Slowly but surely

Around this time of the year, reflection sets in and many tend to ponder about various things in a philosophical haze. Accordingly as we approach the end on January, I have been beset by doubts about my approach to the capital markets.

What if my thoughts on the virtues of value investing, its “proven” advantage over alternative tactics of speculation and technical charting are in fact just empty theories?. Continued volatility in the market hasn’t helped either. Cheap companies have been getting cheaper, or just going nowhere, throughout 2011 and no clear upward trend to reverse this slide has yet emerged.

It was in this state of mind that I came across an extraordinary documentary/program filmed by the BBC in the summer of 2008 where the cameras followed a group of 8 non-financial types/would-be traders as they did battle with the markets over a 10-week period. The appealingly labelled experiment (funded by a generous UK fund manager) was aptly named “Million Dollar Traders” and can be seen in 10 minute mini-episodes here:

Putting aside the emotional drama of the experiment, (no doubt exacerbated by the constant presence of a filming crew), the results of the exercise were most revealing and contributed to affirm me in my convictions.

To cut a long story short, the 8 random folks, (whose only preparation for the show consisted of a check up on basic math skills and an ability to read financial newspapers) selected to trade equities (both long and short) in a sort of market neutral hedge fund strategy, actually outperformed an index of hedge funds over the 10 week period covered!.

Besides the explicit humiliation bestowed on the hyper-fast trading hedge fund community, a set of additional readings can be made:

1. Firstly, 10-weeks is a laughably short period in which to measure performance, no matter what asset class you are dealing with. (Note some of the trades were put on and subsequently liquidated, often at a loss, in 1 hour!).

2. The sheer randomness of the trade outcomes is a testament to the gambling-like nature of this approach.

3. No comment (let alone implicit reference) was made to the enormous brokerage fees incurred in this process as a consequence of the sheer level of activity. Here again, patient thought out value investing wins by a landslide.

4. Last but not least, the behavioural transformation (read: descent into a nervous wreck of the otherwise previously paused participants) indicates that a speculative approach to financial markets is at odds with basic human traits.

Returning now to life in the present (28th January 2012), as pessimism continues to hold a firm grip on collective thought, I personally find much to cheer about.

And, as a concession to those who may feel my previous statement was typically ambiguous, read on for further insights into the reason for my giddy optimism.

• Zimmer (Ticker: ZMH)
• Xerox (Ticker: XRX)
• Dell (Ticker: DELL)
• LyondellBasell (Ticker:LYB)
• BP (Ticker: BP)

Even after a hefty run up from summer ’11 lows on most of these stocks, the value on offer differential versus the price demanded continues to be most generous.

And please note, no need to read the financial press every morning at 06:00 or to chart every tick on your Bloomberg.
Just sit, watch and enjoy.

Look everywhere

One of the basic tenets of Warren Buffet’s much copied investing philosophy is the simple “Invest within one’s circle of competence”. Much like the rest of Mr Buffet’s advice, this one reeks of common sense. As such it would be foolish to ignore, and in essence, few wise investors do.

There is, however an aspect of this simple concept of “competence” and “know-how” that is sometimes misunderstood. Investors all over tend to assume that competence equates familiarity and ultimately can only be obtained in conjunction with physical or geographical proximity. Put simply, few players in the capital markets derive any comfort from investing in distant places.

Given the enormous breadth of investment options available to most western investors on a local basis, in the form of thousands of quoted stocks, corporate and government bonds, commodities, options, currencies and other more sophisticated derivatives, it is fair to ask why one would bother to look beyond one’s home country / market.

Undeniably familiarity helps as it brings comfort and security. Notables such as Peter Lynch of the Magellan Fund, claimed that their best ideas came from daily interactions with local companies which would later make it into his portfolio. Moreover, It is often said that every thousand miles travelled from home in investing terms add an additional layer of complexity; thus requiring further due diligence before clarity can be reached.

No doubt there is substance to this approach of keeping close to home. After all, investing requires a thorough business owner-like mentality and some would argue that this level of knowledge can best be achieved via close interaction with the corporation whose security being analysed.

Personally, I agree on the merits of thorough familiarity with the subject of one’s investment, but I hasten to see geographic proximity or even domestic familiarity (also known as patriotism) as the only way to develop the confidence required to pull the investment trigger.

Consciously investing only in one’s home market leads to a world of opportunity, pun very much intended, being ignored. These days, the vast majority of the information required to make sound investment operations is widely available in a format (electronic) which replaces the need to travel and in fact, to interact with management.

Further concerns regarding accounting treatment differences, currency exposure, or even political risks are for the most part, quite simply overstated. The fact remains that, barring a certain number nations whose record of corporate governance remains questionable, most modern states with liquid capital markets operate under the same rules as those of the USA.

Currency concerns can easily be hedged away (if one desires) and political risk is so far off the table in the majority of northern hemisphere nations as to not warrant anything but a passing reference.

In addition, smaller, less “developed” markets such as those of South Korea and certain European states, tend to be less liquid and more prone to provide significant value discrepancies as a result of their limited following. On the other hand finding simple arbitrage opportunities these days in the NYSE strikes me as an unlikely occurrence.

Given the choice between fishing in large, but overcrowded and mostly depleted lakes versus smaller, relatively unpopular but unspoilt locations, I know which ones I’d draw my attention to...

Going it alone

As the twice-yearly Value Investing Congress (V.I.C) concluded last week, various investing sites provided the observer with a “post-mortem” peak into its conclusions.

Besides the usual, deeply thoughtful, high quality presentations and analyses, I was mostly struck by two things above everything else.

One was the contrarian nature of the recommendations (shorting Green Mountain Coffee Roasters anyone?!) and the other was the level of individualism that is so prevalent among leading investors. By this I mean that no matter how deep the talent bench may be at some of the funds presenting at the V.I.C , the fact remains that both glory and pain are attributable almost exclusively to those at their helm.

Reading letters to investors from high performing funds reveals this feature in clear fashion. Very rarely are references made to the value of consensus decisions or group analysis. Whilst it is true that many great investors cut their teeth at some of the larger funds (think Tiger Management), in their formative years, it is also the case that ultimately a manager worth his salt will set up shop alone.

At a time when some leading investors appear to be faltering such as Bruce Berkowitz at Fairholme (down 27% so far this year) with his ill-timed bet on financials and John Paulson whose Advantage Plus fund is currently down some 32% year-to-date, it is important to ignore the crowd and pay heed to the wise words of Benjamin Graham:

“You’re neither right nor wrong because other people agree with you. You’re right because your facts are right and your reasoning is right—and that’s the only thing that makes you right. And if your facts and reasoning are right, you don’t have to worry about anybody else."

Personally, I take comfort in these words as I continue to invest new money in the markets whilst the cacophony of macroeconomic prognosticators grows ever louder and the global growth engine fails to take off.

My suggestion is to allow for 3-5 years to pass, and to look back at Mr. Paulson’s and Mr. Berkowitz ‘s annualized performance once again before judging too prematurely.

Investing is indeed a lonely game, but in my opinion it’s all the better for it!.

A good time to invest?

The last few weeks in the capital markets have been anything but dull. As most of Europe vacationed, volatility in major stock markets jumped, unnerving many and bringing, (not so fond), memories of September 2008.

To illustrate the point just refer to the broad based S&P 500 index performance in the last 4 weeks: It closed just shy of 1.300 on the last trading day of July, dropped 12% to 1.149 in 5 trading days, shot back up 4,5% to 1.200 by mid-August and corrected back to 1.160 by August 26th.

Right now the S&P is down 6% Year-To-Date and some 12,3% lower from its late April high of 1.363. Put bluntly this market has “gone nowhere in 13 years” as its current price (not adjusted for inflation) is the same it was in October 1998.

As this was happening, macro indicators from across the pond delivered ominous news in the form of unexpectedly low GDP growth forecasts from Europe’s last standing hope (read Germany). Not to mention increasing woes from other peripheral nations as they struggle to contain their growing public sector debt. Making matters worse, even the ultimate asset price inflator, a.k.a. Ben Bernanke, failed to prop up expectations at his recent speech in Jackson Hole. No mention, not even a hint was made of a new round of security purchases by the venerable “Fed”, leaving QE3 fans at a loss.

To cap it all, gold, which has served as the last refuge for many, delivered a brutal 100 $ drop on August 24th, bringing into question, temporarily at least, its suitability as a safe haven. In any case, it had appreciated by some 400 $ since mid-July, so in absolute terms such a correction should not come as a surprise.

Investors, both professionals and ordinary folks (the ones I talk to, at least) are rightly shaken by these events and often looking to exit what they consider to be high risk positions. Indeed, the week ending August 19th saw the biggest level of redemptions form Mutual Fund investors since 2008. According to the Investment Company Institute:

“Rattled investors pulled more than $40 billion from mutual funds in a single week this month as fears about the global economy intensified. The total of $40.3 billion was the biggest amount removed from mutual funds in a week in nearly three years”

Some notable hedge funds too have wound down their exposure over recent months, signaling that caution is the new approach. Dan Loeb, whose Third Point fund has annualized 19% since 1995 and is 8% up YTD, has recently continued his 3-month trend of lowering exposure to equities as is now only 23,3% net long versus 30,7% in spring.

So, is it 2008 all over again?. And what if it is?.

From where I am standing it is not 2008 all over again and even if it closely resembles it, one should not shy away for putting new money to work as we speak.

Firstly, leverage levels are way down from 2008 as corporations have been piling cash on their balances and reducing operating expenses to endure an economic downturn. With the exception of certain corporations (Bank of America comes to mind), public entities are in much better shape than in ’08. Just as importantly, equity prices seem to reflect a long drawn-out economic malaise as the current 12.6 S&P 500 P/E ratio implies. Comparing this starting point with the levels reached before the 2008 debacle should provide investors some comfort.

Whilst a new recession cannot be ruled out, the fact remains that money has to flow somewhere and the alternatives to equities are hardly appealing today. Gold, which lest not forget produces no income, is reaching stratospheric heights, US bonds (10-year) yield little over 2,2% even after the S&P downgrade and the real estate market shows no signs of life.

It is unlikely that we have seen the end of downside volatility for the time being and macro-economic uncertainty may continue to dampen spirits. However, from a valuation standpoint, some compelling company-specific opportunities are appearing and we may soon experience yet another investing “2009”.

To quote Mr. Warren Buffet’s memorable words from October 2008 as he made his landmark investments in GE and Goldman Sachs:

“If you wait for the robins, spring will be over”

Amateur Tennis and Investing Glory

What do Tennis players and investors have in common?.

Not much, surely.

Could you think of a couple of more apparently unrelated activities?. There’s little shared between those at the top the ATP rankings and successful investors. Physical fitness is certainly not one of the common traits. In fact I can think of few activities that are less taxing on the body than indulging in the capital markets.

Shift your focus away however from the Federers and Nadals of this world and towards your average amateur player and you’ll begin to see an emerging picture… Come to think of it, for those of you that partake in the sport, what is the single most important determinant of the outcome in most of your games?.

High ace count? I doubt it.

Blistering fore-hand winners?. Probably not.

Inspired cross-court volleys?. I don’t think so.

How about just consistent reduction in unforced errors?. Yep, that’s it!.

For most of us, and I certainly include myself in this category, tennis is a “loser’s game” with the match going to the player who hits the fewest losers. The same can be said for successful, sustained, long-term investing performance.

I mention this after reading a following wonderful analogy in Howard Marks’ “The Most Important Thing”; itself taken from an article published by Charles Ellis back in 1975 in the Financial Analysts Journal.

Below follows a rather long but eloquent transcript from Mr. Mark’s book which illustrates beautifully the concept:

“His views (Charlie Ellis’) on market efficiency and the high cost of trading led him to conclude that the pursuit of winners in the mainstream stock markets is unlikely to pay off for the investor. Instead you should try to avoid hitting loser. I found this view of investing absolutely compelling.
The choice between offense and defense investing should be based on how much the investor believes is within his or her control. In my view, investing entails a lot that isn’t.

Professional tennis players can be quite sure that if they do A, B, C and D with their feet, body, arms and racquet, the ball will do E just about every time; there are relatively few random variables at work. But investing is full of bad bounces and unanticipated developments, and the dimensions of the court and the height of the net change all the time. The workings of economies and markets are highly imprecise and variable, and the thinking and behavior of the other players constantly alter the environment. Even if you do everything right, other investors can ignore your favorite stock; management can squander the company’s opportunities; government can change the rules; or nature can serve up a catastrophe…

...the bottom line is that even highly skilled investors can be guilty of mis-hits, and the overaggressive shot can easily lose them the match. Thus, defense – significant emphasis on keeping from going wrong – is an important part of every investor’s game”.

So you see, apparently, even us dull “plodders” stand a chance of reaching ultimate investing success.

If only we approached the markets in the same way as we relentlessly return the ball to the open court…

Good things come to those who wait

Regular readers may have noticed the slow-down in my blogging frequency as of late.

Partially, and not surprisingly, it comes down to lack of time. There is however a more subtle yet equally valid reason also at play. Consciously or not, I have been applying a more patient approach to investing matters. This translates into equal amounts of reading, (this part of the equation will not be reduced), but significantly less actual decision making, whether it concerns specific investment action or writings.

In the spirit of one of my very first posts some 2 years ago (see “It’s often better to just sit still”), the last 3 months been a period of much reflection but little action.

The turning point for me came very suddenly and in crystal clear fashion when I mentioned to my wife a very recent (less than 4 weeks old) stock purchase. For you see, the first question that came to her mind was not an enquiry about the company itself or its economic health or financial performance at all. Oh no. She wanted to know how the stock had performed since I acquired it. Once again, note that I had bought it less than a month before…

Not only did I not have an immediate answer, (I do check spot prices but not on an hourly basis), but more importantly I honestly didn’t really care. The security in question had been bought on the basis of its very favorable (read: cheap) valuation on an absolute and on a relative basis, and returns would be obtained by closing this apparent price-to-value gap. Not a feat I expected the market to accomplish in 4weeks!.

As I went on to explain to her the relevance of balance sheet strength, competitive advantage, brand power and a positive cash-flow trend, an interesting thing happened. She acknowledged the importance of these factors but remained inquisitive about the current stock price. This, as it happens, is the way that most of us operate, guided more by the daily gyrations of a volatile marketplace and than by the underlying factors that truly matter in the long run.

Looking back, I see no reason to change my approach, other than the intrinsic difficulty in its daily application. As anyone with an internet connection and access to TV will attest, it is nigh on impossible to shield oneself from the onslaught of economic “news” and financial “information”. These days, as events unfold regarding the Greek debt crisis and the US debt-ceiling debate, all manner of folks seem to be conversing about such, until recently at least, arcane issues. Passivity right now is awfully hard.

Patience, temperament, and a cool head, do not come naturally. Not for most and certainly not for me. There are however, some methods that serve to minimize our natural “instant-gratification seeking” tendency and provide us with good odds of decent returns:

1. Approach investing as you would saving for your kid’s college fund. Set-up a specific separate account and write up a “contract” for yourself detailing under what exceptional circumstances you would withdraw money for this account. Come back and check the balance 10 years from now

2. Set-up news alarms for your chosen stocks (or companies’ in your funds) related to quarterly earnings reports, and major management changes.

3. Track annual financial performance via public filings (10 Q, 10 K) and make a conscious effort to infer stock price from accounting statements and not vice-versa

4. Review long-term (minimum 10-year) individual securities or index / fund performance. Note that even after the horrific crash of 2008, many good companies and funds have already reached new highs. Underperformance for good stocks does not last forever.

5. Think of your financial investments in the same manner as your education. Even though the return on academic training is initially negative and often slow in coming, the passage of time inexorably delivers considerable value

There’s little to be gained from rapid-fire speculation, except heavy broker’s fees, and higher taxes. And with the long-term odds in your favor, I’d rather be a tortoise than a hare…

Back to the "good" old days

Recent furore over the IPO of professional networking site LinkedIn, no doubt substantiated by its first trading day price jump of 109% and its $ 8.95 Billion valuation, smells like déjà-vu.

Despite the considerable bout of common sense spouted by its CEO, Jeff Weiner as he was interviewed on CNBC on May 19th on the day his company started trading on the NYSE, alluding to the limited relevance of first-day performance and LinkedIn’s focus “on the fundamentals”, one can’t help but think that we are back to the merry days of 1999. Have we learnt nothing?

Besides the purchasers of LinkedIn’s post-IPO equity, there are ominous references to the kind of speculative behaviour that led to the stock market crash of 2000-2002. Back then as we approached the turn of the century, no brows were raised when sound valuation criteria, either earnings or asset-based were supplanted by more questionable variables such as “clicks” and “eye-balls”. In this instance, following the “success” (for bankers and insiders at least) of LinkedIn, financial journalists and other commentators were fast to question Price/Earnings ratios as next to meaningless.

The truth however is rather different and for the most part, unpleasant.

Valuation wise, the $ 94 per share price can spell nothing but trouble for the future. Diluted Earnings at the company are reported at around $ 3,7 Million, which translates into 7 cents per in earnings per share (EPS). Put it all together and you get a x 1342 P/E ratio. Sure, some 3 weeks have passed now and, as of the last trading day, the company has shed about $ 2,7 Billion in market cap and now sports a lower, but still outrageous, x 1040 P/E.

For the sceptics out there who expect enormous growth to justify these ratios and drag up the denominator (the “E” in P/E), you’d be wise to note that the company itself expects to break-even in FY2012, thus dashing any hope of an earnings driven price justification. Whilst optimists point to examples such as Google to underpin the LinkedIn investment thesis, there are some notorious differences between the two. Firstly, Google was very profitable ($ 500 Million in earnings in its first year as a public entity), not the case with LinkedIn. More importantly, even the mighty Google has seen its once sky-high P/E ratio and stock price decline and remain flat respectively for the since its peak in November 2007. Today it trades at a reasonable x20 P/E

Using other valuation parameters does little to appease concern as the company is, as you’d expect from an internet play, “asset-light” and therefore trades at x 48 the value of its net assets, or book value.

Despite the ample evidence of the mean-returning nature of stocks (i.e. P/E ratios of over X100 always must and will end in tears), talk abounds of further web-darling IPOs. Bankers and would be speculators eagerly await similar IPO-filing announcements from Facebook, Zynga or Groupon. Business magazines are today busy writing glowing articles on these web 2.0 companies much as they did in ’98 and ’99 with the likes of Webvan, JDS Uniphase or CMGI.

Whilst some of these new ventures will survive and indeed prosper, precedent would suggest to not bet on these names. To put it in the words of Joseph Anthony Wittreich:

“History doesn’t repeat itself, but it does rhyme”.

If the complete disregard for valuation risk, exhibited by the outrageous prices of recent IPOs and even private placements of pre-IPO entities, (of note is Goldman Sachs’s investment in Facebook at $ 50 Billion valuation in January 2011) , were insufficient evidence of an impending bubble, there’s more to show. As in previous periods where temporary infatuation with specific sectors of the economy was the norm, there are other components of the business fabric, which, as if to compensate, are blatantly ignored by the investing public.

Being as it is, with funds a finite resource, it should come as no surprise that profitable, asset-rich, brand-protected, business cycle-proof, price insensitive concerns can be found to trade at single digit P/E ratios. How else does one explain the x9 P/E ratio of Xerox?. The almost euphoric atmosphere characteristic of the “new web players” is offset by an excessive pessimism around older concerns. These days, established entities whose growth rates are not projected to exceed 50% are prematurely labelled as “have-beens”.

There is indeed a party going on (as it was in 1999) but we all know how this one will end!.