Posts tagged ‘investing’
Filet or Mac & Cheese? Investing for Retirement
The financial crisis of 2008-2009 placed a large swath of investors into paralysis based on a fear the United States and the rest of the world was on the verge of irreversible destruction. Regardless of what the newspaper headlines are reading and television pundits are spouting, individuals have to shrewdly plan for retirement no matter what the economy is doing. So then the question becomes, do you want to be eating macaroni & cheese in retirement, or does filet mignon or alternate five-star cuisine sound more appealing? I vote for the latter.
Despite what the government statistics are saying about the current state of benign inflation, you do not need to be a genius to see medical costs are exploding, energy charges have skyrocketed, and even more innocuous items such as movie ticket prices continue to rise. If that’s not a burden enough, depending on your age, there’s a legitimate concern the Social Security and Medicare safety nets may not be there for you in retirement. It is more important than ever to take control of your financial future by investing your money in a more efficient manner (see Fusion), focusing on long-term, low-cost, tax-efficient strategies. Whatever the direction of the financial markets (up, down, or sideways), if you don’t wisely invest your money, you will run the risk of working as a Wal-Mart (WMT) greeter into your 80s and relegated to eating mac & cheese (for lunch and dinner).
Broaden Your Horizons
The last decade has been tough for domestic equities. It’s true that not a lot of compounding of returns has occurred in the domestic equity markets over the last decade (see Lost Decade), but that weakness is not necessarily representative of the next decade’s performance or the past relative strength seen in areas like emerging markets, materials and certain fixed income markets. These alternatives, including cash, would have added significant diversification benefits to investor portfolios during previous years. Rather than focusing on what’s best for the investor, so much financial industry attention has been placed on high cost, high fee, high commission domestic stock funds or insurance-based products. Due to many inherent conflicts of interest, many individual investors have lost sight of other more attractive opportunities, like exchange traded funds, international strategies, and fixed-income investment vehicles.
Rule of 72
Depending on your risk profile, objectives and constraints, the “Rule of 72” implies your retirement portfolio should double from a $100,000 investment now to roughly $200,000 in seven years (to $400,000 in 14 years, $800,000 in 21 years, etc.), assuming your portfolio can earn a 10% annual return. Unfortunately, this snowballing effect of money growth does not work if you are paying out significant chunks of your returns to aggressive brokers and salespeople in the forms of high commissions, fees, and taxes (see a Penny Saved is Billions Earned). For example, if you are paying out total annual expenses of 2-3% to a broker, advisor, or investment manager, the doubling effect of the Rule of 72 will be stretched out to 9-10 years (rather than the above mentioned seven years). If you do not know what you are paying in fees and expenses (like the majority of people), then do yourself a favor and educate yourself about the fee structures and tax strategies utilized in your investments (see also Investor Confusion). If you haven’t started investing, or you are shoveling out a lot of money in fees, expenses, and taxes, then you should reconsider your current investment stretegy. Otherwise, you may just want to begin stockpiling a lot of macaroni & cheese in your retirement pantry.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and shares in WMT, but at the time of publishing SCM had no direct positions 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 the IC “Contact” page for more information.
Digging for iPad Gold with Simplicity
We live in a hyper global competitive world, yet some companies manage to find gold while others unsuccessfully dig for their dreams. What is a major determinant of great companies? Apple Inc. (AAPL), and other companies, may include “simplicity” as a key ingredient. Take the iPad for example. Already the company has successfully exceeded iPad sales target thanks to the shrewd marketing of the simple touch-screen technology. Some call it a glorified iPhone because the iPad uses a very similar interface on a larger scale. Nonetheless, the device is getting rave reviews from the likes of US Today, The Wall Street Journal, The New York Times, Newsweek, and as Stephen Colbert smartly pointed out in his video (below), the iPad even makes salsa to boot. Many estimates point to more than a half million units sold in the first few weeks, making the 2010 estimates of 3-4 million units sold likely too low.
Competition Not a Game Killer
How much more competitive can the personal computer and cell phone markets be? According to the United Nations, we will reach 5 billion subscribers in 2010. With pricing pressure galore, and new Asian competitors popping up all over the place, how can companies grow, let alone make profits? Ever since the revolutionary iPhone was introduced in 2007, rivals have attempted to copy-cat the device. In the meantime, Apple continues to gain market share while they sit on close to $40 billion in cash, not to mention the flood of new cash rolling in the doors ($10+ billion in free cash flow generated in calendar 2009).
Innovation and the Remote Control
One key driver of profitability is innovation, but an elegant solution driven by an out-of-touch engineer with consumer demands will only lead to share losses and headaches. I mean how many times have you pulled your hair out trying to navigate through a 100-button TV remote control or screamed in frustration from attempting to learn a non-Wii videogame?
But Apple is not the only company to find simplicity in its quest for profit domination. In order to be a massive juggernaut like Apple Inc., a company’s product or service must gain mass appeal. A key determinant for mass appeal is simplicity. Beyond Apple, think of other dominant franchises that also operate in massively competitive markets like Wal-Mart Stores (WMT) in retail; Starbucks Corp. (SBUX) in coffee; Google Inc. (GOOG) in internet advertising; Coca Cola Co. (KO) in soda; Netflix Inc. (NFLX) in video rentals, among a host of other category killers. Many of these corporate giants offer products we cannot function or live without. I still find it utterly amazing that my children will never know what life was really like without an internet search on Google or a Caffe Misto Caramel Frappuccino from Starbucks.
All Good Things Come to an End
It’s not clear how much longer these titans of corporate America can thrive. By innovating new products that improve lives in some way, these Dancing Elephants will continue to prosper. But nothing in the stock market is static, so investors should pay attention to several potential derailing factors:
- Valuations: Valuations are extremely important in determining long-run appreciation potential, and chasing winners solely based on momentum (see related article) can lead to problems.
- Market Share Losses: What will be the next computer, cell phone, or e-reader killer? I don’t know right now, but eventually the day will come where these leaders will lose market share to a new kid on the block.
- Rising Costs: Competition is not the only factor in leading to slowing sales and declining profit margins. Inflation either related to labor or other input costs can crimp profits and decay investor appetites.
- Too Big to Succeed: There has been a lot of talk about “too big to fail,” but I strongly believe companies reach a point where they become “too big to succeed.” Either the law of large numbers catches up with these companies making simple math more challenging (think of the supertanker Wal-Mart growing its $400+ billion revenue base), or regulatory scrutiny kicks in (think of Microsoft Corp. [MSFT] and Intel Corp [INTC]).
Size: Peeling More of the Onion
Success can continue for these giants, however at some point “size” becomes a headwind rather than a tailwind. Just as simply as a train can speed down a railway at over 100+miles per hour, under the right conditions the train can derail as well. As Warren Buffett states, when referring to a company’s growth prospects relative to size, “Gravity always wins.”
However, investors should remind themselves that gains can last longer than expected too. Finding “ginormous” winners in many ways is like finding a needle in a haystack. But even if you find the needle in the haystack relatively late in a company’s growth cycle (see Equity Life Cycle story), in many instances there can be a lot of appreciation potential still available. Take Wal-Mart (WMT) for example. If you bought Wal-Mart shares after it rose 10-fold during its first 10 years, you still could have achieved a 60x return over the next 30 years.
Time will tell if Apple will strike additional gold with its iPad introduction, nonetheless Steve Jobs has found an element present in many long-term successful companies…simplicity.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and AAPL, WMT, GOOG, but at the time of publishing SCM had no direct positions in MSFT, SBUX, KO, INTC, NFLX, Nintendo or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Avoiding Automobile and Portfolio Crashes
Personal opinions of oneself don’t always mirror reality. Self perceptions relating to both driving and investing can be inflated. For example, the National Highway Traffic Safety Administration (NHTSA) reports that 95% of crashes are caused by human error, but 75% of drivers say they are better drivers than most.
Contributing factors to crashes include: 1) Distractions; 2) Alcohol; 3) Unsafe behavior (i.e., speeding); 4) Time of day (fatality rate is 3x higher at night); 5) Lack of safety belt; 6) Weather; and 7) Time of week (weekends are worst crash days).
A spokesman for the Insurance Institute for Highway Safety is quick to point out that driving behind the wheel is the riskiest activity most people engage in on a daily basis – more than 40,000 driving related fatalities occur each year. Careful common sense helps while driving, but driving sober at 4 a.m. (very few drivers on the road) on a weekday with your seatbelt on won’t hurt either.
Avoiding a Portfolio Crash
Another dangerous activity frequently undertaken by Americans is investing, despite people’s inflated beliefs of their money management capabilities. Investing, however, does not have to be harmful if proper precautions are taken.
Here is some of the hazardous behaviors that should be avoided by those maneuvering an investment portfolio:
1) Trading Too Much: Excessive trading leads to undue commissions, transaction costs, bid-ask spread, impact costs. Many of these costs are opaque or invisible and won’t necessarily be evident right away. But like a leaky boat, direct and indirect trading costs have the potential of sinking your portfolio.
2) Worrying about the Economy Too Much: The country experiences about two recessions a decade, nonetheless our economy continues to grow. If macroeconomics still worry you, then look abroad for even healthier growth – considerable international exposure should aid the long-term success of your portfolio and assist you in sleeping better at night.
3) Emotionally Reacting – Not Objectively Planning: News is bad, so sell. News is good, so buy. This type of conduct is a recipe for portfolio disaster. Better to do as Warren Buffett says, “Be fearful when others are greedy, and be greedy when others are fearful.” The long-term fundamental prospects for any investment are much more important than the daily headlines that get the emotional juices flowing.
4) Hostage to Short-term Time Horizon: Rather than worry about the next 10 days, you should be focused on the next 10 years. The further out you can set your time horizon, the better off you will be. Patience is a virtue.
5) Incongruent Portfolio with Risk: Many retirees got caught flat-footed in the midst of the global financial crisis of 2008-09 with investment portfolios heavy in equities and real estate. Diversified portfolios including fixed-income, commodities, international exposure, cash, and alternative investments should be optimized to meet your specific objectives, constraints, risk tolerance, and time horizon.
6) Timing the Market: Attempting to time the market can be hazardous to your investment health (see Market Timing article). If you really want to make money, then avoid the masses – the grass is greener and the eating better away from the herd.
Driving and investing can both be dangerous activities that command responsible behavior. Do yourself a favor and protect yourself and your portfolio from crashing by taking the appropriate precautions and avoiding the common hazardous mistakes.
Read Full Forbes Article on Driving Dangers
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 positions 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.
Shanking Your Way to Success: Tiger Woods & Roger McNamee
Spring has sprung and that means golf is back in full swing with the Masters golf tournament kicking off next week in Augusta, Georgia. Next week also marks the return of Tiger Woods in his first competition since news of Tiger’s sex scandal and car crash originally broke. As an avid golf fan (and occasional frustrated player), I must admit I do find a devilish sense of guilty pleasure every time I see a pro golfer shank a ball into the thick of the woods or plop one in the middle of the drink. I mean, how many hundreds of balls have I donated to golf courses across this great nation? Let’s face it, no matter how small, people derive some satisfaction from seeing others commit similar mistakes…misery loves company. Even the world’s elite, including Tiger Woods, slip up periodically.
For quite possibly the worst, nightmarish, meltdown classic of all-time, you may recall Frenchman John van de Velde’s 18th hole collapse at the 1999 British Open in Carnoustie, Scotland.
Investment Pros Shank Too
Investment legend Peter Lynch (see Investment Caffeine profile on Lynch), who trounced the market with a +29% annual return average from 1977-1990, correctly identified the extreme competitiveness of the stock-picking world when he stated, “If you’re terrific in this business you’re right six times out of ten.” Even with his indelible record, Lynch had many disastrous stocks, including American International Airways, which went from $11 per share down to $0.07 per share. Famous early 20th Century trader Jesse Livermore puts investment blundering into context by adding, “If a man didn’t make mistakes he’d own the world in a month.”
Mistakes, plain and simply, are a price of playing the investment game. Or as the father of growth investing Phil Fisher noted (see Investment Caffeine profile on Fisher), “Making mistakes is an inherent cost of investing just like bad loans are for the finest lending institutions.”
McNamee’s Marvelous Misfortune
Since the investment greats operate under the spotlight, many of their poor decisions cannot be swept under the rug. Take Roger McNamee, successful technology investor and co-founder of Elevation Partners (venture capital) and Silver Lake Partners (private equity). His personal purchase of 2.3 million shares ($37 million) in smartphone and handheld computer manufacturer Palm Inc. (PALM) has declined by more than a whopping -75% since his personal purchase just six months ago at $16.25 share price (see also The Reformed Broker). McNamee is doing his best to recoup some of his mojo with his hippy-esque band Moonalice – keep an eye out for tour dates and locations.
Lessons Learned
More important than making repeated mistakes is what you do with those mistakes. “Insanity is doing the same thing over and over again, and expecting different results,” observed Albert Einstein. Learning from your mistakes is the most important lesson in hopes of mitigating the same mistakes in the future. Phil Fisher adds, “I have always believed that the chief difference between a fool and a wise man is that the wise man learns from his mistakes, while the fool never does.” As part of my investment process, I always review my errors. By explicitly shaming myself and documenting my bad trades, I expect to further reduce the number of poor investment decisions I make in the future.
With the Masters just around the corner, I must admit I eagerly wait to see how Tiger Woods will perform under extreme pressure at one of the grandest golf events of the year. I will definitely be rooting for Tiger, although you may see a smirk on my face if he shanks one into the trees.
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 had no direct positions in PALM or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Markowitz’s Five Dimensions of Risk
Eighty-two year old Harry Markowitz, 1990 Nobel Prize winner, is best known for his creation of Modern Portfolio Theory (MPT) in the 1950s. MPT elegantly combines mathematical variables such that investors can theoretically maximize returns while minimizing risk with the aid of diversification. Markowitz’s Efficient Frontier research eventually led to the future breakthrough of the Capital Asset Pricing Model (CAPM).
The Different Faces of Risk
Before we dive further into Markowitz’s dimensions of risk, let’s explore the definitions of the word “risk.” Just like the word “love” is interpreted differently by different people, so too does risk. To some, risk is defined as the probability of loss. To mathematicians, risk often means the historical volatility in returns as measured by standard deviation or Beta. For many individual investors, risk is frequently mischaracterized by emotions – risk is believed to be high after market collapse and low after extended market rallies (see also Wobbling Risk Tolerances article).
The Five Dimensions of Risk
With the procedural definitions of risk behind us, we can take a deeper look at risk from the eyes of Markowitz. Beyond the complex mathematical equations, Markowitz also understands risk from the practical investor’s standpoint. In a recent Financial Advisor magazine article Markowitz reviews the five dimensions of risk exposure:
1) Time Horizon
2) Liquidity Needs
3) Net Income
4) Net Worth
5) Investing Knowledge/Attitudes on Risk
Rather than pay attention to these practical dimensions of individual risk tolerance, countless investors adjust their risk exposure (equity allocation) by speculating on the direction of the stock market, which usually means buying high and selling low at inopportune times. Although it can be entertaining to guess the direction of the market, we all know market timing is a loser’s game in the long-run (see also Market Timing Treadmill article). Markowitz’s first four risk exposures are fairly straightforward, measurable factors, however the fifth exposure (“knowledge and attitude”) is much more difficult to measure. Determining risk attitude can be an arduous process if risk tolerance constantly wavers through the winds of market volatility.
The Double Whammy
Rather than becoming a nervous Nelly, constantly chomping on your finger nails, your investment focus should be on action, and the things you can control. The number one goal is simple….SAVE. How does one save? All one needs to do is spend less than they take in. Like dieting, saving is easy to understand, but difficult to execute. You can either make more money, spend less, or better yet… do both.
The Baby Boomers are not completely out of the woods, but the next generations (X, Y, Z, etc.) is even worse off because they face the “Double Whammy.” Not only are life expectancies continually increasing but the Social Security safety net is becoming bankrupt. Consider the average life expectancy was roughly 30 years old in 1900 and in developed countries today we stand at about 78 years. Some actuarial tables are peaking out at 120 years now (see also Brutal Reality to Aging Demographics). So when considering Markowitz’s risk exposure #1 (time horizon), it behooves you to calibrate your risk tolerance to match a realistic life expectancy (with some built-in cushion if modern medicine does a better job).
Taming the Wild Beast
Every investor’s risk profile is multi-dimensional and constantly evolving due to changes in Markowitz’s five risk exposures (time horizon, liquidity needs, net income, net worth, and knowledge/attitude). Risk can be a wild animal difficult to tame, but if you can create a disciplined, systematic investment plan, you too can reach your financial goals without getting bitten by the numerous retirement hazards.
Read the complete Financial Advisor article on Harry Markowitz
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 had no direct positions in any security mentioned 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.
Dealing with Wobbling Risk Tolerances
The words “risk tolerance” are often used loosely, but unfortunately many investors and advisors look at these terms as an objectively definable statistic, like your blood pressure or cholesterol level. Not only is risk tolerance not a definable statistic, but for most people it is also constantly changing.
Given that investment advisors themselves have a great deal of difficulty maintaining an even emotional keel, it should come as no surprise that most invidual investors have even more volatile risk appetites. Because of the nature surrounding the markets – 24/7 news coverage and non-stop tick by tick price scorekeeping –emotions continually tug at investors’ risk tolerances.
Average Investor NOT on Best Behavior
Certainly in my practice, I’ve seen the direct psychological (and physical) impacts volatile financial markets can have on people’s investment decisions. What makes deciphering risk tolerance even more difficult is the absence of any substantive profile definitions (except for vague categories like conservative, moderate, and aggressive). The foggy risk categorizations are compounded by the aforementioned fluctuating risk tolerances, which usually switch in the wrong direction, at the wrong time. Case in point: the technology bubble bursting. In the late 1990s, risk aversion completely disappeared – everyone and their mother wanted to invest in technology stocks. If you fast-forward to the mid-2000s, you will also recall Bessie the hair salonist and Jimmy the cab-driver taking excessive risk at the peak of the housing bubble.
In a recent Simoleon Sense post, an astute guest contributor (Tim Richards) points to research developed by Carrie Pan and Meir Statman (Santa Clara University – Department of Finance) showing the shortcomings implicit in investor behavior:
“… investors’ risk tolerance varies by circumstances and associated emotions. High past stock returns endow stocks with positive affect and inflate investors’ exuberance, misleading them into the belief that the future holds high stock returns coupled with low risk. Risk tolerance questions asked after periods of high stock returns are likely to elicit answers exaggerating investors’ risk tolerance. Conversely, low past stock returns burden stocks with negative affect and inflate investors’ fear, misleading them into the belief that the future holds low stock returns coupled with high risk. Risk tolerance questions asked following periods of low stock returns are likely to elicit answers underestimating investors’ risk tolerance.”
In addition to ill-advised investor timing, Richards correctly highlights the lack of comparability across various investor types, even if you apply acceptable definitions or numeric levels of risk. Simple allocation to various stock/bond exposure does not adequately capture a client’s risk tolerance. A portfolio with 60% invested in Blue Chip dividend paying companies is a tad different than a portfolio invested 60% in Russian stocks. What an 82-year old retiree in Florida thinks is “aggressive” may differ 180 degrees from what a 32-year old trader on Wall Street may think is “aggressive.”
The Failure of Risk Equations
Academics have attempted to boil the market into elegant mathematical equations, but with the acknowledgement that investing mixes science with behavior, it becomes apparent that the mathematical equations must also incorporate art. However, it can become quite difficult to create an ever changing artistic equation. A perfect example of an equation gone awry is the debacle that unfolded at Long Term Capital Management. Robert Merton and Myron Scholes were world renowned Nobel Prize winners who single handedly brought the global financial markets to its knees in 1998 when it lost $500 million in one day and required a $3.6 billion bailout from a consortium of banks (see also why investors get hurt and Butter in Bangladesh articles).
Even if you are a smart economist who can artistically mix quantitative numbers with investing, the problem becomes people’s preferences and decisions change as the infinite number of variables adjust in the marketplace over time. There certainly are some rules of thumb investors tend to gravitate towards (such as cheap companies with sustainable growth in profits and cash flows), but even for those companies successful at generating income, nobody can unequivocally predict exactly how and when investors will react by pushing prices higher.
Here is what Tim Richardshad to add on the subjects of mathematical models and market efficiency in his Simoleon Sense post:
“So, in recent decades the industry’s approach has been to develop mathematical models which can relegate human behaviour to a set of probability equations, thus allowing profitability and risk to be actuarially managed: fraud is no longer unacceptable – it’s now just a number to be factored into earnings forecasts. This is simply the latest in a long line of industry fads, using the ideas of efficient market theories to design approaches which are right quite a lot of the time and then very, very wrong all at once.”
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“[Markets] are not remotely efficient and it’s just a shame the world had to be brought to the edge of financial meltdown before anyone started listening.”
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“When everyone thinks that markets can’t fail is the time to be very risk adverse, when no-one wants to invest is the time to be greedy. Yet what’s an advisor to do when the know-your-customer questionnaire tells them to do exactly the opposite of what’s in the customer’s best interests?”
Equations can produce detrimental results, so a healthy dosage of skepticism is prescribed.
The Solution: Education, Liquidity, and Income Can Allow More Beauty Sleep
Education about logic pitfalls and the integration of liquidity-based needs into clients’ investment plans is key. Controlling and understanding one’s personal biases can reduce or eliminate common repeated investment mistakes. Covering the investors’ income needs is another essential and practical aspect to investing, especially when it can prevent forced position sales at inopportune times. Extending oneself along the riskier end of the spectrum may have felt comfortable in the mid 2000s, but losses and sleepless nights overwhelmed many investors in 2008 and early 2009. In a bull market, adding too much equity and other risky assets to a portfolio is like pimping heroine to a drug addict – it behooves the advisor to point out the potential dangers of positioning a portfolio too aggressively. Rebalancing your investment portfolio can also act as a natural hedge to prevent exposures from exploding in size or evapaporating away. On the other hand, pitching Armageddon and piling into overpriced risk-free assets during the tail end of a bear market can be just as negligent.
Risk tolerance is an amorphous concept that can lead to suboptimal, knee-jerk investment actions. If you want to earn higher returns, I strongly urge you to pick up a behavioral finance book to sharpen your investment decision-making skills and firm up your wobbling risk tolerance foundation.
Read the whole Simoleon Sense article.
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 had no direct positions in any security mentioned 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.
Cash Flow Statement: Game of Cat & Mouse
Much like a game of a cat chasing a mouse, analyzing financial statements can be an endless effort of hunting down a company’s true underlying fundamentals. Publicly traded companies have a built in incentive to outmaneuver its investors by maximizing profits (or minimizing expenses). With the help of flexible GAAP (Generally Accepted Accounting Principles) system and loose estimation capabilities, company executives have a fair amount of discretion in reporting financial results in a favorable light. Through the appropriate examination of the cash flow statement, the cat can slow down the clever mouse, or the investor can do a better job in pinning down corporate executives in securing the truth.
Going back to 15th century Italy, users of financial statements have relied upon the balance sheet and income statement*. Subsequently, the almighty cash flow statement was introduced to help investors cut through a lot of the statement shortcomings – especially the oft flimsy income statement.
Beware of the Income Statement Cheaters
Did you ever play the game of Monopoly with that sneaky friend who seemed to win every time he controlled the money as the game’s banker? Well effectively, that’s what companies can do – they can adjust the rules of the game as they play. A few simple examples of how companies can potentially overstate earnings include the following:
- Extend Depreciation: Depreciation is an expense that is influenced by management’s useful life estimates. If a Chief Financial Officer doubles the useful life of an asset, the associated annual expense is cut in half, thereby possibly inflating earnings.
- Capitalize Expenses: How convenient? Why not just make an expense disappear by shifting it to the balance sheet? Many companies employ that strategy by converting what many consider a normal expense into an asset, and then slowly recognizing a depreciation expense on the income statement.
- Stuffing the Channel: This is a technique that forces customers to accept unwanted orders, so the company selling the goods can recognize phantom sales and income. For example, I could theoretically sell a $1 million dollar rubber band to my brother and recognize $1 million in profits (less 1-2 cents for the cost of the rubber band), but no cash will ever be collected. Moreover, as the seller of the rubber band, I will eventually have to fess-up to a $1 million uncollectible expense (“write-off”) on my income statement.
There are plenty more examples of how financial managers implement liberal accounting practices, but there is an equalizer…the cash flow statement.
Cash Flow Statement to the Rescue
Most of the accounting shenanigans and gimmicks used on the income statement (including the ones mentioned above) often have no bearing on the stream of cash payments. In order to better comprehend the fundamental actions behind a business (excluding financial companies), I firmly believe the cash flow statement is the best place to go. One way to think about the cash flow statement is like a cash register (see related cash flow article). Any business evaluated will have cash collected into the register, and cash disbursed out of it. Specifically, the three main components of this statement are Cash Flow from Operations (CFO), Cash Flow from Investing (CFI), and Cash Flow from Financing (CFF). For instance, let us look at XYZ Corporation that sells widgets produced from its manufacturing plant. The cash collected from widget sales flows into CFO, the capital cost of building the plant into CFI, and the debt proceeds to build the plant into CFF. By scrutinizing these components of the cash flow statement, financial statement consumers will gain a much clearer perspective into the pressure points of a business and have an improved understanding of a company’s operations.
Financial Birth Certificate
As an analyst, hired to babysit a particular company, the importance of determining the maturity of the client company is critical. We may know the numerical age of a company in years, however establishing the maturity level is more important (i.e., start-up, emerging growth, established growth, mature phase, declining phase)*. Start-up companies generally have a voracious appetite for cash to kick-start operations, while at the other end of the spectrum, mature companies generally generate healthy amounts of free cash flow, available for disbursement to shareholders in the form of dividends and share buybacks. Of course, some industries reach a point of decline (automobiles come to mind) at which point losses pile up and capital preservation increases in priority as an objective. Clarifying the maturity level of a company can provide tremendous insight into the likely direction of price competition, capital allocation decisions, margin trends, acquisition strategies, and other important facets of a company (see Equity Life Cycle article).
The complex financial markets game can be a hairy game of cat and mouse. Through financial statement analysis – especially reviewing the cash flow statement – investors (like cats) can more slyly evaluate the financial path of target companies (mice). Rather than have a hissy fit, do yourself a favor and better acquaint yourself with the cash flow statement.
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 had no direct positions in any security mentioned in this article. References to content in Financial Statement Analysis (Martin Fridson and Fernando Alvarez) was used also. 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.
Inside the Brain of an Investing Genius
Photo Source: Boston.com
Those readers who have frequented my Investing Caffeine site are familiar with the numerous profiles on professional investors of both current and prior periods (See Profiles). Many of the individuals described have a tremendous track record of success, while others have a tremendous ability of making outrageous forecasts. I have covered both. Regardless, much can be learned from the successes and failures by mirroring the behavior of the greats – like modeling your golf swing after Tiger Woods (O.K., since Tiger is out of favor right now, let’s say Phil Mickelson). My investment swing borrows techniques and tips from many great investors, but Peter Lynch (ex-Fidelity fund manager), probably more than any icon, has had the most influence on my investing philosophy and career as any investor. His breadth of knowledge and versatility across styles has allowed him to compile a record that few, if any, could match – outside perhaps the great Warren Buffett.
Consider that Lynch’s Magellan fund averaged +29% per year from 1977 – 1990 (almost doubling the return of the S&P 500 index for that period). In 1977, the obscure Magellan Fund started with about $20 million, and by his retirement the fund grew to approximately $14 billion (700x’s larger). Cynics believed that Magellan was too big to adequately perform at $1, $2, $3, $5 and then $10 billion, but Lynch ultimately silenced the critics. Despite the fund’s gargantuan size, over the final five years of Lynch’s tenure, Magellan outperformed 99.5% of all other funds, according to Barron’s. How did Magellan investors fare in the period under Lynch’s watch? A $10,000 investment initiated when he took the helm would have grown to roughly $280,000 (+2,700%) by the day he retired. Not too shabby.
Background
Lynch graduated from Boston College in 1965 and earned a Master of Business Administration from the Wharton School of the University of Pennsylvania in 1968. Like the previously mentioned Warren Buffett, Peter Lynch shared his knowledge with the investing masses through his writings, including his two seminal books One Up on Wall Street and Beating the Street. Subsequently, Lynch authored Learn to Earn, a book targeted at younger, novice investors. Regardless, the ideas and lessons from his writings, including contributing author to Worth magazine, are still transferrable to investors across a broad spectrum of skill levels, even today.
The Lessons of Lynch
Although Lynch has left me with enough financially rich content to write a full-blown textbook, I will limit the meat of this article to lessons and quotations coming directly from the horse’s mouth. Here is a selective list of gems Lynch has shared with investors over the years:
Buy within Your Comfort Zone: Lynch simply urges investors to “Buy what you know.” In similar fashion to Warren Buffett, who stuck to investing in stocks within his “circle of competence,” Lynch focused on investments he understood or on industries he felt he had an edge over others. Perhaps if investors would have heeded this advice, the leveraged, toxic derivative debacle occurring over previous years could have been avoided.
Do Your Homework: Building the conviction to ride through equity market volatility requires rigorous homework. Lynch adds, “A company does not tell you to buy it, there is always something to worry about. There are always respected investors that say you are wrong. You have to know the story better than they do, and have faith in what you know.”
Price Follows Earnings: Investing is often unnecessarily made complicated. Lynch fundamentally believes stock prices will follow the long-term trajectory of earnings growth. He makes the point that “People may bet on hourly wiggles of the market, but it’s the earnings that waggle the wiggle long term.” In a publicly attended group meeting, Michael Dell, CEO of Dell Inc. (DELL), asked Peter Lynch about the direction of Dell’s future stock price. Lynch’s answer: “If your earnings are higher in 5 years, your stock will be higher.” Maybe Dell’s price decline over the last five years can be attributed to its earnings decline over the same period? It’s no surprise that Hewlett-Packard’s dramatic stock price outperformance (relative to DELL) has something to do with the more than doubling of HP’s earnings over the same time frame.
Valuation & Price Declines: “People Concentrate too much on the P (Price), but the E (Earnings) really makes the difference.” In a nutshell, Lynch believes valuation metrics play an important role, but long-term earnings growth will have a larger impact on future stock price appreciation.
Two Key Stock Questions: 1) “Is the stock still attractively priced relative to earnings?” and 2) “What is happening in the company to make the earnings go up?” Improving fundamentals at an attractive price are key components to Lynch’s investing strategy.
Lynch on Buffett: Lynch was given an opportunity to write the foreword in Buffett’s biography, The Warren Buffett Way. Lynch did not believe in “pulling out flowers and watering the weeds,” or in other words, selling winners and buying losers. In highlighting this weed-flower concept, Lynch said this about Buffett: “He purchased over $1 billion of Coca-Cola in 1988 and 1989 after the stock had risen over fivefold the prior six years and over five-hundredfold the previous sixty years. He made four times his money in three years and plans to make a lot more the next five, ten, and twenty years with Coke.” Hammering home the idea that a few good stocks a decade can make an investment career, Lynch had this to say about Buffett: “Warren states that twelve investments decisions in his forty year career have made all the difference.”
You Don’t Need Perfect Batting Average: In order to significantly outperform the market, investors need not generate near perfect results. According to Lynch, “If you’re terrific in this business, you’re right six times out of 10 – I’ve had stocks go from $11 to 7 cents (American Intl Airways).” Here is one recipe Lynch shares with others on how to beat the market: “All you have to do really is find the best hundred stocks in the S&P 500 and find another few hundred outside the S&P 500 to beat the market.”
The Critical Element of Patience: With the explosion of information, expansion of the internet age, and the reduction of trading costs has come the itchy trading finger. This hasty investment principle runs contrary to Lynch’s core beliefs. Here’s what he had to say regarding the importance of a steady investment hand:
- “In my investing career, the best gains usually have come in the third or fourth year, not in the third or fourth week or the third or fourth month.”
- “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.”
- “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.”
- “The key to making money in stocks is not to get scared out of them.”
Bear Market Beliefs: “I’m always more depressed by an overpriced market in which many stocks are hitting new highs every day than by a beaten-down market in a recession,” says Lynch. The media responds in exactly the opposite manner – bear markets lead to an inundation of headlines driven by panic-based fear. Lynch shares a similar sentiment to Warren Buffett when it comes to the media holding a glass half full view in bear markets.
Market Worries: Is worrying about market concerns worth the stress? Not according to Lynch. His belief: “I’ve always said if you spend 13 minutes a year on economics, you’ve wasted 10 minutes.” Just this last March, Lynch used history to drive home his views: “We’ve had 11 recessions since World War II and we’ve had a perfect score — 11 recoveries. There are a lot of natural cushions in the economy now that weren’t there in the 1930s. They keep things from getting out of control. We have the Federal Deposit Insurance Corporation [which insures bank deposits]. We have social security. We have pensions. We have two-person, working families. We have unemployment payments. And we have a Federal Reserve with a brain.”
Thoughts on Cyclicals: Lynch divided his portfolio into several buckets, and cyclical stocks occupied one of the buckets. “Cyclicals are like blackjack: stay in the game too long and it’s bound to take all your profit,” Lynch emphasized.
Selling Discipline: The rationale behind Lynch’s selling discipline is straightforward – here are some of his thoughts on the subject:
- “When the fundamentals change, sell your mistakes.”
- “Write down why you own a stock and sell it if the reason isn’t true anymore.”
- “Sell a stock because the company’s fundamentals deteriorate, not because the sky is falling.”
Distilling the genius of an investing legend like Peter Lynch down to a single article is not only a grueling challenge, but it also cannot bring complete justice to the vast accomplishments of this incredible investment legend. Nonetheless, his record should be meticulously studied in hopes of adding jewels of investment knowledge to the repertoires of all investors. If delving into the head of this investing mastermind can provide access to even a fraction of his vast knowledge pool, then we can all benefit by adding a slice of this greatness to our investment portfolios.
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 time of publishing had no direct positions in DELL, KO, HPQ or any other security mentioned. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Getting off the Market Timing Treadmill
Most investors have been stuck on the financial treadmill of the 2000s and have nothing to show for it, other than battle scars from the 2008-2009 financial crisis. A lot of running, sweating, and jumping has produced effectively no results. Most media outlets continue to focus on the “lost decade” (see other Lost Decade story) in which investors have earned nothing in the equity markets. After a decade of excess in the 1990s should the majority of investors be surprised? Investing is no different than dieting and exercise – those topics are easy to understand but difficult to execute.
Where are the Billionaire Market Timers?
The financial industry oversimplifies investing and sells market timing as an effortless path to riches – even in tough times. In the search of the financial Holy Grail, the industry constantly crams new software bells and whistles and so-called “can’t lose” strategies down the throats of individual investors. Sadly, there is no miracle system, wonder algorithm, or get rich scheme that can sustainably last the test of time. Sure, a minority of speculators can get lucky and make money by following a risky strategy in the short-run, but as the global economic disaster caused by LTCM (Long Term Capital Management) taught us, even certain successful trading strategies or computer algorithms can stop working in a heartbeat and lead to a widespread bloodbath.
Are you still a believer in market timing? If so, then where are all the billionaire market timers? Famed growth manager, Peter Lynch astutely noted:
“I can’t recall ever once having seen the name of a market timer on Forbes‘ annual list of the richest people in the world. If it were truly possible to predict corrections, you’d think somebody would have made billions by doing it.”
Certainly, there are some hedge fund managers that have hit home runs with amazing market calls, but time will be the arbiter in determining whether they can stay on top.
Sage Speak on Market Timing
If you don’t believe me about market timing, then listen to what knowledgeable investors and thought leaders have to say on the subject. Larry Swedroe, a principal at Buckingham Asset Management, compiled a list including the following quotes:
- Warren Buffett (Investor extraordinaire): “We continue to make more money when snoring than when active.” He adds, “The only value of stock forecasters is to make fortune-tellers look good.”
- Jason Zweig (Columnist): “Whenever some analyst seems to know what he’s talking about, remember that pigs will fly before he’ll ever release a full list of his past forecasts, including the bloopers.” (See also Peter Schiff and Meredith Whitney stories)
- Bernard Baruch (Financier): “Only liars manage to always be out during bad times and in during good times.”
- Jonathan Clements (Columnist): “What to do when the market goes down? Read the opinions of the investment gurus who are quoted in the WSJ. And, as you read, laugh. We all know that the pundits can’t predict short-term market movements. Yet there they are, desperately trying to sound intelligent when they really haven’t got a clue.”
- David L. Babson (Investment Manager): “It must be apparent to intelligent investors that if anyone possessed the ability to do so [forecast the immediate trend of stock prices] consistently and accurately he would become a billionaire so quickly he would not find it necessary to sell his stock market guesses to the general public.”
- Peter Lynch (Retired Growth Manager): “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”
Market Timing Road Rules
Rather than make guesses regarding the direction of the market, here are some investment rules to follow:
- Rule #1: Do not attempt to market time. Statistically it is a certainty that a minority of the millions of investors can time the market in the short-run – the problem is that very few, if any, can time the market for sustainable periods of time. Don’t try to be the hero, because often you will become the goat.
- Rule #2: Patiently make good investments, regardless of the economic conditions. It is best to assume the market will go nowhere and invest accordingly. Paying attention to a hot or cold economy leads to investors chasing their tails. Good investments should outperform in the long-run, regardless of the macroeconomic environment.
- Rule #3: Diversify. In the midst of the crisis, diversification didn’t cure simultaneous drops in most asset classes, however ownership of government Treasuries, cash, and certain commodities provided a cushion from the economic blows. Longer-term, the benefits of diversification become more apparent – it makes absolute sense to spread your risk around.
In some respects, there is always an aspect of timing to investing, but as referenced by some of the intelligent professionals previously, the driving force behind an investment decision should not be, “I think the market is going up,” or “I think the market is going down” – those thought processes are recipes for disaster. I strongly believe an investment process that includes patience, discipline, diversification, valuation sensitivity, and low-cost/ tax-efficient products and strategies will get you off the financial treadmill and move you closer to reaching your financial goals.
Read the Full Larry Swedroe Story
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 time of publishing had no direct positions in BRKA or any other security mentioned. 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.
Fees, Exploitation and Confusion Hammer Investors
The financial industry is out to hammer you. If you haven’t figured that out, then it’s time to wake up to the cruel realities of the industry. Let’s see what it takes to become the hammer rather than receiving the brunt of the pounding, like the nail.
Fees, Fees, Fees
I interface with investors of all stripes and overwhelmingly the vast majority of them have no idea what they are paying in fees. When I ask investors what fees, commissions, and transactions costs are being siphoned from their wallets, I get the proverbial deer looking into the headlight response. And who can blame them? Buried in the deluge of pages and hiding in the fine print is a list of load fees, management fees, 12b-1 fees, administrative fees, surrender charges, transaction costs, commissions, and more. One practically is required to obtain a law degree in order to translate this foreign language.
Wolf in Sheep’s Clothing
These wolves don’t look like wolves. These amicable individuals have infiltrated your country clubs, groups, volunteer organizations, and churches. The following response is what I usually get: “Johnny, my financial consultant, is such a nice man – we have known him for so long.” Yeah, well maybe the reason why Johnny is so nice and happy is because of the hefty fees and commissions you are paying him. Rather than paying for an expensive friend, maybe what you need is someone who can accelerate your time to retirement or improve your quality of life. If you prefer eating mac and cheese over filet mignon, or are looking to secure a position at Wal-Mart as a greeter in your 80s, then don’t pay any attention to the fees you may be getting gouged on.
I don’t want to demonize all practitioners and aspects of the financial industry, but like Las Vegas, there is a reason the industry makes so much money. The odds and business practices are stacked in their favor, so focus on protecting yourself.
Confusion
Investors face a very challenging environment these days, needing to decipher everything from Dubai debt defaults and PIIGS sovereign risk (Portugal-Ireland-Italy-Greece-Spain) to proposed new banking regulation and massive swings in the U.S. dollar. If our brightest economists and government officials can’t decipher these issues and “time the market,” then how in the heck are aggressive financial salesmen and casual investors supposed to digest all this ever-changing data? Making matters worse, the media continuously pours gasoline on fear-inducing uncertainties and shovels piles of greed-motivating fodder, which only serves to make matters more confusing for investors. Do yourself a favor and turn off the television. There are better ways of staying informed, without succumbing to sensationalized media stories, like reading Investing Caffeine!
Pushy financial salespeople complicate the situation by attempting to “wow” clients with fancy acronyms and industry jargon in hopes of impressing a prospect or client. In some situations, this superficial strategy may confuse an investor into thinking the consultant is knowledgeable, but in more instances than not, if the salesperson doesn’t know how to explain the investment concept in terms you understand, then there’s a good chance they are just blowing a lot of hot air.
Here’s what famous growth investor William O’Neil has to say about advice:
“Since the market tends to go in the opposite direction of what the majority of people think, I would say 95% of all these people you hear on TV shows are giving you their personal opinion. And personal opinions are almost always worthless … facts and markets are far more reliable.”
Amen.
Mistake of Trying to Time Market
My best advice to you is not to try and time the market. Even for the speculators with correct timing on one trade rarely get the move right the next time. As previously mentioned, even the smartest people on our planet have failed miserably, so I don’t recommend you trying it ether.
Here are a few examples of timing gone awry:
- Nobel Prize winners Robert Merton and Myron Scholes incorrectly predicted the direction of various economic variables in 1998, while investing client money at Long Term Capital Management. As a result of their poor timing, they single-handedly almost brought the global financial markets to their knees.
- Former Federal Reserve Chairman, Alan Greenspan, is famously quoted for his “irrational exuberance” speech in 1996 when the NASDAQ index was trading around 1,300. Needless to say, the index went on to climb above 5,000 in the coming years. Not such great timing Al.
- More recently, Ben Bernanke assumed the Federal Reserve Chairman role (arguably the most powerful financial position in our Universe) in February 2006. Unfortunately even he could not identify the credit and housing bubble that soon burst right under his nose.
Some of the best advice I have come across comes from Peter Lynch, former Fidelity manager of the Magellan Fund. From 1977-1990 his fund’s investment return averaged +29% PER YEAR. Here’s what he has to say about investment timing in the market:
“Worrying about the stock market 14 minutes per year is 12 minutes too many.”
“Anyone can do well in a good market, assume the market is going nowhere and invest accordingly.”
Rather than attempting to time the market, I would encourage you to focus on discovering a disciplined, systematic investment approach that can work in various market environments (see also, One Size Does Not Fit All).
Financial Carnage
The long-term result for investors playing the game, with rules stacked against them, is financial carnage.
If you don’t believe me, then just ask John Bogle, chairman of one of the fastest growing and most successful large financial firms in the industry. His 1984-2002 study shows how badly the average investor gets slammed, thanks to aggressive fees peddled by forceful financial salesmen and the urging into destructive emotional decisions. Specifically, the study shows the battered average fund investor earning a meager 2.7% per year while the overall stock market earned +12.9% annually over the period.
Source: Bogle Financial Center
It’s Your Investment Future
Given the economic times we are experiencing now, there is more confusion than ever in the marketplace. Insistent financial salespeople are using aggressive smoke and mirror tactics, which in many cases leads to unfortunate and damaging investment outcomes. Do your best to prepare and educate yourself, so you can become the hammer and not the nail.
It’s your investment future – invest it wisely.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including Vanguard ETFs and funds), but at time of publishing had no direct positions in securities mentioned 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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