Avoiding Blow-Ups

Everyone loves a big winner. The problem is: most don’t focus enough on the odds of winning big.  

In baseball, a batter who swings from his heels and knocks it out of the park is considered a hero. In football, a 50 yard Hail-Mary pass that ends in a touchdown is called miraculous.  In basketball, a wild three-point shot that wins the game is considered stellar. But, what are the odds of those outcomes? Sport statisticians know the numbers, and most complain about the show-boats who pull such stunts. Why? Because they know that the odds are terrible, and that it doesn’t consistently win games.

Why do people dwell on big wins? Because huge victories are vivid–everyone can imagine themselves as the star. And, big wins seem much easier than hard work over many years.  Who wants to slog away in obscurity for years hitting singles? Most people don’t–they want home-runs!

When it comes to investing, this attitude is extremely unproductive. Instead of trying to get steady returns over time, investors eagerly gamble their hard-earned savings hoping they can score a big win. 

With investing, as with many other things, this just doesn’t work. If you don’t beleive me, examine the record of Warren Buffett, or almost any other billionaire. You won’t find that they “invested” in a lottery ticket or bought Apple stock.  

Most investors, unfortunately, seem to think that swinging from their heels is how you win, and they invest accordingly. Their results illustrate the failure of such an approach.

As contrast, look at Buffett’s two rules of investing:

  • Rule #1: don’t lose money
  • Rule #2: never forget rule #1

Anything in there about making a big gamble and aiming for a big score? Nope.

Why the boring approach of avoiding losses? Because it works. Show-boating doesn’t win in sports, buying lottery tickets doesn’t lead to happiness, and investing in “winners” that are “certain” to go up a lot doesn’t generate enviable investment results.

Why not pick winners? Because that’s what tons of other people are trying to do, and companies perceived as winners have stock prices that reflect investors’ generally high opinion. The high competition in picking winners makes it a losers game.

There’s not a lot of competition, however, in picking companies that are considered losers. Not surprisingly, this means the odds of good outcomes from investing in supposed “losers” are much better. There is a risk, of course, of investing in the unloved: they may turn out to really be losers.  

And that is why Buffett and so many other value investors focus on avoiding blow-ups. If you buy something that tanks, it will pull you down more than your winners will pull you up. If you can do everything in your power to avoid such blow-ups, your returns will be good–perhaps very good.

How can you minimize the risk of blow-ups? I’ve found there are two keys:

  1. Avoid blow-up situations
  2. Don’t pay too much for a company

Blow-up situations can be due to financial problems. If a company finances its operations with too much debt, it can go bankrupt and its stock can get wiped out. If a company needs funding and it can’t get it–even temporarily–lenders may end up owning the company and you’ll own a worthless stock. This means avoid companies that may have leverage or liquidity problems.

Blow-ups situations also occur for business reasons. Most buggy whip makers were toast as soon as Ford’s cars were a success.  Technological obsolescence can kill a business seemingly overnight. A major change in end markets, like people getting their information from the Internet instead of newspapers, can kill a business, too. Supply can dry up. Regulations can alter the landscape forever. Competition can steam-roll weak players. Business risk is the hardest to assess, but one of the most frequent causes of blow-ups. You have to do a lot of research to assess this risk.

Management is another cause of blow-ups. They can do it with fraud, like Enron or Worldcom; or they can do it with incompetence, like Kodak; or they can do it with bad capital allocation, like Tyco. Management risk may seem harder to judge than business risk, but I find it’s much easier to detect. Evasive management is one thing to look for. Another is inconsistency in measuring their own performance: one quarter it’s sales, then next its market share, the next its customer satisfaction.

Doing everything you can to avoid blow-ups is crucial, but not enough. Sometimes, unpredictable things happen: hurricanes hit, earthquakes occur, sound businesses turn out to be unsound because of new technology that no one saw coming.  If you invest assuming you know everything, you’ll get burned. Acknowledge, from the get-go, that you’re not omniscient, and pay a low price for your investments.

Paying a low price protects you in two ways. First, if a company turns out to be a blow up, you’ll do less damage if you paid a low price. Second, you’ll earn much better returns on the companies that don’t blow up–because you paid a lower price–and that will allow your winners to make up for your infrequent and low-loss losers.

Investing success comes from putting the odds in your favor, and using the right approach. Don’t try to swing for the fences. Instead, avoid picking losers and don’t pay too high a price.

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.

Avoiding Blow-Ups

What’s in a name?

Quick quiz. Would you prefer to work with a: 1) financial planner, 2) investment planner, 3) money manager, or 4) wealth manager?

If you feel like I just asked if you like: 1) pizza, 2) pizza, 3) pizza or 4) pizza, you are not alone. The financial intermediaries who claim to be these things can’t keep it straight, so no one should expect clients to, either.

In a recent study by Cerulli Associates, Inc., 1,500 financial intermediaries were found to mis-identify themselves as something they weren’t, frequently exaggerating the services they offer.

According to the study, 59% of financial intermediaries identified themselves as financial planners–certified to work with clients in building comprehensive plans that include insurance and estate planning. Cerulli’s study, however, found that only 30% of those 59% actually fit that description.

22% of financial intermediaries called themselves investment planners, who focus on asset management, retirement and college savings plans. 56% of the survey’s respondents actually fit that description, which makes it sound like a lot of investment planners try to pull themselves off as financial planners.

11% described themselves as wealth managers, who do comprehensive planning for wealthier clients, but only 6% actually fit the description. Once again, it sounds like an inflated title is used in hopes of generating business.

It turns out that money managers, who manage and build investment portfolios (that’s what I am), were the only group that accurately described what they do. Apparently, they knew what they were and weren’t afraid to describe themselves as such.

I must admit, I’ve run into this confusion a lot with clients, prospective clients, and even friends and family. Someone asks what I do, and I describe that I manage money for people.  Then, they say, “So, you’re a financial planner,” or “So, you’re a stock broker.” I don’t blame them for the confusion, but I do blame my industry.

There are a lot of honest people in the financial services business, but it doesn’t seem like a large majority. Specifically, a culture exists that focuses on commission-based sales, and convincing people to purchase “products.” An old industry adage is that insurance products aren’t bought, they’re sold. Looking at how most financial intermediaries are compensated, you’ll see that the adage is all too true.

I’m highlighting this not just to pat myself and other money managers on the back (whoopee, I’m on Team Honest!), but to illustrate how the financial services industry seems to thrive while confusing clients.  

A helpful term to look for is fiduciary.  A fiduciary “must act for the benefit of their clients and place their clients’ interests before their own” (CFA Standards of Practice Handbook).  

When you go to a Ford dealership, you don’t expect a commission-based salesperson to recommend a Toyota, but when you are talking to a doctor, lawyer or another professional, you should expect them to treat you fairly.

When dealing with a professional, you are placing yourself in a position of trust with someone who is an expert in a field where you aren’t.  It would be unfair, and frequently illegal, if the professional used that position of trust to benefit themselves at your expense.  That is why so many legitimate professional organizations require members to adhere to a code of ethics (and will boot you if you don’t!).

When a so-called financial planner earns a 5% commission (yes, on the gross amount of the dollars you invest) because you invest in the mutual fund they recommend, that’s not adhering to a fiduciary standard.  When an insurance agent earns a 10% commission selling you a whole life insurance policy or variable annuity, it should be clear their supposed advice is tainted by a big conflict of interest.

The best way to protect yourself, whether you’re dealing with someone who claims to be fiduciary or not, is to ask how they are compensated.  That should make it clear whether they are serving themselves first, or you.

What’s in a name?  It turns out, a lot.  

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.

What’s in a name?

Caveman brain and variable cycles

Almost everyone claims to be a long term investor, but few truly are.

A person’s real attitude toward investing only becomes obvious with time.  One person initiates an investment approach and sticks to it for 20 years, while another switches after it doesn’t “work” over three.  The result is almost always good performance for the person who sticks to one approach, and terrible results for the person who changes course every three years.

In my opinion, the cause of this short-term-orientation is twofold.  

First, human psychology really does a number on us.  Our caveman brain evolved to handle different problems.  You don’t need more than three years of data to decide whether you should run from a hungry lion or a pack of wolves.  But, hunter-gatherers and farmers need to think longer-range to survive.  Unusually bad winters and poor rainy seasons don’t happen every year, but when they do, you’d better have enough food and clothing stored, or you won’t survive.  On an evolutionary time-scale, this thinking is pretty new to us.  As a result, we make lots of mistakes when our caveman emotions take over from our long-range, reasoning mind.

I’m as prone to this difficulty as everyone else, much to my distaste.  My biggest investing mistakes are seldom a refusal to sell something bad, but impatiently selling something too soon.  I, too, have suffered from short-term-orientation with investments that weren’t “working,” only to see them take off shortly after selling.  

I sold Berkshire Hathaway in November 2009 (having held it for 3 1/2 years) shortly after Buffett bought the Burlington Northern Santa Fe railroad.  Buffett was clearly signaling that his company would never grow like it had in the past.  The stock then jumped 21% in four months.  I was right about underlying growth, but wrong to have sold at a low price to fundamentals.

I sold UnitedHealth in November 2010 (3 1/2 year holding, also) after company management had repeatedly described how new health care legislation could rapidly change their business model.  The stock proceeded to climb 44% in the eight months after I sold.  Once again, I was right on the fundamentals of the business, but wrong on the decision to sell when price to fundamentals were still too low.

My purpose in giving these examples is not to highlight what a moron I am (I’ve actually gotten many more right than wrong–no really!), but to illustrate that even someone aware of the psychological traps of investing can still fall into them.  The solution is better process, which is fertilized with a thorough, rational analysis of past mistakes.

The second reason I think short-term-orientation sets in has to do with the fundamental nature of investing and business cycles, which are wildly variable in amplitude and duration.  Just as you can’t decide the quality of farmland without considering weather cycles, so you can’t decide what’s going on with an investment without considering investing and business cycles–and that makes analyses more difficult.  

Investing cycles are caused by the boom and bust mentality of investors.  One year investors eagerly pay 20x earnings for an investment, and another year they won’t pay 5x.  This boom-bust cycle is caused by the psychology of investors as a herd.  They go from euphoria to terror and back again over time, and no one can predict how long the cycle takes or when it will reach its zenith or nadir.

Business cycles, which are less psychological than investing cycles, are caused by a variety of things (including government policy, fads and fashions, competitive dynamics, just to name a few).  Like investing cycles, business cycles follow unpredictable paths that can distort the information investors need to make good decisions.  A rational analysis of long-term sales and margins over the full cycle is required, as is an in-depth analysis of industry and company dynamics.  Is a downward cycle permanent, or temporary?  Has a paradigm shift occurred that makes the business model defunct?  Only time will tell.

Investors generally have a hard time handling investing and business cycles.  Its easy to panic and “throw in the towel” when the future is unknown, but it rarely generates good investment returns.  People would love to know if their investment approach is working by seeing results right away, but the world is too complicated to say one, three or even five years of data are enough.  It depends, and each cycle is different than the last.  It’s more constructive to look at long data samples, but few have the patience or desire for such work.

Given that, what’s the solution?  

First, you’ll only stick to an approach over the long run if you really–deep down–know it works.  If you’ve looked at the long term data, you’ll know that value investing crushes growth investing over the long term.  If you spend enough time picking the right approach (or the right manager), it’s possible to ride through periods of under-performance that can last as long as a decade.  If not, you’ll panic and abandon ship at just the wrong time.

Second, you’ll have to do battle with your psychology.  You will feel emotions when your investments tank.  You will want to throw in the towel when something isn’t working for several years.  Be ready to fight your emotions with reason, data, analysis, or whatever else helps you.  I’ve found temporary distraction works, as does exercise, deep breathing, meditation, reading.  Do what you must to hold emotion at bay and focus on the facts.  Only then will you stick to your approach.

Our caveman brain and variable cycles make sticking to an investment approach very difficult, but not impossible.  The rewards, however, are truly extraordinary and well worth the time, effort and intermittent anxiety.  

Find the right approach, and stick to it!

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.

Caveman brain and variable cycles

Big bad banks?

Just a quick note: the U.S. Federal Reserve made $78.9 billion in 2011, second only to its 2010 record haul of $81.7 billion.

Feeling curious, I decided to look up how much money the U.S. big four banks made in their peak years.  Combining their best, Bank of America (2006), Citigroup (2006), JPMorgan (2007) and Wells Fargo (2010) had combined peak earnings of only $70.1 billion (full disclosure: my clients and I own shares of Wells Fargo).

In other words, the banks that are supposedly the cause of all our earthly problems didn’t together, looking at their peak earning years(!), match what the Federal Reserve made by itself in either of the last two years.

The bozos of Occupy Wall Street and everyone else who believes all our problems are due to the greedy, too powerful big banks need a reality check.

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.

Big bad banks?

Five year snap-back

Each quarter, Barron’s publishes how mutual funds performed by sector.  Sectors in this case refers to how mutual funds are categorized, like funds invested in large, mid-size or small companies, growth or value, bonds, international, gold, real estate, science and technology, etc.

I find this information interesting not because I think quarterly or annual performance is meaningful–it’s not.  You have to look at much longer periods, like five or ten years, to get meaningful information, and Barron’s publishes that as well.

And, here’s where things get interesting.  If a particular sector has done well over the last five years, does that mean it is likely to continue to do so going forward?  Not at all.  In fact, a good case can be made that the sectors that do best over the last five years are seldom if ever the one’s that do best over the following five years.

And, that’s what I look for in Barron’s tables.  I look for the sectors that have done best and worst over the last five years because the best will likely become worst and the worst will likely become best.

The analysis isn’t quite that simple, of course (nothing worthwhile in life is that easy), but some interesting data points can be gathered that might prove useful in guessing about the future.

For instance, the best performing sector over the last five years was precious metals (8.09% annualized).  That’s not at all surprising given that gold and silver have been on a tear over the last decade.  Will it be best going forward?  I doubt it.  I’d guess precious metals will continue to do well for a few more years and then tank.  Good luck trying to jump off the elevator before it plummets.

What else has done well?  If you guessed U.S. Treasuries, good for you.  They were the second best performing sector out of 103 sectors(!) with an annualized five year return of 6.99%.  If you think that one will be the best performing over the next five or ten years, please don’t operate heavy machinery.

The a
bsolute worst sector was short bias funds with a -16.61% annualized return.  It’s almost impossible to make money, long term, by going short all the time.  If the world falls apart, short bias funds will perform best over the next five years.  But, then again, you have to wonder whether property rights will be enforced or if the dollars you withdraw will be worth anything.

The Japanese stock market was the next worst sector, with a -13.27% return.  I’d guess that Japan is a very good candidate for a turn-around, but they culturally seem to scorn shareholders so I personally hesitate.  Unlike short-bias funds, I think this one has a good chance of looking brilliant in five or ten years.

The third worst was financial services (-11.09% annualized).  The crash and recovery from 2008 to 2009 makes that unsurprising, and a very likely candidate to out-perform over the next five years.  Like Japan, it has the clear ability to turn around, and everyone hates it, so it’s a great contrarian bet.

After looking at the best and worst stand-outs, I look at small versus large and value versus growth.  Anyone who has studied finance knows that, over the long run, small beats large and value beats growth.  The support and records behind that, both theoretically and empirically, are so strong and long that there is very little reason to believe it will change going forward.

However, the long term record also shows that small doesn’t–each and every year–beat large, and value doesn’t always beat growth.  In fact, long periods of time go by where just the opposite happens.  Such periods are usually followed by a snap-back to historic averages–and profit-making opportunities.

The last five years are very interesting along this dimension, because growth has crushed value and small has beaten large by a much larger margin than is historically usual.  This leads me to believe (and has for several frustrating years now) that value will greatly out-perform growth over the next five years and large will greatly out-perform small.

I’ll admit that I don’t invest with this approach as my starting point: I don’t examine the Barron’s tables and then go do research accordingly.  Quite the opposite, the Barron’s tables simply verify what I’ve been seeing in my bottom-up (security by security) research–that precious metals and U.S. Treasuries look very expensive, and that Japan and financials look very cheap.  It also confirms my experience that large companies seem to have much better return prospects than small, and that value looks much better than growth.

Barron’s report of five year performance isn’t a magic crystal ball, but it does provide some interesting information.  I think we’re likely to see a five year snap-back, and my fundamental research confirms that assessment.

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.

Five year snap-back

A bird in the hand is worth two in the bush

Generally, investors are an optimistic lot. They tend to expect next year will be better than the last one. They tend to over-estimate their abilities. They tend to mistake luck for skill.

Investors are people, after all, and people tend to be over-confident. For proof, simply look at the success of lotteries. The odds are terrible, but the potential payout is huge, so people generally love to play.  

If you ask a lottery player what chance others have of winning, and what chance they themselves have of winning, you’ll almost always get two different answers. “I am special,” they seem to say, “and I will prevail over the odds.”

As far as evolution goes, this is a great attitude to have. Pessimists make lousy leaders, are chronically unhappy, and don’t tend to do what is necessary to succeed. Optimists, in contrast, tend to be better leaders, happier, and more confident in doing what they need to succeed.

When it comes to investing, though, the evolutionary program doesn’t work very well.  

Investing is basically a contest with other people–not a contest with nature. The goal is not just to pick winners, but to pick winners before other people do. Seeing that Apple has succeeded doesn’t do you any good, you have to have seen it before others and acted on that conviction to benefit.

This is why optimists tend to make lousy investors. They invest boldly because they are so sure of themselves. Unfortunately, they are not alone, and investment prices reflect the over-confidence of so many optimists investing boldly.

Optimists assume that high growth will continue. They assume they know more than others. They assume the distant future will look like the recent past. Unfortunately for them, it seldom does.

This attitude isn’t just reflected in the actions of individuals, but in their investment advisers, too. People tend to choose optimistic advisers. They want someone who confidently and boldly predicts good things will happen. They don’t really want a straight-shooter, they want a leader who they believe will take them to new heights. 

This compounds the problem, because even pessimists tend to prefer optimists as advisers. That leaves even fewer pessimists doing the actual investing, thus causing prices to over-reflect the optimistic attitude.

So, why do pessimists make better investors? Because, unlike optimists, pessimists tend to under-estimate their abilities, they tend to think things will get worse, they tend to mistake skill for luck. Instead of investing in “high potential growth,” they tend to invest in actual performance.

A bird in the hand is worth two in the bush. The performance that has actually occurred is worth more than the potential that hasn’t. High growth always slows over time, and low or negative growth almost always improves more than expected.

The pessimist invests in the bird in the hand instead of hoping for two in the bush. It rarely turns out there are two in the bush, and even when there are, they are almost impossible to catch.

The pessimist tends to generate better investment results because he isn’t over-confident.  He doesn’t invest in potential, but in the actual. Being unsure of his ability to predict the future, he doesn’t try. The pessimist ends up selecting investments that optimists hate, and thus pays a very low price for it. 

What happens going forward? The optimist ends up paying a high price and finds out the future isn’t quite as good as he confidently predicted. The pessimist ends up paying a low price and finds out the future isn’t quite as bad as he worried. The optimist’s investment tanks on disappointment; the pessimist’s investment rallies when things turn out less bad than most predicted.

This process is so counter-intuitive that few follow it. Who brags they invested in a near-dead company? Who loves to brag that they invested in Apple? It’s human nature, right?  

To get better results, though, you need to be a bit more skeptical. You need to worry that potential growth will falter, to question your confidence, or to find someone more paranoid than you to do the worrying for you.

It may sound counter-intuitive, but it works. When it comes to investing, hope is foul language. 

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.

A bird in the hand is worth two in the bush