Archive for October, 2009

Morningstar has released new information that over half of mutual fund managers have no money in their own funds. No skin in the game. There is no reason that over half the managers of mutual funds have no investment in their funds except-they are not good investments! I believe we could eliminate a lot more than half of the funds that exist without harming anyone except financial services companies. One of the reasons they are not good investments is Morningstar itself. The style boxes they pioneered (e.g. small cap value funds are one of the 9 equity boxes)are good for Morningstar. They get to rate thousands of funds as a result of their complicity in “filling the style boxes.”  It is also good for financial services companies, who got to roll out scores of funds to fit each of the style boxes. On the other hand, investors have a more simple need- managers who compound their money. A few good managers who are unconstrained, given a mandate to make money and mitigate risk are what investors need. Thousands of style box funds, mostly managed by people with no skin in the game and no mandate to manages investor’s risk instead of their own,……..well,…………what you see is what you get. And, in this case, it ain’t pretty.

We enter another week beginning with a stupendous market rise. With more and more experts sounding words of caution on this market, the bulls seem to respond ever more resolutely by moving the market to new highs. We have seen this movie before. We don’t know when it will end, but we know it is not a happy ending. We need the financial equivalent of the term “post 9/11”. Have we really learned nothing? Isn’t the value of a stock determined by what the return on your investment is likely to be? Once again, the riskiest stocks seem to have the lowest return on your investment going forward, but are the stocks that are rising the fastest.

I understand taking risks when they make sense. For instance, investing in emerging markets makes sense because these economies are likely to have much faster growth over the coming years. So, the risk you take may be rewarded by larger returns than safer investments. Small, financially less stable U.S. companies do not fit this profile. As a group, they are more likely to be losers moving forward than their higher quality counterparts (who have cash to fund operations and growth) and there is no proof that they are about to enter a period of strong growth.

Investors should approach this market with great caution. They should let their gains ride, but with a very short chain from here. Capture profits and limit losses as we move forward in an overheated market. Live to fight another day by remembering we are in a “post 2000” market.

The rally continues against all odds at present. The oddest part of it is that the lower the quality, the higher the gains year to date. The Russell 2000 index (an unmanaged index of 2000 small companies) is now up 22% through September. The price to earnings ratio for the index, according to the Wall Street Journal Market Data Center, is……………………………NIL!!! The 2000 stocks combine to have a loss, so……no ratio of price to earnings as there are no earnings. Forward looking estimates for the next year give the Russell 2000 a price to earnings ratio of over 44. So, if things go really well you will have a net earnings return of just over 2% on your investment for the next year. Do you want to invest in a basket of risky stocks so that you can hopefully earn a bit over 2% if things go well? This is not to say that these stocks can’t get more overpriced in the next year, giving you a terrific return. They can. It is just that the odds are not with you, they are against you.

On the other side of the coin, let’s consider the SPDR Global Titans ETF, made up of the largest multinational companies. It is up just over 16% year to date through September . Nothing to sneeze at, but a far lower return than the Russell 2000. This investment, made up of the highest quality companies from both the United States and other countires, has a price to earnings ratio of just over 15 and a dividend of over 3.5%. So, this investment is priced around historic norms, has a nice dividend return, and is filled with companies who are well poised to survive (and possibly thrive) potential economic problems should they arise.

As a rational investor (investing in often irrational markets), I can’t help but think that the odds are overwhelming from here. You should buy the highest quality, most reasonably priced investments you can find. You may suffer in the short term but should be fine longer term. At the same time, you should be considering taking profits and possibly shorting in the lowest quality parts of your portfolio. Warren Buffet famously said “it is not until the tide goes out that you know who is swimming without trunks.” The tide is likely to go out. It may be very soon or it may be much later. Don’t get caught again.

On reflection, it was an astounding quarter. Last year, we saw a meltdown in asset prices like no other since the great depression. No matter what the type of asset, if it involved any level of risk nobody wanted it and selling it was a painful event. This event took market prices far lower than rationale evaluations and we tried to take advantage of that by buying assets that we thought were extremely undervalued.

A year later, the trend has reversed in a shocking manner. Almost all assets had headed back up in prices at a speed that seems turbocharged. While we expected an initial rebound followed by slow growth, we have witnessed what Vinny Catalano has called a “melt up”. Money has come in from the sidelines and forced asset prices to keep ascending at a rate that seems removed from the reality of our lives. The “new normal” is a world in which a slow economy will not be buoyed by consumers spending money they don’t have to buy things they don’t need. The piggy bank (i.e. home equity withdrawals) is closed and does not appear as if it will be opening any time soon.

Even more astounding, the huge rally has been focused on all risk being rewarded the most. Low quality stocks and junk bonds have led the way, gaining more than high quality stocks and better quality debt instruments. How long can this go on and how will it end? If we knew the answer to those two questions, we could solve all your problems easily and could sit back and watch the unfortunates struggle to not stub their toes. How long can it go on? As long as people continue to pour in from the sidelines and pay little or no attention to fundamental values, the market can continue to go up. How will it end? It can end peacefully if it ends soon-markets can take a breather and allow valuations to catch up slowly to current prices. If the market continues to skyrocket, the end could be less pleasant-another meltdown seems unlikely but can’t be ruled out entirely.

How should we position portfolios moving forward? The answer is cautiously. The gains we expected to see over a period of years have come to us in  a period of months. There are some assets that appear to us to be fairly valued and there are some assets that now appear to us to be somewhat overvalued. We believe that the way forward is to overemphasize quality (which has now gone up as quickly), hold on to assets that appear to be fairly valued, and selectively take some profits in areas that are now overvalued. Couple this will a discipline that includes stop sell limits should the market begin a free fall and some hedging that reduces portfolio risk a bit at this time and you have our strategy moving forward. The game can change quickly from here and we must be ready to react to what is no longer a rally driven by fundamentals. It is a more dangerous moment now- the tail end of a huge rally in what is most likely still a secular bear market.