|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||July 24, 2009|
While the economy is still weak, the market has surged over the past two weeks, with some very real signs of economic life spurring its gains.
First and foremost among those signs of life: second quarter earnings reports, which, by and large, have been better than expected. As of Thursday morning, with almost a third of companies in the S&P 500 having reported, per-share earnings had beaten analysts' estimates by an average of 12%, according to Bloomberg. While those estimates had in many cases been very toned-down, that was still good news, particularly when you consider some of the key bellwethers that surprised on the upside.
For example, Goldman Sachs last week reported a second-quarter profit of $3.44 billion -- not only topping projections but also representing the largest quarterly profit it has ever turned as a public company --while JPMorgan Chase reported a 36% year-over-year profit jump and a 41% increase in revenue, blowing away forecasts. Other banks weren't as successful -- US Bancorp's earnings fell 50%, though they beat expectations and the firm did post record revenues. Wells Fargo, meanwhile, handily beat earnings estimates, but worries about loan losses caused concern, a sign that, while the financial sector seems to be improving more quickly than expected, it's not out of the woods yet.
Other key non-financials also posted strong results. Intel said sales were up 12% from the first quarter, beating estimates by more than $1 billion on surprising consumer demand for computers. And Coca-Cola reported an increase in global sales for the quarter, though U.S. demand remained fairly weak.
There is sentiment in the business world that things will continue to improve. The Conference Board's index of leading economic indicators rose in June for the third straight month, the group said last week, with positive signs including interest rate spreads, building permits, stock prices, average weekly manufacturing hours, vendor performance, and manufacturers' new orders for consumer goods and materials.
The housing sector also provided some good news, though it was tempered by some caveats. The good news: The National Association of Realtors reported this week that existing home sales rose in June for the third straight month, the first time that has happened in more than five years. The caveats: Sales prices, while up from May levels, are still well below where they were a year ago, and sales volume was slightly below June 2008 levels. All in all, three straight months of sales gains is certainly encouraging, but the housing market has made some short-lived head fakes in the past year. It remains to be seen whether this is another head-fake, or the start of a real upward trend.
Finally, unemployment remains a major issue. New jobless claims were up in the most recent week, though slightly below expectations, while continuing claims fell. The way the Labor Department has factored in major layoffs in the auto industry may have skewed these figures, however, so it's hard to get a real sense of whether unemployment rates are showing any signs of relenting.
With no terrible economic news hitting and the positive earnings surprises, the market over the past fortnight has reversed its mini-slide, with the S&P 500 gaining 10.6% since our last newsletter. The Hot List has been even better, surging 15.9%. For the year, the portfolio is now up 29.1%, far ahead of the S&P and its 8.1% gain. And since its inception more than six years ago, the Hot List is up 111.7% while the S&P remains in the red, down 2.4%.
Emotion, Discipline, and the Gurus
With the economy still far from stellar, there remains intense debate over whether or not the "green shoots" we're seeing in the economy are real, and whether the market's rally over the past few months will continue. Some say this is just the start of a long bull run, other says it's a false rebound that will fade.
This debate has been going on for some time now, and the one thing that seems clear is this: Those who have been waiting on the sidelines for the economy to show major signs of recovery continue to miss out on some huge gains. Since March 9, the S&P 500 is up about 45%, while the Nasdaq Composite has been even better, jumping 56%. In the past three months alone -- after the "Is it real?" debate was already well underway -- nine of my models are up more than 20%.
So, while many have been poring over economic reports, investors who have stayed disciplined and didn't let emotion knock them out of the market this past fall or winter have benefited greatly. By sticking to their strategies, they've regained much of the losses incurred in late '08 and early '09. Two of my individual guru-based models -- those I base on the writings of Joel Greenblatt and Benjamin Graham -- have already regained all of their 2008 losses, and continue to pick up stocks selling at low valuations.
Some would argue that you could have simply avoided the losses of last year by getting out of the market at the start of 2008, and then getting back in recently. And that's true -- true, but incredibly unlikely. History has shown that the vast majority of investors have bad timing -- a perfect example is the fact that on March 5, the day before the S&P 500 hit its 666 intraday low, a mere 18.92% of respondents said they were bullish on the American Association of Individual Investors' weekly sentiment survey. And that's how many said they were bullish; I'd be willing to bet that fewer than that had the fortitude to actually put their money where their mouths were.
The reality of investing is that most people jump in and out of stocks at the wrong times. Want proof? Consider the research of DALBAR, Inc. In one of its studies of investor behavior, DALBAR found that over a 20-year period, equity investors earned well less than half the returns that the S&P 500 made. The reason? As markets rise, the data shows that investors pour cash into mutual funds, and when a decline starts, a "selling frenzy" begins. In other words, the research shows that investors tend to do the opposite of the old stock market adage, "Buy low, sell high."
Morningstar has found the same trend. The investment research firm actually measures fund performance in two ways -- the return an investor would have had by putting money in the fund on a certain date and then keeping it there, and, perhaps more importantly, the return an average investor in the fund actually got. The latter figure, which Morningstar calls the "Investor Return", is very often lower than the former figure, showing that investors more often than not jump in and out of funds at the wrong times.
That didn't change in the market madness of 2008. DALBAR's 2008 Quantitative Analysis of Investor Behavior found that equity fund investors lost 41.6% last year, compared with 37.7% for the S&P 500. DALBAR President Lou Harvey had this to say about investors' continued failure to time the market correctly: "For 15 years, [DALBAR] has shown that investor returns lag what performance reports and prospectuses would lead one to believe is achievable. While those returns are, in fact, theoretically achievable, the reality is that investors are not rational, and make buy and sell decisions at the worst possible moments."
Our Biased Minds
Statistics like those from DALBAR and Morningstar make it pretty clear that investors have bad timing. The question, however, is, "Why?"
We don't have to look far for a big part of the answer -- it's in our brains. In recent years, more and more attention has been put on neuroeconomics and behavioral finance, which study how and why investors act the way they act. In my newest book, The Guru Investor, I examine a number of ways in which our brains are wired lead us astray when it comes to investing, causing us to chase after hot, flashy stocks and avoid good, solid, cheap stocks so that we buy high and sell low. Here are some examples of the behavioral biases I mention in the book, as well as some other examples that have popped up in the news recently:
Hindsight Bias: This is when we tell ourselves, "Man, it was so obvious what I should have done last time; now that I've learned my lesson, I'll be able to time things right next time" -- even though it wasn't obvious what we should have last time, and it won't be obvious when it comes to future market-timing decisions.
Fear of Regret: When we make an error in judgment, we feel badly; often, we'll beat ourselves up with "woulda-coulda-shoulda" thinking, which is never pleasant. Because of the unpleasantness of those feelings, one theory on why people sell at the wrong time is that they avoid selling stocks that have lost value, instinctively wanting to postpone those feelings of pain and regret -- even if those stocks now have little prospect of rebounding.
Myopic Loss Aversion: This goes hand-in-hand with fear of regret. According to one study, investors weigh losses more heavily than they do gains, because losses hurt roughly twice as much as gains feel good. Investors will avoid that pain by failing to lock in losses, even if there's little hope that the stock will recover.
Anchoring: This, Forbes' David Serchuk notes, is the tendency to hold on to previously established ideas or opinions -- such as the target price for selling a stock -- even if they're not relevant anymore.
Contra-positive investing: This is when investors allowing previous experience with a stock to influence reinvestment, rather than sticking to the facts and data.
Expectation bias: The Sydney Morning Herald's Marcus Padley notes that this is the tendency to believe in things that you expect. You look for evidence that supports your hopes or expectations, and ignore that which contradicts them.
Of course, all of these biases don't mean that no one is a good market-timer, or that you can't sometimes make what seem to be prescient market calls. But these successes -- which research shows are rare compared to the failures -- can compound the problem, because they give the investor the illusion that he or she can continue to successfully time the market. That encourages him or her to "go on instinct" in future situations -- situations in which they'll most likely be wrong.
How the Gurus Overcome Emotions
While we have a lot going against us as human investors, there are ways to keep your brain from wreaking havoc with your returns. In fact, most of the gurus I follow were cognizant of the biases I mentioned -- sometimes years before such behaviors had names -- and they found ways to limit the impact of those biases and post incredible returns.
For most of the gurus, the solution involved having a systematic approach, one that forced them to buy stocks when they were cheap -- no matter how much fear was involved -- and forced them to buy based on the numbers and fundamentals, not gut reactions or instinct. In a recent interview with Fortune, for example, Warren Buffett said that "investing is simple but it's not easy. The reason it's not easy is because emotions get in people's ways. They get all excited about stocks when they've gone up recently and they get depressed when they've gone down and all of that." Buffett's advice: "You have to sit back and have a [long-term] philosophy."
Buffett says that for him, that philosophy still comes from The Intelligent Investor, a book written 60 years ago by Buffett's friend and mention, Benjamin Graham, who is another of the gurus I follow. In his classic book, Graham said that investors too often followed the crowd and chased "hot" stocks and sold "cold" ones. To succeed, he said that investors needed to distinguish themselves in kind -- not in a fancied superior degree from the pack. They needed to focus not on emotion-causing short-term price fluctuations, but instead on balance sheets and fundamentals.
Other gurus on whom I base my strategies have expressed similar views. James O'Shaughnessy, for example, has said, "Finding exploitable investment opportunities requires the ability to consistently, patiently, and slavishly stick with a strategy, even when it's performing poorly relative to other methods. Disciplined implementation of active strategies is the key to performance." Joel Greenblatt says that discipline is absolutely critical to his approach, because it forces you to buy good stocks on the cheap -- even when others are afraid of them. Peter Lynch has said that "the real key to making money in stocks is not to get scared out of them" by ditching a good strategy when things get rough. And, as you'll see below in this week's Guru Spotlight, David Dreman has made a fortune by sticking to the numbers when other let fear overwhelm them.
Buy Cheap -- Even if It Hurts
Sticking to your strategy when times get tough is painful, to be sure, but it allows you to do a seemingly simple task that is crucial to investment success: buy shares on the cheap. And there's evidence that buying cheap shares, even cheap shares that keep going down in the short term, can lead to much more long-term success than buying more expensive shares that are still rising. A recent T. Rowe Price study looked at four different investors, who started investing in stocks in 1929, 1950, 1970, and 1979. Each invested $500 a month in a fund indexed to the S&P 500 for 30 years, reinvesting all dividends in the fund.
The two investors who started right before major bull runs produced great returns over the first decade. "However," Price's Christine Fahlund noted, "they were accumulating fewer shares at a higher average cost during these robust decades. Moreover, their average returns over the next 20 years were much lower than the returns earned over the subsequent 20 years by the other two investors [who started investing right before big bear markets]. Thus, despite their strong starts, their ending balances after 30 years were remarkably less than half that of the two investors who began investing at the start of bear markets."
The recent downturn, while one of the most painful in history, presented an opportunity to buy shares of good firms on the cheap. And that's what the Hot List did, as it is designed to do. The portfolio remains fully invested in stocks through the market's ups and downs because history has shown pretty clearly that the vast majority of investors don't have the discipline or stomach to stick with their strategy and buy shares when they're cheap. By using a fully invested system that relies purely on quantitative measures, we eliminate the possibility that emotion-driven decision-making will prevent us from buying good shares on the cheap.
Does that make for trying moments or periods? It sure does. But we live through those periods because we know that trying to avoid them will likely lead to even more pain, and because we know that over the long term, a portfolio of stocks with good fundamentals bought at good prices will most likely produce strong returns. By sticking to that approach, we've already recaptured a big chunk of the losses we sustained in one of the worst bear markets ever, and we've positioned ourselves to gain a lot more ground moving forward.
Guru Spotlight: David Dreman
While all the gurus I follow have built their fame and fortunes using different investment approaches, there is at least one striking similarity that most -- if not all -- of them share: They are contrarians. When the rest of Wall Street is zigging, they are zagging; when Wall Street zags, they zig. By having the strength of conviction to march to their own drummers and not follow the crowd, they have been able to key in on the types of strong, undervalued stocks that have made them -- and their clients or shareholders -- very happy.
But while most of the gurus upon which my strategies are based are contrarians, one stands out among all the others: David Dreman. Throughout his long career, Dreman has sifted through the market's dregs in order to find hidden gems, and he has been very, very good at it. His Kemper-Dreman High Return Fund was one of the best-performing mutual funds ever, ranking number one out of 255 funds in its peer groups from 1988 to 1998, according to Lipper Analytical Services. And when Dreman published Contrarian Investment Strategies: The Next Generation (the book on which I base my Dreman strategy) in 1998, the fund had been ranked number one in more time periods than any of the 3,175 funds in Lipper's database.
Born in 1936, Dreman became interested in the stock market at quite an early age. His father was the chief trader at a large commodity firm in Winnipeg, Canada, and young David would often accompany his father to floor of the exchange as a youngster. According to Dreman Value Management's website, while at the exchange he was able to observe first hand the dynamics of a very active market and the reaction of the traders and the markets in general.
After graduating from the University of Manitoba, Dreman first worked as a security analyst at his father''s trading firm in Winnipeg. By 1977, he had opened his own firm, and soon he was posting impressive results by focusing on stocks that were overlooked, "beaten up," or sometimes in the midst of an outright crisis. Throughout his career, he did the same thing, finding winners in such beaten-up stocks as Altria (after the tobacco stock plummeted amid lawsuit concerns) and Tyco (which had been hit hard by an embarrassing CEO fiasco).
How -- and why -- did Dreman manage to pick winners from groups of stocks that few other investors would touch? The answer may at least in part go back to young Dreman's days on his father's trading floor, when he got to see how the market moved, and, more importantly, how the traders responded to it.
Dreman, perhaps more than any other guru I follow, is a student of investor psychology. And at the core of his research is the belief that investors tend to overvalue the "best" stocks -- those "hot" stocks everyone seems to be buying -- and undervalue the "worst" stocks -- those that people are avoiding like the plague, like Altria and Tyco. In addition, he also believed that the market was driven largely by how investors reacted to "surprises", frequent events that include earnings reports that exceed or fall short of expectations, government actions, or news about new products. And, he believed that analysts were more often than not wrong about their earnings forecasts, which leads to a lot of these surprises.
When you put those factors together, you get the crux of Dreman's contrarian philosophy. Because the "best" stocks are often overvalued, good surprises can't increase their values that much more. Bad surprises, however, can have a very negative impact on them. The "worst" stocks, meanwhile, are so undervalued that they don't have much further down to go when bad surprises occur. But when good surprises occur, they have a lot of room to grow. By taking a "contrarian" approach -- i.e. targeting out-of-favor stocks and avoiding in-favor stocks -- Dreman found you could make a killing.
Specifically, Dreman compared a stock's price to four fundamentals: earnings, cash flow, book value, and dividend yield. If a stock's price/earnings, price/cash flow, price/book value, or price/dividend ratio was in the bottom 20 percent of the market, it was a sign that investors weren't paying it much attention. And to Dreman, that was a sign that these stocks could end up becoming winners. (In my Dreman-based model, a firm is required to be in the bottom 20 percent of the market in at least two of those four categories to earn "contrarian" status.)
But Dreman also realized that just because a stock was overlooked, it wasn't necessarily a good buy. After all, investors sometimes are right to avoid certain poorly performing companies. What Dreman wanted to find were good companies that were being ignored, often because of apathy or overblown fears about the stock or its industry. To find those good firms, he used a variety of fundamental tests. Among them were return on equity (he wanted a stock's ROE to be in the top third of the 1,500 largest stocks in the market); the current ratio (which he wanted to be greater than the stock's industry average, or greater than 2); pre-tax profit margins (which should be at least 8 percent), and the debt/equity ratio (which should be below the industry average, or below 20 percent). By using those and other fundamental tests in conjunction with his contrarian indicator tests (the low P/E, P/CF, P/B, and P/D criteria we reviewed before), he was able to have great success finding strong but unloved firms that had the potential to take off once investors caught on to their true strength.
Because Dreman took advantage of the overreactions of others, he found that one of the best times to invest was during a crisis. "A market crisis presents an outstanding opportunity to profit, because it lets loose overreaction at its wildest," he wrote in Contrarian Investment Strategies. "People no longer examine what a stock is worth; instead, they are fixated by prices cascading ever lower. Further, the event triggering the crisis is always considered to be something entirely new." Dreman's advice: "Buy during a panic, don't sell."
As you might imagine, my Dreman-based 10-stock portfolio -- which includes the top stocks picked by my Dreman strategy -- will tread into areas of the market others ignore because of its contrarian bent. Its current holdings, for example, include two financials, some telecoms, a utility, and a healthcare company, all of which involve areas that have been lagging in recent months (except for financials, which still have a significant cloud of fear hanging over them). Here's the full list of the portfolio's holdings:
Banco Bilbao Vizcaya Argentaria SA (BBV)
Cellcom Israel Ltd. (CEL)
Barclays PLC (BCS)
Frontier Communications Corp. (FTR)
Oil States International (OIS)
Rowan Companies Inc. (RDC)
Steris Corporation (STE)
Brasil Telecom Participacoes SA (BRP)
Thomas & Betts Corp. (TNB)
The AES Corporation (AES)
Since its inception, the Dreman-based model has been a strong performer, but it's been a rocky road at times. The portfolio was one of my best from 2003 through 2006, at least doubling the S&P 500's gains in each of those years. But when value stocks went out of favor in 2007, so did the Dreman model. It lost 12% that year and was hit quite hard in last year's crisis, losing another 54.8%.
But then, just as Dreman has done in his career, the portfolio took advantage of others' fears. It snatched up a lot of bargains that others had discarded, and is up 25.4% this year (including 41.7% in the past three months), putting it up 40.3% since its inception more than six years ago. That's an annualized gain of 5.8%, in a period in which the S&P 500 has fallen 0.4% per year. The Dreman model has also been my most accurate approach, making gains on more than 60% of its picks over the long haul.
News about Validea Hot List Stocks
Fuqi International (FUQI): The Chinese jeweler had a big fortnight, surging 33% through Thursday afternoon. The company said it now expects second-quarter earnings per share (due in early August) to be at the high end of the range it previously announced.
BJ Services (BJS): BJ announced a fiscal third-quarter (ended June 30) loss of $32.3 million, or 11 cents per share, compared with a net profit of $142 million, or 48 cents per share, in the year-ago period, according to Reuters, as oil and gas producers cut back activity due to weaker oil and gas prices. Revenues fell 41 percent to $787 million. The loss included more than $23 million in charges for job reductions and inventory and asset writedowns, Reuters stated. The stock was still up 17% since our last newsletter as of Thursday afternoon.
Pfizer Inc. (PFE): Both the European Union and Wyeth shareholders approved Pfizer's $68 billion takeover of Wyeth. The EU approval requires Pfizer to divest a number of animal health operations, Reuters reported. U.S. regulators still must approve the deal.
Meanwhile, Pfizer reported second-quarter income of $2.26 billion, or 34 cents per share, down from $2.78 billion, or 41 cents per share, in the year-ago period. Unfavorable exchange rates reduced revenue by 9%, the Associated Press reported, but Pfizer's earnings results still beat analysts' expectations, and the firm upped its full-year earnings forecast.
The Next Issue
In two weeks, we will publish another issue of the Hot List, at which time we will rebalance the portfolio. If you have any questions, please feel free to contact us at email@example.com.
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