If you search past posts of mine, I wrote a lot at one point about what value investing is. I thought I would reference them in new posts that would talk about why I think 2023 is a year when there’s money to be made from applying value techniques to sort through the stock market wreckage left by the post-pandemic selloff.

I wasn’t happy with what I’d done back then, so I’m going to attempt a sharply condensed version of that past work this week. Here goes:

Take two companies, with identical operations in the same industry in the US, but in different regions of the country. The industry itself is in its infancy, so there are no near-term limits to geographical expansion.

Company A is growing both sales and profits at 10% a year. It can finance its expansion through internally-generated cash, so it has no debt and can pay a small dividend. The stock is trading at 10x current earnings, a PE equal to its growth rate.

Company B has decided to expand faster and is willing to borrow a modest amount. It is growing revenues at 15% a year. Operating leverage from the debt allows it to expand profits at 20%. It pays no dividend. Its stock is trading at 18x earnings, a PE modestly below the growth rate.

If you had to pick one to own, based only on this information, which would you choose to hold stock in?

For a growth investor, the obvious answer is B.

For a value investor, the obvious answer is A.

The value thought process is: Company B is either right in its more aggressive expansion plans, or it isn’t. In the second case, B crashes and burns …and A is the superior investment. In the first, either the board of directors or activist investors will force the board of A to adopt the more aggressive strategy of B or the company will be taken over (maybe even by B). So investors will either benefit from a large PE expansion or end up owning B at a little more than half the current market price of B.

more tomorrow

the consensus view

I think there’s a clear consensus among professional stock market strategists that the first half of 2023 will be weak, maybe extremely weak, before a bounceback of unclear strength in the second. This belief is surprisingly unified–I know of only one exception to this view (who argues we’ll have the reverse–a rebound in 1H23 and a selloff in 2H23).

In the before times, when I was working, this would have been a gigantic buy signal. The reasoning back then was that by the time something had become so entrenched as to become the consensus view most portfolio managers would already have incorporated this into their portfolios. In other words, there was no one left to bet on the consensus. So the sensible move would be to go in the opposite direction and bet against it. The big question would be how to do so, meaning figuring out where one thought the market was likely to move next and, in the most elegant solution, just finishing repositioning as the strategists were figuring this out and changing their minds.

I think that even today it remains a good rule that if there’s a consensus of strategists, their prediction is inevitably wrong. The issue today is what it has always been–how the consensus is wrong. In this case, I think it’s a fundamental issue. Are the strategists too bearish or too bullish?

Caveats:

— while the mind of the market processes data at lightning speed in a bull market, it moves much more slowly in a bear market. In the latter, the market discounts, over and over again, the same negative news …until one day it doesn’t. Boring, maybe, but that’s the way it usually works. I should note, though, that although I’ve lived through a bunch of them bear markets aren’t my strong suit. The most important thing I can bring to the table right now is that the turn from bear to bull seems to announce itself when the market begins to take tiny little bullish steps. I haven’t seen much yet

–while the deep negativity of the current consensus will eventually turn out to be a good sign for the market, I don’t think it necessarily is so today. That’s because the most powerful force in the contemporary stock market is still trading bots, which are reactionary not anticipatory

Another point: I’ve found that an important key to investment success is to understand that you don’t have to have an opinion on everything. It’s much better to have a few things you have a lot of confidence in and avoid betting on stuff you don’t.

So, I’m avoiding the high-level bet on bull or bear by trying to have a portfolio that’s more or less market-direction-neutral. Instead, I’m…

…working around the edges (sometimes this is the best you can do)

–we don’t have to bet on everything. In fact, that’s probably the worst possible strategy. It’s better to bet on/against a few things that you’re the most sure of, and watch them like a hawk. For instance,

–I think the pandemic was the last hurrah for the FAANG stocks. A typical growth company runs for about five years before it has exhausted its competitive advantage in a given area and has to reinvent itself. The FAANGs have done this successfully more than once. Maybe the AAPL car will happen, and produce yet another growth spurt for the company. But I think the group as a whole is well past its best-by date.

I’ve been holding MSFT since the board replaced Steve Ballmer (if there were a way to bet against the Clippers as a franchise, I’d do it) and continue to do so. If nothing else, I think it’s the best of a pedestrian lot.

–it’s probably time to look at stocks that have exposure to non-US markets. That’s because the dollar got a major boost after the invasion of Ukraine, as did Treasury bonds. This defensive positioning by non-US entities has begun to unwind and will probably continue to do so, I think, implying higher US$ profits for Wall Street-traded multinationals

–It may be worthwhile (although I’m not doing this yet) to look at Japan and/or the EU, more on the idea that they’ve been train wrecks than that they’re hot spot of growth

–as for the US, I’m happy, for the time being, to look more like the index than usual. I’m getting my tech exposure (ex MSFT) mostly from ASML + semiconductor makers

–I think the way to approach the former pandemic darlings is as potential value stocks, that is to say, to pay a discount price for net assets on hand, and be willing to wait for something good to happen, rather than to pay for dreams of future glory that may or may not pan out. So much the better if their growth plans are still mostly intact. Much better if forced change of control is a possibility.

all of these “thoughts” posts are laying the groundwork for creating an investment strategy for early 2023.

The stock market, measured by the S&P 500, has entered month 14 of the current bear market; the index (capital changes, i.e., without counting dividends) is down just about 20% over that span. NASDAQ is off about a third.

In terms of the decline so far, this would be a garden-variety bear market. In terms of time, it would need to go on for another three months or so to transition from short to garden-variety.

One can reasonably argue that the economic circumstances of the current bear market have been somewhat worse than garden-variety. Think: pandemic denial (US and China), trade restrictions, coup attempt, war in Ukraine (resulting in higher energy prices, particularly in Europe), collapse of the Chinese property market and (policy induced) implosion of the Chinese tech sector…

One big difference: the government-induced decline of interest rates to the twilight zone level of zero, sparking speculative fever …and, mixing metaphors, a subsequent hangover, as the monetary punchbowl is being withdrawn

Still, Trump’s bizarre policies excepted, for the US these negatives are mostly external shocks rather than domestic business cycle problems. And the Biden administration quickly shifted from pandemic denial to pandemic treatment. Three consequences: the US has been less exposed than elsewhere to the most damaging economic developments; the dollar has strengthened; and foreign safe-haven-driven fixed income flows have countered to some degree the effectiveness of the Fed’s money tightening efforts.

Two important stock market issues:

–the strong consensus view of brokerage firms is that the stock market will be weak during first half of 2023 and will bounce back to some degree in the second. I know of only dissenter. The dictum that the market acts in a way to make the greatest fools out of the largest number of people would suggest that all of the bets on market weakness have already been placed. However,

–Wall Street seems to me to have pivoted sharply away from a strategy of trying to create, and act in advance on, unique research that predicts corporate earnings, toward quick buy/sell reaction when publicly-traded companies’ announce their results. Trading bots instead of research departments. (Yes, to a considerable degree, professional investors become more cautious and reaction-prone–much less willing to pay today for earnings that will come, say, six months or a year in the future–during bear markets, but I think market behavior over the past couple of years has become qualitatively different from taking the customary defensive stance.)

What I conclude from all this tomorrow

Note: earlier today Lululemon (LULU) narrowed the range of expected earnings for 4Q22 (ends 1/31/23) by a tiny amount, citing a margin squeeze during the quarter. To me, it makes sense that new athletic wear would have a low priority at a difficult economic time. Still, the company’s gross margin “squeeze” is a drop from 58% to 57%. The expected earnings, if we take the midpoint of the company’s guidance range, are now $4.245 per share vs a previous $4.25.

As I started writing this, the stock was down by more than 13% in pre-market trading. As I’m finishing, it’s off by about 10%.

Yes, the company has been a star performer in a bad market and the PE is at a very rich 35x. So maybe the company announcement is a trigger for the selloff rather than a cause. But the new information doesn’t appear to me to warrant a 10% drop in the stock price.

Something to watch.

As strange as it is for me to write this, I’m now in my 45th year of watching stocks, well more than half of that dealing with foreign markets in addition to the US. During that time, there’s only one period I lived through that’s remotely like the zero-interest-rate pandemic time that we’re just exiting from.

My other experience was the tail end of the endaka period in Japan that ended in wild flurry of speculation driven by ultra-low interest rates in 1989. The final gasp upward for that speculative market was the “road to the airport” idea. Investment gurus desperate for new things for clients to buy mused that the entire 40-mile stretch of highway from Tokyo to Narita Airport, populated by a motley collection of small business complexes, plus rice fields and idle land, would soon be chock full of skyscrapers testifying to Japan’s economic might.

Yes, there has been considerable development since then, but nothing like 50 miles worth. Almost 35 years later, the dream from back then has yet to come true, and the currency has lost a third of its value vs. the dollar, to boot.

It seems to me that the first step we should take is to go through our holdings with an eye to rooting out similar “story” stocks that may be lurking in some dark corner of the portfolio.

Apart from that, the biggest task for us as investors, to my mind, is to form an opinion about what I’ve been calling trading bot activity. In every bear market, investors’ investment horizons contract. We’re no longer willing to pay for company earnings two years out, or even one. We play our cards close to the vest and we hold fewer cyclical or secular growth names. “It won’t go down much” replaces “this could go up a lot if things go our way.” In the US in the past, however, market sentiment shifts in a positive direction maybe six months before reported earnings start to improve. This is one of the reasons that the stock market is one of the best leading indicators of domestic economic activity.

Looking at recent trading, it seems to me that the market is only reacting to developments once they are publicly announced, rather than anticipating them beforehand, and selling off in a much more negative way than I think the facts warrant. One possibility is that I’m completely wrong, either about valuations or that the overall macroeconomic environment is close to as bad as it’s going to get–and things are actually worse than I perceive. The other is that the market is, at least for now, being driven by newsfeeds rather than securities analysis–and that most potential buyers have left the field until there’s tangible evidence that this period of aggressive selling has come to an end. In the latter case, there’s an opportunity to buy.

Yes, I think it’s important to have an opinion. Mine is that it’s bots ..and that they’re doing loony things. On the other hand, there’s nothing that compels me to make what I’ve decided into the centerpiece of my investment strategy. And it isn’t.

more on Monday

Other than nostalgia, the point of yesterday’s post is my observation that Wall Street no longer seems to be in the business, other than at the broadest macroeconomic level, of figuring out company/industry profit trends and acting on that informed guesswork in advance of public announcement and SEC filing of actual results.

If I’m right, this will likely turn out to be particularly important for the course of the stock market over the first half of 2023 …because my sense is that reported results won’t be particularly good. Two reasons: the more important one is a world economy that’s slowing as interest rates rise, as pandemic-specific consumer spending abates and as global material and product supply chains return toward normal; plus I’m guessing that companies will try to clear the decks for 2023 when the report 4Q22 results in the coming couple of months with large writedowns of inventories and by trying to set expectations low enough that even pedestrian results will seem surprisingly good.

Ideally, what we should all want to see is companies reporting horrible results and the stocks not going down. Recent trading in TSLA shows we’re not there yet. Admittedly, this case is complicated by investors’ loss of faith in Elon Musk’s judgment/management skills. Still, losing 15% of its market value (at Tuesday’s low) on a report that I think could have been anticipated by anyone who did a little digging (I didn’t, but I don’t own the stock) seems like an extreme reaction.

I’ll qualify that a bit. What this also looks like to me is that just as sellers have become conditioned to be super aggressive on a “bad” earnings report, market makers have learned to counter by equally aggressively moving their bids down. This would have two goals: to trick selling bots to sell at lower prices than otherwise and/or to reduce the volume of selling.

Another sign of the time we’re in is a peculiar article I just read on Bloomberg, usually a pretty reliable source of information. It was commenting on studies showing that, in effect, the best training for a professional trader is to play poker rather than study economics.

I have two reactions:

–who didn’t know that?, and

–the Bloomberg article assumes that investing is all about trading. Yes, a good trader, who haggles with other traders about the buying/selling price for additions/subtractions in the portfolio is important for equity portfolio success.

But the article ignores two other aspects to investing, which are typically the larger sources of potential value-added–security analysis, to determine the worth of products/services a publicly-traded company offers, the relative strength of the firm within its industry, and the importance of the industry; and portfolio management, the overall structuring of the portfolio, including the microeconomics of the firms in the portfolio and the positioning of the portfolio to take advantage of macroeconomic tailwinds (and avoid headwinds).

The PM decides sector positioning, the individual stock names and the size of individual stock positions–with the help of securities analysts. Once the decisions of what and how much to buy have been made, the plan is executed by traders.

In fact, in the US investment firms are required to keep trading and investing operations separate. The idea is the prevent portfolio managers from being bribed to steer trading activity (and resulting commissions) one way or another to avoid scandals like the Michael Milken one in junk bonds. I guess the idea is that the poker game is easier to monitor than the economic jousting.

But I think the article accurately expresses how in today’s market the dominant activity is not anticipation of company or industry developments, but bot-driven rapid reaction to public announcements. Bear markets always have a heavier dose of reaction than anticipation, but the former is so dominant in the current market than Bloomberg seems to have forgotten that the latter exists.

This is a big issue for us, I think, over the next six months.