The Holbert Wealth Management Group
of Raymond James & Associates, Inc.
Member New York Stock Exchange/SIPC
Investment Strategy by Jeffrey Saut
The Game of Risk
March 15, 2010
“To be sure, there is no exact definition of what ‘calling’ a market top or bottom involves. In the case of the March 2009 bear market bottom, for example, does ‘calling’ it mean the adviser's portfolio needs to have moved from being all cash to 100% invested in stocks on the exact day of the bottom? If my analysis had relied on a definition as demanding as this, then it wouldn't be surprising that no timers called recent market turning points. But my analysis actually relied on a far more relaxed definition: Instead of moving 100% from cash to stocks in the case of a bottom, or 100% the other way in the case of a top, I allowed exposure changes of just ten percentage points to qualify. Furthermore, rather than requiring the change in exposure to occur on the exact day of the market's top or bottom, I looked at a month-long trading window that began before the market's juncture and extending a couple of weeks thereafter. Even with these relaxed criteria, however, none of the market timers that the Hulbert Financial Digest has tracked over the last decade were able to call the market tops and bottoms since March 2000. These results add up to perhaps the most important investment lesson of all that can be drawn from this week's market anniversaries: Predicting turns in the market is incredibly difficult to do consistently well. That means that, if your investment strategy going forward is dependent on your anticipating major market turning points, your chances of success are extremely low.”
... Mark Hulbert, MarketWatch (3/10/10)
The above excerpt was penned by the esteemed Mark Hulbert in an article titled “Fools R Us.” Appropriately, that article ran in a MarketWatch column on the 10-year anniversary of the NASDAQ Composite’s peak of March 10, 2000. Ten years ago the COMP was changing hands around 5050. At last Wednesday’s anniversary date it closed at 2358.95, for a 10-year loss of some 53%. Meanwhile, since that peak, the S&P 500’s earnings are up approximately 48%, real GDP is better by more than 20%, and interest rates are substantially below where they were back then. If you are a college professor such statistics do not “foot” with your teachings because professors tend to believe stock returns are all about earnings and interest rates. We concur, but would add the caveat, “That is if you live long enough.” As money manager Greg Evans, eponymous captain of Millstone Evans in Boulder, Colorado writes us:
“Hey Jeff, I enjoyed your missive on Mr. Market last week. I use that Warren Buffett allegory quite a bit with clients. One interesting statistic on Berkshire is that its stock price was $38 in 1968 and 8 years later, after trading higher and lower, ended up (again) at $38. Most clients would look at that (performance) and say – it hasn't done anything for 8 years so I am going to sell. But an astute investor, looking at the underlying growth in book value, would see an average annual growth rate of 14.6% over those 8 years and conclude they should buy more. As to your point that over the long-term stock prices are ultimately determined by their book value, earnings and cash flows, I have often run numbers on stocks over a 25 year time frame to show to clients. For example, Coca-Cola's stock price in 1983 was $5.10 (midpoint); and, Coke earned $0.30 per share that year. The stock price today is $54, and they earned $3.05 last year. That’s a 10.8% annualized growth rate on the stock price; and, a 10.6% growth rate on earnings – QED.”
Surprisingly, however, if an investor bought Coke shares at their peak price in 1972, over the next 12 years the company compounded earnings at nearly double-digit rates (with only four down quarters), yet said shareholder actually lost money! The reason was “Mr. Market” was unwilling to capitalize that improvement in earnings anywhere near the P/E multiple of 1972. Regrettably, “Mr. Market” is indeed a manic depressive, which is why the stock market is truly fear, hope, and greed only loosely connected to the business cycle. And that, ladies and gentlemen, is why the successful investor needs to learn how to manage risk. As Benjamin Graham wrote, “The essence of investment management is the management of RISKS, not the management of RETURNS. Well-managed portfolios start with this precept.”
Clearly, Warren Buffett understands this “management of risk” concept for he too has learned when to “play hard” and when not to “play.” Decidedly, his insight to hoard cash, and shun Internet stocks, in the late 1990s was brilliant, yet it was greeted with catcalls that “the old man has lost his touch and just doesn’t get the Internet age.” However, investors benefitted handsomely if they heeded his advice. Enter the aforementioned quote from Mark Hulbert, who essentially is espousing the old market axiom, “It’s TIME in the market, not TIMING the market.” Typically such comments are accompanied by the verbiage, “If you missed the 10 best stock market sessions of the year it kills your returns.” To be sure, over the past 81 years (1928 – 2009) if you missed the 10 best sessions a $1 dollar investment grows to only $15, while staying fully invested returns a little over $45 on that same invested dollar. However, that is only half of the story. To wit, if a prescient investor could miss the 10 worst sessions that same dollar grows to $143.47 – proving the management of “risks” is more important than the management of “returns;” or, that you can make numbers do anything!
That said, while we too don’t believe anyone can consistently “time” the stock market, we do believe in Dow Theory. To us, Dow Theory is like a roadmap for the “primary trend” of the stock market. Recall, Dow Theory gave you a “sell signal” in September 1999 (albeit three quarters too soon), a “buy signal” in June 2003 (a few months too late), and again a “sell signal” in November 2007. Note, it is not Jeff Saut “calling” the stock market, but Dow Theory. More importantly, the Dow Theory “buy signal” of last year currently remains in force. Accordingly, last week we attended this year’s Raymond James Institutional Investors Conference with an “ear” for good risk-adjusted stock ideas. A few names we heard that are also favorably rated by our fundamental analysts include: NII Holdings (NIHD); Eclipsys (ECLP); Alliance Data Systems (ADS); Nuance Communications (NUAN); Polycom (PLCM); Micron Technology (MU); Brunswick (BC); Occidental Petroleum (OXY); Corporate Office Properties (OFC); and Unum Group (UNM), to name but a few. Obviously, there were other interesting presenting companies, but due to time constraints we don’t have time to list them. Also of interest is that some names have yield-oriented convertible preferreds, and/or convertible bonds, worthy of your consideration.
The call for this week: Nassim Taleb (trader extraordinaire) has 10 rules. Rule number 8 reads: “No matter how confident, always protect the downside.” We agree and therefore always try to “look” down before looking up in an attempt to manage the risk. As for the “here and now,” the broadest index them of all, the Wilshire 5000, has strung together 11 consecutive higher sessions, a feat not seen since the mid-1990s. Accordingly, it is pretty over-bought on a short-term basis. That upside skein can be seen in the candlestick charts, which have not experienced a downside “red candlestick” session since the upside reversal of February 25, 2010 (see www.stockcharts.com). We are therefore turning cautious, but not bearish, on a trading basis. That strategy suggests a short-term correction is potentially due, but NOT an intermediate-term bearish decline. Indeed, since the end of the envisioned January/ February “selling stampede,” we have been constructive on stocks. However, we currently think pairing some trading positions, and/or raising stop-loss points, is warranted. Meanwhile, a number of our Japanese recommendations broke-out to the upside in the charts last week, the Reuters/Jefferies CRB Index (commodities) broke below its rising trendline, the 10-Year Treasury Yield Index (TNX/3.71) broke above its 50-day moving average (read: higher rates), the Volatility Index (VIX/17.58) continued to trade below 18 (read: too much complacency), mutual fund cash positions are at historic lows of 3.6%, and the NYSE overbought/oversold indicator tagged a rare overbought reading above 90 last week. Ergo, color us cautious in the very short-term..
Mr. Market
March 8, 2010
“Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkable accommodating fellow named Mr. Market who is your partner in private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.
Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.
Mr. Market has another endearing characteristic: he doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you. But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up someday in a particularly foolish mood, you are free to either ignore him or take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren’t certain that you understand and can value your business far better than Mr. Market, you don’t belong in the game. As they say in poker, ’If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.’”
...Warren Buffett
We revisit Warren Buffet’s “Mr. Market” quip this morning because of a few emails I received regarding last week’s missive. My emailers were upset with the reference to Berkshire Hathaway’s stock performance. To wit:
“Since 1965 the S&P 500’s compounded annual gain (including dividends) was ~9.3% for a compounded return of 5,430%. Over that same timeframe Berkshire’s annual compounded return was 20.3%, or 434,057%. Consistency was the key to Berkshire’s outperformance for over those 44 years the S&P 500 suffered 11 down years, six of which were double-digit declines. Berkshire, however, had only two negative years, neither of which were double-digits. Such risk-adjusted investing has always characterized Warren Buffet for he maintains it isn’t his best ideas that gave him his tremendous track record. It was having a smaller number of bad ideas that resulted in a permanent loss of capital.”
Obviously, Warren Buffet doesn’t measure himself according to fluctuations in Berkshire’s share price. Importantly, he measures himself by growth in book value, which is admittedly less volatile than share price. To be sure, Mr. Market is manic-depressive. “At times he feels euphoric and can see only the favorable factors affecting the business. At other times he is depressed and can see nothing but trouble ahead for both the business and the world.” That manic-depression surfaced in 2008 when Berkshire’s shares lost an eye-popping 50% of their value. However, Berkshire’s book value declined by a mere 9.6%. Still, that stock price performance brought about catcalls that the “old man” (read: Warren Buffet) had lost his touch. We recall similar cries in the late 1990s when Mr. Buffet was cast as a buffoon, who just didn’t “get it,” because he was hoarding cash and shunning Internet stocks. Subsequently, the S&P 500 peaked in the spring of 2000 (@1553) and over the next seven years only gained ~0.008% (to 1565). Meanwhile, the “buffoon” grew his book value by nearly 80% and Berkshire’s share price improved by 268%. As Benjamin Graham noted, “In the short run the stock market is a voting machine, but in the long run it is a weighing machine.” Ladies and gentlemen, over the long-term, the fate of every stock is ultimately driven by the operating results of the underlying business. This is determined by BOOK VALUE, EARNINGS, and CASH FLOWS. Accordingly, measuring Berkshire’s performance on those metrics makes more sense than measuring on its share price.
As the insightful Puru Saxena’s writes:
“Over the past 140 years, the return from American stocks has almost mirrored the growth in corporate earnings. During times of high volatility and great economic uncertainty, it pays to remember that stocks represent partial stakes in operating businesses. Therefore, as long as the businesses you own are producing satisfactory results, it is best to ignore the market’s temporary appraisal of your holdings. It is worth noting that during secular bull-markets, stocks outperform bonds and cash. Conversely, during secular bear-markets, they produce disappointing returns (like they did in 2008). Fortunately, secular bear-markets do not happen very often and they are always followed by lengthy and powerful bull-markets.”
And that, folks, is the real question. Are we in a new secular bull market, or just a tactical rally within a trading range stock market that we have envisioned since the Dow Theory “sell signal” of September 1999? Regrettably, while we would like to believe it is a new secular “bull market,” we are sticking with the strategy that it is a tactical rally within an ongoing “range bound” stock market. If we are wrong, our accounts should experience good returns. If we are right, said accounts should still achieve decent total returns, on a risk-adjusted basis, given our emphasis on dividend paying stocks.
Speaking of dividends, the iShares Trust DJ Select Dividend Index Fund (DVY/$45.36) broke out to a new recovery high last week, as can be seen in the nearby chart. We like dividends and would note that since 1926 dividends have accounted for roughly 44% of the stock market’s total return. Dividends also tend to give investors the “margin of safety” Benjamin Graham spoke of in the last chapter of his book “The Intelligent Investor.” This week a number of stocks in Raymond James’ universe of stocks will go ex-dividend. Some of the names we have recommended include: Home Depot (HD); NTELOS (NTLS); Allstate (ALL); Leggett & Platt (LEG); and Family Dollar (FDO). Meanwhile, CenturyTel (CTL) went ex-dividend last Friday and its share price was reduced accordingly. We think that reduction affords an attractive entry point. We also continue to think small capitalization Japanese stocks are in aggregate one of the world’s cheapest investments. Selling below book value, and at a price-to-sales ratio of 0.40, we believe the risk/reward ratio is attractive. Hereto, we favor dividends and are using Wisdomtree’s Japan Small Cap Dividend Fund (DFJ/$40.73).
The call for this week: One year ago we stated that the bottoming process that began in October 2008 was complete and we were “all in.” We won’t have that same opportunity this year for we’re at the Raymond James 31st Annual Institutional Investors Conference with more than 300 presenting companies and some 700 portfolio managers. Consequently, these will likely be the only strategy comments for the week. Nevertheless, it still appears that the new year’s “selling stampede” ended with the “hammer lows” recorded on February 4th and 5th, and, we tilted accounts accordingly. Meanwhile, March, April, and May are seasonally the strongest months of the year for the S&P 500 (SPX/1138.70). Combine that with the fact that the breadth figures have been stronger than the SPX’s actual price rise, and that positive 4Q09 earnings and revenue surprises have exceeded 70%, and we see no reason to alter our 1200 – 1250 intermediate-term price target. That said, the SPX has expended a lot of energy, rallying rally back to the 1140 – 1150 overhead resistance zone, so it would not surprise us to see the markets stall for awhile before trending higher. As for the recent spate of softening economic reports, it feels like consumers are merely reacting to a winter that is now legend. Our sense is the stormy February data will abate with Spring. Evidently Warren Buffet thinks so as well given his recent statement, “We got past Pearl Harbor (and) we will win the war. It’s going slightly our way.”
“Be Conservative Not Conventional”
March 1, 2010
“Here’s the paradox: the odds are overwhelming I will end up richer by aiming for a good return rather than a brilliant return – and sleep better en route. Folks who seek a killing usually get killed. Gunslingers get shot, and often in the foot, with their own guns. While there is always some guy around on a red-hot streak, his main function is to tempt the rest of us into becoming fools and paupers. A return of 15% to 20% annually is a lot more than most folks realize, or need. If a 30-year old with $10,000 in an IRA gets 15% annually, he’ll be a millionaire before normal retirement. That’s the power of compound interest. If that same 30-year old were to sock away another $2,000 per year at 15%, he would end up as a 65-year old $3 million fat cat. At 20%, it’s an incredible $13 million. That’s a lot, but it’s not too much to ask. The two most definitive studies ever on long-term returns, the Ibbotson/Sinquefield and Fisher/Lorie studies, both point to average annual returns for stocks of 9% plus per year going back to the mid-1920s. So 15% to 20% per year is really 66% to 100% better than the market as a whole. That’s tough but doable. Consistency is the key. It is close to impossible to get a good, long-term, rate of return if you suffer serious negative numbers en route. It’s the math. A single year that is down 30% means you have to get 30% per year positive returns for the next four years to get back on track for a 15% annual average. Or, if you score 20% annually for four years, and then suffer a 30% decline, your five-year average return is only 7%.”
...Ken Fisher, Forbes, 1989
I was reminded of Ken Fisher’s cogent comments from his 1989 Forbes article as I perused Berkshire Hathaway’s annual shareholders’ letter over the weekend. The “memory jog” came while examining Berkshire’s stock market performance. Sure enough, since 1965 the S&P 500’s compounded annual gain (including dividends) was ~9.3% for a compounded return of 5,430%. Over that same timeframe Berkshire’s annual compounded return was 20.3%, or 434,057%. Consistency was the key to Berkshire’s outperformance for over those 44 years the S&P 500 suffered 11 down years, six of which were double-digit declines. Berkshire, however, had only two negative years, neither of which were double-digits. Such risk-adjusted investing has always characterized Warren Buffet, for he maintains it isn’t his best ideas that gave him his tremendous track record. It was having a smaller number of bad ideas that resulted in a permanent loss of capital. “We haven’t taken two steps forward and one step back. We’ve taken two steps forward and a fraction of a step back. Avoiding the catastrophes is really important.”
As usual, Warren Buffet peppers this year’s letter with witticisms that offer useful gleanings to investors. We particularly liked the section titled “What We Don’t Do.” The first bullet point reads:
“Charlie and I avoid businesses whose futures we can’t evaluate, no matter how exciting their products may be. In the past, it required no brilliance for people to foresee the fabulous growth that awaited such industries as autos (in 1910), aircraft (in 1930) and television sets (in 1950). But the future then also included competitive dynamics that would decimate almost all of the companies entering those industries. Even the survivors tended to come away bleeding.”
We revisit Warren Buffet, and Ken Fisher’s, comments this morning because we think 2010 is a transitional year where being “conservative not conventional” is the preferred investment strategy. Accordingly, we like high quality “growth” over “value” and are avoiding companies with highly leveraged balance sheets. We are also looking for companies whose earnings forecasts are being revised upwards, as well as companies with dividend yields. We prefer large capitalization stocks because the drag on relative performance from narrowing credit spreads is waning. Moreover, the current economic, and credit, environments are worse for small/mid-caps; and, large caps tend to outperform when the economic momentum peaks like it appears to be doing. Further, large capitalization companies’ P/E multiples are 20% below those of the small/mid-cap complexes. That said, we are always interested in special situations, no matter what their capitalization flavor.
If indeed this turns out to be a transitional year, we think investors should employ a more dynamic strategy in part of their portfolios. This does not mean we favor the “rapid fire” strategy of trying to day-trade, or even trade on a week-to-week basis. Rather, we favor waiting until the risk/reward ratio is tipped so far in our favor that if we are wrong, we will be wrong quickly with a de minimis loss of capital. For example, we entered 2010 in a pretty cautious mode, worried that the first few weeks of the new year have historically been tricky. Subsequently, we determined the equity markets had fallen into a “selling stampede.” Knowing that such stampedes tend to last 17 to 25 sessions we remained cautious, but continue to add stocks to our “watch list.” Following the climatic downside deluge of February 4th and 5th, we opined the stampede was abating and recommended tranching into (read: buying partial positions) some of the stocks on our various lists. We still feel that way.
That positive view was reinforced last week when the 10-day exponential moving average (EMA) crossed above the 30-day EMA. Additionally, the 50-DMA is turning up and on February 5th the number of S&P 500 stocks above their respective 50-DMAs had shrunk from 92% to ~19%. While that oversold reading has been somewhat corrected by the ensuing rally, roughly 50% of the S&P 500 stocks still remain below their 50-DMAs. Then there was this insight from Minyanville professor Tony Dwyer:
“One indicator that has proven to be an excellent short and intermediate-term buy signal for the S&P 500 is when the percentage of NYSE issues trading above their 10-DMA drops below 10%. The most recent signal was (on) 2/18/10, which represents only the 8th unique instance (rapid multiple signals following the first signal were ignored) in the past 30 years. The average one month gain following the first signal was 5.4%, with a maximum gain of 11.2% and the worst case (and only) loss of 1.31% in 1991.”
Hence, we continue to believe the “selling stampede” is over. To us the question then becomes, will we extend the current rally off February’s “hammer lows,” or will the pattern resemble that of the 1978 and 1979 “October Ouches” whereby the DJIA lost between 10 – 12% in a few short weeks and then based for a month, or two, before giving investors a decent rally. Worth noting is that the DJIA never went decidedly below those “hammer lows,” as can be seen in the attendant chart.
In past missives we have suggested many names for your consideration like CVS (CVS), Cenovus Energy (CVE), Home Depot (HD), Alpha Natural Resources (ANR), and numerous others that can be retrieved from previous reports. And as an aside, China reported last week that it has spent record sums on the importation of coal and liquefied natural gas, which is clearly positive for coal names like Walters Energy (WLT). This morning we give you yet another special situation, namely Goodrich Petroleum (GDP) using its 7.5%-yielding convertible preferred (GDPAN/$35.60). As always, terms and details should be vetted before purchase.
The call for this week: Recently, various economic reports have softened. Why this should come as a surprise is a mystery to us given the stock market’s decline, the employment situation, a political environment that is disgusting on both sides, and a winter that is now legend. However, “Life isn’t about waiting for the storms to pass. It’s about learning to dance in the rain!” Clearly, we are currently “dancing,” thinking the “selling stampede” is over with the only question being, “do we extend the rally off of the February 4th and 5th ‘hammer lows,’ or do we base for awhile as in the aforementioned 1978/1979 examples?” What does concern us was best written by East Shore Partner’s creditable Joan McCullough. To wit:
“George Will said it best when he talked about the equality of opportunity vs. the equality of outcomes. Where the former requires self-determination, the latter requires dependence on the government. Make no mistake about it, we are now all about the ‘equality of outcomes,’ where it only matters, for example, that all adults by age 21, will have 4-year college degrees regardless of ability to write a coherent sentence or multiply 3 x 2.”
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