Posts filed under ‘Education’
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.
Sigmund Freud the Portfolio Manager
Source: Syracuse.com
Byron Wien, former investment strategist at Morgan Stanley (MS) and current Vice Chairman at Blackstone Advisory Partners (BX), traveled to Austria 25 years ago and used Sigmund Freud’s success in psychoanalytical theory development as a framework to apply it to the investment management field.
This is how Wien describes Freud’s triumphs in the field of psychology:
“He accomplished much because he successfully anticipated the next step in his developing theories, and he did that by analyzing everything that had gone before carefully. This is the antithesis of the way portfolio managers approach their work.”
Wien attempts to reconcile the historical shortcomings of investment managers by airing out his dirty mistakes for others to view.
“I think most of us have developed patterns of mistake-making, which, if analyzed carefully, would lead to better performance in the future…In an effort to encourage investment professionals to determine their error patterns, I have gathered the data and analyzed my own follies, and I have decided to let at least some of my weaknesses hang out. Perhaps this will inspire you to collect the information on your own decisions over the past several years to see if there aren’t some errors that you could make less frequently in the future.”
Here are the recurring investment mistakes Wien shares in his analysis:
Selling Too Early: Wien argues that “profit-taking” alone is not reason enough to sell. Precious performance points can be lost, especially if trading activity is done for the sole purpose of looking busy.
The Turnaround with the Heart of Gold: Sympathy for laggard groups and stocks is inherent in the contrarian bone that most humans use to root for the underdog. Wien highlights the typical underestimation investors attribute to turnaround situations – reality is usually a much more difficult path than hoped.
Overstaying a Winner: Round-trip stocks – those positions that go for long price appreciation trips but return over time to the same stock price of the initial purchase – were common occurrences for Mr. Wien in the past. Wien blames complacency, neglect, and infatuation with new stock ideas for these overextended stays.
Underestimating the Seriousness of a Problem: More often than not, the first bad quarter is rarely the last. Investors are quick to recall the rare instance of the quick snapback, even if odds would dictate there are more cockroaches lurking after an initial sighting. As Wien says, “If you’re going to stay around for things to really improve, you’d better have plenty of other good stocks and very tolerant clients.”
It may have been 1986 when Byron Wien related the shortcomings in investing with Sigmund Freud’s process of psychoanalysis, but the analysis of common age-old mistakes made back then are just as relevant today, whether looking at a brain or a stock.
See also: Killing Patients to Prosperity
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 MS, BX, 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.
Spoonfuls of Investment Knowledge
When it comes to investment advice, I’m a sucker for good quotes, so it should come as no surprise that I am highlighting some rousing material I stumbled upon from a 1978 Financial Analyst Journal article written by Gary Helms (Toward Bridging the Gap). Helms is a Wall Street veteran who managed major mutual funds in the 1970s, the research department for Loeb Rhoades & Co. in the 1980s, and the University of Chicago’s endowment in the 1990s. In an attempt to codify conventional investment wisdom he learned in his career, he established the Helms Ultimate Truths (HUT) system, which cataloged the tenets of real world investment wisdom consistent with practical experience. In order to satisfy the numerical needs of quant-jocks programming for an investment Holy Grail, Helms spoon-feeds readers with a list of tenets – each truth has a nine-digit HUT code attached (with tongue firmly in Helms’s cheek). Here is a partial list of my conventional wisdom favorites bundled into categories that I organized:
Hodgepodge Truisms
“Never confuse brilliance with a bull market.”
“You can’t spend relative performance.”
“If anybody really knew, they wouldn’t tell you.”
“None of the old rules work anymore, but then they never did.”
“When everybody likes a stock, it must go down; when nobody likes a stock, it may go up.”
“You never understand a stock until you’re long (or short).
“A penny saved will depreciate rapidly.”
“Chart breakouts don’t count if your own buying does it.”
“The new high list will do better in the subsequent six months than the new low list will.”
Common Sense Commandments
“In a bull market, be bullish.”
“Two things cause a stock to move – the expected and the unexpected.”
“The stock doesn’t know you own it.”
“The market will fluctuate.”
“A portfolio that goes down 50 per cent and comes back 50 percent is still down 25 per cent.”
“An outstanding portfolio always contains an outstanding stock.”
Numerical Rules of Thumb
“You can be 200 per cent wrong when you switch.”
“Money management is 10 per cent inspiration and 90 per cent perspiration.”
“More stocks double than go to zero.”
“The market is a random walk up a 9.3 per cent grade.”
“Nobody has been right three times.”
“Turnarounds take seven years.”
“The bottom is always 10 per cent below your worst case expectation.”
“If you have a great thought and write it down, it will look stupid 10 hours later.”
“If the idea is right, eighths and quarters won’t matter.”
Principles of Selling
“Sell the stock when it runs off the top (or bottom) of the chart.”
“Sell down to your sleep point.”
“Sell the stock when the company announces a new corporate headquarters.”
“Sell when the research file gets full.”
“Sell your losers and let your runners run.”
Investment Management Realities
“The best thing about money management is that it’s indoor work with no heavy lifting.”
“A good portfolio manager never asks a question unless he knows the answer.”
“The first word in analyst is anal.”
“A bright and energetic guy can make all the mistakes in this business in five years, but fools and sluggards can take a lifetime.”
“Analysts write long research reports when they don’t have time to write short ones.”
“Someone will always have a better record.”
“The trouble with managing money is that everybody once made a successful investment.”
“Every time a trade is made, somebody was wrong.”
“Don’t apologize for acting on your instincts if you’ve spent years developing them.”
“Be long term but watch the ticks.”
“You’ll never know who your friends are until you’ve had two bad years in a row.”
“A guy who likes a stock but doesn’t own it has no right to an opinion.”
Ha-Ha Truths
“Bulls make money and bears make money, but pigs get swine flu.”
“The truth will set you free, but Scotch isn’t bad either.”
“Babe Ruth once led the league in strikeouts.”
“Trust everybody but cut the cards.”
“You can’t kiss all the girls.”
“Get caught bluffing once a night.”
“There is more than one way to skin a cat, and six ways to roll a seven.”
Economic Truths
“Cyclic stocks should be bought when their multiples are high and sold when their multiples are low.”
“Growth will bail you out – if you live long enough.”
“All growth is temporary.”
“Half of your portfolio is cyclic, but you don’t know which half.”
“Own West Coast companies in bull markets, Boston companies in bear.”
Helms’s rules can be very helpful, but I think heeding his advice provided in HUT #: 272451-79-9, “All generalizations are false, including this one,” is an important truth. As you can tell from the abbreviated but extensive list, these spoonfuls of investment gems can be both playfully messy and informatively tasty.
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 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.
6 Traits of a Winning Aggressive Investor
“Winning” means different things to different people, including Charlie Sheen. As I have stated in the past, there is a diverse set of strategies to win in the investment business, much like there are numerous paths to enlightenment among the extensive choices of religions. Regardless of the differences, followers of a strategy or religion generally believe their principles will lead them to prosperity (financial and/or spiritual). One specific flavor of investment religion follows a path of aggression, which Douglas Bellemore describes in his book The Strategic Investor, published in 1963.
Modern finance and textbooks teach us the virtues and powers of diversification, but Bellemore has learned from the school of Warren Buffett, who stated, “Put all your eggs in one basket and then watch that basket very carefully.” Buffett also believes, “Diversification is protection against ignorance.” It’s no surprise that Buffett’s partner Charlie Munger also harbors some skepticism on the topic, “Wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results.”
Bellemore’s Big 6
In his book, Bellemore builds upon this bold, concentrated strategy that he taught at New York University for four decades. He believed there are six basic traits necessary for a successful aggressive investor. Here is a synopsis of the characteristics:
1) Patience: Bellemore explains that success in the investment world does not come overnight, and much of the same thought processes necessary to prosper can be found in the in corporate management world.
“Success depends, in large measure, on the ability to select undervalued situations not presently recognized by the majority of investors and to wait for expected developments to provide capital gains which may only come after several years… Many of the personal qualities for successful business management are the same as those for an aggressive investor.”
2) Courage: When it comes to investments, hiding in a cave will not get you very far. On the topic of courage, Bellemore believed:
“The investor must have solid convictions and the courage and confidence emanating from them –that is, courage, at times, to ignore those who disagree…It is this willingness to differ and accept responsibility that distinguishes the top executive and the top investor.”
3) Intelligence: One need not be a genius to be a successful investor, according to Bellemore, but common sense is much more important:
“Many highly intelligent investors have had poor investment records because they lacked common sense, i.e., the down-to-earth, practical ability to evaluate a situation.”
4) Emotional Stability: Bellemore acknowledges the similarities of this trait to patience but emotional stability encompasses a broader context. Here he describes the necessary trait of emotional stability:
“It is needed to prevent the investor from being engulfed in waves of optimism and pessimism that periodically sweep over Wall Street. Moreover, it is required to separate the facts from the entangled web of human emotions.”
5) Hard Work: Ignorance is not an asset in the investment business, therefore in order to become a successful investor it requires hard work. Bellemore underscores the following:
“[An investor] must be knowledgeable about the company in which he considers making an investment, the industry, the position of the company in the industry, and the place and future of that industry in the economy as a whole.”
6) Willingness to Sacrifice Diversification: By definition, Bellemore asserts outsized gains cannot be achieved with diversification:
“Although wide diversification reduces risks by offsetting mediocre selections with good ones, it also reduces substantially the profit or capital gain potential of a portfolio.”
Bellemore acknowledges aggressive investing is not for everyone, and if the six tenets are not followed, the unqualified investor would be much better off by following a conservative, diversified investment approach. The cost of the conservative path, however, is the potential of winning outsized returns. If winning is a priority for you, and your goal is to achieve outperformance, then you and Charlie Sheen would be in agreement to follow Douglas Bellemore’s six traits of an aggressive investor.
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 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.
Cutting Losses with Fisher’s 3 Golden Sell Rules
Returning readers to Investing Caffeine understand this is a location to cover a wide assortment of investing topics, ranging from electric cars and professional poker to taxes and globalization. Investing Caffeine is also a location that profiles great investors and their associated investment lessons.
Today we are going to revisit investing giant Phil Fisher, but rather than rehashing his accomplishments and overall philosophy, we will dig deeper into his selling discipline. For most investors, selling securities is much more difficult than buying them. The average investor often lacks emotional self-control and is unable to be honest with himself. Since most investors hate being wrong, their egos prevent taking losses on positions, even if it is the proper, rational decision. Often the end result is an inability to sell deteriorating stocks until capitulating near price bottoms.
Selling may be more difficult for most, but Fisher actually has a simpler and crisper number of sell rules as compared to his buy rules (3 vs. 15). Here are Fisher’s three sell rules:
1) Wrong Facts: There are times after a security is purchased that the investor realizes the facts do not support the supposed rosy reasons of the original purchase. If the purchase thesis was initially built on a shaky foundation, then the shares should be sold.
2) Changing Facts: The facts of the original purchase may have been deemed correct, but facts can change negatively over the passage of time. Management deterioration and/or the exhaustion of growth opportunities are a few reasons why a security should be sold according to Fisher.
3) Scarcity of Cash: If there is a shortage of cash available, and if a unique opportunity presents itself, then Fisher advises the sale of other securities to fund the purchase.
Reasons Not to Sell
Prognostications or gut feelings about a potential market decline are not reasons to sell in Fisher’s eyes. Selling out of fear generally is a poor and costly idea. Fisher explains:
“When a bear market has come, I have not seen one time in ten when the investor actually got back into the same shares before they had gone up above his selling price.”
In Fisher’s mind, another reason not to sell stocks is solely based on valuation. Longer-term earnings power and comparable company ratios should be considered before spontaneous sales. What appears expensive today may look cheap tomorrow.
There are many reasons to buy and sell a stock, but like most good long –term investors, Fisher has managed to explain his three-point sale plan in simplistic terms the masses can understand. If you are committed to cutting investment losses, I advise you to follow investment legend Phil Fisher – cutting losses will actually help prevent your portfolio from splitting apart.
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.
