Posts tagged ‘Warren Buffett’
Do you remember the panic-inducing headlines related to PIIGS, Crimea, Ebola, Cyprus, and the Flash Crash? Probably not. But if you do remember, these false alarms have likely been relegated to the financial memory graveyard, along with the many other sensationalist news events that have been killed off in the post-financial crisis era. Time will tell whether Brexit dies off or becomes a resurrected concern, like the repeating fears of a China slowdown or Greek collapse. Regardless, as the S&P 500 stock index reaches new all-time record highs, investors are currently shrug off the noise while muttering, “Brexit-Schmexit.”
Individuals have tried to use scary headlines as a timing tool to consistently time market corrections for all of recorded history. Unfortunately, emotional, knee-jerk reactions to alarming news stories rarely is the best strategy. Famed fund manager Peter Lynch said it best when he noted,
“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”
Having invested for some 25 years, experience has taught me not only is conventional wisdom often wrong, but it also is frequently an accurate contrarian indicator. In other words, frightening news often should be an indicator to buy…not sell. Case in point is the U.K. European Union referendum. The Brexit referendum “Leave” vote caught virtually everyone by surprise, but the rebound in stock prices to new record highs may be even more surprising to most observers. However, for investors following the key factors of interest rates, profits, valuation, and sentiment (see also Don’t Be a Fool, Follow the Stool), may not be shocked by the positive price action.
- Interest Rates: For starters, you don’t have to be a genius to realize that stocks become more attractive when there is a scarcity of investment alternatives. When there are an estimated $13 trillion of negative interest rate bonds, a layman can quickly understand a 2%, 3%, or 4% dividend yield offered on certain stocks (and funds) can represent a much more attractive opportunity. With interest rates at record lows (see chart below), the overall dividend yield of stocks has provided a floor for stock prices and has limited the depth and duration of sell-offs and corrections.
- Profits: Corporate profits are near record highs but have been sluggish due to several factors, including the negative impact of the strong dollar on multinational exports; the depressing effect of declining interest rates on the banking sector’s net interest profit margins; the general decline in oil and commodity prices; and general lethargic economic growth overall in international markets (emerging and developed economies). Encouragingly, a stabilization in the value of the U.S. dollar, along with a rebound in energy prices augurs well for a potential shift back to earnings growth in the coming quarters.
- Valuation: On a valuation basis, the Price/Earnings ratio of the stock market is about 10-15% above historical averages (see chart below). The average S&P 500 stock price trades around 19x’s the value of trailing twelve-month earnings. However, in the context of all-time record low-interest rates, a premium valuation is well deserved, especially for those companies paying a dividend and growing their bottom line.
- Sentiment: Since the Great Financial Crisis / Recession, there has been about $1.5 trillion in equity investments that have been pulled out of U.S. equity mutual funds. This statistic is a clear sign of the extreme risk aversion and pervasive pessimism. Despite money flowing out of equity funds, corporations have bolstered the upward trajectory in stock prices with hundreds of billions in corporate stock buybacks and trillions in mergers & acquisition transactions. With all the universal jitteriness, I like to remind investors of Warren Buffett’s credo, “Buy fear, and sell greed.”
Brexit-Schmexit NOT Brexit-Panic
Despite the risk aversion in the marketplace, stock prices in the U.S. continue to grind higher to record levels. The stock market is currently communicating interest rates, profits, valuation, and sentiment are more important factors to price direction than are Brexit and other geopolitical concerns.
The silver lining behind severe investor skepticism is the creation of additional investment opportunities. As famous investor Sir John Templeton stated regarding stock market cycles, “Bull markets are born on pessimism and they grow on skepticism, mature on optimism, and die on euphoria.” Even the most objective observers have difficulty pointing to a broad set of indicators signaling euphoria, and the recent Turkish military coup attempt and domestic gun violence incidents will not squash out the negativity. Until optimism and elation rule the day, there’s no need to worry-schworry.
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 , 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.
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)
- 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.
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.
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.
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.
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.
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.
Why do so many star athletes end up going bankrupt? Rather than building a low-cost, tax-efficient, diversified portfolio of stocks and bonds that could help generate significant income and compounded wealth over the long-term (yawn…boring), many investors succumb to the allure of over-exposing themselves to costly, illiquid, tangible assets, while assuming disproportionate risk.
After all, it’s much more exciting to brag about the purchase of a car wash, apartment building or luxury condo than it is to whip out a brokerage statement and show a friend a bond fund earning a respectable 4% yield.
Many real estate investors in my Southern California backyard (epicenter of the 2008-2009 Financial Crisis) have experienced both ruin and riches over the last few decades. The appeal and pitfalls associated with owning tangible assets like real estate are particularly exemplified with professional athletes (see also Hidden Train Wreck). Consider the fate suffered by these following individuals:
- Mike Tyson: Famous boxer Mike Tyson tore through $300 million on multiple homes, cars, jewels and pet tigers before filing for bankruptcy in 2003.
- Julius Erving: Hall of Fame NBA player Julius “Dr. J” Erving went financially belly-up in 2010 after his Celebrity Golf Club International was pushed into foreclosure. Dr. J. was also forced to auction off coveted NBA memorabilia (including championship uniforms, trophies, and rings) along with foreclosing on his personal $2 million, 6,600-square foot Utah home.
- Mark Brunell: Pro Bowl quarterback Mark Brunell was estimated to have earned over $50 million during his career. Due to failed real estate ventures and business loans, Brunell filed for bankruptcy in 2010.
- Evander Holyfield: Heavyweight boxing champion Evander Holyfield burned through a mountain of money estimated at $230 million, including a 235-acre Utah estate, which had 109 rooms and included at least one monthly electric bill of $17,000.
Inclusion of real estate as part of a diversified portfolio makes all the sense in the world – this is exactly what we do for clients at Sidoxia. But unfortunately, many investors mistake the tangibility of real estate with “lower risk,” even though levered real estate is arguably more volatile than the stock market – evidenced by the volatility in publicly traded REIT share prices. For example, the Dow Jones SPDR REIT (RWR) declined by -78% from its 2007 high to its 2009 low versus the S&P 500 SPDR (SPY) drop of -57% over the comparable period. Private real estate investors are generally immune from the heart-pumping price volatility rampant in the public markets because they are not bombarded with daily, real-time, second-by-second pricing data over flashing red and green colored screens.
Without experiencing the emotional daily price swings, many real estate investors ignore the risks and costs associated with real estate, even when those risks often exceed those of traditional investments (e.g., stocks and bonds). Here are some of the important factors these real estate investors overlook:
Leverage: Many real estate investors don’t appreciate that the fact that 100% of a 10% investment (90% borrowed) can be wiped out completely (i.e., lose -100%), if the value of a property drops a mere -10%. Real estate owners found this lesson out the hard way during the last housing downturn and recession.
Illiquidity: Unlike a stock and bond, which merely takes a click of a mouse, buying/selling real estate can take weeks, if not months, to complete. If a seller needs access to liquidity, they may be forced to sell at unattractively low, fire-sale prices. Pricing transparency is opaque due to the variability and volume of transactions, although online services offered by Zillow Group Inc. (Z).
Costs: For real estate buyer, the list of costs can be long: appraisal fee, origination fee, pre-paid interest, pre-paid insurance, flood certification fee, tax servicing fee, credit report fee, bank processing fee, recording fee, notary fee, and title insurance. And once an investment property is officially purchased, there are costs such as property management fees, property taxes, association dues, landscaping fees and the opportunity costs of filling vacancies when there is tenant turnover. And this analysis neglects the hefty commission expenses, which generally run 5-6% and split between the buying and selling agent. Add all these costs up, and you can understand the dollars can become significant.
Concentration Risk: It’s perfectly fine to own a levered, cyclical asset in a broadly diversified portfolio for long-term investors, but owning $1.3 million of real estate in a $1.5 million total portfolio does not qualify as diversified. If a portfolio is real estate heavy, hopefully the real estate assets are at least diversified across geographies and real estate type (e.g., residential / commercial / multi-family / industrial / retail mall / mortgages / etc).
Stocks Abhorred, Gold & Real Estate Adored
With the downdraft in the stock market that started in late August, a recent survey conducted by CNBC showed how increased volatility has caused wealthy investors to sour on the stock market. More specifically, the All-America Survey, conducted by Hart-McInturff, polled 800 wealthy Americans at the beginning of October. Unsurprisingly, many investors automatically correlate temporary weakness in stocks to a lagging economy. In fact, 32% of respondents believed the U.S. economy would get worse, a 6% increase from the last poll in June, and the highest level of economic pessimism since the government shutdown in 2013 (as it turned out, this was a very good time to buy stocks). These gloom and doom views manifested themselves in skeptical views of stocks as well. Overall, 46% of the public felt it is a bad time to invest in stocks, representing a 12% gain from the last survey.
With investor appetites tainted for stocks, hunger for real state has risen. Actually, real estate was the top investment choice by a large margin, selected by 39% percent of the investors polled. Real estate has steadily gained in popularity since the depths of the recession in 2008. Jockeying for second place have been stocks and gold with the shiny metal edging out stocks by a score of 25% to 21%, respectively.
Successful long-term investors like Warren Buffett understand the best returns are earned by going against the grain. As Buffett said, “Be fearful when others are greedy and greedy when others are fearful,” and we know stock investors are fearful. Along those same lines, Bill Miller, the man who beat the S&P 500 index for 15 consecutive years (1991 – 2005), believes now is a perfect time to buy stocks. Investing in real estate is not a bad idea in the context of a diversified portfolio, but investors should not forget the fallibility of tangibility.
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) including SPY, but at the time of publishing, SCM had no direct position in Z, RWR, 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.
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.
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.
Giving advice to a driver from the backseat of a car is quite easy and enjoyable for some, but whether that individual is actually qualified to give advice is another subject. In the financial blogosphere and media there is an unending mass of backseat drivers recklessly directing investors off cliffs and into walls, but unfortunately there are no consequences for these blabbers. It’s the investors who are driving their personal portfolios that ultimately suffer from crashed financial dreams.
Unlike drivers who mandatorily require a license to drive to the local grocery store, bloggers, journalists, economists, analysts, strategists (aka “pundits”), and any other charismatic or articulate individual can emphatically counsel investors without any credentials, education, or licenses. More importantly than a piece of paper or letters on a business card, many of these self-proclaimed experts have little or no experience of investing real money…the exact topic the pundits are using to direct peoples’ precious and indispensable lifesavings.
It’s easy for bearish pundits like Peter Schiff, Nouriel Roubini, John Mauldin, and David Rosenberg (see also The Fed Ate My Homework) to throw economic hand grenades with their outlandishly gloomy predictions and fear mongering. However, more important than selling valuable advice, the pundit’s #1 priority is selling a convincing story, whether the story is grounded in reality or not. The pundit’s story is usually constructed by looking into the rearview mirror by creatively connecting current event dots in a way that may seem reasonable on the surface.
Crusty investors who have invested through various investment cycles know better than to pay attention to these opinions. As the saying goes, “Opinions are like ***holes. Everybody has one.” Stated differently, the great growth investor William O’Neil said the following:
“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.”
Successful long-time investors like Warren Buffett rarely make predictions about the short-term directions of the market. Long-term investors know the only certainty in the market is uncertainty. At the core, investing is a game of probabilities. The objective of the game is to place your bets on those investments that establish the odds in your favor. As in many professions, however, the right process can have a negative outcome in the short-run. Those talented investors who have experience consistently applying a probabilistic approach generally do quite well in the long-run.
There is an endless multitude of investing advice, regardless of whether you choose to consume it over the TV, in newspapers, or through blogs. That’s why it’s so important to be discerning in your financial media consumption by focusing on experience…experience is the key. If you were to undergo a heart surgery, would you want a nurse or experienced doctor who had performed 2,000 successful heart surgeries? When you fly cross-country, do you want a flight attendant to fly the plane or a 20-year veteran pilot? I think you get the point.
The other factor to consider when comparing advice from a media pundit vs. experienced investor is skin in the game. Investment advisers who have their personal dollars at stake typically have spent a significantly larger amount of time formulating an investment thesis or strategy as compared to a loose-cannon TV journalist or inexperienced, maverick blogger.
There is a lot to consider as you maneuver your investment portfolio through volatile markets. With all the dangerous advice out there from backseat drivers, make sure you have experienced investment advice installed as protective airbags because listening to inexperienced air bags (pundits) could crash your portfolio into a wall.
Related Content: Financial Blogging Interview on Charlie Rose w/ Joe Weisenthal, Josh Brown, Felix Salmon, and Megan Murphy
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own a range of positions in certain exchange traded fund positions, 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.