Tag Archives: performance

The Drop In How Many U.S. Stocks Equaled 1 Greek Economy?

The article shows that the capitalization change of a small number of large-cap U.S. stocks equaled the entire annual output of the Greek economy. This effort is in part to frame the impact Greek turmoil is having on U.S. assets. A qualitative discussion of whether this capitalization change is warranted is included. The title of this article asks readers to guess the number of U.S. stocks whose reduction in market capitalization on Monday was equivalent to the size of annual Greek economic output. The answer: 86 To come up with the figure, I compared the gross domestic product of the Greek economy from the World Bank to the capitalization change of the largest components of the S&P 500 (NYSEARCA: SPY ) by market capitalization until the change in value equated to the Greek GDP of $242B. I had some notable takeaways from this data that I wanted to share with readers. The question for market participants is whether these moves are justified. If the value of an asset is its future cash flows discounted back to the present, then the reduction in domestic equity prices on Monday was either a function of an expectation of lower future cash flows and/or a higher discount rate. The former, lower future cash flows, seems unlikely to have had a large impact given the limited trade between the U.S. and Greece and the fact that the Greek economy is roughly the size of the Minneapolis-area economy. The negative translation effect of broader global cash flows earned by these U.S. companies from a strengthening U.S. dollar would have had a proportionately larger impact. That means that the re-pricing of risky assets is more likely a function of a higher discount rate. The interest rate component of the discount rate fell on Monday as U.S. rates rallied on a flight-to-quality bid signaling that an “equity risk premium” applied to U.S. equities increased to move the discount rate higher. While the outcomes from a potential “Grexit” remain uncertain and difficult to analyze, the transmission mechanism for broader global contagion seems equally uncertain. The potential financial sector link, which roiled equity markets in 2012 given the amount of Greek debt held by European banks at the time, appears to have been muted by a rotation of Greek debt from bank balance sheets to official creditors, enhanced stability mechanisms, European quantitative easing, and much lower yields in the periphery. While the odds of a disorderly outcome in Europe are certainly rising, investors must handicap how much of a risk premium on global assets is justified. While we are likely to continue to see heightened volatility in the near term, if the Greek drama was responsible for the entirety of the move on these 86 companies, I believe that the impact has been overstated already. Disclaimer : My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon. Disclosure: I am/we are long SPY. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Why Do Individual Investors Underperform?

Bonds, dividend investing, ETF investing, currencies “}); $$(‘#article_top_info .info_content div’)[0].insert({bottom: $(‘mover’)}); } $(‘article_top_info’).addClassName(test_version); } SeekingAlpha.Initializer.onDOMLoad(function(){ setEvents();}); Barry Ritholtz posted a good video discussing whether mutual fund managers are skilled or not. I am not going to discuss the points made in that video, however, it did get me thinking about something. I have found that most mutual funds are closet index funds. That is, the vast majority of mutual funds are not engaged in any sort of strategic asset allocation that differentiates them sufficiently from highly correlated index funds. So, your average XYZ Large Cap fund will tend to have a 85%+ correlation to the S&P 500, but it will charge a much higher fee. Over time this will degrade performance since the mutual fund is basically picking 100-200 stocks inside of a highly correlated 500 stock index and charging you a recurring high fee over time. Vangaurd has shown on multuple occasions that it’s fees, not asset picking skill, that drives underperformance. But what’s interesting about these mutual funds is that even though they can’t beat their index they do tend to beat the average individual investor. This has been well documented in research pieces ( such as this one ), but we also know it’s true thanks to investor surveys like the AAII asset allocation survey. Over the last 30 years AAII has maintained a record of individual investor asset allocations and over this period the average allocation has been: Stock/Stock Funds: 60% Bonds/Bond Funds: 16% Cash: 24% What stands out there is the cash position. Of course, “cash” is a bit of a misnomer in a brokerage account because “cash” is usually just T-Bills. The kicker is, cash (or short-term bonds) has been a big drag on performance over the last 30 years. The AAII investor with an average 24% cash position generated just a 8.4% annualized return relative to a 9.1% return for the average investor who invested that 24% in a bond aggregate (your standard 60/40). And keep in mind that this is before accounting for all the inefficiencies documented in the aforementioned research. The interesting point here is that most professional money managers don’t hold a lot of cash at all times. The latest data from ICI showed that the average equity fund had just 3.5% cash. Since bonds and stocks just about always beat cash over a 30 year period we know that the average individual investor with a 24% cash position MUST, by definition, do worse than even the closet indexing professionals. This doesn’t mean the closet indexers are “skilled”. It just means they benefit from being in the game more. Basically, you can’t score if you aren’t even on the field and while closet indexing mutual funds are worse at scoring than their benchmark, they score more often than individuals because the individuals spend too much time out of the game. So, the question is, why do individual investors tend to hold so much cash? I have a few guesses: Individuals are inherently short-term in their thinking because they know, intuitively, that their financial lives are a series of short-terms inside of a long-term. This short-term perspective is a totally rational reaction to uncertain financial markets. A high cash balance provides the ultimate sense of certainty. This is a silly perspective, however, because informed market participants know that financial asset market returns tend to become more predictable over longer periods of time. This does not mean, however, that we should necessarily apply the textbook idea of the “long-term” to our portfolios as this isn’t always consistent with our actual financial lives. This short-term thinking leads most investors to churn their accounts, pay high fees and pay high taxes. Again, it’s an attempt to create certainty in an inherently uncertain financial world. But the attempt to take control in the short-term generally results in lots of detrimental activity that hurts performance. I tend to be prefer a cyclical timeframe because it captures the best of both worlds – it can be tax and fee efficient without taking the irrational textbook “long-term” perspective. This raises a more interesting question. Can this behavior be fixed? I’m not so certain. In a world where we’re prone to thinking in the short-term the idea of “long-term” and even medium term investing is very difficult for most people to maintain. But what it does show is that more investors need to be aware of their behavioral biases and understand the basic arithmetic of asset allocation . You might not become a global macro asset allocation expert, but you can avoid making many of the short-term mistakes that lead to this disparity in performance. Sources: Share this article with a colleague

Drivers Of ROE In The Context Of Portfolio Management

Someone on the Corner of Berkshire and Fairfax message board recently posted this comment referencing Buffett’s well-known piece on inflation from 1977 . In the article, Buffett describes the variables that drive a company’s return on equity. There are only five ways that a company can improve returns: Increase turnover Cheaper leverage (reduce interest charges) More leverage (increase the amount of assets relative to a given level of equity) Lower income taxes Wider margins Notice three of the five drivers of ROE have to do with taxes and leverage. So the pretax returns (as opposed to capital structure variations) are really driven by just asset turnover and profit margins. Some executives at the DuPont Corporation (NYSE: DD ) also noticed these drivers in the 1920s when analyzing their company’s financial performance. They broadly categorized the drivers as turnover, margins, and leverage. For now, I want to leave leverage out of it and think about turnover and margins. Portfolio Turnover I wrote a post a while back discussing the misunderstood concept of turnover in the context of portfolio management. Specifically, the topic of realizing gains (and paying those dreaded taxes). Basically, the idea of short-term capital gains is taboo among many value investors. I think it’s very important to try and be as efficient as possible with taxes. However, I think that tax consideration is only one of the (not the only) factors to consider. We could take Buffett’s five inputs that increase or decrease a company’s ROE and apply them to the portfolio. Basically, as investors, we are running our portfolio just like a business . We have a certain level of equity in the portfolio, and we are trying to achieve a high return on that equity over time. The exact same factors that Buffett talks about above apply to our portfolio. Those five factors are the inputs that will increase or decrease our portfolio ROE (aka CAGR) over time. Notice that taxes is one of the (but not the only) factors. Turnover is also one of the (but not the only) factors. Michael Masters is not a value investor, but he runs a fund that has produced fabulous returns over the past 20 years or so (from what I’ve read, north of 40% annually). You can read about him in the book Stock Market Wizards by Jack Schwager . Now, I don’t understand his specific strategy, and I’m not suggesting it’s one that should be cloned, or copied, etc… I’m just focusing on the turnover concept here. Masters, according to the interview, runs a strategy focused on fundamental catalysts, and holds stocks an average of 2-4 weeks. When he was running a smaller amount of money, he was compounding at 80%+ per year. Of course, he was paying a lot of taxes. His investors – the ones in the highest tax bracket – might be “only” netting 40% or so after tax. But who would be upset with paying a lot of taxes if it means achieving a 40% return on the equity in your capital account? Obviously an extreme example, but the concept illustrates the point that just because you hold stocks for years and years and pay very low taxes doesn’t mean that your after tax ROE will be any better than an investor who pays a lot of tax and achieves a much higher pretax return. I think it’s very difficult to compound capital at 20% or more without some amount of turnover in the portfolio. This doesn’t mean I’m promoting higher levels of activity. I’m not. I think making fewer decisions is often better, and trying to do too many things is very often counterproductive. I’m just saying that the math suggests that some level of turnover is needed if your goal is to compound capital at north of 20% over time. This is one of the reasons I love bargains and deep value special situations in addition to the compounders. As I’ve said before, very few companies compound their equity and earnings at 20% or more over years and years. Those that do often are priced expensively in the market. But to achieve portfolio returns of 20% without paying taxes, you’d have to not only properly identify these companies in advance, but you’d have to have the foresight to invest your entire portfolio in them. How Did Buffett and Munger Achieve Their Results? It’s a difficult proposition to be able to seek out in advance the truly great compounders that will compound at 20%+ for a decade or more, and that’s why investors who focus on bargains and special situations often are the ones with the extreme performance numbers (like Buffett doing 50% annual returns in the 50s, Greenblatt doing 40% annual returns in the 80s and 90s, etc…). It’s unlikely to do 20% annual returns by buying and holding great businesses for a decade without selling. It’s basically impossible to do 30%+ without ever selling. Charlie Munger has promoted the idea of low turnover – and I think his reasoning (as usual) is very sound, but I think he was using the Washington Post as an example – and I think that might be (dare I say) somewhat biased in hindsight. But if you’re looking for decent after tax returns, he’s right. If you can find a company that compounds at 13% per year for 30 years, you’re going to achieve good after tax returns on your capital. But, I think finding the Washington Posts of the world are easier said than done in hindsight, especially when thinking about a 30-year time horizon. Another example I’ve discussed before is Disney (NYSE: DIS ). Buffett bought Disney for $0.31 per share and sold a year later for a 50% gain in the mid-60s. He laments that decision as a poor one, but in fact his equity has compounded at a faster rate than Disney’s stock over time, making his decision to sell out for $0.50 a good one. And that is an extreme example using probably one of the top 10 compounders of all time. Not every stock is a Disney, thus making the decision to sell at fair value after a big gain in a year or two much more likely to be the correct one. Back to Munger’s Washington Post example… I like to consider his audience. I don’t necessarily think he was saying this is the highest way to achieve attractive investment results. My guess is he was trying to convey the importance of long-term thinking and lower turnover. However, when Munger ran his partnership, he was trying to compound at very high rates, and for years did 30% annual returns. He didn’t do this by buying and socking away companies like the Washington Post. He may have had a few ideas like that, but he was a concentrated special situation investor who was willing to look at all kinds of mispriced ideas. Buffett/Munger of Old vs. New I think there is a disconnect between the Buffett/Munger of old, and the Buffett/Munger of today. Their strategies have obviously changed, and their thinking has evolved. But their best returns were in the early years when they could take advantage of the (often irrational) pricing that Mr. Market offered. They were partners with the often moody Mr. Market back then and they took advantage of his mood swings. When they came into the office and Mr. Market was downtrodden, they’d buy from him. And on the days when Mr. Market was excited and overly optimistic, they’d sell to him. Their bargain hunting days provided them and their investors with 20-30% annual returns. They made a lot of money. They paid a lot of taxes. As they compounded capital, they began to evolve. Buffett and Munger both have discussed this, but they both have said with smaller amounts of capital, they’d invest very differently. Buffett bought baskets of Korean stocks in his personal account in 2005 when some were trading at 2 times earnings with net cash on the balance sheet. He’s also done arbitrage situations, REIT conversions, and other things in his personal account that provided attractive, low-risk returns (and very high annualized CAGRs). By the way, this is not an indictment against compounders. As I’ve mentioned before, my investments tend to fall into one of two broad categories: compounders and special situations/bargains. I actually enjoy investing in compounders the most, since they do the work for you. But bargains are the ones that often get more glaringly mispriced for a variety of reasons (not the least of which is the fact that the compounders are great businesses – and everyone knows they are great). But I don’t have a dogmatic approach to investing, and I will look for value wherever I can find it. I’m not sure if this post really has a hard conclusion and maybe this is more of a ramble than anything else. I’m not sure how to sum it up, so I’ll just stop here. These are just observations I have had, and the COBF post on Buffett’s 1977 piece ( which is a great piece to read if you haven’t ) prompted some of these thoughts which I decided to write down and share. I think it’s important to understand the drivers of investment results (portfolio returns on equity) are the exact same factors that drive the ROE of a business. Feel free to add to the discussion if you’d like. Have a great week, and for the golf fans, enjoy the US Open.