|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.
|An interesting quote from The Economist: “Finance is a brain for matching labour to capital, for allowing savers and borrowers to defer consumption or bring it forward, for enabling people to share, and trade, risk.”|
For most of us, the second part of this elegant description of basic capitalism is what drives us to pursue investing in general, and the equity markets in particular. As savers, we defer consumption (save rather than spend) for many events; a first home, a second home, college funds for our kids, retirement for ourselves, etc… As borrowers we bring consumption forward (using loans and credit), for good reasons and bad; the mortgage on our homes, a really expensive watch that we quit wearing after a few weeks, etc…
Strike a balance.
The trick is to strike a balance between what we have and what we owe. Few people are able to buy a new home outright with cash, so a mortgage is usually inevitable. But as long as there is growing equity – a meaningful down payment and the shortest loan period manageable – the house feels more like an asset than a liability. The same idea applies to equity investments. Striking a balance between conservative, income-producing investments and riskier, but potentially more lucrative bets. Through this process, we strive to end up with more assets than liabilities, with more cash than debt, with more peace of mind than useless stuff.
And this gets to the heart of many financial problems, which is a failure to adequately balance assets and liabilities. Owning a million-dollar home isn’t all that great if it cost $1.1 million and was purchased with no money down and a 30-year mortgage that doesn’t begin to create equity until after the first dozen years of monthly payments. This home isn’t a person’s biggest asset but their biggest nightmare.
Over time, with much work and patience.
While enjoying an interview with jazz guitarist Pat Metheny this weekend a comment germane to the discussion of how to be a better investor – or, steward of personal assets – loomed large. He was talking about the changes he has seen while touring worldwide with his band (since 1977) of how people treat time. Metheny stated that people have become, perhaps, too cognizant of how they manage time. Everything is now expected to be accomplished quickly and efficiently. But, he said, to reach the level of expertise required to become a professional musician requires a lot of time and practice – and this cannot be done quickly or efficiently.
Warren Buffett once wrote: “It is not necessary to do extraordinary things to get extraordinary results.” An interesting observation from a guy who did not become one of the richest people on the planet quickly and efficiently, but over time and with much work and patience.
The markets we face today are some of the most volatile in recent memory. Previously reliable correlations between asset classes have broken down. Investment options never before available to individual investors now come in several varieties. We can invest in businesses located and operating, almost any place on earth. And corporate malfeasance, government intervention, currency fluctuations, communications interruptions, disruptive technologies, and irrational behavior still remain challenges to profiting as an investor. Being able to operate in this environment is not a skill that will be acquired quickly and efficiently.
A good beginning.
Becoming a successful investor will not happen by reading the latest edition of Investing for Dummies, or following the weekly ramblings of a financial columnist, or spending a weekend visiting investment web sites on the Internet (though all these things executed in tandem are a good beginning). Yes, people win lotteries, but not deliberately because of their actions, or more importantly, repeatedly over time.
So remember, try and keep three or four months of cash-on-hand for emergencies, keep the majority of equity investments in conservative instruments and avoid using debt to fund a lifestyle your paycheck can’t.
|A market pullback is likely, maybe even inevitable, but market timing is a dangerous game. Carefully and over time is the preferred method of creating wealth.|
With lots of anecdotal evidence suggesting caution when betting on the equities markets these days, maybe we shouldn’t be. An oft-discussed subject in what passes for financial commentary is the sell-in-May-and-go-away theory. The debate is framed by the biases of the respective authors and can be used to support both action and inaction. Then again, maybe it could be a bit of both?
The Boys at Bespoke point out that the results of market returns during May over the last 20 years has appeared to be influenced by the direction of indexes during the first part of the year – May is more likely to be up if equities had a good start to the year. June has statistically proven to be worse than May, but then July has traditionally seen relatively strong returns. And their advice seems about right for most casual investors, “hold-in-May-and-go-away.”
Looking at the views of people whose musings I tend to respect, current market valuations are higher than one might like to see as net purchasers for the long term, but certainly not unreasonable. The recent (apparent) lack of market volatility has masked an underlying trend of segment sell-offs, making last year’s high flyers today’s dogs. And investor sentiment, far from enthusiastic, seems to suggest a continued reluctance of the individual investor to earnestly commit to embracing individual stocks.
So my bias has been toward action over the last couple of months, as it will likely remain over the early part of the summer. Adding the S&P ETF (VOO) on the big down days, but also picking up smaller and more volatile stocks for the short-term. A couple of the names I’ve been playing with (and this is pure gambling) are IRVRF and RUTH. There are still some nifty stocks to own over the long haul (for those of you with some history in the markets, not any nifty-fifty type of opportunities) but these are intended specifically for retirement accounts due to their yield and opportunity to add a bit of upside to a basket of sector-specific ETFs (LTC and BX as examples).
Yes, a market pullback is likely, maybe even inevitable, but market timing is a dangerous game. Just ask Warren Buffett, successful investing is a marathon, not a sprint. Carefully and over time is the preferred method of creating wealth.
|“Avoid the unforced error, nail the basics and don’t take outsized risks” might be the best advice the individual investor can follow.|
An often-underestimated influence on equity and bond markets is the heavy hand of luck. Frankly, you can do everything “right” and still get bad results. And since luck can’t be controlled, knowing how to react – whether that luck initially appears to be good or bad – can separate winners from losers. But just because something can’t be controlled doesn’t mean it can’t be managed.
We all know bad things happen that are beyond our control to foresee or influence. Fires, floods and financial crisis come to mind. So we buy insurance, avoiding home purchases in areas prone to flooding and create investment portfolios that are well diversified with a healthy dose of cash savings. But what else?
One of the best thinkers on this subject, and a terrific writer to boot, is Michael Mauboussin. The man knows how to think about how we think – especially as it relates to investing. I read his terrific 2012 book, The Success Equation, when it first came out. Subsequently, the opportunity to hear him talk about his book in person helped to clarify some of his more nuanced arguments and observations.
One of the many surprises that will be found in The Success Equation is an important reason why individual investors should look to exchange-traded funds as their best bet to achieving financial goals when using the stock markets. Discussed in many posts here at Invest-Notes, by choosing to invest in indexed funds smaller investors earn the market averages over time with much less risk or cost than owning individual stocks or traditional mutual funds. Remember, for as long as equity markets have been measured, they have gone up more often than they go down.
Let the Big Dogs Bark at Each Other Instead of You
As noted recently in The Economist, 70% of U.S. stock markets are now owned by large institutions like Blackrock, Vanguard, Fidelity, pension funds and hedge funds. That percentage was just 35% in the 1980s. This means the self-described investment professionals are competing against each other more fiercely than ever before. As Mauboussin intriguingly suggests, the more skill involved in a competition the bigger the impact of luck on the outcome.
As a reality check, the following is from the prospectus of an initial stock offering (IPO) for a high-tech company that went public in March of 2017. Hyped by many, including the original investors then in a position to sell their much-appreciated shares, this quote sounds like a fair warning in my books, “We have incurred operating losses in the past, expect to incur operating losses in the future, and may never achieve or maintain profitability.” But if this is such a great investment, why would the private owners want to sell their stock in the company? If you had purchased shares at the IPO, you paid the original investors around $26 per share. Your investment is now worth about $13. So, as two of the biggest money-losing companies on the planet begin selling shares, no names but they provide ride-sharing services, best to avoid this ride.
By being honest and observant about the outcomes of our investment strategies – repeatedly and over time – we can create mental models that help anticipate the unexpected (to minimize risk) while expanding opportunities (to maximize upside). You can easily improve your overall return just by minimizing costs like fees and commissions (nail the basics). You can stay calm and remain inactive during times of great stress (avoid unforced errors). You do not have to go head-to-head with the pros (no outsized wager on a hot stock tip).
As Rudyard Kipling noted a century ago, just ”…keep your head when all about you are losing theirs…”
More on… “The Success Equation”-Michael Mauboussin:
The pursuit of wealth (and then figuring out how to keep it when successful) has a long history. The wide-ranging insights below are offered without commentary. However, where additional context is available a good source has been recommended on the pundit or their life. I have read all of the books suggested.
Circa 600 BC
“The observation of the numerous misfortunes that attend all conditions forbids us to grow insolent upon our present enjoyment, or to admire a man’s happiness that may yet, in the course of time, suffer change.”
(Nassim Taleb translates this into the vernacular by quoting Yogi Berra, “it ain’t over until it’s over” in Fooled By Randomness, 2001)
Leonardo da Vinci
“Do not undertake things if you see that you will have to suffer in case you do not succeed.”
“Trust only those who have exercised their minds not on proofs of nature but on the results of their own experiments.”
Estimated net worth in current dollars: $400,000,000,000
(J.D. Rockefeller clocked-in at only $340,000,000,000)
“When I go to bed, I face no obstacles to sleep. I remove with my shirt all the cares of battles and business.”
“I will earn a profit as long as I can.”
The Richest Man Who Ever Lived, Greg Steinmetz, 2015
Netted $3,000,000 in the 1929 market crash.
(Went bankrupt twice before and after 1929)
Cut your losses quickly.
“If a trader doesn’t know his exit before he takes the entry, he might as well go to the racetrack or casino where at least the odds can be quantified.”
Let profits ride until price action dictates otherwise.
“It never was my thinking that made the big money for me. It always was my sitting.”
Control your emotions.
“All through time, people have basically acted and reacted the same way in the market as a result of: greed, fear, ignorance, and hope.”
“Buy all-time new highs.”
“We have met the enemy and they are us.”
“One investor’s two rules of investing:
- Never lose money.
- Never forget rule #1.”
“Concentrate your investments. If you have a harem of 40 women you never get to know any of them very well.”
“Investors operate with limited funds and limited intelligence: They do not need to know everything. As long as they understand something better than others, they have an edge.”
“If I had to sum up my practical skills, I would use one word: Survival.”
Money Masters of Our Time, John Train, 2000
“Excesses in one direction will lead to an opposite excess in the other direction. Think of the market baseline as attached to a rubber string. Any action too far in one direction not only brings you back to the baseline, but leads to an overshoot in the opposite direction.”
“Fear and greed are stronger than long-term resolve. Investors can be their own worst enemy, particularly when emotions take hold.”
“When all the experts and forecasts agree — something else is going to happen.”
As Stovall, the S&P investment strategist, puts it: “If everybody’s optimistic, who is left to buy? If everybody’s pessimistic, who’s left to sell?”
Considered one of the most successful hedge fund managers of all time.
“Make all your mistakes early in life: The more tough lessons you learn early on, the fewer (bigger) errors you make later. A common mistake of all young investors is to be too trusting with brokers, analysts, and newsletters who are trying to sell you something.”
“Don’t make small investments: You only have so much time and energy when you put your money in play. So, if you’re going to put money at risk, make sure the reward is high enough to justify it.”
For more: More Money Than God, Sebastian Mallaby, 2010
Investor and author of What I Learned Losing A Million Dollars, 1994
“There is an inverse relationship between your threshold for pain and success in the markets, so as soon as you feel the pain: get out.”
“I am always thinking about losing money as opposed to making money.”
“No matter how you cut it, there are enormous emotional ups and downs involved.”
More Money Than God, Sebastian Mallaby, 2010
Now, who and what can you add to this list? Leave your comments below…
|Don’t let hubris or fear keep you from considering participation, even in a small way, in the world economy.|
It is a fact that the U.S. now accounts for only 40% of the world’s stock market capitalization. Yet a look at international rankings of market capitalization by country tells a more nuanced story and confirms that the U.S. remains the best bet, by a long shot, for equity investing. However, Invest-Notes has from its earliest days been an enthusiast of international equities. As with most asset classes, international exposure is best pursued through exchange-traded funds, such as VEU (discussed below). And with the recent drawdown in prices around the world, international stocks might be an interesting place to invest some retirement account money at the first of the new year.
After the U.S. the second spot of most valuable equity markets is held by Japan with 7.75%. Number three is China at 7.5% followed, surprisingly, by Hong Kong at 6.75%. Great Britain and France round out the top six with less than 5% each. More importantly, over the last ten years, the U.S. has gone from 34% to the current 39.81%. We are not losing ground to Asian or European nations, but instead growing at an impressive rate. Reports of our economic demise have been wholly mistaken. Japan, Great Britain, and France have all lost ground with the annual growth for China and Hong Kong at about 2% each. This bears taking a moment to think about. Hong Kong has a population of 7.5-million people in a land-locked area of 426 square miles; China has over a billion people occupying 3,700,000 square miles. Even New York City has more land and people than Hong Kong.
Looking behind the headlines, major S&P 500 exchange traded funds (SPY, VOO, RSP) remain the smartest choice for most individual investors to keep most of their long-term savings and investments. Again, get past the hype, and even after the big drop over the last few weeks, the S&P is still flat for the year (though when I originally started work on this article a couple of weeks ago, the S&P was up 5% for 2018). By comparison, the exchange-traded fund used as a proxy for Chinese equities, ASHR, is down over 25% year to date. Over the last 5, 10 and 20-year periods the S&P 500 has delivered annual returns of over 10%. The often-repeated idea that the U.S. is somehow losing its status as the big dog in global finance is wrong. However, hubris is always a bad approach to investing strategies.
Hubris is not an Option.
In their just-released The World in 2019, The Economist features three articles offering thoughts on how world markets might perform next year. On the one hand, there seems to be some level of confidence that the current bull market in America will see at least month 121, an anniversary of what would become the longest market expansion in U.S. history. On the other hand, these same pundits all suggest our next recession will likely begin before the end of 2019.
But the most intriguing suggestion is to ask whether the gap between the U.S. and most other world markets begins to close because the U.S. economy weakens, or everyone else gets stronger or even just stabilizes. One prognosticator suggests that if the U.S. markets soften, the rest of the world will tumble in tandem. Perhaps though trade wars and U.S. federal reserve interest rate hikes could begin to bite domestically more than internationally. Reversion to the mean is not guaranteed, but it happens surprisingly often.
So, why is investing in foreign equities a good idea right now?
Because there have been and will continue to be times when in the on-going race for returns, international stocks can retake the lead position. My best bet is that most readers have not added any international exposure to retirement accounts in a long time.
An exchange-traded fund like the Vanguard All-World Ex-US Index (VEU) make very good sense as a method of diversification. First, VEU currently offers a 3.1% dividend. Second, the expense ratio is 0.1% (that’s one-tenth of one percent). Finally, the U.S. still only has 40% of the equities markets, and there are some very fine companies worth holding in your IRAs and 401Ks. Stocks like Nestle, Novartis, Toyota, Royal Dutch Shell, and Samsung are solid investments – and better owned in a fund than individually. Don’t let hubris (only local matters) or fear (the world has gone crazy) keep you from considering participation, even in a small way, in the world economy.
|The investment books most likely to improve one’s abilities to invest successfully will not be the ones providing recommendations of what stocks to buy, and right now. Most valuable are books providing information to help guide intelligent decision-making.|
The investment books most likely to improve one’s abilities to invest successfully will not be the ones providing recommendations of what stocks to buy, and right now. Nor will a book simply offering models of fund-centric portfolios based on the age, temperament or any other attributes of their intended audience. Most valuable are books providing information to help guide intelligent decision-making. Though the classic works of Benjamin Graham and Philip Fisher are often recommended, their extreme technical orientation serves mostly to alienate less obsessive investors. Below are some suggestions for the less rabid, but no less enthusiastic investor looking to get smarter.
A great place to begin is Winning the Loser’s Game by Charles Ellis, originally published in 1985. It is far too easy to be blinded by success stories like those of Warren Buffett and Peter Lynch. The simple reality – clearly demonstrated by Ellis – is that few people (or mutual funds and their managers, or individual stocks) manage to consistently beat the market over time. His explanation of how people can appear to be great investors when in fact their success is due to statistical survivorship bias is eye-opening. Understanding the damage we inflict on ourselves through preventable mistakes, high-risk gambles and most significantly the fees we choose to pay as investors is vital if we want to be successful as investors. How could have taken over thirty years for this message to sink in?
A personal favorite from 2012 and one, it should be noted that several Invest-Notes readers have been less impressed with, is Antifragile by Naseem Taleb. This investment book is a refinement of his first work, Fooled by Randomness, published about twenty-five years ago. Taleb goes way beyond the idea of a “Black Swan Event” (a term he coined, and title of his best selling book, though not a favorite of mine) and discusses not only how to avoid unexpected events, but how to benefit from them when, not if they happen. As Taleb cleverly explains: experts aren’t; things that can’t happen will; and like physical exercise, stress can be harnessed for self-improvement. Don’t let his arrogance distract you from the invaluable insights being offered. Taleb’s most recent book, Skin in the Game, published earlier this year is also terrific – but more valuable if read after Antifragile.
Another good primer is the original edition of The Millionaire Next Door published in 1996. That some of the book’s conclusions have been shown to be faulty does not take away from the value Millionaire can offer would-be Warren Buffett’s. Short of winning a lottery (and that includes the genetic lottery), fortunes are most likely to be built over time, through luck, hard work, and patience. The many stories discussed in Millionaire provide practical examples of how to make the most of our current situation. This includes the single best thing anyone hoping to accumulate significant assets can do: Live beneath your means. It also helps explain why on lists of the wealthiest Americans over three-quarters are self-made, having created a fortune rather than inheriting one. Yes, you can be the millionaire next door, just not right away.
While The Essays of Warren Buffett is on many lists (and is on my bookshelf), there is another text providing a more insightful overview of how great investors operate. This book from 2000 also demonstrates beyond any doubt that there is no one single path leading to success. Money Masters of Our Time, by John Train, provides provocative insights into the thinking of seventeen of the most successful investors of the 20th century. It is here you will see that Buffett’s earliest successes came with risk most of us would never consider and that he has never repeated. Also worth noting is that several of these investors, among them some of the richest people on the planet, don’t use their wealth as anything but a scorecard. If there was ever proof demanded that having all the money doesn’t necessarily equate to happiness, this book is it.
Finally, More Money Than God by Sebastian Mallaby can do more to explain hedge funds, what they do, and how they work than other investment books you can read. The U.S. financial system, and the Wall Street crowd, in particular, have never met a good idea that couldn’t be abused and corrupted. Read in tandem with Money Managers, the world of investing will look very different when you’re done. The origins of these curious investment vehicles (and the people who created them) are fascinating, with many of the concepts still applicable, even for the individual investors reading this note.
|“All card playing is not gambling, all stock purchases are not investing…”|
– Jim Paul, What I Learned Losing a Million Dollars
What the heck is an investment plan? Open a brokerage account or interview a financial planner and you get handed a questionnaire intended to help determine what kind of investor you are – or will be, as a new client. But how do you answer a question like “Rate your tolerance for risk on a scale of 1-to-5?” A person willing to blow $1000 at the blackjack table while on a vacation in Las Vegas could be appalled at losing that same $1000 on a stock purchase. The glib advice – embarrassingly repeated at Invest-Notes on occasion – that everyone should have “An Investment Plan” isn’t really much help.
Investors must know themselves
Creating an investment plan is not complicated, but it does involve some critical thinking. First, acknowledge we have no control whatsoever over the movement of investments like equities, real estate or gold. There is no way to know if a stock is going to go up, and if it does, how high it can go. On the other hand, how much money you are willing to lose is entirely up to you. In essence, your investment plan is simply a set of rules to ensure that you never lose more money than you can afford.
As an investor, you can tell yourself that the stock you just bought is going to double in price, but that’s just a guess. Deciding that you are not going to lose more than, let’s just say 20%, while waiting to see if your guess is correct is the purpose of a plan. Conversely, suppose you are right and the stock does go up 100%. A decision made in advance to sell the stock anytime it drops more than 20% as the price goes up ensures you turn some of those paper profits into real ones. Prudent investors manage risk by making sure they never let emotions influence their decision making.
Second, you have to decide who you are every single time you make a transaction involving invested capital. You will not always be the same person, and if you become someone new in the middle of an investment episode your odds of failure grow exponentially. Along with a decision on what you are willing to spend in pursuit of a gain, you need to consider who you are. In the final analysis, it’s deciding in advance whether a piece of real estate, a stock, or a poker game (there are successful professionals in this field) is an investment, speculation or a gamble.
Invest-Notes continues to forcefully urge that individual investors anchor their investment and retirement portfolios around exchange-traded funds (ETFs). Specifically, indexed funds of the S&P 500 and international blue-chip stocks. Around this central component, it might make sense to add specialty funds, like those comprised of medical companies (for growth) or utilities (for yield). For the truly adventurous, and being mindful of the risks involved, having a handful of individual stocks can also make sense.
Individual stocks of major companies will find that on September 30, 2018, the description of what business they are in will change. This is not as odd as it might sound. Netflix started as a business to rent DVDs by mail. Disney made cartoons. AT&T was the phone company. Today Netflix has something like 125 million subscribers to a streaming video service that not only offers the same movies they used to rent but creates more custom content than the three TV networks combined. Disney now owns theme parks and ESPN. AT&T just bought Time Warner, go figure. As businesses evolve, so should the way in which we invest in them.
During the formative years of Invest-Notes, there was often discussion of specific trades. After the market mayhem of 2008-2009, not so much so. The shift in focus went from what to trade, to how to trade. This idea of talking about ways to make smart investments by thinking about our behavior will continue, but right now we’re going back to being very prescriptive about a specific investment idea.
New kid on the block
There is about to be a brand-new industry sector that will be composed of big companies coming from other sector funds. This matters, because the Big Daddies of indices, S&P Dow Jones and MSCI, use the GICS stock classifications to determine things like whether Home Depot should be identified as a Consumer Staple, or a Consumer Discretionary stock. In their turn, the Big Daddies of exchange-traded funds, like State Street and Vanguard, use these sector definitions of the S&P 500 and MSCI to decide what stocks will be included in the ETFs that individual investors are buying in ever-increasing amounts.
As a quick reminder, the Global Industry Classification Standard (GICS), is a worldwide standard for stock classification. Established in 1999 with ten sectors, the GICS started with: Consumer Discretionary; Consumer Staples; Energy; Financials; Health Care; Industrials; Technology; Materials; Telecom; and, Utilities.
The only change to this line-up occurred in August of 2016 when the Financial sector was bifurcated to create a Real Estate sector. Discussed here at that time in our article, “The Difference Between Banks and Buildings“, it should be noted that while Invest-Notes correctly identified the pros and cons of the change, we totally whiffed on guessing the subsequent performance of the two sector funds.
The transition taking place on September 30, 2018, is more impactful since it will see three sectors facing major changes to their composition. First, Telecom Services will be renamed Communications Services. Currently, the smallest of the eleven GICS sectors composed of only the stocks in the S&P 500, when Telecom becomes Communications it will grow from 2% of the index to around 10%. The challenge for investors is determining what to do with current sector holdings when some of the biggest stocks in the S&P get shuffled around. Google, Verizon, and Disney are not niche investments. In point of fact, the top holdings in the soon to be Communications Services sector comprise about 10% of the S&P 500.
Now, what happens to the Information Technology Sector when Google, Facebook, and other heavy hitters are no longer part of Technology ETFs and become components in the new Communication Services Sector? Or the Consumer Discretionary Sector (a sizable ETF holding in my personal accounts), where Netflix, Disney, and other big companies will be moving out. And is it a good bet to add one of the big Telecom ETFs – IYZ or VOX – in advance of the reshuffle?
|”Those looking at art purely as an investment might first consider looking elsewhere.” -Melanie Gerlis|
The last line in a thoughtful book by Melanie Gerlis, Art as an Investment?, does not do her work justice, “Those looking at art purely as an investment might first consider looking elsewhere.” In fact, she makes a cautious case for those interested in fine art who also have an interest in investing. But first, full disclosure since I am biased. Both fine art and antiquities constitute a meaningful portion of my investment portfolio. As I write this note, works by Max Beckmann, Chuck Close and Sol Lewitt surround me. A visit to the San Antonio Museum of Art will find a dozen Egyptian antiquities from our collection on display.
Another quote to provide some context for the following conversation comes from another great read, The Value of Art by Michael Findlay, “A collector has one of three motives for collecting; a genuine love of art, the investment possibilities, or its social promise” (quote by Emily Hall Tremaine). Anyone not meeting all three criteria is unlikely to enjoy the rest of this note.
Gerlis undertakes a laudable enterprise by comparing artwork acquired for investment purposes with other asset classes. An editor for The Art Newspaper, she is a knowledgeable commentator on the business of art. Her book makes one-on-one comparisons of fine art to; equity markets, gold, wine, real estate, hedge funds and, intriguingly, luxury goods such as jewelry and watches. By defining each investment’s attributes – such as market transparency, liquidity, market makers, and valuation metrics – she creates a context useful in determining the differences between these investment options.
We’ll focus on the world of fine art starting from a time around 1850. However, a caveat is in order here since the art market is a complicated subject and rather than try to qualify remarks that obviously have exceptions (most of them), let’s just assume that all comments below are, “generally speaking.”
The quick and the dead in art.
Following Gerlis, it seems appropriate to use metaphors taken from the world of investing herein. Conceptually there are two distinct markets with an important overlap. On the one hand are dead artists, the majority of which have some standing in the cannons of art history and criticism. Then there are the living artists whose reputations will evolve for better and worse, as should their artistic output, over a lifetime. In between are the few long-living artists who have achieved accolades likely ensuring their place in history. This can be viewed similarly to that of value and momentum stocks, assuming a gray zone here as well.
Value artists would include names like Cezanne, Pollock, Warhol and, of course, Picasso. Like a big established multinational corporation, the price of the art will fluctuate over time, but there is an expectation of enduring intrinsic value. Both the equity and art markets experience good and bad times, but the trend over long periods is upwards. Categories having demonstrated value over time include Old Master and Impressionist works. The place of post-WW II abstract expressionists also appears to have been firmly established, with Pop Art probably not too far behind. However, much like gold, art tends to maintain value over time, also contributing to the value in art. Paintings, in particular, have a curious tangential value as insurance. During times of crisis, paintings can be quietly transported across borders, their value not being linked to any particular currency, unlike real estate or some equities.
Momentum artists, on the other hand, remain an unknown entity as far as their long-term valuations are concerned. A look at the dot-com stock era is a good context for thinking about contemporary art – where hopes and dreams intersect with savvy marketing to create the “next big thing.” Or not. As one professional dealer put it, the worry is whether a work of art is even worth displaying five years from now.
With the rise of mega-dealers like Gagosian and Zwirner, who make a lot more money than many of the artists they represent, the hype is an ever-present danger. We hear about the unknown artist who finds their work suddenly fetching high prices at auction, but not their peers watching prices drop in the same market space. The books listed at the end of this essay give many examples of just how far a new superstar can fall. And how fast. There is a difference between a fad and a trend. Fads come and go, often with little in the way of residue. Trends are indicative of long-term shifts in taste or behavior. People generally tend to “get” Impressionist paintings. Not so much with “video art.” With contemporary art, the winner can more often be the dealers rather than the artists.
Currently, there is much conversation – and sales activity – being defined by issues unrelated to the value in art. Contemporary art originating in the Middle East and Latin America are hot art commodities right now even if their shelf life is unclear. A decade ago contemporary Chinese art was a market darling, just as the Aboriginal art of Australia had been twenty years before that. On the cutting edge in trendy art markets like New York is work by the alternative lifestyle crowd who now enjoy accolades instead of opprobrium for being LGBTQ. There is also a geographic risk when discussing a “local” artist as these tend to more often be about the person instead of their art. So, what is the value in art?