Tuesday, January 10, 2012

Investment Discipline Needed Now More Than Ever (cont.)

Thanks to those who have shared their views by completing the recent (brief) survey.  To those I haven't heard from, please take a few moments to complete the survey:


It is important feedback as I consider potential changes for 2012.


Now for today's comment......

Investing in financial markets has never been easy, but today's global interconnectedness, massive investment pools geared to hair-trigger shifts in positions, and a precariousness of sovereign credit conditions and the global financial system test the skills and mettle of those who dare to participate in markets.  It's no wonder that many individuals have given up on investing in stock markets.

But with savers continuing to be penalized by receiving a negative return after taxes and inflation, individuals are forced into fending for themselves in financial markets (unless they want to invest directly in a business or real estate, e.g.).  And most institutional investors have long since had the option of holding cash reserves while awaiting better investment opportunities taken away by consultants and impatient asset owners.

So what is a prudent investor to do?  Though institutional investors have a decided information advantage over individuals, individuals are free from the short-term performance pressures of the institutional investor.  And with so much information now available through on-line brokerage firms and the Internet in general, individuals can do just fine if, as Warren Buffett has said, they have the right temperament (not necessarily a brilliant investment mind).  As Buffett has said, an individual investor can be like a baseball player who can wait for a good pitch to hit without worrying about strikes being called.

That's all well and good, but what constitutes a good pitch?  For an investor, as opposed to a speculator, I'd suggest the following.  When overall market conditions are favorable--that is, when valuations are reasonable and the mood of market participants is depressed, or when expectations--for economic and earnings growth--are low, that is a good time to invest.  Trying to forecast the economy or company earnings, especially for years from now with supposed precision--is futile.  It is much better to find situations where others are looking for opportunities elsewhere.

For individual companies, I favor the following as a general practice:  stocks that have lagged the market, are undervalued based on the income statement (price to earnings), balance sheet (price to book value), or the cash flow statement (price to cash flow after subtracting capital spending and dividends); earnings strength (surprise and trend); financial strength; management skill and honesty (and conservative accounting practices); and earnings and dividend growth history and prospects.  For sustainable business and earnings growth situations, I use a variant of the PEG ratio where the sum of the dividend yield plus likely long-term earnings growth is divided by the p/e using current-year earnings estimates.

I always like to maintain cash reserves for opportunities that arise, and--especially with current market volatility--use the great John Templeton's approach of using limit orders to set purchase prices and patiently wait.  Patience, however, is not easy to sustain with the clutter of noisy market information and sharp swings in market prices.  But it is worth a concerted effort.

Steve Lehman

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