yet another investment opinion

2011-10-05T20:34:00.000-05:00

Steve Jobs

Wow- Steve Jobs is dead. I guess we shouldn't be surprised, given his widely reported and increasingly serious health problems.

I've read that he was a very demanding personality, a difficult boss, a high ego individual. Perhaps that's true. But of the 6 billion or so people on earth, he was one who had a singular, incredible impact on the lives of many people. An amazing career: there at the beginning of the personal computer revolution, and still there 30 years later with incredibly innovative and game-changing ideas.

I'm saddened by his death, and in awe of his remarkable life. I'm personally touched because I feel that I grew up in the Jobs era; I'm almost exactly his age (born two weeks earlier). Computer technology changed my life and everybody's life. Many of the advances would have come without Steve, but his unique genius blended technology with design to create incredibly innovative products that benefited all of us.

Thanks Steve. You made your mark on this earth in a way that very few men do. Rest in peace.

Turning The Page

2009-05-17T15:31:00.011-05:00

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

2009-05-12T11:45:00.007-05:00

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

2009-05-06T20:21:00.003-05:00

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

2009-05-04T10:45:00.004-05:00

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?)

2009-04-30T10:19:00.003-05:00

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?

2009-04-29T08:15:00.005-05:00

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

2009-04-28T16:39:00.005-05:00

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

2009-04-22T08:06:00.005-05:00

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

2009-04-15T15:58:00.004-05:00

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

2009-04-09T14:51:00.004-05:00

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

2009-04-08T09:28:00.004-05:00

"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

2009-04-03T12:50:00.009-05:00

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

2009-04-01T12:41:00.002-05:00

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

2009-03-30T09:46:00.003-05:00

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.

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);
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.)
Always ask what can go wrong (Porterfield);
Never extrapolate beyond the observed points of a distribution, you have absolutely no information outside the observed range (Prof. J. Michael Harrison);
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.)
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.)
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

2009-03-29T20:21:00.002-05:00

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

2009-03-27T12:14:00.005-05:00

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

2009-03-25T21:25:00.002-05:00

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?

2009-03-23T19:55:00.002-05:00

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

2009-03-16T17:00:00.003-05:00

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?

2009-03-12T20:15:00.002-05:00

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

2009-03-11T15:38:00.006-05:00

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?

2009-03-09T13:54:00.005-05:00

"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

2009-03-03T19:41:00.004-06:00

" 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

2009-03-01T14:55:00.005-06:00

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.

We're from the government, and we're here to help

2009-02-26T22:07:00.003-06:00

First off, I wasn't an Obama supporter. In fact, I don't think that I've voted for a democratic presidential candidate since George McGovern. But he's got a tough job, and I don't know anyone who doesn't hope that he's very successful. We certainly need effective leadership from Washington.

I don't understand why the stock market has performed so badly. Down about 25% since the election, and down about 12% since the day before he took office. Sure, there are plenty of other factors driving the market. But he gets high marks from the American people. The NYT noted on Monday that "President Obama is benefiting from remarkably high levels of optimism and confidence among Americans about his leadership, providing him with substantial political clout as he confronts the nation’s economic challenges..."

I watched his address to Congress (really to the nation) on Tuesday and I was impressed. He didn't pull any punches in his sobering assessment of the current state of affairs, yet he offered an optimistic view of the future. Troubles? Sure. But we'll get through them. We're Americans-- this is what we do and have always done.

It's hard for me to believe that the stock market hasn't registered the slightest bit of optimism over the stimulus package. Is it perfect? Certainly not. But, as the Obama administration likes to say in paraphrase of Voltaire, let's not let perfect be the enemy of good. They're pouring lots of money into the economy. Some of it will wind up (indirectly) in the stock market. Someday soon, the market will rally, and your favorite TV market expert will explain that the rally has been caused by favorable effect of the stimulus package.

I was amused by the commentary about Sec. Geithner's plan to address the financial crisis. "No details!" "A plan to have a plan". A market pundit explained today that the markets need transparency regarding the government's plans, and those plans are currently quite vague. But it's just not possible to set a detailed plan to cope with a crisis that's continually changing. And if Geithner had offered a detailed plan, that plan would have undoubtedly been picked apart by critics and frontrun by traders. If I were the Treasury Secretary and I did develop a good plan to attack the crisis, the last thing that I'd do would be to show all of my cards. The US government can be very powerful. Who knows whether their plans will ultimately succeed, but I'll bet that they can have a significant positive influence on the markets and the economy at least for some period of time. And Obama's strong popular support will help to propel that influence. I'm not saying that they've found the solution. However, up to this point they haven't received any credit from the market, and they deserve and will get at least some.

Feel free to comment on my liberal bias or complete misunderstanding of basic principles of economics.

Portfolio Update

It takes courage to be a good investor. The easiest time to buy stocks is when they're going up, and the higher they go, the easier it is to buy. We all tell ourselves that we want to be contrarians, to buy the dips. But bottoms are made when even the bulls are filled with self-doubt. Could I just be plain wrong? Maybe, but I'm hanging in there.

Oversold

2009-02-23T20:18:00.005-06:00

I'm not a big fan of technicians, particularly when it comes to calling short-term market moves. And if you've followed my comments over the past 4 months or so, you know that I don't profess to have any expertise in predicting overall market movements. My outlook (reiterated below) is that truly long-term investors will ultimately find that today's market presents an extraordinary opportunity for high quality stocks.

All that said, I believe that the stock market is significantly oversold and is likely to rally in the near term. My analysis isn't particularly sophisticated, but it's based on the observation (mine and others) that markets don't tend to move in the same direction for too many days without some kind of reversal-- even though the reversal frequently represents a countertrend in the context of an overall move. So I'm not saying that the market won't go lower. But the -15% move in the past nine trading days is unusual and unlikely to continue without an interruption.

While I'm certainly not a technician, I do watch certain statistics, and I think that the Relative Strength Index (RSI) is pretty important. Essentially, it attempts to identify stocks or indices that are short-term overbought or oversold. Today, the 14 day RSI for the S&P 500 is about 29. It rarely gets below 30, and the handful of times it's been there in the past ten years have generally produced some good buy opportunities.

Don't get me wrong: the market and the RSI could go a lot lower. The fact that something has followed a certain pattern for the past 10 or 20 or 30 years doesn't mean that it will continue to follow that pattern-- see housing prices for a particularly good example. But I suspect that even if we're headed to 600 or lower on the S&P, we won't go there in a straight line and won't go there without a decent near-term rally.

Portfolio update:

I started a position in WAG today as the stock traded down to my entry point. They pay a 1.8% dividend (about the same as the yield on the 5 year US Treasury note). At consensus estimates of around $2.00/share this year, 12x earnings seems pretty cheap for a high quality company with a great long-term growth record. What I like most about WAG is their new strategy of opening walk-in clinics staffed by Nurse Practitioners or Physician Assistants within their stores. These clinics are open every day and evening. While they don't attempt to treat serious illnesses, think about how much money could be saved for our overburdened health care system if patients with relatively minor symptoms opt for a visit to their local Walgreens rather than to the physician's office or the emergency room. President Obama has identified escalating health care expenses as the number one problem in the soaring budget deficit. WAG's Take Care Clinic sounds like a cost-effective and promising new health care delivery idea.

For those who have recently begun to read YAIO, I'd like to summarize my overall investment outlook by providing this excerpt from a 12/01/2008 entry:

...investments today in high quality stocks will produce substantial returns-- doubles or triples-- in the next two or three years. This is a once in a generation opportunity to acquire stakes in truly world class corporations at deeply discounted prices. They may well get cheaper, maybe much cheaper, in the next year or so. But in 2011, you'll marvel at the fact that you could have bought these stocks at those prices in December 2008.

So what to buy? It's easy. Buy the blue chips. Buy the companies that are the clear worldwide industry leaders. The ones that have the impregnable balance sheets and the multi-decade records of outsized returns to shareholders. It's truly like shooting fish in a barrel. Forget about relative performance. There will certainly be others that outperform. But names like Intel, Boeing, Microsoft, Caterpillar, Coca-Cola, Cisco, and Pfizer (among others) will give you solid double-digit returns or better plus a good dividend over the next few years. They are franchise companies that are rarely available at today's valuations.

What not to buy? Themes. Tips. ETFs. Anything that represents a guess as to the next market tick. Top down ideas like infrastructure or global decoupling. Anything dependent on interest rates, or commodity prices, or the Baltic Dry Index. Don't buy sum-of-the-parts stories, or discounts to NAV. Don't buy it if you have to look up the symbol, or if you can't immediately describe exactly what business they're in. There are just too many exceptional and truly inexpensive companies with virtually zero risk of accounting fraud, or adverse patent rulings, or competitive threats.

The Tail Wags the Dog

2009-02-18T16:01:00.003-06:00

"Gold is going to $1000"

-- heard endlessly today on CNBC by many "experts"

"Holdings in SPDR Gold Shares, the largest exchange-traded fund backed by gold, reached 935.09 tons, climbing above 900 tons for the first time. That's up more than 40 tons from a day ago, and nearly 150 tons higher than a month ago."

--Wall Street Journal 2/12/09

What if Gold ETFs didn't exist? Do you think that they're affecting the price of gold? And what happens if gold prices reverse? It's clearly a very crowded trade. Hedge fund Greenlight Capital, the University of Notre Dame endowment, and the Teacher Retirement System of Texas all bought tens or hundreds of millions of dollars worth of GLD in the latest reporting period (Q4 2008) according to the WSJ.

By the way-- if you're long GLD, have you read the prospectus? I have. It seems that they do have roughly 1/10 of an ounce of gold for every GLD share according to the latest 10k. But in this era of Madoff and Stanford, I'd sure rather have that gold in bars or coins in my basement rather than as an electronic entry for a fund held in my Schwab account.

Here's some interesting quotes from the "Risk Factors" section of the prospectus:

Investors should be aware that the gradual decline in the amount of gold represented by the Shares will occur regardless of whether the trading price of the Shares rises or falls in response to changes in the price of gold.

There is a risk that part or all of the Trust’s gold could be lost, damaged or stolen. Access to the Trust’s gold

could also be restricted by natural events (such as an earthquake) or human actions (such as a terrorist attack)....The Trust does not insure its gold.

In addition, the Custodian and the Trustee do not require any direct or indirect subcustodians to be

insured or bonded with respect to their custodial activities or in respect of the gold held by them on behalf of

the Trust. Consequently, a loss may be suffered with respect to the Trust’s gold which is not covered by

insurance and for which no person is liable in damages.

So if you're buying GLD as a hedge against the world coming to an end, you'd better hope that all of your gold doesn't get lost or stolen in the Apocalypse.

And Oil is no better. Oil ETFs, particularly the USO, are also impacting their underlying markets. ft.com/alphaville quotes an analyst who notes that "the extreme contango on the WTI contract is primarily due to market distortions created by the USO." He calls the ETF "a cancer to the oil market."

And finally, let's talk about Credit Default Swaps. CDSs are theoretically an instrument which provides insurance in the event of a default on an issuer's bonds. They're relatively new, having come to prominence in the past five years or so. They're typically one-to-one agreements with a counterparty. Although they allegedly provide "insurance", in fact they're almost entirely a way for hedge funds and other investors to make bets on changes in the market's perception of an issuer's credit standing. In many ways, they're similar to a short stock position, but they have advantages like no need to borrow the stock and reduced price transparency. Do CDS spreads widen because a company is in trouble, or does a company get in trouble because its CDS spreads have widened?

The height of absurdity is CDS on US Government bonds. "Investors" can buy "protection" against default by the US Government. The price has been increasing, making it a profitable trade for those who have been bearish. But tell me this: if the US Government defaults on its bonds, what are the chances that your counterparty will be able to pay off your bet?

Remember, it was not very many years ago when CDOs were considered to be an innovative instrument for sophisticated investors. CDS and ETFs aren't the market-- they're derivative instruments.

Portfolio Update

It's easy to follow your discipline when it's working. But the market's performance over the past two weeks has been difficult. Keep the faith. We've yet to see any positive market impact from the government stimulus plans, and that rally is on the horizon-- even if it's a bear market rally.

Patience

2009-02-16T19:59:00.003-06:00

I really like the comments by Sandler O'Neill's Chief Strategist Robert Albertson in this week's Barrons interview.

Many such articles consist of the subject reminding people that he predicted the present dire state, and warning that it will get much worse. While Mr. Albertson also seems to have also made some early and accurate calls, I think his outlook is much more realistic and valuable than most.

His most important point is that the government's attempt to stimulate consumer spending is a misguided approach to the problem. The economy needs to delever, and pumping money in an effort to "jump-start" consumer spending ultimately won't help the deleveraging process. The solution is patience-- patience to work through the delevering process as consumers and institutions pay down debt and rebuild savings. Albertson thinks that's a "two or three-year process."

other interesting points:

Don't forget that the banking system earns money, so it can pay down some of the embedded losses through future earnings. Also, while many assets were clearly overvalued in the past, some are just as mistakenly undervalued now (some securities that are current in payments and likely to remain so are being marked down to 30 0r 40 cents on the dollar).

Similarly, we run the risk of being just as wrong on the downside as we were on the upside. Three years ago, few thought that housing prices would ever peak. Now many believe that they'll never bottom.

Don't count out the emerging market economies, particularly Brazil and China. Their domestic markets are huge and growing, and while they have certainly been slowed by the worldwide recession, they are becoming increasingly independent of the United States. We tend to view the world through the lens of our own experience, but it's possible that worldwide demand for commodities and raw materials could continue to grow despite significant weakness in our country.

Bottom line: we'll get through this, but it will take time.

Portfolio update

I was able to start a position in PG at 50 (and a few pennies) last Thursday.

All the News That's Fit to Print

2009-02-11T19:11:00.008-06:00

My core stock portfolio consists of about a dozen names. While I like them all, there are two that I could be said to be passionate about: GOOG and NYT. One of my core investment beliefs is that the internet is one of the most important developments in the history of mankind. (I wrote that last sentence and immediately thought "now that really sounds stupid" but I left it unchanged because I really believe that. It's all about the importance of communication in society, etc., a topic which I'll develop in later posts).

I had planned on writing today's article about the New York Times. I noticed that NTY ranked #496 in Bloomberg's list of average analyst rating for the S&P 500. I know you'll want to know the four that ranked even lower: AIV, EK, GM, and #500 is SHLD Sears Holdings. It's clearly an out-of-consensus long, in my view because it's very misunderstood.

As long as we're on the topic, if you like Covidian, Thermo Fisher, Phillip Morris, Davita, or Baxter you've got plenty of company-- they're the top 5 most loved by analysts. Full disclosure: GOOG ranks 21st.

My thesis on NYT is that most investors only look at two things: financial metrics and an overall view of the newspaper industry. Both are ugly. Newspapers as we know them will go out of business except for a small cult following. They'll be like photographs: before the advent of digital photography, everybody took, developed, and saved photos in a shoebox. But the digital age made 4x6 glossies virtually obsolete. When's the last time that you took in a roll of film and paid to have it developed? If you're under 25 you don't even know what that means. Newspapers are headed in the same direction.

My thesis is that the New York Times is different. Every other newspaper in the country could (will) go out of business and the Times will survive. It's unique. It's our country's national newspaper of record. It's head and shoulders above any other paper in its coverage of national and international news (with the possible exception of the Washington Post). If you're a president, or king, or dictator, a leader in business or religion, and you want to make an official statement, you're not on record unless it appears in the New York Times. It serves a function that's been vital to society since Gutenberg.

It's possible that the Times will someday stop publishing a print edition and appear only on the 'net. I have previously argued that they should get out of the distribution business altogether: let some other company print and deliver the paper under an economic model that makes sense. Most of the financial pressures on NYT stem not from the (profitable) content part but from the expensive distribution function .

So where does Google fit into this? Well, content is a critical part of the internet. Virtually everything on the 'net is about content, and most of it is junk (not the part you look at, but... ). Pageviews drive success (revenue) and content drives pageviews.

I like GOOG because it's by far the dominant internet play. If my earlier statement about the importance of the internet is even close to true, GOOG is the horse that you want to ride. If you only know them as a search engine, you probably can't imagine the scope of their internet projects. Most don't presently produce revenue, but they all serve to position the company as THE internet leader.

I've believed that, at just over $600mm in market cap and about $1.7b in enterprise value, NYT would be a certain takeout candidate. Of course, they have a dual-share structure which gives the Sulzberger family (owners of the paper since 1896) control of the board of directors. Nonetheless, as the stock has slipped from 50 to 5 in the past six years, I'm sure that some of the family members might be more open to a conversation with a deep-pocketed prospective buyer. I have often thought that Google could be that buyer. They've got plenty of cash, they have a history of making acquisitions of content providers (YouTube, Blogger, etc.), and they presumably share the Times's liberal political views.

So that was my topic for today, until I came across this video: The Road to 2014.

If you've read this far, you're probably interested in the topic, so take 8 minutes to watch it. It imagines a world where, frankly, Google takes over. Rather than buying NYT, they render it virtually irrelevant. It's a moral tale, and I'll leave the conclusion to you. It doesn't necessarily make me any less bullish on either stock, but it's a fascinating view of the future, all the more so considering that it's 3 or 4 years old. (Full credit: I found the video and other interesting information at Zoli's blog Resistance is Futile: Google is Unstoppable)

Bottom line: an increasingly connected world will rely on those who can create content as well as those who can organize and deliver it. NYT and GOOG both fit.

Portfolio update

It was tough to watch yesterday's big decline. But I still believe Bob Farrell's thought that the Dow will trade in a range of 7800 to 9800 until people just get tired of thinking about the stock market. I also believe that the government's stimulus package can't be a success unless it produces a big stock market rally. I'm hoping for an opportunity to buy WAG at 25 and PG at 50.

Cisco taps the credit market

2009-02-09T20:49:00.002-06:00

Today Cisco Systems borrowed $4 billion in a combination of 10 and 30 year maturities. The issue was reported to be very well received by investors. Interesting, because the company has a very strong balance sheet with $29 billion of cash and equivalents and only $6 billion in debt. (note for nitpickers: most of their cash is held outside the U.S., which creates tax issues, and $500mm of their debt matures later this month.) Nonetheless, unlike many corporations, they had plenty of options besides today's offering.

So what does this mean? It tells me two things:

This is an interest rate call. The decision by CSCO to issue debt today, at these levels (4.95% for 10 years and 5.90% for 30 years) represents their opinion that present rates are attractively low and not likely to remain here or go significantly lower. That's important because, unlike economists and strategists who freely and frequently offer predictions (see the semi-annual WSJ tables for the dismal record of the consensus), John Chambers & Co. have a significant economic stake in their decision: they will either save or waste millions in interest payments over the life of the bonds.

Some of the most bearish economists and strategists (who, it must be said, have made the most accurate economic forecasts since the onset of the current malaise) foresee continued and deepening recessionary forces and lower interest rates. But while Chambers probably doesn't spend much time with demand curves or productivity functions, he is in a nearly unique position to view the global economy due to CSCO's vast global reach. Doug MacKay at Broadleaf Partners LLC, a longtime CSCO follower, calls Chambers "the accidental economist from Main Street."

And higher interest rates are good. They're good because they're usually a sign of improving economic activity. They give banks and the Fed more room to maneuver. With a bit of inflation, homeowners should see the value of their homes increase and be able to repay their mortgages with cheaper dollars. In the oft-cited case of Japan and the "lost decade", that country was unable to engender inflation and suffered through years of economic weakness. Up to a point, higher rates would be good for the stock market. Of course, we could have too much of a good thing, but that's another topic for another time.

The Strong Get Stronger Along with the interest rate call, this bond issuance is a sign of how much of an advantage strong companies have over competitors in a poor economy. While CSCO easily sold this bond issue, most of their competitors would find it difficult or impossible to borrow even at much higher rates. It's a huge advantage. They can aggressively attack while others can only defend. Customers will be more willing to make long-term commitments with vendors whose future is secure. And CSCO's financial flexibility gives it a tremendous opportunity to make acquisitions and other investments at very attractive prices. This advantage of size and strength is common to the highest quality companies in most industries.

To review my investment philosophy, I believe that high quality, franchise companies are extremely attractively valued at present. While I can't predict the near-term direction of the market, I think that dominant blue chips with bulletproof balance sheets and dominant market positions that have lost a third to a half or more of their market caps in the past six months will likely double or triple in the next three years or so. Many pay unbelievable dividends (INTC at around 4%?). Please see my prior posts including 12/1/08 for more details. My current portfolio includes ABB, BA, CAT, CSCO, DD, GE, GOOG, GS, INTC, SLB, and SYY. (I've also got some NYT, a special case which will be covered in a future post). I have a number of stocks on my watch list waiting for the right entry price. I'll probably miss most of them.

Portfolio Update

I did add to GE position today, but it's still relatively small. Decided not to sell the GOOG calls; as they say in the option markets, three things can happen to overwriters and two of them are bad.

A Better Day for America

2009-02-08T21:52:00.004-06:00

I really like this article by Daniel Gross entitled Declining Declinism http://www.slate.com/id/2210619/

His central point is that forecasters tend to extrapolate recent trends, and they frequently miss the turning points-- both up and down.

Has the recent economic news really got you scared? Me too. No doubt about it, things are bad.

But as Mr. Gross points out, four hundred years of American history has shown that we have faced adversity many times and in every case emerged a stronger and more prosperous nation.

Portfolio update:

I'm probably going to buy more GE tomorrow. Despite my earlier comment about waiting for a dividend cut or rating downgrade, I now think that both events are priced into the stock. CEO Immelt acknowledged both possibilities last week. I'm starting to think that everybody is waiting for the cut or downgrade.

Started a small position in GS last week. They probably stand to gain the most if the US financial system ever recovers. And the stock has been acting well.

Watching GOOG carefully. I really like the company, but the stock is probably a bit ahead of itself. Might think about selling some calls.

Phoenix Rising

2009-02-03T17:43:00.000-06:00

"All financial crises end-- and when they end, they end in ways that create spectacular opportunity" Lawrence Summers

I don't think it's much of a stretch to agree with Prof. Summers. Just as this is the worst financial crisis in our lifetimes, it will eventually produce some of the best money-making opportunities that we've ever seen. Of course, the trick is to find them and to get the timing right. But there will be plenty to be found. I've got some initial thoughts.

Obviously the public securities markets will offer some great chances to buy stocks and bonds at distressed prices. I've written quite a bit about the ability to buy franchise companies at incredibly cheap prices. Big returns if you catch the bottom, but most investors will do well to accumulate stock in high quality companies and hold on through the eventual recovery.

Some of the biggest fortunes have been made by investing in real estate during economic downturns. Certainly the Sam Zell types who get it right stand to make billions. But I've been approached by a few people with small deals that reflect the pervasive damage of the recession-- to make up an example, the guy who owns a small strip mall is unable to roll over his bank note and what was once thought to worth $5 million will be sold to a heavily discounted bid. These deals are out there, and there will be more. I'll bet that your local commercial real estate broker is in touch with lots of situations. In fact, they have started sending flyers (first-class mail) advertising local commercial buildings to residences in my town. What makes them think that my neighbors and I would be interested in a local 60,000 square foot office building? Apparently all of the traditional buyers are out of the market. Sam Zell I'm not, but at the right price, I'd be interested as a part of a group.

Most interesting will be the cherry-picking breakups of big but wounded companies. Things will be very different coming out of this recession, and many traditional business models will no longer work. However, parts of businesses will still be attractive under different terms, with different management. Here's what you'll be seeing: displaced senior executives at large firms that have taken a beating will start companies to compete with their former employers. They'll successfully bring coworkers and customers, and they'll compete very effectively because they won't be saddled with the legacy issues. It's a perfect model for service companies: XYZ is in dire financial straits, so a former SVP recruits salespeople and starts ABC Corp. targeting the same client base. Think about it from several angles: the upside by joining ABC Corp, but also the downside if you're an XYZ shareholder. And think about service companies broadly-- including financials. I'm pretty confident that you'll be seeing lots more on this topic in coming months.

Portfolio Update:

Added to my CAT position as it touched 30. Also, I just couldn't help myself and I doubled up on NYT when it traded under 5.

Why I don't like ETFs

2009-01-31T10:06:00.000-06:00

"I play that with ETFs" is a frequent comment I hear when people talk about their investments. Exchange Traded Funds as originally conceived (like the S&P 500 SPDRs) offered an inexpensive way to gain exposure to a popular index.

But we've moved well past that, and today there are hundreds of ETFs representing everything from Australian Real Estate to Japanese Appliances to Worldwide Water Resources.

I'm not a fan.

1) If you can't pick a stock, what makes you think that you can pick a sector? Often people invest in sector ETFs like biotech or semiconductors because they like the industry but don't want to take the risk of owning the wrong stock (i.e., one which underperforms). I would much rather own a company than an industry. The sector ETF is a diversification strategy, which will reduce your risk of that 50% plunge in a stock when news breaks that the Phase III trial for the lead drug has failed. But diversification works in both directions, reducing both losses and gains. My answer is to not buy a stock with that much risk. If you like biotech, look for some leading biotech stocks. If you can't find any individual stocks that you're willing to invest in, what makes you think that you'll make money with a bunch of them?

2) Do you know what you own? I'll bet that most investors in sector and country ETFs can't name most of the stocks in the ETF. And if you saw a list, there's almost certainly some that you wouldn't consider buying as an individual holding. So why tolerate holdings in your portfolio that you don't like?

But the bigger "know what you own" problem comes with the more exotic ETFs. Let's start with gold. If you own a long gold ETF, you probably want the protection that gold has historically offered in times of great financial stress. But who guarantees your investment if things get really bad? Some financial firm like Bear Stearns or AIG? Citibank? Lloyds of London? And how do you know that there's actually real gold backing your investment? Lots of recent news about once-trusted financial entities that met "black swan" fates. Same goes for other commodity ETFs: do they really own that oil, or corn, or copper?

And then we come to the leveraged ETFs, the "double long" and "triple short" variety. Have you ever asked the sponsors how they manage their positions? It's not simply a matter of buying or selling stocks equal to the ETF position. They use derivatives, and one thing that we've learned in the past year is that derivative instruments can sometimes have unintended consequences. A friend once called one of the sponsoring firms to get the details on how they managed the fund. He was told that they did not disclose that information. So how do we know that, when oil plunges from 147 to 32, your short oil ETF doesn't go bankrupt because of bad hedges?

Quiz question: If I was smart enough to have invested in the double-short Financial Sector ETF (symbol SKF) on the first trade in January 2008 and held that position through the year, how much money would I have made? We all know that financial stocks had absolutely miserable performance in '08. So by being double short, I must have killed it, right? Actually not. In fact, the SKF rose from 99.88 to 103.01 in that 12 month stretch (plus a small dividend). Check it out. The math is a bit complicated, but let's just say that the up days hurt more than down days help. Same thing is true for many leveraged ETFs. My point is that many investors don't really know what they own (until they learn an expensive lesson).

Portfolio update
I'm putting PG on the watch list. It's a great company, and it meets most of my criteria, but until now the stock hadn't come down enough to get me interested. With yesterday's selloff, I'll be looking for a chance to buy it if it continues to decline.

Return to their Rightful Owners

2009-01-27T14:34:00.000-06:00

"In bear markets, stocks return to their rightful owners"

--old investment aphorism, variously attributed to J.P. Morgan and others

Who are the "rightful owners" of stocks?

When I started in the business, it was fairly uncommon for individuals to own stocks. 401k accounts were a relatively recent innovation, and mutual fund ownership was picking up, but not many people owned individual common equities-- just "rich people".

By the time the tech bubble peaked, it seemed as if everyone had a stock portfolio. Remember the cocktail parties of that era, when the guys would talk not about sports or women but about stock tips? Much of that vanished with the bubble, but stock ownership by middle-class households remained high.

The hedge funds had been around for a long time, but they only became a major influence in the stock market in the past 10 years. They own plenty of stock, but it would be hard to call them rightful owners.

I believe that the rightful owners are those who are long-term investors based on an informed opinion of the company's prospects. It's a key difference between investors and traders.

Today I saw several market opinion comments about how dull the market had become. The Dow has been up or down less than 100 points in 7 of the last 10 trading days. My guess is that we're getting close to a stretch of dull market days as investors gradually give up on equities. Many traders will exit if a low volatility environment limits short-term opportunities. But many individuals, currently waiting hopelessly for the rebound in their 401k funds, will also throw in the towel.

That's what will create the bottom. It won't necessarily be a technical (chart) condition or a spike down to a level where everything is just silly cheap. Rather, we're likely to be endure a period where market participants gradually get bored with the market, volume drops, and nobody cares anymore. By that time, stocks stocks will mostly be back in the hands of their rightful owners. May take a while, and it will probably be accompanied by a slow grind lower. But it will be a necessary condition for the bottom.

Portfolio update: I started a position in CAT yesterday following their earnings report as it dipped below my targeted entry point. I like the company and will look to add if it trades down to 30. I began a very small position in GE last week, and I'm waiting for them to lose their AAA rating or cut the dividend before adding. I don't really trust GE, so I'm being very cautious. Other portfolio holdings: ABB, BA, CSCO, DD, GOOG, INTC, SLB, and SYY.

Me and Thain get whacked

2009-01-22T18:04:00.000-06:00

I started my first "real" job in late 1978. Counting that one, I've worked for three companies in the last 30 years. During that time, I've had vacations, but I've never been away from work for more than about two weeks at a time max. For the vast majority of that time, the alarm clock has sounded at around 4:30am and I've been at work by 6. Tomorrow, I'll be sleeping in.

Today John Thain and I (and a large number of my Merrill Lynch colleagues) got laid off, fired, riffed, whatever you want to call it. Footnote: at Bank of America, coworkers are known as associates, not colleagues. Same as WalMart.

Of course, I'm not suggesting that there was any connection between my fate and that of Mr. Thain. But it was an interesting coincidence. I'm sure that he'll do well in his future endeavors. I will too.

I entered the financial services industry in the mid 1980s with a manager trainee job at EF Hutton. I worked as a private client broker to learn the business while preparing for a job in sales management. Hutton was truly a great firm back then. I was proud to be in the business, and proud of my firm. (another footnote: at B of A, it's "the company", not "the firm").

I was young, and in awe of the idea of being a stockbroker. The Dow was around 1300, and the NYSE had recently recorded its first 100 million share day.

But even as a rookie, one thing that I clearly noticed was the grudging respect that my coworkers had for Merrill Lynch. They would tell me how much better we were compared to firms like Paine Webber, or Kidder Peabody, or Smith Barney. But they obviously envied ML. Even the Merrill softball team dominated the local broker league. And as I came to understand the industry, I could see that Merrill brokers were head and shoulders above everyone else in metrics like average production per broker.

I remember well a speech given by a former boss at my first (pre-Hutton) employer. He said "if you don't think that you're working for the best company in the industry, you should quit your job and go to work for the best company." Merrill Lynch was the best in the industry. So when I had an opportunity to take a position at Merrill in 1987, I was quick to move.

I was truly very fortunate to have the chance to spend 21 years at Merrill. It was a great job. I worked with some outstanding people. I grew personally and professionally. My life was truly much richer for the experience-- in fact, it defined my life. I enjoyed some great experiences, and I had an opportunity to do some wonderful things.

But things changed. The economy, the stock market, the world. The firm that was the best in the industry was destroyed by a combination of bad judgment, bad management, and bad luck. The number one job of the CEO of any firm is to avoid blowing up the firm. Merrill blew up. Fortunately, the BankAmerica deal came along (although perhaps not so fortunately for the BofA shareholders).

Lots of good people lost their jobs today. It's a sad time. It feels like a death in the family. But it's not the sudden, tragic kind of death. This one feels like the death of a long-suffering relative; we've long ago reconciled ourselves to the ultimate outcome, and when it comes it's seen as a blessing.

How sad that on my last day I listened to some buffoon on CNBC make toilet jokes about this once-proud firm.

This is a good thing in my life. I'm looking forward to moving on. I'm looking forward to spending more time with my family. I'm looking forward to teaching my 15 year-old son to drive. Next time you see me, I'm hoping that I'll be thinner and healthier. Maybe even the gray hair will be a bit darker. My golf game will be better.

Last week on MLK day, I was driving and heard on the radio a speech from Dr. King entitled "The Drum Major Instinct". In one part, Dr. King imagines his legacy: "I won't have any money to leave behind. I won't have the fine and luxurious things of life to leave behind. But I just want to leave a committed life behind."

I have often thought, as I've charged almost blindly down the path of my Merrill Lynch career, about my own legacy. Will my kids say "Dad made a lot of money, but we didn't get to spend much time with him?" Will people in the community say "He was always too busy to get involved?" Will I reach the end of my life and regret that I didn't take time to learn another language, or volunteer at a shelter, or travel to Africa, or spend more time with my parents? Now I've got the chance.

To all of my friends, best of luck. The current dark days will pass. My life is richer for having known you, and I hope that you'll keep in touch.

Benchmark Bullsh*t

2009-01-05T19:52:00.000-06:00

Q: What do you call an investment manager who substantially outperformed his benchmark in 2008?

A: a big loser.

In most of the past years, your manager would crow about his performance if he beat his benchmark at all. And if he exceeded it by 100bp or more, he would beat his chest with pride.

So last year the S&P 500, the most common benchmark, was down by about 40%. How do you feel if you were down 30%? Happy?

I recall a conversation with a portfolio manager several years ago:

Me: What do you think about XYZ?

PM: We hate it. It's a lousy company in a poor end market. Bad management, an overlevered balance sheet, and selling at an unsustainable valuation.

Me: Well, I notice that you own about a million shares.

PM: Yes. But we're underweight relative to our benchmark.

Forget about your benchmark. Buy stock in high quality companies with good future prospects and attractive current valutions. Maybe you will underperform next quarter. But in the long run you'll make an attractive return.

We're All Contrarians

2009-01-04T20:55:00.001-06:00

One thing that bothers me quite a bit is the possibility that I'm just one of the sheep blindly believing in a stock market revival. I read lots of newspapers, blogs, and research reports, and I realize that there's no shortage of bullish talk. That emboldens the bears, who say that the market can't possibly go up when so many are predicting it.

There's an old, probably apocryphal story about about a sell-side strategist who was making a speech to a group of buy-siders. He asked for a show of hands by those who considered themselves to be contrarian investors. Almost everyone raised his hand.

The bearish argument is always more elegant, more reasoned, more rational. If bulls can give you three general reasons for expecting a higher market, bears can offer ten very specific and seemingly irrefutable points to guarantee a fall.

We're all contrarians now. We've all learned that the path to profit is the one less traveled. We all look to fade the consensus. The problem is that, as everyone fades the consensus, they become the consensus.

Not Another Year Ahead Piece!

2009-01-04T08:19:00.000-06:00

I want to publish my thoughts about 2009- not because I think I can see the future, or because I want to give advice. Rather, I want to have something in print so I can refer to it in coming months and see a snapshot of where I was at the start of the year. That might help me to understand where I made mistakes, and what unanticipated developments caused me to change my thinking.

I think that the stock market made an important bottom on November 20, 2008 at around S&P 750. I allow for an undercut of that bottom. Although every bear market is different, I wouldn't be surprised if we see something like the 2002-03 experience, when the market made its primary low in October (at about 800), rallied to 927 on Jan 10, then fell back to a classic double bottom around 828 on Feb 7 and March 7.

But I do think that the market is presenting us with an extraordinary opportunity over the next 2 or 3 years. I believe that there are many very high quality blue-chip stocks with bulletproof balance sheets and franchise businesses selling at once-in-a-decade valuations. Many offer substantial dividends. I think that these companies could rise 50 to 100% or more in value over the next 2 or 3 years. I'm currently invested in ABB, BA, CSCO, DD, GOOG, INTC, SLB, SYY

If I'm right, I'll almost certainly underperform "the market". In the next bull market, some of the best performers will be high beta names: maybe airlines, or miners, or E&Ps, or beaten-down retailers. But I think that I've found the easy money trade, with very good upside and less risk. If I'm wrong and the market continues down, I'll definitely perform better with these more stable names.

I'm currently about 33% invested in my high-quality portfolio, with the balance in cash. I've been looking for a chance to add to those positions and start a few others, but the market's runup in the past two weeks has taken most of them beyond my target buy points. If the market goes straight up from here, I'll miss an opportunity (although I do have more equity exposure in my retirement accounts). If a new bull market has already begun, I'm willing to take the chance that I'm underinvested. I could easily see more downside, and real losses are more painful than missed gains.

My best guess is that the market trades in a range for at least the next few months. Maybe 750 to 1000 or so, but that range is just a guess. I'll look for a chance to add at the lower end of the range. If it gets up near 1000, I'll consider selling calls on existing positions.

I'm thinking hard about energy stocks. I've only got one (SLB) in the portfolio now. Although I wouldn't expect oil to make a V bottom and charge straight back above 100, I was interested in some recent investor surveys which showed a distinct lack of appetite for energy. The most bullish forecast for oil in 2009 was about $75/barrel , and most expected something around 40 or 50. I'm no expert, but I know that oil is an essential commodity, and recent prices of 40 or lower lots of supply became uneconomical to produce. It wouldn't take much in my opinion to see a slight pickup in demand push prices well above most expectations. It's probably a good "fat tail" trade, buying far out of the money calls. I'll try to play it by adding to SLB and finding one or two more high-quality energy companies that are down 50% or so from recent highs and have great balance sheets.

I'm avoiding beta names. I don't want anything in the portfolio that could get slammed if we find that the drug didn't work, or the hole was dry, or they couldn't roll over their revolving line of credit. No triple short ETFs-- which are really just coinflip bets anyway. No emerging markets, although I wouldn't be surprised if China turns out to put up some great performance in 2009. No small caps, although some very smart smallcap managers with great research will probably have a career year. I don't have great research, so I don't want to own stocks where the smart money sells well before the dumb money (me) discovers a problem. Smart analysts and hedgies can get a great informational edge with many small stocks, but much less so with BA or DD.

I expect that the recession will continue through 2009, and that it will be one of the most severe on record. I think we'll be able to see light at the end of the tunnel by year-end or maybe earlier. I do allow for the possibility--say 10%-- that the current economic malaise extends for much longer than I expect, perhaps 5 years or so. I'll keep some cash around to avoid blowing up, but I certainly will suffer if that happens.

Interest rates and gold should both go up. It's a consensus viewpoint, but I just can't see how all of the government stimulus won't eventually induce significant inflation (although much more dangerous is the possibility that they can't inflate). I don't like bonds. Even with historically wide spreads, higher interest rates will hurt bond prices, and I can get bondlike yields from the dividends on some of my stocks. Munis scare me. I think that many state and local governments are underfunded or worse, and the recession will exacerbate their problems. I don't think that the state of California will default on its debt, but its 6% 30 year paper doesn't interest me.

Finally, a few other names on my stock watch list: CAT, WAG, UNH, PFE, COST, GE, COP, and IBM. I've got some levels in mind if they sell off. No financials. Although I'm certain that the financials will have an absolutely rip-roaring rally at some point, I don't know when. I suspect that they're pretty well washed out, but they don't fit my criteria for bulletproof balance sheet.

So, in summary, there's plenty of money to be made from here in relatively safe stocks. Don't get greedy, and look to add on dips.

Lies, Damn Lies, and Statistics

2008-12-31T17:32:00.001-06:00

On Tuesday we learned from the S&P/Case-Shiller Index report that housing prices had declined by 2.2% in the month of October. That was greater than "analysts" had forecast. Hmmmm....

What do you suppose happened to the price of my home in October? Or yours?
I have no idea, because like the overwhelming majority of homes in the country, mine didn't sell last month. It wasn't offered for sale, and I had no intention of selling it. Like most people, I bought my home because I needed a place to live, and it suited my needs and my budget. Some day I'll sell it, and I hope and expect that I'll get a fair price. But why do we need monthly price statistics on something with very low turnover? How does anyone know what the price of my home was in November, or October, or last year? The same is true for art, or wine, or antiques.

We get a myriad of statistics every day. Durable Goods Orders. Producer Price Index. Continuing Unemployment Claims. Merchandise Trade Deficit. Non-Farm Payroll Employment. Sometimes, the reports come from government bureaus, which use them for planning and tracking. But sometimes, they're created by individuals and organizations for publicity purposes (see The Challenger Report of Announced Layoffs) or simply to make a profit. Over a long period, many of the better statistics can help us to understand long-term factors in the economy. But in the short term, they're mostly useless.

However, the media, in its effort to cover the stock market like a sporting event, thrives on statistics. CNBC frequently shows an onscreen bug with the countdown to a report's release (37 minutes to December Retail Sales!). And often a market's move is ascribed to some random event: "Stocks dropped today after traders were disappointed by an unexpectedly large fall in the Empire State Manufacturing Index."

The only statistic that really matters is the one that you see on your stock monitor-- the current quote. A stock, or a barrel of oil, (or your home, for that matter) is worth what someone will pay for it right now. Don't get hung up on statistical analysis; the market price tells you everything you need to know. And if it's an asset that rarely trades and doesn't have a current quote (like your home) don't pay much attention to some theoretical price.

Beware the unknown unknowns

2008-12-21T11:38:00.000-06:00

There are known knowns. There are things we know that we know. There are known unknowns. That is to say, there are things that we now know we don’t know. But there are also unknown unknowns. There are things we do not know we don’t know.

Donald Rumsfeld, 2/12/2002

A successful investor needs to not only be intelligent and insightful, but also pragmatic. Know what you don't know. But one also needs to allow for events and outcomes that simply can't be anticipated-- the "unknown unknowns."

I thought about this when I read an article in today's Chicago Tribune . It was a "year ahead" piece on the economy and financial markets, with opinions from various experts. Professor Erik Hurst, of the University of Chicago business school, on housing prices:

Housing prices will fall another 15percent to 20 percent in the next couple of years, he predicts. "We've got a long way to go."

His study of market data stretching back decades gives him 100 percent confidence in his prediction, he said. "A big increase in price movements is followed by big declines. Take it to the bank."

Hmmmm.... "100% confidence"? based on his study "stretching back decades"?

I can only hope that he was severely misquoted. If not, I think he's an idiot. Let's think about this. First, what's his data set? "Stretching back decades" could mean as little as 20 or 30 years. But let's assume that he has gone back 190 years (otherwise he would have said centuries, no?). I know that Schiller and others have looked at housing prices back to the 1800s, but how good is that data? Do you really think that they have good records for a broad range of housing transactions dating back that far? Sure, there may be history for some houses on Beacon Hill dating back to the 1600s. But what about the sod huts in Nebraska in the 1870s?
I'd be willing to bet that many home sales went unrecorded or otherwise lack good records at least as recently as the 1930s. And many of the meticulous details that we have today, dutifully reported on CNBC like sports scores, date back to the 1970s or '80s.

But even if we have good data back to the early 1800s, Prof. Hearst is telling us about a study of cycles: a big increase is followed by big declines. How many times has that happened? I can assure you that one of the most basic assumptions about home prices prior to 2007 was that they never go down. This is what got us into the present mess. On a national basis they had virtually never declined. So how many cycles could have been captured in his research? I'll assume that he has looked at regional cycles and other data. Maybe he has captured 20 such events? I'd think that's a generous assumption.

One of the my earliest and best lessons in investing involved my only commodity trade. We were just out of college, and a good friend had taken a job as a commodities broker. He found an investment opportunity in lumber futures: it seemed that there was a seasonal pattern that had worked in 16 of the past 17 years. He put together a group of our friends to open an account and take advantage of this pattern. I think that I invested $2000.

Guess what? By the time that our contract had expired, that lumber trade's record was 16 out of 18. I lost it all. But for $2000, I learned a very valuable lesson about correlation.

One of my favorite quotes from Fooled By Randomness author Nassim Taleb:

My classical metaphor: A Turkey is fed for a 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.

Perhaps housing prices will fall 15 to 20 percent in the next couple of years. Or maybe they'll fall 50 percent, or maybe they'll go up. Far too many unknown unknowns here. Wanna bet that if we were to interview the Professor in a few years, and it turns out that his 100% confidence prediction was wrong, he'd cite some unforseen events to explain his error? Unprecedented government intervention, currency crisis, runaway inflation, change in tax laws, etc. etc. The point is that we can rarely if ever be certain about anything. The successful investor attempts to know what he doesn't know, and makes allowances for the unknown unknowns.

Back to Basics

2008-12-16T09:18:00.000-06:00

A long time ago, I had a conversation with an investment manager for relatively small firm with a good performance record. There was no secret to his process, he said. "We just buy stock in high-quality companies and hold on to it for a long time."

Bernie Madoff blows up as investors are shocked--SHOCKED-- that a strategy which reported rock steady monthly returns through 20+ years of market volatility was proven to be fraudulent. Newspaper articles go to great lengths to explain the intricacies of "split-strike options."

Today's WSJ notes that a manager who ran a fund which is down 82% this year has "stepped down." STEPPED DOWN? What were they thinking when the fund was down 50%? Why didn't they fire him then?

Hedge funds closing or restricting redemptions in the face of abysmal returns. One of the largest and most prominent is down by 50% this year, and it's got plenty of company. It becomes an accepted tenet of mainstream institutional investment philosophy that common stock investments are shunned in favor of allocations to hedge funds, private equity funds, commodity funds, and other "alternative assets".
Not so many years ago, a large pension fund would invest its assets in three categories: stocks, bonds, and cash. Today, the Harvard university endowment's asset allocation chart shows 11 separate categories of non-cash investments, about three quarters of which are things other than domestic stocks and bonds.

I'm generally a subscriber to the efficient markets theory. I believe that information gets disseminated quickly, and reflected in the market just as quickly. So you think that the economy's gonna be bad for the next six months? No kidding-- so does everyone else. That's why the stock market has fallen 40% or so. But what do you think that everyone else will be thinking next? That's the question! As Keynes said, successful investing lies in anticipating the anticipations of others.

Everyone's looking for an edge. Everybody wants to find the stock, or the asset class, or the manager or strategy that produces outsized returns (and with minimal risk, too). People stood in line, like cattle headed to the slaughterhouse, for a chance to invest with Madoff or some high-profile hedge funds.

There are literally thousands of investment management firms, ranging from esoteric black-box hedge funds to the sleepiest rural bank trust department. They're all looking at generally the same data. Some have vastly superior resources to provide for sophisticated computer analysis or local surveys of Tibet yakherders cellphone purchase intentions. But in the end they all think they can outperform the market. Some do, for a time. But even the most heralded, like Bill Miller or a prominent hedge fund, eventually find that their luck runs out. As Nassim Taleb would say, if you have 1000 monkeys picking stocks over 10 years, one of those monkeys will rank as the #1 stockpicker with the best 10-year average.

So why don't we just buy stock in high-quality companies and hold on to it for a long time? Well, for one thing it's not in the best interests of asset managers, or brokers, or investment committees, or consultants, or fund-of-funds, or most analysts. It probably isn't such a good thing for writers of financial blogs, either. But it probably is a good thing for you.

Wherein I Achieve Peace With The Market

2008-12-01T19:29:00.000-06:00

"All financial crises end-- and when they end, they end in ways that create spectacular opportunity" Lawrence Summers

hard to explain.

The Dow was down 680 points today.

Over the past three months, when the market got hit hard like this, I'd get depressed. Didn't want to look at my account value online-- just didn't want to know. I lost a lot of money in the market this year.

But today is very different. I'm actually glad for the selloff. In fact, I hope that the market has a similar decline tomorrow, and the next day. Why? Because the market is presenting me with a spectacular opportunity.

Why now? Why is this better than previous declines? Why couldn't I have said the same thing 2000 Dow points ago? Answer: gut feeling.

I could give a more elegant answer. I could talk about my zero boundary theory (the lower it goes, the closer it is to the bottom) I could refer you to the John Hussman (by way of Henry Blodget) web post http://clusterstock.alleyinsider.com/2008/12/what-the-stock-market-will-be-worth-if-earnings-go-to-zero which argues that the more the market drops, the more attractive it becomes for long-term investors.

But in the end, big stock market returns are made when everyone else is consumed by panic. We all know this ("Buy when there's blood in the streets") but it's incredibly hard to do. It's not just when the dumb money sells. They may have sold long ago, or maybe they'll never sell. Bottoms are made when us smart guys-- the "smart money"-- just can't stand it any more. We buy with both hands down 20%, and we puke down 40% ("this is a disaster-- get me out").

My gut is telling me that we're at the inflection point. That doesn't mean that today was the bottom. But it means that we're not going much lower. Into the 7's on the Dow? Maybe. Probably. But not into the 6s. So how's my gut's historical performance? Pretty good. I'm not exaggerating when I say that I feel very strongly about this: right now, today, right here. No guarantees, but it's a feeling that I don't get very often and that I've learned to trust.

I'm not predicting a near-term rally. Maybe yes, maybe no. What I'm feeling is that investments today in high quality stocks will produce substantial returns-- doubles or triples-- in the next two or three years. This is a once in a generation opportunity to acquire stakes in truly world class corporations at deeply discounted prices. They may well get cheaper, maybe much cheaper, in the next year or so. But in 2011, you'll marvel at the fact that you could have bought these stocks at those prices in December 2008.

So what to buy? It's easy. Buy the blue chips. Buy the companies that are the clear worldwide industry leaders. The ones that have the impregnable balance sheets and the multi-decade records of outsized returns to shareholders. It's truly like shooting fish in a barrel. Forget about relative performance. There will certainly be others that outperform. But names like Intel, Boeing, Microsoft, Caterpillar, Coca-Cola, Cisco, and Pfizer (among others) will give you solid double-digit returns or better plus a good dividend over the next few years. They are franchise companies that are rarely available at today's valuations.

What not to buy? Themes. Tips. ETFs. Anything that represents a guess as to the next market tick. Top down ideas like infrastructure or global decoupling. Anything dependent on interest rates, or commodity prices, or the Baltic Dry Index. Don't buy sum-of-the-parts stories, or discounts to NAV. Don't buy it if you have to look up the symbol, or if you can't immediately describe exactly what business they're in. There are just too many exceptional and truly inexpensive companies with virtually zero risk of accounting fraud, or adverse patent rulings, or competitive threats.

And yes, I know that we're in the worst recession of our lifetime. I know that housing prices haven't bottomed. I know that the payroll employment number on Friday will be a well below pessimistic expectations,that the unemployment rate is going to 10%, and that retail sales this Christmas season will be the worst since the Stone Age.

Bottom line: The market's not going much lower. It may take a while to recover--maybe a long while. But you can become an owner in some unbelievably great companies at incredibly good valuations right now. And they have dividends that compensate you very well while you wait.

From the Wayback Machine

2008-11-29T20:18:00.000-06:00

Too much time on my hands over the weekend. I dug around in the archives, both physical and electronic. From a box of old magazines, I came across Newsweek issues from December 2, 1974 (Cover story: "How Bad a Slump?") and January 20, 1975 ("Out of Work"). Some quotes that could have been lifted from today's issues:

"The recession worsens. Layoffs proliferate. Profits fall. Bankruptcies swell... And the worst is yet to come."

"Each day last week brought fresh reports of layoffs--massive ones in the auto industry and lesser ones in plants producing products as varied as textiles, electric organs and bicycles."

and from a New York Times editorial 12/29/1974 (via web archive), about a week after the market had bottomed:

"The year is ending with much of the nation in a state of deep anxiety over the course of the economy. There has been nothing like the present degree of apprehensiveness—or confusion—about the business outlook since 1930. And the question on everybody’s mind is whether years like 1931 and 1932 lie ahead."

By the way, of the many interesting things in boxes in my basement, I was most amused by the AIG 2001 annual report, which proclaimed boldly on the cover "The Greatest Risk Is Not Taking One."

I interview myself

2008-11-22T09:05:00.000-06:00

In this, my first blog post, I thought that I'd start out with an interview. After considering a few other candidates, I decided to interview myself.

YAIO: So what do we do now? Staring in the face of a nasty recession or worse, worldwide markets in shambles, seemingly nowhere to hide?

ME: I get the feeling that we're at an important inflection point now. Sure, there's lots of bad economic stuff ahead, and plenty of people have been blown up trying to call the bottom. I'm not saying that things won't get worse, but for the first time I'm seeing signs that we're at a turning point. We probably aren't at THE bottom, but we're near A bottom.

Just this past week I feel that the market left the path of "nasty bear" and strayed into "irrational". The thing that was most notable to me was the 9 point rally in 30 year treasury bonds on Thursday. NINE Points! I don't know what the previous record was, but I'll bet it was less than Four. Some media reports pointed to that move as an extreme manifestation of flight to safety and fear. I've got news for you: you don't buy 30 year bonds for safety, and in particular you don't buy them up nine points for safety. That was a mechanical move, probably by fixed income investors desperate for duration. It reminded me in some ways of the Volkswagen short-covering explosion last month.

YAIO: So what does that tell equity investors?

ME: We've seen some extreme moves in the markets lately. But it's dangerous to try to fade the extreme moves. Merely the fact that the stock market loses 50% of its value isn't a reason to buy-- it could certainly lose another 50% and then maybe another 50% after that!. Remember the quote attributed to Keynes: "the market can stay irrational longer than you can stay solvent". But in my experience these extreme moves that touch all asset classes often end with some type of blowoff. I think that the treasury move was a blowoff that signals a turning point.

But I'm not saying that a nine point move in the long bond is a sign that the stock market will rally. It's just an ingredient in a mix that gives me a bullish gut feeling. Here's what else is in that mix: First, the stock market's recent move is clearly an extreme. Before yesterday's rally, we were as oversold as we've ever been-- ever. Even if the S&P is going to zero, it won't go straight there. The biggest rallies occur in bear markets. That's the market's way of keeping honest. There are no free lunch, one-way trades.

Second is the zero boundary theory. Like I said, we're not going to zero, but the lower we get, the closer we are to the bottom. I can't tell you what the limit is on the upside: the S&P could go to 1500 or 15,000. P/E could go to 100x or higher. Just ask anyone who shorted tech stocks during that bubble. But I'm a lot more certain about predicting the downside limit. While individual stocks can go to zero, the entire market can't. Despite my comment above, I'm pretty confident that the market will absolutely not go below400-- let's say 500, which is still plenty conservative. That's still another 35% lower than Friday's close, which would be very ugly. But it defines your lower limit and your risk. But the upside, unlike the downside, is theoretically unlimited. I like those odds: 35% downside, unlimited upside.

YAIO: How do you know that the S&P won't go below 500? What are your valuation metrics?

ME: I suppose that's possible. But you can't protect against every single risk, or you'd never ride in an airplane or walk across the street. If a sub-500 S&P would cause you to lose your house or cause your family to starve, you shouldn't be in the equity market. I'm not saying that there's absolutely no chance of the market going to that level or lower, but it seems like a pretty safe bet. And as far as valuation, 500 would be 10x a $50 S&P earnings level. I'm not a big fan of valuation metrics because they seem to be least helpful just when you need them the most. But 10x $50 seems pretty dire.

YAIO: Some have suggested that both bull and bear forecasts will be wrong, and that the market will just flop along around this level for a long time-- possibly years.

ME: That could be. Bob Farrell predicts that we'll trade in a range of Dow 7800-98oo for a while, probably into next summer or so. That sounds about right to me. But from today's level, it gives us a pretty good trading opportunity. I'd be a seller if we neared the upper end of that range any time soon. But that's up over 20% from here.

YAIO: What do you think about the fact that you seem to be in line with the consensus in saying the market is cheap? Don't we need to wait for some type of capitulation?

ME: Frankly, that does bother me a bit. I think that most investment advisors are telling their clients not to sell-- it's too late, and that it's a mistake to puke at the bottom. However, if they're not recommending selling now, it's hard for me to believe that they'll get bearish at lower levels, even if the economy continues to weaken. Also, keep in mind that people running investment advisory businesses have a built-in bias. They've already seen their assets under management (and therefore their fee income) drop by nearly half. If you advise people to go to cash, why do they need an investment advisor? So you stay long, and if the market recovers, your business recovers. If the market continues to go down, the advisor's not worse off than if clients sold everything and went away.

But I am watching the consensus/contrarian thing. I see both bullish and bearish indicators every day. I think that when we ultimately bottom, it won't be because we've reached a point of maximum pessimism on some indicator. Rather, I think that we'll bottom after we go through a period where people just don't care about the equity markets for a while.

YAIO: Sounds like you're saying we're due for a bounce, but you don't have much confidence in the long term. What should we be buying now?

ME: That's about right. It depends on your time horizon. I'd focus on two strategies. First, there's the silly cheap stocks. They're short term trades into the bounce. Pick your own favorites here, but look for companies with fundamental franchise value even if the near term earnings picture is poor. Most of the large cap (or should I say "formerly large cap") banks fit this category. Also some media companies like NYT. I'll think about it and come up with some more names in subsequent posts.

The second strategy is to use this as an opportunity to make long-term investments in great companies at attractive prices. Boeing, Caterpillar, Exxon, Coca-Cola, Pfizer and IBM are a few that come to mind. If you're willing to invest for five years or more, I think that the risk-reward tradeoff for stocks like these is extraordinarily favorable. Take half-sized positions now, and prepare to buy more if they get cheaper (if you've got the stomach for it, consider selling out-of-the-money puts for the other half position, but that's a discussion for another day). The problem with this strategy is that most people don't have the required level of patience and discipline. They watch the value of their account and are likely to get scared out in a market selloff. Some very smart investors counsel to never add to a losing position. It's hard to do, but I think if you've got the right investments and the market gives you an opportunity to buy more at a lower price, you take it.

Finally on the topic of long-term investments, be sure to look for long-term growth opportunities. Although you'll hear plenty of advice to avoid investments in technology companies due to a cyclical downturn, many tech innovations are as anti-cyclical as you can get. Computers and cell phones will always get cheaper and better. The internet is a huge influence in our lives today, but it will only get more important in the future. Pick your own way to play tech, but be sure to have some in your portfolio. For my money, there's not much better than Google, and at yesterday's price of about 250, it's got a great risk/reward profile.

YAIO: Hmmm... you sound like a pretty smart guy. I presume that you've been a successful investor?

ME: honestly, not really. My biggest mistake was to steadily add to my equity portfolios over the past 20 years, and although I did quite well in the early years, that strategy has been a net loser since about 1998. I was brought up on the philosophy that as long as you've got a long-term horizon, stocks are the only place to be. "Long-term equity returns average 10%..." we all assumed that was true. But it's a lot more likely to be true in the near future now that we're back at the 1998 index levels.

that's it for now.

thanks