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.


taking out a fresh sheet of paper

the tyranny of what we own

The current structure of our equity holdings exerts an influence on our investment thinking in a number of ways.  Most are normally invisible.  Usually it’s only when performance begins to get ugly that we turn a totally objective eye on what we own.

For one thing, there’s a powerful psychological tendency for our gaze to jump over positions that are losing us money (because we need to be right).  As a result, the dogs of the portfolio stay hidden longer than any of us would like to admit.  That’s why regular performance attribution analysis is so important.  (I’m not saying that we should jettison a holding if it doesn’t live up to our expectations right away.  We should give those expectations a sanity check, though, if the stock takes a nose-dive shortly after day one.)

For another, in a taxable account, we all are tempted to let the IRS tail wag the dog.  That is to say, we all weigh, at least semi-legitimately, the capital gains tax due on profitable holdings as a cost of making any change.  Because the tax is a concrete here-and-now expense, as opposed to the maybe-it-will-happen, maybe-it-won’t potential of future capital gains, it tends to have much more influence than it should in the decision to sell or not.

In a wider sense, there’s always a certain inertia associated with any portfolio, even while it’s still meeting our general performance expectations.  It is our intellectual child, after all.  We’ve done a lot of work in bringing it into being.  We know that more trading and more portfolio turnover, however emotionally satisfying, are almost always associated with worse investment results.  So why rock the boat.

taking out a fresh piece of paper

Periodically, though, it’s useful to ask ourselves what we would buy if we were creating a new portfolio from scratch.

Try it.

Don’t work from a list of existing holdings.  Sit down instead with a blank piece of paper (or document or spreadsheet).   Use whatever research materials you have at hand–a copy of Value Line, a discount broker’s screening services, a list of S&P 500 sector weightings and major constituents.  Read the company annual reports and 10-Ks.  Figure out what a portfolio–built today–should look like.  While you’re doing this, don’t look at what you already own.

When you’re done, compare this list–names and weightings–with what you actually hold.

You may be surprised at the differences.

why write about this now?

When I was managing money for others, I’d do the “clean sheet” exercise every six months or so.  I asked the portfolio managers working for me to do the same.

As it turns out, I’m currently investing in an IRA a lump sum pension distribution I recently received.  I want the money to be in more mature, income oriented stocks than I’d normally be attracted to.  This is compelling me to create a new portfolio from scratch, one with somewhat different objectives than I’m used to.  Hence this post.

I decided to read through a three-month cycle of Value Line reports as a way of generating new ideas.  I’ve been looking at the safety rankings and historical data on dividends and earnings growth.

I’ve been surprised at how many potentially interesting stocks I’ve found.  (Some of the prose reports in VL are quite good;  in others, the main virtue seems to me to be that they have a specific word count rather than any information.  Be careful about the performance rankings:  as I read the aggregate data, they no longer have the predictive power they once did.)

What also strikes me is how few of the stocks I already hold I’m eager to put into the new account.  Part of this, I’m sure, is simply a difference in investment objectives.  But part may also be an indication that some of my holdings are beginning to show their age.