China article

Despite its all-too-common use of the ridiculous term, “state capitalism,” this article outstandingly spells out the case for China to experience an economic crisis in the next 5-10 years: Time Magazine, Why China Will Have an Economic Crisis.  

China can and might change course, but it’s current path is one we’ve seen before and will end in tears.

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.

China article

Lucky, or good?

One of the hardest things to do well, especially as an investor, is to learn from our mistakes.

When we pick an investment that does well, it’s easy to think about it, analyze it, dwell on how smart we are. But, when an investment goes against us, it can be very tempting to put those losses into our mental dustbin and try to forget them.

This temptation really should be resisted, because learning from our mistakes is more important than celebrating our victories.

Just as important, and more often overlooked, is that we should examine critically our successes, too. Sometimes good outcomes are due to luck and not skill. We need to understand which occurred to improve our results over time.

I like to look just as hard at my failures and my successes, because learning from both can reveal powerful lessons that can be applied in the future. I’ve found this can lead to much better investment results over time.

There are several questions I ask myself with both successes and mistakes:

  1. What happened at the underlying business in terms of fundamentals?
  2. What happened to the market price and valuation with respect to those fundamentals?
  3. Was I lucky, or good?

(I ask more questions than this, but these are the most important ones.)

When I invest, I do it based on certain assumptions about underlying growth in sales or book value and underlying margins or returns on equity. My first question is to figure out how far off I was in evaluating those underlying fundamentals. Did the company grow faster or slower than I expected? Were the margins higher or lower? What led to those outcomes and how was that different than my expectation?

My first question is about the underlying company separate from the market’s reaction to it. The second question is about how the market reacted to those fundamentals. Sometimes a company does worse than you think it will, but the market’s opinion becomes more favorable than you thought it would. Sometimes a company does better than expected, but the market’s opinion about the business becomes worse.  

The answers to the first two questions helps me answer the third question: was I lucky or good? When a company does much worse than I expect, but the market’s opinion about the company improves, that’s more lucky than good. When a company does much better than expected, but the market’s opinion sours, that’s unlucky.  

It’s very important to differentiate between luck and skill with investing. If you’ve been lucky and don’t identify it as such, you’re likely to repeat that process and see your luck run out. I had a lot of success buying technology companies from 1996-2000 each time prices pulled back temporarily.  That success was more luck than skill, and I ended up paying the price later when that strategy no longer worked.  

It’s also important to differentiate between bad luck and bad skill. If you pick a company that does well, but sell it because the market’s opinion of the company worsens over time, you will likely miss large future gains. A good process may lead to bad results occasionally, but that’s a bad reason to give up on the good process.

Learning from mistakes can be very time consuming, and that puts many people off. You have to go back and look at historical fundamentals over time, you have to look at how the market reacts to those fundamentals, you have to adjust for temporary changes like recessions or transitional industry dynamics, you have to keep track of your initial expectations and how they changed over time. It’s not simply a matter of looking at your returns in a vacuum, but of evaluating your results relative to your expectations, market reactions and alternative options.

I believe the effort is well worth it, though. When you realize you had good luck instead of good skill, you can prevent that process from happening in the future. If you realize you’ve been unlucky and not unskillful, you can keep that process in place to profit when the odds turn your way. 

No one relishes examining bone-head mistakes in detail, or realizing one’s brilliant outcome was luck instead of skill. But if you like improving results over time, the effort is well worth 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.

Lucky, or good?

Extraordinarily average

Regression to the mean is a well documented phenomenon in investing, as it is in many other areas of life. 

It refers to the basic tendency of a statistical series to move toward average over time. Just as trees don’t grow to the sky and average IQ’s don’t double in a generation, returns on equity investments tend to move toward average, too.  

As I described in my January blog, this phenomenon can be used to profitable advantage, and now seems to be one of those times.  

Why do I think that? Because group performance of some stocks seem to be far out of line from long term history, and if those relationships are restored–as they always seem to be–then money can be made investing in a way that supports a regression to the mean.

To flesh this out, let me describe one way of looking at historic returns: by assessing them relative to company size and valuation. For example, you can group large companies together and small companies together, or look at companies with high price to earnings (growth) or low price to earnings (value).  

One popular way to look at this, used commercially by Morningstar and described academically in a famous study by Fama and French, is to break companies by size and valuation in to four groups: 1) small value, 2) small growth, 3) large value and 4) large growth.

I like to look at this data over 5 year periods to observe whether one group is moving further from average and may snap back.

Over the very long term, from 1927 to 2011, small value has been the best performing group, followed by large value, large growth and small growth. In fact, over 84 years of data, small value did 3.7% better than average, large value did 0.5% better than average, large growth did -1.7% worse than average, and small growth did -2.4% worse than average.  

If you’ve ever heard someone say buy small companies or value companies, they were referring to this long term data set.

But, there is a problem with just buying small value without further thought, because your particular returns depend on how far from average the data is at the time you purchase. If small value has done much better than average when you buy, it won’t generate historically average results for you. And, if small value usually does best but has been worst recently, you’ll probably do much better than historic average.

Knowing the long term average and recent performance can lead to profitable discoveries, in other words.

With this in mind, how has recent performance looked? Instead of small value leading the pack over the last 5 years, small growth has. The 84 year historic worst group–small growth–has been best over the last 5 years (+4.9% better than historic average). In my opinion, this seems like a terrible time to buy small growth.

Large growth, usually the second worst group, has been the second best group with 3% better returns than usual. Small value, usually the best group, has been the second worst, -2.5% worse than historic average. Large value, historically the second best group, has under-performed by -5.4%!

Does this mean something fundamental has changed, or will regression to the mean bring things back to average. Both analysis and experience leads me to believe that regression to the mean will occur like it always has, making small growth a poor place to invest and large growth the belle of the ball over the next 5 years.

Will this smooth transition begin the minute I publish this blog? Almost certainly not. And, that’s the rub: regression to the mean happens over the long term, not the short term. We don’t know when things will regress, only that they almost certainly will.

Will large value greatly out-perform small growth? I don’t know how soon or by how much, but I am very comfortable betting it will over time. As always, I’ve put my money where my mouth (blog?) is.

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.

Extraordinarily average

Better than zero

This seems like a bad time to be an index investor.

The market’s impressive return since November is getting investors excited again, so it’s time to dampen that euphoria with a realistic look at future returns.

By my estimates, the S&P 500 looks likely to provide a poor return of 3% over the next five years. After inflation, taxes and fees, I think someone investing in or holding an S&P 500 index fund or ETF will be lucky to break even. I doubt many investors expect or want such returns.

I base my estimate on normalized earnings per share of the S&P 500 since 1948, which have grown at a remarkably steady rate of 6% per year over that time.

Add a 2% dividend to that growth, and it seems like you’d get an 8% return. But, you have to keep in mind the price you pay for those earnings and dividends.

Currently, the S&P 500 is trading at around 19 times normalized earnings per share, but the historic average since 1948 is closer to 15 times. Going from 19 to 15 times earnings over the next 5 years would subtract 5% from returns each year, leaving you with the 3% I mentioned above.

Inflation since 1948 was a bit over 3%, not to mention the dent from fees (even low fees of 0.2% will hurt). The end result is a 0% or less annualized, after-inflation return over the next 5 years–not very enticing.

Like all estimates, mine, too, may turn out wrong. The economy may grow less than 6%, especially with the debt and entitlement burdens the U.S. faces (see the work of Reinhart and Rogoff for their take on why GDP growth is likely to slow).  

Inflation may be more or less than I forecast. Dividends could be higher, too. But growth, inflation and dividends are unlikely to be far different than my estimates, meaning the actual result may be a bit higher or lower, but essentially the same.

The multiple to earnings may go much higher or lower on it’s way to 15, too. In 2000, it topped out at 37. In 2007, it topped out at 26. Assuming that will happen again and that you can time getting out at that top seems a bit foolish, though.  

On the low end, the earnings multiple could drop below 10, like it did in the late 1940’s and mid 1970’s to early 1980’s. Such lows would mean significantly negative after-inflation returns (which would almost certainly be temporary in nature).  

Like I said above, you can play with the numbers a bit and come out with slightly different outcomes, but the underlying math won’t move the meter much. Index investing looks like a poor option from here.

What are the alternatives? Bond yields are dismally low, and a spike in inflation would quickly eliminate that yield. Commodities (including gold) may continue to soar, but a hard landing in China’s economy seems a distinct possibility, and could easily gut that return overnight. Real estate may be coming back, but the high returns seen from the 1970’s to mid 2000’s will not return.

What’s left?  For me, stock picking seems to provide the best answer (not surprisingly, I’m talking my own book, here). Some of the companies in the S&P 500 will thrive and some will dive, and successfully picking the thrivers could generate acceptable, though not outstanding, returns over the next five years.  

Buying companies at 10 times earnings that, on average, grow at 6% a year and pay dividends of 3% provides a return of 9%, even with no multiple expansion to the 15 average seen historically (which would obviously increase returns). Taking away 3% inflation and management fees of 1.5% gives a 4.5% pretax return. This may not make you salivate with greed, but it would mean your money would grow by 25% in real value over the next 5 years instead of shrinking.  

There are no guarantees such an outcome will occur, but I feel quite comfortable putting my money into situations with that type of underlying math.  

Index investing may have low fees, but low fees on no return seems like a poor deal to me.

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.

Better than zero

Stock picking: not dead, yet

In my most recent client letter, I had a section about the death of stock picking.

I highlighted that correlations between stocks within the S&P 500 have been very high with the index itself, particularly since late 2007.  

This means it’s been very hard to pick stocks that beat the index, because if almost all the individual stocks in an index march in lock-step, it’s going to be very hard to beat the index.

There’s been a lot of speculation about why high correlations occurred. One theory is that Exchange Traded Funds (ETFs) have taken over for individual stocks as the investment vehicle of choice. Another theory is that high-frequency traders have caused all stocks to trade together. Still another is that markets have been moving in sync because everyone is scared out of their wits since markets and economies started tanking in 2008.

None of these explanations seem satisfactory.  

If ETFs were the cause, then wouldn’t stocks have marched in lock-step with the advent of the index fund, or highly diversified mutual funds? No, that didn’t really happen.

How about high-frequency traders? If that were ultimate cause, then each advent of new, faster trading technology or smaller decimal trading would coincide with higher correlations. Again, not so much.

As for the fact that everyone is scared? Is that really new? Does anyone really think that recent events are scarier than World War I, Spanish Flu, a world-wide Great Depression, World War II, the threat of nuclear annihilation, or Boy George?  

If markets didn’t become and stay correlated at those points, why would we expect them to have done so now?

And, that was the point I tried to make in my client letter: that high correlations are not that unusual, and they have always ended as abruptly as they’ve begun.  

Lo and behold, correlations of stocks within the S&P 500 tanked in January and my clients beat the market by 4% (on an absolute, not annualized, basis) that month.

Did something suddenly change? Did Europe’s problems go away? Did the U.S. fix its government debt? Did Japan’s economy recover? Has China avoided a hard landing? No, no, no, and no.

Were ETFs eliminated? Did high-frequency traders all go on vacation? Are people no longer scared? No, no and no.

So, why the change? I don’t know, and I don’t really care.  

Successful investing isn’t about reading tea-leaves and guessing future turns in the market, it’s about investing in individual businesses that you understand at low prices and then holding until short-term-oriented investors recognize underlying value.

The attempt to explain and predict crowd psychology has been–and always will be–a dead-end.

Will correlations stay low? I have no idea about the short term, but I’m certain high correlations will come and go over time. Will my clients and I retain our gains?  Again, I don’t really know.

But, that’s no barrier to long term investment success.

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.

Stock picking: not dead, yet