|Should you buy a stock whose price is at a 52-week or all-time high? Or does this even matter to someone looking to invest for the long term?|
Some very smart investors offer conflicting advice.
It has been argued that the overall trend of the market is the key driver of short-term gains or losses.
When the market is moving up, even mediocre stocks can enjoy an uptick in stock price (“the trend is our friend”). Conversely, when the market is moving forcefully down, even good investments can take a hit (“when the tide goes out…”). This also implies that a questionable investment might look better than it is (the trend), while a downtrodden equity may be a good buy (the tide).
So, it can make sense to purchase stocks at high watermarks when the market is moving down because that should be a sign of additional strength. Likewise, delaying the purchase of a stock on the rebound when the overall market trend is up can provide a margin of safety. Recently we’ve seen a shift in the fortunes of stocks, but between industry segments instead of the overall market, offering some evidence of these assumptions. And while the bubble-debate doesn’t much interest me, the recent flurry of SPAC’s makes me nervous. These Special Purpose Acquisition Companies are simply funds that raise money to invest without having any idea what they might end up investing in. The entire point of using a SPAC is to bring companies to market without having to fully disclose a business’s finances. Which sounds more like gambling than investing.
Connected to this line of thought is the concept that over longer periods of time, “reversion to the mean” should be respected.
Put another way, stocks that go up too fast should tend to come back down, while stocks that drop precipitously can often bounce back. All of this is, of course, based on the premise that a pop or drop in an equity is not caused by an outlier event like accounting fraud or sudden product failure. But ultimately, the real problem is that using heuristics in these situations can also mean that we are confusing luck with skill.
My response to a boast about the skill involved in selecting Tesla at a propitious moment was, “Over the last twelve months fourteen other stocks outperformed Tesla so, maybe, you just got lucky?” Tesla is down about 30% since that conversation and my friend is still buying “the dips” but hasn’t added any other new positions to his portfolio. Duke Ellington once replied when asked what makes someone a professional in their field, “The pro can do it twice.”
I typically follow a stock for several weeks, or even months, before taking a position. This allows for time to learn about the company, read an annual report, fully understand what the business does and how it makes money, and see what triggers stock price movement. My preference has typically been to buy on weakness or adverse news. But reading some of the thoughtful commentaries that suggest purchasing on strength, has me reconsidering this bias. That a stock’s valuation is improving may a good sign, not an ominous warning.
No answers here, just something to think about.
Even when looking at stocks for the long haul, it makes sense to acquire a position in an equity investment when the odds favor maximizing the long-term returns. As volatility moves stocks over time – some because of macro events (a down market overall), others because of events specific to the stock (bad earnings report) – the investor should always be looking for an edge while avoiding the falling knife.
|True diversification should mean looking across everything we own and ensuring there is always something of value that can be monetized, regardless of the economic environment.|
Investing is not a zero-sum game. It is also a fallacy that someone else must lose money for you to profit. All the talk about “beating” the averages serves only to distract from the point, which is to generate a meaningful return on your investments while minimizing any risk of significant loss. Important and often overlooked is the ability to monetize those assets when you need them. This implies an investor should own a variety of assets, often referred to in the investment world as Diversification.
The notion that you simply have to have a specific number of stocks or mutual funds to achieve a “well balanced” portfolio seems to miss the point; especially when numbers ranging from 10 to 500 have been suggested by very smart people as what it takes to be diversified. Warren Buffett observed that too much diversification is difficult to manage (the actual quote is “If you have a harem of 40 women you never get to know any of them very well.”). The S&P 500 index gets its name from the number of stocks it holds – out of a possible 6000 equities found in an all-U.S. stocks fund.
Yet a laser focus on equity investments is to risk being not truly diversified. If all your assets are in stocks and/or bonds, what happens when financial markets swoon? Were you at all concerned about your stock portfolio during the market mayhem of 2009? On the other hand, if the bulk of your assets are gold coins stored in a safe deposit box what happens if the bank building is destroyed? If most of your assets are leveraged rental properties, what happens when you need cash fast? True diversity should mean looking across everything we own and ensuring there is always something of value that can be monetized, regardless of the economic environment.
One of the most successful family dynasties of all time, the Rothschild’s, have followed a very simple formula for diversification that has proven robust for over 400 years. It is just too easy to look at a stock portfolio or collection of rental houses while overlooking the many other things of value that you own, or that you can add to help create a truly diversified collection of assets. There is a benefit to working with the Rothschild model, even if just as a mental exercise, because it forces you to consider the bigger picture.
- One-third in cash; this includes equities, bonds, T-bills, exchange-traded funds, foreign currencies, certificates of deposit, and pretty much everything else represented by paper.
- One-third in real estate; this includes a primary residence(s), vacation home(s), income-producing property such as ranches, farms, even raw land.
- One-third in art and collectibles; this includes not just paintings and Egyptian antiquities, but jewelry (think gold, precious gems, wristwatches), furniture, fine china and flatware, a classic automobile, and pretty much any object that has a market value and can be sold.
Whatever your financial goals, follow your own instincts, not those of people who might view the world differently than you do. And don’t get distracted by what other people claim to be achieving. Remember, you don’t have to “beat” anything over time to create wealth. The only thing that really matters is the value and availability of your assets when you really need them.
|The most important takeaway from today’s musings is the importance of having a personal Investment Policy to help guide your asset acquisition activities.|
About twenty-five years ago I wrote my first Investment Policy. The intention was to create a document that could help guide financial decision making knowing that my circumstances and goals would change over time. A recent review of that policy (which for a long time I referred to annually; not so much in the last few years) was rewarding and I share a couple of observations here. There were four parts to the original version that have been gently modified over the years. For our purposes today, only the first and second are discussed.
Part one of this investment policy consisted of three sentences intended to be touchstones under any circumstance and have never been changed. It still frustrates me I didn’t grasp the value of these ideas a decade earlier:
- Spend less than we earn
- Eliminate and eschew debt
- Continually increase the value of our assets
Easy to explain the immense worth of these three. First, for most people what they save will be a lot more than what they make with investment speculations. Second, most financial traumas find their origin in debt. Finally, what ultimately matters is having assets that can be monetized when you most need them.
Part two was specifically intended for use when evaluating the merits of specific investments like stocks, mutual funds, and bonds. Later these concepts guided me in acquiring what has become the largest component of my portfolio, real estate (mostly physical but also by proxy in equity markets):
- Being reasonable
- The long-term
- A global perspective
- Reversion to the mean
Over decades the equity markets go up more than they go down.
The actual ratio is up about 60% versus down about 40% of the time. However, this does not hold true for individual stocks. After 50 years, less than 90 of the original members of the S&P 500 are still viable businesses. Over shorter periods of time, the valuation of any given business can vary wildly making it difficult to determine the mean price of any given stock. My frustration when trying to gauge when a stock has gone up too fast (growth) or dropped too low (value) led me to discount the merits of the “Reversion” metric. My heavy involvement in buying and selling rental properties in the half-dozen years before the sub-prime debacle also left me questioning this notion.
Side-stepping the mortgage fiasco of 2008-2009 by pure luck I was able to look (somewhat) objectively at what happened. A personal need to shut down a long-running partnership led to selling an inventory of a dozen rental properties at top prices in 2007 (all but one going sight unseen to buyers in California). This led me to understand very precisely what Nassim Taleb describes as a “Black Swan event.” While continuing to purchase income-producing real estate, I have not and will not re-enter the single-family home rental market.
The conundrum of “Reversion to the mean” versus “Black Swan events”.
So, the conundrum of “Reversion to the mean” versus “Black Swan events” has my mind moving back toward finding more relevance in “the mean” than Black Swans. Mostly due to some challenging reading over the last few years about theoretical mathematics my understanding of how to gauge the mean of a range of numbers has become more nuanced. A Black Swan is by definition unknowable and is best managed by a focus on “Diversification.” In other words, make sure you have a range of relatively uncorrelated assets to prevent a permanent impairment of capital if one of those asset groups becomes unexpectedly worthless. And don’t owe more money than you can repay in a cash crunch.
As for “Reversion to the mean,” it also needs to be understood in terms of “Diversification.” There are many metrics available to assess the value of equity and other investments. Looking just at the stock price (or selling price for real estate) is a risky business. Amply demonstrated by the technology big boys – Apple, Microsoft, Google – price-to-earnings may be a less valuable measure than price-to-sales. Maybe a change in debt level is a better context in which to think about a potential acquisition? When considering if something is worth adding to your asset collection, the exercise of analyzing a mean valuation is worth the effort.
The most important takeaway.
Yet the most important takeaway from today’s musings is the importance of having a personal Investment Policy to help guide your asset acquisition activities. Without some guiding principles, it can be all too easy to get caught up in the madness of crowds or entangled in the webs of greed. Or, as described once as the lesson Warren Buffett offers us, “The pursuit of unchanging goals through ever-changing means.” Think about it.
As it tends to do in tumultuous times, gold is once again shining brightly.
There was a sort-of Mea Culpa recently by one of my favorite financial authors, Jason Zweig, in the Wall Street Journal. Reflecting back on a comment made five years ago disparaging gold as an investment, he admits that the 10.5% annual return has since enjoyed made a hash of that prognostication. And while still urging caution he also offers up some valuable insights. Most important is a reflection on how diverse – and often contradictory – theories on why gold is being recommended at any given time.
At the opposite end of the “why buy gold” spectrum today was exemplified by a recent note from a less informed and more fanatical newsletter writer suggesting Now is the time to buy gold. As it tends to be in these politically extreme publications, the lack of logic is stunning. In the middle of July, a warning is sent about a bill introduced into the House of Representatives in March but now “redacted” (the correct word is “retracted”). But the bill could be reintroduced at some undefined time in the future, and if passed could cause the dollar to crash in value: so, Buy Gold Now. Why was there no recommendation to buy gold in March at less than $1,500 an ounce when there was actually a possibility of the bill passing? Why Buy Gold Now at $1,900 an ounce with that threat/justification gone?
“You can buy stock in companies that mine gold, or companies that sell gold. You can buy futures contracts and gamble on the direction of gold prices without ever taking ownership of anything physical. And, of course, there are mutual funds and exchange-traded funds – some own real gold, others just paper proxies and still others holding both.”
More worryingly over the short term is the simple statistic that one year ago exchange-traded funds held $118-billion in assets and today those same gold ETFs hold $215-billion. That represents a lot of new gold owners buying at a time of record-high prices. Now, just for grins, I offer up a couple of paragraphs from an Invest-Notes blog post on August 4, 2014, discussing some thoughts around asset allocation. This was prior to Zweig’s disparaging comments on gold as an investment:
Perhaps the easiest way to demonstrate this concept is gold.
You can just buy physical gold as bars, coins, or jewelry. You can buy stock in companies that mine gold, like Newmont (NEM) or companies that sell gold, like Tiffany’s (TIF). You can buy futures contracts and gamble on the direction of gold prices without ever taking ownership of anything physical. And, of course, there are mutual funds and exchange-traded funds – some own real gold, others just paper proxies and still others holding both.
However, when gold finds itself out of favor, all of these “diversified” assets will decline in value. In the last ten years, the price of an ounce of gold has been as low as $400 and as high as $1850. Gold has lost nearly a third of its value in the last 18-months. TIF was clearly an outlier in the list above, yet it has seen its share prices move between $19 and $100 over the same time.”
(A quick update; last ten-year pricing for an ounce of gold $1000 to $1,900. For TIF the stock price has been $38 to $138.)
Gold is simply a diversifier that can easily fit into most portfolios in a number of different forms but should be kept to a single-digit percentage of your overall holdings. Personally, I’ve got a couple of dozen gold coins purchased over the last twenty years, and there’s usually a junior gold mining stock somewhere in my equity portfolio. In fact, gold coins like the $20 Saint Gaudens are gorgeous as a physical object and could be classified as either a commodity or an artwork – depending on how specific you get with your asset allocation preferences. More important is knowing that successful portfolios tend to be built over time and rarely by making big additions (or sudden reductions) based on the latest shout-out from the crowd.
Finally, for your consideration, in Investnotes #5 from November 13, 2007:
One of the most successful family dynasty’s of all time, the Rothschild’s, have followed a very simple formula for diversification that has proven robust for over 400 years. There is a benefit to working with this model, even if just as a mental exercise, because it allows for considering the bigger picture. It is too easy to look at a stock portfolio or collection of rental houses while overlooking the many other things of value that are owned, or that can help create a truly diversified collection of assets.
1. One-third in cash; this includes equities, bonds, mutual funds, foreign currencies, certificates of deposit, and pretty much everything else represented by paper.
2. One-third in real estate; this includes a primary residence(s), vacation home(s), income-producing property, and raw land.
3. One-third in art and antiquities; this includes not just paintings and Greek pottery, but jewelry (think gold, precious gems, wedding rings, and wristwatches), furniture, fine china and flatware, and pretty much any object that has a market value.”
|A real investment strategy is not a document or a forecast, but a viewpoint about how to respond to the forces at work around us.|
I am often admonished by my boxing trainer to breathe. Trying to control my footwork and find a proper response to an attack and put my punches in a logical sequence my brain can over-load and I forget to breathe. Time to back-up, clear the mind, regain focus and…breathe. While it is always a challenge to manage our investment portfolios, exceptional times add even more pressure, often leading to poor decision making. Or, just as often and just as bad, a refusal to make any decision. As the old saying goes, “Many a false step was made by standing still.”
So, we’re going to look at some ways to look at our portfolios and do some strategizing (which sounds a lot cooler than ‘financial planning’). Dislocations like the ones we’ve been experiencing during the pandemic suggest previous assumptions may no longer make sense, or even be viable. Time to review our financial performance measurements, think about our biases, make sure our plans (dreams) remain clearly in focus and…breathe.
Step one is to have an investment strategy.
A real investment strategy is not a document or a forecast, but a viewpoint about how to respond to the forces at work around us. A financial strategy simply answers the question, “What does my desired future look like?” What do you want? What do you want to achieve, do or have? And don’t make small plans or aim for easy goals – these do not have the power to push us to achieve the greatness we are capable of.
Next, think operationally.
What needs to be done to achieve success? What allows us to determine if the things we are doing supports our investment strategy, moving us closer to our goals? For any goal related activity, assign a probability of its value, and be honest about it. One way to think about tasks that don’t offer an obvious outcome is to admit, “I am not sure, this is why I am not sure, and this is roughly how unsure I am.” If you can’t convince yourself, or put the odds of success above 80%, then move on to the next idea.
How are you going to operate? How are you going to execute the tasks required to reach your financial goals? Bank (cash and certificates of deposit), brokerage (equities, fixed income, and debt instruments), realtor and/or property manager (real estate), or safe deposit box (gold and jewelry)? Do you want a support team, an investment advisor or are you a lone wolf? Regardless of your choice, there will be a cost involved, just accept that and move on. Remember, the biggest expense will likely be the mistakes you make, including not taking advice from people you are paid for guidance. While most of these types of decisions will only need to be made once, or twice, they can have a big impact on how hard it is to achieve your goals – if at all.
Finally, what are you going to do to limit your downside losses?
Every truly successful investor in the public eye will admit to worrying more about losses than profits. Making a profit on an investment is a possibility, but not certain, and is unlikely to be the result of anything you can influence. The risk of losing money on an investment is a reality and will happen, often because of something you do (or don’t do). If you are risk-averse and find yourself making quick decisions based on emotion or fear, how you answer the questions in the previous paragraph is critical. Investing in stocks and bonds is not a requirement for long term financial success. Saving is far important than investing and most financial problems are caused by debt.
|During the last financial crisis, a manager at UBS commented that every investor should have a “SWAN” account—for “sleep well at night.”|
It’s a fool’s errand to try and explain daily gyrations in equity markets. The ride since the S&P 500 hit an all-time high just a few weeks ago has been dramatic, and any further declines should surprise no one.
“How many things were articles of faith to us yesterday, which are fables to us today?” Montaigne
Moving past more jawboning about the totally unprecedented shutdown of economic activity, the way forward is far from clear. The U.S. economy has been put into a forced coma in an effort to prevent further deterioration (which is not to make light of the terrible physical and emotional toll we see growing around us every day – it is simply a fact that I discuss investments here, not medicine – this analogy notwithstanding). It’s not certain that the government will be reviving its patient anytime soon. And it is possible that the restart will take far longer to achieve than we can imagine.
I suppose we could be generous and suggest that the government has thrown a financial bone (a few trillion dollars) to small businesses and their now unemployed minions. And despite some seeming confusion, it looks like the banks and really big businesses stand to make out pretty good too, again. Yet by implying (promises don’t exist in the House, Senate or Oval Office) that the Fed “will do whatever it takes” for the next couple of months we are being warned the worst may yet be to come.
So how do we save and invest now? Wall Street-ers will tell you that this, too, shall pass. Probably, maybe, or maybe not. Better to wait until the fog clears, or start buying equities now because the first bounce off of the bottom is where most of the gains will come as markets recover? Personally, I’m making assumptions that have led me to use this last updraft to sell some ETFs and build cash for when the time comes to get serious about buying again. I’ll be on the sidelines for a while yet.
“Don’t trust a brilliant idea unless it survives the hangover.” Jimmy Breslin
Two examples are shared here:
First, my enthusiasm for emerging markets has completely evaporated.
Considering the impact of COVID-19 on the United States and our uneven responses, the idea that countries like India (three times the size of the U.S. population with a fraction of the medical infrastructure) will not see economic chaos is unthinkable. The Pacific Rim (and even Russia) haven’t begun to be hurt like the U.S. but almost certainly will. My bet is that supply chains get shorter as the world acts more local than global. After a couple of decades, I’m finally eliminating this asset class from my portfolios. When the time is right, the proceeds will be reinvested into non-U.S. blue-chip companies.
Second, publicly-traded REITs and real estate tied to equity markets will likely struggle mightily over the medium term.
Known for their great yields and high payouts (in the case of Real Estate Investment Trusts, required by law to distribute the majority of earnings to shareholders) it will be tough to pay dividends when companies and people don’t have to pay rent. How many restaurants, nail and hair salons or tattoo parlors will still be needing retail space six months from now? And what are the long-term ramifications of businesses learning that much of what needs to happen to ensure happy customers does not have to happen in centralized locations? Physical real estate makes up the largest part of my investable assets (all of which I’ll note are debt-free) so it no longer makes sense to have real estate exposure through equity markets. These funds will be reinvested in my S&P 500 ETF.
Yet the most important takeaway might just be that cash is still king and liquidity matters more than ever. The focus today isn’t about making money, but preserving it. You don’t want to be forced into making decisions about your equity investments because one or another financial obligations have come due.
During the last financial crisis, a manager at UBS commented that every investor should have a “SWAN” account—for “sleep well at night.” Agreed.
As financial markets continue in their highly erratic trajectory, amid Covid-19, they leave opportunity (as well as shock and awe) in their wake. This is a time when it is especially important to avoid emotional reactions and focus on intelligent decision-making. Revisiting some notes made a decade ago during more quiet times – specifically, the sub-prime mortgage crisis – here are five suggestions that might help to both calm nerves and enhance decision-making capabilities.
1. Don’t make more predictions than your data can support.
As Warren Buffett once noted, “You should invest in a business that even a fool can run, because someday a fool will.” Now that a virus has taken over management at so many companies, we’ll have to see which fools have been the wisest in preparing for tough times. What does the company do and how does it make money? Beyond this, short of being a member of the company’s management team, there’s not much else you can know for sure. Restaurants and hotels will likely take longer to return to normal than makers of household products. Dividends and yield will suffer.
2. Focus on the not-too-distant future; near-term forecasts are more certain than 10-year projections.
The future has always been hard to predict and this fact is unlikely to change just because investors wish it would. Assuming China doesn’t see a second wave of infections (an “if” worth watching for) it appears the worst is now in their rearview. After a few months, life begins to look familiar in Chinese cities. Let’s hope it stays that way and we follow a similar path, needing 24-weeks instead of 24-months to begin our recovery. But there seems little sense to talk about what the economy might look like at this time next year, or even year-end. Always be suspicious of undue emphasis on the long-term, especially when the short-term isn’t looking so good.
3. Be wary of precision; it is better to be vaguely right than precisely wrong.
Too much detail gives a false sense of security. It’s just human nature to think someone predicting that earnings for the S&P in 2020 will be $174.44 must know more than someone who simply suggests that earnings will be more than the estimated $163 achieved in 2019. Yet all we can really expect now is that the S&P will struggle and is unlikely to achieve any growing earnings growth over 2019. Don’t trust anyone making an earnings prediction for 2020 or 2021. The financial markets will likely do worse than what we enjoyed in 2019 and you should plan accordingly.
4. Income isn’t always income.
A stock or stock fund paying a big dividend is not a safe place to hunker down. Even a 6% dividend doesn’t mean much if the value of the underlying asset has dropped over 25% since January (the average for stocks in the S&P 500, so far). Four years of dividends have evaporated and many high yield investments will be forced to cut their payouts, possibly even before the virus fades, adding even further downward pressure to already stressed investments. The current yield of the S&P 500 is now over 4% – which won’t mean much if we’re only halfway to the bottom for equity prices.
5. Avoid greed.
I fully believe that our country will get through this – just as we do with hurricanes and financial shenanigans. But there is currently no end in view to the Covid-19 crisis and bottom-feeding at this point is more likely to make you poorer, not richer. Frankly, if you depend on your savings to live on, consider some selective cash-raising opportunities. Sub-prime saw a 50% decline from top to bottom – we’ve only seen half that amount, so far. At this point panic is bad, but being a Pollyanna might be worse. Make sure your umbrella is big enough to keep you dry until the storm passes.
|We tend to brag about our most recent brilliant investment while conveniently forgetting our more frequent whiffs.|
Chapter eleven from the first book of essays by Michel de Montaigne serves as a welcome reminder that some truths are beyond debate. A minor noble, occasional public servant and prolific reader Montaigne began writing short works of critical self-reflection around 1570. He referred to these works as essays and, effectively, created a novel genre. (As a side note, 400 years later the Argentinian Jorge Luis Borges would, effectively, perfect the essay.)
The title of chapter eleven is deceptively perfect as it relates to our theme herein, investing. This brief essay covers two important topics often overlooked by individual investors; survivorship bias and forecasting. As to the first, we’ll quote Montaigne, “Besides, no one keeps a record of their mistakes, inasmuch as these are ordinary and numberless; and their correct divinations are made much of as they are rare, incredible and prodigious.” As has been often reflected upon here at Invest-Notes, when reviewing every stock transition I’ve made over a 12-month period, the many bad trades are inevitably left in the dark, overshadowed by the occasional big winner. We tend to brag about our most recent brilliant investment while conveniently forgetting our more frequent whiffs.
The glaring error in an otherwise interesting book on the wealthy, The Millionaire Next Door, is this failure to acknowledge the losers. We meet a few very successful businessmen, owners of dry cleaners, who have quietly amassed meaningful fortunes. But no mention is made of the thousands of dry cleaners who not only didn’t make a million dollars but went broke trying. Montaigne tells the story of a skeptic in ancient Greece shown a chapel filled with votive offerings from sailors who survived shipwrecks to prove the beneficence of the gods. The skeptic observes, “Those who were drowned, in much greater numbers, are not portrayed here.”
More importantly, we talk about the records of Warren Buffett and Peter Lynch though never discuss the vast majority of professional investors who went broke or settled into quiet mediocrity. There is a reason books that discuss the “habits of super successful investors” all seem to talk about the same people. Not that many people are successful over a meaningful period of time. Of course, there are big winners, but always remember that the losers are “numberless.” Only with hindsight do we know who survived. This applies equally to individual stocks and hedge funds – no one talks about the ones who didn’t make it.
“…there is no use in knowing what is to be, for it is wretched to be tormented to no purpose.” -Cicero
As to forecasting, we should all know better. The idea that we can tell what is going to happen to the price of any individual stock over a period of a few months is self-deceptive. An analysis showing where a stock price will be 5-years from now is a lie. It has been demonstrated that over meaningful lengths of time the equity markets go up more often than they go down, so while dips can be ferocious, recovery has proven a relatively safe expectation. But this is based on the movement of a cohort of equities, not an individual stock.
As Nassim Taleb has said repeatedly, if the author of that glowing 5-year analysis doesn’t have at least half his net worth invested in the stock under discussion don’t believe anything being said.
The follow-on is our tendency to look at how much we can make instead of how much we can lose. Yes, there is money to be made if an investment increases in value. But when a company you invest in goes bankrupt (as recently happened to me with a private equity deal) being able to write-off the loss is small consolation. At the time I did the deal it never occurred to me that a total loss of invested capital was a possibility. But the lesson learned was a confirmation of one of the most important rules when investing; never make a bet so big that a loss can leave you with a permanent impairment of capital. While painful, and embarrassing, financially there is no change to my lifestyle or future prospects.
So, since we can never know the future we must avoid prognostication. Because when our bets on future outcomes start going off track, or derail completely, the best we can do is reflect wistfully on what might have been. This, in turn, can lead us to fear the future. What if we are wrong again? Opportunity becomes something to be feared, best to avoid. Instead, focus on the here-and-now, what we know and not what might be. I’ll be doing more private equity deals but now with a focus on risks, not just rewards.
|Successful investing is almost always a result of critical thinking and patience. When you decide to purchase any financial investment the reasons you would sell are just as important as why you are buying.|
An unfortunately common story heard from investment managers is about the tendency for people to panic during market drops. The problem is multifaceted with otherwise sober investors suddenly trying to time the market, taking losses on stocks, giving up dividend income and possibly generating unnecessary tax bills. And when the panic ends? How to determine when to start purchasing equities again, yet another opportunity for market timing – an activity long demonstrated to be harmful to your portfolio.
This is not to say an investor should never sell, just that any decision to make changes in the holdings of a portfolio should be a result of planning, done deliberately and with intention. Not during a time of emotional and financial stress. And while tax implications don’t apply to IRA or other retirement accounts, we must still be mindful of what an unrealized gain means.
So, let’s do a thought experiment today. We’re going to look at a gold coin (let’s make it a one-ounce American Gold Eagle) and ten shares of Apple stock (AAPL). Let’s assume that these assets are in a retirement account that is unlikely to see any withdrawals for another decade. Today that gold coin is worth about $1,450, and the ten AAPL shares around $2,000. Now for the fun…
In 2016 that gold coin was valued at $1,100, but in 2011 it was about $2,000. It is the same coin and has never been removed from the safe deposit box since 2006 when you originally purchased it. With a current value of $1,450, have you made $350 or lost $550? Yes, a trick question, since you only paid $600 for that American Gold Eagle in 2006. Same with AAPL; in 2016 the ten shares were worth about $950 and in 2012 they were worth $750. But in 2006 you paid $150 – yes, one hundred and fifty dollars for ten shares.
In summary, for both the coin and the stock over the last ten years each has been worth more and less than their value today. Selling in a panic could mean you create a tax liability further diminishing any gain. In a taxable investment account, if you sell the coin or the stock you immediately owe tax on any gain but can deduct any losses against profits from other equity sales. In a retirement account, you don’t owe taxes, but if you sell at a loss, you cannot use that loss as a tax credit to offset other winners. In theory (and real-life) you can buy a stock, sell it for what you paid for it, and still lose money. Or take big losses that can’t be used to offset profitable trades.
Until you sell an asset it is only worth whatever anyone will pay for it. Gold has demonstrated an ability over very, very long periods of time to be an asset that holds its value. Consider that Benjamin Franklin wrote that in his lifetime an ounce of gold would buy a very nice suit. And a bespoke suit can be had today for $1,500. Holding gold in your portfolio is a way to preserve wealth rather than create it.
As for AAPL, well, the first iPhone was sold in 2007 spurring a revolution in communication that led AAPL to become (on-again, off-again) the most valuable company on the planet. But whether a share costs $12 or $200, it still represents only a minuscule ownership stake of a publicly held company that has demonstrated a highly volatile price history. AAPL has also shown, that like the overall markets, while the water is often choppy, it has historically gone up more than it has gone down and continues to seek a higher level. A poor earnings report can mean a dive in the value of individual shares but is as likely to be temporary as not. Until such time as AAPL begins to underperform consistently or suddenly faces formidable competition, a snap decision to sell could prove to be an expensive mistake. AAPL is in your portfolio with an eye towards making a profit.
Whether either investment should have a place in your collection of assets is determined by your goals. And when you decide to purchase any financial investment the reasons you would sell are just as important as why you are buying. Successful investing is almost always a result of critical thinking (don’t panic as markets move dramatically up or down) and patience (it’s a marathon, not a sprint). Heaven is not the day after tomorrow.
|The analogy of keeping credit risk low coupled with the value of dividends as a potential income stream suggest it is possible to move the odds, as much as possible, in your favor with some thoughtful analysis…. or put another way, you want to create a steady income by only using financially solid stocks.|
When loaning money for a home or automobile purchase lenders rely heavily on a person’s credit score (also known as a FICO score). The idea being, that certain behaviors and traditional spending patterns can determine risk levels – the higher the score, the lower the risk of default. Traditionally scores were based on things like your history of timely (or not) payments on other debts; the length of your credit history and how much you currently owe; other types of credit you have (or had) including charge cards, loans, mortgages, and banking history.
Recently, in an effort to improve predictions of creditworthiness, some new information is being collected and aggregated. Gathered mostly from digital sources, it’s worth considering how you might stack-up against these new data points: uses both names in contact information forms; consistent travel patterns; limited contact with few entities; uses Uber; and, no regular contact with people who have bad credit. Now you really know why they want you to keep that location finder activated on your mobile device and check-in at Facebook regularly.
The reason I bring this up is due to shifts in the investing landscape which makes some traditional metrics used to measure value not so effective and suggests we might need to reconsider what criteria to use in scoring our investment prospects. Traditionally there have been three go-to metrics to make a quick, back of the napkin assessment of a potential equity investment. In other words, what’s the fastest way to determine the creditworthiness of a business you are thinking of owning part of? This, in turn, allows you to focus on learning more about only stocks that fit your investment profile.
A prime example is the price-to-book (P/B) ratio. Essentially the P/B value of a company is a measure of debt to assets – which when divided by the number of shares gives a ratio that might be a reasonable measure of financial soundness. An example of how this works is to look at a million-dollar piece of real estate owned by an individual.
When what looks good is bad.
If you own (hold the title) on a property valued at a million bucks, there are a couple of scenarios that can make this good or bad. If you hold a clear title (no mortgage or commercial loans) then you have an asset that reflects positively on your total net worth. On the other hand, if the property was financed by a loan of $1,00,000 and due to the vagaries of the real estate market it is now worth less than a million, you are at-risk – the property is a liability. This same concept was for a long time a significant marker for making investment decisions. The value of the tools a company uses to make its products can ensure the ability to survive hard times. If a factory and the land it sits on, are mostly paid for, this can make for an attractively low P/B. A business that owns a fleet of company vehicles has a liability, not an asset. The vehicles are depreciating items needing to be insured, maintained and ultimately replaced. The fleet can only be sold for less than the acquisition price and incurs an ongoing expense. Your loan to this company (through the purchase of stock) carries greater risk and would have a high P/B.
With outsourcing, a now standard practice, a company like Amazon (AMZN), that absolutely requires delivery vehicles, can operate just fine without actually owning any trucks. Uber (UBER) is now the biggest taxi service in the world, and they don’t own vehicles. The drivers who use Uber’s software to operate as individual contractors are the ones responsible for purchasing and bare all associated expenses. So, with hard-to-value assets like intellectual property being the driver of value, P/B might not provide much insight into a company’s cash value. And when a company gets in financial difficulties or goes bankrupt, fixed assets can often be the only way investors can recoup even a fraction of their investment. For our discussion, let’s compare AMZN and Apple (AAPL). P/B for AMZN is over 18, for AAPL 8 and generally speaking a good ratio is less than 4. This could imply that your investment in AMZN has a greater credit risk than AAPL, even though AAPL carries a P/S double the average.
Another classic metric is the price-to-earnings (P/E) ratio. Assuming that a company is profitable – that it makes more money than it spends – the P/E is a reasonable way to calculate how much owning part of that profit stream will cost. A low P/E implies that the cost to buy some of a business’s profits is reasonable and that at some point in the foreseeable future you will have paid off the cost of your investment and the profits can become income. This might be best understood by thinking about dividends. If you buy a share of stock for $20 and get an annual dividend of $1 (5%) at some point you will get back what you paid for the share (which is then an asset, like a loan-free piece of real estate) and the dividend becomes income (like receiving rent from that loan-free piece of real estate).
But when a company isn’t profitable either there is no P/E or the gap between what the company is spending versus what it is earning becomes untenable. The P/E for amazon is north of 70, where the average long-term ratio for the market as a whole is around 18. This implies that it could take up to 4x longer for your investment in AMZN to become profitable than one in AAPL whose P/E is 16. One excuse investors use to justify stocks with a nosebleed P/E is that they have “momentum.” The assumption is the company is growing so fast that eventually, they will make more money than they spend. One culprit of the dot-com crash at the start of the new millennium was this kind reasoning.
In a similar vein, the price-to-sales (P/S) ratio can help identify stocks whose price offer compelling value. Using a formula that includes the total value of a company (the market capitalization) and the number of shares outstanding divided by 12-months of sales or revenue the P/S is like the P/E since it is intended to quantify the value of individual shares. The biggest limitation of the P/S is it doesn’t take into account if a company is profitable, or will ever be profitable. Using our example one more time, both AMZN and AAPL have a P/S of 3.5, which is considered high, but not unreasonable.
Now a quick summary. AMZN has rarely been profitable and continues to spend more than it makes. According to our traditional metrics, its P/B suggests it is a risky investment; the P/E suggests the stock is expensive and doesn’t offer much value; but, the P/S implies the stock is not grossly overvalued. AAPL has long been profitable by making things like phones and computers for both business and retail use. The P/B reflects less credit risk than AMZN, but more than average. The P/E says this is a good time if you want to buy some stock, while P/S urges caution around equity purchases. All of which points to a merely average credit score for AMZN and a slightly better one for AAPL which also gets points for paying a dividend (making for a quicker payback on that initial purchase of stock). One last point here, now that Microsoft (MSFT) had got its groove back it scores between AMZN and AAPL using our criteria here.
What does all this mean to you?
The most widely held exchange-traded funds are SPY and VOO, both indexed to the S&P 500. Passive investors and their retirement accounts (401Ks and IRAs) should be anchored with a large position in one of these index funds. The primary reason being that in any given year most of the stock market gains will come from just a handful of stocks. By owning a fund composed of the 500 biggest and usually best companies in America you get to take advantage of the fact that stocks go up more often than they go down. Investors get the benefit of upside in the winningest equities and at the same time hedging the performance of struggling stocks while still earning a modest dividend.
Hopefully, you have accounts intended for both short-term needs and long-term goals. These should be structured to meet your investment objectives and would likely vary in composition. Specifically, outsized risk should play no part in a retirement account, especially as you get older and the opportunity to rebuild after a significant loss becomes more daunting. The analogy of keeping credit risk low coupled with the value of dividends as a potential income stream suggest it is possible to move the odds, as much as possible, in your favor with some thoughtful analysis.
As it currently stands, of all 500 companies in the S&P index funds, MSFT, AMZN, and APPL make up a full 10% of total shares. The benchmark index is structured so that stocks with the largest market capitalization have a heavier weighting. The alternative for an S&P index is an index fund that is equal-weighted – meaning regardless of company size, all components in the fund have an equal percentage of shares. An example is the Invesco S&P 500® Equal Weight ETF (RSP) where the total shares of each company are around .23%. So, the MSFT-AMZN-AAPL triad makes up less than 1% of this index. I own two of these funds in a ratio of 65% VOO to 35% RSP and regard the combo as a single holding.
Personally, I still find the idea of weighting as criteria for fund composition a bit uncomfortable, which explains why S&P index funds are only 25% of the equity holdings in my retirement accounts. If you subscribe at Morningstar, one of their more valuable tools is a program that aggregates all the holdings in a portfolio and compares them to the S&P index. By comparison, my IRA is composed of 14 individual investments, not all of which are index funds, with several holdings having been in the account for a couple of decades. The idea is to increase the dividend stream without using riskier equities. Or put another way, I want to create a steady income by only using financially solid stocks. According to Morningstar analysis, my IRA has both a lower P/E and P/B ratio and almost twice the yield of the S&P 500 index. In an account intended for the long-term, I aim to keep my portfolio credit score high.