 8:09 am Leave a comment

The Art & Science of Successful Investing

As I described in my book, How I Managed $20,000,000,000.00 by Age 32, I believe successful investing is achieved by integrating aspects of both art and science. The science aspect of investing is fairly straightforward – most of the accounting and valuation math involved could be solved by a 7th grader. The more challenging aspect to successful investing is controlling the vacillating emotions of fear and greed when searching for attractive investments.

When people ask me about my investment philosophy, I do not like to be pigeon-holed into one style box because normally my portfolios hold investments that outsiders would deem both value and growth oriented. Since I am an absolute return investor, I am more concerned about how I can maximize upside returns while minimizing downside risk for my investors.

Because valuation is such an important factor in my process (price always matters), the most accurate description of my style would likely be “high octane GARP” (Growth At a Reasonable Price). While many GARP investors limit themselves to current or historical valuation metrics, my process has allowed me to take a more long-term, forward looking analysis of valuations, which has directed me to participate in some large winners, like Amazon (AMZN), Apple (AAPL), and Google/Alphabet (GOOGL), to name a few. To many observers, positions like these have traditionally been falsely considered “expensive” growth stocks.

Case in point is Google/Alphabet, which went public at $85 per share in 2004. At the time, the broad Wall Street consensus was the IPO (Initial Public Offering) price was way overheated. As it turned out, the stock has reached $1,000 per share and the Price-Earnings ratio (P/E) was a steal at less than 3x had you bought Google at the IPO price. ($85 2004 price/$33.98 2017 EPS estimate). Google is a perfect example of a dominant market leader that has been able to grow earnings dramatically for many years. In short order after going public, Google’s earnings ended up more than quintupling in less than three years and the stock price quintupled as well, proving that ill-advised focus on stale, traditional valuation metrics can lead you to wrong conclusions. Certainly, finding stocks that can increase in value by more than 11x fold is easier said than done, however, applying longer-term valuation metrics to dominant growth leading franchises will allow you to occasionally find monster winners like Google.

The greatest long-term winners don’t start off as the largest weightings, but due to the compounding of returns, position sizes can explode over time. As Peter Lynch states,

“You don’t need a lot of good hits every day. All you need is two to three good stocks a decade.”

 

Google/Alphabet proves what can appear expensive in the short-run is, in many cases, wildly cheap based on future earnings growth. Earnings tomorrow may be significantly larger than earnings today. Lynch emphasizes the importance of earnings over current prices,

“People concentrate too much on the ‘P’ (Price), but the ‘E’ (Earnings) really makes the difference.”
 “Just because a stock is cheaper than before is no reason to buy it, and just because it’s more expensive is no reason to sell.”

 

The Google/Alphabet chart below shows the incredible price appreciation that can be realized from compounding earnings growth.

The Google example also underscores the importance of patience. Although the stock has been a massive home-run since its IPO, the stock barely budged from late 2006 through 2011. Accurately picking the perfect timing to make an investment is nearly impossible. I concur with Bill Miller when he stated,

“We expect the stocks we buy today to contribute to our performance several years hence. While it’s nice if they contribute to this year’s performance, this year’s performance should be driven by decisions we made in previous years. If we keep doing this, we hope that we will provide adequate returns in the future.”

 

Regarding timing, Miller adds,

“Nobody buys at lows and sells at highs except liars.”

 

The Sidoxia Philosophy

Over time, as I have fine-tuned my investment philosophy, I have not been bashful in borrowing winning ideas from growth gurus like Peter Lynch, Phil Fisher, William O’Neil,  and Ron Baron, to name a few. By the same token, I am not shy about stealing ideas from value veterans like Warren Buffett, Seth Klarman, and Bill Miller as well.

While I don’t agree with Warren Buffett’s “forever” time horizon, I do believe in the power of compounding he espouses, which requires a longer-term investment horizon. The power of compounding is accelerated not only by committing to a long-term horizon, but also by the benefits accrued from lower trading costs and taxes. What’s more, taking a long view lowers your blood pressure and creates fewer ulcers. Legendary growth manager, T. Rowe Price, captures the essence of this idea here:

“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.”

 

The Science of Investing

As discussed earlier, successful investing is an endeavor that involves the practices of both art and science – too much of either approach can be detrimental to your financial health. Quantitative screening can be an excellent tool for identifying new securities for research along with streamlining the fundamental analysis process. However, many investment funds rely too heavily on the quantitative science. The adage that “correlation does not equal causation” is an important credo to follow when reviewing various quantitative models (see Butter in Bangladesh).

The collapse of the infamous, multi-billion Long Term Capital Management hedge fund should also be a lesson to everyone (see When Genius Failed ). If world renowned Nobel Prize winners, Robert Merton and Myron Scholes, can single-handedly bring the global market to its knees as a result of using inconsistent and unreliable quantitative models, then I feel validated for my fundamentally-based investment approach.

While there are some artistic facets to valuation techniques, in large part, the valuation science is a fairly straightforward mathematical exercise. Unfortunately, the market consists of emotional and unpredictable individuals who continually change their opinions. Eventually the financial markets prod prices in the right direction, but over shorter time intervals, proper investment analysis requires some imperfect estimation.

Emotions regularly result in individuals overpaying for stocks, and this tendency is a risky strategy for any investment. In many cases investors chase darling stocks highlighted in news headlines, but regrettably these pricy investments often end up performing poorly. When it comes to hot stocks, I’m on the same page as famed value investor Bill Miller,

“If it’s in the papers, it’s in the price. One needs to anticipate, not react.”

 

Usually a news event that makes headlines is already factored into the stock price. The financial markets are generally forward looking mechanisms, not backward looking.

The Art of Investing

“It’s tough to make predictions, especially about the future.”

-Yogi Berra

Investing is undoubtedly a challenging undertaking, but like almost any profession, the more experience one has, the better results generally achieved. Experience alone does not guarantee extraordinary performance, in large part due to emotional pressures. Investing would be much easier for everyone, if you didn’t have to worry about controlling those pesky emotions of fear and greed. The best investment decisions, and frankly any decision, are rarely made under these heightened emotions.

The most successful set of investors I have studied and modeled my investment process after are professionals who have married the quantitative science with the fundamental art of investing. At Sidoxia, we use a disciplined cash flow based valuation approach, along with thorough fundamental analysis to identify attractively valued, market leading franchises that can sustain above average growth. It sounds like a mouthful, but over time, it has worked well for the benefit of my clients and me.

The market leading franchises we invest in tend to have a competitive advantage, whether in the form of superior research and development, low-cost manufacturing, leading marketing, and/or other exceptional functions in the company that allow the entity to consistently garner more growth and more market share from its competitors. Quality franchises tend to also employ first-class management teams that have a proven track record, along with thoughtful, systematic processes in place to maintain their competitive edge. These competitive advantages are what allow companies to produce exceptional earnings growth for extended periods of time, thereby producing outstanding long-term performance for shareholders.

Finding sustainable growth in competitive niche markets is nearly impossible, and that is why I center my attention on large or emerging sectors of the economy that can support long runways of growth. When analyzing companies with durable, long runways of earnings growth, I concentrate on those developing, share-taking companies and dominant market leaders. In other words, disruptive companies that are entering new markets with vast potential and established companies that are gaining significant share in large markets. Well-known growth authority, Phil Fisher summarized the objective,

“The greatest investment rewards come to those who by good luck or good sense find the occasional company that over the years can grow in sales and profits far more than industry as a whole.”

 

I am privileged and honored to manage the hard earned investments of my clients. If this was a simple profession, everyone would do it, and I would not be employed as an investment manager. I have developed what I believe is a superior way of managing money, but I realize my investment process is not the only way to make money. If you were to assemble 10 different investment managers in the same room, and ask them, “What is the best way to invest money?,” you are likely to get 10 different answers. Having been in the investment industry and managed money for over 25 years, my experience has shown me that the vast majority of professional managers have underperformed the passive benchmarks. However, there are investment managers who have survived the test of time. For those veterans incorporating a disciplined, systematic approach that integrates the artistic and scientific aspects of investing, exceptional long-term returns can be achieved and have been achieved.

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, AMZN, GOOG/GOOGL, and 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.

June 18, 2017 at 7:25 pm Leave a comment

Head Fakes Surprise as Stocks Hit Highs

In a world of seven billion people and over 200 countries, guess what…there are a plethora of crises, masses of bad people, and plenty of lurking issues to lose sleep over.

The fear du jour may change, but as the late-great investor Sir John Templeton correctly stated:

“Bull markets are born on pessimism and they grow on skepticism, mature on optimism, and die on euphoria.”

 

And for the last decade since the 2008-2009 Financial Crisis, it’s clear to me that the stock market has climbed a lot of worry, pessimism, and skepticism. Over the last decade, here is a small sampling of wories:

With over five billion cell phones spanning the globe, fear-inspiring news headlines travel from one end of the world to the other in a blink of an eye. Fortunately for investors, the endless laundry list of crises and concerns has not broken this significant, multi-year bull market. In fact, stock prices have more than tripled since early 2009. As famed hedge fund manager Leon Cooperman noted:

“Bull markets don’t die from old age, they die from excesses.”

 

On the contrary to excesses, corporations have been slow to hire and invest due to heightened risk aversion induced by the financial crisis. Consumers have saved more and lowered personal debt levels. The Federal Reserve took unprecedented measures to stimulate the economy, but these efforts have since been reversed. The Fed has even signaled its plan to reduce its balance sheet later this year. As the expansion has aged, corporations and consumer risk aversion has abated, but evidence of excesses remains paltry.

Investors may no longer be panicked, but they remain skeptical. With each subsequent new stock market high, screams of a market top and impending recession blanket headlines. As I pointed out in my March Madness article, stocks have made new highs every year for the last five years, but continually I get asked, “Wade, don’t you think the market is overheated and it’s time to sell?”

For years, I have documented the lack of stock buying evidenced by the continued weak fund flow sales. If I could summarize investor behavior in one picture, it would look something like this:

Corrections have happened, and will continue to occur, but a more significant decline will likely happen under specific circumstances. As I point out in Half Empty, Half Full?, the time to become more cautious will be when we see a combination of the following trends occur:

  • Sharp increase in interest rates
  • Signs of a significant decline in corporate profits
  • Indications of an economic recession (e.g., an inverted yield curve)
  • Spike in stock prices to a point where valuation (prices) are at extreme levels and skeptical investor sentiment becomes euphoric

Attempting to predict a market crash is a Fool’s Errand, but more important for investors is periodically reviewing your liquidity needs, time horizon, risk tolerance, and unique circumstances, so you can optimize your asset allocation. There will be plenty more head fake surprises, but if conditions remain the same, investors should not be surprised by new stock highs.

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.

June 10, 2017 at 2:33 pm 2 comments

Political Showers Bring Record May Stock Flowers

This article is an excerpt from a previously released Sidoxia Capital Management complimentary newsletter (June 1, 2017). Subscribe on the right side of the page for the complete text.

There has been a massive storm of political rain that has blanketed the media airwaves and internet last month, however, the stock market ignored the deluge of headlines and focused on more important factors, as prices once again pushed to new record highs. Over the eight-year bull market, the old adage to “sell in May, and go away,” once again was not a very successful strategy. Had investors heeded this advice, they would have missed out on a +1.2% gain in the S&P 500 index during May (up +7.7% for 2017) and a +2.5% surge in the technology-driven NASDAQ index (+15.1% in 2017).

Keeping track of the relentless political storm of new headlines and tweets almost requires a full-time staff person, but nevertheless we have summarized some of the political downpour here:

French Elections: In the wake of last year’s U.K. “Brexit”, fears of an imminent “Frexit” (French Exit) resurfaced ahead of the French presidential. Emmanuel Macron, a 39-year-old former investment banker, swept to a decisive victory over National Front candidate Marine Le Pen by a margin of 66% to 34%.

Firing of FBI Director: President Trump fired FBI Director James Comey based on the recommendation of deputy attorney general Rod Rosenstein, who cited Comey’s mishandling of Hillary Clinton’s private email server investigation. The president’s critics claim Trump was frustrated with the FBI’s investigation into the administration’s potential ties with Russian officials in relation to the 2016 presidential elections. Comey is expected to testify next week to Congress, where he will likely address reports that President Trump asked him to drop the FBI’s investigation into former National Security Advisor Michael Flynn during a February meeting.

Trump Classified Leak to Russians: Reports show that President Trump revealed classified information regarding the Islamic State (ISIS) to the Russian foreign minister during an Oval Office meeting. The ISIS related information emanating from Syria reportedly had been passed to the U.S. from Israel, with the provision that it not be shared.

Impeachment Talk and Appointment of Independent Special Prosecutor: Heightened reports of Russian intervention coupled with impeachment cries from the Democratic opposition coincided with Deputy Attorney General Rod Rosenstein’s announcement that former FBI director Robert Mueller III would take on the role as an independent special counsel in the investigation of Russian interference in the 2016 election. Rosenstein had the authority to make the appointment after Attorney General Jeff Sessions recused himself after admitting contacts with Russian officials. The White House, which has denied colluding with the Russians, issued a statement from President Donald Trump looking forward “to this matter concluding quickly.”

Kushner Under Back Channel Investigation: President Trump’s son-in-law and senior advisor, Jared Kushner, is under investigation over discussions to set up a back channel of communication with Russian officials. At the heart of the probe is a December meeting Kushner held with Sergey Gorkov, an associate of Russian President Vladimir Putin and the head of the state-owned Vnesheconombank, a Russian bank subject to sanctions imposed by President Obama. Back channels have been legally implemented by other administrations, but the timing and nature of the discussions could make the legal interpretation more difficult.

Trump’s First Foreign Trip: A whirlwind trip by President Trump through the Middle East and Europe, resulted in commitments to Middle East peace, multi-billion contract signings with the Saudis, pledges to fight Muslims extremism, calls for NATO members to pay their “fair share,” and demands for German President Angela Merkel to address the elevated trade deficit with the U.S.

Subpoenas Issued to Trump Advisors: The House Intelligence Committee issued subpoenas to ousted National Security Adviser Michael Flynn and President Trump’s personal attorney, Michael Cohen, as it relates to potential Russian interference in the presidential campaign. Flynn reportedly plans to invoke his Fifth Amendment rights in response to a separate subpoena issued by the Senate Intelligence Committee.

Repeal and Replace Healthcare: The Republican-controlled House of Representatives narrowly passed a vote to repeal and replace the Affordable Care Act after prior failed attempts. The bill, which allows states to apply for a waiver on certain aspects of coverage, including pre-existing conditions, received no Democratic votes. While the House passage represents a legislative victory for President Trump, Senate Republicans must now take up the legislation that addresses conclusions by the nonpartisan Congressional Budget Office (CBO). More specifically, the CBO found the revised House health care bill could leave 23 million more Americans uninsured while reducing the federal deficit by $119 billion in the next decade.

North Korea Missile Tests: If domestic political turmoil wasn’t enough, North Korea conducted an unprecedented number of medium-to-long-range missile tests in an effort to develop an intercontinental ballistic missile (ICBM) capable of hitting the mainland United States. Due to the rising tensions, the U.S. and South Korea have been planning nuclear carrier drills off the coast of the Korean peninsula.

Wow, that was a mouthful. While all these politics may be provocative and stimulating, long-time followers of mine understand my position…politics are meaningless (see Politics-Schmolitics). While a terrorist or military attack on U.S. soil would undoubtedly have an immediate and negative impact, 99% of daily politics should be ignored by investors. If you don’t believe me, just take a look at the stock market, which continues to make new record highs in the face of a hurricane of negative political headlines. What the stock market really cares most about are profits, interest rates, and valuations:

  • Record Profits: Stock prices follow the direction of earnings over the long-run. As you can see below, profits vacillate year-to-year. However, profits are currently surging, and therefore, so are stock prices – despite the negative political headlines.

Source: Dr. Ed’s Blog

  • Near Generationally Low Interest Rates: Generally speaking, most asset classes, including real estate, commodities, and stock prices are worth more when interest rates are low. When you could earn 15% on a bank CD in the early 1980s, stocks were much less attractive. Currently, bank CDs almost pay nothing, and as you can see from the chart below, interest rates are near a generational low – this makes stock prices more attractive.
  • Attractive Valuations: The price you pay for an asset is always an important factor, and the same principle applies to your investments. If you can buy a $1.00 for $0.90, you want to take advantage of that opportunity. Unfortunately, the value of stocks is not measured by a simple explicit price, like you see at a grocery store. Rather, stock values are measured by a ratio (comparing an investment’s price relative to profits/cash flows generated). Even though the stock market has surged this year, stock values have gotten cheaper. How is that possible? Stock prices have risen about +8% in the first quarter, while profits have jumped +15%. When profits rise faster than prices appreciate, that means stocks have gotten cheaper. From a multi-year standpoint, I agree with Warren Buffett that prices remain attractive given the current interest rate environment. To read more about valuations, check out Ed Yardeni’s recent article on valuations.
Overall, the political showers continue to come pouring down, but the economic flowers have been blooming. Politics are fun to talk about, but when it comes to your investments, do yourself a favor and pull out your umbrella, turn off the politics, and take advantage of the sweet smell of the flowers.

 

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.

June 3, 2017 at 4:52 pm Leave a comment

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