Posts tagged ‘value’
Sifting Through the Earnings Rubble
An earthquake of second quarter earnings results have rocked the markets (better than expected earnings but sluggish revenues), and now investors are left to sift through the rubble. With thousands of these earnings reports rolling in (and many more in the coming weeks), identifying the key investment trends across sectors, industries, and geographies can be a challenging responsibility. If this was an easy duty, I wouldn’t have a job! Fortunately, having a disciplined process to sort through the avalanche of quarterly results can assist you in discovering both potential threats and opportunities.
But first things first: You will need some type of reliable screening tool in order to filter find exceptional stocks. According to Reuters, there are currently more than 46,000 stocks in existence globally. Manually going through this universe one stock at a time is not physically or mentally feasible for any human to accomplish, over any reasonable amount of time. I use several paid-service screening tools, but there are plenty of adequate free services available online as well.
Investing with the 2-Sided Coin
As Warren Buffett says, “Value and growth are two sides of the same coin.” Having a disciplined screening process in place is the first step in finding those companies that reflect the optimal mix between growth and value. I am willing to pay an elevated price (i.e., higher P/E ratio) for a company with a superior growth profile, but I want a more attractive value (i.e., cheaper price) for slower growth companies. I am fairly agnostic between the mix of the growth/value weighting dynamics, as long as the risk-reward ratio is in my favor.
Since I firmly believe that stock prices follow the long-term trajectory of earnings and cash flows, I fully understand the outsized appreciation opportunities that can arise from the “earnings elite” – the cream of the crop companies that are able to sustain abnormally high earnings growth. Or put in baseball terms, you can realize plenty of singles and doubles by finding attractively priced growth companies, but as Hall of Fame manager Earl Weaver says, “You win many more games by hitting a three-run homer than you do with sacrifice bunts.” The same principles apply in stock picking. Legendary growth investor Peter Lynch (see also Inside the Brain of an Investing Genius) is famous for saying, “You don’t need a lot of good hits every day. All you need is two to three goods stocks a decade.”
Some past successful Sidoxia Capital Management examples that highlight the tradeoff between growth and value include Wal-Mart stores (WMT) and Amazon.com (AMZN). Significant returns can be achieved from slower, mature growth companies like Wal-Mart if purchased at the right prices, but multi-bagger home-run returns (i.e., more than doubling) require high octane growth from the likes of global internet platform companies. Multi-bagger returns from companies like Amazon, Apple Inc. (AAPL), and others are difficult to find and hold in a portfolio for years, but if you can find a few, these winners can cure a lot of your underperforming sins.
Defining Growth
Fancy software may allow you to isolate those companies registering superior growth in sales, earnings, and cash flows, but finding the fastest growing companies can be the most straightforward part. The analytical heavy-lifting goes into effect once an investor is forced to determine how sustainable that growth actually is, while simultaneously determining which valuation metrics are most appropriate in determining fair value. Some companies will experience short-term bursts of growth from a single large contract; from acquisitions; and/or from one-time asset sale gains. Generally speaking, this type of growth is less valuable than growth achieved by innovative products, service, and marketing.
The sustainability of growth will also be shaped by the type of industry a company operates in along with the level of financial leverage carried. For instance, in certain volatile, cyclical industries, sequential growth (e.g. the change in results over the last three months) is the more relevant metric. However for most companies that I screen, I am looking to spot the unique companies that are growing at the healthiest clip on a year-over-year basis. These recent three month results are weighed against the comparable numbers a year ago. This approach to analyzing growth removes seasonality from the equation and helps identify those unique companies capable of growing irrespective of economic cycles.
Given that we are a little more than half way through Q2 earnings results, there is still plenty of time to find those companies reporting upside fundamental earnings surprises, while also locating those quality companies unfairly punished for transitory events. Now’s the time to sift through the earnings rubble to find the remaining buried stock gems.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and WMT, AMZN, AAPL, 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.
Eggs or Oatmeal: Binging on Over-Analysis
I about chuckled my way out of my chair when ESPN reminded me of the absurd over-analysis that takes place in the sports world (I can’t wait for the 8 hour pre-game show before the upcoming Super Bowl) through a 30-second, football commercial. Typically when sports analysts get together, the most irrelevant issues are scrutinized under a microscope. After endless wasted amounts of time, the viewer is generally left with lots of worthless information about an immaterial topic. In this particular video, San Diego NFL quarterback Phillip Rivers innocently asks Sunday Countdown football analysts Chris Berman, Mike Ditka, Keyshawn Johnson, Tom Jackson, and Cris Carter whether they would like some eggs or oatmeal for breakfast?
Mayhem ensues while the analysts breakdown everything from the pros of frittatas and brats to the cons of cholesterol and sauerkraut. After listening to all the jaw flapping, Phillip Rivers is left dejected, banging his head against the kitchen refrigerator. It is funny, I feel much the same way as Phillip Rivers does when I’m presented with same overkill analysis found plastered over the financial media and blogosphere.
Analysis of Over-Analysis
Just as I mock the excess analysis occurring in the financial world, I will move ahead and assess this same over-thinking (that’s what we bloggers do). If this much analysis takes place when examining simple options such as eggs vs. oatmeal, or AFC vs. NFC, just imagine the endless debate that arises when discussing the merits of investing in a simple, diversified domestic equity mutual fund. Sounds simple on paper, but if I want to be intellectually honest, I first need to compare this one fund versus the thousands of other equity fund offerings, not to mention the thousands of other ETFs (Exchange Traded Funds), bond funds, lifecycle funds, annuities, index funds, private equity funds, hedge funds, and other basket-related investment vehicles.
Mutual funds are only part of the investment game. We haven’t even scratched the surface of individual securities, futures, options, currencies, CDs, real estate, mortgage backed securities, or other derivatives.
The investment menu is virtually endless (see TMI – Too Much Information), and new options are created every day – many of which are indecipherable to large swaths of investors (including professionals).
Sidoxia’s Questions of Engagement
Not all analysis is psychobabble, but separating the wheat from the manure can be difficult. Before engaging in the never-ending over-analysis taking place in the financial world, answer these three questions:
1.) “Do I Care?” If the latest advance-decline statistics on the NYSE don’t tickle your fancy, or the latest “breaking news” headline on monthly pending home sales doesn’t float your boat, then maybe it’s time to do something more important like…absolutely anything else.
2.) “Do I Understand?” If conversation drifts towards complex currency swaptions comparing the Thai Baht against the Brazilian Real, then perhaps it’s time to leave the room.
3.) “Is This New News?” Not sure if you heard, but there’s this new shiny metal called gold, and it’s the cure-all for inflation, deflation, and any-flation (hyperbole for those not able to translate my written word sarcasm). The point being, ask yourself if the information you receive is valuable and actionable. Typically the best investment ideas are not discussed 24/7 over every media venue, but rather in the boring footnotes of an unread annual report.
Investing in the Stock Market
For individual securities it’s best to stick to your circle of competence with companies and industries you understand – masters like Peter Lynch and Warren Buffett appreciate this philosophy. Once you find an investment opportunity you understand, you need a way of appraising the value and gauging a company’s growth trajectory. As Charlie Munger and Warren Buffett have described, “value and growth are two sides of the same coin.” Cigar-butt investing solely using value-based metrics is not enough. Even value jock Warren Buffet appreciates the merit of a good business with sustainable expansion prospects. As a matter of fact, some of Buffett’s best performing stocks are considered the greatest growth stocks of all-time. If you cannot assign a price (or range), then you are merely playing the speculation game. Speculation often comes in the form of stock tips (i.e.,stock broker or Jim Cramer) and day trading (see Momentum Investing and Technical Analysis).
We live in a world of endless information, and the analysis can often become overkill. So when overwhelmed with data, do yourself a favor by asking yourself the three questions of engagement – that way you will not miss the forest for the trees. As for stocks, stick with industries and companies you understand and develop a disciplined investment process by appraising both the growth and valuation components of the investment. If making these decisions are too difficult, perhaps you should stay in the kitchen and have Phillip Rivers whip you up some scrambled eggs or serve you a bowl of oatmeal.
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 DIS, BRKA/B, 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.
The Invisible Giant
Bruce Berkowitz has not exactly been a household name (he apparently is not even Wikipedia-worthy). With his boyish looks, nasally voice, and slicked-back hair, one might mistake Berkowitz for a graduate student. However, his results are more than academic, which explains why this invisible giant was recently named the equity fund manager of the decade by Morningstar. It’s difficult to argue with long-term results, especially in the roller coaster market like we’ve experienced over the last ten years. The Fairholme Fund (FAIRX) fund earned a 13% annualized return over the ten-year period ending in 2009, beating the S&P 500 index by an impressive 14%.
Click here to view Bloomberg invterview with Bruce Berkowitz
How He Did It
Berkowitz states the stellar performance was achieved by
“Ignoring the crowd and going towards stressed areas that many people are running from…We make our judgments based on the cash that securities generate.”
Fairholme is effectively a “go anywhere” fund that adheres tightly to the value-based philosophy. Berkowitz’s portfolio is centered on equity securities, but his team has also shown willingness to go up and down the capital structure, if they find value elsewhere.
The Fund and its History
Berkowitz started the fund in 1999 as an extension of his separate account business, which was created in his previous life at Smith Barney and Lehman Brothers. The Fairholme fund tends to concentrate around 15 to 25 securities on average, with some holdings accounting for more than 10% of the portfolio. An example of Fairholmes concentration is evidenced by its favorably timed trade in the energy sector, which resulted in a 35% weighting in the fund. Fortunately Berkowitz redeployed that winning position – before energy prices cratered in 2008 – into unloved areas like healthcare and defense stocks.
Berkowitz models his investment style after Warren Buffett, focused on good businesses with prolific cash flows. Like many value investors, Berkowitz fishes for contrarian based ideas residing in pockets of the market that are out of favor. He also likes to have a significant weighting in “special situations,” which are limited to about 25% of the portfolio. In order to take advantage opportunities, Berkowitz is not shy or bashful about carrying around a good chunk of cash in his pocket. He likes to keep about 15% on average to scoop up out of favor opportunities.
The Future of Fairholme
I commend Berkowitz for his admirable record, but I caution investors to not go hog wild over outperforming funds. He has crushed the market over an extremely challenging investment period, but investors need to remember that “mean reversion,” the tendency for a trend to move towards averages, applies to investing styles too. Concentrated, go-anywhere, large cap value, market timing funds that outperform for ten years at a time may underperform or outperform less dramatically over the next ten years. Just ask Bill Miller (see also Bill Miller Revenge of the Dunce article), concentrated value manager at Legg Mason, about mean reversion. Miller beat the market for 15 consecutive years before recently ending up in the bottom 10-year decile (1-star Morningstar rated) after some bad concentrated bets and poor investment timing. Another challenge for Fairholme is size (currently around $10.5 billion in assets under management). Having managed a multi-billion fund myself (see also my book), I can attest to the complexities Berkowitz faces in managing a much larger fund now.
Regardless, Berkowitz’s performance should not be ignored given his sound philosophy and achievement over an unprecedented period. Already, just a few weeks into 2010, Fairholme is ranked #1 in its fund category by Morningstar.
This is one invisible man you should not let disappear off your radar.
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 FAIRX, LM, BRKA/B or MORN. 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.
Too Big to Sink
If I got paid a nickel for every time I heard the phrase “too big to fail” to describe the state of affairs of our major financial institutions, I’d be retired on my private island by now. Jeremy Grantham, famed value investor and Chairman of Grantham Mayo Van Otterloo, recently compared the redesigning of our financial system to the Titanic and aptly described the hubris surrounding the ship’s voyage as “too big to sink!”
Mr. Grantham argues that many of the financial institution reform proposals have an irrelevant, misguided focus on improving the safety of the Titanic’s lifeboats rather than the structural design or competence of the captain. Maybe it’s better to plan for disaster prevention rather than disaster preparation? Grantham adds:
“By working to mitigate the pain of the next catastrophe, we allow ourselves to downplay the real causes of the disaster and thereby invite another one.”
When analyzing system failures, incentives are important to understand too. For example, the ship was “under-designed” and the captain had an ill-advised reward baked into a compensation bonus, if he beat the speed record (see article on compensation).
The Solution
Rather than protecting the bankers’ interests, Grantham contends we need “smaller, simpler banks that are not too big to fail.” At the heart of these massive financial conglomerates, pruning is necessary to separate the risky, proprietary trading departments, thereby ridding an “egregious conflict of interest with their clients.” As a former fund manager for a $20 billion fund, I was acutely aware of how my fund trading information and my conversations were being tracked by investment bankers and traders for themselves and their clients’ benefit. When the banks are managing your money alongside their own money, greed has a way of creeping in.
Beyond the prop trading desk legislation, Grantham believes those financial institutions “too big to fail” should be cut down into smaller pieces that can actually fail. Many of these entities are already what I like to call, “too complex to succeed,” evidenced by the stupefied responses provided by Congressmen and the CEOs of the banking institutions during the aftermath of the crisis. Reintroduction of some form of Glass-Steagall legislation (separation of investment banks from commercial banks) is another recommendation made by Grantham.
These suggestions sound pretty reasonable to me, but the bankers scream “If we become smaller and simpler and more regulated, the world will end and all serious banking will go to London, Switzerland, Bali Hai, or wherever,” Grantham adds in a mocking voice. If the foreigners want to operate irresponsibly, then Grantham says let them suffer the negative consequences every 15 years, or so.
The political will of legislators will be tested if substantive financial reforms actually come to pass. Jeremy Grantham understands the extreme importance of reform as explained concisely here, “A simpler, more manageable financial system is much more than a luxury. Without it we shall surely fail again.” Fail that is…like a sinking Titanic.
Read Jeremy Grantham’s Full Quarterly Newsletter
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: 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.
Style Drift: Hail Mary Investing
The mutual fund investing game is extraordinarily competitive. According to The Financial Times, there were 69,032 global mutual funds at the end of 2008. With the extreme competitiveness comes lucrative compensation structures if you can win (outperform) – I should know since I was a fund manager for many years. However, the compensation incentive structures can create style drift and conflicts of interest. You can think of style drift as the risky “Hail Mary” pass in football – you are a hero if the play (style drift) works, but a goat if it fails. When managers typically drift from the investment fund objective and investment strategy, typically they do not get fired if they outperform, but the manager is in hot water if drifting results in underperformance. Occasionally a fund can be a victim of its own success. A successful small-cap fund can have positions that appreciate so much the fund eventually becomes defined as a mid-cap fund – nice problem to have.
Drifting Issues
Why would a fund drift? Take for example the outperformance of the growth strategy in 2009 versus the value strategy. The Russell 1000 Growth index rose about +28% through October 23rd (excluding dividends) relative to the Russell 1000 Value index which increased +14%. The same goes with the emerging markets with some markets like Brazil and Russia having climbed over +100% this year. Because of the wide divergence in performance, value managers and domestic equity managers could be incented to drift into these outperforming areas. In some instances, managers can possibly earn multiples of their salary as bonuses, if they outperform their peers and benchmarks.
The non-compliance aspect to stated strategies is most damaging for institutional clients (you can think of pensions, endowments, 401ks, etc.). Investment industry consultants specifically hire fund managers to stay within the boundaries of a style box. This way, not only can consultants judge the performance of multitudes of managers on an apples-to-apples basis, but this structure also allows the client or plan participant to make confident asset allocation decisions without fears of combining overlapping strategies.
For most individual investors however, a properly diversified asset allocation across various styles, geographies, sizes, and asset classes is not a top priority (even though it should be). Rather, absolute performance is the number one focus and Morningstar ratings drive a lot of the decision making process.
What is Growth and Value?
Unfortunately the style drift game is very subjective. Growth and value can be viewed as two sides of the same coin, whereby value investing can simply be viewed as purchasing growth for a discount. Or as Warren Buffet says, “Growth and value investing are joined at the hip.” The distinction becomes even tougher because stocks will often cycle in and out of style labels (value and growth). During periods of outperformance a stock may get categorized as growth, whereas in periods of underperformance the stock may change its stripes to value. Unfortunately, there are multiple third party data source providers that define these factors differently. The subjective nature of these style categorizations also can provide cover to managers, depending on how specific the investment strategy is laid out in the prospectus.
What Investors Can Do?
1) Read Prospectus: Read the fund objective and investment strategy in the prospectus obtained via mailed hardcopy or digital version on the website.
2) Review Fund Holdings: Compare the objective and strategy with the fund holdings. Not only look at the style profile, but also evaluate size, geography, asset classes and industry concentrations. Morningstar.com can be a great tool for you to conduct your fund research.
3) Determine Benchmark: Find the appropriate benchmark for the fund and compare fund performance to the index. If the fund is consistently underperforming (outperforming) on days the benchmark is outperforming (underperforming), then this dynamic could be indicating a performance yellow flag.
4) Rebalance: By periodically reviewing your fund exposures and potential style drift, rebalancing can bring your asset allocation back into equilibrium.
5) Seek Advice: If you are still confused, call the fund company or contact a financial advisor to clarify whether style drift is occurring in your fund(s) (read article on finding advisor).
Style drift can potentially create big problems in your portfolio. Misaligned incentives and conflicts of interest may lead to unwanted and hidden risk factors in your portfolio. Do yourself a favor and make sure the quarterback of your funds is not throwing “Hail Mary” passes – you deserve a higher probability of success in your investments.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: 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. Wade W. Slome, CFA, CFP is a contributing writer for Morningstar.com. Please read disclosure language on IC “Contact” page.
Howard Right on the Mark(s)
Legendary investor Howard Marks opines on the financial markets in his recently quarterly client memo. One should pay attention to these battle-tested veterans with scars to prove their survival skills. Rather than neatly package a common theme from the long document I will highlight a few areas.
Marks is cautious but sees better buying opportunities ahead.
Recent Past vs. Long Past: For most of the 16 page memo Howard Marks reminisces on his 40+ years in the investment industry and contrasts the 2003-2007 period with the majority of his years. He states in the old days, “There were no swaps, index futures or listed options. Leverage wasn’t part of most institutional investors’ arsenal…or vocabulary. Private equity was unknown, and hedge funds were too few and outré to matter. Innovations like quantitative investing and structured products had yet to arrive, and few people had ever heard of ‘alpha.'”
Marks on Siegel: Marks targets Wharton Professor Jeremy Siegel as a contributor to the overly bullish mentality of 2003-2007, “Siegel’s research was encyclopedic and supported some dramatic conclusions, perhaps foremost among them his showing that there’s never been a 30-year period in which stocks didn’t outperform cash, bonds and inflation…but…30 years can be a long time to wait.”
Marks on Risk: “So yes, it’s true that investor’s can’t expect to make much money without taking risk. But that’s not the same as saying risk taking is sure to make you money…If risky investments always produced high returns, they wouldn’t be risky.” On the psychological impacts of risk, Marks goes on to say, “When investors are unworried and risk-tolerant, they buy stocks at high p/e ratios and private companies at high EBITDA multiples, and they pile into bonds despite narrow yield spreads and into real estate at minimal “cap rates.'”
On Quant Models and Business Schools: Marks quotes Warren Buffet regarding the complexity of quantitative models, “If you need a computer or a calculator to make a calculation, you shouldn’t buy it.” Charlie Munger adds his two cents on why quantitative models exist: “They teach that in business schools because, well, they’ve got to do something.”
Investing as a Mixture of Art & Science: In my book I describe investing as a combination of “Art” and “Science.” Marks addresses a s similar insight through an Albert Einstein quote:
“Not everything that can be counted counts, and not everything that counts can be counted.”
Views on the Credit Rating Agencies: To highlight the absurdity of the mortgage credit rating system, Marks compares the agencies’ ratings to hamburger: “If it’s possible to start with 100 pounds of hamburger and end up selling ten pounds of dog food, 40 pounds of sirloin and 50 pounds of filet mignon, the truth-in-labeling rules can’t be working.”
If you would like to access the remainder of memo, click here to read the rest. Overall, Mr. Marks gives a balanced view of the markets and economy, but feels “better buying opportunities lie ahead.” Thankfully, I’m finding some myself.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
Investing Caffeine 
