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.


strategy for 2014: yearend tax selling

I won’t be writing my strategy thoughts for 2014 for a few weeks.  However, it’s not too early for all of us to be thinking seriously about yearend tax selling, both as a market phenomenon and as a part of our personal portfolio management.

A disclaimer before I begin:  I’m an investor, not a CPA.  To get all the ins and outs of the capital gains tax rules, read the appropriate IRS or other tax authority publications.

why it happens

For most taxable investors in the US and mo,st other areas I’m aware of, the tax year ends with the calendar year on December 31st.  (One major exception is mutual funds and ETFs.  Their tax years generally end on October 31st–giving them time to close their books and make required distributions to their customers–who must pay tax on these receipts–before 12/31).

Investment gains are taxable once they’re “realized,” i.e., once the investment is sold.  But tax is due only on the net gain–that is, after subtracting any realized investment losses–not the gross amount.

In an ideal world, we’d all be doing tax planning constantly.  The reality is different.  Professionals believe (correctly, in my view) that taxes aren’t the most important elements of portfolio construction, so sometimes, in my attention, they pay shockingly little attention.  The rest of us just wait around until the end of the tax year approaches.

the phenomenon

For taxable professionals, like insurance companies or banks, who hold “balanced” portfolios of several asset classes (stocks, bonds, alternatives), they’ll try to match sales of, say, money-losing bonds and money-making stocks so that the net effect is zero taxable income.

Or it may be that guidelines, either internal or regulatory, require them to prune large winning bets.  In that case, they’ll scour the rest of the portfolio for anything with a loss attached to it and heave that overboard–just to knock down the tax bill.

This all occurs in the six-week period from early November to mid-December.  Clunkers may be sold more aggressively but there’s also downward pressure on winners as well.

For individuals, the main focus of selling tends to be small-cap names that have performed poorly.  They tend not to be sold with a very light touch.  Instead, individuals typically dump them out without much/any regard for price–just to get rid of them.  This sets the stage for the “January effect” as these beaten up stocks rebound after the first of the new year.

taking advantage

If the advent of tax season isn’t the reason for doing some serious thinking about what positions we want to take into 2014, it can at least be the occasion for doing so.  For example, serial clunkers in our portfolios tend to find ways to make our eyes skip over them when we examine our holdings.  It’s much harder for them to hide when we’re specifically looking for red ink to make use of

Similarly, we all love our big winners.  But we also have to .remember that at some point the risk of holding a (for us) humongous position outweighs the possible future gains.  Yearend is a good time to consider whether to trim.  Don’t be like a hapless acquaintance during the internet bubble who rode JDS Uniphase from $ 3 to $1000 (a position of $100,000 to $30 million) …and back down again.  Think Mark Cuban instead.

A more aggressive tactic would be to shop around for rebound candidates among this year’s big losers.  They may be pushed down by, say, another 10% before the year is out as holders shove them out the door to take tax losses.  This is not my style, so I have no words of advice, other than that you better do your homework before taking the plunge.

“wash” sales

One more point:  You can sell a position that’s deep in the red to recognize the loss and then buy it back.  But the IRS says you have to wait 30 days before the buyback to be able to take the loss.

I’m not a fan of the tactic, although some people may be able to do this successfully.  For me, it would be perpetuating the delusion that I haven’t made a mistake.

the strange struggle for control of Dell Inc. (DELL)

the emphasis is on strange

I’m not a DELL fan and haven’t been for a long time.  I’m relieved to not be in the position of having to decide what to do with my DELL shares, since I don’t own any.

The control struggle, so far:

Michael Dell, the founder and holder of 16% of the equity, thinks he–and his partner, Silver Lake Management–can breathe life back into the husk of a once-powerful company.  Their price for doing so, however, is all of the upside.

They are being opposed by investment manager Southeastern Asset Management, which had accumulated a large position in DELL (apparently at higher cost) and by corporate buccaneer Carl Icahn.  These two appear to believe that DELL is a treasure trove of undervalued assets that would be worth significantly more than today’s share price either under better management or in an orderly sale.  They balk at both the Michael Dell description of the DELL malady and the price of the cure.

I don’t have an opinion.  My hunch is that technological change and Asian competition have undermined the DELL edifice much more than Southeastern thinks.  I’m not persuaded by Southeastern’s published valuation.  But I haven’t done the work that might back up my hunch  with facts.

The strange stuff?   …two things:

1.  ISS

ISS is a proxy voting advisory firm.  It exists, in my view, mostly because the Federal government requires investment managers to cast votes for all the shares that they have in their portfolios for all corporate actions–and to do so in a way that benefits their clients best.

If management companies made the needed voting decisions in-house, they’d have to hire staff.  No matter what they did, they’d still run the risk of second-guessing by Washington.  So, they’ve outsourced the job to third-party firms like ISS, who collect data, analyze and make voting recommendations.  This saves mutual fund and pension managers time and money.  And ISS deflects potential blame from them   …sort of like an insurance policy.

In this case, ISS is recommending that clients vote in favor of the Michael Dell buyout proposal.

The strange thing is that, if the New York Times is to be believed, ISS’s rationale is that, like me, it’s skeptical that the Dell ship can be righted.  The Times quotes ISS as making the oh-so-British analogy that Michael Dell’s bid to buy DELL may be akin to “trying to catch a falling knife.”  In other words, it’s a bad idea and one where he’s likely only to hurt himself.  (For fans of British equity research prose, he may also be viewed as in the process of “grasping a poisoned chalice”, thinking it’s “a nettle.”)

For ISS, $13.65 a share is at or above the point where there’s any reward to holders for accepting the risks of a failed turnaround.

My translation: ISS thinks both buyout groups are crazy.

2.  failed proxy solicitation

DELL’s board of directors has approved the Dell/Silver Lake bid and called for a shareholder vote on it.

Two ground rules agreed to by all parties:

–Mr. Dell’s stock doesn’t get a vote, and

–any shares that don’t cast a ballot will be counted as voting “no.”

No big deal, I thought.  Institutions will vote the way ISS says.  And individuals always enthusiastically back anything that management recommends, no matter how loony or contrary to their interests it may be.

But no!!!!!!

In this case, individuals are resisting the blandishments of proxy solicitation firms (who call you up at dinnertime, plead their case and take your vote, then and there) in a way they never do, and are declining to vote.

Mr. Dell has asked to have the vote tally postponed   …twice.  There’s no reason to do so other than that he doesn’t have enough votes to win.  And now he’s telling the board he’ll toss in another $.10 a share if they change the rules so that non-voting shares aren’t counted as doing anything.

It’s hard to see what individuals gain by not voting.  It may be that they find it too hard to decide and have opted to take whatever fate brings them–although, as I mentioned earlier, generally individuals never have trouble backing management.  My hunch is that most holders have a loss and find it too difficult psychologically to take an action that will cause that loss to be realized.


selling a stock (iii): it’s done its work

To the extent that we, as individual investors, hold specific stocks rather than an index ETF or fund, each stock should have a specific purpose.  Most times, it’s that we think the stock in question will outperform the index.  (That’s not always true.  Some investors, for example, will hold stocks that pay a large dividend.  For them, the stock is a substitute for a bond.)

The rationale for holding an individual stock generally falls into one of two patterns:

1.  the company is mature and slow-growing.  For one reason or another, it has fallen out of favor with Wall Street and is unusually cheap compared with either its breakup value or its future earnings prospects.  This routinely happens with companies whose businesses are highly sensitive to the business cycle.

Here the analysis is pretty straightforward.  You establish a target price and sell when (or if) the stock reaches it.

You might, for example, think that Barnes and Noble has a breakup value of, say, $25 a share (I don’t, but clearly some people think the number is at least that high).  If so, you would presumably have sold it when the rumor surfaced in TechCrunch that MSFT was preparing a bid for the Nook division.

Or you might observe that, say, a farm equipment maker typically trades at 8x peak earnings during an upcycle and that it’s trading today at 5x your estimate of peak earnings.  So you buy in anticipation of a 60% gain–and sell if/when the stock hits your target price.  (That’s typically long before earnings hit their peak level.)

2.  the company is small, fast-growing and, many times, trading at a high multiple of today’s earnings.  Here the sell decision is more subjective and less clear-cut.  At one time, WMT was a stock like this, as was IBM, ORCL, CSCO, MSFT or CHS (Chico’s).

In each case, there’s a qualitative or “story” aspect to the name.  In WMT’s case, it was that it made a ton of money by building superstores on the outskirts of US towns that had a population of under 250,000.  At some point–long before the financials began to signal a slowdown in growth–WMT began to run out of small towns to build new stores in.  That “qualitative” deterioration is usually the time to sell.  The sell decision is a little more complicated in each case, but that’s the general rule.

two notes

Even if you sell at the perfect time, that doesn’t mean that the stock doesn’t continue to go up.  If the overall market continues to advance, that movement will drag just about every stock along with it.  The “losers” will be stocks that don’t rise as fast as the market.  But they too will have higher prices.

The two types of stocks I’ve described above are typically called value stocks (#1) and growth stocks (#2).  You can read lots more about their characteristics by searching for “growth” or “value” on this blog.


selling a stock (ii): found a better one

A valid reason for selling a stock in your portfolio is that you’ve found a similar one with better risk-return characteristics.

Sounds straightforward:  you own one that you think can go up by 25% and, perhaps by studying the industry further, have found a competitor with a better product that you think can go up by 50%.  So you switch.  What could be simpler?

Strangely (to me, anyway), it’s not what people–even investment professionals–always do.

Consider this situation:

You find a stock trading at $100 a share that you think can go to $120, a 20% return.  You buy it.  Instead of going up, however, it drops to $90, even though the company’s prospects haven’t changed.  So the stock now has a return potential of 33.3%.

You find a close substitute, again trading at $100 a share.  But this second company has the potential to go to $150, a 50% gain.

What do you do?

Decide before you read further, please.

Believe it or not, virtually every securities analyst I’ve ever trained to be a portfolio manager says he’d wait for the first stock to rise to $100, then sell it and use the proceeds to buy the second.

Why is that the wrong answer?

Forget that you already own the first stock.  That’s irrelevant.  You can sell it in an instant at almost no cost.

You have a choice between a stock that can go up by 33.3% and one that can go up by 50%.  Both have similar risk profiles.  You should be holding the second, not the first.

Why do people want to continue to hold the first?  …it’s because their judgment is colored by the fact that they have a loss on it.  They’re more concerned about being right in their initial judgment than they are about making the highest profit.  So they don’t fully process the new information they develop.  The second stock isn’t going to wait at $100 for you to satisfy your ego.  Besides, in a taxable account, a recognized loss has at least some tax value.