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Wait Until You Get A Pitch Right Where You Want It!

One of the most successful investors in history received the only A+ from Professor Benjamin Graham (of Graham and Dodd “Security Analysis” fame) at Columbia: the chairman and chief executive officer at Berkshire Hathaway, Inc., which traded as low as $38 per share in the early 1970s and now trades around $219,000 per share. If you haven’t guessed who by now, it’s Warren Buffett. How does he do it? Well, the following are excerpts from financial media interviews back in the late 1980s: “The most important quality for an investor is temperament, not intellect. You don’t need tons of IQ in this business. You don’t have to be able to play three dimensional chess or duplicate bridge. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd. You know you’re right, not because of the position of others, but because your facts and your reasoning are right. . . . Most investors do not really think of themselves as owning a piece of the business. The real test of whether you are investing from a value standpoint or not is whether you care if the stock market opens tomorrow. If you’ve made a good investment, it shouldn’t bother you if they close down the stock market for five years. You own a piece of business at the right price and that’s what’s working for you. . . . In 30 years of investing I have never bought a technology company. I don’t have to make money in every game. There all kinds of things I don’t know about-like cocoa beans. But, so what! I don’t have to know about everything. The securities business is the perfect business. Every day you literally have thousands of the major American corporations offered you at a price, and a price that changes daily, and nothing is forced upon you. There are no called strikes in the business. The pitcher just stands there and throws balls at you and you can let as many go by as you want without a penalty. In real baseball, if the ball is between the knees and the shoulders, you either swing or you get a strike called on you. If you get three strikes, you’re called out. In the securities business, you stand there and they throw U.S. Steel at $28 and General Motors at $80, and you don’t have to swing at any of them. They may be wonderful pitches, but if you don’t know enough, you don’t have to swing. And you can stand there and watch thousands of pitches, and finally you get one right there where you want it, something that you understand and is priced right – and then you swing . . .” On many occasions I have said, “The rarest thing on Wall Street is patience!” That quote is akin to Buffett’s quote, “If you don’t know enough, you don’t have to swing.” For most of last year, we didn’t “swing.” Then, in late August, our model told us to “swing” and we did. That was the week of the August 24, 2015 “lows” around 1800 on the S&P 500 (SPX/2091.58). The next time we “swung” was on December 11, 2015 when our model called for a “rip your face off” rally. About a week and a half later, we had to admit that was a bad “call.” In this business, when you are wrong, you admit it quickly for a de minimis loss of capital. So we came into 2016 with a defensive stance. But on Friday, February 5, CNBC’s Becky Quick asked me what the model was “saying” now. I responded, “It is saying we bottom next week” and we are tilting accounts according. It was during that week (February 11 to be exact) the SPX retested its August 2015 “lows” and the rest, as they say, is history. So where does this leave us now? Well, the consensus “call” is that we are either making a “top” followed by a big decline or we are at the top of the trading range that has been intact since October 2014 (~1800 – ~2130) and now the SPX is headed back down. That view is reflected in this excerpt from our friends at the Boston-based Fidelity organization: While this rally may continue to play out, the stock market may not break out of its year-long trading range until earnings growth stabilizes and the policy divergence between the Fed and other central banks ends. We are not of that view. Our work suggests the SPX will break out to the upside of the over-one-year trading range. As stated in prior missives, To me, this feels very much like 2013 where the markets ground down every short seller into the May timeframe before a near-term top arrived. If that pattern plays here, it would fit nicely with my internal energy indicator, whose energy would be totally used up by mid-May. It still feels like new highs to me. And maybe, just maybe, the S&P Total Return Index is pointing the way higher as it traded to new all-time highs while the D-J industrials notched new reaction highs (INDU/18003.75). Now, if the D-J Transports (TRAN/8085.98) can better its November 2015 closing high of 8301.80, we will have a Dow Theory “buy signal.” If not, it will be an upside non-confirmation and likely lead to a pullback in stocks. If the Trannies are going to make a new reaction high, it will have to come quickly, because as stated, by mid-May, the equity market’s internal energy should be totally used up. As for earnings season, while it is still a small sample of the S&P 500 companies that have reported 1Q16 earnings, 78.3% have beaten their lowered estimates (as of last Thursday). That is the best showing since 3Q09 and much better than the past few quarters. There have been some high-profile company “misses,” but the operative word (at least so far) for this earnings season is “beat.” Perhaps the better-than-expected earnings season is telegraphing stronger GDP numbers in the months ahead, although last week’s economic reports were on the softer side. This week, we get a slew of economic reports (Durable Goods, GDP, Core PCE, etc.) as well as the FOMC meeting. As I have repeatedly stated, IMO, if the Fed doesn’t raise rates this week, I doubt if they raise rates until after the election. However, the bond markets seem to think something’s afoot as the Roll-Adjusted Ultra Long Bond Future has broken down in the charts suggesting higher interest rates (chart 1). And, that could be what caused the Bloomberg US Dollar Index to try and reverse it downtrend (chart 2). Or maybe the interest rate complex is anticipating stronger GDP growth in China where energy and electricity consumption is strengthening and things like the Shanghai Steel Rebar Futures are surging (chart 3). It is also worth noting that, last week, Schlumberger said the crude oil surplus would be gone by year’s end and Caterpillar sees its business bottoming globally. The call for this week: Well, today is actually session 50 (I miscounted when I said last Friday was session 48, because I failed to account for one of the holidays) in the second-longest “buying Stampede” I have ever seen. As SentimenTrader’s cerebral Jason Goepfert writes, “The S&P 500 has gone 10 weeks since trading below a prior week’s low. This is the longest such streak since 2011 and among the most impressive since 1928.” That skein has left most of the macro sectors overbought. We are also within a week of the month of May where the market’s internal energy wanes. We have been steadfastly bullish since our model telegraphed the SPX would bottom the week of February 8; however, while we do expect an upside breakout by the SPX to new all-time highs, we are not real excited about adding to the many stocks featured in these reports since those February lows. In fact, according to one particularly brainy colleague, “Everything is expensive except emerging markets.” This morning, futures are flat as participants await the Fed meeting. Click to enlarge Click to enlarge Click to enlarge

Base Hits Vs. Swinging For The Fences

I just got done reading Jeff Bezos’ annual letter to shareholders , which is outstanding as it always it. As I finished it, I spent a few minutes thinking about it. He references Amazon’s (NASDAQ: AMZN ) style of “portfolio management”. He doesn’t call it that, of course, but this passage got me thinking about it. Since I wrote a post earlier in the week about portfolio management, I thought using Bezos’ letter would allow me to expand on a few other random thoughts. But here is just one clip from many valuable nuggets that are in the letter: Bezos has always gone for the home run ball at Amazon, and it’s worked out tremendously for him and for shareholders. Would this type of swinging for the fences work in investing? I’ve always preferred trying to go for the easy bets in investing. Berkshire Hathaway ( BRK.A , BRK.B ) is an easy bet . The problem, though (or maybe it’s not a problem, but the reality), is that the easy bets rarely are the bets that become massive winners. Occasionally, they do – Peter Lynch talked about how Wal-Mart’s (NYSE: WMT ) business model was already very well known to investors in the mid 1980s, and it had already carved out significant advantages over the dominant incumbent, Sears (NASDAQ: SHLD ). You could have bought Wal-Mart years after it had already proven itself to be a dominant retailer, but also when it still had a bright future and long runway ahead of it. So sometimes, the obvious bets can be huge winners. But this is usually much easier in hindsight. After all, Buffett himself couldn’t quite pull the trigger on Wal-Mart in the mid 1980s – a decision he would regret for decades. At the annual meeting in 2004, he mentioned how, after nibbling at a few shares, he let it go after refusing to pay up: “We bought a little and it moved up a little and I thought maybe it will come back a bit. That thumbsucking has cost us in the current area of $10 billion.” So sometimes, obvious bets can be huge winners. But many times, the most prolific results in business come from bets that are far from sure. Jeff Bezos has always had a so-called moonshot type approach to capital allocation. The idea is simple: there will be many failures, but no single failure will put a dent in Amazon’s armor, and if one of the experiments works, it can return many, many multiples of the initial investment and become a meaningful needle-mover in terms of overall revenue. Amazon Web Services (AWS) was one such experiment that famously became a massive winner, set to do $10 billion of business this year, and getting to that level faster than Amazon itself did. The Fire phone was the opposite – it flopped. But the beauty of the failures at a firm like Amazon is that while they are maybe a little embarrassing at times, they are a mere blip on the radar. No one notices or cares about the Amazon phone. If AWS had failed in 2005, no one today would notice, remember, or care. So this type of low-probability, high-payoff approach to business has paid huge dividends for Amazon. I think many businesses exist because of the success of a moonshot idea. Mark Zuckerberg probably could not have comprehended what he was creating in his dorm room in the fall of 2004. Mohnish Pabrai has talked about how Bill Gates made a bet when he founded Microsoft (NASDAQ: MSFT ) that had basically no downside – something like $40,000 is the total amount of capital that ever went into the firm. “Moonshot” Strategy is Aided by Recurring Cash Flow One reason why I think this approach works for businesses, and not necessarily in portfolio management, is simply due to the risk/reward dynamic of these bets. I think a lot of these bets that Google GOOG , GOOGL ) and Amazon are making have very little downside relative to the overall enterprise. Most stocks that have 5-to-1 upside also have a significant amount of downside. I think lost dollars are usually much more difficult to replace in investing than they are in business, partially because businesses usually produce recurring cash flow. Portfolios have a finite amount of cash that needs to be allocated to investment ideas. Portfolios can produce profits from winning investments, and then these profits can get allocated to other investment ideas, but there is no recurring cash flow coming in (other than dividends). Employees, Ideas, and Human Capital Not only do businesses have recurring cash flow, they also have human capital, which can produce great ideas that can become massive winners. Like Zuckerberg in his dorm room – Facebook (NASDAQ: FB ) didn’t start because of huge amounts of capital, it started because of a really good idea and the successful deployment of human capital (talented, smart, motivated people working on that good idea). Eventually, the business required some actual capital, but only after the idea, combined with human capital had already catapulted the company into a valuation worth many millions of dollars. There was essentially no financial risk to starting Facebook. If it didn’t work, Zuckerberg and his friends would have done just fine – we would have most likely never have heard of them, but they’d all be doing fine. If AWS flopped, it’s likely we would have never noticed. There would be minor costs, and human capital would be redeployed elsewhere, but for the most part, Amazon would exist as it does today – dominating the online retail world. Google will still be making billions of dollars 10 years from now if it never make a dime from self-driving cars. So, I think this type of capital allocation approach works well with a corporate culture like Amazon’s. Bezos himself calls his company “inventive”. They like to experiment. They like to make a lot of bets. And they swing for the fences. But the cost of striking out on any of these bets is tiny. And you could argue that any human capital wasted on a bad idea wasn’t actually wasted. Amazon – like many people – probably learns a ton from failed bets. You could argue that these failures actually have a negative cost on balance – they do cost some capital, but this loss that shows up on the income statement (which, again, is very small) ends up creating value somewhere else down the line due to increased knowledge and productive redeployment of human capital. So, I think there are advantages to this type of “moonshot bet” approach that works well within the confines of a business like Amazon or Google, but might not work as well within the confines of an investment portfolio. This isn’t always the case – I recently watched The Big Short (great movie, but not as good as the book ), and the Cornwall Capital guys used these types of long-shot bets to great success. They used options (which inherently have this type of capped downside, unlimited upside risk/reward) and turned $30,000 into $80 million. But I think this would be considered an exception, not the rule. I think most investors have a tendency to arbitrarily tilt the odds of success (or the amount of the payoff) too much in their favor with these types of long-shot bets. They might think a situation has 6-to-1 upside potential, when it only has 2-to-1. Or they might think there is a 30% chance of success, when there is only a 5% chance. It’s a subjective exercise – this isn’t poker or blackjack, where you can pinpoint probabilities based on a finite set of outcomes. So, I think many investors would be better off not trying to go for the long-shots – which, in investing, unlike business, almost always carry real risk of capital destruction. Berkshire Hathaway manages a business using a completely opposite style of capital allocation. Instead of moonshots, it goes for the sure money, the easy bets. It’s not going to create a business from scratch that can go from $0 to $10 billion in 10 years. But nor does it make many mistakes. There is no right or wrong approach. As Bezos says, it just depends on the culture of the business and the personalities involved. I think certain businesses that possess large amounts of human capital, combined with the right culture, the right leadership, and a collective mindset for the long term can benefit from this type of moonshot approach. They can, and should, use this style of capital allocation. Ironically, I think investments in such well-managed, high-quality companies with great leadership and culture are often the sure bets that stock investors should be looking for. Either way, from a portfolio management perspective, I think it’s easier to look for the low-hanging fruit.

The Psychology Of Investing

The longer that I’ve been at this investing thing, the more convinced I am that the difference between an average investor and a good investor is all in the mind. I’ve been investing for over 15 years now and I’ve learned a lot along the way. I think it took me the better part of a decade to work out what makes a good business and a quality investment. The much harder aspect of investing is to summon the courage to commit your capital in the face of hundreds of other people telling you otherwise. These people can be respected investment analysts, talking heads on TV, and even your own friends and family. I now have a pretty good idea of what makes my cut as a high-quality business. That tends to be a business that produces high returns on equity in excess of 20%, strong free cash flow generation and conversion of revenue to free cash flow, all combined with a strong market opportunity and rapidly growing topline growth. Now these businesses aren’t necessarily easy to find; however, when you do identify them they are easy to spot. The harder aspect of investing is to commit your capital to these high-quality opportunities that you’ve identified in the face of 101 reasons not to do so. I’ll give you an example. Celgene (NASDAQ: CELG ) is an exceptionally high-quality business with strong rates of revenue growth and good cash flow generation. However, when you look at the stock, it’s had a rough go of things over the last three months. My own purchase is down a good 10% from where I made it. There are all manner of concerns with the stock, most of which I believe will prove to be relatively immaterial over the next five years. The biggest threat is the regulation of drug pricing under the Democrats. There is also the threat that Celgene may be unsuccessful in diversifying its revenue base away from Revlimid, its chief moneymaker. All those things are likely to be unfounded. It’s not in the Democrats’ best interest to make drug discovery unattractive to commercial interests. That will just dry up funding and investment into areas of medicine that have a real human need. Celgene also managed to negotiate a deal with the generic drug manufacturer that will effectively push out its window of exclusivity to almost 2025. That’s almost 9 years for the company to explore new partnerships, invest in new R&D and acquire potential companies that can diversify its revenue base. Yet, despite of this, the company’s stock price remains stubbornly near one-year lows while other companies are now routinely making 52-week highs. I’ve committed capital to Celgene; however, I feel I twang of remorse whenever I check my trading account and see this position solidly in the red while most of my other recent growth investments are now well in the green. I was thinking further about exactly why that is in my case. I don’t think it’s an aversion to losses. Rather I believe that in general we all have a desire for positive affirmation. That’s true for us with our friends with family and even in the workplace. We all want validation that we’ve made the right choices in all aspects of my life. Unfortunately in investing, things don’t this work that way unless you happen to ride a solid growth stock that just consistently appreciates month after month and year after year. You’re not going to get positive reinforcement of your investment decision continually. If you’re looking at taking deep value positions where you have the potential for the greatest upside, you need to lose the desire for positive affirmation and that’s not easy. In fact, it’s really hard because when you see that position continuously in the red, it makes you think that others in the market know something that you don’t or that you have missed something in your analysis. Deep value investing is a pretty lonely game. Invariably it means going against the crowd in almost every bet that you make. And this is where Buffett really stands out for me . More than any other investor, he has shown a unique ability to shut out external influences on his thinking and just go with his gut conviction in purchases of American Express (NYSE: AXP ), Solomon Brothers and to a lesser extent Coca-Cola (NYSE: KO ). These investments were all done at times when those companies were on the nose. American Express suffered from the effects of a salad oil scandal which effectively cut the company’s share price in half. Solomon Brothers suffered from a devastating bond trading scandal which at one point threatened it with bankruptcy. Even Coca-Cola ( KO ) looked like a business that was heading for a sustained slowdown at the point when Buffett invested, with annual revenue growth declining from 17.1% the decade earlier to just 5.2%. I look at my own current list of holdings, and there are more than a few that have suffered or are suffering through crises where investors doubt their ability to make a comeback. CochLear ( OTC:CHEOF ) was the most recent example of a situation where a devastating company event was successfully overcome by the company. Before 2011, CochLear was a high-quality, high-growth business delivering cochlear implants across the world. In fact, the business was the market leader for implants. Unfortunately in 2011, the company suffered from a product recall that sent the company’s share price down by almost 40%. When you are a healthcare company with a reputation for high quality, a product recall event could potentially be a devastating reputational blow. I recognized the opportunity and went in guns blazing . CochLear subsequently recovered lost market share and continues to grow strongly. The net result is that the share price has more than doubled from the lows that it reached during this period of crisis. However, it wasn’t smooth sailing. In fact, the company’s share price was depressed for a period of six months after I made my investment and there was more than an occasion there where I had to reflect and think about whether I’d made the right move. In more recent times, investors have been making assumptions that Chinese economic growth is going to slide to a standstill, and with that, the prospects of Baidu (NASDAQ: BIDU ) and Alibaba (NYSE: BABA ), two of China’s great growth stories will be heading down the toilet. However, both these companies have such strong competitive advantages that I took the view that they will likely prosper for a long time and proceeded to buy. In less than a month, the market subsequently reassessed its view of the Chinese recession and, more importantly, the long-term prospects of Baidu and Alibaba, and I find both positions up more than 17% from where I made my initial investment. The one remaining position that I have which is a real test of my conviction in the company and its ability to overcome adversity is my investment in Chipotle (NYSE: CMG ) that I’ve written about here extensively. The company has significant problems in regaining customer confidence in relation to its E. coli and norovirus scandals. This is a play where you have to believe that customers will ultimately forget these incidents over time, and the company can bring back customer trust and reestablish its position as a provider of high-quality food. However, it’s hard to see this as a long-term outcome when you’re bombarded with images of empty stores and constant analyst downgrades and reminders of incidents on social media of customers getting ill. I look at this investment as a test of my long-term ability to pick a company that has the potential to rebound after significant negative company events, and also as a test of my ability to stick with a position whose outcome is uncertain but which has the potential for significant upside. Investing is as much a test of your character as anything else. It tests the level of conviction that you have in your research and your ideas, and it’s the ultimate test because you literally have to put your money where your mouth is and be prepared to wait a long time to see if your conviction was correctly placed. Those that have the ability to master their emotions and drown out the noise truly have the qualities to be successful long-term investors. Given his track record of making many such successful contrarian plays in the presence of significant negative events and placing large amounts of capital in these plays, I place Warren Buffett at the very top of investors with the greatest mastery of their psychology. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.