Posts filed under ‘Education’
Mr. Market Bullying Investors
Source: Photobucket
There’s been a bully pushing investor’s around and his name is “Mr. Market.” Volatility is Mr. Market’s partner in crime, and over the last 10 trading days Mr. M has used volatility to school equity investors to the tune of 1,600+ point swings, which has contributed to equity investors’ failing grade over the last few months. Who is Mr. Market? Charles Ellis, author of Winning the Loser’s Game (1998) described him best:
“Mr. Market is a mischievous but captivating fellow who persistently teases investors with gimmicks and tricks such as surprising earnings reports, startling dividend announcements, sudden surges of inflation, inspiring presidential announcements, grim reports of commodities prices, announcements of amazing new technologies, ugly bankruptcies, and even threats of war.”
How has Mr. Market been stealing investors’ lunch money? The process really hasn’t been that difficult for him, once you consider how many times investors have been heaved into the garbage can over the last decade, forced to deal with these messy events:
• 2001 technology bubble beating
• 2006 real estate collapse
• 2008 – 2009 financial crisis and recession
• 2010 “flash crash” and soft patch
• 2011 debt ceiling debate and credit rating downgrade
With this backdrop, investors are dropping like flies due to extreme bully fatigue. Over the last four months alone, approximately $75 billion in equities been liquidated, according to data from the Investment Company Institute – this is even more money withdrawn than the outflows occurring during the peak panic months after the Lehman Brothers collapse.
The Atomic Wedgie
Exhibit I (Source: Photobucket)
Mr. Market understands the severity of these prior economic scars, which have been even more painful than atomic wedgies (reference Exhibit I above), so he opportunistically is taking advantage of fragile nerves. Introducing the following scary scenarios makes collecting lunch money from panicked investors much easier for Mr. Market. What is he using to frighten investors?
- A potential Greek sovereign debt default that will trigger a collapse of the Euro.
- Slowing growth in China due to slowing developed market economic activity.
- Possible double-dip recession in the U.S. coupled with an austerity driven downturn in Europe.
- Lack of political policy response to short and long-term economic problems in Washington and abroad.
- Impending deflation caused by decelerating global growth or likely inflation brought about by central banks’ easy monetary policies (i.e., printing money).
- End of the world.
Bully Victim Protection
Of course, not all of these events are likely to occur. As a matter of fact, there are some positive forming trends, besides just improving valuations, that provide protection to bully victims:
- Not only is the earnings yield (E/P – 12-month trailing EPS/share price) trouncing the yield on the 10-year Treasury note (~8% vs. ~2%, respectively), but the dividend yield on the S&P 500 index is also higher than the 10-year Treasury note yield (source: MarketWatch). Historically, this has been an excellent time to invest in equities with the S&P 500 index up an average of 20% in the ensuing 12 months.
- Jobs data may be poor, but it is improving relative to a few years ago as depicted here:
Source: Calafia Beach Pundit
Source: Calafia Beach Pundit
- Record low interest rates and mortgage rates provide a stimulative backdrop for businesses and consumers. Appetite for risk taking remains low, but as history teaches us, the pendulum of fear will eventually swing back towards greed.
Source: Calafia Beach Pundit
As I say in my James Carville peace from earlier this year, It’s the Earnings Stupid, long term prices of stocks follow the path of earnings. Recent equity price market declines have factored in slowing in corporate profits. How severely the European debt crisis, and austerity have (and will) spread to the U.S. and emerging markets will become apparent in the coming weeks as companies give us a fresh look at the profit outlook. So far, we have gotten a mixed bag of data. Alpha Natural Resources (ANR) acknowledged slowing coal demand in Asia and FedEx Corp. (FDX) shave its fiscal year outlook by less than 2% due to international deceleration. Other bellwethers like Oracle Corp. (ORCL) and Nike Inc. (NKE) reported strong growth and outlooks. In the short-run Mr. Market is doing everything in his power to bully investors from their money, and lack of international policy response to mitigate the European financial crisis and contagion will only sap confidence and drag 2011-2012 earnings lower.
Punching Mr. Market
The warmth of negative real returns in cash, bonds, and CDs may feel pleasant and prudent, but for many investors the lasting effects of inflation erosion will inflict more pain than the alternatives. For retirees with adequate savings, these issues are less important and focus on equities should be deemphasized. For the majority of others, long-term investors need to reject the overwhelming sense of fear.
As I frequently remind others, I have no clue about the short-term direction of the market, and Greece could be the domino that causes the end of the world. But what I do know is that history teaches us the probabilities of higher long-term equity returns are only improving. Mr. Market is currently using some pretty effective scare tactics to bully investors. For those investors with a multi-year time horizon, who are willing to punch Mr. Market in the nose, the benefits are significant. The reward of better long-term returns is preferable to an atomic wedgie or a head-flush in the toilet received from Mr. Market.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, and FDX, but at the time of publishing SCM had no direct position in ANR, ORCL, NKE, 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.
The Political Art of Investment Commentators
There are approximately 2 billion people surfing the internet globally and over 150 million bloggers (source: blogpulse.com) spewing their thoughts out into cyberspace. Throw in economists, strategists, columnists, and the talking heads on television, and you can sleep comfortably knowing there will never be a shortage of opinions for investors to sift through. The real question regarding the infinite number of ideas floating around from the “market commentators” is how useful or harmful is all this information? These diverse points of view, like guns, can be useful or dangerous – depending on an investor’s experience and knowledge level. Deciphering the nuances and variances of investment opinions can be very challenging for an untrained investing eye or ear. While there are plenty of diamonds in the rough to be discovered in the investment advice buffet, there are also a plethora of landmines and booby traps that could explode investment portfolios – especially if these volatile opinions are not handled with care.
No Credentials Required
Unlike dentists, lawyers, accountants, or doctors, becoming a market commentator requires little more than a pulse. All a writer, squawker, or blogger really needs is an internet connection, a keyboard, and something interesting or provocative to talk about. Are any credentials required to blast toxic gibberish to the millions among the masses? Unfortunately there are no qualifications required…scary thought indeed.
In order to successfully navigate the choppy investment opinion waters, investors need to be self-aware enough to answer the following key questions:
• What is your investment time horizon?
• What is your risk tolerance? (see also Sleeping like a Baby)
With these answers in hand, you can now begin to evaluate the credibility and track record of the market commentators and match your personal time horizon and risk profile appropriately. Ideally, investors would seek out prudent long-term counsel, but in this instant gratification society we live in, immediate fear and greed sells advertisements and attracts viewers. Even if media producers and editors of all stripes believed focusing on multi-year time horizons is most beneficial for investors, some serious challenges arise. The brutal reality is that concentrating on the lackluster long-term does not generate a lot of advertisement revenue or traffic. The topics of dollar-cost averaging, asset allocation, diversification, and rebalancing are about as exciting as watching an infomercial marathon (OK, actually this is quite funny) or paint dry. More interesting than the sleepy, uninspiring topics of long-term value creation are stories about terrorist threats, DSK sex scandals, Bernie Madoff Ponzi schemes, currency crises, hacking misconduct, bailouts, tsunamis, earthquakes, hurricanes, 50-day moving averages…OK, you get the idea.
Focus on Long-Term and Do Not Succumb to Short-Termism
Regrettably, there is a massive disconnect between the nano-second time horizons of market commentators and the time horizons of most investors. Moreover, this short-termism dispersed instantaneously via Facebook, Google (GOOG), Twitter, and traditional media channels, has sadly infected the psyches and investment habits of ordinary investors. If you don’t believe me, then check out some of the John Bogle’s work, which shows how dramatically investors underperform the benchmark thanks to emotionally charged reactions (see Fees, Exploitation, and Confusion Hammer Investors).
Although myopic short-termism is not the solution, extending time horizons too long does no good for investors either. As economist John Maynard Keynes astutely noted, “In the long run we are all dead.” But surely bloggers and pundits alike could provide perspectives in multiple year timeframes, rather than in multiple hours. Investors would be served best by turning off the TV, PC, or cell phone, and using the resulting free time to read a good book about the virtues of patient investing from successful long-term investors. Stuffing cash under the mattress, parking it in a 0.5% CD, or panicking into sub-2% Treasuries probably is not going to get the job done for your whole portfolio when inflation, longer life expectancies, and the unsustainable trajectory of entitlements destroy the value of your hard-earned nest egg.
Investment Commentators Look into Politician Mirror
Heading into a heated election year with volatility reaching historic heights in the financial markets, both politicians and investment commentators have garnered a great deal of the media spotlight. With the recent heightened interest in the two fields, some common characteristics between politicians and investment commentators have surfaced. Here are some of the similarities:
- Politicians have a short-term incentives to get re-elected and not get fired, even if there is an inherent conflict with the long-term interest of their constituents; Investment commentators have a short-term incentives to follow the herd and not get fired, even if there is an inherent conflict with the long-term interest of their constituents;
- Many politicians have extreme views that conflict with peers because blandness does not get votes; Many investment commentators have extreme views that conflict with peers because blandness does not get votes;
- Many politicians lack practical experience that could benefit their followers, but the politicians have the gift of charisma to mask their inexperience; Many investment commentators lack practical experience that could benefit their followers, but the commentators have the gift of charisma to mask their inexperience;
Investing has never been so difficult, and also has never been so important, which behooves investors to carefully consider portfolio actions taken based on a very volatile and inconsistent opinions from a group of bloggers, economists, strategists, columnists, and various other media commentators. Investors are bombarded with an avalanche of ever-changing daily data, much of which is irrelevant and should be ignored by long-term investors. As you weigh the precious value of your political votes in the upcoming election season, I urge you to back the candidates that represent your long-term interests. With regard to the financial markets, I also urge you to back the investment commentators that support your long-term interests – the success of your financial future depends on it.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, and GOOG, but at the time of publishing SCM had no direct position in Facebook, Twitter, 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
Shoot First and Ask Later?
The financial markets have been hit by a tsunami on the heels of idiotic debt negotiations, a head-scratching credit downgrade, and slowing economic data after a wallet-emptying spending binge by the government. These chain of events have forced many investors and speculators alike to shoot first, and ask questions later. Is this the right strategy? Well, if you think the world is going to end and we are in a global secular bear market stifled by a choking pile of sovereign debt, then the answer is a resounding “yes.” If however, you believe the blood curdling screams from an angered electorate will eventually influence existing or soon-to-be elected politicians in dealing with the obvious, then the answer is probably “no.”
Plug Your Ears
Anybody that says they confidently know what is really going to happen over the next six months is a moron. You can ask those same so-called talking head experts seen over the airwaves if they predicted the raging +35% upward surge last summer, right after the market tanked -17% on “double-dip” concerns and Fed Chairman Ben Bernanke gave his noted quantitative easing speech in Jackson Hole, Wyoming. I’m still flicking through the channels looking for the professionals who perfectly envisaged the panicked buying of the same downgraded Treasuries Standard and Poor’s pooped on. Oh sure, it makes perfect sense that trillions of dollars would flock to the warmth and coziness of sub-2% yielding debt in a country exploding with unsustainable obligations and deficits, fueled by a Congress that can barely blows its nose to a successful negotiation.
The moral of the story is that nobody knows the future with certainty – no matter how much CNBC producers would like you to believe the opposite is true. Some of the arguably smartest people in the world have single handedly triggered financial market implosions. Consider Robert Merton and Myron Scholes, both renowned Nobel Prize winners, who brought global financial markets to its knees in 1998 when Merton and Scholes’s firm (Long Term Capital Management) lost $500 million in one day and required a $3.6 billion bailout from a consortium of banks. Or ask yourself how well Fed Chairmen Alan Greenspan and Ben Bernanke did in predicting the credit crisis and housing bubble.
If the strategist or trader du jour squawking on the boob-tube was really honest, he or she would steal the sage words of wisdom from the television series secret agent Angus MacGyver who articulated, “Only a fool is sure of anything, a wise man keeps on guessing.”
Listen to the “E”-Word
If you can’t trust all the squawkers, then whom can you trust (besides me of course…cough, cough)? The answer is no different than the person you would look for in other life-important decisions. If you needed a serious heart by-pass surgery, would you get advice from a nurse or medical professor, or would you listen more closely to the top cardiologist at the Mayo Clinic who performed over 2,000 successful surgeries? If you were looking for a pilot to fly your plane, would you prefer a 25-year-old flight attendant, or a 55-year old steely veteran who has 10 million miles of flight experience? OK, I think you get the point…legitimate experience with a track record is key.
Unfortunately, most of the slick, articulate people we see on television may look experienced and have some gray hair, but the only thing they are experienced at is giving opinions. As my great, great grandmother once told me, “Opinions are a dime a dozen, but experience is much more valuable” (embellished for dramatic effect). You are better off listening to experienced professionals like Warren Buffett (listen to his recent Charlie Rose interview), who have lived through dozens of crises and profited from them – Buffett becoming the richest person on the planet doesn’t just come from dumb luck.
If you are having trouble sleeping, you either are taking too much risk, or do not understand the nature of the risk you are taking (see Sleeping like a Baby). Things can always get worse, and the risk of a self-fulfilling further decline is a possibility (read about Soros and Reflexivity). If you are determined to make changes to your portfolio, use a scalpel, and not an axe. The recent extreme volatility makes times like these ideal for reviewing your financial position, goals, and risk tolerance. But before you shoot your portfolio first, and ask questions later, prevent a prison sentence of panic, or your financial situation may end up behind bars.
[tweetmeme source=”WadeSlome” only_single=false https://investingcaffeine.com/2011/08/20/shoot-first-and-ask-later/%5D
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 MHP, CMCSA, 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.
Sleeping like a Baby with Your Investment Dollars
Amidst the recent, historically high volatility in the financial markets, there have been a large percentage of investors who have been sleeping like a baby – a baby that stays up all night crying! For some, the dream-like doubling of equity returns achieved from the first half of 2009 through the first half of 2011 quickly turned into a nightmare over the last few weeks. We live in an inter-connected, globalized world where news travels instantaneously and fear spreads like a damn-bursting flood. Despite the positive returns earned in recent years, the wounds of 2008-2009 (and 2000 to a lesser extent) remain fresh in investors’ minds. Now, the hundred year flood is expected every minute. Every European debt negotiation, S&P downgrade, or word floating from Federal Reserve Chairman Ben Bernanke’s lips, is expected to trigger the next Lehman Brothers-esque event that will topple the global economy like a chain of dominoes.
Volatility Victims
The few hours of trading that followed the release of the Federal Reserve’s August policy statement is living proof of investors’ edginess. After initially falling approximately -400 points in a 30 minute period late in the day, the Dow Jones Industrial Average then climbed over +600 points in the final hour of trading, before experiencing another -400 point drop in the first hour of trading the next day. Many of the day traders and speculators playing with the explosively leveraged exchange traded funds (e.g., TNA, TZA, FAS, FAZ), suffered the consequences related to the panic selling and buying that comes with a VIX (Volatility Index) that climbed about +175% in 17 days. A VIX reading of 44 or higher has only been reached nine times in the last 25 years (source: Don Hays), and is normally associated with significant bounce-backs from these extreme levels of pessimism. Worth noting is the fact that the 2008-2009 period significantly deteriorated more before improving to a more normalized level.
Keys to a Good Night’s Sleep
The nature of the latest debt ceiling negotiations and associated Standard & Poor’s downgrade of the United States hurt investor psyches and did little to boost confidence in an already tepid economic recovery. Investors may have had some difficulty catching some shut-eye during the recent market turmoil, but here are some tips on how to sleep comfortably.
• Panic is Not a Strategy: Panic selling (and buying) is not a sustainable strategy, yet we saw both strategies in full force last week. Emotional decisions are never the right ones, because if they were, investing would be quite easy and everyone would live on their own personal island. Rather than panic-sell, investments should be looked at like goods in a grocery store – successful long-term investors train themselves to understand it is better to buy goods when they are on sale. As famed growth investor Peter Lynch said, “I’m always more depressed by an overpriced market in which many stocks are hitting new highs every day than by a beaten-down market in a recession.”
• Long-Term is Right-Term: Everybody would like to retire at a young age, and once retired, live like royalty. Admirable goals, but both require bookoo bucks. Unless you plan on inheriting a bunch of money, or working until you reach the grave, it behooves investors to pull that money out from under the mattress and invest it wisely. Let’s face it, entitlements are going to be reduced in the future, just as inflation for food, energy, medical, leisure and other critical expenses continue eroding the value of your savings. One reason active traders justify their knee-jerk actions and derogatory description of long-term investors is based on the stagnant performance of U.S. equity markets over the last decade. Nonetheless, the vast number of these speculators fail to recognize a more than tripling in average values in markets like Brazil, India, China, and Russia over similar timeframes. Investing is a global game. If you do not have a disciplined, systematic long-term investment strategy in place, you better pray you don’t lose your job before age 70 and be prepared to eat Mac & Cheese while working as a Wal-Mart (WMT) greeter in your 80s.
• Diversification: Speaking of sleep, the boring topic of diversification often puts investors to sleep, but in periods like these, the power of diversification becomes more evident than ever. Cash, metals, and certain fixed income instruments were among the investments that cushioned the investment blow during the 2008-2009 time period. Maintaining a balanced diversified portfolio across asset classes, styles, size, and geographies is crucial for investment survival. Rebalancing your portfolio periodically will ensure this goal is achieved without taking disproportionate sized risks.
• Tailored Plan Matching Risk Tolerance: An 85 year-old wouldn’t go mountain biking on a tricycle, and a 10 year-old shouldn’t drive a bus to his fifth grade class. Sadly, in volatile times like these, many investors figure out they have an investment portfolio mismatched with their goals and risk tolerance. The average investor loves to take risk in up-markets and shed risk in down-markets (risk in this case defined as equity exposure). Regrettably, this strategy is designed exactly backwards for long-term investors. Historically, actual risk, the probability of permanent losses, is much lower during downturns; however, the perceived risk by average investors is viewed much worse. Indeed, recessions have been the absolute best times to purchase risky assets, given our 11-for-11 successful track record of escaping post World War II downturns. Could this slowdown or downturn last longer than expected and lead to more losses? Absolutely, but if you are planning for 10, 20, or 30 years, in many cases that issue is completely irrelevant – especially if you are still adding funds to your investment portfolio (i.e., dollar-cost averaging). On the flip side, if an investor is retired and entirely dependent upon an investment portfolio for income, then much less attention should be placed on risky assets like equities.
If you are having trouble sleeping, then one of two things is wrong: 1.) You are taking on too much risk and should cut your equity exposure; and/or 2.) You do not understand the risk you are taking. Volatile times like these are great for reevaluating your situation to make sure you are properly positioned to meet your financial goals. Talking heads on TV will tell you this time is different, but the truth is we have been through worse times (see History Never Repeats, but Rhymes), and lived to tell the tale. All this volatility and gloom may create anxiety and cause insomnia, but if you want to quietly sleep through the noise like a content baby, make yourself a long-term financial bed that you can comfortably sleep in during good times and bad. Focusing on the despondent headline of the day, and building a portfolio lacking diversification will only lead to panic selling/buying and results that would keep a baby up all night crying.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including emerging market ETFs) and WMT, but at the time of publishing SCM had no direct position in TNA, TZA, FAS, FAZ, 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.
Winning the Stock Rock Turning Game
There are a few similarities between dieting and investing. There are no shortcuts or panaceas to achieving success in either endeavor – they both require plain old hard work. Any winning investment process will have some sort of mechanism(s) to generate new stock ideas, whether done quantitatively through a screening process or more subjectively through other avenues (e.g., conferences, journals, investor contacts, field research, or Investing Caffeine – ha). As many investors would agree, discovering remarkable stock picks is no effortless undertaking. A lot of meaningless rocks need to be turned before a gem can be found, especially in an age of information overload. I believe investing guru Peter Lynch said it best:
“I always thought if you looked at ten companies, you’d find one that’s interesting, if you’d look at 20, you’d find two, or if you look at hundred you’ll find ten. The person that turns over the most rocks wins the game.”
Depending on the duration of your investment time horizon, stock gems can be more abundant in certain time periods relative to others. The shorter the timeframe, the more important timing becomes. Looking at a few major turning points illustrates my point. Although hindsight is 20/20, it is clear now (and for a minority of investors 11 years ago) that the pickings were slim in March 2000 and virtually endless in March 2009 –practically anything purchased then went up in price.
Investing is not a game of certainty, because if it was certain, everyone would be sipping umbrella drinks on their personal islands. Since investing involves a great deal of uncertainty, the name of the game is stacking probabilities in your favor. If you have a repeatable process, you should be able to outperform the markets in the long-run. In the short-run, a good process can have a bad outcome, and a bad process can have a good outcome.
Macro vs. Bottom-Up
Gaining a rough sense of the macro picture can increase the probabilities of success, but more importantly I believe a bottom-up approach (i.e., flipping over lots of stock rocks) is a better approach to raising odds in your favor. The recent volatility and pullback in the market has left a sour taste in investors’ mouths, but great opportunities still abound. That’s the thing about great stocks, they never disappear in bear markets and they eventually flourish – more often when a bull market returns.
Characterizing the macro game as difficult is stating the obvious. Although there are only about two recessions every decade, if you watch CNBC or read the paper, there are probably about 20 or 30 recessions predicted every 10 years. Very few, if any, can profitably time the scarce number of actual recessions, but many lose tons of money from the dozens of false alarms. You’re much better off by following Lynch’s credo: “Assume the market is going nowhere and invest accordingly.”
Land Mine or Gold Mine?
Not everyone believes in the painstaking process of fundamental analysis, but I in fact come from the COFC (Church of Fundamental Research), which firmly believes fundamental research is absolutely necessary in determining whether an investment is a land mine or a gold mine. Others believe that a quantitative black box (see Butter in Bangladesh), or technical analysis (see Astrology or Lob Wedge) can do the trick as a substitute. These strategies may be easier to implement, but as well-known money manager Bill Miller indicated, “This is not a business where ignorance is an asset; the more you work at it, the better you ought to be, other things equal.”
By doing your investment homework on companies, not only will you gain better knowledge of your investment, but you will better understanding of the company. Regardless of your process, I’m convinced any worthwhile strategy requires conviction. If you have loose roots of interest in a stock, the wind will blow you all over the place, and ultimately rip the roots of your flimsy thesis out of the foundation. I contend that most lazy and simplistic processes, such as buying off tips, chasing winners, or letting computers buy stocks might create short-term profits, but these methods do not engender conviction and will eventually lead speculators to the poor house. If simple short-cuts worked so well, I think the secret would have gotten out to the masses by now. Rather than trading off of tips or questionable technical indicators, Peter Lynch advises investors to do their homework and “buy what you know.”
There is no single way of making money in the stock market, but I’m convinced any worthwhile process incorporates a process of pulling weeds and watering new flowers. But to generate a continuous flow of new stock idea gems, which are necessary to win in the investment game, you will need to turn over a lot of stock rocks.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Performance data from Morningstar.com. 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 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.
Snoozing Your Way to Investment Prosperity
When it comes to investing, do you trade like Jim Cramer on Red Bull – grinding your teeth to every tick or news headline? With the advent of the internet, an unrelenting, real-time avalanche of news items spreads like a furious plague – just ask Anthony Weiner. As fear and greed incessantly permeate the web, and day-trading systems and software are increasingly peddled as profit elixirs, investors are getting itchier and itchier trading fingers. Just consider that investment holding periods have plummeted from approximately 10 years around the time of World War II to 8 months today (see GMO chart below). Certainly, the reduction in trading costs along with the ever-proliferating trend of technology advancements (see Buggy Whip Déjà Vu) is a contributor to the price of trading, but the ADHD-effect of information overload cannot be underestimated (see The Age of Information Overload).
Source: GMO (James Montier)
But fear not, there is a prescription for those addicted, nail-biting day-traders who endlessly pound away on their keyboards with bloody hangnails. The remedy is a healthy dosage of long-term growth investing in quality companies and sustainably expanding trends. I know this is blasphemy in the era of “de-risking” (see It’s All Greek to Me), short-term “risk controls” (i.e. panicking at bottoms and chasing performance), and “benchmark hugging,” but I believe T. Rowe Price had it right:
“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.”
This assessment makes intuitive sense to me, but how can one invest for the long-term when there are structural deficits, inflation, decelerating GDP growth, international nuclear catastrophes, escalated gasoline prices, and Greek debt concerns? There are always concerns, and if there none, then you should in fact be concerned (e.g., when investors piled into equities during the “New Economy” right before the bubble burst in 2000). In order to gain perspective, consider what happened at other points in history when our country was involved in war; came out of recession; faced high employment; experienced Middle East supply fears; battled banking problems; handled political scandals; and dealt with rising inflation trends. One comparably bleak period was the 1974 bear market.
Let’s take a look at how that bear market compared to the current environment:
Then (1974) Now (2011)
End of Vietnam War End of Iraq War (battles in Afghanistan and Libya)
Exiting recession Exiting recession
9% Unemployment 9% Unemployment
Arab Oil Embargo Arab Spring and Israeli-Palestinian tensions
Watergate political scandal Anthony Weiner political scandal
Franklin National Bank failure Banking system bailout
Rising inflation trends Rising inflation trends
We can debate the comparability of events and degree of pessimism, but suffice it to say the outlook was not very rosy 37 years ago, nor is it today. History never repeats itself, but it does tend to rhyme. Although attitudes were dour four decades ago, the Dow Jones exploded from 627 in late 1974 to 12,004 today. I’m not calling for another near 20-fold increase in prices over the next 37 years, but a small fraction of that improvement would put a smile on equity investors’ faces. Jim Fullerton, the former chairman of the Capital Group of the American Funds understood pundits’ skepticism during times of opportunity when he wrote the following in November 1974:
“Today there are thoughtful, experienced, respected economists, bankers, investors and businessmen who can give you well-reasoned, logical, documented arguments why this bear market is different; why this time the economic problems are different; why this time things are going to get worse — and hence, why this is not a good time to invest in common stocks, even though they may appear low.”
Rather than getting glued to the TV horror story headline du jour, perhaps investors should take some of the sage advice provided by investment Hall of Famer, Peter Lynch (Lynch averaged a +29% annual return from 1977-1990 while at Fidelity Investments). Rather than try to time the market, he told investors to “assume the market is going nowhere and invest accordingly.” And Lynch offered these additional words of wisdom to the many anxious investors who fret about macroeconomics and timing corrections:
• “It’s lovely to know when there’s recession. I don’t remember anybody predicting 1982 we’re going to have 14 percent inflation, 12 percent unemployment, a 20 percent prime rate, you know, the worst recession since the Depression. I don’t remember any of that being predicted. It just happened. It was there. It was ugly. And I don’t remember anybody telling me about it. So I don’t worry about any of that stuff. I’ve always said if you spend 13 minutes a year on economics, you’ve wasted 10 minutes.”
• “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”
• “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.”
Real money is not made by following the crowd. Real money is made by buying quality companies and securities at attractive prices. The prescription to generating above-average profits is finding those quality market leaders (or sustainable trends) that can compound earnings growth for multiple years, not chasing every up-tick and panicking out of every down-tick. Following these doctor’s orders will lead to a strong assured mind and a healthy financial portfolio – key factors allowing you to peacefully snooze to investment prosperity.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Performance data from Morningstar.com. 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 TROW, 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.
O’Neil Swings for the Fences
Approaches used in baseball strategy are just as varied as they are in investing. Some teams use a “small ball” approach to baseball, in which a premium is placed on methodically advancing runners around the bases with the help of bunts, bases on ball, stolen bases, sacrifice flies, and hit-and- run plays. Other teams stack their line-up with power-hitters, with the sole aim of achieving extra base hits and home runs.
Investing is no different than baseball. Some investors take a conservative, diversified value-approach and seek to earn small returns on a repeated basis. Others, like William J. O’Neil, look for the opportunities to knock an investment out of the park. O’Neil has no problem of concentrating a portfolio in four or five stocks. Warren Buffett talks about how Ted Williams patiently waited for fat pitches–O’Neil is very choosy too, when it comes to taking investment swings.
The Making of a Growth Guru
Born in Oklahoma and raised in Texas, William O’Neil has accomplished a lot over his 53-year professional career. After graduating from Southern Methodist University, O’Neil started his career as a stock broker in the late-1950s. Soon thereafter in 1963, at the ripe young age of 30, O’Neil purchased a seat on the New York Stock Exchange (NYX) and started his own company, William O’Neil + Co. Incorporated. Ambition has never been in short supply for O’Neil – following the creation of his firm, O’Neil the investment guru put on his computer science hat and went onto pioneer the field of computerized investment databases. He used his unique proprietary data as a foundation to unveil his next entrepreneurial baby, Investor’s Business Daily, in 1984.
O’Neil’s Secret Sauce
The secret sauce behind O’Neil’s system is called CAN SLIM®. O’Neil isn’t a huge believer in stock diversification, so he primarily focuses on the cream of the crop stocks in upward trending markets. Here are the components of CAN SLIM® that he searches for in winning stocks:
C Current Quarterly Earnings per Share
A Annual Earnings Increases
N New Products, New Management, New Highs
S Supply and Demand
L Leader or Laggard
I Institutional Sponsorship
M Market Direction
Rebel without a Conventional Cause
In hunting for the preeminent stocks in the market, the CAN SLIM® method uses a blend of fundamental and technical factors to weed out the best of the best. I may not agree with everything O’Neil says in his book, How to Make Money in Stocks, but what I love about the O’Neil doctrine is his maverick disregard of the accepted modern finance status quo. Here is a list of O’Neil’s non-conforming quotes:
- Valuation Doesn’t Matter: “The most successful stocks from 1880 to the present show that, contrary to most investors’ beliefs, P/E ratios were not a relevant factor in price movement and have very little to do with whether a stock should be bought or sold.” (see also The Fallacy of High P/Es)
- Diversification is Bad: “Broad diversification is plainly and simply a hedge for ignorance… The best results are usually achieved through concentration, by putting your eggs in a few baskets that you know well and watching them very carefully.”
- Buy High then Buy Higher: “[Buy more] only after the stock has risen from your purchase price, not after it has fallen below it.”
- Dollar-Cost Averaging a Mistake: “If you buy a stock at $40, then buy more at $30 and average out your cost at $35, you are following up your losers and throwing good money after bad. This amateur strategy can produce serious losses and weigh down your portfolio with a few big losers.”
- Technical Analysis Matters: “Learn to read charts and recognize proper bases and exact buy points. Use daily and weekly charts to materially improve your stock selection and timing.”
- Ignore TV & So-Called Experts: “Stop listening to and being influenced by friends, associates, and the continuous array of experts’ personal opinions on daily TV shows.”
- Stay Away from Dividends: “Most people should not buy common stocks for their dividends or income, yet many people do.”
Managing Momentum Risk
Although O’Neil’s CAN SLIM® investment strategy does not rely on a full-fledged, risky style of momentum investing (see Riding the Momentum Wave), O’Neil’s investment approach utilizes very structured rules designed to limit downside risk. Since true O’Neil disciples understand they are dealing with flammable and volatile hyper-growth companies, O’Neil always keeps a safety apparatus close by – I like to call it the 8% financial fire extinguisher rule. O’Neil simply states, “Investors should definitely set firm rules limiting the loss on the initial capital they have invested in each to an absolute maximum of 7% or 8%.” If a trade is not working, O’Neil wants you to quickly cut your losses. As the “M” in CAN SLIM® indicates, downward trending markets make long position gains very challenging to come by. Raising cash and cutting margin is the default strategy for O’Neil until the next bull cycle begins.
While some components of William O’Neil’s “cup and handle” teachings (see link)are considered heresy among various traditional financial textbooks, O’Neil’s lessons and CAN SLIM® method shared in How to Make Money in Stocks provide a wealth of practical information for all investors. If you want to add a power-hitting element to your investing game and hit a few balls out of the park, it behooves you to invest some time in better familiarizing yourself with the CAN SLIM® teachings of William O’Neil.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Wade Slome, President of Sidoxia Capital Management (SCM), worked at William O’Neil + Co. Incorporated in 1993-1996. SCM and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in NYX 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.
Getting Paid to Eat Bon-Bons and Sell Options
I have a diverse set of interests, and two of my passions include eating assorted bon bons, and buying stocks low (selling them high). The only thing better than that is to also get paid for doing those same activities. Until I get paid for competing on the national bon bon competitive eating circuit, I’ll stick to getting paid for selling (“writing”) options.
The Mechanics of Option Writing
There are many places to learn about the basics of options, but for simplicity purposes think of options as tools for speculating, hedging, and generating income. Unfortunately, most people trading options lose money because of speculation and numerous shortcomings. Like guns, knives, or any other weapon, if properly used, these self-defense option tools can provide owners with significant benefits. If however the weapons are used irresponsibly, the consequences can be deadly. The same principles apply to options investing – beneficial in the right hands, disastrous in the wrong hands (see also Butter Knife or Cleaver article).
A Pricey Option Illustration
In order to illustrate the mechanics of option writing, let’s use Priceline.com Inc. (PCLN) as an example:
Suppose I did my in-depth fundamental research on Priceline and upon completion of my due diligence I realized that the stock is fairly valued at its current share price of $529. However, upon further consideration I realize I would love to buy 100 shares at a discount price of $500 if Priceline shares pulled back. In mirror-like fashion my fundamental valuation process may also indicate an adequate selling valuation level at a $560 premium.
Based on these previous assumptions, I could profitably sell (“write”) one naked put option with a strike price of $500 and an expiration date in October (approximately five months from today), in exchange for $3,560 in upfront cash less comissions.* That’s right, someone is going to pay me thousands of dollars to buy something I am openly willing to purchase at lower prices anyway. In bon bon terminology, speculators are paying me to eat bon bons, an activity I love even without upfront cash payments from others. In the case of an escalating Priceline share price, I prefer to sell covered calls (i.e. own underlying stock position plus simultaneously selling a call option), consistent with my valuation sell price targets (strik price of $560 per share).
Selling Insurance
Since writing options is effectively like selling insurance, it intuitively follows the best time to sell insurance is when people (investors) are the most nervous. If you were a fire insurance carrier and wanted to maximize collections, setting prices a week after a large fire in the hot, dry summer season around the firework-laden 4th of July may not be a bad choice. In the equity markets, the VIX (Volatility Index) is often referred to as the “fear gauge,” which can be used as an indicator to optimize premium collections from options sales.
Options, which are part of the derivatives family, get lumped into these wide set of financial instruments that billionaire investor Warren Buffett called “weapons of mass destruction.” The ironic part of that whole situation is that despite the evil titling of these instruments, Buffett has used these “weapons of mass destruction” extensively, more recently with his strategies related to selling index options – see Insurance Weapons of Mass Destruction. For those who followed the financial crisis of 2008-2009, observers fully realize that American International Group (AIG) was selling insurance on credit defaults (Credit Default Swaps). Regrettably, the CDS market was not regulated to a similar extent as the more sophisticated options and futures market.
Eating bon bons for pay can be satisfying, and so can trading stocks for cash, when buying them low and selling them high. On the other hand, these same activities can prove to be harmful if abused or misused. If you eat bon bons in moderation, and receive premiums from thoroughly researched naked puts and covered calls, then you have nothing to worry about.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: *Based on 5-9-11 closing trade data from Yahoo Finance. 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 PCLN, AIG, VXX or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Getting & Staying Rich 101
Fred J. Young worked 27 years as a professional money manager and investment counselor in the trust department at Harris Bank in Chicago. While working there he learned a few things about wealth accumulation and preservation, which he outlines in his book How to Get Rich and Stay Rich.
There is more than one way to skin a cat, and when it comes to getting rich, Young describes the only three ways of getting loaded:
1.) Inherit It: Using this method on the path to richness generally doesn’t take a lot of blood, sweat, and tears (perhaps a little brown-nosing wouldn’t hurt), but young freely admits you can skip his book if you are fortunate enough to garner boatloads of cash through your ancestry.
2.) Marry It: This approach to wealth accumulation can require a bit more effort than method number one. However, Young explains that if the Good Lord intended you to find your lifetime lover through destiny, then if your soul-mate has a lot of dough Young advises, “You [should] graciously accept the situation. Don’t fight it.”
3.) Spend < Earn: Normally this avenue to champagne and caviar requires the most effort. How does one execute option number three? “You spend less than you earn and invest the difference in something you think will increase in value and make you rich,” simply states Young. Sounds straightforward, but what does one invest their excess cash in? Young succinctly lists the customary investment tools of choice for wealth creation:
- Real estate
- Own their own business
- Common stocks
- Savings accounts (thanks to the magic of compound interest rates) – see also Penny Saved is Billions Earned
Rich Luck
If faced with choosing between good luck and good judgment, here is Fred Young’s response:
“You should take good luck. Good luck, by definition, denotes success. Good judgment can still go wrong.”
Like many endeavors, it’s good to have some of both (good luck and good judgment).
The Role of Courage
Courage is especially important when it comes to equity investing because buying stocks includes a very counterintuitive behavioral aspect that requires courage. Following the herd of average investors and buying stocks at new highs is easy and does not require a lot of courage. Young describes the various types of courage required for successful investing:
“The courage to buy when others are selling; the courage to buy when stocks are hitting new lows; the courage to buy when the economy looks bad; courage to buy at the bottom…The times when the gloom was the thickest invariably turned out to have been the best times to buy stocks.”
Keeping the Cash
Becoming rich is only half the challenge. In many cases staying rich can be just as difficult as accumulating the wealth. Young points out the intolerable pain caused by transitioning from wealth to poverty. What is Young’s solution to this tricky problem? Seek professional help. The risks undertaken to build wealth still exist when you are rich, and those same risks have the capability of tearing financial security away.
There are three paths to riches according to Fred Young (inheritance, marriage, and prudent investing). Some of these directions leading to mega-money require more effort than others, but if you are lucky enough to have deep pockets of riches, make sure you have the discipline and focus necessary to maintain that wealth – those deep pockets could have a hole.
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 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.
The Fallacy of High P/E’s
Would you pay a P/E ratio (Price-Earnings) of 1x’s future earnings for a dominant market share leading franchise that is revolutionizing the digital industry and growing earnings at an +83% compounded annual growth rate? Or how about shelling out 3x’s future profits for a company with ambitions of taking over the global internet advertising and commerce industries while expanding earnings at an explosive +51% clip? If you were capable of identifying Apple Inc. (AAPL) and Google Inc. (GOOG) as investment ideas in 2004, you would have made approximately +2,000% and +600%, respectively, over the following six years. I know looking out years into the future can be a lot to ask for in a world of high frequency traders and stock renters, but rather than focusing on daily jobless claims and natural gas inventory numbers, there are actual ways to accumulate massive gains on stocks without fixating on traditional trailing P/E ratios.
At the time in 2004, Apple and Google were trading at what seemed like very expensive mid-30s P/E ratios (currently the S&P 500 index is trading around 15x’s trailing profits) before these stocks made their explosive, multi-hundred-percent upward price moves. What seemingly appeared like expensive rip-offs back then – Apple traded at a 37x P/E ($15/$0.41) and Google 34x P/E ($85/$2.51) – were actually bargains of a lifetime. The fact that Apple’s share price appreciated from $15 to $347 and Google’s $85 to $538, hammers home the point that analyzing trailing P/E ratios alone can be hazardous to your stock-picking health.
Why P/Es Don’t Matter
In William O’Neil’s book, How to Make Money in Stocks he comes to the conclusion that analyzing P/E ratios is worthless:
“Our ongoing analysis of the most successful stocks from 1880 to the present show that, contrary to most investors beliefs, P/E ratios were not a relevant factor in price movement and have very little to do with whether a stock should be bought or sold. Much more crucial, we found, was the percentage increase in earnings per share.”
Here is what O’Neil’s data shows:
- From 1953 – 1985 the best performing stocks traded at a P/E ratio of 20x at the early stages of price appreciation versus an average P/E ratio of 15x for the Dow Jones Industrial Average over the same period. The largest winners saw their P/E multiples expand by 125% to 45x.
- From 1990 – 1995, the leading stocks saw their P/E ratios more than double from an average of 36 to the 80s. Once again, O’Neil explains why you need to pay a premium to play with the market leading stocks.
You Get What You Pay For
When something is dirt cheap, many times that’s because what you are buying is dirt. Or as William O’Neil says,
“You can’t buy a Mercedes for the price of a Chevrolet, and you can’t buy oceanfront property for the same price you’d pay for land a couple of miles inland. Everything sells for about what it’s worth at the time based on the law of supply and demand…The very best stocks, like the very best art, usually command a higher price.”
Any serious investor has “value trap” scars and horror stories to share about apparently cheap stocks that seemed like bargains, only to later plummet lower in price. O’Neil uses the example of when he purchased Northrop Grumman Corp (NOC) many years ago when it traded at 4x’s earnings, and subsequently watched it fall to a P/E ratio of 2x’s earnings.
Is Your Stock a Teen or a Senior?
A mistake people often make is valuing a teen-ager company like it’s an adult company (see also the Equity Life Cycle article). If you were offered the proposition to pay somebody else an upfront lump-sum payment in exchange for a stream of their lifetime earnings, how would you analyze this proposal? Would you make a higher lump-sum payment for a 21-year-old, Phi Beta Kappa graduate from Harvard University with a 4.0 GPA, or would you pay more for an 85 year old retiree generating a few thousand dollars in monthly Social Security income? As you can imagine, the vast majority of investors would pay more for the youngster’s income because the stream of income over 65-70 years would statistically be expected to be much larger than the stream from the octogenarian. This same net present value profit stream principle applies to stocks – you will pay a higher price or P/E for the investment opportunity that has the best growth prospects.
Price Follows Earnings
At the end of the day, stock prices follow the long-term growth of earnings and cash flows, whether a stock is considered a growth stock, a value stock, or a core stock. Too often investors are myopically focused on the price action of a stock rather than the earnings profile of a company. Or as investment guru Peter Lynch states:
”People may bet on hourly wiggles of the market but it’s the earnings that waggle the wiggle long term.”
“People Concentrate too much on the P (Price), but the E (Earnings) really makes the difference.”
Correctly determining how a company can grow earnings is a more crucial factor than a trailing P/E ratio when evaluating the attractiveness of a stock’s share price.
Valuations Matter
Even if you buy into the premise that trailing P/E ratios do not matter, valuation based on future earnings and cash flows is critical. When calculating the value of a company via a discounted cash flow or net present value analysis, one does not use historical numbers, but rather future earnings and cash flow figures. So when analyzing companies with apparently sky-high valuations based on trailing twelve month P/E ratios, do yourself a favor and take a deep breath before hyperventilating, because if you want to invest in unique growth stocks it will require implementing a unique approach to evaluating P/E ratios.
See also Evaluating Stocks Vegas Style
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, AAPL, and GOOG, but at the time of publishing SCM had no direct position in NOC, 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.
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