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In our most recent series written by Jamie Cornehlsen, Denver CFA and founder of Capstone, FLOW examines how we seek out investments and make selections based on current market trends and future forecasts. Part one of our series focuses on the pros and cons of commercial investments.
With the recent decline in the stock market, I’ve began to wonder what it really means to invest. This question takes me back a couple of years ago to when I attended the Berkshire Hathaway Annual Meeting. The meeting in itself was a spectacle for investors, as Warren Buffett and Charlie Munger drew in over 19,000 attendees to Omaha, Nebraska.
What really struck me was that both Buffett and Munger urged the attendees to think of each and every investment as though they were going to purchase the entire company for themselves.
I knew it was important, so I logged it away in my “Mind Palace”, what Sherlock Holmes calls his memory vault.
After so many years of high valuations and low interest rates in the stock market, I found myself growing antsy, in search of my own reasonable investment. Without one to be had, I even thought about buying a liquor store.
A good friend had purchased one and I was slowly recognizing the benefits of owning such an establishment. I was following the financials closely and had become aware of the store’s ability to generate cash flow. In addition, I realized people tend to purchase more alcohol during slow economic times, therefore offsetting investments that decreased in value during economic slowdowns.
Assuming a Sizable Workload for a 10% Return
Owning a liquor store would produce about a 10% return on my capital, meaning that for the money I put down, I could expect (as the owner) to generate a 10% return each year. Some years would fare better than others, while some years I would not make my 10% return.
My wife and I met with the business broker. We toured the store covertly as customers and visited nearby liquor stores as well.
Owning the liquor store was possible and I was hopeful for the generated 10% returns; however, as the owner I would still have to run the store. This meant buying the liquor at reasonable prices, interviewing and hiring staff, maintaining a weekly shift schedule and enduring the drama that employees can often create.
In the end, we decided not to invest in the liquor store. The 10% returns were attractive, but the additional work necessary to run the business made the potential return a less desirable deal than I was willing to take on.
Stay tuned for the next FLOW post, where I discuss the second investment I contemplated making in the market.
Have investors lost interest in General Electric after the departure of Jack Welch? It certainly appears so. A recent article in Fortune Magazine, For GE, Breaking Up is Hard To Do, indicates that investors have lost their enthusiasm for the once high-flying behemoth.
One of the conclusions in the article that states “GE’s changing revenue sources have failed to satisfy investors” is unfortunately off base. The article shows a graph of how cumulative returns since 2000 have actually declined slightly.
It’s not revenue as the article implies, but rather high valuations that have failed to satisfy investors. Value Line indicates that GE’s valuation in 2000 was 40.1 times higher than the company’s earnings. From a price of close to $60 per share in 2000 to a price of $24 recently, the poor performance in the stock price has less to do with changing the revenue mix and more to do with high starting valuations in 2000.
Scaring Off Investors with High Valuations
A high opening valuation will reduce a stock’s price performance. A low valuation will increase the chance of a stock escalating in price.
Unfortunately for GE, stock prices have routinely under-performed as valuations in 2000 simply started off too high to entice investors.
When a company’s beginning valuation is in alignment with earnings, capital appreciation will be highly correlated with the company’s earnings growth rate.
GE may diversify its revenue base or concentrate it even more. But starting at the current valuation will unlikely satisfy investors moving forward.
Were you one of the many individuals who sold stock when the market began to sink in 2008? How much had the market fallen before you sold?
These are two good questions to ask yourself, as the best way to predict your willingness to take future risks is to analyze how you reacted in the last go-around.
If you did sell when the market was down, perhaps now is the time to do something different with your portfolio. For example, Craig L. Israelsen suggests diversifying across seven asset classes dispersed into 12 different mutual funds, in what he calls the 7Twelve portfolio.
This is very similar to the Yale endowment that looks to gain a higher investment return by allocating share between several investment strategies and classes.
Some investors who are diversified across multiple assets groan when the S&P 500 is on a tear, as they believe they could be earning more if they were in an index fund that tracked the S&P 500.
The S&P 500 is an index of 500 of the largest companies in the United States. The weighting of each stock is based on its market cap. Apple has the largest market cap assuming the greatest position within the index, with a weighting of 4.03%, while the smallest holding, Diamond Offshore Drilling represents just 0.01%. Consequently, if the top 10 companies are doing well in the S&P 500 index, the overall index usually performs well. However, the index excludes small companies in either the mid-cap 400 index or the small-cap 600 index. These are companies that are even smaller than Diamond Offshore drilling.
Additionally, the S&P 500 leaves out other investments, such as real estate, commodities, infrastructure, international stocks and bonds. There are times that having these additional investments help in doing two things: smoothing out returns to avoid significant losses, and producing stronger returns by not losing as much as the S&P 500. However, when the S&P 500 is the strongest, investors grumble about not having all their investments in one place, often forgetting they can lose all the gains they have experienced recently.
However, these investors are the same individuals who sell quickly when the stock market declines.
Celebrate the Little Things
There are two additional strategies that behavioral finance has taught us. One is to rejoice over the small wins. The second is to pay less attention to your investments.
Weber’s law states that we prefer to experience small, continual wins rather than one sizeable gain. Rather than looking for a single grand lottery payday, we should be searching for the things that benefit us day in and day out.
Divert Your Attention
Second, we all know of people who look at their investment statements weekly. If you find yourself concerned about whether your account has gone up or down on a weekly basis, you should think about tucking those reports away and create a schedule to view them on a monthly, quarterly, or even annual basis.
It’s also important to avoid selling out when there is a decline in the market. Refraining from this can significantly benefit your returns over time. Recent research conducted by Vanguard indicated that average annual returns can increase by almost 2% per annum if individuals continue to hold their investments as the stock market corrects.
Hang On To Your Investments Longer
The pain associated with loss is often greater than what is felt with gains. As a result, people tend to avoid monetary losses at all costs. When individuals have loss aversions, they tend to sell all of their investments during periods of market disruption. While freeing themselves from low-value investments may be comforting at the time, this decision often results in stocks being sold at the worst possible moment.
The reactions that individuals have to market fluctuations are often reoccurring; therefore, if you sold out in 2008, it is highly likely you will do the same the next time the market takes a turn for the worse. Consequently, you should look to diversify your investments.
No matter what your approach to buying and selling may be, it is always helpful to remove your focus on the day-to-day gyrations of the stock market and look for ways to enjoy the small wins throughout your investment process.
by Ted Schwartz
As we near new “all-time highs” for the Dow Jones average, the financial services community seems about to throw a party. I say leave the champagne on ice! I don’t want to be a curmudgeon, but…..
The very lowest bar for any investor is the rate of inflation. If your investments don’t at least keep up with the rate of inflation, you have lost money in terms of real buying power. There is no reason to save if you do not at least keep your current buying power.
So, the Dow all time high was reached in October of 2007. The website Inflationdata.com has a calculator that computes the inflation from then through January of 2013 at over 10%. So, if we hit a “new high” it will mean that market losses over the past five plus years are all the way down to 10% in real terms! The clock will continue ticking on inflation, so who knows when you will finally really break even in this market. Hardly seems like a reason to celebrate to me.
By Ted Schwartz
If you tune in to politics recently, you are encouraged to take sides in a false dichotomy. You are asked to choose between the people who believe in the free market and the people who believe in government (AKA “Socialism”). This is an absurd choice as both paths would lead to total destruction. Unfettered free markets are not in place to deal with long term societal issues. The government is not in place to deliver optional goods and services to people in an efficient manner. So, fortunately, we have a hybrid system that attempts to carve out a middle ground that allows us to muddle through. So, the real question for this and every election is, what is the optimal mix going forward of government and capitalism.
Free market capitalism seems to be the optimal system to provide goods and services to people. As its focus is primarily on profitability, a layer of regulation is necessary to protect the health and welfare of the public. Too much regulation can harm the market system and too little leads to toxic excesses (see 2008!).
The government’s main role is to look after society’s best interests now and in the future. That includes many complex and unprofitable tasks (how do we protect people from fire, workplace safety, what goods and services should we provide to poor children, how do we protect the earth for future generations, what infrastructure is needed to support the private sector). These big picture items are beyond the scope of the market economy. Some tasks offer no hope of profit ever and some offer no current profit so will be shirked by the market economy.
Both the government and the private sector have a tendency towards waste and excess if left to their own devices. We, the voters and taxpayers, are charged with closely monitoring these systems, serving as a check and balance to unfettered power, and ultimately choosing where we should set the mix of government and private enterprise to maximize outcomes. It is a very tough and very important decision that we face, but it is not the decision bandied about on television and in the media.
By Ted Schwartz and Kevin Starkey
Bill Gross has always been one of the few voices that we at Capstone believe is worth listening to. The world’s largest fixed income manager got that way through solid performance over decades. His thinking is usually lucid and his worldview often intriguing. As other financial industry talking heads are peddling something and Bill sells fixed income, could he be selling something new?
That said, he seemed to fall off of a turnip truck this week. He forecasted anemic real GDP growth of 1.5% per year for the US for the next decade. We are not forecasters, so will not take issue with this gloomy forecast. However, he went on to say that “if real GDP grows at 1.5%, then a diversified portfolio of stocks and bonds would probably grow at 1.5% as well.”
While GDP growth would certainly be correlated to expected stock returns, the 1:1 correlation that Mr. Gross throws in to the equation has been pulled from thin air. The long term growth rate of GDP is rather consistently around 3% per year. The long terms real return of stock is around 6.5% per year. In other words, stocks have historically grown at a rate far higher than GDP.
Why would this be true? Well, financial physics is about the basics of return on equity. As companies are already earning money every day as we enter Mr. Gross’ 1.5% decade, the companies have earning that are considerable to add to their bottom lines before we consider growth. Companies can 1) distribute money they earn through dividends; 2) they can use it for share buybacks that should increase stock prices; 3) they can use it for expansion, acquisitions, and debt reduction which should increase net earnings. All of these choices should yield shareholder returns well in excess of Mr. Gross prediction of GDP growth. So, even with his dire prediction, we may hope for returns that are rather paltry but well above Mr. Gross’ calculations. Stay tuned for the pitch!
By Kevin Starkey and Ted Schwartz
Sell in May and go away for the summer this year? Maybe not, according to data compiled by our research partner Hidden Levers. In a recent study they conducted of Election Year markets, this year has gone amazingly well to the script for election years. Hidden Levers studied election years from 1926 thru 2011 and found the first 3 months of the year had positive average returns in the S&P 500 Index for each month. Check mark for 2012! The next two months have had negative average returns historically. Check mark for again for 2012! June has had a positive average return historically. You guessed it, check mark for 2012!
So, what does history tell us about the balance of the year? Historically, July and August are the two best months of election year returns. Then, they are followed by a small negative in September and a small positive in October. Then, the certainty of Election Day sets in and we have a positive return in November and December.
This year has played to form perfectly so far. Can that continue through the balance of the year? It seems odd when this year and period seems so different from the norm, yet it has been so predictable year to date that we would not bet against returns continuing to approximate the norm over coming months.