I’ve been writing Practical Stock Investing for something over five years now.  I decided to go back through my archives so look at the most looked-at (and possibly read) posts over that time.  I’m going to re-post ten over the next two weeks.  This will give you a chance to see some of my earlier work that you may have missed.  And I’ll have time for home repairs I’ve been putting off.  I may just see a couple of baseball games and watch the basketball playoffs, though.

Here’s #5.

Every market has issues that are often well understood by local investors but not to foreigners.  China found this out a few years ago when a government-related company bid for Unocal, a US oil and gas company whose Pacific Basin reserves it found attractive.  The same for Dubai, when it bought a UK company that held US port operations.  In both cases, Washington vetoed the transactions.

The US isn’t alone in this practice.  Foreigners will find it hard to buy companies in Continental Europe–even EU members may be unable to make acquisitions in neighboring countries.   And Japan has enacted laws over the past ten years that make foreign takeovers all but impossible–as if the informal barriers already in place weren’t enough.

Stock markets in developing countries have these issues, too–but they also have others that are orders of magnitude greater.  They include: Continue reading →

I’ve been writing Practical Stock Investing for something over five years now.  I decided to go back through my archives so look at the most looked-at (and possibly read) posts over that time.  I’m going to re-post ten over the next two weeks.  This will give you a chance to see some of my earlier work that you may have missed.  And I’ll have time for home repairs I’ve been putting off.  I may just see a couple of baseball games and watch the basketball playoffs, though.

Here’s #4

Anyone who wants to actively select individual country funds or individual stocks in the markets of less developed nations has to consider a number of basic issues, the answers to which investors in developed markets take for granted.  These include:

political stability, or the lay of the land. In most developed countries, politics makes for interesting discussion, but ultimately is not a crucial element in investment success.

Russia, in contrast, jumps out to me as a country where reading the political runes is more important than analyzing the assets or profit growth potential of any particular company and where the government’s attitude to foreign investors can change overnight.  But there are lots of other examples, as well, like: Continue reading →

I’ve been writing Practical Stock Investing for something over five years now.  I decided to go back through my archives so look at the most looked-at (and possibly read) posts over that time.  I’m going to re-post ten over the next two weeks.  This will give you a chance to see some of my earlier work that you may have missed.  And I’ll have time for home repairs I’ve been putting off.  I may just see a couple of baseball games and watch the basketball playoffs, though.

Here’s #3.

One of the earlier posts I wrote on this blog had to do with absolute vs. relative performance.  I reread it today and am generally satisfied with what I wrote then.  One exception, though.  I think the post came at the topic from the rather narrow perspective of a professional investor, who is already convinced that the best way–or at least one good way–to achieve absolute performance is to try to achieve relative results.

In this post, I’d like to broaden my discussion of the topic by adding two observations, one psychological, the other economic:

1.  One of the most important of the (many) clichés Wall Street uses is that market turns, especially upturns, come out of nowhere and catch most investors by surprise.  Not only that, but the initial move up can cover a lot of ground in a short time.  Missing this initial surge, so the argument goes, is virtually impossible to recover from.  Brokers typically cite academic studies that the greatest part of the market’s gains over a business cycle come in only about 10% of the trading days.  Be out of the market on those days and you’re toast.

I think there’s something to that argument.  I’d like to add my own twist to it, though.

In my experience, lots of professionals can either tell when the market is getting toppy or when it’s stunningly cheap.  But I don’t know anyone who has been able to do both.  Wall Street is a very gossipy place, so if there were such a person, word would get around–despite the individual’s desire to keep his ability to time the market a secret (so others wouldn’t begin to study his every move and his skill would remain his edge alone).  In addition, just off the top of my head I can think of three former professional acquaintances who “called” the top of the market, one in 1984 and two in 1986, with disastrous results for both them (two were fired) and their clients.

Look at the record of hedge funds, whose aggregate performance failed to match that of the S&P 500 every year since 2003.

Anyway, I think some investors have bearish temperaments and can call tops but not bottoms.  Others, like me, have a bullish cast of mind.  We can call bottoms but not tops.

2.  Assume that we live in a world that’s characterized by:  a) inflation; and b) economic growth.  Each implies that stock prices will tend to rise.

a.  Modern economics comes out of systematic study of the Great Depression of the 1930s.  One of the highest goals of monetary policy around the world is to avoid a recurrence.  In particular, the world wants to avoid a repeat of the deflation that marked that period.

Other than in the case of Japan, which has consistently chosen to have deflation rather than permit structural societal change, the world has been successful in doing so.  Let’s suppose (and fervently pray) that this continues.  What does this mean for stocks?

Stocks are priced in nominal terms, in dollars of the day.  But they represent ownership claims on real assets and business operations.  Inflation means that nominal prices in general are rising.  So there should be a tendency for the nominal value of the corporations whose shares of stock are publicly traded to rise as well.  Ultimately, this should translate into a tendency for stock prices to rise, even in the absence of real economic growth.

b.  But, as an empirical observation, there’s real economic growth all over the place.  The US economy, which has been closer to the caboose of the world economic train than the locomotive, is still 50% larger than it was a decade ago.  New nations have entered world commerce.  We have notebooks, netbooks, tablets, iPhones, iPods, social networking, online shopping, biotech, medical advances–lots of stuff we didn’t have ten years ago.  Why?  …because many people around the world like to build and invent new things.  Publicly traded firms–where else do entrepreneurs get the money they need to grow their companies?–participate very substantially in this growth.

My point is that the path of least resistance for stocks–due to inflation and to real economic growth–is up.

Yes, I believe what I’ve just written is true.  Maybe it’s a cartoon version of the truth, but it’s true.  That’s not really what I’m trying to convey in this post, though.  What I want to say is that professional investors in general opt to try for relative performance rather than absolute because they believe this, too.

Note:  reading this post in 2014, I’m not quite as cheery today as I was back when I originally wrote it.  I’m willing to stick with the general conclusions, but dysfunction in Washington is proving a bigger headwind to growth than I’d imagined.

I’ve been writing Practical Stock Investing for something over five years now.  I decided to go back through my archives so look at the most looked-at (and possibly read) posts over that time.  I’m going to re-post ten over the next two weeks.  This will give you a chance to see some of my earlier work that you may have missed.  And I’ll have time for home repairs I’ve been putting off.  I may just see a couple of baseball games and watch the basketball playoffs, though.

Here’s #2.

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.

I’ve been writing Practical Stock Investing for something over five years now.  I decided to go back through my archives so look at the most looked-at (and possibly read) posts over that time.  I’m going to re-post ten over the next two weeks.  This will give you a chance to see some of my earlier work that you may have missed.  And I’ll have time for home repairs I’ve been putting off.  I may just see a couple of baseball games and watch the basketball playoffs, though.

Here’s #1.

investor preferences

A large number of investors in the US want to buy stocks where the underlying companies are growing profits rapidly.  The same is true in many other stock markets of the world.  For such investors, earnings per share growth is the main metric they look for when transacting.

This isn’t an immutable law of equity investing, however.  To a large degree, the search for growth is also a question of investor preferences.  In the US, the market I have the longest experience with, I’ve seen the mix of price and growth that investors prefer change dramatically several times.  In my view, this has been not so much because the macroeconomic environment has changed, but because the personal circumstances of investors (their age and wealth) did.

Also, I’ve seen other markets where preferences are quite different, where a “good” stock is one that pays a high dividend and where the company is mature enough that it has little need to spend on expansion.  These are markets where the search is for income, not for growth.  Taiwan in the 1980s is the first strong example I’ve encountered personally (technology stocks there couldn’t list unless they were willing to pay a 5% yield!).   But the US in the pre-WWII era seems to me to have been another.

the search for income

Not every company can grow at a rapid clip for a long time.  As well, some companies temporarily experience declining profits, either because the economy has turned against them cyclically, or because they’ve just lost their way.  In any of these cases, the large group of investors I’ve mentioned above lose interest in the stocks and more or less consign them to the equity junk pile.

There’s a whole set of other professional investors–in fact, in the US they are arguably in the majority–who evaluate stocks not on their earnings growth potential but on the companies’ ability to generate cash from operations.  There are many variations on this approach.  But all use cash flow per share as their main tool.  Such investors calculate an absolute worth for the company (usually a present value of cash flows over, say, ten years) and compare that with the share price.  They buy what they hope are the most undervalued stocks.

Around the globe, such value investors expect that at some point either the company’s fortunes will take a cyclical turn for the better, or that other investors will realize the undervaluation they see, or (in the US at least) that pressure will be brought to bear on the company to improve its operations.

[By the way, about two years ago, I wrote a series of posts on growth investing vs. value investing that you might want to read.  Take the test (which of two stocks would you buy) to see if you’ve got more growth or value tendencies.]

the stock as a quasi-bond

The key to this approach, viewing it through my growth investor eyes, is to regard the stock as a quasi-bond.

Let’s say the firm is now generating $1 a share in cash from profits and $2 a share in cash from depreciation and amortization.  That’s $3 a share in yearly cash flow.  Taking a ten-year investing horizon, the company will generate a total of $30, even with no growth at all–if the firm can get away without serious new capital investments.  If we were to assume that the company could achieve an inflation-matching rise in cash flow, then the present value of the stream of cash flow is $30.  (Yes, this is a vast oversimplification, but it is the thought process.  Remember, too, we’re also figuring there’s nothing left after ten years.)

What would a company like this sell for on Wall Street?  $20 a share?  …less?

We do have a yardstick, since if we reverse the profit and depreciation figures the description in the last paragraph is a rough approximation of INTC.  The value investor’s explanation for serious undervaluation is that people are so worried about the possibility that processors using designs from ARM Holdings will gradually eat in to INTC’s markets that they are overlooking the latter’s substantial cash generating power.

happy vs. unhappy shareholders

Another way of putting the difference between looking at earnings per share and cash flow per share–

–investors look at eps to gauge a firm’s value when they’re happy with the way the company is performing;

–they look at cash flow per share when they’re not, when they’re trying to figure out how much the company would be worth with different management, or in private hands, or after being acquired by a competitor.

The risk the first group takes is that all good things eventually come to an end.  The worry of the second group is that they’ll be unable to pry the company out of the hands of current management.