Archive for September, 2013
Investing: Coin Flip or Skill?
The Sidoxia Monthly Newsletter will be released in a few days (subscribe on right side of the page), so here is an Investing Caffeine classic to tide you over until then:
Everyone believes they are above-average drivers and most investors believe successful investing can be attributed to skill. Michael Mauboussin, author and Chief Investment Strategist at Legg Mason Capital Management, tackles the issue of how important a role luck plays in various professional activities, including investing (read previous IC article on Mauboussin) in his meaty 42-page thought piece, Untangling Skill and Luck.
Skill Litmus Test
Whenever someone becomes successful or a sports team wins, doubters often respond with the response, “Well, they are just lucky.” For some, the intangible factor of luck can be difficult to measure, but for Mauboussin, he has a simple litmus test to evaluate the level of skill and luck credited to a professional activity:
“There’s a simple and elegant test of whether there is skill in an activity: ask whether you can lose on purpose. If you can’t lose on purpose, or if it’s really hard, luck likely dominates that activity. If it’s easy to lose on purpose, skill is more important.”
Mauboussin uses various sports and games as tools to explain the relative importance that skill (or lack thereof) plays in determining an outcome. At one extreme end of the spectrum you have a brain game like chess, in which a skillful chess pro could beat an amateur 1,000 times in a 1,000 matches. In the field of professional sports, at the other end of the spectrum, Mauboussin hammers home the relative significance luck contributes in professional baseball:
“In major league baseball the worst team will beat the best team in a best-of-five series about 15 percent of the time.“
Here is a skill-luck continuum provided by Mauboussin:
Source: Legg Mason Capital Management
Streaks vs. Mean Reversion
Mr. Mauboussin spends a great deal of time exploring the implications of skill and luck in relation to streaks and mean reversion. In the streak department, Mauboussin uses Joe DiMaggio’s record 56-consecutive game hitting stretch. He acknowledges the presence of luck, but skill is a prerequisite:
“Not all skillful performers have streaks, but all long streaks of success are held by skillful performers.”
When detailing streaks, Mauboussin may also be defending his fellow Legg Mason colleague Bill Miller (see Revenge of the Dunce), who had an incredible 15 consecutive year of besting the S&P 500 index before mean reverting back to lousy human-like returns.
This is a nice transition into his discussion about mean reversion because Mauboussin basically states this reversion concept dominates activities laden with luck (as shown in the Skill-Luck Continuum chart above). Time will tell whether Miller’s streak was due to skill, if he can put together another streak, or whether his streak was merely a lucky fluke. Unlike the judicial world, investment managers are often treated as guilty until proven innocent. For now, Miller’s 1991-2005 streak is being treated as luck by many in the investment community, rather than skill.
Nobel-prize winner Paul Samuelson may believe differently since he concedes the existence of skillful investing:
“It is not ordained in heaven, or by the second law of thermodynamics, that a small group of intelligent and informed investors cannot systematically achieve higher mean portfolio gains with lower average variabilities. People differ in their heights, pulchritude, and acidity. Why not their P.Q. or performance quotient?”
Peter Lynch’s +29% annual return from 1977-1990 is another streak on which historians can chew (read more on Lynch). I, like Samuelson, will give Lynch the benefit of the doubt.
Creating a Skillful Analytical Edge
Unlike the process of mowing lawns, in which more applied work time generally equates to more lawns cut (i.e., more profits), the investment world doesn’t quite work that way. Many people could work all day, stare at their screen for 23 hours, trade off of useless information, and still earn lousy returns. When it comes to investing, more work does not necessarily produce better results. Mauboussin’s prescription is to create an analytical edge. Here is how he describes it:
“At the core of an analytical edge is an ability to systematically distinguish between fundamentals and expectations.”
Thinking like a handicapper is imperative to win in this competitive game, and I specifically addressed this in my previous Vegas-Wall Street article. Steven Crist sums up this indispensable concept beautifully:
“There are no “good” or “bad” horses, just correctly or incorrectly priced ones.”
A disciplined, systematic approach will incorporate these ideas, however all good investors understand the good processes can lead to bad outcomes in the short-run. By continually learning from mistakes, and refining the process with a constant feedback loop, the investment process can only get better. On the other hand, schizophrenically reacting to an endless flood of ever-changing information, or fearfully chasing the leadership du jour will only lead to pain and sorrow. Fortunately for you, you have skillfully completed this article, meaning financial luck should now be on your side.
Read full Mauboussin article (Untangling Skill and Luck) here
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. Radio interviews included opinions of Wade Slome – not advice. 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.
Sidoxia’s Slome Hits Airwaves
Sidoxia’s President & Founder Conducts Series of Radio Interviews Spanning Topics Ranging from the Stock Market & Syria to Financial Planning & Government Debt
Click on Interview Links Below:
Memphis
Memphis
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. Radio interviews included opinions of Wade Slome – not advice. 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.
Sports, Stocks, & the Magic Quadrants
Picking stocks is a tricky game and so is sports betting. With the NFL and NCAA football seasons swinging into full gear, understanding the complexity of making money in the stock market can be explained in terms of professional sports-betting. Anybody who has traveled to Las Vegas and bet on a sporting event, understands that choosing a winner of a game simply is not enough…you also need to forecast how many points you think a certain team will win by (see also What Happens in Vegas, Stays on Wall Street). In the world of sports, winning/losing is measured by point spreads. In the world of stocks, winning/losing is measured by valuation (e.g., Price/Earnings ratios).
To make my point, here is a sports betting example from a handful years back:
Florida Gators vs. Charleston Southern Buccaneers (September 2009): Without knowing a lot about the powerhouse Southern Buccaneers squad from South Carolina, 99% of respondents, when asked before the game who would win, would unanimously select Florida – a consistently dominant, national franchise, powerhouse program. The question becomes a little trickier when participants are asked, “Will the Florida Gators win by more than 63 points?” 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. Worth noting, had you selected Florida, the overwhelming favorite, the 59 point margin of victory would have resulted in a losing wager (see picture below).
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.
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 (undervalued or overvalued).
To illustrate my point, let’s take a look at Sidoxia’s “Magic Quadrant“:
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 (~100x 2014 P/E) for Tesla Motors, Inc (TSLA) for its rapid electric car growth vs. paying a much lower valuation (~10x 2014 P/E) for Pitney Bowes Inc (PBI) for its 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.
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 TSLA, 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.
Perception vs. Reality: Interest Rates & the Economy
There is a difference between perception and reality, especially as it relates to the Federal Reserve, the economy, and interest rates.
Perception: The common perception reflects a belief that Quantitative Easing (QE) – the Federal Reserve’s bond buying program – has artificially stimulated the economy and financial markets through lower interest rates. The widespread thinking follows that an end to tapering of QE will lead to a crash in the economy and financial markets.
Reality: As the chart below indicates, interest rates have risen during each round of QE (i.e., QE1/QE2/QE3) and fallen after the completion of each series of bond buying (currently at a pace of $85 billion per month in purchases). That’s right, the Federal Reserve has actually failed on its intent to lower interest rates. In fact, the yield on the 10-year Treasury Note stands at 2.94% today, while at the time QE1 started five years ago, on December 16, 2008, the 10-year rate was dramatically lower (~2.13%). Sure, the argument can be made that rates declined in anticipation of the program’s initiation, but if that is indeed the case, the recent rate spike of the 10-year Treasury Note to the 3.0% level should reverse itself once tapering begins (i.e., interest rates should decline). Wow, I can hardly wait for the stimulative effects of tapering to start!
Source: Calafia Beach Pundit
Fact or Fiction? QE Helps Economy
Taken from a slightly different angle, if you consider the impact of the Federal Reserve’s actions on the actual economy, arguably there are only loose connections. More specifically, if you look at the jobs picture, there is virtually NO correlation between QE activity and job creation (see unemployment claims chart below). There have been small upward blips along the QE1/QE2/QE3 path, but since the beginning of 2009, the declining trend in unemployment claims looks like a black diamond ski slope.
Source: Calafia Beach Pundit
Moreover, if you look at a broad spectrum of economic charts since QE1 began, including data on capital spending, bank loans, corporate profits, vehicle sales, and other key figures related to the economy, the conclusion is the same – there is no discernible connection between the economic recovery and the Federal Reserve’s quantitative easing initiatives.
I know many investors are highly skeptical of the stock market’s rebound, but is it possible that fundamental economic laws of supply and demand, in concert with efficient capital markets, could have something to do with the economic recovery? Booms and busts throughout history have come as a result of excesses and scarcities – in many cases assisted by undue amounts of fear and greed. We experienced these phenomena most recently with the tech and housing bubbles in the early and middle parts of last decade. Given the natural adjustments of supply and demand, coupled with the psychological scars and wounds from the last financial crisis, there is no clear evidence of a new bubble about to burst.
While it’s my personal view that many government initiatives, including QE, have had little impact on the economy, the Federal Reserve does have the ability to indirectly increase business and consumer confidence. Ben Bernanke clearly made this positive impact during the financial crisis through his creative implementation of unprecedented programs (TARP, TALF, QE, Twist, etc.). The imminent tapering and eventual conclusion of QE may result in a short-term hit to confidence, but the economy is standing on a much stronger economic foundation today. Making Ben Bernanke a scapegoat for rising interest rates is easy to do, but in actuality, an improving economy on stronger footing will likely have a larger bearing on the future direction of interest rates relative to any upcoming Fed actions.
Doubters remain plentiful, but the show still goes on. Not only are banks and individuals sitting on much sturdier and healthier balance sheets, but corporations are running lean operations that are reporting record profit margins while sitting on trillions of dollars in cash. In addition, with jobs on a slow but steady path to recovery, confidence at the CEO and consumer levels is also on the rise.
Despite all the negative perceptions surrounding the Fed’s pending tapering, reality dictates the impact from QE’s wind-down will likely to be more muted than anticipated. The mitigation of monetary easing is more a sign of sustainable economic strength than a sign of looming economic collapse. If this reality becomes the common perception, markets are likely to move higher.
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.
100-Year Flood ≠ 100-Day Flood
This article is an excerpt from a previously released Sidoxia Capital Management complementary newsletter (September 3, 2013). Subscribe on the right side of the page for the complete text.
Investors experienced a 100-year flood in 2008-2009 and now it seems a broad array of media outlets endlessly bombards us with new, impending 100-day floods that are expected to drown investment portfolios and wash the economy into recession. The -3% drop in the S&P 500 index during August is symptomatic of investor nervousness.
This is nothing new. The media has been reporting scary forecasts every day over the last four years. Yesterday, we heard about the flash crash, Dubai, debt ceiling debate, Greece, Cyprus, eurozone demise, presidential election uncertainty, fiscal cliff, Iranian nuclear threats, North Korean provocations, and other potentially deadly floods.
Today, the worrisome flood forecasts include Syria, bond tapering, rising interest rates, debt ceiling part II, Ben Bernanke’s Federal Reserve successor, sequestration part II, Egypt, mid-term Congressional elections, and other natural and artificial disasters.
Despite a tsunami of unrelenting worries, the fact remains that corporate profits are at record levels (see chart below), corporations are holding record levels of cash, and even with a weak performance by stocks in August, the market is still up +15% this year, only off all-time record highs.
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| Source: Calafia Beach Pundit |
Notwithstanding the recent record levels, stock ownership is at 15-year lows (see Markets Soar and Investors Snore) and skepticism still reigns supreme. By the time the coast is clear, and confidence returns, the opportunities will be vastly diminished. For the overwhelming majority of Baby Boomers and younger retirees, the investing game will remain challenging.
Wear a Raincoat & Ignore Data
Rather than succumbing to fears arising from volatile data and gloomy predictions, it is better to grab an investment raincoat and ignore the data. Sticking to your long-term investment plan is paramount. Legendary investor Sir John Templeton encapsulated the relationship of emotions and stock prices perfectly when he stated, “Bull markets are born on pessimism and they grow on skepticism, mature on optimism, and die on euphoria.” Fellow investor extraordinaire Peter Lynch highlighted the irrelevance of tracking macroeconomic data by noting, “If you spend 13 minutes a year on economics, you’ve wasted 10 minutes.”
When describing investment success, Lynch went on to say, “Whatever method you use to pick stocks or stock mutual funds, 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.”
We’ve all survived the 100-year flood of 2008-09 with our lives, but confidence has been beaten down with the subsequent list of scary, misplaced forecasted floods over the last four years. Patient, long-term investors have been handsomely rewarded, with approximately +150% returns in stocks from the lows, but ominous economic predictions will persist. While the next 100-year flood probably won’t be here for another generation, disastrous forecasts will continue. As I’ve pointed out earlier, there is no shortage of concerns. There is always something horrible going on in this world somewhere and there will always be something to worry about. Who knows, tomorrow could bring an earthquake, terrorist attack, Russian currency crisis, Iranian regime change, Zimbabwean hyperinflation, or some other unforeseen concern.
There will be plenty of economic thunderstorms and showers ahead, but hiding in inflation eroding cash, or attempting to time the market is a recipe for financial disaster. Volatility is here to stay, so that’s why it’s so important to have a disciplined investment plan in place. Creating a globally diversified portfolio, across numerous asset classes, to smoothen volatility in a manner that meets your time horizon and risk tolerance is critical. Do yourself a favor and have your grandchildren (not you) worry about the next 100-year flood…that way you can ignore the multitude of phantom, 100-day floods.
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.
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