When something is going wrong…(l) General

Finding and fixing mistakes is very important…

Most equity professionals will tell you that it’s at least as important to identify and fix mistakes as it is to find and hold stocks that will outperform.  Yes it’s a cliché, but that’s another way of saying it’s really and obviously true.

…but it’s harder than it seems

It’s less likely that a professional will tell you how hard this is to do.  It may be they’re unaware themselves.

I picture the situation as being like a professional baseball hitter coming up to bat.  On the one hand, he is absolutely convinced that he is going to hit the ball safely and get on base.  On the other hand, if you ask him what his chances are of hitting .400 for the year (that is, hitting safely in 40% of his at bats), he would probably laugh and say that no one in the major leagues has done that in over fifty years.

Similarly, every time an investment professional, or any of us, for that matter, makes a trade, we all think–whether we are conscious of this or not–that we know better than the guy on the other side.  If we’re buying a stock we think the seller is foolish to part with it; if we’re selling, we think the buyer is overpaying.  At the same time we know, at least intellectually, that two-thirds of the professional active managers in the US underperform the S&P 500.

Why am I going on about this?…because the character trait that makes any of us able to enter a buy order, our strong conviction that we know more than the other guy, is the same characteristic that stands in our way when we’re trying to figure out whether we’ve made a mistake.

The hard part is recognizing a mistake

The important issue for an investor is not how to fix a mistake–that’s easy: you sell the stock, you make your portfolio look more like the index.  The really key issue is how to recognize that you’re making one (before you’ve lost half your money).

Three posts on this topic

I’m going to write about this topic in three posts:  this one contains general comments; the other two will be what techniques a value investor typically uses and what techniques his growth counterpart employs.

Luckily, we’re not baseball players

Yes, investing is a lot like baseball–both experience-intensive craft skills.  But when it’s the baseball player’s turn at bat, he has to go up to the plate and swing, whether the pitcher is an All Star who never gives up a hit, or a rookie who can’t get anybody out and is just about to be sent back to the minor leagues for more seasoning.

We don’t.  We have the luxury of picking the pitchers we want to face.  We can sit on the bench and eat sunflower seeds until we see one we like.  Brokers may encourage us to transact, because that’s how they make their money, but we don’t have to.

One of the most important things I think any investor has to learn is that he doesn’t have to have a opinion about everything–and express that opinion in buying and selling.  This is a recipe for failure.

A few things we know a lot about, not a lot of things we know a little about

We should be just the opposite.  We need to have a few well-reasoned and well-researched ideas that lead us to stocks/mutual funds/ ETFs that we conclude are worth more than the market now realizes.  It’s better to have one or two things that we know a lot about than it is to have two dozen half-baked ideas.

First, create a safety net

There a number of basic investment planning steps you can take that, among other things, will help you detect where one of your investment ideas may be going wrong.  You should:

1.  have a plan and write it down–a “strategy,” if you will.  If you document your reasoning and your expectations, it’s easier to compare the outcome with them.  See my posts on Constructing a Portfolio.

2.  in your planning, establish maximum position sizes, based on your risk tolerance.  Keep to them when implementing your plan.  This will ensure you don’t put all your eggs in one basket.  Again, see Constructing a Portfolio.

3.  Monitor your performance, position by position, regularly.  This will prevent your eyes from “accidentally” skipping over the clunkers in your portfolio.  See my posts on Measuring Performance.

4.  especially for positions that may not be performing as you expect, watch how they are doing against peers (for a stock, Google Finance seems to me to have the best peer groupings).  Look at performance on very sharply up days and on down days.  If the position is weak relative to the market on both sorts of days, that’s usually a strong indication of trouble.  See my post on Down Days.

5.  know yourself.  Everyone has different strengths and weaknesses.  Over time, you’ll see that there are some arenas, say technology or the consumer, where you’ll do well, and others, say, biotech, where you will have little success.  Or it might be that you’re comfortable with larger capitalization stocks and not so much with smaller, riskier issues.

The first sign of impending trouble will be when you venture into areas where you have not been successful in the past.  I’m not saying don’t do this.  How else will you learn?   But you will want to have a small position size and the willingness to make a fast exit, if need be.

That’s it for today.  In my next posts, I’ll deal with how value investors and how growth investors typically find and deal with mistakes.

What makes a down day interesting–even for long-only investors, which is most of us anyway

I’m writing from about 10:30 am to noon, New York time, on Friday October 16th.

Although I have “down day” in the title of this post, I don’t really mean just down days.  I mean counter-trend days.  But, inevitable corrections along the way notwithstanding, I think the major stock market trend is up and will be up for at least the next year.  So I’m satisfied with the title.  You’d follow an analogous procedure for an up day in a down market.

What’s important in a down day

It isn’t so important that the day stays down, or ends down.  What is important is that some ugly counter-trend opinion that you can study and think about gets expressed in prices.

Two useful tasks

There are two useful things you can do on a day like this:

–you can “read” the stock prices to get an insight into what investors in general are thinking by observing what they are actually doing, and

–you can take your own investment temperature to see how emotionally involved you are in your portfolio or your stocks (that’s a bad thing).

“Reading” the prices

On a day like this, you should expect that short-term investors will take profits in sectors and stocks that have gone up a lot over the past few months.   You should expect profit-taking to be especially strong for sectors/stocks that have gone up sharply over the past short while–month-to-date, or even a couple of days.

On the other hand, although they may be dragged down again today with the rest of the market, you should expect stocks that have been poor performers and that people have been selling for an extended period of time to perform better than the averages.  After all, for these stocks, a day like today is nothing special.

Actuality vs. expectations

That’s the picture to expect.  What you should do is look for sectors/stocks that are not performing in line with the past two paragraphs.  Such stocks will probably fall into two categories:

serial clunkers (underperforming stocks that continue to underperform today–usually a very bad sign) and

very strong, continuing winner, stocks (usually a very good sign).

Your intention shouldn’t be to get an absolute, can’t-be-wrong reading on the market, but rather to notice what is happening that doesn’t fit–either with the typical market pattern on a day like this or with your strategy for the market.  You may be able to raise your conviction for some ideas and perhaps get an early warning of changes you need to make.

Turning to today’s market,

One thing that really jumps out to me is that although energy stocks have been the best-performing group in the S&P so far this month, and are up as a group almost 10% since the end of September, they’re down considerably less than the market today. Materials, another economically sensitive group, is doing unusually well also, although not performing as strongly as energy.  I think the important thing about both these groups is that they are bets on global economic recovery, without having to bet specifically on recovery in the US.

Another is Harley Davidson (HOG).  I haven’t owned this stock for years.  As I picture it, the company’s customers are almost all Americans.  They’re either biker outlaws or aging accountants/dentists who have read On the Road or seen Easy Rider too many times and are trying to relive–or just plain-old live–their youth.

The products are expensive and easily postponable purchases.  On the surface, the earnings they reported two days ago were poor.  Yet, after an initial dip, the stock was up strongly yesterday and is (so far) up again today.

I’m not really interested in buying the stock, although I’l admit to be contemplating buying a Harley t-shirt.  As you may know from Keeping Score, I lost my enthusiasm for the consumer discretionary sector at the end of August.  But here’s a consumer discretionary–really discretionary–stock doing well.   I’ve looked a F and scrolled through a series of retail names and all are weak today, except TGT and WMT.  Everything else seems to fit with a weak US consumer.  Still, HOG is a data point I wouldn’t have expected and is therefore worth thinking about.  I’ll have to be alert for any similar data.

Another notable stock is WYNN, which I own. It has been very weak over the past week and is underperforming today, too.  It’s trading in line with other casinos, but that’s cold comfort.  As a group, casinos are now doing worse than hotels.  I’m not going to do anything for now, but I’ve got to watch this stock more closely.

I could go on, but I’m sure you get the idea of what you should be doing.

“Know thyself”

The second thing you can do is examine yourself.  Are you willing to look at prices and perform the kind of check I’ve just been describing about the strategic layout of your equity investments?  Are you able to think about, and perhaps actually make, changes to your portfolio based on data you collect?  If so, everything is probably fine.

If not, if, on the other hand,  you become really emotional–you refuse to look, or are uncomfortable at the thought of  (even temporarily) loss-making investments, then you may have a problem.   It could be as simple as having had too much caffeine this morning.  Or you may have built more risk into your portfolio than you believe you should have, or are temperamentally suited to have.  Or you may have some stocks that, deep down inside, you know you should sell but you can’t seem to pull the trigger.  In any event, you may want to start from the ground up examining your strategy.  You might also want to read my thoughts on constructing a portfolio.

Are hedge funds honest?: an NYU study

The short answer is–not so much.

The study results:  one in five hedge funds misrepresent themselves to investors

The study, led by Prof. Stephen Brown of NYU, looked data on 444 hedge funds complied by a hedge fund due diligence firm, HedgeFundDueDiligence.com.   The researchers found that about a fifth of hedge fund managers misrepresented themselves to the due diligence firm–even though they knew HFDD had been hired by potential clients to verify all the statements the hedge funds made.

In particular:

–in 21% of the cases, hedge funds misrepresented prior legal or regulatory problems,

–in 15% of the cases, failed to disclose some or all of their prior legal or regulatory difficulties,

–in 28% of the cases, hedge funds provided incorrect or unverifiable assertions about assets under management, performance or other investment issues,

20% of the managers lied to HFDD during interviews ( the researchers euphemistically call this “bad recall”),  that is, they misstated either their performance, assets under management or their own experience or education.

Liars talk big and then fail

The study found that firms where HFDD detected misrepresentation tended to report better investment performance their peers  (No surprise here.  If someone is going to lie, why would they say the results were bad). They also tended to be more likely to fail.

The biggest indicators of possible trouble…

The only clear indicator of potential problems that the academic researchers found was not having a Big 4 auditor (think:  Madoff or Stanford).  There were other, less statistically significant, signs, as well.  Suspect firms tended to price their assets themselves and to switch support services frequently (presumably because the incumbent support firms had discovered misrepresentation and wouldn’t tolerate it).

…and of “clean” firms

Non-problem firms tended to have several common characteristics:  their results were priced by a third party, they were audited by a Big 4 accounting firm, and they kept the same support vendors for long periods of time.

Investors typically hired HFDD in several instances…

Clients normally asked for a HFDD report when a hedge fund was large, had a record of superior performance, charged high fees or didn’t have a Big 4 auditor.

…but the reports made no difference in whether clients invested or not…

The study shows that making false statements in the due diligence process didn’t deter investor interest or slow down flows of new money into a hedge fund.  One exception:  having a manager exhibit “bad recall” in an interview was a negative.

..and clients invested at just the wrong time.

Previous studies have shown that the bulk of the superior performance for most hedge funds comes in their formative years, when they are trying to make a name for themselves and attract clients.  By the time money comes rolling in, however, the best days for performance are already gone.  This study shows the same thing.  Clients request the due diligence studies right at the zenith of fund performance and of money inflows.  The chart in the NYU study that shows performance for the two years following a due diligence investigation goes straight downhill.

What Intel said: 3Q09 earnings conference call

I listened to Intel’s 3Q earnings conference call yesterday afternoon.

The company was upbeat, with good reason.  The results were higher both than analysts’ estimates and the company’s guidance, which had been upwardly revised during the quarter.

The positive news for the overall IT industry is that demand for INTC’s products was significantly above seasonal patterns in all regions of the world–except Europe, where demand was only slightly above the seasonal norm.  INTC expects this above trend performance will continue into next year.

Consumers are the big PC buyers.  Server demand from corporations and from “cloud computing” middlemen is also good.  The big surprise, to me anyway, is that INTC is seeing companies warming up to buy new laptops and desktops next year.  Why?  Their existing machines are on average 5-6 years old, so repair costs are rising.   So, too, are support issues for the XP operating system they’re running.

Normally, it’s consumers, not companies, who buy machines where a new, potentially buggy, operating system is installed.  But apparently corporations are willing to take a chance on Windows 7.  My guess is this is more a reflection of how badly the old machines currently in use are, than a ringing endorsement of the new MSFT product.

I’m no INTC expert.  I’ve generally preferred to own smaller, niche companies with faster earnings growth prospects.  But the company gives the impression of being much better organized than I remember it.  And the fact that the company has tightened its belt significantly while beginning to experience sharp increases in demand for its products suggests we’ll see positive operating leverage from the company for a while yet.  I can understand why investors might prefer to hold INTC shares while it’s growing so rapidly rather than take the risk of owning a smaller, less well capitalized firm.

I was also to interested to hear some of the sell side analysts asking questions on the call express skepticism about the durability of the netbook category.  Their idea seems to be that consumers have traded down to netbooks during recession and that they will trade back up to traditional laptops as their economic circumstances improve.  I think that’s wrong–that netbooks address a new market segment–that, by the way, is growing very fast and will continue to do so.  INTC agrees with me (for whatever that’s worth).

In fact, INTC has recently announced that it’s configuring its Atom microprocessors for netbooks so they’ll work with Linux as well as MSFT operating systems, and will open apps stores (like APPL’s) in conjunction with Taiwanese netbook makers.

What are Purchasing Power Parity (PPP) and Purchasing Power Parity GDP?

Purchasing Power Parity (PPP) is a name that covers a number of loosely related ideas.  The most important, I think, are:

–PPP as a theory of predicting long-term exchange rate equilibria, and

–the calculation and comparison of country GDPs using PPP.

In the first sense, PPP answers the question of  what exchange rate would prevail in an ideal world where workers in different countries all have equal compensation.  In the second, PPP says what country GDPs should really be if the value of non-traded goods were factored into the calculation–not just traded goods.

PPP and currency values

PPP is a labor theory of value.  The basic idea is that the average worker, no matter what country he works in, should earn enough money to buy stuff that will give him the same standard of living as a worker in any other part of the world.  This is the equilibrium condition.  If, at any given time, this condition does not hold, currency exchange rates will realign themselves so that equilibrium is established.

I first encountered PPP as a practical thing when it came into vogue in the mid-Eighties, a period of great instability in exchange rates.   It was for a while the preferred method of currency forecasting.  It didn’t work very well, however.   Apart from the more general question of whether value of a good in trade is determined by the amount of labor expended in its making, there were three practical issues:

1.  tastes may differ from culture to culture, so determining “equal” baskets of goods and services across countries isn’t as easy at it sounds,

2.  in the real world, prices subject to local cartels or government regulation may change only very slowly, and

3.  other factors, like the emergence of substitutes or a significant change in the price level (think:  Japanese deflation in the Nineties) can do the work ascribed in this theory to currency movements.

Purchasing Power Parity GDP

GDP calculated under PPP is a different matter.  The issue first arose, I think, in connection with the rapid growth of the mainland Chinese economy during the Eighties, when it averaged double-digit annual expansion of real GDP.  This compares with the US, which averaged, say, 3%.    Whatever imprecision there may have been in the actual numbers reported by the two countries, it was clear that China had grown much, much faster than the US during the decade.

The conventional way to compare countries’ GDP is to take the local currency number for each economy and translate the result into come reference currency, typically the US$.  The common sense result guess for the Eighties would have been that China had doubled in size relative to the US during the decade.  But when the conventional calculations were done, China had actually shrunk in relation to the US.

The problem?–the conventional calculation uses market exchange rates, which express the relative price relationships among traded goods, like cars, and uses that relationship as a proxy for the value of all goods in an economy.  That doesn’t work well.  In an emerging economy, a haircut, a bus ride, even cellphone service will typically be much cheaper than in a developed economy.

Seeing the US/China result was enough to prompt the World Bank to attempt to make GDP calculations that included non-traded goods as well.  These are the 2008 World Bank figures.  The results are startling, though less so than they would have been two or three years ago, when Brazil, India and Russia would have had their approximate PPP rankings but would have been out of the top ten in the conventional ones:

—————–rank   % of world GDP         —–  rank    % of PPP GDP

US                         1                 23.4%                       1              20.3%

Japan                  2                    8.1%                        3               6.2%

China                 3                  7.1%                        2               14.3%

Germany             4                     6.0%                     5               4.2%

France                 5                     4.6%                     8               3.0%

UK                        6                     4.3%                     7                3.0%

Italy                      7                    3.8%                   10               2.6%

Brazil                  8                     2.6%                     9                2.9%

Russia                9                     2.6%                      6                 3.3%

Spain                10                     2.6%                    12                 2.0%

Canada             11                      2.3%                   14                1.7%

India               12                     2.0%                     4                 4.9%

Mexico             13                     1.8%                      11               2.2%

Note that China and India are together about the same size as the US as a percent of world GDP when measured by PPP, vs. less than 40% of the US when measured conventionally.