Tag Archives: investment

How Long Should I Give An Investment Plan?

Even the most brilliantly crafted investment plan has to be given time to work. The markets are inherently volatile but also inherently profitable. And when you start investing in the markets, you are very likely to see many highs and lows as the market gyrates before you see permanent gains. And since asset allocation involves crafting a portfolio out of many sectors which have low correlation, one component of your portfolio certainly will experience an early loss. Diversification means you will always have something to complain about. Perhaps the most important part of implementing an investment plan is the wisdom to know when one category doing poorly means you should do something and when it means nothing. We know from behavioral finance that many people give up on a brilliant investment philosophy too soon. They chase returns rather than rebalancing. And we know from studies on mutual fund flows that investors underperform the very mutual funds they are invested in because they buy funds after they have gone up and they sell funds after they have gone down. We don’t want to be the foolish investor who sells at the bottom only to reinvest at the top of the next bubble. Here is the primary question to help you discriminate between a brilliant investing strategy and a mistake: Do you have sufficient data to justify the long-term mean returns you want? It is a mistake to select an investment sector based on recent returns. In order to get meaningful statistics, you need to use the longest time horizon possible. Even 30 years is not long enough to judge which investment will have a higher mean return for the next 30 years. For example, we recently had a 30-year time period where long-term bond returns beat the return for stocks . Periodically, it is wise to reevaluate your investment selection to see if you made a mistake. You may have been enamored by the ability of a fund manager to select stocks . You may have thought a fund was worth higher fees and expenses. You may not even have understood what you were investing in. You may have invested in something that has a low or even negative mean return. Or you may have invested in an illiquid asset. If you do find a mistake, it is always a good time to sell a bad investment. There is no reason to “wait for a rebound,” because a better investment will on average rebound better for you. During the portfolio construction process, look for sectors with a high expected return, a low volatility, and a low correlation with other components of your portfolio. Then, when you experience the volatility, ask yourself if it behaved as you expected. Imagine that you have invested in a fund tracking the S&P 500 Index and it quickly experienced over two years a -19% annualized loss. Wondering if you made a mistake, you ask yourself, did your experience fit what your data expected? To answer this question, you look at the range of returns experienced by the S&P 500 Index since 1928 (all the data we have). The mean return (not including dividends) is about 7%. In the graph below, you can see this as the graph funnels around a 7% return the longer the number of years. The thick bars are 1-standard deviation from that mean; the thin bars are two standard deviations. Click to enlarge Returns within one or two standard deviations are commonplace returns. The data doesn’t just expect these, it predicts them. Within one standard deviation of the mean are approximately two out of every three returns experienced. Meanwhile, approximately 22 out of every 23 returns are within two standard deviations. As you can see, it depends on the number of years how wide the range of predicted annualized returns. Over a one-year time period, one standard deviation from the mean is from -13.00% to 28.07%. Meanwhile, over a thirty-year time period, one standard deviation from the mean is 5.45% to 8.53%. Two standard deviations for one-year time periods is -33.53% to 48.06%, and for thirty-year time periods, it is 3.91% to 10.08%. When you look at two-year time periods, the two-standard-deviation set of returns is from -21.81% to 34.56%. The return you experienced, -19%, falls in this time period, making it commonplace. Your data not only expected it, your data predicted it. Despite one-, two-, and three-year time periods all having moderate annualized losses within one-standard deviation, for the S&P 500 Index at a 7-year holding period, the bottom of the one-standard deviation range (2 out of every 3 returns experienced) rises above zero to a positive 0.02%. The bottom of the two-standard deviation range (22 out of every 23 returns) rises above zero after a 19-year period. Even good indexes which are part of a carefully crafted portfolio on the efficient frontier have a bad decade. Get rid of them at the low and you are liable to miss the recovery as the index returns revert to the mean and have some greater than average growth. And while individual stocks can go to zero, broad indexes cannot. To ensure this fact, your funds should be comprised of a large number of holdings. There is no such thing as over diversification. A large number of holdings helps ensure that the category is worth a place in your asset allocation for the long term even when returns are below average for a period of time. There are reasons to remove a sector from your asset allocation, but not simply for returns that are below average. The opposite is true, however. When a category experiences rapid appreciation, investors piling in may cause the price to rise faster than the expected earnings. A higher than normal forward P/E ratio can be an indicator of lower than expected future returns. Dynamic asset allocation would suggest trimming the allocation to sectors with a higher forward P/E ratio so that when the sector reverts to the mean, you have less experiencing the fall. Sometimes even a good investment can drop precipitously. Approximately 1 out of every 23 times the stock market will experience returns greater than two standard deviations from the mean. The markets are more abnormal than a normal Gaussian bell curve. This non-Gaussian mathematics is called Power Laws and forms the basis for fractals. Stock returns experience 4 or more standard deviations greater than normal statistics would predict. Gaussian statistics experience greater than 3 standard deviations approximately 0.2% of the time whereas the stock market experiences greater than 3 standard deviations approximately 0.56% of the time . When returns are outside of two standard deviations, the same analysis applies, but the hype from the financial news media is terrifying. The worst 12-month return for the S&P 500 was -70.13% (a 4-standard deviation loss) and ended June 30, 1932. The best 12-month return ended just 12 months later and was 146.28% (a 7-standard deviation gain). I take comfort in the fact that unusually large drops are often followed by unusually large gains. A similar pairing happened during the crash of 2008. The 12 months prior to 2/28/2009 experienced a -44.76% drop (a 3-standard deviation loss). The next 12 months appreciated 50.25% (a 3-standard deviation gain). For the most part, short-term returns should not ruin a brilliant long-term investment strategy. Normally, it is best to rebalance your portfolio selling what has gone up and buying what has gone down. If you can’t stomach rebalancing your portfolio, at least don’t lose heart and abandon the plan.

If All Investments Were Private

This piece is another one of my experiments, please bear with me. “Measure Twice, Cut Once” – A very intelligent woman (I suspect) whose name never got recorded the first time it was uttered “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.” – Warren Buffett Imagine for a moment: The public secondary markets didn’t exist Investment pooling vehicles were all private, and no one published NAV estimates Stocks and bonds existed, but they were only formally offered through the companies themselves, and all private secondary trading was subject to a right of first refusal on the part of the issuing corporation. This includes short-term debts like commercial paper. Banks and life insurance companies still offer products to retail savers/investors, but nonforfeiture laws didn’t exist, and CD penalty clauses were very ugly. In other words, because of no public secondary markets, the price of liquidity was very high, with a strong incentive to hold financial instruments to their maturity date. Accounting rules are only partially standardized. Deposit insurance still exists. So does limited liability. In this thankfully fictitious world, what would investing be like? The main factor would be that liquidity would be dear. Because the “out” doors for liquidity are thin or closed for a long time, money would go into any investment only after great study. The 4 Cs of credit would be present with a vengeance – character, capacity, capital and conditions – and character would be chief among them as J. P. Morgan famously said. This would be true even if one were investing in the stock of a firm, rather than the debt. Investing in such a world, even with limited liability, is tantamount to an economic marriage back in a time where divorce was mostly for cause, and not easy to get. You’d have to be very certain of what you were doing. Perhaps you would diversify, but one would quickly realize how difficult it can be to keep up with a bunch of private firms – we take for granted how information flows today, but with private firms, you are subject to the board and management. What do they choose to share with outside passive minority investors? Excursus: It is said that it is easy to teach a child to say “please,” because it is the equivalent of “gimme.” It is harder to teach them “thank you,” until they realize that it means, “I’d like an option on the next deal.” Why would private firms choose to be open with outside private minority investors? They want a continuing flow of capital, and with no secondary markets, that can be difficult. Granted, there are always hucksters that say with P. T. Barnum, who is alleged to have said, ” There’s a sucker born every minute .” Those characters exist regardless of market structure, but in a healthy culture, they are a small minority in the markets. The same would apply to the debt markets. The fourth C, Conditions, would also impact matters. If you can’t get out easily/cheaply, then you will limit the term of the borrowing at which you are willing to lend, unless there are features allowing for participation in the upside, such as stock conversion rights. You might also find that insolvency becomes a very personal matter, as prior capital providers who know the business better than others, are invited to “prepackaged reorganizations” when the business is illiquid or insolvent. The bankruptcy code might still exist, but gaining enough data on a firm in trouble would probably prove difficult. The board and management, unless legally compelled, might not find it in their interests to be open. Control is a valuable option, one that is only surrendered when the situation is virtually hopeless. That said, a man very good at estimating character and business value could make some amazing profits, because “in the land of the blind, a one-eyed man is king.” And, the opposite would be true for many, as they get taken advantage of by less scrupulous management teams. Back to the Present “…[R]isk control is best done on the front end. On the back end, solutions are expensive, if they are available at all.” – Me, in this article , and a bunch of others. The purpose of what I just wrote is to get you to think about an illiquid world as a limiting concept. All of the problems of our world are there, usually in a form that is less severe than we experience because of the benefit of liquid secondary markets and vehicles for diversification. If valuable for no other reason, market panics make liquidity disappear, and it is useful to think about what you will do in an absence of liquidity before the time of trouble happens. The same is true of corporations needing liquidity. Buffett said something to the effect of, “Get financing before you need it; it may not be available later.” It’s also useful to consider more carefully the financial commitments that you make, so that you don’t make so many blunders. (True for me, too.) The ability to trade out of investments is useful but limited, because we don’t always recognize when we are wrong, and mechanical trading rules can lead us to the “death by one thousand cuts.” Beyond that, realize that character does matter. A lot. The government tries as hard as it can, but it is far better at punishing fraud after the fact than it is catching fraud before the fact. It will always be that way because the law is tilted in favor of the one in control; it has to be, or property rights are meaningless. But consider those that try to warn about financial disasters – they do not get listened to until it is too late. Madoff, Enron, housing bubble, various short sellers alleging improprieties, etc., etc. Very few listen to them, because seeming success talks far louder than an outsider. My counsel is the same as always, just look at the risk control quote above. But to make it stark, ask yourself this, a la Buffett, “Would you still buy this if you couldn’t sell it for ten years?” Then measure twice, thrice, ten times if needed, and cut once. Disclosure: None

It’s Not All About Earnings

Earnings, earnings, earnings: On Wall Street, profits are king. Headlines are filled with references to prominent companies’ earnings – panic often ensues if a firm falls even a few pennies short of analysts’ profit expectations. And when pundits talk about valuations, either of individual stocks or the market as a whole, they more often than not base their assessment on the price/earnings ratio. But earnings don’t always tell the whole story. In fact, oftentimes other metrics can provide an even better gauge of how a company or the market is doing. The Price/Sales Investor strategy I track on Validea.com is a good example. The key variable it looks at is the price/sales ratio – PSR – which compares a company’s market capitalization to the amount of sales it has taken in over the past year. The approach is inspired by the work of Kenneth Fisher, who in his 1984 investing classic Super Stocks pioneered the use of the PSR as a way to evaluate stocks. Fisher thought there was a major hole in the P/E ratio’s usefulness. Part of the problem, he explained, is that earnings – even earnings of good companies – can fluctuate greatly from year to year. The decision to replace equipment or facilities in one year rather than in another, the use of money for new research that will help the company reap profits later on, and changes in accounting methods can all turn one quarter’s profits into the next quarter’s losses, without regard for what’s truly important in the long term – how well or poorly the company’s underlying business was performing. But while earnings can fluctuate, Fisher found that sales were far more stable, and a better gauge of a company’s strength and prospects. On Validea.com, I track a number of strategies I’ve developed based on the approaches of history’s most successful investors. My 10-stock Price/Sales Investor portfolio is one of my best performers, averaging annualized returns of 10.5% since its mid-2003 inception vs. just 5.8% for the S&P 500. How exactly does the Price/Sales Investor strategy work? It starts, of course, with the PSR, looking for companies with PSRs below 1.5, and really getting excited when a PSR is under 0.75. One caveat: Because companies in what Fisher called “smokestack” industries – that is, industrial or manufacturing type firms that make the everyday products we use – grow slowly and don’t earn exceptionally high margins, they don’t generate a lot of excitement or command high prices on Wall Street. Their PSRs thus tend to be lower than those of companies that produce more exciting products. The Price/Sales Investor approach looks for smokestack firms with PSRs between 0.4 and 0.8; it is particularly high on those with PSR values under 0.4. The Price/Sales Investor method also incorporates several other criteria based on Fisher’s work. They include: average net profit margins of at least 5% over the past three years; debt/equity ratio of no higher than 40%; positive free cash flow; and inflation-adjusted earnings growth of at least 15% per year over the long term. For companies in the technology and medical industries, it also looks at the price/research ratio – the firm’s market cap divided by the amount it spends on research. The more research spending the better (since good research can lead to future profits), with a price/research ratio under 5% the best case. Fisher isn’t the only investment guru whose research has pointed to the PSR as a great tool. James O’Shaughnessy, another of the strategists upon whom I base my investment models, made the metric a key part of his top growth strategy in his 1996 classic, What Works on Wall Street . O’Shaughnessy found that a combination of a high relative strength over the past year (relative strength is the percentage of stocks in the market that a particular stock has outperformed) and a low price/sales ratio (under 1.5) was a dynamic combination that could identify hot growth stocks that were still cheap. As always, when using a quantitative screening model like my Fisher- or O’Shaughnessy-inspired models, you should invest in a basket of stocks to diversify away stock-specific risk. With that in mind, here are a handful of picks that these 2 approaches are high on right now. Sanderson Farms (NASDAQ: SAFM ) : Mississippi-based Sanderson, founded in 1947, is engaged in the production, processing, marketing and distribution of fresh and frozen chicken and other prepared food items. It employs more than 11,000 employees in operations spanning five states and 13 different cities, and is the third largest poultry producer in the United States. Sanderson ($2 billion market cap) has a growth/value combo that impresses my Fisher-based model, which likes its 31.7% long-term inflation-adjusted EPS growth rate and 0.7 price/sales ratio. The strategy also likes that Sanderson’s debt/equity ratio is less than 1%, and that it is producing nearly $5 in free cash per share. Thor Industries, Inc. (NYSE: THO ) : Thor ($3.2 billion market cap) manufactures and sells a wide variety of recreational vehicles throughout the US and Canada, including the Airstream line of campers and trailers. Its products include conventional travel trailers, fifth wheels and park models. In addition, it also produces truck and folding campers and equestrian and other specialty towable vehicles. Thor gets high marks from my Fisher-based model, in part because of its 0.76 PSR. The strategy also likes the RV-maker’s 17% long-term inflation-adjusted growth rate, lack of any long-term debt, and $2.78 in free cash per share. Foot Locker, Inc. (NYSE: FL ) : This specialty athletic retailer ($9 billion market cap) gets strong interest from my O’Shaughnessy-based model, which likes its 1.2 PSR. This approach also looks for firms that have upped earnings per share in each year of the past five-year period, which Foot Locker has done. And, as I mentioned above, it likes to see strong momentum behind its holdings, and Foot Locker’s 12-month relative strength of 72 fits the bill. Southwest Airlines Co. (NYSE: LUV ) : This one-time upstart has become a major player in the industry, taking in nearly $20 billion in annual revenues. The Dallas-based firm operates Southwest Airlines and AirTran Airways, and gets strong interest from my O’Shaughnessy-based model. A big reason: its 1.4 PSR. The strategy also likes its persistent earnings growth over the past five years and its solid 72 relative strength. Disclosure: I am/we are long SAFM, THO, FL, LUV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.