|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.
|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.
|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.
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…