Sunday, May 17, 2009

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.

Tuesday, May 12, 2009

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.

Wednesday, May 6, 2009

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."

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.

Monday, May 4, 2009

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.