History Lesson & Bear Market Advice

History tends to repeat itself. The economy and the stock market are no different. We have had, and will continue to have, economic expansions followed by recessions. To give you an idea of what to expect, consider the last recession.

It was the result of another bubble bursting (in Silicon Valley, not housing). In 2 1/2 years (early 2000 through late 2002) the S&P 500 fell by 50.5%. Investors felt massive pain and many took dramatic action by getting out of the market. That was the right emotional decision in their minds at the time (because they didn’t want to take any more pain) but it backfired financially.

After a 2 1/2 year bear market, the S&P 500 bottomed in October 2002 and rose by 105.1% over the next 5 years. Those investors who stuck with the market and even added to their investments as prices dropped reaped huge rewards. Those who exited the market out of fear missed out.

With the market down more than 35% in the last year, what should investors do now? For the answer all we need to do is look at history. About 97% of all five year periods have seen the stock market go up, as have nearly 100% of all 10-year periods. If you are a long term investor (5 year time horizon or more by my standards) the numbers imply you should stay in the market.

You may have noticed that Warren Buffett has been very active in the market in recent weeks, investing billions of dollars. Is he crazy? No, he simply knows that when prices drop significantly there are bargains to be had. Future stock price returns are going to be higher during bear markets than bull markets because prices are lower. It isn’t any different from buying a house, a car, or a cart of groceries. When things go on sale, we should buy more of them. Have you ever been to the store, seen your favorite cereal on sale, and bought a couple extra boxes than normal because of the price? I know I have.

Stock investing shouldn’t be any different than grocery buying. It is true that it all sounds so simple, but isn’t because emotions and psychology come into play more with stocks. Warren Buffett has the perfect temperament for the market, so he can step in and buy when everyone else is selling. His famous quote is “be greedy when others are fearful and fearful when others are greedy” and he is acting on that principle through all of this.

It is not an easy thing to do, though. Most people want to get out of stocks right now, not sit tight or buy more. That is what their emotions are telling them to do. Unfortunately, it is not the right decision to make for an investor who has the time to wait things out for several years.

I will conclude with a story. During the first week of October 2002 I wrote a letter and sent it out to about three dozen friends and family members. I explained that the stock market was very depressed but that there were tremendous investment opportunities out there. I made the case that allocating money with Peridot Capital at that time would likely prove very profitable over the coming years.

Guess how many people invested new money with me? None. The responses were predictable, although I had hoped some would take me up on my offer. Many recipients simply ignored the letter completely. Some responded by telling me that they had sworn off the market after they had lost so much. One declined my offer by explaining “As you know, this is not the easiest environment to lure potential investors.” Very true, but ironically, it was the perfect time to do so.

A week after I sent out that letter, the S&P 500 index bottomed out at 768.63 on October 10, 2002. Over the next five years the market more than doubled and reached an all-time high of 1,576.09 on October 11, 2007.

So my bear market advice in as few words as possible would be:

1) If you have a 5-10 year investment time horizon, or longer, do not sell your stocks simply because prices have fallen significantly and it is scary to watch the daily market swings and read the dire news headlines.

2) If you have the financial means, and are comfortable doing so, adding to your investments during times like these will most likely prove very profitable as long as you can take a long term view on the investment.

3) Don’t pay attention to the daily market volatility and headlines if you don’t have to. If you are investing for 5 or 10 years, who cares what the market does today, this week, or this month? It’s irrelevant. Warren Buffett often says that he wouldn’t care if the market shut down for a few years and reopened because he is confident in the long term prospects of the stocks he owns.

If only we could make that happen in times like these. It would ease the short term pain and also ensure long term gain.

What To Do In Times Of Panic

Is “panic” too strong of a word to describe the markets in recent days? I don’t think so. Consider a couple of examples outside of the investment banking space:

1) Constellation Energy (CEG)

My old utility company when I grew up in Baltimore, Constellation is the parent of Baltimore Gas & Electric. CEG gets 20% of their earnings from energy trading and had contracts with Lehman Brothers. Although CEG’s net exposure to Lehman’s bankruptcy was immaterial, investors panicked and sent the stock down from $60 last week to as low as $13 on Tuesday. Today Warren Buffett’s 88% owned MidAmerican Energy agrees to buy CEG for $26.50 in cash, or about 75% of the company’s book value, in a deal that alleviates counterparty concerns over CEG’s liquidity.

2) State Street (STT)

State Street fetched $68 before 10:00 this morning and hit $29 shortly after 1:00pm. State Street is listed as a large holder of all the troubled financial stocks, which worried people, but STT is a custodian for their clients and index funds and does not own the vast majority of the stocks in question. They simply act as custodian and collect fees for doing so. STT issued a press release this afternoon trying to clear things up and assured investors their money market funds had not dropped below $1 in NAV.

There is no doubt in my mind that we are simply in the midst of a worldwide financial panic. The UK just restricted all short selling in financial stocks until the dust settles. Fear and mostly unsubstantiated rumors are driving price action right now.

So what should an investor do in this environment? It might surprise you, but I have been making very few moves during all of this craziness. Trading when fear, panic, and rumors have taken over doesn’t make much sense because prices are not based on reality but rather perception. Lack of confidence and uncertainty about what is true and what is not is a deadly combination for financial markets and many firms. It doesn’t matter if Morgan Stanley (MS) is not in trouble. If clients think they might not be, they will pull their money and set off a “run on the bank”scenario. That very situation will likely forced them to sell the company in the heart of the panic, regardless of what the reality is.

As long as you know and understand what you own and have done adequate fundamental analysis, I would suggest standing pat and waiting for things to settle down. Like LTCM, the Asian financial crisis and every other financial market panic, this one too will be over at some point. When that happens we can get back to good ol’ fundamental investing. Fortunately, most of the people reading this blog, as well as myself and my clients, can wait for the storm to pass.

Full Disclosure: No positions in any of the companies mentioned at the time of writing

Lesson Learned from Failed Investment Banks: Leverage Feels Great Until It Bankrupts You

How do companies with such great assets go belly up within days once a cascade of bad things start happening? At the outset of 2008 we had five major independent investment banks and now we have two (Goldman Sachs & Morgan Stanley). A core reason is that the leveraged finance business model is a very poor one. It allows you to make a killing when times are good, but on the flip side it can bankrupt you within days when the tide turns. That is not a risk-reward scenario that companies should embrace.

Imagine how easy it is to get caught up in the leverage game. Pretend you have $10 and are allowed to borrow $300 against it, for a leverage ratio of 30-to-1 (a common ratio for investment banks in recent years). If you are paying 5% interest on the loan and can earn just 6% on the $310 in capital you now control, you can earn a profit of $3.60 ($18.60 less $15.00 in interest) on your original $10.00 in capital for a return of 36%. Pretty cool, huh?

Well, only when you actually make money on what you are investing the money in. Consider the same example when your investment loses 5% of its value. After paying interest on the loan, you only have $279.50 left but still owe $300 to the lender. Now you are in trouble. To pay back the loan you need to borrow another $21.50 (if someone will lend it to you) and even if you can do that, you have lost your original $10 in capital.

The leveraged finance game, at least at the level these investment banks were playing it (leverage ratios of 25, 30, or 40 to 1) is very, very dangerous. Investors beware.

A final note about business models. AIG (AIG) is trying to sell assets in order to raise at least $40 billion in new capital because the ratings agencies may downgrade their credit rating if AIG can’t come up with the new money. Reports are that a ratings change could bankrupt AIG within days if that downgrade should occur.

What kind of business model is this? Moody’s and S&P downgrading your credit rating results in your company going bankrupt in 2-3 days? Not only is that simply ridiculous in terms of relying on one party to remain solvent, but even more unreal is that these are the same ratings agencies that don’t have a clue how to rate anything. Remember, they had triple A ratings (the highest possible) on packages of subprime mortgages! If subprime mortgages are of the highest credit quality, what would prime mortgages be considered?

Short term, the unraveling of these firms will hurt, but long term, from what we are learning about these business models, maybe they should never have been anywhere near as big as they were to begin with.

Full Disclosure: No position in AIG at the time of writing

Backlogs Are Overrated

Just a quick note before I head out for the weekend. In the face of oil peaking at $135 per barrel in recent days we have seen many of the airlines cancel planned deliveries of new planes they were going to add to their fleets over the next few years. Those plane orders are now unnecessary as the carriers are cutting capacity.

The big point here is that investors often go gaga over industrial suppliers’ backlog. The longer the backlog the more predictable their revenue stream over the longer term, or so the investors would have you believe. Due to long lead times customers do have to place orders far in advance, often years ahead of time. Hence, the suppliers report their backlogs to investors to give them an idea of future business.

All of this appears to be very important, except for the crucial point that a customer (an airline for instance) can simply cancel their orders whenever they want since they are not binding. A large backlog may look really nice, until customers start canceling orders.

Now, would I prefer a large backlog to a small backlog? Of course. That said, I think backlogs in general are overrated on Wall Street since the orders are not binding. As a result, backlogs don’t always translate into revenues.

Market Action Shows How Much Negativity Is Priced Into Stock Prices

One of the most important things to know about investing is that the stock market is a discounting mechanism. That does that mean? It means that expectations for future events are reflected in stock prices ahead of time, before the events actually occur. People who try to guess what the headlines next week are going to be, and invest accordingly, might not make any money in the market. Remember, stock prices go up or down not based on how well the underlying companies do, but rather how well the companies do relative to the market’s expectations.

I bring this up because today’s market action shows us that a lot of bad news has already been priced into equities. UBS (UBS) reported astonishing writedowns of $19 billion and Lehman Brothers (LEH) raised $4 billion of capital even though they claim they don’t really need it. Pretty bad headlines, but the Dow is up 260 points as I write this. Last month when Bear Stearns (BSC) nearly went belly-up the market reacted by dropping 1%, and has risen ever since. Many might have expected a far worse reaction to such startling news.

Now, this is not to say we are completely out of the woods and the market will soar from here. In fact, I think we will be range-bound for the foreseeable future. That said, it appears that things would have to get significantly worse for the market to take a huge hit from current levels. Hopefully first quarter earnings reports won’t have any big negative surprises. If that is the case, those who are claiming we are in a bottoming process might be right, in the short term anyway.

Full Disclosure: No positions in the companies mentioned at the time of writing

Differentiating Between Trading and Investing

John writes:

Hi Chad,

How do you differentiate between “trading” and “investing”? I’m always curious to hear what people think is the difference.

Thanks for the question, John. I don’t think there is too much of a debate over the difference, and my views likely aren’t much different than most, but I’m happy to give my personal thoughts on the topic.

The main difference between “trading” and “investing” is time horizon. Investors are long term players. They are investing in a business and are making an optimistic bet about the fundamentals of that business in the future. If they pay a reasonable price, and their analysis of the business prospects are correct, they will make money over time (regardless of overall market environment) because over the long term both valuation and earnings determine the value of a business, and thus the per share price of a company’s stock.

Furthermore, since investors are willing to take a long term view (years rather than days, weeks, or even months) on an investment, they are likely to buy more shares as a stock drops in price. The main goal is to minimize one’s cost basis in order to maximize profits over time. Temporary drops in share price aren’t likely to change an investor’s opinion of a stock’s long term investment merit, unless of course the fundamental outlook changes in a meaningful way.

Conversely, traders are short term oriented. They tend to care very little about valuation or the long term earnings power of a business. Since they won’t own the stock long enough for future business fundamentals to influence share price, they are more likely to use chart patterns and follow the momentum when buying stocks.

Since traders are more like speculators (making educated guesses as to short term price movements) than investors are, they are likely to use stop loss orders to limit downside risk. If a trade goes against them, they cut their losses quickly and look for other opportunities. Even if the market reaction in the short term is illogical and unsubstantiated, since they aren’t willing to hold the stock long term and wait for the inefficient market to correct itself, they can not afford to wait things out until cooler heads prevail.

Here is an analogy for you; investors are the casinos, whereas traders are the gamblers. Investors have the odds stacked in their favor, just as the casinos are guaranteed winners over time because the games they offer have a win percentage built-in. Over time, the economy grows and corporate earnings grow, hence stock prices rise over long periods of time. Thus, investors (who by definition are long term players) have the odds stacked in their favor.

Traders, on the other hand, are trying to win big on short term trends, much like a blackjack player hopes for a hot shoe and then cashes out his/her chips. The gambler knows that they don’t have a statistical advantage but they play nonetheless, trying to make some money and getting out before they give it all back. Now, I grant you that traders aren’t at a statistical disadvantage, so the comparison isn’t perfect, but whether or not the market goes up or down tomorrow is pretty much a coin flip, so traders’ odds are about 50/50, although they try and boost those numbers with technical analysis, momentum trading, etc. Much like a trader’s stop loss order will limit losses in the market, many gamblers will come to a casino with a certain amount in their wallets, to ensure they don’t incur severe losses.

Casinos and investors know very well that in the short term they might lose money to a hot table or an analyst downgrade, but over time they feel comfortable because they know the odds are in their favor to make money. They are patient enough to wait for their payout, whether it comes from the 5% edge at the roulette table they operate, or long term earnings growth generated by a publicly traded company they have invested in.

Beware of Phrases Like “Cheapest in 20 Years”

This week’s Barron’s highlighted shares of entertainment giant Disney (DIS) as being the cheapest they have been in 20 years. I just wanted to remind people that arguments like this in general don’t really make much sense. This is not about Disney itself (it is not an overvalued stock) but rather the whole idea that bulls on certain stocks like to look at one particular period in the past, and assume that those conditions should apply today.

These days you hear people say that certain stocks or sectors (or the market for that matter) haven’t been this cheap since the early 1980’s, and thus conclude they should be aggressively bought. What they fail to mention is that the period from 1982 through 1999 was the greatest bull market the U.S. stock market has ever seen, and P/E ratios were in a historically high range during that time. Therefore, investors should not assume that those valuations were “normal” and therefore should and will always be applicable.

The Barron’s piece suggests that Disney’s current forward P/E of more than 14 (the current market multiple) is too low because the stock typically trades at a 30% premium to the market. Again, just because a stock traded at a 30% premium a long time ago, that multiple does not stay relevant forever. P/E ratios are largely based on future growth expectations. If Disney is going to grow earnings less robustly over the next two decades than it did over the last two, it stands to reason its P/E should be lower.

My point is not to bash Disney specifically (no meaningful opinion there), but to remind investors that current valuations are based on investor expectations of the future, not historical data. Surprisingly, many people still look at average P/E ratios from the past 10 or 20 years to determine where a stock should trade today, but I would caution you to pass on that type of valuation methodology.

Full Disclosure: No position in Disney at the time of writing

A Fresh Look and a Possible Anecdotal Contrarian Indicator

Over the weekend I hope to update this blog’s template to make it organized a little more efficiently. I’m not a web designer, and don’t hire one, so every once in a while the site gets unappealing in my eyes and I try to refresh it a bit. I’m just letting you know so if you visit here over the weekend and things are screwy, you’ll know why and that it will be fixed shortly. And please give suggestions if you think improvements to the layout can be made.

On an unrelated anecdotal evidence tangent, I got a call today from a client who requested I slash their financial services exposure by 50% (it had been a market-weight allocation — 18%). This type of anecdotal evidence often serves as a contrarian indicator, so I am interested to see if financials bottom out here in coming weeks and months. I got the call at 2:43pm central time, when the Financial Select Sector SPDR (XLF) was trading around $26.70 so we can track this random indicator. Maybe it signals capitulation, maybe not, but it’s always amazing to see how many times capitulation indicates that a bottom is near, even in something as random as this situation.

Have a good weekend!

Excerpts from Bill Miller’s Latest Letter

As usual, quality insights from the manager of Legg Mason Value Trust in his latest shareholder letter dated February 10, 2008. In my view, a couple are definitely worth posting:

On the constant chatter of possible recession:

Investors seem to be obsessed just now over the question of whether we will go into recession or not, a particularly pointless inquiry. The stocks that perform poorly entering a recession are already trading at recession levels. If we go into recession, we will come out of it. In any case, we have had only two recessions in the past 25 years, and they totaled 17 months. As long-term investors, we position portfolios for the 95% of the time the economy is growing, not the unforecastable 5% when it is not.

On Microsoft’s offer for Yahoo:

The 60% premium MSFT offered for YHOO highlights what we believe are the significant opportunities present in our portfolios. Clients and shareholders are understandably disappointed when the performance of their portfolio does not keep pace with the broader market. But the price of a publicly traded security is one thing, and its value is something else. Price is a function of short-term supply and demand characteristics, which are heavily influenced by the most recent news and results. Value is the present value of the future cash flows of the business, and that is what we focus on.”

What To Do When Investments Turn Into Great Trades

John from California writes:

“I know you are a long term investor, but given that one of your 2008 Select List picks just went up 30% in a matter of days, I’m stuck as to what to do, sell or hold on? Any thoughts?”

John, thanks for the question. A common answer to this dilemma (feeling compelled to book gains even if your time horizon has not played out yet) is to sell a portion of the position. This gives you the best of both worlds by booking some profits but staying in the stock. Oftentimes I will sell half of a position if I’m really torn about what to do.

However, this works best with large gains (say 100%) because you accomplish both taking a lot off the table and maintaining a sizable position for meaningful further gains. With a 30% gain, however, selling half brings your overall position size down to about one-third less than the level it was less than a week ago, which could very well be too small for your taste.

In that case, I might consider selling 20%-25% rather than 50% in order to keep a full sized position for the long term. After all, the Select List is geared for intermediate to long term investors, even if gains over the first week for one of the picks was unusually high. Hope that helps.