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So You Want To Be A Stock Picker

After a rough start to the new year, a lot of investors might be tempted to buy into “fallen angel” companies at or near all-time lows. They’re not hard to find. In the tech sector, GoPro (NASDAQ: GPRO ) and Fitbit (NYSE: FIT ), two profitable and recently public companies, have taken major hits. GoPro is down 90 percent from its all-time high. Fitbit has lost two-thirds of its peak value. Another sector where investors might be looking to buy low is energy, where scores of service and exploration companies are down 90 percent or more. Established names like Denbury Resources (NYSE: DNR ), Forbes Energy (NASDAQ: FES ), Gastar Exploration (NYSEMKT: GST ), Basic Energy (NYSE: BAS ), Bill Barrett (NYSE: BBG ), and Ultra Petroleum (NYSE: UPL ), among others, have all been creamed, and could seem like bargains. All I can say is: buyer beware. As far as GoPro, Fitbit, and other beleaguered tech stocks are concerned, anyone thinking about buying them should ask a basic, but extremely important question: will these companies exist in five years? There is a chance the answer to that question is no. And even if they do survive, how likely is it that they will enjoy a meaningful stock price recovery? The best-case scenario for GoPro and Fitbit could very well be that their stocks trade sideways for the foreseeable future before a larger business acquires them at a modest premium. The worst case? They disappear entirely, wiping out their shareholders. Energy is an even riskier proposition. All of the companies I named, and many more in the space, are choking on onerous debt loads. The bond markets know this. The high yields on each company’s bonds are strong indicators that many of them will chapter out before the price of oil has a chance to recover. If you think I’m being overly pessimistic, I recommend an eye-opening 2014 report (PDF) by J.P. Morgan Asset Management analyst Michael Cembalest titled, “The Agony and the Ecstasy.” Cembalest’s analysis shows that a shocking number of stocks not only go down, they stay down: Using a universe of Russell 3000 companies since 1980, roughly 40% of all stocks have suffered a permanent 70 percent plus decline from their peak value. [emphasis added]. Consider that statement for a moment. Over time, four in ten stocks lose almost three quarters of their peak value – and never recover . And that’s not the only grim finding. The median (note: not mean) stock massively underperforms the index: The return on the median stock since its inception vs. an investment in the Russell 3000 index was -54%. This report should be mandatory reading for both institutional and retail investors. Yet it was hardly mentioned in the financial press after its release. It should also be mandatory reading for short-sellers, because the lessons it imparts are just as valuable on the short-side as the long. During 25 years managing a long/short fund, I have watched scores of companies file bankruptcy and go to zero. Yet most short-selling funds – maybe all – have terrible track records. Famous New York short seller Jim Chanos’ Kynikos fund is reportedly down over 80 percent since inception. The largest public short-biased fund, Federated’s Prudent Bear Fund (ticker BEARX), is down 75 percent over the last 18 years. Why? Because most short-sellers try to uncover frauds and accounting scandals like Enron and WorldCom – and that is a terrible way to make money. Finding and profiting from crooked businesses is incredibly hard. For every accounting fraud, many, many more companies simply fail. Restaurant chains Boston Chicken, Chi-Chis, Planet Hollywood and Koo Koo Roo all filed bankruptcy since I started my fund; as did retailers Circuit City, Bombay, Blockbuster, Sharper Image and Kmart. Failure among public technology companies has been widespread, as well. According to Cembalest’s report, energy, information technology, and telecom stocks have the highest failure rates. Since 1980, roughly half of Russell 3000 stocks in these three sectors dropped 70 percent or more from their peak and never recovered. Looking back, it’s easy to see why most of these stocks lost value. Too bad hindsight isn’t a great investment strategy. Great investors like Warren Buffett take a clear-eyed measure of where a business is likely to wind up several years in the future. What makes this so hard, as Cembalest writes, is the excessive optimism that permeates Wall Street and corporate America: While the losses on the stocks in our case studies may seem obvious or inevitable with the benefit of hindsight, in all likelihood the company’s management, its board of directors, research analysts, credit rating agencies and its employees all firmly believed in its long-term success. I’ve witnessed this optimism bias at countless troubled companies over the years. And, as I’ve written before, one of my hobbies is collecting outrageously positive reports from Wall Street analysts. My favorite is a strong buy recommendation from a prestigious brokerage for Planet Hollywood dated one year before it filed for bankruptcy. Much like GoPro today, Planet was supposedly “building a brand.” Investors picking through the wreckage of the markets today would be wise to consider that failed logic, as well as the lessons of Cembalest’s report.

The Fat Pitch Lurking In Frontier Markets

The Fat Pitch Lurking in Frontier Markets 2015 was a challenging year for most investors as global growth concerns reduced risk appetites globally. Frontier Markets were no exception with all major Frontier Market indices posting double-digit negative returns. That said, I have not been this excited about opportunities within Frontier Markets since 2008 and the work recently completed confirms my enthusiasm. To borrow a phrase used by my former boss and mentor at GMO, Jeremy Grantham, there is a “fat pitch” lurking in Frontier Markets – a baseball reference to game situations when odds of getting an easy pitch to hit are high. This fat pitch is in value stocks in Frontier Markets. Relative valuations of Frontier Markets value stocks are near their 2008 low relative to Frontier Market growth stocks. We define “value” as the bottom two quintiles of our investible Frontier Market universe based on price-to-book and “growth” as the top two price-to-book quintiles. By creating “value” and “growth” indices, we analyzed the yearly returns of each subset of stocks. The value and growth indices were rebalanced each quarter and were calculated both by equal weighting and market capitalization weighting the constituents. The results are as follows: For the period of 2007 to the end of 2015, the value index had an average price-to-book discount to growth stocks of approximately 70% ranging +/- 10% over the nine-year period. Not surprising, value does not do well during periods of heightened market risk. Regardless of whether the indices are weighted equally or by market capitalization, value massively underperformed during 2008 and 2015 relative to growth stocks. In fact, value stocks performed abysmally, underperforming by 1,600 basis points versus growth stocks in both years. The performance of value versus growth when market risk abates and valuations mean revert is powerful. During 2009, value stocks trounced Frontier Market growth stocks by a whopping 4,200 basis points. This is remarkable and highlights the low intra-correlation among Frontier Market stocks given that the two indices are created from the same Frontier Market universe and are not separate asset classes such as stocks and bonds. In addition, by comparing the difference in performance between the market cap weighted value index and the equal weighted value index, it is clearly evident that large cap value does much better than small cap value during subsequent rebound periods. Admittedly, this is a small sample size, but it is hard to make an argument why today value should be permanently impaired. Some investors may find it psychologically easier to allocate to an asset class as it is rising. However, the recent sell-off has provided a plethora of undervalued Frontier Market stocks that are less exposed to global uncertainties. For long-term investors, the recent market rout may prove to be an excellent entry point for those who have been contemplating an allocation to Frontier Markets.

Simple Investing Strategies Cannot Remain Entirely Simple For Long

By Rob Bennett Simple investing strategies are sound investing strategies. The key to success is sticking with a strategy long enough for it to pay off. Complex strategies cause investors to lose focus. Unfocused investors have a hard time sticking with their strategies through dramatic changes in circumstances. The greatest virtue of Buy-and-Hold is its simplicity. However, Buy-and-Hold purists take the desire for simplicity too far. Buy-and-Holders have told me that one big reason why the strategy was not changed following Robert Shiller’s “revolutionary” (his word) finding that valuations affect long-term returns is that it would complicate it to add a requirement that investors adjust their stock allocations in response to big valuation shifts in an effort to keep their risk profiles roughly constant. If that’s so, they made a terrible mistake. Buy-and-Hold does not call for allocation adjustments to be made in response to valuation shifts because the research showing the need for them did not exist at the time the Buy-and-Hiold strategy was being developed. Once the strategy was set up in the way that it was, changing allocations came to be seen as a complication. Isn’t it more simple to stick with one allocation at all times? I don’t think so. Buy-and-Hold seemed simple in the days when we did not realize how much the long-term value proposition of stocks is altered by the valuation level that applies at the time the purchase is made. We now know that the investor who fails to make allocation adjustments is thereby permitting his risk profile to swing wildly about as valuations move from low levels to moderate levels to high levels. In the long term, there is more complexity in a strategy that calls for wild risk profile shifts than in one that requires the investor to check valuation levels once per year and to change his stock allocation once every ten years or so. That’s all that is required for investors seeking to keep their risk profiles roughly stable. That extra one hour or so of work performed every decade reduces the risk of stock investing by 70 percent and saves the investor a lot of emotional angst during price crashes. It is the losses suffered in price crashes that cause investors to abandon Buy-and-Hold strategies (at the worst possible time!). Devoting an additional one hour of work to the investing project renders price crashes virtually painless for investors following the updated Buy-and-Hold approach (Valuation-Informed Indexing). It’s not only engaging in transactions that adds complexity. Figuring out how to respond when large losses of accumulated wealth are experienced is a huge complication, one that Buy-and-Holders did not consider when devising the first-draft version of the strategy. There are other ways in which Buy-and-Hold has become more complicated over the years. In the early days, there were few types of index funds available. Investors were generally advised to go with a Total Stock Market Index Fund. That’s still a good choice. But today’s investor has dozens of options available to him. He can invest only in small caps or only in mid caps or only in large caps or can mix or match in all sorts of ways. Traditionalist Buy-and-Holders often express dismay at the number of choices available, bemoaning the added complexity that comes with added options. I am sympathetic to those feelings. The core Buy-and-Hold idea – that it is by keeping it simple that investors avoid falling into emotional traps and confusions – is an idea of great power. Purchasing a Total Stock Market Index Fund still makes a great deal of sense for the typical, average investor. But I don’t believe that dogmatism on this question is justified. It adds only a limited amount of complexity for an investor to focus on small caps or large caps or mid caps. And some investors find appeal in focusing their investing dollars in the ways that new types of index funds permit. Some investors don’t feel safe investing in anything other than large caps. Some like the excitement of small caps and would be inclined to try to pick individual stocks rather than to index if investing in a Total Stock Market Index Fund were the only available option. In relative terms, an investor who purchases a large cap index fund or a small cap index fund or a mid cap index fund might thereby be avoiding more complex options that would draw him in if he were to try to follow a purist path. And of course many investors like to invest in different segments of the market. Investing in a high-tech index fund is riskier than investing in a broad index fund. But it is less risky than investing in any one high-tech company. Buy-and-Hold dogmatics would argue that only the investor who chooses a broad index fund is a true Buy-and-Holder. My take is that the success of the Buy-and-Hold strategy inevitably created demand for a greater variety of investing options and that there is no way to keep the Buy-and-Hold concept from becoming a bit more complicated over time. Another big change since the early days of Buy-and-Hold is that many investors no longer limit themselves to broad U.S. indexes but seek participation in the global marketplace. That makes sense, doesn’t it? Our economy is gradually becoming a global economy. There are numerous complexities that come into play as the transition proceeds. The U.S. has long had a stable economic system. So going global adds risk. However, that might be true only historically and not on a going-forward basis. It might be that the risky thing on a going-forward basis is to continue to invest solely in the U.S. market. The Buy-and-Hold Pioneers did not anticipate having to make decisions re such questions. They thought they had solved the complexity problems once and for all. These questions just turned up as time passed. The full reality is that they always do! Simple investing strategies cannot remain entirely simple for long. Valuation-Informed Indexing will become more complex over time too. We have 145 years of U.S. stock market data available to us today to determine when valuations have changed enough to require an allocation adjustment and how big a allocation adjustment is required. As more years of data are recorded, our understanding of what sorts of allocation adjustments are either needed or desired will become sharpened and refined. That’s good. We want to have as much historical data available to us for guiding our allocation shifts as possible. But it cannot be denied that the decision-making process will become somewhat more complex as more considerations are taken into account. That’s just the way of the world. Humankind’s understanding of the world about it improves over time and those improvements undermine our ability to keep things simple. Simple is good. But a purist stance is not realistic in the fast-changing (because it is fast improving!) world in which we live today.