Shaping a Portfolio for 2010 (IV)–Individual Stocks (i)-General Thoughts

Recapping again:  Our hypothetical investor decides to place 85% of his equity money in an S&P 500 index fund and another 10% in sector funds following the business cycle.  The strategy, which has to be continuously monitored and tested for its accuracy, is that, after almost two years of discounting bad economic news, stock markets are much more likely to shift their attention to the possibility of a better economy next year than to continue to discount the current situation.

What’s left to invest?  –the 5% that’s going to go into individual stocks.  This will be the highest risk portion of the portfolio, and will most likely consist of two or three names.

How do you figure out what to hold?  You want to end up holding a stock where:

–you’re confident you know something about it that the market generally isn’t yet aware of;

–that “something” is important enough to move the stock price up a lot;

–you have a way of monitoring whether your insight is proving to be right or not;

–you have an exit strategy.

These four points will lead to different stocks for different people.  But in the US, it’s much more important to have a fundamentally sound stock that you know a lot about than to be invested in the strongest sector (in non-US markets, in contrast, it’s probably better to have  weak stock in a strong sector).

Knowledge

Ideas can come from anywhere.  In his first book, Peter Lynch (of Fidelity Magellan fame) talks about noticing Dunkin’ Donuts because he bought coffee there on the way to work.  One of my relatives pointed out Chicos to me (while it was still a good stock) years ago.  Watching my kids play Guitar Hero made me add to Activision.

One advantage we may have over professional investors is that they tend to be finance experts who live affluent, urban lifestyles.  As a result, they probably don’t experience as much of everyday American life as the average citizen.  They may also not have the deep knowledge that one may get from a lifetime of work in a specific industry.  They may be able to assess the stock market relevance of information faster, but others have the information earlier.

The important thing is to find an area where you have reason to believe that you have an edge.

Relevance

I’ll admit that I’ve never liked GE, which has always seemed to me to more a product of  former chairman Welch’s PR skills than stellar operating performance.  In any event, it’s an interesting case because one might have known its industrial prospects in China inside-out, but the most important determinant of GE’s stock price has been the collapse of its always-opaque finance arm.

You could also have spotted the growth potential of Coach while it was buried in Sara Lee, but that didn’t do you any good until the business was spun off.

Apple is perhaps the best recent example where individual investors understood the potential for a new product, the i-Pod, to double the profits of the company long before Wall Street did.

A Blueprint

Ideally, you’ll have a spreadsheet that projects the company’s revenues and costs, line-of-business by line-of-business, over the next several years.  You’ll also reconcile cash flows. You’ll monitor your projections against company announcements.  And you’ll try to have some early warning indicators that can give you a heads-up if things are going especially well or poorly.

You may not be able to develop the spreadsheet data that I’ve just described.  But you should at least be aware that this is the minimum the professional competition has.

What other monitoring can you do?  You can pretty easily get on a company’s email list by signing up on its website.  Anyone can listen either to the quarterly results conference calls or their internet replays.  You should also download and read the annual and quarterly reports and their SEC equivalents, the 10-k and 10-q.

Many times trade associations or government agencies have valuable information about overall industry trends.  If you’re lucky, you may be able to identify an indicator that is closely related to a company’s revenues or costs.  You can visit  trade association or government websites.  Often you can call to ask questions.  There may also be product user group websites, or, in the case of big companies, websites dedicated to the company itself.

Sometimes you can find a key customer or supplier, whose results shed light on those of the company you’re interested in.  In Intel’s early days, for example, the newest chips ran so hot they had to be put in ceramic packages, which were supplied by two publicly-traded Japanese companies.  These firms’ announcement of new orders were very closely linked with Intel’s.  More recently, monitoring makers of components for small form factor hard disk drives has given good insight into demand for Apple’s i-Pods, which are the dominant product using such drives.

Exit Plan

I think that before you buy a stock, you should be able to state your general investment idea in a few short sentences, sort of like an elevator speech.  For example:

CAT makes construction equipment.  It’s a cyclical company at the bottom of the cycle.  It typically trades from 5x cash flow in bad times to 10x cf in good times.  It’s now at 5x.  I think cash flow can double in the next five years and CAT can easily trade at 8x again.  Therefore the stock can more than triple.   (I’m a growth investor, so don’t take this as conviction on my part.  I just made this up after looking at CAT historical data.)        or

AAPL is just about to open an online iTunes store.  This will stimulate sales of the iPod tremendously, to the point where the product can add at least 50% to company profits–and maybe more–each year for the next two, boosting the growth rate from 25%.  If we’re lucky, the combination of Apple Stores and i-Pod will get more computer users to make their next laptop a Mac, boosting profits further.  Wall Street thinks the company is growing at 25%/year and trading at 40x.  It’s actually growing at 80%+ and trading at 28x.  The multiple can expand to the true growth rate,  meaning the stock can triple.

Two short statements of an investment thesis.  Also two exit plans.  As long as the stock is doing what the thesis says it should, hold the stock.  As soon as the company starts not living up to the thesis, either recalibrate or just sell.

20th Century Business (Inventory) Cycle

This is a simplified version of how the business cycle progresses.  The detailed ins and outs aren’t necessarily that key for investors.  By far the most important thing  is to have a standard framework for trying to anticipate where new economic energy, hence earnings growth, will come from.

Preliminaries:

The most basic goal of US economic policy is maximum sustainable economic growth, meaning the highest number we can have without creating accelerating inflation.  The Federal Reserve is the primary agency charged with meeting this goal.  Its main tool is interest rate policy.  (Other countries have different basic goals.  For the EU or Japan, which suffered from hyper-inflation in the first half of the last century, the main thing is to have no inflation.  Economic growth comes second.)

The Fed seems to think that the maximum sustainable rate of growth for GDP in the US is about 2% per year now, and that inflation should be no more than about 2%.  This would mean that nominal growth should average about 4%.  These figures are lower than would have been the case twenty years ago, when the target numbers would have been 3% and 3%, meaning nominal growth of about 6%.

In this framework, the Fed has two roles.  It either provides interest rates that are low enough to stimulate growth when the economy is advancing at below its potential, or it raises rates to a level that slows growth when the economy is expanding rapidly enough to run the risk of accelerating inflation.

Starting out–the Road to Overheating

Let’s say that one day consumers decide, for one reason or another, to spend more in stores than they have been.  Stores realize that they don’t have enough sales help and that they’re starting to run out of merchandise.  So they hire more workers.  They call up factories and increase their orders.  If business is really good, they also ramp up their expansion plans, creating more demand for workers and materials in the construction industry.

Factories, in turn, have to hire more workers.  They, too, dust off their expansion plans, creating further ripples of expansion in the construction and machine tools industries.

At some point, the economy starts to run out of unemployed workers.  Companies that want to continue to expand can only do so by hiring workers away from other companies by offering higher salaries.  Wages, traditionally the main source of inflation in the US, start to accelerate.

Contractionary Phase–the Fed Raises Rates

The Fed’s role now changes from encouraging growth to protecting against inflation.  It raises interest rates.  The rise has two functions:  it has some economic effects by itself; it also serves a a signal that the Fed thinks the economy is growing too quickly and is going to do what it takes to slow things down.

Let’s look at what happens to a store.  Say that its policy is to have 10 weeks’ sales worth of merchandise on its shelves and that before the increase in customer buying it was selling 90 units a week.  So it had 900 units in stock, either in the store or somewhere else in its supply chain.  As customers raise their buying to 100 units a week, the store sees it only has 9 weeks worth of merchandise in stock.  But when it calls the factory, it most likely anticipates further increases in customer buying, so it raises its weekly order to 110 units and asks for an additional 200 units so that it will end up with 1100 units in stock.

After the Fed starts to raise rates, let’s say consumers cut their buying back to 80 units a week.  This would mean that the stores–partly because of their more aggressive attitude toward inventories, partly because of the customer pullback–now have 14 weeks of inventory in stock.  So the stores slow their expansion plans and cancel orders for  4 weeks worth of merchandise, as fast as they can.  After the stores phone their cancellations in, the factories are shocked to find themselves without any work for the next month.  They lay off workers and cancel their orders for new machine tools and buildings.  Because of this, the plant construction business may have no work for an even longer time.  They, too, reduce spending and lay off workers.

This process is called the inventory cycle because it revolves around the cyclical expansion and contraction of inventories of goods.  

In this example, a 20% change in consumer spending–which may result from a 10% decrease in income–creates inventories that are 40% more than stores want to carry, factory production that temporarily drops to zero and a capital goods industry that’s completely out of luck.  The numbers may be heroic but the distribution of pain is at least directionally correct.

 

Recovery and Expansion–the Fed Reverses Course

At some point, the economy slows below its trend rate of growth and the threat of inflation dissipates.  The Fed then switches roles in favor of promoting growth.  It begins to lower interest rates.  This move again has a dual character:  it stimulates growth and it signals that Fed policy has changed.  

In traditional financial theory, a lower interest rate makes some business capital spending projects viable that had made no economic sense at higher borrowing rates.  In one way of looking at recovery, these projects begin to be acted on.  If they haven’t already, layoffs stop.  Firms hire workers, who earn income and begin to spend more on goods.  This reinvigorates stores, which also hire more workers.  In other words, industry leads in recover, with the consumer following.  

In my experience, this is the path recovery takes in most places outside the US.  It isn’t the way it works here, though.  In the US inventory cycle, as soon as the Fed starts to lower rates consumers go back into the stores.  The consumer leads industry.  One explanation for this behavior is the “wealth effect,” the idea that the value of consumers’ houses or stock portfolios typically rise on the reversal of Fed policy and the accompanying feeling of greater prosperity leads to spending in advance of income growth.  The “wealth effect” explanation doesn’t have to be right.  It’s the behavior that counts.

Traditionally, a Four-Year Cycle…

This whole process used to take close to four years, with 2.5 years of expansion and 1.0-1.5 years of contraction in the economy and a similar pattern in the stock market, leading the economy by about six months.

…but Future Inventory Corrections May Have a Different Shape

This pattern may still hold true on the domestic side of emerging economies.  But in the US at least, we now have extensive supply chain software installed in the big companies in most industries.  The internet allows global dissemination of this information at low cost.  We have larger and more vertically integrated firms in many industries, so manufacturers can see far down the distribution chain.  As a result,  many of the uncertainties that compelled CEOs to react slowly to changing economic circumstances twenty or thirty years ago are now gone.  So the inventory cycle may look less like a sine wave and more like a sharp drop, long bounce along the bottom, sharp move up and gradual bounce upward.

The stock market has also changed, and can react to new economic information far more quickly than it used to be able to.  A huge market for derivatives is available now that was in its infancy thirty years ago.  Transaction volumes in the physical market are also very large multiples of what they were then.  And short-selling was less accepted as a mainstream institutional or individual investment strategy.    But in the old days, there were substantial barriers–apart from business considerations–that limited portfolio managers’ ability to quickly become more defensive or aggressive.

Looking back, I suppose that it shouldn’t be too surprising that the stock market cycle and the inventory cycle were closely related.  But we may find in the future that the traditional pattern of leads and lags between the economy and the stock market have been more a function of the instruments we have had at hand to express our economic conclusions than anything else, and so may no longer hold true.

Currency Effects on Stocks

No Comprehensive Currency Theory

I don’t think we have a really good, comprehensive theory of how currencies interact.  Maybe this is because currencies haven’t been floating for that long.  But today’s commercial world is also radically different from what it was a generation ago.  Countries around the globe have been pretty consistently promoting free trade and trying to coordinate interest rate and other macroeconomic policies.  At least partly as a result, the past twenty or thirty years have seen immense growth in international trade, and the rise of large global firms in Asia, Latin America and Europe, to match the scope of their US counterparts.  Of course, trade in services, where incremental manufacturing costs may be negligible, has risen dramatically as well.

Stocks vs. Bonds–Different Rules

Currency movements can be a crucial issue for investors to plan for. The picture most investors have, I think , is modelled on how the international bond market works. But currency issues for government bonds are radically different from those for stocks.  

An international (100% foreign) or global (US + international) bond manager almost always places a derivative overlay on top of his bond positions.  He does this partly to try to exploit inefficiencies in the foreign exchange markets.  He also wants to bring his results back into the reference currency in which his performance is judged.  Most important, he wants to protect his portfolio from possible future currency losses that he may anticipate but which are not yet expressed in today’s prices.  After all, when you get down to it, government bonds are just streams of future payments in nominal terms over a set time frame in a specified currency.  Bonds don’t have a life of their own. They can’t act to ward off the adverse effects of currency shifts by developing new products, the way companies can. or by shifting procurement to lower-cost countries, or doing currency hedging themselves.

A (highly simplified) example.  Imagine that you buy a government bond yielding 10% issued by a country with a large trade deficit (the value of what it imports is greater than the value of what it sells to the rest of the world–an unsustainable condition).  One day, investors wake up and start to worry about the fact that this country has to continually borrow money to pay for imports and maybe that it can’t generate enough foreign exchange to make its interest payments.  This is sort of like the way the credit rating agencies start to worry about a consumer who continues to run up credit card debt.  Now, the world may tolerate a trade deficit  for a longer time if it’s to finance purchases of industrial machinery that will be used to make stuff for the export market, but in this case let’s assume the imports are all consumer goods, like flat screen TVs.  

Investors express their worry by selling the currency, pushing it down 5%.  The country’s government realizes it will be hard to continue borrowing from the rest of the world if the currency is weak, so it tries to defend the currency by raising interest rates to 11%.  

An investor in this country’s government bonds has lost in two ways.  Since rates are now 11%, his 10% bond is worth less than par.  And, if he is unhedged, he has likely suffered a bigger loss from the currency decline.

Mexico as an Example

For stocks, the situation can be substantially different.  The most startling instance I can think of is Mexico after the country came near to collapse in 1982.  During the following decade, the peso lost about 99% of its value and local interest rates reached well above the 50% level (I’ve looked in a haphazard way on the internet for the actual numbers, without success.  But I figure they’re not so important).  Yet stock investors made more money in dollars in the Mexican market during that period than in virtually any other market in the world.

Mexico is admittedly an extreme case.  It started in 1982 from a position of near government bankruptcy, due toheavy reliance on oil and excessive borrowing to finance consumption rather than investment.  But its citizens had an heroic commitment to transforming the country’s economy.  They continued a reform agenda despite eight years in a row of falling real wages.  In addition, the government made it illegal for a period for people to transfer money out of the country.  So local investors gravitated to stocks to try to preserve the purchasing power of their pesos.   The general point is still valid, though–that a stock investor can prosper in a weak currency environment, even without going into the currency futures markets to hedge, as long as he selects stocks correctly. 

Currency Effects on Economic Activity

Speaking in the simplest terms, a drop in a country’s currency has two short-term effects:  it acts like a decline in interest rates by stimulating overall economic activity; and at the same time it shifts economic energy among sectors, rearranging the relative winners and losers within the economy.   In the long term, at least in theory, things settle back to where they were before.  The only lasting effect is a higher level of inflation.

As the local currency falls, imported goods become more expensive.  Buyers look to local alternatives, so import-competing businesses get a boost.  So, too, export-oriented firms, because locally produced goods are now cheaper on the world markets.  Local vacationers stay home, because overseas trips are now more expensive; foreigners flock to the local vacation spots in larger numbers.  Foreigners may find property and other asset values more attractive and buy, as well.

On the other side of the coin, anyone who uses now higher-cost foreign materials in his products is a loser.  So too are importers of foreign finished goods, and the foreign firms who supply anything to the local market. 

Rules for Stocks

1.  Therefore, all other things being equal, you want to hold a company that has its costs in weak currency countries and its revenues in hard currency countries.  This will produce the widest margins.  It also explains why the furniture industry has shifted from Europe and the southern US to China and the higher end of the clothing industry is quickly following along.

2.  You have to think things out from the perspective of an investor in the company’s home market.  Imagine two chocolate companies, each with half its business in the US and half in continental Europe.  One is listed in the US, the other in France.  Let’s assume the euro is a stronger currency than the dollar.  The US one is likely to be an outperformer on Wall Street, the French one is likely to be a relative loser in Paris.

3.  Most large companies hedge at least some of their foreign exchange exposure through currency derivatives all the time.  Most companies highlight this fact only when they have currency losses, not when they have gains.  It’s human nature, but it gives investors an overly optimistic idea of margins.

4.  Sometimes, all things aren’t equal.  Sometimes, a company can have a unique set of desirable products, or some other reason to be experiencing an extended period of super-strong growth, and currency effects aren’t big enough to destroy the investment case.   Example:  if you were a euro- (or Dmark-) based investor in the late Eighties, would you buy Microsoft?  True, you would have had a currency loss by holding a dollar-denominated asset, but between 1986 and 1999, MSFT went up more than 500x in dollars.

5.  I’ve always found the currency derivative market to be tough to make money in.  It’s dominated by very sophisticated large banks, who spend 100% of their time thinking about currency and who always seem to be one or two steps ahead of me.  So except in extreme cases of misvaluation, mostly with yen, I’ve tended to avoid it.  In the example in rule #4, I realize that I would have maybe 30% more if I hedged the currency exposure.  But I have no edge in currency.  And worrying about currency would take away from time thinking about stocks–thus lessening the chances of finding a MSFT.  So I’d have to be content with 500x rather than 650x, but would have a greater chance of making the “smaller” amount of money.

6.  Currencies move quickly, stocks usually follow more slowly.  I’m not sure why this is the case, or that it will continue to be so in the future.  But I’ve found that there’s usually time to position yourself more favorable, even after a currency move has begun.  The other side of the coin is that you may have to wait for a month or so for the equity markets to price in the effects of a currency change.

7.  The “all other things being equal” works best in emerging markets and with commodity-like products.  Big multinationals in developed economies typically can choose among multiple sources of supply in different countries, so they can try to mitigate negative effects of currency by shifts in procurement.  Also, they tend to have more complex products, where customers may have no choice but to accept higher prices.  They can hedge, as well, by locating assembly plants close to customers, and through the currencies in which they denominate their debt.

8.  Note:  emerging markets can have other serious pitfalls.  It’s important to learn the local rules of the game before starting to play.  Stay tuned for a post on this.

Absolute vs. Relative Performance

Absolute performance

Most individual investors judge investing success by asking whether at the end of some standard time period, say, a year, they have more money than they started with or less.  In other words, they judge performance on an absolute standard:  +8% is a good year, -3% is a bad one.

Relative performance

Professional investors normally use a different yardstick.  They, and their customers,  judge their performance by a relative standard.  How has the manager done versus a benchmark index?  How has the investor done in comparison with a universe of his peers?  Looking at performance this way, if the benchmark is the S&P 500 and it’s +10% for the year, then +8% isn’t so hot.

If the client wants a low risk approach and has said, in effect, try to get some outperformance if you can but it’s very important that you not underperform by more than 100 basis points (=1%), then +8% is horrible.  (One might reasonably ask why a client would ever hire an active manager and give him instructions like this, but I’ve seen it done.)  On the other hand, if the client wants a higher risk approach and has hired a manager he thinks will outperform over a market cycle but who will be +/- 400 bp in any given year, then two percentage points under the index isn’t so bad.

Performance vs. peers

Performance vs. peers is a secondary measure that institutional investors use.  Almost always, it’s a weaker criterion than performance vs. the index, especially so in the US.  Here, almost no active manager beats the index.  But one can argue that a manager has at least some skill if he does better than other managers.  There are times, however, when comparison vs. peers serves a very useful function.  For international managers during the Nineties, the “lost decade” for Japan, for example, virtually every manager beat the international EAFE index by underweighting the Japanese market.  So customers began to differentiate performance either by separately analyzing performance vs the index in Japan and in non-Japanese markets or, more commonly (I think) by comparing managers with each other.

Individual investors

Individual investors strike me as wanting the best of both worlds.  They want index-beating performance in the up markets, and also expect to avoid making a loss in the down years.  Hence, the appeal of Bernard Madoff or of hedge funds.  After a good several-year run, the average hedge fund has underperformed the S&P 500 every year from 2003 onward, before completely blowing up in 2008.  We all know the Madoff story.

Gains every year are hard (impossible?) to achieve

Why is absolute return so hard to achieve, apart from holding cash-like instruments like a money market fund or treasury bills (both of which are yielding pretty close to zero at the moment)?  It’s because interest rates change with the business cycle.

Take the case of a 10-year treasury bond.  Suppose you buy one for $1000.  It’s currently yielding about 3%.  So you’ll get a payment of $30 yearly from the treasury and your $1000 back in 2019.  That won’t change, no matter what happens in the economy between now and then.  The 3% yield is more or less determined by the federal funds rate (the overnight lending rate between banks) has been set very close to zero–say, .25%–because the economy is so weak.

Over the next few years, we hope, the economy will get better and the fed funds rate will rise to a more normal 3%.  The yield on a 10-year bond newly issued then will probably be around 6%.  What happens to the price of your bond?  Well, if a yearly payment of $60 plus return of principal at the end of the bond’s life is worth $1000, then our yearly payment of 3% plus return of principal must be worth less.  It’s possible that, in a given year, that the decrease of value of our bond will be greater than the 3% coupon payment we receive.  In other words, we’ll have a loss that year on our investment.

That may not matter so much to us.  We have a guaranteed stream of income and we’ll get all our principal back at the end of ten years.  So our investment objectives are probably all being met.  In fact, if we thought a bout it a little more we might conclude that what we really want is stability of income.    In addition, it may well be that having a temporary loss (short-term volatility) isn’t a particularly important investment objective for most people, even though it is the most common measure of risk used by academics and pension consultants.

Why relative performance?

What makes relative performance, as hard as index outperformance may be to achieve, so popular a way of judging managers?

For one thing, the practical task of management is easier. The question of which stock will likely perform better, AAPL or DELL, is almost entirely about the strengths and weaknesses of the two companies and about the relative valuation of their stocks.  If I’m competing against an index that has DELL in it and I hold AAPL instead, I’ll outperform if AAPL does better, no matter whether they go up or down.  In contrast, the question of whether AAPL will go up or not is also one about the state of the world economies and the direction of currencies and interest rates, among other things.  And in the past year or so, we’ve seen the stock go from about $200 a share down into the $80s, without much change in the underlying company’s results.

It allows managers to specialize.  If a manager runs a health care portfolio or specializes in Pacific Basin stocks, he can presumably develop a depth of knowledge–both about the stocks and about the composition of the index–that will enhance his returns.

Part of the responsibility for portfolio risk shifts back to the client, or at least away from the manager.  In most cases, the client has an advisor–a financial planner, a broker, a pension consultant–who helps make the ultimate decision about where a given manager fits in the client’s overall portfolio.

Another aspect of the last two points is that the manager doesn’t have to coordinate his actions with other portfolio managers, or even understand the risk perameters of the client’s overall holdings.  That’s done by the advisor or the client himself.

This way of operating–multiple managers operating in isolation but coordinated by a third party–got a huge boost from the Employee Retirement Income Security Act (ERISA) of 1974.  By setting more stringent requirements for the professional training and experience of pension managers, ERISA encouraged companies to seek third-party managers for their pension funds.  This gave rise to a bevy of consulting firms to help companies develop asset allocation strategies for their pensions, as well as to help select and monitor third-party investment managers.  The consultants promoted a philosophy of centrally (company + consultant) developed investment plan carried out by a diversified group of highly specialized managers.  As luck would have it, this created a key role, rich in fee income, for the pension consultants themselves.  Companies didn’t mind that much, because they were transferring the risk of underperformance from themselves to the managers and the risk of picking the wrong investment firms to the consultants.  Since managing corporate pensions was an immense growth business for investment companies in the Seventies and the Eighties, the consultant-approved model of highly focused managers became the industry norm.

Individuals and a Hybrid Model

The traditional model for a retiree has had two parts:

–to secure a steady stream of income through a defined benefit pension plan + social security, using an absolute standard for assessing what is good enough; and

–to hedge agains unforseen circumstances, including inflation, by holding equities, whose performance would be judged (if at all) by a relative standard.

This traditional world has been turned upside down in recent years.  But that”s a story for another day–actually it’s the story this blog hopes to tell for some time to come.

Note:  See more recent comments on this topic in my 9/29/10 post.