Posts filed under ‘Education’
Short Interest Coiled Springs
If short interest measures the amount of bearish bets against a particular stock, then what are you supposed to do with that data? The answer really depends on your view regarding the research quality of the bears. If you believe the bears have done excellent homework, then it will pay to pile onto the bearish bandwagon and short the stock. There’s just one problem…it’s virtually impossible to know whether the brains of Warren Buffett are leading the shorting brigade, or the boobs of Snookie from Jersey Shore are driving the negative bets.
The situations that I find especially appealing are the cases in which your research conclusions are extremely bullish, yet a large herd of traders have piled up their pessimistic short positions up to the sky in the belief share prices are going lower. These “crowded shorts” provide a large tailwind of pending buy orders – effectively pouring gasoline on the fire – if you are arrogant enough, like me, to believe your bullish thesis will play out. These “short squeezes” occur often when fundamental momentum lasts longer than the bears expect, or when downbeat expectations do not come to fruition. A classic short squeeze occurred when well-known investor Whitney Tilson recently covered his Netflix Inc. (NFLX) short position (see Whitney the Waffler), pushing a high priced stock even higher. Short interest reached almost 13 million shares in September 2010, and declined to a little more than 11 million shares a few weeks ago (compared to about 53 million shares outstanding). Given the stock’s price action, and Tilson’s response, the short interest has likely declined – at least temporarily.
The Challenge of Timing
Shorting is difficult enough with the theoretical unlimited losses hanging over your head, but timing is of the essence too. Often, a short-seller may be correct on their unconstructive view on a particular stock, but the heat in the kitchen gets too hot for them to stick around for the main course. Shorting stocks in a down market can be just as easy as buying in an up market – making money in your shorts in a rising market is that much more difficult.
Rather than follow the herd of short sellers as a trading strategy, I choose to stick with the credo of legendary investor Benjamin Graham, who stated:
“You’re neither right nor wrong because others agree with you. You’re right because your facts and reasoning are right.”
It’s my strong belief the long-term share price of a stock is driven by the sustainable earnings and cash flows of a company. The direction of price and earnings (cash flow) may diverge in the short-run, but in the long-run the relationship between price and profits converges.
Shorting Criteria
The criteria for shorting a stock are just as varied as the factors used to buy a stock, but these are some of the factors I consider when shorting a stock:
- Weak and/or deteriorating market share positioning.
- Excessive leverage – substandard financial positioning.
- Weak cash flow based quality of earnings.
- Management mis-execution and deteriorating fundamentals.
- Expensive valuations on an absolute and relative basis.
A stock is not required to exhibit all these characteristics simultaneously in order to generate a profitable short position, but the framework works for me.
If long investing is your main focus, then I urge you seek out those heavily shorted stocks that maintain attractive growth opportunities at attractive prices. If you are going to seek out rising stocks, you may as well use the assistance of a coiled spring to get you there.
Click Here to Check Out High Short Interest Stocks
Click Here for NYSE Shorts at WSJ
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and NFLX, 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.
Creating Your Investment Dashboard
Navigating the financial markets can be difficult in this volatile environment we’ve experienced over the last few years, which is why it is more important than ever to have a financial dashboard to ensure you do not drive off a cliff. If investors do not have the time or focus to drive their financial future, then perhaps for the safety of themselves and others, they may consider taking the bus or hiring a chauffeur. For those committed to handling their finances on their own, the road may become rocky, so here are some important factors to monitor on your financial dashboard:
1) Fundamental Direction: Before you decide on an investment destination, it is important to know whether trends are accelerating (speeding up) or deteriorating (slowing down) – see also Forecasting – Trend Analysis.
2) Are You Going the Speed limit? Nobody wants to get a costly speeding ticket, therefore assessing valuation metrics on your dashboard is a beneficiary tool. If you are speeding along the highway at a 100 miles per hour in an expensive stock (e.g., trading at a 50x+ Price/Earnings multiple), then there is little room for error. When traveling that fast you can forget about the price of a speeding ticket, because hitting a pothole at those speeds (valuation) can be much more costly to your portfolio, if you are not careful.
3) Temperature Outside: There’s a huge difference between driving in the icy-cold snow and in 100 degree heat. Each environment has its own challenges. The same principle applies to the financial markets. On occasion, sentiment can become red hot, forcing heightened caution, whereas during other periods, chilling fear can scare everyone else off the roads, leaving clear sailing ahead.
4) Optimal Tire Pressure: Low pressure or bald tires can lead to treacherous driving conditions. A company with healthy cash flow generation relative to its market capitalization can make your investment ride a lot more stable (see also Cash Flow Register). Dividends and share buybacks are generated from healthy and stable cash flows…not earnings.
5) Driver Skill Level: People generally believe they are better than average drivers, however statistics tell a different story. By definition, half of all drivers must be below average. If you are going to put your life’s retirement assets into stocks, you might as well select those companies led by seasoned management teams with proven track records.
Many investors drive blindly without relying on a dashboard. In the investment world, visibility is not very clear. Often, weather conditions in the financial markets become rainy, dark, and/or foggy. If you don’t want your portfolio to crash, it makes sense to build a reliable dashboard to navigate through the hazardous investment road conditions.
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.
Performance Beauty in Eye of Beholder
The average person may be a good judge in picking the winner of a beauty contest, but unfortunately your average investor is ill-equipped to sift through the thousands of mutual funds and hedge funds and thoughtfully discern the relevant performance metrics for investment purposes.
Investment firms however, are well-equipped with smoke, mirrors, and a tool-chest filled with numerous tricks. Here are a few of the investment firms’ gimmicks:
- Cherry Picking: Fund firms are notorious with cutting out the bad performance numbers and cherry picking the good periods. As investment guru Charles Ellis reminds us, the wow factor results of “investment performance become quite ordinary by simply adding or subtracting one or two years at the start or the end of the period shown. Investors should always get the whole record – not just selected excerpts.”
- Limited Time Period: Often the period highlighted by investment firms is insufficient to make a proper conclusion regarding a manager’s outperformance capabilities. Ellis acknowledges that gathering enough yearly performance information can be practically challenging:
“By the time you had gathered enough data to determine whether your fund manager really was skillful or just lucky, at least one of you would probably have died of old age.”
- Fee Disclosure: Some managers’ performance figures look stupendous until one realizes once hefty fees are subtracted from the reported figures, what previously looked top-notch is now average or below-average. It is important to read the small print or ask tough questions of the broker peddling a fund.
- Audited Figures: Legitimacy of performance is key, and there are different levels of audited figures. Global Investment Performance Standards (GIPS) compliance is an industry accepted standard. For pooled investment vehicles, audited results from regional or national accounting firms can be important too.
- Misused Rating Systems: Morningstar is the 800 pound gorilla in the mutual fund world and provides some useful data. Unfortunately, most Morningstar investors use the data incorrectly. A 2000 study by the Journal of Financial and Quantitative Analysis discovered, “There is little statistical evidence that Morningstar’s highest-rated funds outperform the medium-rated funds.” On this subject, Charles Ellis points out the following:
“While Morningstar candidly admits that its star ratings have little or no predictive power, 100 percent of net new investment money going into mutual funds goes to funds that were recently awarded five stars and four stars…Indeed, in the months after the ratings are handed out each year, the five-star funds generally earn less than half as much as the broad market index!…Morningstar ratings are misleading investors into buying high and selling low.”
Investors need to be careful in how they use the ratings – simply buying 4-5 star funds and selling star-losing funds can be a heartburning recipe for bad results. Buying high and selling low usually doesn’t turn out very well.
Find Winners…Then What?
Even if you are successful in identifying the winning funds, those same funds tend to underperform in subsequent periods. Ellis, a believer in passive index investing, noticed only 10% of active managers outperformed over 25 years, and the odds of sustaining outperformance in subsequent periods diminished even further.
Charles Ellis also noticed a fat-tail syndrome of losers versus winners. For example, Ellis found 2% of active managers outperformed over a set time period, but a whopping 16% underperformed the market over a similar timeframe. Consistent with these findings, Ellis stresses that past performance does not predict future results, with one exception: “The worst losers do tend to keep losing. If you do decide to select active investment managers, promise yourself you will stay with your chosen manager for many years…changing managers is not only expensive, but it usually doesn’t work.”
Professionals to the Rescue
Well, if individuals are not in a position to pick future winning fund managers, then thank heavens the professional consultants can help out…not exactly. Ellis was blunt about the capabilities of those professionals selecting active investment managers:
“Pension executives and investment consultants who specialize in selecting the best managers have, as a group, been unsuccessful at selecting managers who can beat the market.”
Ellis uses a respected firm as an example to prove his point:
“Cambridge Associates reports candidly, ‘There is no sound basis for hiring or firing managers solely on the basis of recent performance.’”
At the end of the day, finding current winners is not a problem, but sifting through the massive quantity of funds and selecting future winners is very challenging for individuals and professionals alike. The financial industry would like you to believe picking the future performance beauty winner is a simple task – the data seems to indicate otherwise. Rather than wasting your money attempting to pick the beauty winner, perhaps your money would be better spent on purchasing a tiara for yourself.
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 MORN, Cambridge Associates, 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.
Playing the Field with Your Investments
For some, casually dating can be fun and exciting. The same goes for trading and speculating – the freedom to make free- wheeling, non-committal purchases can be exhilarating. Unfortunately the costs (fiscally and emotionally) of short-term dating/investing often outweigh the benefits.
Fortunately, in the investment world, you can get to know an investment pretty well through fundamental research that is widely available (e.g., 10Ks, 10Qs, press releases, analyst days, quarterly conference calls, management interviews, trade rags, research reports). Unlike dating, researching stocks can be very cheap, and you do not need to worry about being rejected.
Dating is important early in adulthood because we make many mistakes choosing whom we date, but in the process we learn from our misjudgments and discover the important qualities we value in relationships. The same goes for stocks. Nothing beats experience, and in my long investment career, I can honestly say I’ve dated/traded a lot of pigs and gained valuable lessons that have improved my investing capabilities. Now, however, I don’t just casually date my investments – I factor in a rigorous, disciplined process that requires a serious commitment. I no longer enter positions lightly.
One of my investment heroes, Peter Lynch, appropriately stated, “In stocks as in romance, ease of divorce is not a sound basis for commitment. If you’ve chosen wisely to begin with, you won’t want a divorce.”
Charles Ellis shared these thoughts on relationships with mutual funds:
“If you invest in mutual funds and make mutual funds investment changes in less than 10 years…you’re really just ‘dating.’ Investing in mutual funds should be marital – for richer, for poorer, and so on; mutual fund decisions should be entered into soberly and advisedly and for the truly long term.”
No relationship comes without wild swings, and stocks are no different. If you want to survive the volatile ups and downs of a relationship (or stock ownership), you better do your homework before blindly jumping into bed. The consequences can be punishing.
Buy and Hold is Dead…Unless Stocks Go Up
If you are serious about your investments, I believe you must be mentally willing to commit to a relationship with your stock, not for a day, not for a week, or not for a month, but rather for years. Now, I know this is blasphemy in the age when “buy-and-hold” investing is considered dead, but I refute that basic premise whole-heartedly…with a few caveats.
Sure, buy-and-hold is a stupid strategy when stocks do nothing for a decade – like they have done in the 2000s, but buying and holding was an absolutely brilliant strategy in the 1980s and 1990s. Moreover, even in the miserable 2000s, there have been many buy-and-hold investments that have made owners a fortune (see Questioning Buy & Hold ). So, the moral of the story for me is “buy-and-hold” is good for stocks that go up in price, and bad for stocks that go flat or down in price. Wow, how deeply profound!
To measure my personal commitment to an investment prospect, a bachelorette investment I am courting must pass another test…a test from another one of my investment idols, Phil Fisher, called the three-year rule. This is what the late Mr. Fisher had to say about this topic:
“While I realized thoroughly that if I were to make the kinds of profits that are made possible by [my] process … it was vital that I have some sort of quantitative check… With this in mind, I established what I called my three-year rule.” Fisher adds, “I have repeated again and again to my clients that when I purchase something for them, not to judge the results in a matter of a month or a year, but allow me a three year period.”
Certainly, there will be situations where an investment thesis is wrong, valuation explodes, or there are superior investment opportunities that will trigger a sale before the three-year minimum expires. Nonetheless, I follow Fisher’s rule in principle in hopes of setting the bar high enough to only let the best ideas into both my client and personal portfolios.
As I have written in the past, there are always reasons of why you should not invest for the long-term and instead sell your position, such as: 1) new competition; 2) cost pressures; 3) slowing growth; 4) management change; 5) valuation; 6) change in industry regulation; 7) slowing economy; 8 ) loss of market share; 9) product obsolescence; 10) etc, etc, etc. You get the idea.
Don Hays summed it up best: “Long term is not a popular time-horizon for today’s hedge fund short-term mentality. Every wiggle is interpreted as a new secular trend.”
Peter Lynch shares similar sympathies when it comes to noise in the marketplace:
“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.”
Every once in a while there is validity to some of the concerns, but more often than not, the scare campaigns are merely Chicken Little calling for the world to come to an end.
Patience is a Virtue
In the instant gratification society we live in, patience is difficult to come by, and for many people ignoring the constant chatter of fear is challenging. Pundits spend every waking hour trying to explain each blip in the market, but in the short-run, prices often move up or down irrespective of the daily headlines. Explaining this randomness, Peter Lynch said the following:
“Often, there is no correlation between the success of a company’s operations and the success of its stock over a few months or even a few years. In the long term, there is a 100% correlation between the success of a company and the success of its stock. It pays to be patient, and to own successful companies.”
Long-term investing, like long-term relationships, is not a new concept. Investment time horizons have been shortening for decades, so talking about the long-term is generally considered heresy. Rather than casually date a stock position, perhaps you should commit to a long-term relationship and divorce your field-playing habits. Now that sounds like a sweet kiss of success.
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.
Your Portfolio’s Silent Killer
Shhh, if you listen closely enough, you may hear the sound of your portfolio disintegrating away due to the quiet killer…inflation. Inflation is especially worrisome with what we’ve seen happening with commodity prices and the drastic fiscal challenges our country faces. Quantitative Easing (read Flying to the Moon) has only added fuel to the inflation fear flames.
Whether you’re a conspiracy theorist who believes the government inflation data is cooked, or you are a Baby Boomer just looking to secure your retirement, it doesn’t take a genius to figure out that movies, pair of jeans, a tank of gas, concert tickets, or healthcare premiums are all going up in price (See also Bacon and Oreo Future).
Inflation starting to heat up. Source: IMF/Bloomberg via Financial Times
Companies are currently churning out quarterly results in volume and seeing the impact from commodity prices, whether you are McDonald’s Corp. (MCD) facing rising beef prices or luxury handbag maker Coach Inc. (COH) dealing with escalating leather costs, margins are getting crimped. Investors, especially those on fixed income streams, are experiencing the same pain as these corporations, but the problem is much worse. Unlike a market share leading company that can pass on price increases onto its customers, an investor with piles of cash, and low yielding CDs (Certificates of Deposit), and bonds runs the risk of getting eaten alive. Baby Boomers are beginning to reach retirement age in mass volume. Life spans are extending, and this demographic pool of individuals will become ever-large consumers of costlier and costlier healthcare services. If investments are not prudently managed, Baby Boomers will see their nest eggs evaporate, and be forced to work as Wal-Mart (WMT) greeters into their 80s…not that there’s anything wrong with that.
Every day investors are bombarded with a hundred different scary headlines on why the economy will collapse or the world will end. Most of these sensationalist scare tactics distort the truth and overstate reality. What is understated is what Charles Ellis (see Winning the Loser’s Game) calls a “corrosive power”:
“Over the long run, inflation is the major problem for investors, not the attention-getting daily or cyclical changes in securities prices that most investors fret about. The corrosive power of inflation is truly daunting: At 3 percent inflation – which most people accept as ‘normal’ – the purchasing power of your money is cut in half in 24 years. At 5 percent inflation, the purchasing power of your money is cut in half in less than 15 years – and cut in half again in 15 years to just one-quarter.”
In order to bolster his case, Ellis cites the following period:
“From 1977 to 1982, the inflation-adjusted Dow Jones Industrial Average took a five-year loss of 63 percent…In the 15 years from the late 1960s to the early 1980s the unweighted stock market, adjusted for inflation, plunged by about 80 percent. As a result, the decade of the 1970s was actually worse for investors than the decade of the 1930s.”
Solutions – How to Beat Inflation
Although the gold bugs would have you believe it, we are not resigned to live in a world with worthless money, which only has a useful purpose as toilet paper. There are ways to protect your portfolio, if you are properly invested. Here are some strategies to consider:
- TIPS (Treasury Inflation Protection Securities): These government-guaranteed tools are a useful way to protect yourself against rising inflation (see Drowning TIPS).
- Equities (including real estate): Bond issuers do not generally call up there investors and say, “You are such a great investor, so we have decided to increase your interest payments.” However, many publicly traded stocks do exactly that. Wal-Mart Stores (WMT) is an example of such a company that has increased its dividend for 37 consecutive years. As alluded to earlier, stocks are unique in that they allow inflationary pressures placed on operating profits to be relieved somewhat by the ability to pass on price increases to customers.
- Commodities: Whether you are talking about petroleum products, precious metals (those with a commercial purpose), or agricultural goods, commodities in general act as a great inflationary hedge. Another reason that commodities broadly perform better in an inflationary environment is because the U.S. dollar can often depreciate, which commonly increases the value of commodities.
- Short Duration Bonds: Rising rates are usually tied to escalating inflation, therefore investors would be best served by reducing maturity length and increasing coupon.
There are other ways of battling the inflation problem, but number one is saving and investing across a broadly diversified portfolio. If you want to secure and grow your nest egg, you need to use the silent power of compounding (see Penny Saved is Billion Earned) to combat the silent killer of inflation.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, WMT, TIP, equities, commodities, and short duration bonds, 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.
Operating Earnings: Half-Empty or Half-Full?
A continual debate goes on between bulls and bears about which earnings metric is more important: reported earnings based on GAAP (Generally Accepted Accounting Principles) or “operating earnings,” which exclude one-time charges and gains, along with non-cash charges, such as options expenses. Bulls generally prefer operating earnings (glass half-full) because they are typically higher than GAAP earnings (glass half-empty), and therefore operating earnings make valuation metrics more attractive. This disparity between earnings choice is even broader over the last few years due to the massive distortions created by the financial crisis – gigantic write-downs at the vast majority of financial institutions and enormous restructurings at non-financial companies.
Options Smoptions
The options expense issue can also become a religious argument, similar to the paradoxical question that asks if God can create a rock big enough that he himself cannot budge? Logic would dictate that operating earnings should adequately account for option issuance in the denominator of the earnings per share calculation (Net Income / Shares Outstanding). As far as I’m concerned, the GAAP method reducing the numerator of EPS (Earnings Per Share) with an expense, and increasing the denominator by increasing shares from option issuance is merely double counting the expense, thereby distorting reality. Reading through an annual report and/or proxy may not be a joyous experience, but the exercise will help you triangulate share issuance estimates to forecast the drag on future EPS.
On a trailing 12-month basis (Sep’09 – Sep’10), Standard & Poor’s calculated reported earnings with about a -9% differential from operating earnings, equating to approximately a 1.5 Price/Earnings multiple point differential (17.8x’s for reported earnings and 16.2 x’s for operating earnings). For the half-glass full bulls, the picture looks even prettier based on 2011 operating earnings forecasts – the S&P 500 index is priced at roughly 13.6x’s the 2011 index earnings value of $95.45.
Forward More Important Than Backwards
As I make the case in my P/E binoculars article, the market is like a game of chess – a good player doesn’t care nearly as much about an opponent’s last moves as he/she cares about the opponent’s future moves. Financial markets operate in the same fashion, future earnings are much more important than prior earnings. From a practical standpoint, GAAP earnings are relatively useless. Market purists can evangelize about the merits of GAAP earnings until they are blue in the face, but the fact of the matter is that investors are whipping prices all over the place based on Wall Street EPS forecasts – based on operating earnings (not GAAP). In many instances, especially throughout much of the financial crisis, operating earnings will more closely align with the cash flows of a company relative to GAAP earnings, but detailed fundamental analysis is needed.
As far as I’m concerned, much of this GAAP vs Non-GAAP earnings debate is moot because both reported earnings and operating earnings can both be manipulated and distorted. I prefer using cash flows (see Cash Flow Statement article) because cash register accounting – the analysis of money coming in and out of a company – limits the ability of bean counters to use smoke and mirror strategies traditionally saved for the income statement. In other words, you cannot compensate employees, do acquisitions, distribute dividends, or buyback stock with GAAP earnings…all these functions require cold, hard cash. The key metric, rather than EPS, should be free cash flow per share. Growth companies with high return prospects should be given some leeway, but if the projects don’t earn a return, eventually cash resources will dry up. When EPS is materially higher than free cash flow per share, yellow flags fly up and I do additional research to understand the dynamics causing the differential.
These earnings-based arguments will likely never get resolved, but if investors focus on bottom-up analysis on individual security cash flows, determining whether the glass is half-empty or half-full will become much easier.
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. The trailing 12 month data was calculated by S&P as of 1/19/2011. Forward 2011 operating earnings were calculated as of 1/18/2011. 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.
New Year’s Investing Resolutions
As we exit 2010 and enter 2011, many people go through the annual ritual of making personal New Year’s resolutions. Here is a list of go-to resolutions if you haven’t made one, or are having trouble coming up with one.
1) Lose weight
2) Spend More Time with Family & Friends
3) Quit Smoking
4) Quit Drinking
5) Enjoy Life More
6) Save Money & Get Out of Debt
7) Learn Something New
8) Help Others
9) Get Organized
10) Travel More
I have a few on the list above that I would like to work on, but when it comes to investing, there are a few other resolutions I am looking to make or maintain in 2011:
1) Don’t be a Hog. The last few years have produced excellent returns, but we all know that pigs get fat, and hogs get slaughtered. Cashing the register and banking some of my gains can be frustrating when positions charge higher, but sticking to a disciplined approach pays off handsomely in the long-run and helps navigate through the volatile times.
2) Follow Crash Litmus Test. Only buy what you would confidently purchase at lower prices. Sure, company or industry fundamentals can change over time, but for the vast majority of the time, companies and industries do not undergo paradigm shifts. Even though there are a 1,001 bombs that get launched daily, explaining why the world is coming to an end, I do my best to block out the useless noise and stick to the numbers and facts.
3) Remove Name Creep. It’s easy to fall in love with every new stock that walks by, but limiting the number requires a conviction discipline that pays off in the long run. Academic research and practical experience dictate diversification can be achieved without spreading yourself too thin. As Warren Buffett says, “I prefer to keep all my eggs in one basket and watch that basket closely.”
4) Tirelessly Turn Stones. I love my portfolio right now, but I know there are unique opportunities out there that can improve my results, if I take the time and make the effort.
5. Don’t Rush Into Tips. I’ve purchased or shorted securities recommended by respected investors, but it is important to do your own homework first. Even if these ideas work in the short-run, tips usually fall into loose hands and get punted at the worst times. Perform adequate due diligence to strengthen the roots of your thesis for volatile times.
6. Don’t Get Drunk on Story Stocks. There is never a shortage of great ideas, but many of them carry hefty price tags and have high expectations baked into future earnings growth estimates. Even if great stories exist in abundance, there is a shortage of great managers that can profit from great ideas. Associated high prices can however quickly turn a great story into a sad story – once excessively high expectations are not met, prices eventually will collapse.
7. Build Contingency Plan for Overconfidence. It’s important to have an exit strategy or contingency plan in place if things do not play out as planned. Overconfidence can be the pitfall for many investors, and this is not surprising when factoring in how highly people generally feel about themselves. Most believe they are better than average drivers, parents, and have superior intuition. This same overconfidence may not harm you in the real world, but in the financial markets, overconfidence can result in a woodshed beating. Confidence will not kill your portfolio, but arrogant confidence will.
8. Stick to Knitting. We all have our strengths and weaknesses. I do my best to stay away from my blind spots. As legendary baseball player Ted Williams discussed in his book The Science of Hitting, players are much better off by patiently waiting for the fat pitch in the sweet spot of the strike zone before swinging. Finding your sweet spot and not venturing out of your circle of competence is just as important in the investing world as it is in baseball hitting.
9. Trade Less. Trading is fun and exciting, but paying commissions on top of bid-ask spreads, impact costs, and other fees removes some of the enjoyment. Trading is a necessary evil to make profits, but requires the trader to be right twice – once on the sale, and another time on the purchase. Even if you are right on both sides of the trade, chances are the fees, taxes, commissions, and impact costs will remove most if not all of the profits.
10. Learn from Mistakes. Unfortunately, 2011 will be another year that I will not remain mistake-free. Conveniently forgetting investment mistakes is a great rationalization mechanism, but forever sweeping blunders under the rug without learning from them will not make you a better investor.
If you are able to set aside some of those Bonbons and pay off those credit card balances, then maybe you can join me and take on an investing resolution or two. Don’t worry, like all resolutions, you always have the option of making the resolution without following through!
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 Art of Weather Forecasting and Investing
Source: Photobucket
I’ve lived across the country and traveled around the world and have experienced everything from triple-digit desert heat to sub-zero wind chill. The financial markets experience the same variability over time.
Forecasting the weather is a lot like forecasting the stock market. In the short-run, volatility in patterns can be very difficult to predict, but if efforts are energized into analyzing long-term factors, trends can be identified.
For example, I live here in Southern California, and although weather is fairly homogenous, the variability can be significant on a day-to-day basis. I’m much more likely to be accurate in estimating the long-term climate than the forecast seven days from now. I’m not trying to rub salt in the wounds of those people freezing in Antarctica or the upper-Midwest, but forecasting a climate of 72 degrees, sunny, and blue skies is a good fall-back scenario if you are a television weatherman in Southern California.
Charles Ellis, author of the Winning the Loser’s Game – “WTLG” (see Investing Caffeine article #1 and article #2), highlights the weather analogy more convincingly:
“Weather is about the short run; climate is about the long run – and that makes all the difference. In choosing a climate in which to build a home, we would not be deflected by last week’s weather. Similarly, in choosing a long-term investment program, we don’t want to be deflected by temporary market conditions.”
Ellis adds:
“Like the weather, the average long-term experience in investing is never surprising, but the short-term experience is constantly surprising.”
In the financial markets the weather predicting principle applies to long-term economic forecasts as well. Predicting annual GDP growth can often be more accurate than the expected change in Dow Jones Industrial Index points tomorrow or the next day.
Economic Weathermen
As I outlined in Professional Guesses Probably Wrong, economists and strategists use several means of making their guesses.
- One method is to simply not make forecasts at all, but rather use some big words and current news to explain what currently is happening in the economy and financial markets.
- A second approach used by prognosticators is to constantly change forecasts. Consider a person making a weather forecast every minute…his/her forecast would be very accurate, but it would be changing constantly and not provide much more value than what an ordinary person could gather by looking out their own window.
- Thirdly, some use the “spaghetti approach” – throw enough scenarios out there against the wall and something is bound to stick – regardless of accuracy.
- Lastly, the “extend and pretend” method is often implemented. Forecasters make big bold economic predictions that garner lots of attention, but when the expectations don’t come true, the original forecast is either forgotten by investors or the original forecast just becomes extended further into the future.
Coin Flipping
If the weather analogy doesn’t work for you, how about a coin-flipping analogy? The short-term randomness surrounding the consecutive number of heads and tails may make no sense in the short-run, but will mean revert to an average over time. In other words, it is possible for someone to flip 10 consecutive “tails,” but in the long-run, the number of times a coin will land on “tails” will come close to averaging half of all coin tosses. The same dynamic is observed in the investment world. Often, short-term spikes or declines are short lived and return toward a mean average. IN WTLG, Ellis provides some more color on the topic:
“The manager whose favorable investment performance in the recent past appears to be ‘proving’ that he or she is a better manager is often – not always, but all too often – about to produce below-average results…A large part of the apparently superior performance was not due to superior skill that will continue to produce superior results but was instead due to that particular manager’s sector of the market temporarily enjoying above-average rates of return – or luck.”
Regardless of your interests in weather forecasting or coin-flipping, when it comes to investing you will be better served by following the long-term climate trends and probabilities. Otherwise, the performance outlook for your investment portfolio may be cloudy with a chance of thunderstorms.
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.
Ellis on Battling Demons and Mr. Market
A lot of ground was covered in the first cut of my review on Charles Ellis’s book, Winning the Loser’s Game (“WTLG”). His book covers a broad spectrum of issues and reasons that help explain why so many amateurs and professional investors dramatically underperform broad market indexes and other forms of passive investing (such as index funds).
A major component of investor underperformance is tied to the internal or emotional aspects to investing. As I have written in the past, successful investing requires as much emotional art as it does mathematical science. Investing solely based on numbers is like a tennis player only able to compete with a backhand – you may hit a few good shots, but will end up losing in the long-run to the well-rounded players.
Ellis recognizes these core internal shortcomings and makes insightful observations throughout his book on how emotions can lead investors to lose. As George J.W. Goodman noted, “If you don’t know who you are, the stock market is an expensive place to find out.” Hopefully by examining more of Ellis’s investment nuggets, we can all become better investors, so let’s take a deeper dive.
Mischievous Mr. Market
Why is winning in the financial markets so difficult? Ellis devotes a considerable amount of time in WTLG talking about the crafty guy called “Mr. Market.” Here’s how Ellis describes the unique individual:
“Mr. Market is a mischievous but captivating fellow who persistently teases investors with gimmicks and tricks such as surprising earnings reports, startling dividend announcements, sudden surges of inflation, inspiring presidential announcements, grim reports of commodities prices, announcements of amazing new technologies, ugly bankruptcies, and even threats of war.”
Investors can easily get distracted by Mr. Market, and Ellis makes the point of why we are simple targets:
“Our internal demons and enemies are pride, fear, greed, exuberance, and anxiety. These are the buttons that Mr. Market most likes to push. If you have them, that rascal will find them. No wonder we are such easy prey for Mr. Market with all his attention-getting tricks.”
The market also has a way of lulling investors into complacency. Somehow, bull markets manage to make geniuses not only out of professionals and amateur investors, but also cab drivers and hair-dressers. Here is Ellis’s observation of how we tend to look at ourselves:
“We also think we are ‘above average’ as car drivers, as dancers, at telling jokes, at evaluating other people, as friends, as parents, and as investors. On average, we also believe our children are above average.”
This overconfidence and elevated self-assessment generally leads to excessive risk-taking and eventually hits arrogant investors over the head like a sledgehammer. Michael Mauboussin, Legg Mason Chief Investment Strategist and author of Think Twice, is a current thought leader in the field of behavioral finance that tackles many of these behavioral finance issues (read my earlier piece).
The Collateral Damage
As mentioned by Ellis in the previous WTLG article I wrote, “Eighty-five percent of investment managers have and will continue over the long term to underperform the overall market.” When emotions take over our actions, Mr. Market has a way of making investors make the worst decisions at the worst times. Ellis describes this phenomenon in more detail:
“The great risk to individual investors is not that the market can plummet, but that the investor may be frightened into liquidating his or her investments at or near the bottom and miss all the recovery, making the loss permanent. This happens to all too many investors in every terrible market drop.”
With the market about doubling from the early 2009 equity market lows, this devastating problem has become more evident. With volatility rearing its ugly head throughout 2008 and early 2009, investors bailed into low-yielding cash and Treasuries at the nastiest time. Now the stock market has catapulted upwards and those same investors now face significant interest rate risk and still are experiencing meager yields.
The Winning Formula
Ellis acknowledges the difficulty of winning at the investing game, but experience has shown him ways to combat the emotional demons. Number one…know thyself.
“’Know thyself’ is the cardinal rule in investing. The hardest work in investing is not intellectual; it’s emotional.”
Knowing thyself is easier said than done, but experience and mistakes are tremendous aids in becoming a better investor – especially if you are an investor who spends time studying the missteps and learns from them.
From a practical portfolio construction standpoint, how can investors combat their pesky emotions? Probably the best idea is to follow Ellis’s sage advice, which is to “sell down to the sleeping point. Don’t go outside your zone of competence because outside that zone you may get emotional, and being emotional is never good for your investing.”
Finding good investment ideas is just half the battle – fending off the demons and Mr. Market can be just as, if not more, challenging. Fortunately, Mr. Ellis has been kind enough to share his insights, allowing investors of all types to take this valuable investment advice to help win at a losing game.
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.
Winning the Loser’s Game
Besides hanging out with family and friends, and stuffing my face with endless amounts of food, the other benefit of the holidays is the quality time I’m afforded to dive into a few books. While sinking into the couch in my bloated state, I had the pleasure of reading an incredible, investment classic by Charles Ellis, Winning the Loser’s Game – “WTLG” (click here to view other remarkable book I read [non-investment related]). To put my enthusiasm in perspective, WTLG has even achieved the elite and privileged distinction of making the distinguished “Recommended Reading” list of Investing Caffeine (located along the right-side of the page). Wow…now I know you must be really impressed.
The Man, The Myth, the Ellis
For those not familiar with Charley Ellis, he has a long, storied investment career. Not only has he authored 12 books, including compilations on Goldman Sachs (GS) and Capital Group, but his professional career dates back prior to 1972, when he founded institutional consulting firm Greenwich Associates. Besides earning a college degree from Yale University, and an MBA from Harvard Business School, he also garnered a PhD from New York University. Ellis also is a director at the Vanguard Group and served as Investment Committee chair at Yale University along investment great David Swensen (read also Super Swensen) from 1992 – 2008.
With this tremendous investment experience come tremendous insights. The original book, which was published in 1998, is already worth its weight in gold (even at $1,384 per ounce), but the fifth edition of WTLG is even more valuable because it has been updated with Ellis’s perspectives on the 2008-2009 financial crisis.
Because the breadth of topics covered is so vast and indispensable, I will break the WTLG review into a few parts for digestibility. I will start off with the these hand-picked nuggets:
Defining the “Loser’s Game”
Here is how Charles Ellis describes the investment “loser’s game”:
“For professional investors, “the ‘money game’ we call investment management evolved in recent decades from a winner’s game to a loser’s game because a basic change has occurred in the investment environment: The market came to be dominated in the 1970s and 1980s by the very institutions that were striving to win by outperforming the market. No longer is the active investment manager competing with cautious custodians or amateurs who are out of touch with the market. Now he or she competes with other hardworking investment experts in a loser’s game where the secret to winning is to lose less than others lose.”
Underperformance by Active Managers
Readers that have followed Investing Caffeine for a while understand how I feel about passive (low-cost do-nothing strategy) and active management (portfolio managers constantly buying and selling) – read Darts, Monkeys & Pros. Ellis’s views are not a whole lot different than mine – here is what he has to say while not holding back any punches:
“The basic assumption that most institutional investors can outperform the market is false. The institutions are the market. They cannot, as a group, outperform themselves. In fact, given the cost of active management – fees, commissions, market impact of big transactions, and so forth-85 percent of investment managers have and will continue over the long term to underperform the overall market.”
He goes on to say individuals do even worse, especially those that day trade, which he calls a “sucker’s game.”
Exceptions to the Rule
Ellis’s bias towards passive management is clear because “over the long term 85 percent of active managers fall short of the market. And it’s nearly impossible to figure out ahead of time which managers will make it into the top 15 percent.” He does, however, acknowledge there is a minority of professionals that can beat the market by making fewer mistakes or taking advantage of others’ mistakes. Ellis advocates a slow approach to investing, which bases “decisions on research with a long-term focus that will catch other investors obsessing about the short term and cavitating – producing bubbles.” This is the strategy and approach I aim to achieve.
Gaining an Unfair Competitive Advantage
According to Ellis, there are four ways to gain an unfair competitive advantage in the investment world:
1) Physical Approach: Beat others by carrying heavier brief cases and working longer hours.
2) Intellectual Approach: Outperform by thinking more deeply and further out in the future.
3) Calm-Rational Approach: Ellis describes this path to success as “benign neglect” – a method that beats the others by ignoring both favorable and adverse market conditions, which may lead to suboptimal decisions.
4) Join ‘em Approach: The easiest way to beat active managers is to invest through index funds. If you can’t beat index funds, then join ‘em.
The Case for Stocks
Investor time horizon plays a large role on asset allocation, but time is on investors’ side for long-term equity investors:
“That’s why in the long term, the risks are clearly lowest for stocks, but in the short term, the risks are just as clearly highest for stocks.”
Expanding on that point, Ellis points out the following:
“Any funds that will stay invested for 10 years or longer should be in stocks. Any funds that will be invested for less than two to three years should be in “cash” or money market instruments.”
While many people may feel stock investing is dead, but Ellis points out that equities should return more in the long-run:
“There must be a higher rate of return on stocks to persuade investors to accept risks of equity investing.”
The Power of Regression to the Mean
Investors do more damage to performance by chasing winners and punishing losers because they lose the powerful benefits of “regression to the mean.” Ellis describes this tendency for behavior to move toward an average as “a persistently powerful phenomenon in physics and sociology – and in investing.” He goes on to add, good investors know “that the farther current events are away from the mean at the center of the bell curve, the stronger the forces of reversion, or regression, to the mean, are pulling the current data toward the center.”
The Power of Compounding
For a 75 year period (roughly 1925 – 2000) analyzed by Ellis, he determines $1 invested in stocks would have grown to $105.96, if dividends were not reinvested. If, however, dividends are reinvested, the power of compounding kicks in significantly. For the same 75 year period, the equivalent $1 would have grown to $2,591.79 – almost 25x’s more than the other method (see also Penny Saved is Billion Earned).
Ellis throws in another compounding example:
“Remember that if investments increase by 7 percent per annum after income tax, they will double every 10 years, so $1 million can become $1 billion in 100 years (before adjusting for inflation).”
The Lessons of History
As philosopher George Santayana stated – “Those who cannot remember the past are condemned to repeat it.” Details of every market are different, but as Ellis notes, “The major characteristics of markets are remarkably similar over time.”
Ellis appreciates the importance of history plays in analyzing the markets:
“The more you study market history, the better; the more you know about how securities markets have behaved in the past, the more you’ll understand their true nature and how they probably will behave in the future. Such an understanding enables us to live rationally with markets that would otherwise seem wholly irrational.”
Home Sweet International Home
Although Ellis’s recommendation to diversify internationally is not controversial, his allocation recommendation regarding “full diversification” is a bit more provocative:
“For Americans, this would mean about half our portfolios would be invested outside the United States.”
This seems high by traditional standards, but considering our country’s shrinking share of global GDP (Gross Domestic Product), along with our relatively small share of the globe’s population (about 5% of the world’s total), the 50% percentage doesn’t seem as high at first blush.
Beware the Broker
This is not new territory for me (see Financial Sharks, Fees/Exploitation, and Credential Shell Game), and Ellis warns investors on industry sales practices:
“Those oh so caring and helpful salespeople make their money by convincing you to change funds. Friendly as they may be, they may be no friend to your long-term investment success.”
Unlike a lot of other investing books, which cover a few aspects to investing, Winning the Loser’s Game covers a gamut of crucial investment lessons in a straightforward, understandable fashion. A lot of people play the investing game, but as Charles Ellis details, many more investors and speculators lose than win. For any investor, from amateur to professional, reading Ellis’s Winning the Loser’s Game and following his philosophy will not only help increase the odds of your portfolio winning, but will also limit your losses in sleep hours.
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 GS, 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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