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."

What if I'm wrong?

"There are no atheists in foxholes"

-- attributed to Ernie Pyle and others

The above quote speaks to the difficulty in holding to one's beliefs under times of extreme stress.  It's easy to be a long-term investor when the trend is in your favor.  However, current market conditions, the most severe in my lifetime, are testing the resolve of every investor.  We tell ourselves that we're in it for the long haul, that current stock prices offer a once in a generation opportunity, and that we're investing with a multi-year horizon.  However, it's almost impossible to ignore the relentlessly bearish news.  It seems as if everyone is giving up or thinking about it. Seems like there are no long-term investors in a bear market.  

Of course, there's the famous Keynes quote about how the market can remain irrational longer than you can remain solvent.  That of course is true.  So I've been doing some thinking.  I think that any intellectually honest person must occasionally ask himself:  Could I be wrong?  And if so, how?    

So what if I'm wrong?  Where could this go?  First, it's important to understand that we'll come out of this with a new paradigm.  This won't be a typical recession/recovery pattern.  That's why those experts who try to identify an ever lower bottom target will be at worst completely wrong and at best completely misleading.  This economic event is a game changer.  It's not like anything that we've experienced in the past, so historical metrics like trough Price/Earnings and Price/Book are pretty much meaningless.  Jeff Jarvis takes a good first stab at what the other side of this crisis could look like in The Great Restructuring. 

Secondly, the market is constrained by some ultimate bottom that's greater than zero.  It obviously wasn't S&P 800 or 700, but the stocks in the index have some real value that's supported by real assets:   property, inventory, receivables, and real cash on the balance sheet, to say nothing of brand equity and goodwill.  We can debate the value of those assets, but it's a real number.  Maybe you'd rather have a dollar's worth of gold than a dollar's worth of Procter&Gamble stock, but would you prefer the dollar of gold to ten dollars worth of downtown Cincinnati real estate?   So when you read about experts who think that the S&P index could go to  600 or 500 or even 400, remember that the lower it goes, the closer it gets to the ultimate bottom.  Would you invest in the stock market today if you were certain that your risk was no more than 15% downside and your reward could be as much as 100% or more?  That's a pretty good trade, and in my opinion it's not an unrealistic scenario.  The lower the market goes, the closer it comes to the bottom.   

Then what are the outcomes that would prove me totally incorrect?  It seems to me that there are two:    Obviously the first is Financial Armegeddon-- a complete meltdown of the system.  It could happen, and if it did we're all screwed.  Sure, you could bring your gold coins to the supermarket to exchange for meat and bread, but what makes you think meat and bread would be available even to exchange  for gold?  It could happen, but it's tough to hedge and will produce an unhappy outcome even for the bears. 

Second is the prolonged recession.  If it lasts more than four years, I'm completely wrong.  Media Star Nouriel Roubini predicts the L shaped recession:  down and staying down.  In that circumstance, Treasury notes might do well, but they might not.  Stocks would probably exhibit basing behavior with limited further declines.  Treasuries would do well initially but ultimately be decimated by oversupply and currency debasement.  This one is somewhat more likely, but if it happens I think that my portfolio of high quality dividend paying stocks will hold up as well as anything. 

Finally, I need to allow for the unknown and unanalyzable.   Intelligent investors must make allowances for their own shortcomings.  The economy is an incredibly complex mechanism, and merely to guess correctly on one or two aspects scarcely guarantees an accurate overall assessment.  Peter Schiff absolutely nailed the risk in housing, but his hedge fund was a poor performer because he incorrectly extrapolated the impact on the dollar.  Kyle Bass is a very smart guy and he couldn't have been more right about the worldwide economic collapse, but his fund was only up 6% in 2008-- better than most, but not the type of home run that investors probably expected given his boldly bearish predictions.

I believe that the current economic crisis will be well on its way to being resolved sometime in  2010.   I don't know where the market will go in the near term.  But my core belief is that good quality stocks purchased today will produce substantial returns-- doubles or more-- in three to four years.  

Portfolio Update

I have a full position in Google, my largest holding, so I won't be buying more.  However, I believe that under 300 it's an extremely attractive investment opportunity.

 

We're in Big Trouble

" this problem is real, very big, and isn't going to be fixed in time...   There is no likelihood whatsoever that the banking system is going to make it...  we are in for a major disaster."

-- USA Today, Feb 15

The above quote appeared in an article in USA Today on February 15, 1999.  It applied not to the present economic crisis but to the looming Y2K problem.  You don't have to spend much time on Google to come up with some examples of really dire predictions about that crisis.  Here's one:  

"the world's stock markets will (crash).... A worldwide run on the banks will create havoc in the investment markets. People who have placed their retirement hopes in stocks and mutual funds will see their dreams vanish. How reliable will stocks and mutual funds be if the banking system has closed down? How will you even get paid? How will your employer get paid? How will governments get paid?"

But, you say, the current problem is MUCH worse than Y2K.  Sure, we know that now.  But at the time, it was the stuff of doomsday predictions.  Truly no  one knew just how bad it would get.  Blogger Paul Kedrosky, whose post last week  gave me this idea, explains what happened and why we the world didn't come to an end on Jan 1, 2000:

"So, why didn't the worst happen? In part what happened is this: People acted. While they were late, slow, stupid, and error-prone, they did what people do when a big enough alarm bell is rung loudly and long enough: They tried to figure out what they could do in the time they had to reduce their risk, and they did those things."

The problems that lie ahead are big.  They're also mostly pretty visible.  What's not so visible are the solutions.  But that doesn't mean that they don't exist or won't arise.  People will act.  

Portfolio update

I bought a little more GE today.  It's still my smallest position, and it's risky, but if/when the market stops going down it should have a good move up.  I just hope that that move comes from somewhere around the present level and not from much lower.

The Oracle Speaks

When Warren Buffett speaks, people listen.  And his most anticipated pronouncements come in the Chairman's Letter portion of Berkshire Hathaway's annual report, which was released yesterday.  There are already lots of comments in print and on the web from various experts offering interpretations of the letter.  In the true spirit of Yet Another Investment Opinion, I decided to (briefly) share mine.

Treasury Bonds 

"When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary".

This comment by Buffett will produce some interesting macroeconomic research reports tomorrow morning from the brokers and research shops.  Many of the most ardent bears on the economy have insisted that treasury bond levels are not due to a bubble, but rather to the high demand for secure income in a risky and deflationary environment.  It will be interesting to see if anyone has the guts to say that Warren is wrong (perhaps he is, but will anyone challenge him?).

Here's why you should care:  First, many other bonds are priced relative to treasuries.  Most municipals and good quality corporates are priced by observing the rate for a U.S. Treasury of similar maturity and then adding a spread.  For example, you could buy a treasury note with a five year maturity  and a yield of about 2.00%.  A similar maturity corporate bond like the newly issued Chevron 3.95% offers a yield of about 4%, for a spread of 2% (200 basis points)  A good quality tax-exempt municipal bond might yield 2.25%, or a spread of 25 basis points.  While both of those spreads are extremely high relative to their historical levels, the yields themselves (4% and 2.25%) aren't particularly unusual.  

Bond bulls will tell you that you should buy bonds mostly because they're very cheap.  But they're only cheap because of the wide spreads.  Since 1980, that five-year treasury yield has ranged from 16% to just over 1% with an average of around 7%.  Now I'll quickly admit that today's economic situation is very different from that of the early 1980s.  And good quality bonds in short maturities are very suitable investments for risk-adverse portfolios.  However, if Buffett is right about the treasury bubble, when the bubble pops those corporates and munis aren't going to look nearly as cheap.

Municipal Bonds

Buffett notes that, while historical default rates for munis have been very low, it's likely that they'll get much worse.  His point is primarily about the influence of insurance on default rates, and I'll leave it to you to read if you're interested.  However, he comments on pressures facing municipalities:

"Local governments are going to face far tougher fiscal problems in the future than they have to date.The pension liabilities I talked about in last year’s report will be a huge contributor to these woes. Many cities and states were surely horrified when they inspected the status of their funding at yearend 2008. The gap between assets and a realistic actuarial valuation of present liabilities is simply staggering."

Finally on munis, although it's not a Buffet point:  Munis are bought by rich people.  They help rich people avoid taxes.  Take a look at the Obama budget plan and think about how tax-avoidance plans for rich people will be treated in coming years. 

Interest rate risk, credit risk, and political risk.

I don't want to seem to be overly bearish on bonds.  But with the stock market down 50%, I see lots more opportunity in equities.  Sure, you can lock in low single digit yields in bonds.  But I'm betting that over the next 5 years, stocks will do substantially better.

Portfolio Update

I added to my DuPont position on Friday.  Current holdings:  ABB Limited, Boeing, Caterpillar, Cisco, DuPont, General Electric, Google, Goldman Sachs, Intel, New York Times, Procter&Gamble, Slumberger, Sysco, and Walgreen.