Monthly Archives: December 2010

2011 S&P profits

December 26, 2010 By in Current Market Thoughts, Portfolio management, Shaping a portfolio for 2011, Stock ideas, Strategy, Uncategorized Tags: , , , , , Leave a comment

I usually don’t read Barron’s. Early in my career–and that was a long time ago–I combed through it carefully every weekend.  But I found that any time I relied on an idea that appeared in the magazine I lost money.  Of course, I was much less experienced then, and I had done what I considered careful research in every case.  But I concluded that, although I didn’t know why reading Barron’s did me no good, I knew that for me its ideas were toxic.  So I stopped.

Yesterday morning, I found complimentary copies of the Wall Street Journal and Barron’s on my front lawn.  So I brought both inside and paged through Barron’s for the first time in years.

It seems a lot more superficial than I remember it.  The Market Week section still has a ton of statistics, but the rest of the magazine struck me as a mere shadow of its former self.  It could just be me, but it may also be the effect of the change of ownership of the magazine that put it in the Rupert Murdoch empire.  After all, that same move clearly resulted in a sharp decline in the quality of the business information in the Journal.

Still, one column in the main section, Profit Growth:  From Great to Good, caught my eye (it also appeared online as: Yearning for Earnings in 2011).  It contained advice that didn’t exactly square with the evidence advanced for it, but the interesting part was a table from ThomsonReuters that aggregated the consensus earnings estimates of Wall Street brokerage firms for the S&P in 2010 and 2011.

In my earliest posts (I began writing this blog just before the market bottom in 2009), I’ve written extensively about what happens in the early days of a market rebound from recession. But we’re now 5 quarters from the low point in S&P profits, 6 quarters since the official end of recession and 7 quarters from the bottom in the stock market.  In other words, we’re no longer in the early days of recovery.  In a typical up cycle, lasting maybe three years, investor emphasis gradually shifts from value stocks that benefit from the overall economic rebound to growth stocks that are capable of generating their own earnings momentum internally, with only a mild tailwind from the economy aiding them.

The table illustrates the point or maturing recovery pretty sharply.  It shows that S&P earnings will likely have grown by 32% year on year in the fourth quarter.  That will cap off four quarters in which S&P profits will have expanded by 38% vs. the prior year.

Prospects for 2011?  A 13% advance, or only about a third of the rate of 2010.  A glance at value- and growth-oriented market indices suggests the corresponding shift from value to growth began to take place in early September.

The chart also breaks out growth prospects by industry, as follows:

–on the low-growth side of ledger:  utilities, health care, technology and staples

–on the high-growth side:  materials, financials, industrials, consumer discretionary and energy.

I’m not sure these figures are enough to base an investment strategy on.  On second thought, they may be useful in delineating the underperforming industries, the ones like health care and utilities that have persistently slow earnings growth.  So they show you the areas to avoid.

But this part of the market cycle typically also favors smaller capitalization names, so in an industry undergoing rapid structural change, like technology, the sub-par overall growth rate may mostly reflect the fact that newer, smaller companies are eating the lunch of older-generation giants.

Overall, the chart has two messages:  2011 offers the possibility of being another 10%+ year for stock prices, but it will be harder to achieve outperformance than 2010 has been.


fixing mistakes: psychological barriers

December 24, 2010 By in Constructing a Portfolio, Fixing mistakes, Portfolio management Tags: , , , 2 Comments

Merry Christmas!!

One of my first bosses used to say that it takes three good stocks to offset the negative effects of one clunker.  Today, I’m not sure that’s the right ratio–a lot depends on investment style.  Also, I think the number is bigger than that in bear markets, where bad news is discounted heavily and good news is ignored, and smaller in bull markets.  But the ratio is certainly greater than 1 at all times.  That’s why it’s catching mistakes early is crucial to investment success.

Recently I’ve been reading books on decision-making.  I got the first, Jonah Lehrer’s How We Decide, from one of my sons.  I saw a review of the second, The Art of Choosing, by Sheena Iyengar, and bought it myself.  Both cover a lot of the same material, and in the same order.  This may be due to the Columbia connection between the authors.  Lehrer was an undergraduate there; Iyengar teaches there.  How We Decide is more readable and refers to a much larger number of experimental results.  The Art of Choosing focuses more on research Ms. Iyengar has done herself, and emphasizes that the psychological picture we create of ourselves for ourselves will be internally consistent–but won’t always correspond with reality.

Both books highlight the fact that we all tend to hold beliefs that we come to on a non-scientific basis.  For example, we all tend to think that we’re above average at just about everything we do.  Once we’ve made a decision, we tend to defend it by searching only for information that reinforces our opinion.  We also tend to ignore or screen out any data that calls our initial decision into question.  In fact, if we have believed something different in the past, we also gradually rewrite our memories (shades of Orwell) so that we come to believe we’ve always thought what we think now.

Even worse than all this, the more important the initial belief, the more likely we are to do this.

While this tendency may be relatively harmless if I think I’m handsome or witty or a good dancer, it’s an absolute disaster for an investor.  It’s a very great difficulty for professionals, who need very strong egos to withstand two aspects of the job:  many of the economic factors that influence the portfolio are outside the manager’s control, and at least 40% of the decisions managers make turn out to be wrong.

The professional manager has to keep his confidence from shattering, but at the same time be open enough to reality to stop his mistakes from destroying his portfolio performance.

How do you do this?

Two ways:

attitude

You have to be aware of the tendency to need to be right all the time, and resist it.  You have to actively scan news sources to look for negative information about your investment ideas.   A professional has to make it clear to sellers of research that you don’t regard a negative opinion or negative information as insulting or a reason to stop associating with them.

measurement

In my experience, every portfolio has its dark corners where underperforming stocks fester. Periodic performance measurement and stock-by-stock attribution analysis are the only cures.

Some investors–I’m not one of them–will also have mechanical rules that compel them to immediately sell a stock if, for example, it drops by 15% from its purchase price or earnings results fall short of internal/external analysts’ estimates.  The first rule seems to me to work better for value investors than their growth counterparts.  The second appeals to me more, but–at the risk of succumbing to the self-deception I’m writing about–I don’t subscribe to it.  My issue:  the risk of missing an AAPL or a MON or a COH because of a temporary earnings disappointment is too high.

 

 

 

 

 

is a bond fund exodus beginning?

December 23, 2010 By in Current Market Thoughts, ETFs Vs. Mutual Funds, Portfolio management, Shaping a portfolio for 2011, Strategy Tags: , , , , , , , Leave a comment

money is starting to flow out of bond funds

The Investment Company Institute, the trade organization of the the mutual fund industry, reported on Tuesday its weekly estimate of the money flowing in and out of the industry’s products.  The current report covers the week ending December 15th.

The equity news is the same as it has been for a long while–investors are taking $2 billion or so out of domestically-oriented funds each week and putting a somewhat smaller amount into foreign/global funds.

The real changes are coming on the bond side, both taxable and tax-exempt.

Over the past month or so, municipal bond funds have lost a total of $14 billion to net redemptions, presumably on worries about credit quality

For the past two weeks, for the first time since the collapse of Lehman in late 2008, taxable bond funds have had sizable withdrawals–$1.3 billion in the period ending 12/8 and $4.9 billion in the week of 12/15.

Why is this happening?

Bond yields are rising, as investors sense that the worse cyclical effects of the financial crisis are behind us.  Economic indicators and corporate reports are suggesting the US economy is stronger than the consensus had thought.  Markets are concluding that we’re past the cyclical lows for interest rates and that the Fed may begin to restore a normal (read: higher) level of rates sooner rather than later.

This means bond funds are potentially facing a headwind that will likely produce capital losses.

Where is the money going?

That’s not clear.  Some mutual fund consultants, like EFPR of Cambridge, Massachusetts, say the bond fund withdrawal money is going into equity funds.  Others are suggesting that it’s being parked on the sidelines in money market funds.

The ICI data, which cover the entire US mutual fund industry, don’t show either.

The ICI releases a separate weekly report on money market fund assets. That shows money market fund assets as being flat since the beginning of the month.  Assets held by retail investors are actually up slightly.

As mentioned above, the ICI data have shown a continuing small loss of money from equity funds over the past couple of years.  There’s a sharp shift within the equity category from US to non-US, but a net drain nonetheless.  That hasn’t changed.

So where is the money going?

A Bloomberg article that talks about he ICI numbers speculates that some is going into direct purchases of bonds.  This makes some sense:  you avoid the management fee mutual funds charge; and, unlike funds, individual government bonds mature–and you get your principal back.  I  suspect this is being done by individuals, not the institutions the article suggests, however.

I think a large chunk of this “lost” money will eventually end up in the stock market, either through individual equity purchases or stock ETFs.  Why?  Historical patterns suggest stocks are flat to up during a cyclical rise in interest rates, while bonds fall.  Also, to the extent that customers are withdrawing money from load mutual fund organizations–and Bloomberg suggests this is happening at places like Pimco–and forfeiting the sales charges they have paid, this suggests a certain finality to their actions.  My guess is that such investors are taking out a fresh sheet of paper and rethinking their asset allocations.

If so, we should see evidence of a more equity-friendly attitude as the new year begins.  Given that taxable investors typically greet January by selling winners they have nursed into the new tax year, a large inflow of new money should be easy to detect.

 

 

 

 

 

equity position size (ll): you and me

December 22, 2010 By in Constructing a Portfolio, Fixing mistakes, Portfolio management, Position sizes, Shaping a portfolio for 2011, Strategy Tags: , , , , , Leave a comment

It’s much easier to write about how professionals deal with the size and number of positions they hold in their portfolios.  That’s because money management firms create products that have certain risk parameters and leave it to customers to decide whether they want the product or not.  It’s impossible, however, to write very specifically for individuals without knowing anything about their financial circumstances and psychological makeup.  So you should take what follows as general thoughts rather than specific advice.

two issues to figure out

I think there are two aspects to the question of position size for non-professionals.  Both stem from the fact that stocks are risky investments. One is objective, the other subjective.  They are:

–Your own objective financial situation, given your age, income and accumulated wealth.  The question is how much risk–and the associated possibility of loss–can you afford to take.  Determining this is what financial planning, whether you do it yourself (probably using the tools on a discount broker’s website) or hire a professional to help you, is for.

For a twenty-something, having 90% of savings in stocks and having one or two positions that are each 5% of equity holdings is probably ok–assuming you’ve done appropriate research.  The two big equity positions amount to 9% of the person’s accumulated wealth.  By far his largest asset, however, is probably his human capital–his lifelong earning potential–rather than savings.  He has plenty of time for a risky investment to work out or to recover from even a large mistake.

For a sixty-something, on the other hand, having two 5% positions is probably also ok–relative to one’s overall equity holdings.  But that’s assuming the person in question has an age appropriate asset allocation. In most circumstances going into retirement with as much as 90% of your savings in equities is crazy.

–Your temperament, your tolerance for risk and–a factor I didn’t really understand until I stopped being a full-time money manager–the amount of time and effort you’re willing to devote to studying the companies whose stock you hold and following corporate developments.

I’ve often listened to casino company CEOs trying to position their gambling services as entertainment.  They joke that if you spend $500 on opera tickets you get a few hours of music but, unlike a casino jaunt, you have absolutely no chance of leaving the performance with any of the money you came in with.

As far as the stock market is concerned, this is a “Know thyself.” issue.  If you’re going to act on “hot tips” from a friend or from some guy on TV whose background and track record you know nothing about, you’re entertaining yourself, not investing.  You’ll probably lose your shirt.  So keep positions to negligible amounts.

One other editorial comment:  there’s a whole generation of Americans on the verge of retirement, whose pension savings are in IRAs or 401ks or other defined contribution pools of money.  We’ll likely live for thirty more years.  But there’s no monthly check in the mail from the company we worked for, like our parents had.  Our lifestyle will depend on the investment results from savings we’re responsible for managing.  Not taking much time or interest in doing so is probably not the greatest option.

let’s say you want to invest, not just entertain yourself

1.  Investing is a craft skill–like being a baseball player or a carpenter.  It doesn’t require you to be an Einstein.  It is experience-intensive, though.  This means you have to do your homework and serve an apprenticeship.  You start by investing small amounts, keeping records of your decisions, analyzing your results and thereby figuring out what you’re good at and what you’re not.  Even the best professional investors aren’t good at everything.  But they know they do a few things very well and stick to them.

2.  I’m not a fan of paper portfolios.  I don’t think they have enough meaning.  If you wanted to be a professional baseball manager, better to manage a high school team than to be in a bunch of fantasy leagues.  Start with tiny amounts of money.

3.  Over years of training portfolio managers, I’ve found that inexperienced managers always have great difficulty in making position sizes large enough to make a difference to performance.  As I mentioned in my post yesterday, a 50 basis point (.5%) position is probably not going to affect overall portfolio results one way or another.  It’s a waste of time.  In addition, if you have nothing but 50 basis point positions, you have to watch 200 stocks.  That’s an impossible task–and you’ll probably be killed by not catching your mistakes in time (that’s another topic, but trust me, it’s true).

For most seasoned professionals–growth investors, anyway–their top 10 positions make up around a quarter of their portfolios.  If you were to analyze it, the rest would probably look a lot like the manager’s benchmark index.  So the portfolio will likely rise or fall on the ten stocks big positions.  The task of monitoring them is manageable.  And if two outperform the benchmark by 20% each in a year, the manager will have about a 100 basis point gain vs. the index (it probably won’t be exactly 100 bp–it’ll depend on whether the market is going up or going down).  For US managers, that’s usually enough to put you in the top quartile.

4.  I think individual investors, once they’ve gotten enough experience to make intelligent judgments, should consider taking a (modified) page from the professional’s book.  This means:

–invest most of your equity allocation passively, through index funds or index ETFs

–complete your equity holdings with a small number of individual stocks (I have around a half-dozen, but I’m willing to spend a lot of time monitoring them)

–determine a maximum position size. Consider both the possible impact of a losing position on your equity holdings and on your overall savings.  If you’re, say, fifty years old and subscribe to the rule that your equity holdings should be the same percentage of your total savings as 100 – your age (which I think is a reasonable first approximation), then you have 50% of your holdings in stocks.

Suppose the individual stock you have the most confidence in were to be 5% of your equity holdings.   If that stock went to zero, you’d lose 2.5% of your wealth.  Is that acceptable?  If that is, then I think a reasonable approach to active management would be to establish three 3% positions and have the remainder of your equity holdings passive.

You should, of course, have a plan for what happens if your stocks go up, as well as for what you’ll do if they go down.  But the action you derive from determining a maximum position size is that you begin to trim the position if you’re fortunate enough to have it reach 5% of the equity total.  You don;t just let it grow.

–determine a minimum active position size, as well.  This is a much trickier topic than it appears on the surface.  I think positions below 1% of your equity holdings are a waste of precious analytical resources.  Let’s say you set that as a minimum size.

The complexity arises this way:  suppose you start out with a 1% position and the stock drops by 20%.  Do you average down and restore the position to 1%?  …or do you say you’ve made a mistake and sell?  A lot depends on your own level of self-awareness and your tolerance for risk.

As for myself, for example, bitter experience has taught me that if I have a large position that goes against me and I average down, disaster quickly follows.  So when a large position performs poorly nowadays, I either decide to hold on or to sell.  I never add.

On the other hand, averaging down is a standard tool of most value investors.

So alhtough it’s important to have worked out a plan, though, it will depend a lot on you as to what the plan actually is.


equity position size (l): professionals

December 21, 2010 By in Position sizes Tags: , , Leave a comment

how much of a stock is too much?  how much is too little?

The answer is, of course, that it depends. The biggest factor, to my mind, is whether you have developed the skills to analyse the companies whose stocks you own and are willing to put in the (significant amount of) time necessary to do so.  In other words, there are different rules for active professionals and for you and me.  But there are both subjective and objective guidelines.

In the most general sense, positions shouldn’t be so small that if you put in the time and they work out the resulting gain is so small that you don’t notice the difference.  On the other hand, they shouldn’t be so large that if they crash and burn they make a horrible dent in your lifestyle that you will be years in recovering from.

From a psychological point of view, you don’t want to take on so much risk that you can’t get to sleep at night.

In my experience, professionals starting out tend to build positions that are too small.  If, for example, what you think is your best idea ends up being .5% of your portfolio and goes up 20% more than the market during a year (i.e., if your idea is a success) you’ve added .1% to your portfolio performance.  No one will notice.

I have less direct experience with private individuals.  My impression, though, is that virtually no one reads the basic information about itself that a company sends to shareholders and files with the SEC–annual and quarterly reports, and the SEC equivalents, the 10-K and 10-Qs.

some specific rules

for professionals

growth vs. value

On average, US-based value investors hold about 100 positions.  Their growth counterparts typically have more concentrated portfolios, with around 50 positions.

Part of this is custom or habit.  To me, and I’ve worked in both value and growth shops, the sense behind the difference is this:

Value investors use more mechanical screens and deal in a universe of more mature companies, where information is more readily available.  So they can rely on third-party research to a great degree.  In addition, value investors typically have a better handle on what they think will happen rather than when the hoped-for favorable developments will occur.  Nevertheless, like all professional investors, their performance is judged by consultants on a yearly basis (or even shorter time periods).  The larger number of positions increases the likelihood that something good will happen in a given year.

There are fewer true growth stocks than there are good value stock candidates.  Growth companies are often in new or highly technical industries, and so typically require more intense research than value stocks.  Less high-quality information is available from third parties so the manager and the in-house research department have to do a larger part of the work themselves.  The smaller universe to choose from and the greater amount of effort needed to keep up with company developments both argue for more concentrated portfolios.

mutual funds

Stock mutual funds are subject to diversification requirements mandated by Federal regulation.  These include both sector/industry concentration limits as well as caps on the size of individual positions.  These rules have two outstanding peculiarities:

–25% of the portfolio assets are exempt from the diversification rules.  As far as the SEC is concerned, you can use that 25% to build one gigantic position (and I’ve seen some competitors do so) and it’s still ok.

–The position size limitation rule that applies to the other 75% is usually stated as prohibiting that you’re not allowed to have individual stock positions bigger than 5% of the fund’s assets.  That’s not quite right.  The rule is that the manager is not allowed to make a purchase that will cause a position to breach the 5% ceiling.

The difference is that you’re not required to sell any part of a position that exceeds 5% of the assets, either because it has performed much better than the rest of the portfolio (think: AAPL) or because the fund is having redemptions.  In the latter case, the manger can opt not to sell any part of a 5%+ position, making it bigger by default.

Actually, for holders of actively manager funds, it’s probably worth your while to take a look at the list of holdings contained in shareholder reports.  The vast majority of funds abide by internal rules that are much more conservative than the ones from the regulators. Occasionally, though, I’ve seen high-profile funds that are run in a very highly concentrated fashion.  Typically, the fund company won’t go out of its way to call shareholder attention to this potential risk.  And because third parties rely on academic definitions of risk as being short-term fluctuations in net asset value, they won’t pick up on this either.

Tomorrow:  rules for you and me.