|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||May 29, 2009|
While a number of fears -- some well-deserved -- are still hanging over the economy, the past two weeks have seen the rise of some very real economic "green shoots", to use what has become the phrase-of-the-day in financial news.
For starters, the credit markets -- whose grinding halt was perhaps the most significant part of the crisis that sent the market reeling last September -- are showing major signs of improvement. In fact, Bloomberg News reported this week that "by almost any measure, credit markets have recovered most of the losses caused by September's collapse of Lehman Brothers". The Libor-OIS spread, which measures banks' reluctance or willingness to lend, fell to just 0.45 percentage point this week, the lowest level in almost 16 months and less than one-eighth of what the spread was in October, when fears were raging, according to Bloomberg.
In addition, yesterday the Federal Reserve announced that, for the second week in a row, no investment firms took loans from its emergency lending program in the week ending May 27. Prior to these past two weeks, the last time that happened was early September, according to the Associated Press.
The housing market -- whose woes have gone hand in hand with the credit market's -- is giving a much more mixed picture. The National Association of Home Builders said last week that its housing market index rose in May, the second straight month it increased. The report reflected growing optimism among builders, AP reported. Existing home sales, meanwhile, rose almost 3% in March, the National Association of Realtors said this week, another good sign. Much of that increase was due to more action in the lower-priced areas of the market, however. Home prices fell in March in 17 of the 20 metro areas tracked by the S&P/Case-Shiller Home Price Index, falling an average of 2.2%.
For the housing market, however, the real bad news came yesterday, when the Mortgage Bankers Association reported that more than 12% of U.S. mortgage holders were in foreclosure or at least one payment past due, the highest level registered since the group started tracking the figure. Equally troubling: Prime fixed-rate loans -- those given to borrowers with good credit -- now represent the largest portion of foreclosures, more than the subprime loans that caused so much trouble over the past year. The reason: As the recession has worn on, more and more people have lost their jobs or had their hours cut, causing them to default.
Despite the continued housing troubles, the market kept rising over the past two weeks, as other signs of hope popped up. The Commerce Department reported this week that durable goods orders -- a key measure of business confidence -- rose almost 2% in April, the biggest increase since December 2007.
Just as businesses are expressing a more hopeful outlook, so too are consumers. The Conference Board's Consumer Confidence Index jumped in May, rising 35%. It was the second straight month the index has increased, rising to its highest point since September of last year. A Conference Board official said that, while confidence levels are still weak by historical standards, "as far as consumers are concerned, the worst is now behind us" -- a hopeful sign in an economy largely driven by consumer spending.
Employment figures also offered a bit of hope recently, with new jobless claims coming in less than expected last week. New claims are thus continuing to trend downward from their March high.
All of this was positive enough on balance to help push the S&P 500 up another 1.5% over the past fortnight, as the index continued the climb it began in early March. The Hot List fared even better, jumping 7.7%. That puts the portfolio up 16.0% in 2009, while the S&P is up 0.4%. Since its inception in July 2003, the Hot List also remains well ahead of the market, having gained 90.2% versus the S&P's -9.4% decline.
The Missing Piece
As the markets have continued to rise, many pundits and strategists have warned that a correction is coming, and have cited the swiftness and steepness of the recent climb as a reason. Time to sell off a lot of stocks, they say, and take whatever profits you've scooped up in the past 11 or so weeks.
In our past two newsletters, I've taken issue with such claims. I wouldn't be shocked if there were some sort of correction, but the bottom line is that I still believe the proposition of selling off stocks that remain attractively priced in order to avoid a correction that may or may not come is not worth the risk.
All of this begs an important question, however: When should you sell a stock? When it has gained a specific amount? Lost a specific amount? When certain economic indicators turn negative? It's a critical and often overlooked component of portfolio strategy, one so important that I dedicated an entire chapter to it in my latest book, The Guru Investor. Given the current market conditions, I thought it would be a good time to take a look at an excerpt from that critical chapter.
(Note: I've edited the following excerpt for length. This portion of the chapter deals with the fundamental reasons for selling stocks. You should be aware that another factor that can come into play in sell decisions -- though to a much lesser degree, in my opinion -- is the tax status of your account.).
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. As of May 23, 2008, the average annualized gain for the 10 guru-based strategies discussed in this book was 16.2 percent when the portfolios were rebalanced monthly, 15.4 percent when rebalanced quarterly, and 10.4 percent when rebalanced annually.
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: Warren Buffett
With his humble mid-west beginnings, plainspoken wisdom and wit, and incredible wealth, it's no wonder that Warren Buffett has become the most-watched investor in the world. But while the juxtaposition of Buffett's fortune (Forbes estimated his net worth at $37 billion earlier this year) with his love of simple pleasures (he's a big fan of Cherry Coke and cheeseburgers) is intriguing, the more important piece of the Buffett puzzle for investors is this: How did he do it?
My Buffett-based Guru Strategy attempts to answer that question. Based on the approach Buffett reportedly used to build his fortune, it tries to use the same conservative, stringent criteria to choose stocks that the "Oracle of Omaha" has used in evaluating businesses.
Before we get into exactly how this strategy works, a couple notes about Buffett and my Buffett-based strategy: First, while most of my Guru Strategies are based on published writings of the gurus themselves, Buffett has not publicly disclosed his exact strategy (though he has hinted at pieces of it). My Buffett-inspired model is based on the book Buffettology, written by Mary Buffett, Warren's ex-daughter-in-law, and David Clark, a Buffett family friend, both of whom worked closely with Buffett.
Second, while most of my Buffett-based method centers on a company's fundamentals, there are a few non-statistical criteria to keep in mind. For example, Buffett likes to invest in companies that have very recognizable brand names, to the point that it is difficult for competitors to take away their market share, no matter how much capital they have. One example of a current Berkshire holding that meets this criterion is Coca-Cola, whose name is engrained in the culture of America, as well as other parts of the world.
In addition, Buffett also likes firms whose products are simple for an investor to understand -- food, diapers, razors, to name a few examples.
In the end, however, for Buffett, it comes down to the numbers -- those on a company's balance sheet and those that represent the price of its stock.
In terms of the numbers on the balance sheet, one theme of the Buffett approach is solid results over a long period of time. He likes companies that have a lengthy history of steady earnings growth, and, in most cases, the model I base on his philosophy requires companies to have posted increasing earnings per share each year for the past ten years. There are a few exceptions to this, one of which is that a company's EPS can be negative or be a sharp loss in the most recent year, because that could signal a good buying opportunity (if the rest of the company's long-term earnings history is solid).
Another part of Buffett's conservative approach: targeting companies with manageable debt. My model calls for companies to have the ability to pay off their debt within five years, based on their current earnings. It really likes stocks that could pay off their debts in less than two years.
Smart Management, and an Advantage
Two qualities Buffett is known to look for in his buys are strong management and a "durable competitive advantage". Both of those are qualitative things, but Buffett has used certain quantitative measures to get an idea of whether a firm has those qualities. Two of those measures are return on equity and return on total capital. The model I base on Buffett's approach likes firms to have posted an average ROE of at least 15% over the past 10 years and the past three years, and an ROTC of at least 12 percent in those time frames.
Another way Buffett examines a firm's management is by looking at how the it spends the company's retained earnings -- that is, the earnings a company keeps rather than paying out in dividends. My Buffett-based model takes the amount a company's earnings per share have increased in the past decade and divides it by the total amount of retained earnings over that time. The result shows how much profit the company has generated using the money it has reinvested in itself -- in other words, how well management is using retained earnings to increase shareholders' wealth.
The Buffett method requires a firm to have generated a return of 15 percent or more on its retained earnings over the past decade.
One more area Buffett examines: capital expenditures. He doesn't like to invest in companies that must spend a lot of money on major facility or equipment upgrades, or that need to spend a lot of money on research and development to stay competitive. My Buffett-based model thus looks for companies that have positive free cash flows, an indication that the company is generating more cash than it is consuming.
The Price: Is It Right?
The criteria we've covered so far all are used to identify "Buffett-type" stocks. But there's a second critical part to Buffett's analysis: price -- can he get the stock of a quality company at a good price?
One way my Buffett-based model answers this question is by comparing a company's initial expected yield to the long-term treasury yield. (If it's not going to earn you more than a nice, safe T-Bill, why take the risk involved in a stock?)
To predict where a stock will be in the future, Buffett uses not just one, but two different methods to estimate what the company's earnings and stock's rate of return will be 10 years from now. One method involves using the firm's historical return on equity figures, while another uses earnings per share data. (You can find details on these methods by viewing an individual stock's scores on the Buffett model on Validea.com, or in my new book, The Guru Investor.)
This notion of predicting what a company's earnings will be in 10 years may seem to run counter to Buffett's nonspeculative ways. But while using these methods to predict a company's earnings for the next 10 years in her book, Mary Buffett notes: "In most situations this would be an act of insanity. However, as Warren has found, if the company is one of sufficient earning power and earns high rates of return on shareholders' equity, created by some kind of consumer monopoly, chances are good that accurate long-term projections of earnings can be made."
A Strong Rebounder
My Buffett-based 10-stock portfolio is well ahead of the S&P 500 since its December 2003 inception. Where the model has really excelled, however, is coming out of downturns. In 2004, as we were emerging from the lengthy recession associated with the tech stock bust, the Buffett portfolio surged 37.3%, more than quadrupling the S&P's 9% gain. In addition, after struggling in 2007 and 2008 amid the latest recession and bear market, the portfolio has bounced back strong this year as things have begun to turn around. The portfolio is up 16.8% in 2009 -- including 30.7% in the past three months -- while the S&P is up 0.4% for the year. It's no surprise given Buffett's penchant for pouncing on good, beaten down stocks, which usually abound during tough times as investors let fear get the best of them. (One of Buffett's mantras is that investors "should try to be fearful when others are greedy and greedy only when others are fearful.")
These stocks are not the kind of sexy, flavor-of-the-month picks that catch most investors' eyes; instead, they are proven businesses selling at good prices. That approach, combined with a long-term perspective, tremendous discipline, and an ability to keep emotions at bay, is how Buffett has become the world's greatest investor. Whatever the size of your portfolio, those qualities are worth emulating.
News about Validea Hot List Stocks
NetEase.com Inc. (NTES): On May 20, NetEase reported a first-quarter profit of 416.7 million renminbi ($61 million, or $0.47 per American Depository share), up 55 percent from 269.4 million renminbi a year earlier. Revenue increased 20 percent to 781.7 million renminbi ($114.4 million), the Associated Press reported, adding that analysts were expecting a profit of $0.46 per ADS on sales of $116.3 million. The results were boosted by strong user loyalty for the firm's games and "robust online communities," while the sales numbers missed analysts' expectations because of weak advertising revenue, AP stated.
Lufkin Industries Inc. (LUFK): As oil prices continued to climb, Lufkin gained almost 15% over the past two weeks (through yesterday's close), making it the Hot List's biggest gainer since our last newsletter.
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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