Posts tagged ‘Peter Lynch’

Avoiding Cigarette Butts

cigarette-butt-1579806

Too many investors hang their hat on investments that seem “cheap”. Unfortunately, too often something that looks like a bargain turns out to be a cigarette butt from which investors are hoping to take a last puff. As the old adage states, “you get what you pay for,” and that certainly applies to the world of investments. There are endless examples of cheap stocks getting cheaper, or in other words, stocks with low price/earnings ratios going lower. Stocks that appear cheap today, in many cases turn out to be expensive tomorrow because of deteriorating or collapsing profitability.

For instance, take Haliburton Company (HAL), an energy services company. Wall Street analysts are forecasting the Houston, Texas based oil services company to achieve 2016 EPS (earnings per share) of $0.32, down -79%. The share price currently stands at $37, so this translates into an eye-popping valuation of 128x P/E ratio, based on 2016 earnings estimates. What has effectively occurred in the HAL example is earnings have declined faster than the share price, which has caused the P/E to go higher. If you were to look at the energy sector overall, the same phenomenon is occurring with the P/E ratio standing at a whopping 97x (at the end of Q1).

These inflated P/E ratios are obviously not sustainable, so two scenarios are likely to occur:

  • The price of the P/E (numerator) will decline faster than earnings (denominator)
    •                                             AND/OR
  • The earnings of the P/E (denominator) will rise faster than the price (numerator)

Under either scenario, the current nose-bleed P/E ratio should moderate. Energy companies are doing their best to preserve profitability by cutting expenses as fast as possible, but when the product you are selling plummets about -70% in 18 months (from $100 per barrel to $30), producing profits can be challenging.

The Importance of Price (or Lack Thereof)

Similarly to the variables an investor would consider in purchasing an apartment building, “price” is supreme. With that said, “price” is not the only important variable. As famed investor Warren Buffett shrewdly notes, the quality of a company can be even more important than the price paid, especially if you are a long-term investor.

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

 

The advantage of identifying and owning a “wonderful company” is the long-term stream of growing earnings. The trajectory of future earnings growth, more than current price, is the key driver of long-term stock performance.

Growth investor extraordinaire Peter Lynch summed it up well when he stated,

People Concentrate too much on the P, but the E really makes the difference.”

 

Albert Einstein identified the power of “compounding” as the 8th Wonder of the World, which when applied to earnings growth of a stock can create phenomenal outperformance – if held long enough. Warren Buffett emphasized the point here:

“If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”

 

Throw Away Cigarette Butts

I have acknowledged the importance of aforementioned price, but your investment portfolio will perform much better, if you throw away the cigarette butts and focus on identifying market leading franchise that can sustain earnings growth. The lower the growth potential, the more important price becomes in the investment question. (see also Magic Quadrant)

Here are the key factors in identifying wining stocks:

  • Market Share Leaders: If you pay peanuts, you usually get monkeys. Paying a premium for the #1 or #2 player in an industry is usually the way to go. Certainly, there is plenty of money to be made by smaller innovative companies that disrupt an industry, so for these exceptions, focus should be placed on share gains – not absolute market share numbers.
  • Proven Management Team: It’s nice to own a great horse (i.e., company), but you need a good jockey as well. There have been plenty of great companies that have been run into the ground by inept managers. Evaluating management’s financial track record along with a history of their strategic decisions will give you an idea what you’re working with. Performance doesn’t happen in a vacuum, so results should be judged relative to the industry and their competitors. There are plenty of incredible managers in the energy sector, even if the falling tide is sinking all ships.
  • Large and/or Growing Markets: Spotting great companies in niche markets may be a fun hobby, but with limited potential for growth, playing in small market sandboxes can be hazardous for your investment health. On the other hand, priority #1, #2, and #3 should be finding market leaders in growth markets or locating disruptive share gainers in large markets. Finding fertile ground on long runways of growth is how investors benefit from the power of compound earnings.
  • Capital Allocation Prowess: Learning the capital allocation skillset can be demanding for executives who climb the corporate ladder from areas like marketing, operations, or engineering. Regrettably, these experiences don’t prepare them for the ultimate responsibility of distributing millions/billions of dollars. In the current low/negative interest rate environment, allocating capital to the highest return areas is more imperative than ever. Cash sitting on the balance sheet earning 0% and losing value to inflation is pure financial destruction. Conservatism is prudent, however, excessive piles of cash and overpaying for acquisitions are big red flags. Managers with a track record of organically investing in their businesses by creating moats for long-term competitive advantage are the leaders we invest in.

Many so-called “value” investors solely use price as a crutch. Anyone can print out a list of cheap stocks based on Price-to-Earnings, Enterprise Value/EBITDA, or Price/Cash Flow, but much of the heavy lifting occurs in determining the future trajectory of earnings and cash flows. Taking that last puff from that cheap, value stock cigarette butt may seem temporarily satisfying, but investing into too many value traps may lead you gasping for air and force you to change your stock analysis habits.

investment-questions-border

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing had no direct position in HAL 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.

 

April 9, 2016 at 5:32 pm Leave a comment

Chasing Headlines

Chasing FreeImages

It’s been an amazing start to the year. First the market cratered on slowing China economic concerns, domestic recessionary fears, deteriorating oil prices, and negative interest rates abroad. In response to all these worries (and others), stocks dove more than -11% (S&P 500 Index) in January, before settling down. Subsequently, the market has made a screaming recovery, in part due to dovish monetary policy comments (i.e., reduction in forecasted interest rate hikes) and diminished anxiety over a potential global collapse. Month-to-date stocks are up an impressive +5.4%, and year-to-date equities are flattish, or down less than -1%.

With an endless amount of information flowing across our smart phones and computers, it becomes quite easy and tempting to chase news headlines, just like a hyper dog chasing a car. But even once an investor catches up (or reacts) to a headline, there’s confusion around how to profit from the fleeting information. First of all, every plugged-in hedge fund and institutional investor has likely already traded on the stale information you received. Second of all, rarely is the data relevant to the long-term cash generating capabilities of the company or economy. And lastly, the news is more often than not, instantly factored into the stock price. Chasing news headlines only eaves individual investors holding the bag of performance-shattering transactions costs, taxes, and worn-out pricing.

The heightened volatility in late 2015 and early 2016 hasn’t however prevented investors and so-called pundits from attempting to time the market. Any battle-tested investment veteran knows it’s virtually impossible to consistently time the market (see also Market Timing Treadmill), but this fact hasn’t prevented speculators from attempting the feat nonetheless. Famed investment guru, Peter Lynch, who earned an average +29% annual return from 1977-1990, summed it up well when he stated the following:

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”

 

The Important Factors

As I’ve written many times in the past, the keys to long-term stock performance are not knee-jerk reactions to headlines, but rather these following crucial factors (see also Don’t Be a Fool, Follow the Stool):

  • Profits
  • Interest Rates
  • Sentiment
  • Valuations

On the profit growth front, corporate income has been pressured by numerous headwinds over the last few years, including an export-shattering increase in the value of the U.S. dollar and a profit-squeezing collapse in energy sector earnings. As you can see from the chart below, the value of the U.S. dollar increased by about 25% from mid-2014 to early-2015, in part because of diverging global central bank policies (more hawkish U.S. Fed vs. more dovish ECB/international central banks). Since that spike, the dollar has settled into a broad range (95 – 100), and the former forceful headwind have now turned into modest tailwinds. This trend is important because an estimated 35-40% of corporate profits are derived from international operations.

Adding insult to injury, the roughly greater than -70% decline in forward energy earnings over the last 18 months has caused a significant hit to overall S&P 500 profits. The tide appears to be finally turning (or at least stabilizing) however, as we’ve seen oil prices rebound by about +30% this year from the lows in January. If these aforementioned trends persist, profit pressures in 2016 are likely to abate significantly, and may actually become additive to growth.

U.S. Dollar 3-26-16

Source: Barchart.com

Profits are important, but so are interest rates. While incessant talk about the path of future Fed policy continues to blanket the airwaves (see also Fed Fatigue), absent a rapid increase in interest rates (say 300-400 basis points), interest rates remain unambiguously positive for equity markets, providing a floor for the oft-repeated volatility in financial markets. As long as stocks are providing higher yields than many bonds, and depositors are earning 0% (or negative rates) on their checking accounts, stocks may remain unloved, but not forgotten.

And speaking of unloved, the sentiment for stocks remains sour. One need look no further than the quarter-billion dollars in hemorrhaging outflows out of U.S. equity funds (see ICI Long-Term Mutual Fund Flows) since 2014. This deep underlying skepticism serves as a positive contrarian indicator for future equity prices. Right now, very few individual investors are swimming in the pool – the time to get out of the stock market pool is when everyone is jumping in.

And lastly, valuations remain very much in line with historical averages (approximatqely 17x 2016 projected earnings), especially considering the generational low in interest rates. Bears continue to point to the elevated CAPE ratio, which has been a disastrous indicator the last seven years (and longer), as a reason to remain cautious. The ironic part is that valuations are virtually guaranteed to improve a few years from now as we roll off the artificially depressed years of 2008-2010.

When you add it all up, zero (or negative) interest rates, combined with the other key factors of profits, sentiment, and valuations, equities remain an important and attractive part of a diversified long-term portfolio. Your objectives, time horizon, and risk tolerance will always drive the proportion of your equity allocation. Nevertheless, some bond exposure is essential to smooth out volatility. Regardless of your investment strategy, chasing headlines, like a dog chasing a car, serves no purpose other than leaving you with a tired, unproductive investment portfolio.

investment-questions-border

www.Sidoxia.com

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.

March 26, 2016 at 12:29 pm Leave a comment

Invest with a Telescope…Not a Microscope

Telescope-Microscope

It was another bloody week in the stock market (S&P 500 index dropped -3.1%), and any half-glass full data was interpreted as half-empty. The week was epitomized by a Citigroup report entitled “World Economy Trapped in a Death Spiral.” A sluggish monthly jobs report on Friday, which registered a less than anticipated addition of 151,000 jobs, painted a weakening employment picture. Professional social media site LinkedIn Corp. (LNKD) added fuel to the fire with a soft profit forecast, which resulted in the stock getting almost chopped in half (-44%)…in a single day (ouch).

It’s funny how quickly the headlines can change – just one week ago, the Dow Jones Industrial index catapulted higher by almost +400 points in a single day and we were reading about soaring stocks.

Coherently digesting the avalanche of diverging and schizophrenic headlines is like attempting to analyze a windstorm through a microscope. A microscope is perfect for looking at a single static item up close, but a telescope is much better suited for analyzing a broader set of data. With a telescope, you are better equipped to look farther out on the horizon, to anticipate what trends are coming next. The same principle applies to investing. Short-term traders and speculators are great at using a short-term microscope to evaluate one shiny, attention-grabbing sample every day. The investment conclusion, however, changes the following day, when a different attention-grabbing headline is analyzed to a different conclusion. As Mark Twain noted, “If you don’t read the newspaper, you are uninformed.  If you do read the newspaper, you are misinformed.”

Short-termism is an insidious disease that will slowly erode short-run performance and if not controlled will destroy long-run results as well. This is not a heretic concept. Some very successful investors have preached this idea in many ways. Here are a few of them:

‘‘We will continue to ignore political and economic forecasts which are an expensive distraction for many investors and businessmen.” –Warren Buffett (Annual Newsletter 1994)

‘‘If you spend more than 14 minutes a year worrying about the market, you’ve wasted 12 minutes’’ –Peter Lynch

Excessive short-termism results in permanent destruction of wealth, or at least permanent transfer of wealth” -Jack Gray Grantham

 

On the flip side, those resilient investors who have succeeded through investment cycles understand the importance of taking a long-term view.

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.” –Peter Lynch

The farther you can lengthen your time horizon in the investment process, the better off you will be.” – David Nelson (Legg Mason)

Long term owners are more relaxed, more informed, more patient, less emotional.” –John Templeton

If you are really a long-term investor, you will view a bear market as an opportunity to make money.” –John Templeton

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.” –Don Hays

In the long run, one of the greatest risk to your net worth is not owning stocks. Bonds do not grow. They can only return their face value at maturity…Inflation is a silent, insidious tax that erodes your net worth…Fortunately, there is an easy way to keep pace with and even beat inflation, and this is stocks.” – John Spears

In the short-term, the stock market is a voting machine; in the long-term a weighing machine.” -Benjamin Graham

 

There has been a lot of pain experienced so far in 2016, and there may be more to come. However, trying to time the market and call a bottom is a fruitless effort. Great companies and investments do not disappear in a bear market. At times like these, it is important to stick to a systematic, disciplined approach that integrates valuation and risk controls based on where we are in an economic cycle. Despite all the recent volatility, as I’ve repeated many times, the key factors driving the direction of the stock market are the following: 1) Corporate profits; 2) Interest rates; 3) Valuations; and 4) Sentiment (see also Don’t Be a Fool, Follow the Stool). Doom and gloom “Death Spiral” headlines may currently rule the day, but the four key stock-driving factors on balance remain skewed towards the positive…if you have the ability to put away your microscope and take out your telescope.

investment-questions-border

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing had no direct position in LNKD 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.

February 6, 2016 at 11:05 pm Leave a comment

Don’t Do Something…Just Stand There!

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Like a full plane hitting a rough patch of turbulence, investors have been shaken by the recent price volatility in the stock market over concerns of a slowing Chinese economy, plummeting oil prices, and a host of other alarming headlines. As a result, investors are left picking up the pieces of the S&P 500 decline, which currently sits off -11% from its 2015 highs (down -15% at the 1/20/16 low). The picture looks even uglier if you consider the Russell 2000 small cap index, which has collapsed -21% from its 2015 highs (-26% at the 1/20/16 low).

What now, and what does this mean? There has been all kinds of crazy technical trading activity occurring around heavy options expirations, stop-loss selling, and short cover buying. With all the frenetic gyrations in the stock market (e.g., 2,000 point swing in the Dow Jones over the last month), there have been no shortage of opinions on TV, on the internet or at the watercooler. However, the best sage advice probably came from 86-year-old investor legend, John “Jack” Bogle (founder of Vanguard Group – $3.4 trillion in assets under management at 12/31/15), who emphatically told investors to “Don’t do something…just stand there!”

The advice to “stay the course” can be very counter-intuitive to human nature. In periods of stress, our brains tend to revert back to our ancestors’ Darwinian survival instincts, which tell us to flee from the ferocious lion (see also Controlling the Investment Lizard Brain). The fact is these periods of turbulence are normal – no different than a bumpy flight into San Francisco. In fact, we’ve hit quite a few choppy air pockets in recent years:

  • Debt Downgrade/Debt Ceiling Debate/European PIIGS Crisis (-22% in 2011)
  • Arab Spring/Grexit Fears (-11% in 2012)
  • Fed Taper Tantrum (-8% in 2013)
  • Ebola Outbreak (-10% in 2014)
  • China Slowdown Fears (-13% in 2015)

Through all of this mayhem, including the current 2016 dip, the stock market has still managed to rise an impressive  +77% since the 2011 pullback, which sure beats the sub-1% yield earned on bank CDs.

Inevitably, with the recent price breakdown, speculation has begun to swirl around the dreaded “R”-word (aka, recession) again. In general, this is a fruitless effort. When the smartest Nobel Prize winning economists fail miserably at predicting recessions, it’s hard to believe you or I will have a much better success rate. The great investor Peter Lynch astutely summed up recession forecasting as follows:

“It’s lovely to know when there’s recession. I don’t remember anybody predicting 1982 we’re going to have 14 percent inflation, 12 percent unemployment, a 20 percent prime rate, you know, the worst recession since the Depression. I don’t remember any of that being predicted. It just happened. It was there. It was ugly. And I don’t remember anybody telling me about it. So I don’t worry about any of that stuff. I’ve always said if you spend 13 minutes a year on economics, you’ve wasted 10 minutes.”

 

The noted Nobel Prize winning economist Paul Samuelson offered this shrewd observation on recessions as well:

“The stock market has called nine of the last five recessions.”

In other words, the stock market can predict recessions, but often times it is a horrible indicator for the health of the economy (e.g., see 2011-2015 above).

While I am definitely not a Nobel Prize winning economist, I can objectively point to supporting evidence showing we currently are not on the edge of a new recession. It is certainly true that a strong U.S. dollar and a Q4 energy earnings deterioration has been a drag on earnings, but these factors only paint a small part of the picture. Without going into gory economic detail, you do not need to be an expert to understand basic macro trends like employment, housing, auto sales, gasoline prices, and interest rates are providing a buttress to the economy.

As you can see from the chart below, the -73% cut in Q4 energy sector earnings, along with challenged exports from multinational corporations, has pressured profitability in the S&P 500. However, if you strip out the energy sector, earnings continue to grow. And although it’s early in the 2016 earnings reporting season, so far 73% of companies are beating estimates by 3% on average.

Earnings Q4-15

The economic winds are definitely spinning, and we may not be completely through the turbulence, but rather than panicking, you’re probably best served by following the advice of Jack Bogle by standing through the turmoil and look for opportunities when the volatility settles.

investment-questions-border

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing 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.

January 23, 2016 at 4:08 pm 5 comments

10 Ways to Destroy Your Portfolio

With the increased frequency of heightened volatility, investing has never been as challenging as it is today. However, the importance of investing has never been more crucial either, due to rising life expectancies, corrosive effects of inflation, and the uncertainty surrounding the sustainability of  government programs like Social Security, Medicare, and pensions.

If you are not wasting enough money from our structurally flawed and loosely regulated investment industry that is inundated with conflicts of interest, here are 10 additional ways to destroy your investment portfolio:

#1. Watch and React to Sensationalist News Stories: Typically, strategists and pundits do a wonderful job of parroting the consensus du jour. With the advent of the internet, and 24/7 news cycles, it is difficult to not get caught up in the daily vicissitudes. However, the accuracy of the so-called media experts is no better than weather forecasters’ accuracy in predicting the weather three Saturdays from now at 10:23 a.m. Investors would be better served by listening to and learning from successful, seasoned veterans (see Investing Caffeine Profiles).

#2. Invest for the Short-Term and Attempt Market Timing: Investing is a marathon, and not a sprint, yet countless investors have the arrogance to believe they can time the market. A few get lucky and time the proper entry point, but the same investors often fail to time the appropriate exit point. The process works similarly in reverse, which hammers home the idea that you can be 200% wrong when you are constantly switching your portfolio positions.

#3. Blindly Invest Without Knowing Fees: Like a dripping faucet, fees, transaction costs, taxes, and other charges may not be noticeable in the short-run, but combined, these portfolio expenses can be devastating in the long-run. Whether you or your broker/advisor knowingly or unknowingly is churning your account, the practice should be immediately halted. Passive investment products and strategies like ETFs (Exchange Traded Funds), index funds, and low turnover (long time horizon / tax-efficient) investing strategies are the way to go for investors.

#4. Use Technical Analysis as a Primary Strategy: Warren Buffett openly recognizes the problem with technical analysis as evidenced by his statement, “I realized technical analysis didn’t work when I turned the charts upside down and didn’t get a different answer.” Legendary fund manager Peter Lynch adds, “Charts are great for predicting the past.” Most indicators are about as helpful as astrology, but in rare instances some facets can serve as a useful device (like a Lob Wedge in golf).

#5. Panic-Sell out of Fear & Panic-Buy out of Greed: Emotions can devastate portfolio returns when investors’ trading activity follows the herd in good times and bad. As the old saying goes, “The herd is lead to the slaughterhouse.” Gary Helms rightly identifies the role that overconfidence plays when ininvesting when he states,”If you have a great thought and write it down, it will look stupid 10 hours later.” The best investment returns are earned by traveling down the less followed path. Or as Rob Arnott describes, “In investing, what is comfortable is rarely profitable.” Get a broad range of opinions and continually test your investment thesis to make sure peer pressure is not driving key investment decisions.

#6. Ignore Valuation and Yield: Valuation is like good pitching in baseball…very important. Valuation may not cause all of your investments to win, but this factor should be an integral part of your investment process. Successful investors think about valuation similarly to skilled sports handicappers. Steven Crist summed it up beautifully when he said, “There are no ‘good’ or ‘bad’ horses, just correctly or incorrectly priced ones.” The same principle applies to investments. Dividends and yields should not be overlooked – these elements are an essential part of an investor’s long-run total return.

#7. Buy and Forget: “Buy-and-hold” is good for stocks that go up in price, and bad for stocks that go flat or decline in value. Wow, how deeply profound. 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) excessive 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.

#8. Over-Concentrate Your Portfolio: If you own a top-heavy portfolio with large weightings, sleeping at night can be challenging, and also force average investors to make bad decisions at the wrong times (i.e., buy high and sell low). While over-concentration can be risky, over-diversification can eat away at performance as well – owning a 100 different mutual funds is costly and inefficient.

#9. Stuff Money Under Your Mattress: With interest rates at the lowest levels in a generation, stuffing money under the mattress in the form of CDs (Certificates of Deposit), money market accounts, and low-yielding Treasuries that are earning next to nothing is counter-productive for many investors. Compounding this problem is inflation, a silent killer that will quietly disintegrate your hard earned investment portfolio. In other words, a penny saved inefficiently will lead to a penny depreciating rapidly.

#10. Forget Your Mistakes: Investing is difficult enough without naively repeating the same mistakes. As Albert Einstein said, “Insanity is doing the same thing, over and over again, but expecting different results.” Mistakes will be made and it behooves investors to document them and learn from them. Brushing your mistakes under the carpet may make you temporarily feel better emotionally, but will not help your financial returns.

As the year approaches a close, do yourself a favor and evaluate whether you are committing any of these damaging habits. Investing is tough enough already, without adding further ways of destroying your portfolio.

investment-questions-border

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

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.

December 6, 2015 at 12:52 pm 17 comments

To Test or Retest?

Acting Masks

In Shakespeare’s tragedy Hamlet, the main character Prince Hamlet raises the existential question to himself, “To be, or not to be, that is the question?” With the recent -13% correction in the S&P 500 index, and subsequent mini-rebound, a lot of investors have also been talking to themselves and asking the fundamental question, “To test or retest, that is the question?” The inability of Fed Chairwoman dove, Janet Yellen, to increase the Federal Funds interest rate target by 0.25% after nine years only increased short-term uncertainty.

For investors playing in the stock market, uncertainty and corrections are par for the course. Howard Getson at Capitalogix recently pointed out the following.

Since 1900, on average, we’ve experienced…

  • -5% market corrections: 3 times/year.
  • -10% market corrections: 1 time/ year.
  • -20% market corrections: 1 time/3.5 years.

However, no market correction is the same. Sure it would be nice if, during every bull market, the pain from any -10% correction lasted a second – similar to ripping off a Band-Aid. Unfortunately, when you live through such rapid and violent corrections, as we just did, volatility tends to stick around for a while. And in many instances, any brief rebound in stock prices is met with another downdraft in prices that retests the recent lows in prices.

In the recent correction example, a retest of the lows would mean another -5% drop, on top of Friday’s -2% cut, to a level of 1,867 on the S&P 500 index. This is definitely a realistic probability (see chart below).

Chart Source: MarketSmith (Powered by IBD)

Chart Source: Investors.com (Powered by IBD)

Although corrections are quite common, violent corrections are less common. Scott St. Clair, an analyst at MarketSmith, a division of William O’Neil & Co., recently did a study examining the frequency of 10%+ corrections occurring in four days or less across the three major indices (Dow Jones Industrial, S&P 500, and NASDAQ). Before the latest -15% decline in the NASDAQ from August 19th to August 24th, St. Clair only identified drops of -10% or more (in four trading sessions) eight previous times since the Great Depression (six of the eight periods are listed below).

  • DJIA May 1940 -26% in eight days
  • DJIA May 1962 -16% in 10 days
  • S&P 500 Aug 1998 -15% in five days
  • S&P 500 July 2002 -25% in 13 days
  • S&P 500 October 2008 -33% in 15 days.
  • S&P 500 August 2011 -19% in 13 days

Following all these corrections, the market always rebounded, but what St. Clair showed was in many cases stock prices had to retest the previous lows before advancing again.

As Mark Twain said, “History doesn’t repeat itself but it often rhymes,” which explains why this study is a useful historical exercise to prepare investors for potential future downdrafts. With that said, for long-term investors, much of this utility is marginal at best and useless at worst.

If you can’t handle the volatility, you need a more diversified portfolio, or you need to park your money in a savings account or CD and watch it melt away to inflation.

In reviewing corrections, famed growth investor Peter Lynch said it best:

 “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.”

Whether the August 24th low was the only test of this correction, or investors retest it again, is a moot point. Ignoring irrelevant headlines and focusing your attention on a low-cost, tax-efficient, globally diversified investment portfolio is a better use of your time. That is a tenet for which Hamlet would certainly be willing to die.

Investment Questions Border

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) , 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.

September 19, 2015 at 2:57 pm Leave a comment

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 Jordan Spieth). 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 transferable 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, including KO, but at time of publishing had no direct positions in DELL, 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.

August 15, 2015 at 10:00 am 5 comments

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