Quality will rule

Now that financial Armageddon seems to have been avoided and the stock market is up over 55%, a lot of investors are wondering where to invest next. My answer: quality.

Quality is always a good place to invest, but it may be particularly important going forward. There are a couple of reasons I think this.

One is that quality companies have mostly been left behind in the rally since March. They haven’t completely been left behind, mind you, but they aren’t up 55% like the rest of the market. They’re not up as much because…they were never down as much.

The companies that tanked most from September 2008 to March 2009 were those many thought faced significant bankruptcy risk. When investors realized they wouldn’t go bankrupt (at least, not yet), their prices took off. In some cases, those companies doubled and tripled in price!

Looking forward, such low-quality companies are unlikely to continue out-performing. Significant economic and financial risks still exist, and such companies weren’t exactly healthy to begin with. That’s not the strongest vote of confidence for future returns.

The second reason I think quality companies will out-perform is because they hold all the cards. They weren’t overly indebted to begin with, they had strong market share and superior products, they tend to have excellent growth opportunities due to international markets, they have the financial resources that allows for growth, and they have the management talent to execute.

Add those positives to prices that haven’t really taken off, and you have an ideal situation. When you combine a quality company’s excellent prospects with low historical prices relative to fundamentals, you have a recipe for excellent returns.

As Warren Buffett once said, “If a business does well, the stock eventually follows.” I can’t make any promises about when the quality stocks will follow fundamentals, but I’m very confident it will take place within a 3 – 5 year time horizon.

For those of you interested, I recently reworked my website. I tried to make it more straightforward and my value proposition clearer. Please visit and tell me what you think. I also added my business, Athena Capital, to facebook. Become a fan if you’re so inclined.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The myth of the rational investor

One aspect of my job I love best is reading to broaden my horizons. I recently finished a book by Dan Arielly called Predictably Irrational: The Hidden Forces That Shape Our Decisions. It was an eye-opening look into how real humans make decisions and what traps to avoid.

This may sound like heady stuff, but it’s quite useful to a professional investor like me. You see, I happen to be human, and knowing the errors that humans frequently make can help me avoid mistakes and become a more successful investor over time. Quite practical, really.

Arielly highlights that most economic theory, up until the pioneering research done by behavioral economists, tended to assume that humans make fully rational decisions, especially when it comes to spending money. On the contrary, research has shown that we humans make all kinds of silly mistakes.

For example, we tend to over-value what we own. Before we buy a car, say a VW bug, we want to pay as little as possible for it. But, once we’ve bought it, we suddenly value it much more than we did before ownership. We won’t sell it unless we can get top-dollar, even though we didn’t think it was worth top-dollar when we bought it. And, the longer we own it, the more attached we can become, especially if we put a lot of work into ownership. I’ll think about that the next time I go to sell a stock. I may want a price no one’s willing to pay simply because once I’ve owned it for a while. Using objective value measures like price to earnings or price to book value give me an objective reference point to avoid this trap.

Another problem for humans is we want to keep our options open. Keeping options open makes sense in many contexts, but not when economic costs outweigh benefits. Arielly and crew showed how people generally over-weigh the benefit of keeping options open, literally to the degree of putting a higher price on keeping options open than the benefit derived. By trying to keep our options open, we frequently get distracted from the true objective. I’ll remember this the next time I go to make an investment decision. When considering investment options, I know that wanting to keep my options open may distract me from making a good decision. Instead, I’ll make the best decision given the facts and move on.

We humans are also greatly impacted by our expectations, and we may never change our minds even when confronted with contrary evidence. Arielly and his colleagues demonstrated through several experiments how people’s pre-conceived notions literally impact their experiences. This is easy to find with investing, too. Once we buy an investment with the vision of great wealth pouring down on us, we hold on to that vision long after the facts have shown the vision to be faulty. This is a great thing to keep in mind when making investment decisions. Am I ignoring evidence? Am I looking for opinions different than my own? Can I dig for dis-confirming evidence instead of just looking for proof that backs my pre-conceived notion?

Being human has many wonderful benefits, but being rational decision makers, in the economic sense, is not one of them. This doesn’t mean we should throw in the towel, it just means we have to be very objective when making investment decisions. This book helps me ask myself: 1) am I over-valuing something simply because I own it? 2) am I losing economic benefits because I want to keep options open? 3) am I looking for dis-confirming evidence to contradict my pre-conceived notions? Such questions lead to better decision making and better investment results.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The long road back

The stock market has rallied strongly since March, and this has a lot of investors feeling optimistic again.

A lot of the numbers touted by the press (with Wall Street’s careful nudging) foster this cycle of optimism. For example, the S&P 500, on a price-only basis, is up 56% from its ominous intra-day bottom of $666.79 (March 6, 2009). 56% sounds very impressive, indeed!

But, the context of that 56% number is important. If you bought a company for $100 a share and it fell to $1 (99% decline), and then rallied to $1.56 (up 56% from the bottom, but down 98% from purchase price), you’d have a 56% “gain.” Not as impressive when put that way.

The same context should be included in any analysis of the S&P’s meteoric 56% increase.

The S&P 500 peaked on 10/9/2007 at $1,565.15. That means, on a price-only basis, the S&P 500 is down 34% even after it’s 56% increase. It’s not very impressive to have gained 56% when 1/3 of your wealth is still missing in action.

This is where most investors get confused because percentage changes aren’t intuitively obvious (why, oh why, do teachers spend so much time on trigonometry and calculus and so little on the math of compounding!?). Percentage changes must be put in context and looked at over longer time periods, otherwise they can give an incomplete impression and perhaps even deceive.

Let me illustrate. My clients’ growth accounts were down 24% from the end of October 2007 (the month when the market last peaked) through the end of August 2009 (including fees and dividends, consult my notes on performance for full disclosure). Down 24% sounds bad, but not when you compare it to the S&P 500 total return (includes dividends): down 31%.

Down 24% may not sound much more impressive than down 31% because they are both down a lot. But, when you’re down 24%, it takes a 32% gain to get back to breakeven; when you’re down 31%, it takes a 45% gain to get back to breakeven. It will likely take less time to climb 32% than 45%.

Stretching these number out over time illustrates why a broader context and longer time periods are important.

My clients’ growth accounts are up 5.76% since inception (4/30/05) versus down 3.30% for the S&P 500. If “big-whoopledeedoo” is your response, I don’t blame you–it might not sound impressive at first glance.

But, from a broader context, that means my clients were 9% ahead of the S&P 500 after 4 years and 4 months, and that’s worth a lot over the long run where even small out-performance adds up. 2% out-performance (which I am by no means promising) means 50% more wealth over a 20 year period. That can really make a difference.

Even with its recent climb, the market still has a long road back.

Another factor in thinking about the 56% climb is valuation–what is the market likely to do going forward? If the market were dramatically under-valued, then that 56% climb may keep going. But, what if that 56% climb started from fair value or over-valuation? Then expecting the dramatic rise to continue wouldn’t make sense.

By my calculations, the S&P 500 is very close to fair value right now. Assuming underlying growth of 3%, inflation of 3%, and a 3% dividend yield, the expected return going forward is around 9% a year. At 9% a year, it would take the market another 5+ years to climb another 56%. Just because the market has risen a lot doesn’t mean it will continue to do so.

I’m not making a market prediction. I’m just trying to illustrate that the market’s recent rise must be kept in context, must be looked at over a broader time span, and must be looked at with respect to underlying fundamentals.

Given that, the market could rise, fall or remain flat. I have no idea what it’ll do. But, it would not be reasonable to take the 56% rise and extrapolate that performance going forward.

It’s a long road back, and it’ll likely take some time to cover the distance.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

“Good” company versus good stock investment

One of the most difficult concepts to grasp in all investing is the difference between a “good” company and a good stock investment.

The intuitive take most people have is that a “good” company is a good stock investment. Seems to make sense, doesn’t it?

But, this is rarely the case. Why? Because a company’s stock price reflects how people in general think of it.

If everyone loves a company and buys its stock, then its stock price will rise to meet that growing demand. Popular stocks have high prices relative to their underlying value.

“Good” companies, as recognized by the vast majority of people, tend to be over-priced.

The opposite is true for “bad” companies. When the vast majority of people think a company is garbage, its stock price reflects that lack of demand. Unpopular companies tend to have low prices relative to fundamentals.

“Bad” companies, as recognized by most people, tend to be under-priced.

This is very counter-intuitive for most people and a bit hard to handle. It doesn’t seem to make sense to buy something everyone hates and sell something everyone loves. After all, can the majority be consistently wrong?

Yes. The proof of the pudding is in the eating, and when you buy “bad” companies and sell “good” companies, you get better returns than if you sell “bad” companies and buy “good” companies. The statistical studies on this are too numerous to detail here, but the solid weight of statistical and anecdotal study is that “bad” companies’ stocks out-perform “good” companies’ stocks.

You can implement this strategy in a non-concentrated way by simply buying the hated and selling the loved. I recommend high diversification for this approach because some of those “bad” companies will actually turn out to be bad and some of those “good” companies will turn out to be good investments. You need the benefit of a large number of investments to get everything to average out and get good results.

Another approach, that I believe generates better results, is to work hard to figure out which companies are good and perceived “bad.”

As you may have noticed, I’ve been using quotation marks around “good” and “bad” to indicate good or bad as seen by the majority. But, the majority isn’t always right. Sometimes a “bad” company is a very good investment because it is actually good and everyone perceives it to be bad. Then, not only do you have the long run tailwind of a good company’s underlying fundamentals that time will make clear, but you also get to buy it at a “bad” company discount to underlying value. Then, you can get some truly phenomenal long term investing results.

This is the approach that I use. I buy companies everyone seems to hate where I believe the crowd is wrong.

It’s tough to implement this approach, though, because when you tell people what you’re buying, they look at you like you’re crazy (frequently a sure sign of good investment). It’s hard to be on the extreme minority side of opinion, and with investments people can be very passionate about their views (people like to tell you how stupid you are and all the things you aren’t paying attention to). Sometimes, the majority turns out to be right and you end up looking and feeling like a fool. That’s the price you pay to get outstanding results, though, and it’s well worth it.

Remember, a “good” company isn’t necessarily a good investment. Knowing the difference can mean the difference between good and bad investing results.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.