positioning in a trendless market…

…that is, in the kind of market we have now.

At stock market bottoms, like the epic one we saw in March 2009, the most highly economically cyclical stocks and the ones with the weakest capital structures (i.e., the most out-of-control debt) are invariably the ones that are the most beaten down.  Because of this, they’re the ones that react the most positively to the first rays of hope that the worst economic news is behind us.

As the market and business cycles mature, leadership gradually shifts from these “value” names to secular growth stocks.  The latter are the least cyclically sensitive and are ones whose investment merit consists in their ability to grow earnings (1) faster than the consensus expects and (2) for a longer period of time than is generally recognized.

Entering year seven after the bottom, we’re deep into the growth stock period.  Dyed-in-the-wool value investors will doubtless be poring over the financials of oil and other commodity production companies.  But the strength of the market will be in technology, social media and Millennial-oriented stocks, I think.

A flat market gives us more time to search for them.

We should also be considering what is likely to happen once this up-one-day, down-the-next period is over.  My view is that the current doldrums are being caused by higher-than-normal valuation, not by perceptions of an upcoming economic slowdown.  If I’m correct, as time passes and company earnings grow, price earnings ratios will gradually shrink.  This will restore more attractive valuation  …and the market will begin to rise again.  When this will happen–and what occurs in the meantime–is less clear.  My answers are “late summer” and “nothing much.”  Alternatives might be “after the first Fed interest rate increase” and “the market goes down 5% – 10%.”

In the current market climate, there’s an easy way to check if my portfolio positioning is in line with my theorizing.

On up days in the market, my holdings should do at least as well as the market; on down days my portfolio will likely underperform.  Conversely, if I have a defensive posture, I should outperform on weak days and underperfrom on strong ones.

The portfolio from heaven will outperform around the clock.  A portfolio potentially in need of overhaul will underperform no matter what.

I normally don’t advocate analyzing portfolio performance on a day-to-day basis.  That’s because there’s often a lot of noise in daily price movements.  And short-term trends may make sense to day traders but no one else.  So there’s a risk that we get shaken out of long-term winning positions by getting scared by meaningless short-term craziness.

Still, in the current market circumstances–and if we don’t get emotionally caught up in the price movements–we have a chance to observe over a short period of time whether our portfolios have the structure we intend them to have.




portfolio checkup

A friend who’s studying in the Netherlands and just starting out as an investor emailed me a question about what a portfolio checkup/cleanup is supposed to do.  I thought I’d reply in this post and in tomorrow’s.

two objectives

Basically, you analyze your portfolio carefully and at regular intervals to do two things:

–so you know for sure how your portfolio plan is working and what quantify which stocks or ideas are adding to or subtracting from your performance, and

–so you gradually learn about your investing personality.  By this I mean what things you typically do well and which ones you aren’t so good at.  You want this information, as painful as it may sometimes be to find out, so that you can emphasize the former and minimize the latter.  After all, the main goal is to earn/save money–not to massage your ego.

#1  figuring out performance

There’s a purely mechanical aspect to this.  You have a benchmark like the S&P 500, by which you judge your performance (you could achieve this return by buying an index fund.  You should only spend time and effort to select individual stocks or focused ETFs/mutual funds if you expect a return higher than the index fund will give you).

Over the past three months, the S&P 500 is down about 7.5% (ouch!).  Over the past month, it’s up about 9%.

Your first task is to calculate how your portfolio has performed vs the S&P over the interval you’re studying–both as a whole and each individual issue.  (For what it’s worth, after a long period of doing well, my stocks have been clobbered over the past month.)

what to do with this data, once it’s collected

a.  look for outliers, especially big losers.  Everyone has losers.  Everyone, even the most seasoned professional, also has an almost infinite capacity for denial.  My first mentor as a portfolio manager used to say that it took three winners to offset the damage that one big loser can do if it’s left to run amok and not caught early. So finding losers and eliminating them is important.

b.  ask if your plan is working.  This presupposes you have a plan.  A checkup may well bring out that you’re not bringing your intelligence, knowledge and experience to the party but are, so to speak, mailing it in and hoping that’s good enough.  (We all find out quickly that it isn’t.  Although individual market participants may not be the sharpest pencils, the collective entity is extremely acute.)

For example, in general my plan is:

–world economies are still expanding, although slowly.  So I’m still positioned for an up market.  The EU has me worried.  I’m thinking about shading toward larger, stodgy sort-of-growth stocks as a defensive measure but haven’t done anything much yet.

–there will continue to be a sharp separation between haves (mostly meaning having a job) and the have-nots (the 10% or so long-term unemployed in the US).  I want to own stocks that cater to the former and want to avoid stocks whose market is the latter.

–Asian, especially Greater China, exposure is a good thing, because that’s where most of the world’s economic energy is centered

–I think the continuing proliferation of smartphones, tablets and e-readers plus the rapid development of cloud computing mean there’s money to be made in at least some tech stocks.

For me, the relevant question is how this is working out for me overall.  The answer is:  great, until about a month ago.

A second aspect of figuring out performance is to look, stock by stock, at plan vs. performance.  Reading any of my posts about TIF will get you my stock-specific plan since I bought the security about a year ago.  Again, until about a month ago, things were working well  …since then, not so much.

c.  acting on this information

Even in the best of times, the stock market is always a process of two steps forward, one step back.  Also, all stocks, even the long-term winners, have periods of underperformance.  There’s a real experience-and temperament-based art to deciding how to react to the data that show your stocks are underperforming.

In my case, I’m thinking so far that this is a temporary adjustment phase.  But I’ve also got to at least begin to consider how I’d rearrange my holdings if the underperformance persisted.  This thought process–and the possible move to action–is partly a question of risk tolerance, partly of conviction in the correctness of my analysis of individual stocks, and partly a judgment, based on experience, of what is a normal trading pattern vs. a fundamental change in market direction.

More tomorrow.

analyzing your portfolio performance over the past three months

measuring performance

I’ve written before about how important it is for us as stock market investors to calculate and analyze the performance of our portfolios on a regular basis.

There are two related reasons for doing this:

1.  We want to identify what ideas/stocks are working for us in the portfolio and which ones aren’t.  Based on this, we decide where to take profits and where to stop the bleeding.

2.  We also want to learn about ourselves, and our strengths and weaknesses in decision-making.  This isn’t like training for the Olympics.  We don’t need to be perfect at everything.  But we want to at least be able to identify situations where we continually shoot ourselves in the foot–and just not do that anymore.

doing it now

On July 7th, the S&P 500 closed at 1353.  On October 3rd, it closed at 1099, for a decline of 18.8%.  On an intraday basis, from 7/7-10/4 the fall was 21%.

The markets appear to be stabilizing now, as politicians in Europe make noises about finally addressing the EU’s Greece/banking crisis.  It’s too soon to say for sure that the worst is over (although I suspect it is).  But whatever the case may be, it’s important to look at your portfolio after a decline of this magnitude and ask yourself how you fared.

how to do it

In all likelihood, you don’t have data from your brokerage account that tells you either what your portfolio as a whole, or any individual security in it, was worth on the beginning and end dates.  So the easiest way to proceed is to use a Google chart to compare the performance of the S&P 500 (or whatever benchmark you measure your portfolio against) with each of the stocks/mutual funds/ETFs you own.  You can find more details toward the end of my post on “method to the madness” a few days ago.

what to look for

1.  One question is whether you’ve outperformed or underperformed the benchmark. But that’s just the start.

2.  Growth investors outperform in up markets and underperform when the market is declining.  Value investors, who have a more defensive bent, do the opposite.  So a second question is whether your portfolio has performed in line with your design.

3.  Is your design really what you wanted?  Is it appropriate for your financial circumstances, or is it too risky–or not risky enough (not the usual problem, but possible)?

4.  What were your strongest and weakest stocks?

5.  Is there a pattern to either the good ideas or the bad ones?  Be careful here.  Over this period, utilities stocks would have been stellar names, capital goods or materials stocks were probably at the bottom of the pile.  That’s not what I mean. You’re looking for behavioral patterns that lead you astray so that you can change them.

Do the weak stock ideas come from names you hear on CNBC?  Are the good names ones where you know the financials backwards and forwards and the bad ones those you know less well?  Are the horrible stocks tips from cousin Fred the broker?  Are the large positions winners and the small positions losers–or the reverse (which would be a more serious issue)?

Some fixes are easy:  turn off the TV; do your homework; don’t act on Fred’s advice; don’t bother with the small positions (or weight each position equally if the small ones are good but the big ones are killing you).

6.  How are your positions doing in the rebound?  Stocks rarely outperform in both up and down markets.  Great if you have one or more of these.  In contrast, in my experience it’s a big red flag if a stock underperforms on the way down and remains an underperformer in a market bounce.  Any like these are ones that need your immediate attention.

7.  Are the reasons you bought each security still valid?

two other thoughts

–Looking at your portfolio decisions with a critical eye is something you need to do regularly.  One time won’t be enough to detect behavior patterns.  But you’ve got to start somewhere.  My experience is that even professionals make mistakes that would be easy to correct–like “don’t listen to Fred”–except that they aren’t aware they’re making them.

–For an analysis like this, don’t use year-to-date numbers.  What you want to see is how your stocks have done in the downturn.  Otherwise, if you have had significant under- or outperformance earlier in the year, that performance difference will just muddy the waters.  An example:

Suppose you have a security/portfolio that was 20 percentage points ahead of the S&P through July 7th.  That would mean you had a gain of 27.7%.  On October 3th, your holdings are down 2.7%, which is ten percentage points better than the market.  How much performance have you lost during the downturn?

The answer isn’t ten percentage points.  It’s five!  During the period we’re considering, the S&P 500 fell by 18.8%.  Your investment went from 127.7 to 97.3.  That’s a fall of 23.8%.  The difference between the fall in the index and in the investment is five percentage points.  The rest of the year-to-date loss comes from the fact that the investment has lost its 18.8% from a starting point that already incorporates a large year-to-date gain.  The gain portion also suffers a loss.

stock prices can “talk”

not for everyone

I look at the prices of the stocks I hold every day.  Sometimes, but not always, I’ll look several times intra-day.  The advent of smartphones has made this possible for everyone to do, both for US and foreign stocks.  This is so, almost no matter where you are.

It takes a substantial amount of self-control and emotional discipline to do this productively.  I’ve seen almost every professional investor I’ve worked with, including myself, at one time or another mesmerized–and paralyzed into inaction–by staring at random fluctuations of stocks marching across the screen that’s virtually always on your desk.  The only short-term cure is to turn the machine off.  Otherwise, it’s kind of like watching a trashy TV show.  You know it’s a waste of time but you’re sucked in.

With TV, this compulsion to watch may come when you have other, unpleasant, stuff to do.  For investors, it’s typically when plans have gone awry and you’re hoping against hope that a miracle will happen and you’ll see the situation reversing itself on your computer.  It never works.

Still, there’s sometimes information to be gleaned from stock prices.  Sometimes, the movements are unusual in that they’re not random.  The only way you can tell is by checking them regularly.

how I learned

My first international portfolio job, managing holdings in smaller (that is, non-Japan) Pacific Basin markets, was also my first time working in non-US markets.  Every morning my boss would call me into her office.  She always had a report showing prices and volumes for all the major stocks–whether we held them or not–in all the areas I was responsible for.

She would name a stock.  I had to tell her the stock price change, in dollars and cents and in percentage terms, the trading volume and who the major brokers were who were active in the stock–both on the buy and sell side.  I also had to say how the trading in this stock compared with the trading in similar stocks in the same industry.

This grilling went on for 15-30 minutes, every day for several months.  I stopped having to do this, I think, when I started to give my boss significant information that she didn’t already have.  Although I wouldn’t have described the process as pleasant, my boss forced me over a period of time to try to distinguish between random and information-laden price/volume data and to think about and improve my analytic/intuitive capabilities in this area.  Otherwise, I might still be in that room!

an (obvious) example

A number of years ago, I owned a Canadian energy royalty trust.  The stocks were primarily owned by Americans attracted by high income.  I bought after they collapsed when Canada announced the payouts were going to become subject to Canadian income tax.  The stock I bought had a 14% dividend yield that was slated to be gradually reduced to 8% as the new income tax was phased in.

One afternoon, very close to 4pm, someone placed a million share order, at the market, in the stock.  The US$20 million that the order represented amounted to about half a day’s volume and was maybe 100x the size of the typical order.  The broker who got the order seemed to do the minimum legally required to find stock away from his in-house market maker and then filled the order, pushing the stock price up about 5% in the process.

This trade screamed that something unusual was going on.  Maybe you should  think twice before saying someone with $20 million to spend on a single stock is a total idiot, but this trade was done in a way that would humiliate any professional trader.  So either the buyer was an idiot by entering a huge order with no price sensitivity, or he knew something that the market wasn’t yet aware of.  The “something” also had to be such that even waiting until the next day was an unacceptable risk.

A few weeks later, the stock was bid for by a Middle Eastern sovereign wealth fund at a 25% premium.

why I’m writing about this today

As regular readers of this blog will know, I like the casino industry–because it’s simple to analyze–and I own both WYNN and 1128 (Wynn Macau).  Overnight, 1128 was up 8.7% to HK$15.98, after hitting an intra-day high of HK$16.40.  The stock just doesn’t normally move more than a few percent in a day.

Sands China (1928) and Galaxy Entertainment (0027) were both up 4.6%.  The Hang Seng, in contrast, was up 1.2% and its China Enterprises index was up 1.5%.

These are all unusual price movements, although 1128 jumps out as extraordinary, especially since all three stocks have been star performers in the Hong Kong market this year and are all trading at relatively high PE ratios.

What’s going on?  My guess is that information is leaking out that the Golden Week holiday has gone surprisingly well for the Macau casinos–and especially so for the American-run ones.

What am I doing as a result?  I’m hanging on to my entire 1128 position longer than I would otherwise.  In my analysis of the Wynn-related companies posted earlier this year, I had used a sum-of-the-parts method to look at WYNN.  I started with the idea that HK$15 (20x what I estimated 2010 eps would be) was a fair price for 1128.  Although I may not have written it, I’ve been thinking that HK$18 (same multiple, eps up 20%) is a reasonable first target for Wynn Macau for 2011.

Ordinarily, I’d be selling a portion of the 1128 I hold, maybe with a limit order of HK$16.50, hoping to buy it back later on at a lower price.  I think I’m going to wait and see, instead.

Addendum:  WYNN gained 8.5% in New York trading on Monday in a flat overall market.  If we figure that 1128 represents at current levels about 70% of the market value of WYNN, the move up in 1128 is the equivalent of a 6% rise in WYNN.  The “extra” 2.5% is the interesting part of the parent’s performance.

Portfolio Management–How often to measure(ii), Analyze performance monthly

Most professionals, and many institutional clients, use portfolio attribution reports as a key tool for interpreting the results a portfolio manager achieves. I’ve always found it an excellent planning tool, as well.

I’ve looked on the internet, admittedly not as hard as I probably should have, for a service providing anything remotely resembling a performance attribution report and have found nothing.  At some point, I should probably have an attribution tool on this blog, but for now you’ll have to construct a simple one for yourself.

What I describe below is a rough-and-ready tool.  It takes shortcuts that simplify the calculations, so the results are not accurate to the last basis point.  But for us, that’s not the most important thing.  The reason to do create a periodic performance attribution report is to establish a procedure for sitting down and thinking about the actively-managed portion of a portfolio, seeing what is going right and what is going wrong, and deciding what–if anything–to do about it.

For anyone who’s interested, I’ll talk about the major simplifications at the end of the post. Continue reading