Posts filed under ‘Education’
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.
Reasoning with Investment Confusion
Some things never change, and in the world of investing many of the same principles instituted a century ago are just as important today. So while we are dealing with wars, military conflicts, civil unrest, and natural disasters, today’s process of filtering and discounting all these events into stock prices is very similar to the process that George Selden describes in his 1912 book, “Psychology of the Stock Market.”
Snub the Public
Investing in stocks is nowhere close to a risk-free endeavor, and 2008-2009 was a harsh reminder of that fact. Since a large part of the stock market is based on emotions and public opinion, stock prices can swing wildly. Public opinion may explain why the market is peaking or troughing, but Selden highlights the importance of the silent millionaires (today’s billionaires and institutional investors), and that the true measurement of the stock market is dollars (not opinions of the masses):
“Public opinion in a speculative market is measured in dollars, not in population. One man controlling one million dollars has double the weight of five hundred men with one thousand dollars each. Dollars are the horsepower of the markets–the mere number of men does not signify.”
When the overwhelming consensus of participants is bullish, by definition, the small inexperienced investors and speculators are supplied stock from someone else – the silent, wealthy millionaires.
The newspaper headlines that we get bombarded with on a daily basis are a mirror reflection of the general public’s attitudes and when the euphoria or despondency reaches extreme levels, these points in time have been shown to correlate with market tops and bottoms (see Back to the Future Magazine Covers).
In the short-run, professional traders understand this dynamic and will often take a contrarian approach to news flow. Or as Seldon explains:
“A market which repeatedly refuses to respond to good news after a considerable advance is likelely to be ‘full of stocks.’ Likewise a market which will not go down on bad news is usually ‘bare of stock.’”
This contrarian dynamic in the market makes it virtually impossible for the average investor to trade the market based on the news flow of headlines and commentator. Before the advent of the internet, 98 years ago, Selden prophetically noted that the increasing difficulty of responding to sentiment and tracking market information:
“Public opinion is becoming more volatile and changeable by the year, owing to the quicker spread of information and the rapid multiplication of the reading public.”
Following what the so-called pundits are saying is fruitless, or as Gary Helms says, “If anybody really knew, they wouldn’t tell you.”
Selden’s Sage Advice
If trading was difficult in 1912, it must be more challenging today. Selden’s advice is fairly straightforward:
“Stick to common sense. Maintain a balanced, receptive mind and avoid abstruse deductions…After a prolonged advance, do not call inverted reasoning to your aid in order to prove that prices are going still higher; likewise after a big break do not let your bearish deductions become too complicated.”
The brain is a complex organ, but we humans are limited in the amount and difficulty of information we can assimilate.
“When it comes to so complicated a matter as the price of stocks, our haziness increases in proportion to the difficulty of the subject and our ignorance of it.”
The mental somersault that investors continually manage is due to the practice of “discounting.” Discounting is a process that adjusts today’s price based on future expected news. Handicapping sports “spreads” involves a very similar methodology as discounting stock prices (read What Happens in Vegas). But not all events can be discounted, for instance the recent earthquake and tsunami in Japan. When certain factors are over-discounted or under-discounted, these are the situations to profit from on a purchase or shorting basis.
The Dow Jones Industrial Average traded below a value of 100 versus more than 12,000 today, but over that period some things never change, like the emotional and mental aspects of investing. George Selden makes this point clear in his century old writings – it’s better to focus on the future rather than fall prey to the game of mental somersault we call the stock market.
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 Illusion of the Reverse Split
Source: Photobucket
“Citi is a fundamentally different company than it was three years ago. The reverse stock split and intention to reinstate a dividend are important steps as we anticipate returning capital to shareholders starting next year.”
Okay, so Citigroup is paying out a whopping 1/10 of one penny per your current share price (compared to $.49 per share before the financial crisis) and Vikram is telling me I should be excited. Maybe additional ecstasy should be kicking in once shareholders learn they will receive 1 pie with no slices, rather than 1 pie with 10 slices? These same share-slicing and re-piecing gimmicks were implemented in the pre and post dot-com era with no beneficial value. If this truly was such a novel idea, I wonder why smart people like Warren Buffett have chosen not put such amazing, whiz-bang ideas to use. The lauded 1-10 reverse split planned by Citigroup could also be used to raise Berkshire Hathaway’s share price from $127,766 per share to $1,277,660 per share. One share of post reverse-split BRKA could buy you 288,410 shares of Citigroup today.
Proponents of the reverse split cite the institutional benefits provided by the move. Not only will institutions previously prohibited from buying single digit equity securities now be able to buy Citigroup shares, but institutions will also be able to pay lower commissions because the current 29 billion shares outstanding will be reduced to a measly 2,900,000,000 shares. In reality, reducing share count through a reverse split may fool a few unknowledgeable speculators, but prudent investors understand a reverse split does not impact the value of the company one iota.
The fact of the matter is that earnings and cash flow growth will be the main drivers behind institutional shareholder buying of Citigroup’s stock.
Famous investor John Templeton simply stated, “In the long run, the stock market indexes fluctuate around the long-term upward trend of earnings per share.”
Peter Lynch appreciated the importance of earnings too: “People may bet on hourly wiggles of the market but it’s the earnings that waggle the wiggle long term.”
So while Citigroup may not be a horrible stock, the announcing of a 1 for 10 reverse stock split will not be a share price savior. So rather than let the illusion of capital structure gimmicks inform your decisions, investors would be better served by focusing on the sustainability and growth of earnings and cash flows.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in BRKA/B, C, 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.
Shoring Up Your Investment Stool from Collapse
With March Madness just kicking into full gear, there’s a chance that your gluteal assets may be parked on a stool in the next two weeks. When leaning on a bar countertop, while seated on a stool, we often take for granted the vital support this device provides, so we can shovel our favorite beverage and pile of nachos into our pie holes. OK, maybe I speak for myself when it comes to my personal, gluttonous habits. But the fact remains, whether you are talking about your rump, or your investment portfolio, you require a firm foundation.
The main problem, when it comes to investments, is the lack of a tangible, visible stool to analyze. Sure, you are able to see the results of a portfolio collapse when there is no foundation to support it, or you may even be able to ignore the results when they remain above water. But many investors do not evenperform the basic due diligence to determine the quality of their investment stool. Before you place your life savings in the hands of some brokerage salesman, or in your personal investment account, you may want to make sure your stool has more than one or two legs.
In the money management world, investors typically choose to buy the stool, rather than build it, which makes perfect common sense. Many people do not have the time or emotional make-up to manage their finances. If left to do it themselves, more often than not, investors usually do a less than stellar job. Unfortunately, when many investors do outsource the management of their investments, they neglect to adequately research the investment stool they buy. Usually the wobbly industry stool operates on the two legs of performance chasing and commission generation (see Fees, Exploitation, and Confusion). For most average investors, it doesn’t take long before that investment strategy teeters and collapses.
If the average investor does not have time to critically evaluate managers that take a long-term, low-cost, tax-efficient strategy to investing, those individuals would be best served by following Warren Buffet’s advice about passive investments, “A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money.”
The Four Legs of the Investment Stool
For DIY-ers (Do-It-Yourself-ers), you do not need to buy a stool – you can build it. There are many ways to build a stool, but these are the four crucial legs of investing that have saved my hide over my career, and can be added as support for your investment stool:
1.) Valuation: I love sustainable growth as much as anything, just as much as I would like a shiny new Ferrari. But there needs to be a reasonable price paid for growth, and paying an attractive or fair price for a marquis asset will improve your odds for long-term success.
“Valuations do matter in the stock market, just as good pitching matters in baseball.”
-Fred Hickey (High Tech Strategist)
2.) Cash Flows: Cash flows, and more importantly free cash flows (cash left over after money is spent on capital expenditures), should be investors’ metric of choice. Companies do not pay for dividends, share buybacks, and capital expenditures with pro forma earnings, or non-GAAP earnings. Companies pay for these important outlays with cash.
“In looking for stocks to buy, why do you put so much emphasis on free cash flow? Because it makes the most sense to me. My first job was at a little corner grocery store, and it seemed pretty simple. Cash goes into the register; cash comes out.”
-Bruce Berkowitz (The Fairholme Fund)
3.) Interest Rates: Money goes where it is treated best, so capital will look at the competing yields paid on bonds. Intuitively, interest factors also come into play when calculating the net present value of a stock. Just look at the low Price-Earnings ratios of stocks in the early 1980s when the Fed Funds reached about 20% (versus effectively 0% today). In the long run, higher interest rates (and higher inflation) are bad for stocks, but worse for bonds.
“I don’t know any company that has rewarded any bondholder by raising interest rates [payments] – unlike companies raising dividends.”
-Peter Lynch (Former manager of the Fidelity Magellan Fund)
4.) Quality: This is a subjective factor, but this artistic assessment is as important, if not more important than any of the previous listed factors. In searching for quality, it is best to focus on companies with market share leading positions, strong management teams, and durable competitive advantages.
“If you sleep with dogs, you’re bound to get fleas.”
-Old Proverb
These four legs of the investment stool are essential factors in building a strong investment portfolio, so during the next March Madness party you attend at the local sports bar, make sure to check the sturdiness of your bar stool – you want to make sure your assets are supported with a sturdy foundation.
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 Fairholme, Ferrari, 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.
Killing Patients to Investment Prosperity
All investors are optimistic, every time they open up a position, but just like surgeons, sometimes the outcome doesn’t turn out as well as initially anticipated. When it comes to investing, I think this old Hindu proverb puts things into perspective:
“No physician is really good before he has killed one or two patients.”
So too, an investor does not become really good until he kills off some investment positions. But like surgeons, investors also have to understand the most important aspect of tragic events is learning from them. In many cases, unexpected outcomes are out of our control and cannot be prevented. This conclusion, in and of itself, can provide valuable insights. But on many occasions, there are procedures, processes, and facts that were missed or botched, and learning from those mistakes can prove invaluable when it comes to refining the process in the future – in order to further minimize the probability of a tragic outcome.
My Personal Killers
Professionally, I have killed some stocks in my career too, or they have killed me, depending on how you look at the situation. How did these heartrending incidents occur? There are several categories that my slaughtered stocks fell under:
- Roll-Up, Throw-Up: Several of my investment mistakes have been tied to roll-up or acquisition-reliant growth stories, where the allure of rapid growth shielded the underlying weak fundamentals of the core businesses. Buying growth is easier to create versus organically producing growth. Those companies addicted to growth by acquisition eventually experience the consequences firsthand when the game ends (i.e., the quality of deals usually deteriorates and/or the prices paid for the acquisitions become excessive).
- Technology Kool-Aid: Another example is the Kool-Aid I drank, during the technology bubble days, related to a “story” stock – Webvan, a grocery delivery concept. How could mixing Domino’s pizza delivery (DZP) with Wal-Mart’s (WMT) low-priced goods not work? I’m just lazy enough to demand a service like that. Well, after spending hundreds of millions of dollars and never reaching the scale necessary to cover the razor thin profit margins, Webvan folded up shop and went bankrupt. But don’t give up hope yet, Amazon (AMZN) is refocusing its attention on the grocery space (mostly non-perishables now) and could become the dominant food delivery retailer.
- Penny Stocks = Dollars Lost: Almost every seasoned investor carries at least one “penny stock” horror story. Unfortunately for me, my biotech miracle stock, Saliva Diagnostics (SALV), did not take off to the moon and provide an early retirement opportunity as planned. On the surface it sounded brilliant. Spit in a cup and Saliva Diagnostic’s proprietary test would determine whether patients were infected with the HIV virus. With millions of HIV/AIDS patients spread around the world, the profit potential behind ‘Saliva’ seemed virtually limitless. The technology unfortunately did not quite pan out, and spit turned into tears.
The Misfortune Silver Lining
These stock tragedies are no fun, but I am not alone. Fortunately for me, and other professionals, there is a nine-lives feline element to investing. One does not need to be right all the time to outperform the indices. “If you’re terrific in this business you’re right 6 times out of 10 – I’ve had stocks go from $11 to 7 cents (American Intl Airways),” admitted investment guru Peter Lynch. Growth stock investing expert, Phil Fisher, added: “Fortunately the long-range profits earned from really good common stocks should more than balance the losses from a normal percentage of such mistakes.”
Warren Buffett takes a more light-hearted approach when he describes investment mistakes: “If you were a golfer and you had a hole in one on every hole, the game wouldn’t be any fun. At least that’s my explanation of why I keep hitting them in the rough.”
Some investors purposely forget traumatic investment experiences, but explicitly sweeping the event under the rug will do more harm than good. So the next time you suffer a horrendous stock price decline, do your best to log the event and learn from the situation. That way, when the patient (stock) has been killed (destroyed), you will become a better, more prosperous doctor (investor).
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, WMT, and AMZN but at the time of publishing SCM had no direct position in DZP, Webvan, Saliva Diagnostics, American intl Airways, 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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