|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||March 4, 2011|
The economic news continues to be mixed, with the turmoil in the Middle East having had the biggest impact on the financial world over the past couple weeks.
The situation in Libya touched off a spike in oil prices, which weighed on the market. In terms of fundamentals, the situation doesn't seem as bad as the markets are making us believe -- Libya provides only about 80,000 barrels of oil per day to the U.S., according to the U.S. Energy Information Administration; our biggest oil trading partner, Canada, provides almost 2 million. Of course, Libya's troubles will have a greater impact on its larger oil-trading partners, like Italy and France, and we'll have to see whether that will create a domino effect that impacts the U.S. For now, however, the fears seem a bit overblown.
Closer to home, last week brought signs of continued improvement in the labor market. New claims for unemployment in the week ending Feb. 19 came in under 400,000 for the second time in three weeks; the last time that happened was July 2008. Continuing claims, meanwhile, fell by about 4% in the most recent week for which data was available (ending Feb. 12), and were about 21% below their year-ago level. The Labor Department is scheduled to release its February employment report today, and it will, as always, be watched intently by investors.
One area in which concerns have heightened recently: housing. The latest S&P/Case-Shiller home price indices readings showed that both the 10-city index and 20-city indices dropped slightly in December, with the 10-city falling 0.36% vs. November and the 20-city falling 0.41%. The two indices finished the year 1.2% and 2.4%, respectively, below their year-ago levels.
In terms of home sales, there were mixed reports. The Commerce Department said that new home sales fell 12.6% in January (vs. December), coming in at about half of what is viewed as a "healthy" level. The median price of the sales also fell almost 2%. On the other hand, the National Association of Realtors said that existing-home sales rose almost 3%, and, for the first time in seven months, reached a level that was higher than the year-ago level.
Despite the housing market's continued malaise, consumer confidence is on the rise, with the Conference Board's sentiment index reaching a three-year high in February. The report followed on the heels of the Thomson Reuters/University of Michigan consumer sentiment index coming in at an eight-month high earlier in February.
As for the markets, since our last newsletter, the S&P returned -0.7%, while the Hot List returned -2.4%. So far in 2011, the portfolio stands at 1.2% vs. 5.8% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 173.1% vs. the S&P's 33.0% gain.
Knowing When to Fold 'Em
The concerns about the Middle East tumult may have sent many investors heading for the door in the past week or two. It's no surprise, really; bad news or crises often do just that, leading investors to lose all discipline and succumb to the crowd mentality.
The Hot List is designed to avoid such crowd-following behavior. Many of the gurus upon whom my strategies are based -- investors like Warren Buffett, for example -- are known for their willingness to buy, not sell, during a crisis. And many have built their fortunes by buying stocks when others are shunning them; average investors often later realize they have overreacted and jump back into the market only after the big money has been made.
If the Hot List doesn't sell when we hit macroeonomic bumps in the road, when does it sell? We touched on this a bit last newsletter, when I reviewed the data for the various rebalancing periods we use on Validea.com. This week, I thought we'd go a bit deeper into our selling strategy, looking not only at how our rebalancing system works, but why we choose to handle our selling the way we do.
Selling is such an important -- and overlooked -- part of the investment process that I dedicated an entire chapter to it in my most recent book, The Guru Investor: How to Beat the Market Using History's Best Investment Strategies. Below, I've taken excerpts from that chapter that I think best explain our approach.
The Missing Piece: Determining When to Sell
While a lot of strategies out there tell you how to buy stocks that will make nice gains, there are few that address the second half of the stock investing equation: when to sell - the proverbial brakes on our car. It's amazing, really, because for many investors, deciding when to sell is a harder decision than deciding what to buy. Cabot Research, a behavioral finance consulting firm, has found that even top-performing mutual fund managers may be missing out on 100 to 200 basis points per year because of poor sell decisions, Institutional Investors Amy Feldman noted in a June 13, 2008 article entitled "Know When To Fold 'em" Seeing as how amateur investors tend to do much worse than the pros (as we learned in Chapter 1), it's likely that the average, nonprofessional investor suffers even greater losses because of poor sell decisions.
Part of the reason investors struggle with selling is that advice on the topic is somewhat lacking in the investment world. A survey performed by Cabot and the CFA Institute found that more than 70 percent of professional investors used a selling approach that was not highly disciplined or driven by research and objective criteria, Feldman noted in her piece, so it seems most of the pros aren't offering a whole lot of guidance here. But another part of why sell decisions are so hard involves an old, familiar foe: our own brains.
Just as our brains tell us to avoid unpopular stocks and jump on hot stocks when we're buying, they also cause havoc when we're trying to figure out when we should sell a stock. If you've ever put money into the market, you've almost surely found this out the hard way.
A few phenomena make selling and sticking to a selling plan a difficult task. For starters, there's the "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. And that's certainly true when we take a loss on a stock. Hindsight is always 20/20, and we end up thinking that we could have easily avoided what turned out to be a bad move. 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.
This is similar to the concept of "myopic loss aversion" that we examined in the previous chapter. In his 1999 paper, "The End of Behavioral Finance," Professor Richard H. Thaler of the Chicago University explains that loss aversion refers to the observed tendency for decision makers to weigh losses more heavily than gains; losses hurt roughly twice as much as gains feel good. Locking in losses thus hurts a lot so we'll avoid selling stocks for a loss even after they no longer have good prospects to delay that hurt.
Why are losses so painful? The fact that they are a shot to our egos seems to be part of the reason. Professors Kent Daniel and Sheridan Titman state that people tend to ignore or underweight information that lowers their self-esteem in "Market Efficiency in an Irrational World," which appeared in the 1999 volume of the Financial Analyst Journal. "For example," they write, "investors may be reluctant to sell their losers because it requires that they admit to making a mistake, which could lead to a loss in confidence and have deleterious consequences. For similar reasons, investors may systematically overweight information that tends to support their earlier decisions and to filter out information that suggests the earlier decisions were mistakes." Essentially, we'll twist the facts to avoid admitting mistakes so that we feel better about ourselves, and our stock-picking abilities. That keeps us from feeling badly about ourselves, but it also keeps us from learning from those mistakes.
Another common mistake many investors make is holding on to winners too long. In his 2001 book Navigate the Noise: Investing in the New Age of Media and Hype, Richard Bernstein notes that growth fund managers often do just that because they are encouraged to do so by all the good news regarding companies' prospects. A perfect example would seem to be the tech stock boom of the late 1990s. Blinded by the hype, most of those people who had made huge sums of money ignored logic and held on to their stocks too long, only to see them come crashing down.
So with all of these challenges, how do you stave off emotion and make good, sensible sell decisions? The same way that you keep emotion at bay when deciding what stocks to buy: By using a disciplined system that makes sell decisions based on cold, hard fundamentals, not emotion-driven hunches, or arbitrary price targets. That's what we've done with our model portfolios, as well as with our investment management business, and we think that's a big reason why the results have been so good.
To understand how and why our sell system works, you have to go back to the basic premise behind our buy strategy. And that is that over the long term, investors gravitate toward stocks with strong fundamentals because those are the strongest companies, and that causes those stocks' prices to rise over time. We buy because of the fundamentals not just because the price is high or low or rising or falling. Remember, the only way price comes into the decision to buy is in how it relates to the stock's fundamentals that is, in the form of such variables as the price-sales ratio or price-earnings ratio.
When you're building your portfolio, then, you want to pick the stocks that have the best fundamentals because (sorry to sound like a broken record) over the long run, investors gravitate toward stocks with strong fundamentals because they are the strongest companies.
Okay, great, you're saying, but that's buying stocks; we've already covered that. What does this have to do with selling stocks?
Well, it has everything to do with selling. If you're buying stocks because they have strong fundamentals, and (everyone now), over the long term, stocks with strong fundamentals tend to rise, you should hold on to a stock as long as it continues to meet the fundamental criteria you used to select it. Whether the stock has dropped sharply since you bought it or whether it has skyrocketed is no matter; what matters is where the stock's fundamentals stand right now. Price, just as with buying, matters only in terms of how it relates to the fundamentals (what the stock's P/E or P/S ratios are, for example).
Many investors will sell a stock because its price has fallen and they think they need to cut their losses, or because the price has risen and they think the "smart" thing to do is to take the profits rather than risk the stock coming back down. But those are arbitrary, emotional decisions. Remember, you bought the stock because its strong fundamentals made it a good bet to gain value; if its fundamentals are still strong, why wouldn't it still be a good bet to gain more value?
If the stock's fundamentals have slipped, however, so that it no longer meets the criteria you used to buy it, it's time to sell and replace it with another stock that does meet your criteria (and one that thereby has better prospects of rising in value).
The selling assessment is thus an ongoing reevaluation of where a stock stands right now. You must continually reassess what the stock's prospects are going forward, not what they were a month ago, six months ago, or whenever you bought it.
The next question, then, is what "continually assess" means. Should you check once a day to make sure your holdings still meet your criteria? Once a week? Once a month? Once a year? Since mid-2003 we've been running model portfolios based on each of our Guru Strategies. For each model, we've constructed separate portfolios that use different rebalancing periods - monthly, quarterly or annually. The model portfolio returns reported at the end of each guru chapter are those of our 10- and 20-stock portfolios using the monthly rebalancing period. On average, this monthly rebalancing tends to produce the highest raw return; the quarterly and annual portfolios, while still ahead of the market, tend to produce less excess return over the time period for which we have results.
The prevalence of inexpensive discount brokerages has made trading very cost-effective today (especially for larger portfolios) and, for many reading this, a monthly portfolio rebalancing is attractive and can be done easily and cheaply with the right online broker. Nevertheless, it's important to understand that the monthly rebalancing approach does require more a bit more work, time, and commitment. If you're a busy professional, a retiree who likes to travel or a stay-at-home-mom with young children a less frequent rebalancing approach might work better for you and give you a better chance at following the strategy more consistently. So the important point here, whether you use a one-month rebalancing or a different time frame that works for you, is this -- you need to re-examine your portfolio at set intervals, to assess how your holdings stand relative to the reasons you bought them. If they no longer meet the criteria you used to pick them, you should consider replacing them with new stocks that do make the grade.
You can also use your rebalancing period to reweight your portfolio in case some of your holdings have gained or lost a bunch, and now make up a disproportionate part of your portfolio. The idea here is to keep things close to equally weighted. It doesn't have to be perfect, though; if one stock gains a little ground so that it makes up a few more percentage points of your portfolio than the other stocks, you don't need to go selling a couple shares and getting hit with trading charges just to even things out exactly. To keep this simple, you might want to set a reweighting target percentage. For example, anytime a holding's weight in your portfolio becomes 10 percent more or less than your target weight, you buy or sell shares of it to bring it back to that target.
By sticking to a firm rebalancing plan, you keep emotion and hype from impacting your selling decisions. You sell at regular intervals, and you sell based on fundamentals. Just as with buying stocks, there's no place for hunch-playing or knee-jerk reactions here. There are a couple rare occasions, however, when you should sell a stock without waiting for the rebalancing date to arrive. If a firm is involved or allegedly involved in a major accounting or earnings scandal, you should sell the stock immediately, because you can no longer trust its publicly disclosed financial data. In addition, if a firm has become a serious bankruptcy risk since the last rebalancing, you should also sell its stock immediately.
Another thing to keep in mind when it comes to selling stocks is that no investor, not even the greatest investors in the world, are right all the time. Remember what Martin Zweig says: "In the long run, a 60 percent success rate translates into huge gains, a 50 percent rate into solid gains, and even a 40 percent rate can beat the market." When it comes to the stock market, no one is right all the time or even nearly all the time. Even the great Warren Buffett makes bad investments. Just read Berkshire Hathaway's annual report, and Buffett will often speak candidly about where he's gone wrong.
While you'll never be right all the time, you can be right more than you're wrong, however. In the end, the key is to develop a fundamental-based selling and rebalancing plan and stick with it, no matter what. When your portfolio does lose ground from time to time, you'll inevitably feel the urge to sell certain stocks and go after others on a whim or a hunch to make up ground. But if you have a detailed, quantitative selling system in place, you can help keep short-term emotions from wreaking havoc with your long-term performance.
Guru Spotlight: Kenneth Fisher
For decades, the price-to-earnings ratio has been the most widely used valuation measure for stock investors, and a key tool in the arsenals of many of the gurus I follow. While legendary investors like Benjamin Graham, Peter Lynch, and John Neff all used the ratio differently, they and many others agreed that the ratio itself was a key to finding bargain-priced stocks. The investing public and media seems to share their view, with the P/E ratio having long been the only valuation metric that most newspapers include in their daily stock listings.
But in 1984, Kenneth Fisher sent a shockwave through the P/E-conscious investment world. Fisher -- the son of Phillip Fisher, who is known as the "Father of Growth Stock Investing" -- thought there was a major hole in the P/E ratio's usefulness. Part of the problem, he explained in his book Super Stocks, is that earnings -- even earnings of good companies -- can fluctuate greatly from year to year. The decision to replace equipment or facilities in one year rather than in another, the use of money for new research that will help the company reap profits later on, and changes in accounting methods can all turn one quarter's profits into the next quarter's losses, without regard for what Fisher thought was truly important in the long term -- how well or poorly the company's underlying business was performing.
While earnings can fluctuate, Fisher found that sales were far more stable. In fact, he found that the sales of what he termed "Super Companies" -- those that were capable of growing their stock price 3 to 10 times in value in a period of 3 to 5 years -- rarely decline significantly. Because of that, he pioneered the use of a new way to value stocks: the price-to-sales ratio (PSR), which compared the total price of a company's stock to the sales the company generated.
Fisher's findings -- and his results -- helped make the PSR a common part of investment parlance, and helped make him one of the most well-known investors in the world. (He is a perennial member of Forbes' list of "The 400 Richest Americans", his money management firm oversees tens of billions of dollars, and he is one of Forbes' longest running magazine columnists.) The common sense, mostly quantitative approach he laid out in Super Stocks also caught my attention, and led me to create my Fisher-based Guru Strategy.
It's important to note that today, Fisher says his approach to investing has evolved quite a bit since Super Stocks. The key to winning big on Wall Street is knowing something that other people don't, he believes, and when too many people became familiar with PSR investing, he says he needed to find other ways to exploit the market.
So why have I continued to use my Super Stocks-based model? Two reasons: First, Fisher's publisher reissued the book in 2007, with the same PSR focus. Second, the strategy flat out works. From its July 2003 inception through the end of 2010, my 10-stock Fisher-based portfolio gained 163.9% (13.9% annualized), while the S&P 500 gained just 25.7% (3.1% annualized). That makes it one of my most successful long-term strategies.
Price-to-Sales and "The Glitch"
Fisher is a student of investor psychology, and his observations about investor behavior are what led to his PSR discovery. Often, he found, companies will have a period of strong early growth and become the darlings of Wall Street, raising expectations to unrealistic levels. Then, they then have a setback. Their earnings drop, or continue to grow but simply don't keep pace with Wall Street's lofty expectations. Their stocks can then plummet as investors overreact and sell, thinking they've been led astray.
But while investors overreact, Fisher believed that these "glitches" are often simply a part of a firm's maturation. Good companies with good management identify the problems, solve them, and move forward, and as they do the stock's price begins to rise again. If you can buy a stock when it hits a glitch and its price is down, you can make a bundle by sticking with it until it rights the ship and other investors jump on board.
The key in all of this was finding a way to evaluate a firm when its earnings were down, or when it was losing money (remember, you can't use a P/E ratio to evaluate a company that is losing money, because it has no earnings). The answer: by looking at sales, and the PSR.
According to the model I base on Fisher's writings, stocks with PSRs below 1.5 are good values. And the real winners are those with PSR values under 0.75 -- that's the sign of a Super Stock. To find the PSR, Fisher says to take the total value of a company's stock, i.e. its market cap (the per-share price multiplied by the number of shares outstanding). We then divide that number by the firm's trailing 12-month sales.
One note: Because companies in what Fisher called "smokestack" industries -- that is, industrial or manufacturing type firms that make the everyday products we use -- grow slowly and don't earn exceptionally high margins, they don't generate a lot of excitement or command high prices on Wall Street. Their PSRs thus tend to be lower than those of companies that produce more exciting products, Fisher said. He adjusted his PSR target for these firms, and the model I base on his writings looks for smokestack firms with PSRs between 0.4 and 0.8; it is particularly high on those with PSR values under 0.4.
Beyond the PSR
While the PSR was key to Fisher's strategy, he warned not to rely exclusively on it. Terrible companies can have low PSRs simply because the investment world knows they are headed for financial ruin.
Other quantitative measures Fisher used include profit margins (he wanted three-year average net margins to be at least 5 percent; the debt/equity ratio (this should be no greater than 40 percent, and is not applied to financial firms); and earnings growth (the inflation-adjusted long-term EPS growth rate should be at least 15 percent per year).
Fisher also made an interesting observation about companies in the technology and medical industries. He saw research as a commodity, and to measure how much Wall Street valued the research that a company did, he compared the value of the company's stock (its market cap) to the money it spends on research. Price/research ratios less than 5 percent were the best case, and those between 5 and 10 percent were still indicative of bargains. Those between 10 and 15 percent were borderline, while those over 15 percent should be avoided.
One of the Best
The variety of variables in my Fisher-based model are a big part of why I think it continues to work, long after the PSR has become a well-known stock analysis tool. While it uses the PSR as its focal point, it also makes sure firms have strong profit margins, earnings growth, and cash flows, and low debt/equity ratios. That well-rounded approach helped it get through one of the worst periods for the broader market in history and stay far, far ahead of the market over the long haul -- all while the PSR has been a well-known investing tool. I expect this solid approach will continue to pay dividends over the long haul.
Now, here's a look at the stocks that currently make up my 10-stock Fisher-based portfolio.
China Integrated Energy Inc. (CBEH)
World Fuel Services Corporation (INT)
Clearwater Paper Corp. (CLW)
GameStop Corp. (GME)
Dollar Tree, Inc. (DLTR)
Ross Stores, Inc. (ROST)
Aeropostale, Inc. (ARO)
Telecom Argentina S.A. (TEO)
Fuel Systems Solutions, Inc. (FSYS)
Lincoln Educational Services (LINC)
News about Validea Hot List Stocks
Dollar Tree, Inc. (DLTR): On Feb. 23, Dollar Tree announced fourth-quarter profit of $162.5 million, or $1.29 a share, up from $135 million, or $1.01 a share, in the year-ago period. Net sales were up 11% to $1.73 billion.
Ensco Plc (ESV): On Feb. 23, Ensco reported fourth-quarter profit attributable to Ensco shareholders of $131.2 million, or 93 cents per share, down from $206 million, or $1.46, a year earlier. Revenue fell 18 percent to $408.5 million, which beat analysts' forecasts, according to Reuters. The profit decline was attributed to declines in utilization and day rates.
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 firstname.lastname@example.org.
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