Tuesday, April 28, 2015

"Swing Thoughts" for this Market

            With apologies to the non-golfing readers, I am going to go with a golf analogy this quarter. We have, after all, just emerged from Masters week which is the equivalent of Holy Week for the avid golf fan. Years ago, I picked up a book by legendary golf teacher Harvey Penick called Penick’s Little Red Book. Penick’s resume included teaching many successful tour players like Ben Crenshaw, Tom Kite, and Kathy Whitworth while remaining an active instructor well into his 80’s. Despite Penick’s relative anonymity, the book succeeded, selling more than one million copies to become the best-selling sports book of all time.* Why? Because Penick’s teaching worked. It made the average golfer play better.

            Penick relied on short, memorable anecdotes to drive home important points. He gave his pupils a “swing thought” – the one thing they were to think about before stepping up to hit a shot. For example, when Penick’s student, Betsy Rawls was in a playoff for the 1951 US Open Championship he sent her a one-sentence telegram. It said: “Take dead aim!” This was her ONLY thought when she approached her golf ball. Betsy won the playoff.**

            Many golfers don’t experience similar success not because they lack talent, good instruction or sound equipment but, in large part, because the swing thoughts they have in their head before they bring the club back are wrong (or, perhaps, they have too many of them).  Likewise, individual investors don’t achieve the returns they should because of flawed thinking prior to and while they are deploying or monitoring their personal capital.  Barry Ritholtz, a leading Wall Street commentator and strategist, notes that since ERISA was passed in 1974 enabling IRAs and, eventually, 401(k) accounts, the market has returned about 11% annually.  However, the average investor has gained only 3% per year. ***  This is commonly known as the “behavior gap.”  Bad thinking leads to bad investment behavior in the same way that bad swing thoughts lead to bad golf swings.  In both cases, the result is bad.  In one case, the cost is some lost golf balls and a bad afternoon outside; in the other case, the cost might be a college tuition payment or a deferred retirement date, or worse.

            Just as people hired Harvey Penick so that they would score better versus how they might score without his input, we believe folks hire Punch and Associates so they might achieve better results versus what they might achieve without our involvement.  So what is the equivalent of a good swing thought for putting money to work or staying invested in THIS market?  We have several, in particular, for folks taking a passive approach toward overseeing the active management of their portfolio:
  •       Think “Zig,” think “Zag,” but mostly, think long term.
        "The market timers’ Hall of Fame is an empty room."   -- Jane Bryant Quinn
         
Despite having heard this quote early in my career, I had to lose some of my own money to realize the veracity of it.  Nobody on the Forbes 100 list got there by jumping into and out of businesses on a regular basis.  Why should we advise our clients to do differently?  We are contrarian investors, so it is in our nature to examine parts of the market that have a) attracted the least amount of attention, or b) declined recently or have not participated in the market’s advance.  In many cases, these areas have the most upside over our expected holding period.
  • Forget the headlines. 
         “News is to the mind what sugar is to the body.”   -- Rolf Dobelli (www.dobelli.com), 2010

I challenge anyone to name a time when you read a mainstream headline and it allowed you to make a better decision.Think of what it takes for something to become a headline.  Many people —not just one or two—have to be clubbed over the head with the effects of an issue or the concern over what might happen; they then  gather in a room discuss it some more, ping-pong the issue back and forth, and maybe table the headline for future publication.  Something more happens in the real world – stocks go up, stocks go down, the dollar spikes, oil crashes, etc. – and they decide to create the headline.  How is this headline going to help you?  The fact that it was created means that its effects have already been felt.  You can’t profit from it, and it will likely create unneeded angst.
  •          Volatility does not equal risk.  
With markets up and a Fed tightening in the offing, markets will no doubt fluctuate more.  Warren Buffett dedicated several paragraphs in his annual letter to the difference between volatility and risk.  He is the world’s most successful investor, and he does not buy into the conventional wisdom about it: “stock prices will always be far more volatile than cash-equivalent holdings.  Over the long term, however, currency-denominated instruments are riskier investments — far riskier investments — than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions.  That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk.  Though this pedagogic assumption makes for easy teaching, it is dead wrong:  volatility is far from synonymous with risk.  Popular formulas that equate the two terms lead students, investors and CEOs astray.”

Warren’s business partner, Charlie Munger, defines risk more succinctly: “using a stock’s volatility as a measure of risk is nuts.  Risk to us is 1) the risk of permanent loss of capital, or 2) the risk of inadequate return.”
  •              Don’t get too excited/depressed.

    “We have met the enemy, and he is us.”         -- Pogo, 1970
The market has recovered over 200% from its bottom in 2009.  That’s a 20% + annual return for the S&P 500.  Pretty exciting, right?  The previous 10 years (1999-2009) was different.  The S&P lost about one-third, or almost 4% annually.  Pretty depressing, huh?  Excitement causes people to want more of what excites them.  Depression causes people to want to stop the pain.  While these emotions are normal, acting on them with your money is not recommended.  Most of our clients have been with us during both of these historical periods, and we believe most will be with us during distinct periods which will evoke similar extreme emotions in the future.  This is when proper swing thoughts are critical.


3
4.     
*         Golf.com/instruction/Penick
      **     The Little Red Book, Penick 1992
     ***    www.ritholtz.com/blog


Thursday, January 24, 2013

A Behavioral Margin of Safety

                In 1991, one of the least-known, best investors of our time wrote a book called Margin of Safety. Seth Klarman, the author and Chairman of the highly-respected hedge fund, Baupost Group, did not take long to figure out that publishing was not going to be where his bread was buttered. He published only 5,000 copies and stopped printing what many value investors  now consider “the bible”. Today the book fetches $2500 a copy on Amazon but might be found used on eBay for $1000. Klarman could now likely turn a tidy profit publishing a few more copies but that clearly was not his objective in the first place. His objective was to get out of his head and on to paper what is the truth about why very few people are highly successful investors and most range from average to outright failures. Most investors, he concludes, focus on return and not risk.

                In the book, Klarman goes out of his way to focus on risk. He notes, “A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world."

                Klarman goes on to discuss several methodologies for examining what the true value of a company is versus the perception of its value as portrayed by its stock price. He mentions many methods for evaluating the “real” value of a company -- practices which can be executed by most undergraduate-level finance students. Klarman knew that his formulas and assumptions could be perfect, but unless perception (stock price) and reality merged, he would not make money. The gap needed to be wide enough to account for uncertainties and peoples’ perceptions needed to change.

                While this all seems dull and mathematical so far, great investors like Klarman, Buffet, and Soros are acutely aware that current circumstances  and the corresponding investor behavior they elicit is what leads to any disconnect between the market price and the true value of each of their holdings. They believe that the ideal circumstance for identifying the widest gap (best margin of safety) is when the fewest number of people agree with them. This happens when the behavior of other investors is contrary to their own.  Great investors also know that extreme behavior is not permanent behavior.  Attitudes can change more rapidly than fundamentals and money can be made anticipating these attitudinal shifts.  Money can be made buying companies (or industries, or markets) with the highest “behavioral” margin of safety. Capital can be protected by avoiding (or shorting) those with the lowest behavioral margin of safety (crowded trades).

           What is also quite clear to us is that the longer an investment behavior persists (e.g. buying bonds, selling energy stocks, buying large cap growth stocks, etc.) the greater the likelihood that this behavior will sow the seeds to its own reversal.  At these "behavioral inflection points" the selling will dissipate and turn into buying and the buying into selling.  Said differently, the stocks (or bonds, commodities, real estate) with the lowest behavioral margin of safety are those that have already  gone up the most for the longest period of time.

        When I think of recent history, I think of the stock of Apple.  In September of 2012 the stock eclipsed $700 per share.  Since October of ‘08 Apple ascended to that level in a mesmerizing fashion growing at an annual rate of more than 60%.  Few managers who expected to beat their benchmarks could afford to be left out of this stock.  At $700 per share there was still a cogent argument as to why the stock had a fundamental margin of safety.  Excluding the over $120 of cash per share the company had on its balance sheet,  Apple was still trading at under 12 times its forecasted earnings. This was cheaper than many slower growing, lower quality companies in the S&P 500.  But how high was its behavioral margin of safety?  Did everybody who was going to buy it already own it?

        While this practice is difficult to quantify, I would hazard to guess that the behavioral margin of safety was not high for this investment.  According to Nick Murray Interactive, Apple was one of the top ten holdings in over seven hundred equity mutual funds; four hundred had it as their single largest holding.  400 mutual funds quantitatively demonstrated that this was the single stock that was going to help them the most in beating the market averages over the foreseeable future after it had already gone up more than just about any other stock over the previous four years.  It takes some courage to own any single company.  With Apple it took a great deal more courage not to own it.  I have no idea how this company will perform from current levels ($500 per share a/o 1/2012) but Nick Murray said it best when he commented, “We may no longer be willing to accept even excellence from Apple, because we have in some sense started pricing in magic.”

            The behavioral margin of safety for the stocks in general can vary over time. As we enter 2013 stocks have recovered over 100% from their lows in March of 2009.  One would think that the average investor increasingly participating is one of the reasons for this recovery.  This is not the case. According to Gallup, every year since the recovery began the “participation rate” of American household in stocks has declined.  The participation rate sits at 54%, the lowest level since Gallup started measuring the data in 1999.  Everybody who can own stocks clearly does not own stocks. Every dollar that could come into the stock market has yet to be committed.  We would need to see more investors behaving with impunity before waving the caution flag to our loyal constituency.

Thursday, December 27, 2012

The Search For Oracles


"The greatest blessings come by way of madness."  -- Socrates on the Oracle of Delphi

     The focus on recent headlines and worries about the Fiscal Cliff has distracted investors away from the factors critical to long term investment success.  We are content to leave the predictions to others and instead spend our time trying to find value-priced companies that have the potential to grow substantially over time, thereby unlocking the powerful force of compounding.  

     I recently had the privilege of traveling to one of the most important sites of the ancient world:  The Temple of Apollo at Delphi.  Delphi was the longtime home of the priestess of Apollo, an Oracle who was believed to be able to predict the future based on her ability to communicate directly with the Greek Gods.  The Oracle's prominence began to grow immensely sometime around 800 BC and held steady for over 1,000 years ending only with the fall of the Roman Empire.  Citizens from all over the Mediterranean made the long and difficult journey through the mountains simply to seek the Oracle's divine prophecies.  In fact, many of the best known figures of the period (such as Alexander the Great, Cicero, and the Roman Emperor Hadrian) based their decisions for war and politics on her responses to their questions.  The Oracle's prophecies were widely credited as being highly accurate, which is reflected in the incredibly vast store of wealth that was accumulated by the temple (satisfied visitors were expected to make significant donations and gifts).  In many ways, the Oracle can be said to have started the first, and perhaps most enduring, global consultancy.*

     So what does the story of the Delphic Oracle have to do with investing?  When I was touring the site, I couldn't help but think that it speaks to a core element of human behavior.  We all would like to be able to know the future before making decisions regarding inherently uncertain events.  This dynamic is perhaps strongest in today's investment world which is obsessed with predicting the future and constantly in search of modern day Oracles.  CNBC interviews filled with questions about the course of short term events illustrate this quite well with common questions along the lines of, "How will the Greek Parliament vote?", "Where is the price of Gold headed this week?", and our recent favorite, "How are you positioned for the Fiscal Cliff?".  This tendency has helped create a headline-focused trading culture built on the mistaken belief that investing is a predictioneer's game--that those who can most accurately predict the outcome of headline events perform the best.**  The end result is that many investors:
  • Spend considerable time trying to predict headlines
  • View their portfolio in the context of recent news (shows such as Fast Money and Options Action are indicative of this mindset)
  • Trade incessantly, holding securities for increasingly short periods of time (the current average holding period of a stock is now only 3.2 months)
  • Engage in herd-like behavior, crowding in and out of the popular stocks and industries of the moment
  • Spend little time examining fundamentals and the underlying value of businesses
     The most successful investor of our time has been dubbed the "Oracle of Omaha" by the media.  This title strikes us as particularly ironic given Mr. Buffett's well articulated philosophy of generally avoiding predictions.  That doesn't stop people from asking him to predict the future, though, and the most recent Berkshire shareholders' meeting was filled with questions about recent headlines.  His response: "In 53 years, Charlie and I have never had a discussion about buying or selling in which we talked about macro affairs."  Indeed, Buffet has repeatedly advised investors to "stop trying to predict the direction of the stock market, the economy, interest rates or elections."  This sage advice has not been heeded by the masses.  It is clear to us that Buffet's success has had almost nothing to do with his ability to predict the outcomes of events.  Instead, it has been a direct result of his behavioral investment philosophy combined with a keen analytical ability to value businesses and buy them at prices which offer significant value--something we attempt to do on behalf of our investors each day. 




*As a footnote, an interesting question is how the Delphic Oracle held prominence for over 1,000 years while being engaged in such a difficult activity as predicting the future?  With the benefit of history, we now know that the Oracle had a secret.  Upon reaching the large Temple, guests would be lead to a small chamber, the Adyton, where the Oracle (typically a young woman) would receive guests while sitting on a tripod over a smoky vent.  Upon hearing a question, she is said to have become hysterical and begin to speak in "incomprehensible tongue" which was explained to come straight from Apollo.  Male priests would interpret her rantings and write a short, one or two sentence prophecy.  Research now indicates that her erratic behavior was due to the fact that the vent emitted a natural hallucinogenic gas.  While it is incredible to think that ancient visitors would give credence to the rantings of a drug induced teenaged girl, her behavior would have been something most visitors had never seen before, making the experience more believable.  The real power of the Oracle resided in the Priests who actually wrote down the predictions.  It is believed that the priests were great scholars who turned Delphi into a large information gathering center (a powerful tool in an ancient world where information was scarce).  They were able to research questions beforehand and dispense appropriate wisdom and advice.  For uncertain events (such as, "Will my unborn child be a boy or a girl?"), there was more gamesmanship, and the Oracle is famous for delivering prophecies which could be interpreted as being correct regardless of the outcome (the answer: the double entendre, "A boy not, a girl.").

**Notably, this behavioral tendency has also created incentives for pundits to make bold and extreme predictions.  A correct prediction of a low probability event has the potential to instantly elevate the media profile of the individual making the prediction, while a failed prediction is forgotten or can easily be explained away.  Thus, making a bold prediction has a favorable risk/reward trade-off especially for individuals seeking increased notoriety. 

Friday, November 16, 2012

Small Cap Valuations: Market Cap Bias and the Dangers of Headline P/E Ratios

       Using headline valuation metrics as a barometer can be particularly dangerous and misleading, especially for the Russell 2000 Index.  In addition to distorting the index, a market cap "blind spot" has created persistent inefficiencies (and opportunities) at the smaller end of the small cap universe.  Our small cap strategy, with a current median market cap of roughly $350 million, concentrates on smaller companies because this is precisely where thorough research matters the most.  
  
      During our recent conversations with institutional investors and consultants, we have frequently heard that "small caps look expensive."  Indeed, the Russell 2000 currently sports a headline P/E ratio of nearly 30x trailing earnings compared to around 14x for the S&P 500.  Is this conclusive evidence that small caps are overvalued -- especially relative to large caps?  

      We have been somewhat puzzled by this conclusion, as it contradicts what we have been seeing "on the ground."  As bottom up investors, we spend our time researching one company at a time.  While we are inherently intimidated by high valuations, we continue to come across plenty of small, well-run enterprises which appear to be both undervalued and out of favor.  Likewise, many of the quarterly earnings conference calls we tune in to have continued to garner muted interest at best (with some having no Q&A participants at all)--not exactly a sign of "irrational exuberance" for small caps.  Both of these observations are confirmed by the most recent additions to our small cap portfolio which are valued well below the Russell 2000 Index by most metrics.  So...what gives?

      One part of the explanation lies in the structural market bias we have previously referred to as the "market cap blind spot."  A majority of sell side analysts and professional money managers concentrates on the largest companies in the small cap universe and ignores the smallest ones.  This stubborn reality is reflected in the holdings data for buy-siders:  the average small cap mutual fund in the Bloomberg universe has a median market cap of $1.8 billion - a full three and a half times the $491 million median of its Russell 2000 benchmark.  In addition to creating persistent inefficiencies in the small cap marketplace, this bias has distorted valuations within the index itself.  An average of the valuation metrics presented indicates that the largest quintile of the Russell 2000 is 20% more expensive than the smallest.  This relationship underpins a counterintuitive dynamic in small caps, namely, the size of the company--not necessarily the merits of the business--is often the determining factor of its valuation.  This contrasts sharply with large caps, where size generally plays no discernible role in company valuations.

Evidence of the Blind Spot

 Russell 2000 Median Valuations by Quintile (10/31/2012)*

Market Cap (Millions)
Trailing P/E
Forward P/E
Trailing EV/EBITDA
# of Analysts
1 (Largest)
1,642
18.6
15.2
13.5
10
2
854
16.7
14.1
12.4
8
3
491
16.3
13.9
13.3
7
4
269
16.4
13.6
11.8
5
5 (Smallest)
150
14.9
13.2
11.3
4

 S&P 500 Median Valuations by Quintile (10/31/2012)*
  

Market Cap (Millions)
Trailing P/E
Forward P/E 
Trailing EV/EBITDA
# of Analysts
1 (Largest)
56,433
15.2
13.2
12.3
28
2
19,999
14.7
13.8
12.4
24
3
7,722
16.4
13.8
12.2
19
4
7,668
16.8
14.5
12.2
19
5 (Smallest)
3,932
15.5
12.8
11.5
16

*We chose to use median data to eliminate the effect of extreme numbers and also believe it is more representative of company valuations found in each quintile. Data assembled from Bloomberg, L.P.

      Because of market cap bias, the Russell 2000's headline P/E (a weighted average) is inflated, as the most expensive companies have the greatest representation in the index.  This dynamic is further compounded by the fact that the Russell 2000 has more than twice the proportion of companies with exceptionally high P/E ratios* (often caused by marginal recent profitability).  In our view, median data produces a far more meaningful comparison because it is less affected be these distortions.  We also believe that median data is more indicative of the valuations of a "typical" company in the index and also more representative of the characteristics which an active manager is most likely to uncover during his or her research.

*10% of Russell 2000 names have a P/E ratio over 40 compared to only 5% of S&P 500 names.     

Median Data Comparison (10/31/2012)


Market Cap (Millions)
Trailing P/E
Forward P/E
Trailing EV/EBITDA
# of Analysts
Sales Growth
Earnings Growth
Median R2K Company
491
16.9
14.2
8.9
7
5.5%
7.0%
Median S&P 500 Company
12,495
15.9
13.6
9.0
23
2.4%
4.5

      When examined on a median basis, the valuation disparity narrows substantially: small caps are only 4% more expensive than their large cap counterparts despite appearing twice as expensive on a headline P/E basis.  We think that this slight valuation premium for small caps is more than warranted considering their stronger sales and earnings growth characteristics (in red). 

Friday, September 28, 2012

Mis-Impressions


I’m a huge golf fan. I’m a bigger Ryder Cup fan. So Friday morning was the start of a golf fan’s “best 3 days”. The TV was on but I was not tuned in. I had to work.  I looked up every once in a while to see how my American favorites were doing against their European counterparts, and every time I did something bad was  happening to the  Americans. I saw Tiger hit balls into the woods, I saw Furyk “ lip out” putts, so I naturally assumed we were getting our “collective American butts” kicked in the morning session. Much to my surprise this was not the case. Americans and Europeans were tied when the morning session concluded. It occurred to  me that this must be how many  individual investors feel about stocks and the stock market.

Research points out that this is exactly the case. Franklin Templeton surveyed one thousand Americans in 2010, 2011 and 2012, and asked them how they thought the stock market had finished at the end of the previous year. For the year 2009, in which the S&P 500’s total return was 26.5%, 66% of the thousand respondents said that it had been down or flat. For 2010, when total return was 15.1%, 48% of those surveyed said that it had ended down or flat. For 2011, the return was 2.1%, and 53% of respondents said that the market had been down or flat. What’s worse is that, based on these “embedded impressions” and the continuous negative media drumbeat, these same folks are likely deferring investments or vacating well thought out financial plans. Over $300 billion has been withdrawn from actively managed equity mutual funds since the market bottomed in March of 2009(The S&P 500 is up 115% since then). The money is still trickling out because when people glance up at the screen it looks like Phil or Tiger missed another putt.

I guess the  choice is to pay attention or turn the TV off.