acting in repsonse to last week’s market gyrations

Everybody’s first reaction to a period of falling markets is to pretend that nothing unusual is happening and not look at his/her portfolio.   My experience is that “everybody” includes the majority of professional investors.  There are, however, two measures we can take to strengthen our portfolios if we have the courage to analyse what has happened to our holdings during a volatile period like the past six trading days.

We can:

–gather information, and

–act to modify our portfolio structure.

gathering information

Professionals have performance attribution software, which will calculate performance vs. an index plus a holding’s contribution to overall outperformers/underperformance for any/all of their stocks/funds over any period.  I do the stock by stock performance calculation by hand and then rank the outperformers/underperformers by their impact on the portfolio,  rather than trying to figure out exact performance contribution.  I find that’s good enough.

What I look for:

Aggressive stocks will typically outperform on up days and underperform on down days.  Defensive stocks should do the opposite.  Performing in line with their character is no news.  But stocks that outperform on both up and down days are.  So, too, are dogs that underperform no matter what the daily market direction. I think there’s inevitably a message that the market is sending through such stocks.  It’s well worth trying to figure out what that must be.

Time permitting, we should also look at representative stocks not in our portfolios to figure out the same thing.  (Professionals also have this comparative information, for all the stocks in the index they’re competing against, available at the push of a button.)

Note:  results for ETFs may be problematic, since a computer failure at BNY Mellon, which prices many ETFs for others, made NAV quotes for many unavailable last week.

The S&P 500 was down by 2.3% over the past six days.  Although this is a short time, arguably a defensive portfolio should have done better than this, an aggressive one worse.  If I think I’ve built a defensive structure and my portfolio is down by 6%, I should probably rethink what I’m doing.  If my “aggressive” portfolio is down by 1%, I should be thanking my lucky stars–but also trying to figure out whether this is due to excellent stock picking or to poor construction.  If I’ve accidentally assembled a collection of stocks that acts contrary to what I intended, I’ve probably got to at least ponder how to change it.

Early last week I tossed one long-term clunker in my portfolio overboard and replaced it with what I consider a better stock.  For trades like this, I also ask myself how that’s turned out so far.  Admittedly, a week is a very short period of time.  But this will give me an idea whether I have a good feel for current market action or not.


I’ve often begun the process of analysis and reconstruction thinking that I should make my overall holdings either more aggressive or more defensive.  Almost always, I end up making changes–but they’re virtually never the global ones I’ve intended.  Instead of altering the direction of the ship, I find myself patching holes in the bottom of the boat instead.  This usually improves the portfolio, and it prevents me from dong something crazy wrong during a period of stress.

My alterations tend to be one of two types:

–I trade out of stocks that are underperforming on both up and down days and into ones in the same general industry or thematic area that are performing in a healthier way, and

–I find that chronic clunkers become more visible to my eye in volatile times.  (In my view, everyone’s portfolio has at least a few of these.)  Because they’ve never gone up, they tend to have less downside than stars, whose owners have much more profit to take when they’re nervous.  I find a time like this ideal to switch from the former to the latter.  This ends up being most of what I do.


For me, the most difficult market transition to read in advance is the shift from a generally upward trend to a bear market, the garden variety of which can last for the better part of a year, and entail losses of, say, 20% in the S&P 500.

Typically, what induces a bear market is recession.  I don’t think we’re in that market/economy situation today.  If it were, patching leaks in the hull wouldn’t be enough.  A change to a more defensive direction would be warranted.







a strange story involving the business cycle and being wrong

I once had a young colleague with lots of potential, whom I liked very much and who was an excellent securities analyst  …but who had only limited stock market success despite loads of potential.

Ass an apprentice portfolio manager, this person came to me with the idea of building a significant position in a company that made carpets.  The firm was well run, apparently had sustainable earnings growth momentum and was trading at a low price earnings multiple.   In this instance, I didn’t do my job as a supervisor well, more or less rubber-stamped the idea and okayed the purchase.

Soon after that (this was 1993), the Fed began to raise interest rates.  This is something I had been anticipating but–maybe because this wasn’t crucial to the structure of my own portfolio–was information I failed to bring to bear on the carpet company idea.  Higher interest rates slow down both residential and commercial construction, something which is bad for, among other things, sales of carpets.  Replacement demand slows down, too.

I went to my colleague, explained the situation–including the source of my mistake, and urged selling the stock.  We did, with a modest loss.  The issue ended up losing almost two-thirds of its value in subsequent months.

Now the weird part.

Eight years or so later, my colleague came into my office to rehash this trade–which I had long since forgotten.  The point was not to suggest that we buy the stock again–which would have been a fabulous idea, since business cycle conditions were finally very favorable.  Instead, it was to say that my colleague had in fact been 100% correct in recommending the stock all those years ago (apparently the stock has finally reached the point where its cumulative performance matched that of the S&P 500.

I didn’t know what to say.  This was somewhat akin to my aunt Agnes explaining that she was switching from natural gas to oil because the gas burner in the basement was really a malevolent space alien.

Why am I recalling this strange story–much less writing about it–now?

Two reasons:

–we’re coming very close to another period of Fed-induced interest rate hikes.  This is bad of early business cycle companies, including housing, commercial construction and related industries in the US, and

–it’s a life lesson about investing.  My former colleague had extreme difficulty in recognizing an analysis was wrong or that a stock, for whatever reason, wasn’t working.  But portfolio investors in the stock market are always acting on very imperfect information.  And economic conditions, both overall and in inter-firm competition, are changing all the time.  So having what one thinks is a better analysis than the other guy simply isn’t enough to ensure success.   Recognizing when things aren’t going well, stepping back to regroup and seeking out possible sources of mistakes are all crucial, too.  Denial may salve the ego, but it makes us poorer, not richer.


two types of orders: market and limit

As a professional, I always believed that the key to success was to have a sound strategy and good stock selection.  I’m still convinced this is true.

At the same time, good execution of my plan through competent trading–buying and selling the stocks in my portfolio–while a secondary objective, could add or subtract a percentage point from my overall performance during a year.  Given that the typical active portfolio manager underperforms the S&P 500 by around one percentage point yearly, good trading can be worth its weight in gold.  Having been blessed with good traders most of my career, and cursed with one horrible trader I couldn’t get rid of for about a year, believe me I know the difference between the two.

The main tool we as individuals have to control the trades we do is our choice between limit and market orders.

types of orders

market order is one where our instructions are to buy a certain amount of a stock at the market price, that is, the price at the time the human or computer that will transact for us receives the order.  Except in the most unusual circumstances–I can’t remember this ever happening with an order of mine–the transaction will always occur.  Sometimes, the price will differ a little from what we’ve seen on the screen a moment before entering the order, but in practical terms we’ll always buy/sell the stock.

limit order, on the other hand, is one where we specify the exact price where we want the transaction to happen.  That may or may not occur on a given day.  Limit orders take two main forms, day  and GTC (Good Til Cancelled).  GTC orders are, technically speaking, really not exactly what the name says.  They most often are tagged with a time limit, say, three or six months, after which they expire if not renewed. When entering an order online, a message will typically pop up giving an expiration date.

choosing one

As regular readers will know, I’m a growth stock investor.  For people like me, I believe firmly in the cliché that the more important decision is how we sell, not how we buy (more about this on Monday).


I tend to buy in two or three transactions.  I’ll almost always use a market order, for about a third of what I ultimately intend to own ,just to establish a new position.  I’ve found over the years that owning a small amount of a stock focuses my mind on it in a way that simply thinking about it, or having it in a paper portfolio, doesn’t. This also protects me a bit from the stock running away on the upside before I’ve finished buying.

My intention will be to buy the rest in one or two more transactions, hopefully at progressively lower prices.  If the market allows me, I’ll use limit orders to acquire the rest. I may decide, however, that I don’t have enough time to do so before others discover the stock.  If so, I’ll buy the rest at market.


If I change my mind about a stock, that is, if I realize that my favorable view is probably wrong, I’ll sell all I own at market–and relatively quickly.  On the other hand, if the stock has gone up a lot, and my sale is motivated by price, I’ll usually use limit orders.

For example, one of my sons and I own both own Tesla (TSLA), at his suggestion.  We decided to sell half of our holding at $260 (I’m thinking the rest should go at $275, but I haven’t broached the subject with him yet).  We placed a limit order about a week ago.  It hit yesterday.  (For what it’s worth, I think a large convertible bond offering is imminent and that, like last year, it will mark a near-term top in the stock.  And, of course, we can’t forget that this is a highly speculative, if intriguing, issue.)

More on Monday.



equity portfolio analysis to do now

Investors, even professionals, typically don’t want to look at their equity portfolios during a market downdraft.  It’s too ugly and too painful.  I’ve always thought, however, that if you can keep yourself from becoming too emotionally distraught from viewing what is after all a natural occurrence in equityland, you can get a lot of valuable insight into how the market will unfold as stocks inevitably turn up again.

Just from eyeballing charts–I’m too lazy to go back and do precise calculations–we had a particularly long and deep correction in 2011, two (maybe three, depending on how you count) in 2012, two 5%+ corrections in 2013–all before this one in 2014.

I’m pretty sure this correction has ended.  No one knows for sure until the downturn is clearly in the rear view mirror–and sometimes my native optimism gets the better of me.  I feel better  having made this disclaimer, even though there’s been enough if a reversal of form in stocks previously being pummeled (meaning most of my portfolio) to have me pretty well convinced

In any event, I think we should all do what I’m about to recommend, even if there does turn out to be another leg down.

First, two rules:

— Generally speaking, when the market declines value stocks go down less than the market; growth stocks go down more.  When the market begins to rise again after a correction, the pattern reverses itself.  We want to find stocks that are acting out of character–both good and bad.

–Often market leadership–meaning the industries/sectors that do the best–changes during/after a correction.  This change may simply validate ideas we already have  …or it may show us some economic development that we’d overlooked so far.  Either way we want to identify and ride new trends.

use a chart

For me, the simplest way to do this is graphically.  Set up a Google or Yahoo chart that will compare the performance of each stock in your portfolio with the S&P 500 from September 19th until now and look for anomalies.

Throw in some well-known names, stocks you think you might like but don’t own, volume leaders…to get a feel for what’s going on with names you don’t own.

The best case is a stock that has outperformed on the way down and which is rebounding more strongly than the market.

The worst is the opposite   …a stock that underperforms during the downturn and fails to bounce back during the rebound.  These are ones you especially want to detect and investigate.  In my book, you have to have very compelling reasons to hang on to a stock like this.  In my view, you don;t want a stock like this to be your largest position, no matter what reason you come up with.

Do this without having any expectations.  Just see what the numbers say.  Then you can begin to interpret.

Don’t make excuses in advance for stocks.  If a holding has, say, declined by a third during the correction and isn’t rebounding,  chances are that something is wrong.  Facebook (I don’t own it), on the other hand, did better than the market on the way down and continues to outperform.  Other social media stocks appear to be doing the same.

More tomorrow.



fixing mistakes: fast death vs. slow death

mistakes in general

One of the more important influences on my professional development was my immediate boss when I was running my first international portfolio.  I’ve written about her before.

–Her constant grillings on overnight Pacific stock prices pounded into my head the importance of observing daily price movements for the information they may contain.

–Her theory, or perhaps that of her British top-down mentor, that it takes three good stocks to offset the negative effects of a single clunker instilled in me how crucial it is to find and weed out mistakes as quickly as possible.

(An aside:  her idea was that a good stock could advance by 10% in a year, but that a bad stock would go down by a third before the average manager would smell the coffee.  I don’t think the numbers are necessarily accurate, but the sentiment is.)


fast death vs. slow death

Another of my boss’s favorite sayings–which has also become one of mine–is that “fast death is always preferable to slow death.”

What does it mean, you ask?

It has to do with fixing mistakes.

Suppose you have a large position in a mid-cap or small-cap stock  …one with low volume and/or a wide bid-asked spread.  You discover that business is not as good as you’d anticipated and the stock is likely to drop like a stone once more investors put two and two together.  What do you do?

Two choices:

–try to slowly trade your way out of the position, dribbling a little each day into the market (so that no one will notice you’re selling (as if you could keep this secret!).  That’s slow death.

–just shove the stock out the door, while others are still clueless.  Push the stock down 5%–10%, if need be–to unload most/all of it.  That’s fast death.  (This is the simplified version.  There’s technique involved in selling a large position, but that’s the general idea.)

Why is fast death preferable?

If the stock ends up 10% lower as your last shares get sold (and you’ve sold in equal amounts all the way down), your average price will be down 5%.  That’s not bad.

For one thing, you have the money to use to buy something else.

More important, if someone else discovers what you know and uses the fast death strategy, you’ll still have almost all your stock but the price will be 10% lower.  Even worse, the other guy will have used up a bunch of gullible buyers.  And his violent action will set alarm bells ringing that may cause any remaining potential buyers to change their minds.  Then you’re really in trouble.

People who choose slow death are delusional, in my view.  They don’t frame their situation using the fast death/slow death paradigm.  They want to pretend they haven’t made a mistake and that they therefore don’t need to act with any urgency in selling the bad stock.  In fact, they may think, maybe they don’t need to sell it at all.  They can consign it instead to the imaginary back room where bad stocks hide and can’t be seen (every portfolio has one).

why write about this?

It isn’t that we, as individual investors, encounter this every day.

What makes me think of this now is that bond investors are facing a similar situation in the overall bond market.  We know interest rates are starting to rise and that the upward movement has a very long way to go.  So losses are baked in the cake for anyone how continues to hold.  Why no fast death so far?

lessons from J C Penney (JCP)

preliminary 1Q13 results

In conjunction with arranging a five-year $1.75 billion loan through Goldman, JCP has filed an 8-k in which it gives preliminary information about the April 2013 quarter.

–Sales were $2.635 billion, down 16.4% year-on-year (comp store sales = -16.6%).  Looking at a two-year comparison, sales are down by 33.2% from (the pre-Ron Johnson) 1Q11.

–Cash on hand at the end of 4Q12 was $930 million.  During 1Q13, JCP borrowed an additional $850 million, by drawing half its beefed-up bank credit line.  As of May 4th, the company had cash of $821 million.  In other words, JCP has blown through the entire $850 million, plus another $109 million in three months.


1.  When things go wrong, they often have a runaway train character.  Ron Johnson joined JCP in late 2011.  Almost immediately, sales went into a tailspin.  By mid-2012 it was clear that something was desperately wrong and needed to be fixed.

But no one acts right away.  There’s always the temptation to wait just a little while longer in hopes the tide will change.

In addition, a company’s plans may be set in stone months in advance.  There are advertising campaigns, construction plans, and billions of dollars of (the wrong) merchandise in the stores–with more of the same on order.

In this case, nine months after starting to back away from the Johnson strategy, JCP is still losing cash at the rate of over $250 million a month.

2.  Cash tells the story, in a trouble company.  That’s cash flow, cash on hand and cash the company can borrow.

In the JCP case:

–cash flow is -$250 a month,

–cash on hand is $821 million, and

–borrowing power is $2.6 billion (the $1.75 billion loan arranged by Goldman plus the remaining $850 million in JCP’s bank credit line).

Assuming its banks don’t get cold feet and withdraw the credit line, JCP has total cash available of $3.4 billion.  That’s enough to sustain a cash drain at the 1Q13 rate for another 13 months.

3.  Riding coattails is a risky business.  The Financial Times website posted an article last evening titled “Tips from Wall Street gurus fail to reward faithful.”  In it, the FT looks at the performance of the hedge fund “best ideas” presented at last year’s Ira Sohn conference in New York.  In the aggregate, the tips underperformed the S&P 500.  Some, like JCP, were unbelievable clunkers.

Two factors:

–even the best equity managers are wrong 40% of the time, and

–some managers become celebrities mostly through their own aggressive marketing efforts rather than by having stellar performance.  Or they parlay a one- or two-year hot streak into an entire career.  Caveat emptor.

celebrity deathmatch: Bill Miller vs. Jon Corzine

the importance of fixing mistakes

My earliest mentor as a portfolio manager continuously pounded into my head the need to find and fix mistakes before they get out of control and destroy your performance.  This is crucial, she said, and she was right.

In her view (I’m simplifying), a good stock might get you 10 percentage points over the index return in a year.  A bad stock, on the other hand, might cost you 30 percentage points before you admit to yourself that you’ve made a mistake and sell.  Therefore, it takes three good stocks to offset the damage done by one bad one.

In other words, common sense says that you’d better spend a lot of time on the lookout for underperforming names in your portfolio.

Why the 3:1 relationship?  Why not 1:1?  I don’t know.  I do know that the bad stocks are uglier than good stocks are pretty.   As to reasons, it may be the professional investor’s disease.  Every time he buys a stock he thinks he knows more than the consensus.  That takes a huge ego.  But the same ego can get in the way of recognizing that you’re wrong.  Or it may just be that when an unfavorable event occurs, holders all rush to sell.  This activity itself depresses the stock significantly.

In any event, it’s PM 101 that you can’t fall in love with your holdings.  You have to develop some way of identifying the clunkers (everyone has them; it’s a fact of life) before they wreck your portfolio.

Miller vs. Corzine

Bill Miller and Jon Corzine are recent instances of famous Wall Street figures who forgot this lesson, with disastrous consequences.

a difference

There is a crucial difference between the two, however.

Every manager knows his asset size, his cash position and his daily inflows and outflows almost to the penny.  A professional trader working on margin knows the size of his equity in real-time and monitors it just as closely.  I find it extremely difficult to believe that an “extra” $600 million or $1.2 billion could plop down into accounts you’re managing without your noticing it.  That’s doubly true if the money is needed to stave off a ruinous margin call.  You’d have to know, in my opinion, and would immediately want to understand where it came from.


What do the two managers have in common, other than their inglorious ends?

Both were very successful for an extended time within the long period of interest rate declines in the US that occurred between 1982 and, say, 2005.  That period, which is over now, taught managers to expect that even extreme risk-taking would eventually be bailed out by lower interest rates.  Neither man seems to me to have understood that this strategy no longer works.

Both appear to have forgotten to play defense.

My guess is that Mr. Miller regarded the recent financial crisis as a replay of the savings-and-loan meltdown that he successfully navigated in the early 1980s.  So he had reason to believe that he had an edge over other, less experienced stock market investors.  Mr. Corzine, on the other hand, strikes me as being more like a professional athlete who returns to the field after a decade working in an office and assumes that he can perform at the major league level from day one.  He seems to me not to have noticed that the other guys were faster, stronger and had instincts honed by never having fallen out of game shape.

In a lot of ways, professional investors are like kids playing video games.  Firms that employ them typically recognize this and install checks and balances that either force them to consider the business consequences of their actions or set portfolio parameters beyond which they are not permitted to go.  Both Miller and
Corzine seem to me to have been so deeply entwined in the management of their firms, however, that the firm’s risk controls were overridden.

Both are cautionary tales for investment professionals.