Turning The Page

This will probably be my last post to Yet Another Investment Opinion. Tomorrow I'll be starting a new position as a Financial Advisor (stockbroker) with a large investment firm. It's typical in the industry to restrict communications such as blogs, and while I don't know the specific policies of You and Us, I'd have to assume that they'll ask me disseminate my opinions through approved channels only. Thanks to all who have read and offered compliments and suggestions. I felt that I was just hitting my stride, and I was honored to have one of my posts picked up by financial website SeekingAlpha. If you have any comments or questions, please send me an email at yetanotherinvestmentopinion (at) gmail (dot) com.

I'd like to end with a recap of my core investment opinions. However, please understand that while this represents my beliefs as of 5/17/2009, my outlook will change over time, and I will not update it here. But you can always email me.

The market has pulled back slightly from its recent high. The bears are reawakening. A New York Times article today quotes a visionary who warns: "... we're still perhaps a decade away from the end of the secular bear market." In the current issue of Barron's, permabear Alan Abelson turns to Uberbear Bob Prechter who forecasts a 50% to 80% decline. Yawn. Why is everyone so focused on the recent 35% rally but forgetful that the market is still down 45% from the peak? If the S&P500, which touched 666 in March before rebounding to about the level where it started the year, had instead spent the past 20 weeks meandering around the unchanged level, would we still be hearing so much about a reckless and unsustainable rally?

For my portfolio, I believe that I can buy stock in high quality companies and experience 50 to 100% appreciation in the next three to five years. I think that interest rates rise during that time. An optimistic scenario would be for me to double the value of my stock portfolio, and then sell it and invest in high-quality corporate and municipal bonds at higher yields.

I'm only investing in individual stocks and individual bonds. Please see prior posts about my aversion to mutual funds, ETFs, hedge funds, managed accounts, partnerships, and the entire range of investment products which subordinate my interests to the interests of their operators and sponsors. I'm also a believer in investing and a skeptic about trading. My time horizon is not forever, but it's certainly measured in years rather than minutes.

I think that far too much investment research relies on spurious correlations. Just because it happened this way last time, or the last ten times, doesn't mean that it will happen the same way next time. I quoted Taleb:

My classical metaphor: A Turkey is fed for 1000 days—every days confirms to its statistical department that the human race cares about its welfare "with increased statistical significance". On the 1001st day, the turkey has a surprise.

I believe that the market and the economy have handed us a rare opportunity to buy stocks at a level that could produce outstanding appreciation with relatively limited risk. As fund manager John Hussman observed in a December market comment:

After over a decade of strenuous overvaluation, stocks are now undervalued. Not ridiculously cheap, but undervalued and likely to deliver satisfactory long-term returns to even passive investors. It's certainly possible that stock prices could fall further by the time that the current market downturn is over, but to some extent, the profound depth of the recent selloff has given value investors something of a “freebie.” Investors have already priced in a worst-case scenario – treating a near-Depression with unemployment north of 10% as a certainty. Yet even in the Great Depression, the market didn't reach the current price/peak-earnings multiple until late 1931, when unemployment was already pushing past 15%. In 1974 and 1982, valuations were lower, but largely because interest rates (commercial paper in 1974 and long-term Treasury yields in 1982) surged to 12-15%. Yes, the economy and earnings will probably continue to weaken, but value investors can observe the evolution of the economy here with reasonable comfort that the market has already discounted a good amount of bad news already.

I recommend that you read the full article which takes a very long-term view of stock valuation.

The Seven Deadly Sins of Investment

Most investors have experienced significant losses in the past year. It might be worthwhile to review past mistakes in order to produce better future returns. Following are some reasons for poor performance. How many of them do you recognize in your own portfolio?

1) Reliance on Diversification. As long as your portfolio was diversified among various asset classes, your risk of any one big disaster was pretty small. Right? Actually not. The lesson of the 2008 debacle was that there was no place to hide. Stocks, bonds, commodities... pretty much every asset class got hit hard. Even some categories of cash-like instruments (auction rate preferreds) suffered. As much as we'd like to believe that some of our investments will move opposite of others, we learned a valuable lesson about correlation: In times of crisis, all correlations move to 1. In other words, when the stuff hits the fan, everything goes down. Don't be fooled into thinking that a "diversified" portfolio carries significantly lower risk.

2) Focus on a Benchmark Investment Advisors and the media are intensely focused on performance versus a benchmark (like the S&P 500). "We've outperformed the market by 400 basis points" is a frequent boast by investment managers. But if you beat the market in 2008, you still lost about 1/3 of your money. Forget about relative performance. Absolute performance (did you win or lose?) is what counts.

3) Too Much Faith in Experts It's been a bull market for opinions. Analysts, strategists, and particularly academics are frequently quoted in the media. If a Harvard Business School professor said that the market will go down, it must be true, right? Actually not. The one academic study that I'd like to see but never will is the one that compares professors' predictions with actual outcomes. At any given time, there are people who predicted the present market results. But remember that, if 100 monkeys pick stocks, one of those monkeys will rank #1 in stockpicking.

4) Abdicating Responsibility You are responsible for your own assets and your own investment results. No one else has the same stake in the outcome. You must understand what you own, and in particular the risks that threaten your investments. By the time that you realize your Global Macro Diversified Opportunity 130-30 Future Ventures Fund has dropped by 50%, it's too late to ask what exactly it is. You must understand exactly what you own, and what risks you face.

5) Betting on Statistical Modeling Most analysts, portfolio managers, and investment consultants build models to predict how a portfolio or an individual investment would perform under a variety of assumptions. They all sound pretty good: multi-factor dividend discount model, Monte Carlo distribution scenario using 2000 outcomes, etc. Unfortunately, most of them didn't come close to predicting the market rout in the second half of 2008. More complicated doesn't equal better. See YAIO May 6 (Crunching the Numbers) for more on this topic.

6) Buying Financial Innovation Every bull market produces "hot" financial products. Don't blame the brokers-- mostly they're just responding to investor demands. From conservative "principal protected" products to enhanced yield investments designed for those seeking a free lunch, financial products follow a basic law of economics: supply rises to meet demand. But the basic law of investments remains that only US government 90 day T-bills are "risk free." Any investment that promises a return greater than T-bills is accompanied by greater risk. And if the advertised return is well above the T-bill rate, you had better assume that the risk is also well above.

7) Overestimating abilities. There are literally hundreds of thousands, perhaps millions, of people who spend their days watching the tape and studying stocks. They all have computers, and charts, and spreadsheets. Some of them are mopes (the dumb money), but some are smarter than you. Markets are generally pretty efficient. If you buy a stock, you're buying it because you think it will go up in value. However, you're buying it from someone who thinks it's going down. Are you smarter than the seller? Perhaps not. Know what you know, and in particular know what you don't know.

So what's the solution? How can we avoid the sins? Is diversification always a bad idea? There's no magic answer, but I'll reiterate some of the principles that I've discussed since my first post:

The simpler the better. I only want to own individual stocks and individual bonds.

Know what you own. Even if you use an advisor (and I recommend that you do) you're still responsible for understanding your basic investment strategy and its attendant risks.

Be conservative and patient. You don't need to own securities. Wait for the market to present an opportunity. I believe that the stock market's 45% decline from the Oct '07 peak gives us a rare opportunity. Bonds aren't there yet.

Invest, don't speculate. Despite media rants about how "buy and hold is dead", the big money is made by long-term investors. Short-term traders, if successful at all, are only successful for a short term.

Finally, if you're a new reader, I recommend that you go back and read some of my initial posts from November and December. They cover more of my basic investment philosophies.

That's all. Thanks for taking some of your valuable time to read my posts. I understand that there are plenty of investment opinions out there. Glad that you came to Yet Another.

No Trees Grow To The Sky

It's been a great run.  The S&P 500 is up about 35% from the March low.  One of the best rallies in my career.  

So now what?  Up another 35% in the next nine weeks?  That would be nice.  But unlikely.

There's an old saying that no trees grow to the sky.  Nothing goes straight up forever.  So we'll probably have a pullback.  Could be soon.  Perhaps beginning today.  What will you do?

It would be nice if we could sell here and buy after the correction.  But we can't.  It just doesn't work that way.  You might be fortunate enough to sell near a top, and buy back near a bottom.  Since we never know where the tops and bottoms are until afterwards, it requires a fair bit of luck.  Here's a more common scenario:  Sell at the first sign of a pullback.  At first you're right, but you need two good calls, and you miss the second one (getting back in).  As the market climbs back (and it will) you wait for one more pullback.  But it never really comes, and you end up reinvesting above your initial sell level. 

Or this one:  you sell because you expect a pullback.  It doesn't happen.  The market continues to rise.  You kick yourself because you're a long-term investor and you never intended to try to time the market.  At first you pray for a correction so you can get back in, but eventually you capitulate and buy back at a higher level.  Only then does the correction come.

You don't believe it could happen?  I've seen both scenarios many times.  They've happened to me too.  It's just too hard to time the market.  

My suggestions:

1) Expect volatility.  Easy to say, but hard to do.  It's human nature to be excited when you see the value of your portfolio rise, and to be unhappy when it falls.  If you truly are a long-term investor, you should understand that even a secular bull market will have temporary pullbacks.  The best time to remind yourself of this is after a strong upturn.

2) Keep some cash for the inevitable corrections.  Never go "all in."  You should always have a certain portion of your portfolio in cash.  When the market corrects, you'll have the opportunity to buy more at low levels.  

Eventually the market will move down.  When that happens, the bears will raise their I-told-you-so flags and predict that "you ain't seen nothin' yet."  They'll offer S&P 500 targets of 600, or 500, or 400.  Could we get there?  I suppose so.  Who knows?  But they've been wrong for the last 35% move, and they'll be wrong long-term. 

Don't become too elated over short-term rallies, and don't get too depressed when the inevitable correction comes.

Crunching the Numbers

At Berkshire Hathaway's annual meeting last Saturday, Buffett and Charlie Munger commented on what the WSJ called "their complete disdain for modern portfolio theory and the use of higher-order mathematics in finance."  

I agree.  Over the years, I've seen analysts produce incredibly complex models used to make valuation judgements on stocks.  What's not said is that the models frequently are based on some core assumptions which may or may not prove to be true.  For example, until 2008 most assessments about mortgage insurance stocks offered a range of outcomes based on various levels of "HPA" (housing price appreciation).  They typically showed how revenue and earnings projections varied depending on whether housing prices rose by 2%, or 4%, or 6 or 8% per year.  A few wacky analysts even "stress-tested" their models with the assumption that home prices didn't appreciate at all!  We all know how that turned out.

Some other quotes from the meeting:

Mr. Buffett said he was once asked by a student at the University of Chicago, a hub of modern portfolio theory,  "What are we learning that's most wrong?"  To which Charlie Munger quipped, "How do you handle that in one session?"

Mr. Buffett on complex calculations used to value purchases:  "If you need to use a computer or a calculator to make the calculation, you shouldn't buy it."

Mr. Munger on the same theme:  "Some of the worst business decisions I've ever seen are those with future projections and discounts back.  It seems like the higher mathematics with more false precision should help you but it doesn't.  They teach that in business schools because, well, they've got to do something."

Here's a link to the WSJ article.

I'm not anti-intellectual, or even anti-business school.  But new investment theories come and go.  Core principals like quality businesses, talented management, and solid balance sheets stand the test of time.

Sysco Foods

I mentioned last week that Sysco Corporation is my favorite stock.  They reported quarterly earnings today, and I listened to the conference call.  Some thoughts: 

1)      Sysco dominates its industry (Institutional Foodservice Distribution).  There are two principal nationwide competitors, dozens of regionals, and literally thousands of local distributors.  Both of the national competitors (U.S. Foodservice and Performance Food Group) are owned by private equity firms.  This isn’t a great industry for private equity investment, and I’m sure that the PE firms are looking to exit at the very first opportunity.  Why is this important?  Because you run a business differently if you’re looking to maximize near-term profitability.  Sysco can afford to make longer-term business investments and plans. 

2)      In difficult economic times, small competitors get squeezed hard.  This is a scale business—bigger is better.  Sysco is much better positioned to ride out the recession.  Meanwhile, many smaller competitors fold or look to merge with a stronger partner.  Sysco has traditionally grown through acquisition, and they’re seeing a significant pickup in acquisition opportunities, presumably at attractive prices. 

3)      Few investors and analysts really understand Sysco.  It’s covered by  10 sell-side analysts.  Two have “buy” ratings, the rest are “neutral” (that in itself is a positive sign).  The analysts are typically specialists in the food industry (Heinz, General Mills, Kraft) or the retailing industry (Safeway, Walgreen, Costco).  But Sysco is really a transportation logistics company.  Their essential function is to manage the movement of millions of cases of merchandise from thousands of SKUs to tens of thousands of customer locations.  They buy, pick up, store,  assemble orders, load and route trucks, deliver, invoice and collect.  It’s not a retailer, and they don’t make food.  It really should be covered by transportation analysts.  Lucky for us that it’s not. 

4)      Thirty years ago, as large mainframe computers were becoming widespread in local distribution centers, an industry executive predicted that the company with the best information technology would dominate the industry.  This business has billions of discrete bits of data, from individual case costs and prices to truck routing, freight consolidation, and inventory management.  Superior IT can squeeze costs, and in a low margin business like this every basis point counts.  Sysco is well ahead of all competitors on this measure.  It's a difficult task in the industry, particularly for companies built by acquisitions.  Interestingly, Sysco alluded on the today’s conference call to some future announcements about benefits from the integration of its software systems.   

5)      Inflation generally helps Sysco’s margins.  A 10% markup on a $20 case of product remains 10% if the product’s price goes up to $21, but the gross profit dollars increase by 10 cents/case.  I don’t want to overemphasize this point, but it seems as if the disinflationary environment that has prevailed in the past few years has flattened out and might start to provide an additional tailwind. 

6)      The stock is cheap at 12 times next year’s estimated earnings.  Because of their record of stable growth, it has often sold at 20 to 30 times future earnings.  By most measures (price to cashflow, price to sales, price to book, etc) it’s at the lowest level in at least 20 years.  Yet the competitive environment has never been more opportune.  Solid balance sheet, A1/A+ credit rating, and a 4% dividend.  

This is an investment, not a trade.  If the economy remains weak, the restaurant industry will continue to suffer.  However, as things recover I believe that Sysco is very well positioned deliver improving business results and a higher stock price.  

Everyone's Waay Too Bullish (Bearish?)

Investor sentiment is a great indicator.  It pays to be bullish when everyone else is bearish, and vice versa.  The problem is that there are many sentiment measures, and they hardly ever point in the same direction.  At any given time, a bull and a bear could each produce convincing arguments that they had staked out a contrarian position because everyone else was on the other side.  

For example, the current issue of Barron's features a semi-annual poll of professional money managers.  59% describe themselves as bullish or very bullish, a statistic that was quoted by at least one bearish economist to bolster his negative view.  However, he didn't point out that in the same survey, 58% of those same managers said they believe that the stock market has not yet bottomed, despite the Dow's 6469 low in March.  That widespread disbelief in the current rally seems like a very bullish sign.  

I read many blogs every day on my Google Reader (a great invention!).  My sense is that most of the investment blogs favor the bearish side.  Birinyi Associates excellent Ticker Sense blog maintains a weekly sentiment poll of prominent investment bloggers and currently shows bears outnumbering bulls by 39% to 28% (the rest are neutral).  I was particularly struck by one recent blogpost which highlights a bullish report by an economist.  It drew 58 reader comments, 45 of which were negative (and mostly of the "you must be crazy to think that things are getting better" variety).

I don't know whether we've seen the bottom, or which way the market will go in the coming weeks or months.  But I do know that the start of the next bull market will be marked by plenty of initial skepticism.  The most prominent bears, those who gained fame for having correctly forecast the current economic disaster, won't suddenly turn bullish at the bottom.  They'll be fighting the tape all the way up, until they finally fade away.  

And consumer behavior will follow a predictable path, swinging from fear to greed.  Prospective home buyers are currently very cautious because they think that home prices are still declining. However, eventually it will become apparent that the housing market has bottomed and is turning up.  At that point sentiment will shift (and probably rather quickly) from fear of overpaying to fear of missing a great deal.  Similar great deals in airfares, cruises, and consumer durable goods will quickly disappear.

Portfolio update

I've been slowly adding to positions over the past month.  I also added two new stocks to the portfolio:  Nokia and Exxon.  So here's the updated list:  ABB Ltd, Boeing, Caterpillar, Cisco, DuPont, Exxon, General Electric, Google, Goldman Sachs, Intel, New York Times, Nokia, Procter&Gamble, Slumberger, Sysco, and Walgreen.  

My favorite stock right now is probably Sysco Foods.  I'll write about it in detail after they report earnings next week.  Also, the current market advance won't continue forever, so expect to see a reversal at some point.  I'm not smart enough to catch the short-term moves, but I remain confident that the market will be much higher in the next few years.  

Buy, Sell, or Hold?

WSJ article today talks about the growing number of investors and investment advisers who have abandoned the "buy and hold" approach.  That's become a very common media theme, particularly among the geniuses on CNBC:  "you've got to trade markets like these.  Buy and Hold has been a disaster for everyone over the past ten years."  Last night I received a cold call from a broker in New York.  He wanted to tell me about his firm's (J.T. Marlin?) successful trading ideas.  He started with the assumption that I knew trading was the only path to success in the current market environment.

Trading your way to profits is largely a myth.  I've been around many professional traders for decades, and I know that it's a very difficult way to make money.   Most people are unsuccessful. I can't do it on a consistent basis, and I'll bet that you can't either.

Sure, buy and hold hasn't worked.  Not in the last ten years, not in the last year.  But that's because if you bought ten years ago you bought near the peak.  If you bought one year ago, you bought near a peak.  Now I'm not smart enough to call tops or bottoms, but I can measure big declines.  If you had bought in March 2003, after the S&P 500 had fallen by nearly half from its 2000 high, you would have almost doubled your investment over the next four years.  And many high quality stocks like ABB, CAT, DD, and BA were up three to six times off the bottom.  

If and when the market sustains a significant advance, I won't be advocating buy and hold.  I'll be taking profits, trimming positions, writing calls, and hoping to move money into munis at more attractive levels.  But after the substantial market decline which brought us to present levels, I'm quite content to buy quality individual stocks and hold with the expectation of significant appreciation.  The fact that many other market participants have abandoned buy and hold only makes me more confident that my strategy is correct.

The Ivy Portfolio II

As promised (YAIO April 15), I read The Ivy Portfolio.  I have to say that I started with a negative bias.  Although the Harvard and Yale endowments have produced superior investment returns for the past 23 years (generally a very good period for any equity investor), they lost roughly a quarter of their assets-- $5 to $10 Billion-- in the current bear market.  My first impression of the book is that the authors began the project  well before the debacle of late 2008 and rushed to publish before their conclusions were completely discredited.  It's worth noting that both Harvard and Yale endowments operate with a June fiscal year end, so their 2008 annual reports don't include information about the damage suffered in July to December.  

To be fair, the authors do note in passing that 2008 was a bad year.  However, the book is peppered with statistics based on periods ending before 6/30/08.  For example, consider this: 

 "The worst years for Harvard and Yale were -2.7% and -0.2%, respectively--pedestrian compared to the -17.99% experienced by the S&P 500 in 2002 and the stunning drawdowns of 2008..." 

That's a joke given what we know about their current performance.

However, I did find plenty of value in the book.  Let's cut to the bottom line first.  The fundamental conclusion is that a traditional stocks/bonds/cash portfolio allocation is inferior to one which includes alternative assets such as private equity, venture capital, hedge funds, and commodities.  To simplify things for the individual investor, the book recommends an allocation of equal parts domestic stocks, foreign stocks, bonds, commodities, and real estate, rebalanced regularly.  

On the positive side,   there's a good discussion of some of the behavioral biases that hurt investment performance.  For example, quoting Philip Fisher:

"None of us likes to admit to himself that he has been wrong... More money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other single reason."     

Or Warren Buffett on "anchoring":

"When I bought something at X and it went up to X and 1/8th, I sometimes stopped buying , perhaps hoping that it would come back down.  We've missed billions when I've gotten anchored.  It cost us about $10 billion (by not buying enough Wal-Mart)."                                                                                                              

Also some good sections about trend-following and avoiding losses. 

However, I disagree with much of the advice about portfolio diversification through the use of funds.  The outperformance of the Harvard and Yale endowments certainly was due in large measure to timely investments in alternative asset classes like hedge funds, commodities, and private equity.  But that doesn't mean that it will work for you, or even that it could have worked for you.  The authors are quick to acknowledge that the endowments had access to some of the very best funds and partnerships--ones closed to most investors.  The average individual investor risks being put into a basket of very average (or worse) alternatives.  

And finally, here's a more balanced view of Yale's portfolio management from Portfolio.com: Cash Me If You Can.

                          

Q&A

Based on some recent conversations with readers, I thought that it might be worthwhile to review my thoughts on a few common questions:

I'm sitting on some cash.  When should I buy?

My core belief is that the stock market will be much higher in 5 years-- that's 2014.  I think that the Dow and S&P can double over that time.  If the S&P 500 index, which closed at 850 yesterday, can get to 1700 in 5 years, it will have appreciated at a compound annual rate of about 14.87% .  Add to that any dividends.

That's a pretty good rate of return.  Of course, the market won't go straight up.  Also, you won't get in at the bottom.  It's just not possible to accurately predict the market's short-term moves.

So here's the answer:  First, decide how much of that cash you can truly afford to invest for a five-year horizon.  Then, invest 1/3 of it today.  Look for opportunities to invest the rest over the next few months.  But don't focus on "the market."  Buy very high quality companies with strong balance sheets and truly talented management, and look to add to positions on dips.

I know of some really cheap small cap stocks.  Should I have some of them in my portfolio?

No.  Now is not the time to be buying small cap, or emerging market, or other more risky stocks. It's not that they can't or won't work-- in fact, if the economy and the market improves more quickly than I expect, those stocks will significantly outperform my high quality portfolio.  But that potential of higher reward comes with higher risk.  If the economy continues to weaken, you could see significant losses.  The sweet spot in the risk-reward tradeoff lies in high quality stocks. In my opinion your upside is 15% per year and your downside is fairly small.

What stocks should I be buying now?

My core portfolio consists of ABB Ltd, Boeing, Caterpillar, Cisco Systems, DuPont, General Electric, Google, Goldman Sachs, Intel, New York Times, Procter & Gamble, Slumberger, Sysco Foods, and Walgreen.  I chose them because they are big companies with strong balance sheets and a dominant position in their industries.  I believe that they have minimal risk of being put out of business by a new invention or regulatory change or lawsuit.  These are franchise companies that are rarely available at present valuations.  (please note that New York Times is a special case and an exception; see prior posts for more on NYT).  

I have several names on a watch list, and I'm looking for a chance to add a few if/when prices fall.

Why can't I just buy ETFs or mutual funds?  If the market doubles in five years, won't I do just as well with them?

I want to own individual stocks (and individual bonds when the time comes).  If I lose money on my investments, I want to know that it's because Caterpillar didn't sell enough tractors rather than some failed correlation bet by some fund manager.  And I don't like ETFs because they almost certainly include stocks that I wouldn't want to buy outright.  Take the SPY (S&P 500 index ETF).  It's got lots of financial stocks, and I still think they're too risky at this point.  I want to select my own stocks, not own them simply because they're part of an index or ETF.

As far as mutual funds or other actively managed vehicles, keep in mind that the most managers' objectives are not the same as yours.  You want to grow your net worth with an appropriately limited amount of risk.  The manager wants to beat some benchmark.  That's why, in extreme years like 2008,  your manager can look like a star  while you lose a quarter of your investment.  Forget about benchmarks.

Speaking of 2008, how would your strategy have performed?

Large cap high quality stocks got hit hard last year.  That's why I'm buying them now-- because they're very inexpensive.  I wasn't recommending this portfolio 12 months ago.  It was a much different environment, and much harder to read.  I think that we're now in a unique position that has only come along a few times in my career.  The dramatic recent selloff coupled with ten years of flat-to-down performance has finally put the odds in my favor.  Stocks aren't guaranteed to go up in the next five years, but I'm pretty certain that they won't keep going down.  At some point in the future-- maybe it's two years rather than five-- the valuation disconnect will swing back to a more normal level and the outlook will become less clear.  When that happens I'll likely have a different strategy.

What about bonds?  There are some pretty attractive yields available.

True.  You can buy some high quality bonds with yields around 6 or 7%.  Compared to treasury bonds, spreads are at record highs.  Also, some have pointed out that 6 or 7% isn't much less than the long-term average return in equities, and with much less risk.  

My problem with bonds:

1)  you lock yourself into a maximum return.  DuPont has a 10 year bond that yields about 6%-- that's the most that you'll get.  However, I think that DuPont stock could double, and it pays a dividend yield of 5.84%.  Of course, the stock is riskier, and the dividend could get cut.  But I think that the risk-reward is decidedly in favor of the stock.  

2)  interest rates are unlikely to go down much from here, but there's a pretty good chance that they'll go up due to the massive government stimulus and an improving economy.  I don't want to make an interest rate bet, but that's clearly a negative for those who lock in today's rates with a bond purchase.

3)  although spreads are high, you can't spend spread.  Absolute yield levels of are roughly at the midpoint of where they've been in my career.  

That's not to say that I would not own any bonds.  I wouldn't put all of my eggs in any one basket, including a basket of stocks.  But at current prices, I have a strong preference for stocks. My hope is that my stock portfolio will double as interest rates slowly rise, and I'll then be able to shift a significant part of my portfolio into bonds to lock in a secure income stream for my retirement years.

That's it for now.  If you have any other question, please use the comment function below and I'll respond.  You can comment anonymously if you wish.

and thanks to reader Lisa for some thoughts that prompted this post.

The Ivy Portfolio

I happened across a blog called designing better futures by Nick Gogerty.  Smart guy, and he's got a lot of interesting things to say.  

I was particularly interested in his recommendation of a book called The Ivy Portfolio.  "Ivy" refers to Ivy League colleges and in particular the endowment funds of Yale and Harvard, which enjoyed spectacular returns for many years.  I had read another review of this recently published work, and I remember thinking that the authors suffered from poor timing.  Sure, these funds had performed very well leading up to the present Big Bear market, but didn't they get crushed along with everybody else?

So I tried to find current performance info.  Because their fiscal years end on June 30, there's not a lot of hard numbers for 2008-09.  However, several articles suggest that they were down 25% in the second half of 2008, and it's unlikely that Q1 2009 showed much improvement.  

But what surprised me the most came in recalculating the numbers.  The first page of the book trumpets the number 16.62% as the annualized return for Yale's portfolio between 1985 and 2008.  By way of example, it tells us that $100,000 invested in 1985 would be worth $4,000,000 by June 2008.  OK, but what about after June?  I assumed a 25% drop in value (to $3,000,000) and recalculated the annualized return.  To my suprise, the return percentage barely budged:  it fell from 16.62% to 15.33%.  I would have guessed that it would have been a much lower number.

That's an amazing statistic that underscores the power of compounding, which has been called the Eighth Wonder of the World.  It also underscores the awesome performance of the Yale endowment.  

Generally, I'm skeptical of the Ivy plan, which seems to emphasize asset allocation as the most important determinant of investment performance.  There's plenty of academic research to support that theory, but its success is predicated on your ability to identify the right asset classes.  However, I have ordered the book, and I look forward to reading it on my vacation next week.  I'll report back to you soon.

An interesting sidelight:  One of Nick Gogerty's recent posts features a video on TED.com (which is an awesome video site-- its tag is "riveting talks by remarkable people" and you should certainly check it out)  with a presentation from the MIT Media Lab.  If you're interested in the next generation of technology, particularly stuff like smartphones and netbooks, this is well worth eight minutes of your time.  Click here.

Improve Your Diet

As I mentioned yesterday (Clearing the Forest), one of the beneficial results of the current economic crisis will be the clearing of the excesses which built up like plaque in the financial arteries of our markets.

You should want the same thing in your portfolio as you do in your diet:  healthy, high quality, minimally processed, and with few additives.  Avoid sugar, polyunsaturated fat, and hedge funds.

Unfortunately, many of these entities are even now viewed by financial advisors as alpha producing diversification vehicles.  Fund-of-Funds, Private Equity, Managed Futures, etc.  Got some in your portfolio?  I'll bet that diversification into the commodity fund was only diversified to the extent that it gave you an additional source of capital loss in the past year.  

In bear markets, you want to build a portfolio of stocks and bonds. High quality individual stocks and bonds. Not funds.  Not partnerships with names like Pegasus Global Macro Leveraged Opportunities LP.

When we eventually return to a sustained bull market, there will come a time to look at more aggressive investments (e.g., smallcap growth).    But not yet.

Clearing The Forest

"These things gotta happen every five years or so, ten years. Helps to get rid of the bad blood."

Clemenza,  The Godfather

Many things in markets and in the economy move along a steady long-term trend, but that doesn't mean they stick closely to the trendline.  Instead, we experience a cycle of overshoot and undershoot.  

Until recently, the top graduates of the top colleges and business schools overwhelmingly pursued jobs on Wall Street.  Overshoot.  When I graduated from business school, the hottest career was consulting. Ten years ago, everyone wanted to work for a dotcom.  Now I hear that law schools are seeing a big increase in applications.

That's a common phenomenon.  An industry, or a career, or a location, or an investment opportunity gets "hot", and people pour in.  Basic economics:  capital, including human capital, flows to the areas of highest returns.  Of course, as more capital flows in, returns get diluted and often turn negative.  Lower returns reduce the capital inflows.  Capital becomes scarce. Lather, rinse, repeat.

For much of modern economic history, the business cycle has oscillated between boom and bust. Periodic recessions served to balance inventories, labor, and other supply-demand factors. However, until recently the US economy had gone for almost twenty years without a recession (the brief 01-02 hiccup doesn't really count).  As a result, a thick underbrush built up in the economic forest.

So as painful as this current recession is, it's part of a healthy and necessary cleansing process. When we eventually emerge from it, we'll find many beneficial effects.  Consumer balance sheets will be significantly better.  Excesses in industries like housing and autos will have been purged. Business bankruptcies, as painful as they are to owners and employees, will allow the survivors to become healthier and more profitable, and will sow the seeds for new entrepreneurs.  Job losses will eventually become job gains, and will provide new opportunities for a new generation of workers.

Investment opportunities follow a similar cycle.  I have previously quoted the aphorism about how bear markets return stocks to their rightful owners.  It's painful to watch the decimation in your 401k.  However, by the time this is over you'll have an opportunity to acquire stock in some truly outstanding businesses at once-in-a-generation prices. 

Buffett and others have often commented on the curious behavior of investors, who collectively seem to prefer to pay high prices and avoid low priced merchandise in the stock market.  Don't obsess over the past.  Be glad that we're heading toward a time of great opportunity-- opportunity for entrepreneurs, businessmen, and investors.  Will you be ready?

 

Dear Fellow Shareholders

We're just now starting to receive company 2008 annual reports, and this year the CEO Letter to Shareholders is particularly interesting.  A friend called my attention to this one from JP Morgan's Jamie Dimon.  

Dimon offers a balanced assessment of JPM's 2008 performance and outlook for '09 and beyond. However, most valuable is his fairly concise review of the global financial crisis and his recommendations for change.

He's not shy about spreading blame, from banks and brokers to borrowers, hedge funds, regulators, and even pension plans and universities. 

There are many gems here, but I particularly like his comments about how we got here.  It's fashionable today for some to say I-told-you-so and to accuse regulators, risk managers, and others of being "asleep at the switch," but Dimon says: 

"...many of the main causes, in fact, were known and discussed abundantly before the crisis.  However, no one predicted that all of these issues would come together in the way that they did and create the largest financial and economic crisis of our lifetime."

To those who attempt to predict the markets by drawing historical comparisons, he warns:

"Even the most conservative of us, and I consider myself to be among them, looked at the past major crises (the 1974, 1982, and 1990 recessions; the 1987 and 2001 market crashes) or some mix of them as the worst-case events for which we needed to be prepared.  We even knew that the next one would be different--but we missed the ferocity and magnitude that was lurking beneath."

Keep in mind that I have plucked these quotes from a 28 page letter.  I don't mean to imply that Dimon is offering excuses.  But I think that his comment provide good perspective as our elected representatives investigate How Could This Have Happened?

The meat of the letter lies in two sections which address Causes and Solutions.  Here's an outline; I would encourage you to click through to read the details.

Fundamental Causes And Contributions To The Financial Crisis

The burst of a major housing bubble

Excessive leverage pervaded the system

The dramatic growth of structural risks

Regulatory lapses and mistakes

The pro-cyclical nature of virtually all policies

The impact of huge trade and financing imbalances

The Future Of Our System (solutions)

The need for a systematic regulator with much broader authority

The need to simplify our regulatory sustem

The need to regulate the mortgage business in its entirety

The need to fix securitization

The need to fix Basel II

The need to get accounting under control

The need for appropriate counter-cyclical policies

The need for policies in health care, pensions, energy and the environment, infrastructure and education that will serve us well over time 

In all, a very good review from someone who was an active participant in the drama.

PPIP and the Cash Cyclone

Have you ever seen a Cash Cyclone?  You can find them at arcades, amusement parks, etc.  You can even rent one for parties.  A contestant stands inside the cylinder to which cash has been added.  A fan is turned on, and the money blows and swirls around.  The contestant tries to grab as much cash as he can before time runs out.

This is how the Treasury's Public-Private Investment Program works.  Only a limited number of institutions are permitted to play, as the WSJ complains in an editorial today Treasury's Very Private Asset Fund

That's why I like my investment in Goldman Sachs stock.  There's nobody better at Cash Cyclone.  I'm trying not to be too cynical, but over the years they've proven to be particularly astute at recognizing when there's money blowing around, and grabbing their share.  The government needs investors for the program to work, and it's offering particularly generous terms.  Watch for Goldman to do its patriotic duty and not incidentally help its share price.

What They Used to Teach You

I really like this list of What They Used to Teach You at Stanford Business School, written by a guy who was class of 1972 and spent most of his career in i-banking.   It addresses many of my beliefs about investing and investment research, particularly the overreliance on formulas and extrapolation of observed data.  You can read the full article (from Portfolio.com) here.

1. Don't use many financial ratios or formulas, and when you've picked the few that will actually tell you what you want to know, don't believe them very much (Prof. James T.S. Porterfield);
2. Remember that any damn fool can compute an IRR or DCF. The trick is to find a business that can return 20% after tax, understand its critical indigenous and exogenous variables, and then run it so it meets its return target. (Prof. Alexander Robichek.)
3. Always ask what can go wrong (Porterfield);
4. Never extrapolate beyond the observed points of a distribution, you have absolutely no information outside the observed range (Prof. J. Michael Harrison);
5. Remember that you can always break the bank at Monte Carlo by doubling your bet on red at the roulette table every time you lose. The problem is it will break you first; It's called "the takeout." Therefore, always manage your financial structure so that takeout is not an issue. (Porterfield.)
6. Big M (today Nassim Taleb's Black Swan) is never a part of the optimal solution. If it shows up in the answer with any coefficient greater than zero, you have the wrong answer and have to continue to do program iterations. (Harrison.)
7. There is never any excuse for looking through the substance of an economic transaction, whatever the accounting, and if the accounting permits you to do so, it's wrong (Prof. Charles T. Horngren.)

Fortune Tellers

I often don’t agree with columnists in the Sunday NYT Business section, but today three unrelated articles came together for me.   I thought that they contained some good investment lessons.  I’ll address the first two here, and leave the last for a subsequent article. 

I may tend to run on here, so let me give you the conclusions first and you can decide whether to read more or save time and go about your business. 

1)      Everyone tries to use correlations and statistical analysis to predict the future, but it’s a very difficult if not useless endeavor. 

2)      Analysts focus on the things that they can analyze, but many other factors are more important but unanalyzable. 

3)      Times of extreme stress bring big changes.  That’s the natural order of things, and while it can be painful, it’s usually necessary and good. (See next post). 

 

Mark Hulbert writes about a recent study  by two finance professors who challenge the conventional notion that long-term equity investments always produce superior returns Strategies - Now the Long Run Looks Riskier, Too, for Investors.  Essentially, they endorse the old saw that past performance is no guarantee of future performance.  Although we all nod our heads in agreement, most of what passes for equity investment research is based on the premise that past performance does indeed  predict future performance. 

The professors note that uncertainty increases with the holding period, and that the reason for the good historical equity record in the U.S. over the past century could be attributable to some non-investment related effects like having won two World Wars.  They conclude that “other things being equal… you (should) probably lower your portfolio allocation to stocks”.   I conclude:  other things are never equal.

Robert Schiller, another finance professor (wouldn’t all of our problems be solved if the world was run by finance professors?) addresses the field of social psychology in the investment world It Pays to Understand The Mind-Set.  Professor Schiller explains social psychology as “a theory of mind—defined by cognitive scientists as humans’ innate ability… to judge others’ changing thinking… It is a judgment faculty, quite different from our quantitative faculties.” 

“Of course, forecasts based on a theory of mind are subject to egregious error. They cannot accurately predict the future. But the uncomfortable truth has to be that such forecasts need to be respected alongside econometric forecasts, which cannot reliably predict the future, either.” 

This is a very important point.  Stock investments are like icebergs:  only a small portion of the essential information is visible.  There’s a vast mass of unknown and unpredictable information, including the changing motivations of customers, competitors, and other investors, beneath the surface.  Yet rather than to acknowledge the huge inherent unknowns, analysts engage in silly exercises to micro analyze the small part that is visible and extend their conclusions to the whole.  For the most part, they all have access to the same data, often provided to them by the company or the government.  They produce surveys, and channel checks, and sophisticated models.  They issue buy and sell opinions in an effort to distinguish their particular outlook.  But in the end, they all have essentially the same understanding of the investment, and it’s a limited understanding. 

I’m not trying to pick on analysts (buy side or sell side).  My comments apply equally to most economists.  It’s not that they aren’t smart, or hard-working, or experienced.  But the nature of the job requires that they make predictions, and they almost never acknowledge the extremely high degree of randomness. 

So what’s the bottom line?  Be skeptical of anyone who offers investment predictions.  But be particularly skeptical of investment predictions that are based on extensive and rigorous statistical analysis, because they’re probably based on only an obvious and small part of the whole.

Don't Be Fooled

Interstate 70 heading eastbound toward Denver, descending from the Continental Divide.

OK, I know that it's a cheesy analogy, but I always enjoy seeing these signs on the ride back to Denver coming from a ski vacation.  They remind me of the stock market.  We may be near the bottom, but there's probably a few more miles of steep grades and sharp curves. 

 

Let's just hope that we don't have to use this:

Makin' A List

I'm actually a bit disappointed over the market's recent runup.  While I've made a lot of investments in the past several months, I've still got plenty of cash.  I'm hoping for an opportunity to put more to work.  

As I have mentioned in previous posts, I don't expect to go all in at the exact bottom.  I still believe Bob Farrell's prediction that the market will wander in a range of Dow 7800 to 9800 for quite a while-- until most investors lose interest.  Obviously, at today's close of 7750, we're clearly at the bottom end.  But I'd sure like to get another chance to buy below 7000.

So my conclusion is that I'll add to existing positions over the next week or two.  I'll take average position size up by about 25%.  I wouldn't be surprised to see the market pull back somewhat after the recent runup, and I'll be hoping to add at lower levels.  However, because I still believe that the stocks in my portfolio can double or triple over the next 3 to 4 years, I won't be too cute about trying to squeeze out that last 10% .  

Also, I'm thinking about some new names to add.  At the right price, I'd like to own COST, ECL, JNJ, KO, and one or two more energy stocks.  Do you have any suggestions?  

Portfolio update

My core portfolio remains ABB, BA, CAT, CSCO, DD, GE, GOOG, GS, INTC, NYT, PG, SLB, SYY, and WAG.  

Did You Miss The Rally?

The stock market, as measured by the S&P 500, has risen by more than 20% since the low on March 9, although it's still down by almost 50% from the October 2007 high.  Today it was up by almost 7%.  

I spoke to a friend who expressed a sentiment that's pretty common:  "Damn!  I had a feeling that I should have put money into stocks when it got down that far two weeks ago!"  He missed his opportunity to buy at the bottom.  

News Flash:  NOBODY buys at the bottom.  That's what makes a bottom.  A money manager friend once wrote in his annual letter to clients:

"We never buy at the bottom or sell at the top.  Therefore, when we buy a stock for your account, you should expect that it will go down after we buy it.  When we sell one of your stocks, you should expect that it will go up after we sell it."

Q. So what should you do now in the aftermath of a 20% rally?  A. The same thing that you should have been doing all along.  We're still presented with a great opportunity to invest in stocks for a long-term horizon.  The events of the past two weeks should not have changed your strategy, which should be to buy high-quality assets at distressed prices.  Stock in a good business that trades at 12x earnings is a bargain.  The fact that it traded at 10x last week shouldn't alter your decision.  

Many people got scared out of the stock market over the past six months-- often with good reason.  But now that they're out, they're kicking themselves for not buying back in.  Don't succumb to the tick-by-tick moves.  Continue to invest in high quality individual stocks with attractive valuations.  A stock that fell from 50 to 20 over the past year may still be a great investment.  The fact that it touched 16 last week is immaterial.

But if you're truly worried about chasing this rally, here's a suggestion:  enter good-til-cancelled limit orders down 10% or so.  Even if the market is about to triple, it won't go there in a straight line.  There will be further declines.  Buying the dips makes theoretical sense, but in practice it's hard to do.  We celebrate rallies and despair declines.  GTC orders help to instill discipline.  

Random Observations: 

I just returned from a long weekend in Las Vegas.  Although I've heard plenty of stories about bad times and low room occupancy rates, the hotels and restaurants were busy.  Granted, it was a weekend of the NCAA basketball tournament and the start of college spring break, but it I had some trouble getting golf tee times and restaurant reservations.  

My wife works at a women's clothing store in our town.  Last weekend they set an all time record for sales volume.  She reports:  "People are leaving for spring break and they need clothes.  They don't care about the economy."

I watched Barack Obama on 60 Minutes last night.  Gotta give him credit-- he's out there delivering his message.  CBS last night, NBC's Tonight Show last week...I'm sure that ABC will get its chance soon too.  He's very media savvy.  A confident leader can be very effective in these troubled times.

Rally Time

I've received several comments in the past few days from people wondering if the market's rally since March 10 is a sign that the bottom is in place.  My answer:  I have no idea.

Too many investors are bipolar paranoid schizophrenics.  They overreact to short-term moves.  They get depressed when the market declines, and elated during rallies.  These are the people who help to create tops and bottoms, because they buy when stocks are going up and sell when they're going down.  

My core belief is that high-quality stocks purchased at current prices will double or triple in the next three or four years.  That's a reasonably bold prediction in itself.  I think it's got a reasonably good chance of success.  Let's think about what that means-- if a stock doubles in four years, it will have generated an annualized return of about 19% over that period (excluding dividends).  If it triples in three years, that's about 44% per year.  Of course, not every one in my portfolio will triple.  However, I believe that at current levels, the risk reward tradeoff is firmly in my favor.  How much lower can the market go?  The S&P 500 isn't going to zero.   It isn't going to 200.  I'm not nearly as smart as some famous bearish prognosticators, but even they seem to be looking at a worst case bottom around, let's say, 500.  If the market is there in three years, that means it would have returned a compound annual rate of negative 12.6%/year over three years.  To me that's a very favorable risk/return bet-- up 19% to 44% versus down 12.6%.  These numbers seem overly precise, and they are.  I'm merely trying to put some theoretical bands on my expectations.  

But the point is, don't agonize over every tick.  If you get depressed when the S&P trades down 20%, maybe you shouldn't be in the market.  There's no law that says you have to invest in stocks.  Conversely, don't high-five your spouse or your drinking buddies after a five day rally.  Both of these things will happen, but they're mostly short-term noise around a bigger trend.  

The Chicken or The Egg?

How do we get out of this mess?  There seems to be a consensus view that the economy, and the stock market, can't bottom until housing prices stop declining.  After all, weak housing prices equal mortgage defaults, which decimate structured credit securities (aka "toxic assets") which then destroy the capital base of banks, which leads to a host of other evils.  The bears tell us that housing prices have another 15% to fall before the bottom (interestingly, they've been using the "down 15% target" for about a year.  No matter how much housing prices fall, they still predict another 15% decline.  They've been right so far, but they won't be right at the bottom).

I predict that stocks will bottom before housing.  Think about it:  if you're in the market for a home, you almost certainly feel the negative wealth effect of the stock market.  Let's assume that it's your first house, or that your personal economic situation has so far rendered you somewhat immune to the disaster that's visited the rest of the country.  If I've got lots of cash and want a house, no way I'm going to grab for that falling knife of housing prices.  I'm watching my 401k disintegrate every week, and the stock market weakness makes me feel poorer.  Most people with enough assets to be able to afford a house have at least some exposure to the stock market, and they're suffering from a severely negative wealth effect.  Think about it:  what would you do?

On the other hand, a stronger stock market can work wonders.  It tells home buyers that the worst is over.  It also makes them feel wealthier.   It alleviates the worst fears of depression.   Even if they don't follow every tick of the market, they feel better when the news is no longer dominated by depressing news.

Ask your local real estate agent.  I'd bet that there's a pretty good correlation, but I'll bet that the stock market leads.  Assuming that tomorrow's market action continues or at least supports the recent trend, it should be a good weekend for house hunting.

Portfolio update

Today's news about Google Voice is another in a series of amazing developments from this company.  Google is going to take over the world.  While analysts twist themselves up predicting attach rates, and cost-per-click, search query growth, GOOG is attacking dozens of traditional industries with a long-term strategy that doesn't lend itself to P/E estimates or quarterly reports.  Read about Voice and ask yourself: why do you need AT&T or Verizon?  Read about Chrome and Gmail and Docs and ask why you need Microsoft (yeah, the operating system's coming too... gOS anyone?).  How about healthcare-- 23andMe is mapping your DNA, Google Health maintains your medical records... Finance, Video, Books... all "free."  They've got the proverbial camel's nose under lots of tents.  Eventually you'll carry a GOOG card in your wallet to access everything from banking to travel to entertainment.  Not that that's bad... for now.

Call me crazy, but I just don't think that most investors realize the importance of the internet, or the dominant position that GOOG is carving out.  Eventually they'll be broken up in an antitrust action like AT&T in the early 1980s.  However, there's plenty of money to be made in the stock before that happens.

 

Revealed: The Real Reason for Yesterday's Big Rally

Reporter:  "Why did you lose this game?"

Manager:  "We lost because the other team scored more runs."

The stock market gained about 6% yesterday, posting the biggest one-day gain in months.  What caused the rally?  

On days with big moves, everybody's asking.  "What's causing this rally?"  Very often, there's no real answer.  But that doesn't stop people from offering explanations.  Clients ask brokers and traders.  Traders ask each other.  Reporters and analysts review news reports and sources in an effort to find something.

Most news reports attributed the rally to reports that an internal Citigroup memo broke unexpected good news about the company's profitability.  However, I'm pretty sure that it was not the cause but merely the most convenient explanation.  The memo to employees was clearly designed to be a morale booster.  Having seen many such memos while I worked for a Wall Street firm, I can tell you that significant, market-moving news is never disseminated in this manner.  As the Financial Times noted today:

"If management e-mails actually "communicated" anything they would be banned.  Risks of a leak means workers are subjected to anodyne words on how valued they are or that their company is uniquely positioned to cope with the challenges ahead."

Also, public companies are extremely sensitive to the requirements of SEC Regulation FD,

which prescribes specific ways to disseminate material nonpublic information.  CEO Pandit would not have offered important new news in an internal memo.

There were a few other explanations-- possible return of the uptick rule, Bernanke comments, etc.  But it took even more of a stretch to believe that they caused the huge rally.

So now I'll reveal the real reason for the rally:

More buyers than sellers.

Yup, that's it.  More buy interest--lots more-- pushed prices up.  I'm not trying to be funny, but it's important to understand that on any given day a multitude of small factors combine to produce market action.  Occasionally there's a specific market moving event:  a big earnings surprise  from an important company, significant economic reports, Fed action, or significant non-economic news.  But on most days, there's no real reason for the market to have moved up or down.  That's just the way it works.  However, you'll never see this headline in the WSJ:  Dow Down 200 Points-- No One Knows Why.  

Last Monday, March 2, was a bad day in the market.  The S&P 500 declined by almost 5%.  Just before the close, I heard a radio reporter explain that the market's weakness was because Warren Buffett, in his annual letter to shareholders published the prior Saturday, had warned that the economy "will be in shambles throughout 2009--and, for that matter, probably well beyond..." 

While it's true that Buffett said that, it was hardly market-moving news and almost certainly not the reason for the selloff.

So here's my point:  The stock market is not an entity that can be meticulously analyzed and catalogued.  Thanks to the internet, cable news, and a heightened public interest in the market over the past 20 years, there's lots more information available.  But much of that information is useless or worse.  Don't overanalyze it, and don't pay attention to anyone who tells you that they can explain every tick.  The best investors know what they don't know, and there's quite a lot that they don't know.  Be particularly suspicious of anyone who can tell you where the market (or an individual stock) is going to bottom or peak.  

And I'll bet you a dollar that within the next week you hear someone on TV or radio tell you that the market fell on "profit taking" or rose on "bargain hunting."