Friday, February 8, 2013

Individual Investors Do Stand a Chance

It is understandable that many individual investors have given up on investing in the stock market.  The Wall Street crowd has gotten rich over the years, while their clients often were left holding hyped investments that rose amid euphoric markets, but which fell sharply when more sober judgments prevailed.  After the stock market collapses from 2000-2002 and again from 2007 to March 2009, who can blame individuals for looking elsewhere for investment opportunities.  After the financial collapse of 2008, individuals have withdrawn several hundred billion dollars from equity mutual funds.

But individual investors should not give up, as they do indeed have a chance to earn respectable returns.  The media are filled with advice and forecasts from economists, investment strategists, security analysts, and fund managers.   But when it comes to investing, the forecasts rarely work out.  Investors are usually better off going contrary to the conventional wisdom.  After all, in order to "buy low and sell high," one must go against the popular mood--even among the supposed experts--since, when the mood is gloomy current conditions are bad (but assets are depressed in price and are cheap).  Conversely, when the mood is euphoric current conditions are good (but assets have already risen sharply in price and are consequently expensive).  Starting price matters in investing.

Entering a market that is expensive leaves poor odds for success, and entering a depressed market leaves much better odds and a margin for error (some say "margin of safety").  It's like trying to swim down a river that has a current of 10 miles per hour.  When one buys into a market that is historically cheap (undervalued) or is out of favor, it is like having the current at your back.  It would be easy for most of us to float down the river with the 10-mile-per-hour current at our backs.  If, however, one buys into a market that is historically expensive (overvalued), it is like trying to swim against the current of 10 miles per hour.  Not many of us would be able to make progress against such a stiff current.

One of this era's most esteemed investors, Warren Buffett, has said that individuals don't need superior intelligence to be good investors.  They instead need superior temperament, specifically the ability to go against the crowd and to be patient.  He has likened investing in stocks to being at the plate in baseball but not having any strikes being called.  Under such conditions, the batter can wait until a "fat pitch" crosses the plate before swinging.

The antithesis of the individual investor is probably the hedge fund investor.  Hedge funds are unconstrained funds run by supposedly the most savvy investors in the business.  Some, such as Bridgewater Associates, have tremendous long-term returns.  But like with mutual funds, most have only pedestrian returns and are not worth the high fees that are charged.

What happened to these purported masters of the investment universe?  In 2012, hedge funds on average returned only 6.7%, versus 17% for global stock markets (the MSCI All-Country World Index).  In the U.S., the S & P 500 returned 16%.  This was the fifth time in the last seven years that hedge funds have trailed major stock market indexes.  It is true that hedge funds don't invest in just stocks, so that might be an unfair comparison.  But an investor who simply used stock and bond index funds last year in a 60% stock index/40% bond index portfolio, would have returned 12%, nearly double the return generated by the average hedge fund.

Goldman Sachs estimates that the average hedge fund return over the next five years will be only 4-5% per year.  Given that and the historic record of hedge funds, why have the richest individuals and many endowment and pension funds invested so much money in hedge funds, which have total assets of $2.2 trillion?  

I used the 60% stocks/40% bonds example to make a point.  But I do not endorse the practice of having a fixed allocation among stocks, bonds, and other assets at all times.  It makes no sense to have a fixed percentage in stocks, regardless of whether stocks are historically cheap or expensive.  (Remember the analogy of swimming down a river.)  

That doesn't mean that one needs to be a market timer either.  Just pay general attention to the prevailing mood (market sentiment), whether markets are depressed in price or "frothy" after an extended rise in price, and whether the investment is cheap or expensive (based on e.g.,  its dividend yield or earnings multiple) versus its history.

And forget about the expert forecasts.

Steve Lehman

Monday, January 28, 2013

The Individual Investor Is Back--Only to Be Walloped Again?

After withdrawing more than four hundred billion dollars from equity mutual funds over the past several years, mutual fund investors in the last several weeks have made the largest purchases of equity funds in years.  

If investors are moving funds from bonds to stocks, I understand the motivation.  Bonds have been in a bull market for more than thirty years, while stock markets have been challenging over the past 10-13 years.   Most bond funds have negative returns in this first month of 2013, and I expect relatively modest returns--or even losses--from bonds ahead.  But to move from cash to stocks now, after a more than doubling in stock market returns over the past four years, I wonder whether mutual fund investors are again chasing performance, as they did in 2000 at the multi-decade peak in the stock market or in 2007 and 2008.

I consider most stock markets to be quite risky for new buying at this moment.  Sentiment and technical measures reflect an extraordinarily overbought market with excessive enthusiasm and little regard for risks that might arise.

There are some exceptions.  Some individual stocks remain attractively priced, such as Fresh Del Monte (FDP), Alliance Grain Traders (AGXXF), and Vodafone (VOD).  I also continue to think that gold and gold stocks (or the GDX exchange-traded fund) are one of the few depressed areas left in the market, along with instruments linked to volatility (such as VIXY).  Otherwise, I strongly think it is a time to realize some gains and step back for a breather.

Steve Lehman

S & P 500:  1500
FDP:  26.1
AGXXF:  13.2
VOD:  27
GDX:  41.6
VIXY:  12.65

Thursday, January 24, 2013

"Operation Barn Door" and Apple

A former colleague of mine used to quip that "operation barn door" had taken place after an investment decision--usually by senior management--well after the damage had already been done.  I see this now with Apple stock.

In response to yesterday's earnings announcement by the company that disappointed many, the shares are expected to open 10% lower today.  That would bring the total decline in the stock price to 35% since it peaked at $705 late in the summer before the launch of the iPhone5.

After the company's announcement late yesterday (after the close of the stock market), one prominent analyst reduced his rating on the stock from "buy" to "hold" along with his price target from $800 to $500.  Is the stock really worth 40% less than it was an hour earlier?

Yet, that is the behavior of the herd-following analysts (and many portfolio managers).  They couldn't get enough of Apple on the way up, as it was a "must own" stock that caused many portfolio managers to trail their index benchmarks because they didn't own the stock--or didn't own enough of it compared to its weighting in the benchmark index.  Analysts repeatedly raised their price targets on the stock, and when the stock reached $700, analysts tried to outdo each other in their enthusiasm for the stock, with some setting price targets of $1000.  

So less than six months later, with the stock at $465, the same analysts are racing to cut their price targets and ratings on the stock.  Again, this is only after the stock has fallen 35%.  Thanks a lot for that advice.

The stock now has a p/e multiple on current-year earnings of 9 (or only 7 if the cash on the balance sheet were used to buy back stock).  The balance sheet is in superb condition, with cash equivalents equal to almost one third of the company's stock market value.  I'd resist the crowd and wade in to buy Apple today.

Steve Lehman

Apple:  $465

Tuesday, January 22, 2013

Income Sources

I was concerned a year ago that dividend stocks had become too much in vogue--and historically expensive versus the stock market overall--even though they remained attractive versus bonds.  And has usually happens when an asset is relatively expensive, the return on dividend stocks lagged the stock market overall in a strong year for equities.

I think the dividend stocks again are relatively attractive, but on a more selective basis, for income-oriented investors.  In Europe, for example, the Euro Stoxx 50 Index is up 33% since mid 2012.  Yet, the average dividend yield is 3.5%, while the yield on the 10-year German government bond is only 1.5%.  Even compared to corporate bond yields, the average dividend yield is 40% higher than the yield on investment-grade corporate bonds.  Both yield spreads are historically high in favor of equities.

So when a stock like Total (TOT) still yields 5.6%, there is value there.  GDF Suez (GDFZY) yields nearly 10%, and the stock is down 25% over the past year (and 67% over the past five).  I would be comfortable holding both of those stocks.  But since I think stock prices overall are likely to decline, I would hedge long positions by going long volatility or purchasing put options on the the major market indexes

Steve Lehman

S & P 500:  1483
TOT:  52.5
GDFZY:  20.5

Friday, January 18, 2013

Corporate Mergers and Write Offs

Large corporate acquisitions often seem not to work out.  When one company acquires or merges with another, at the time the rationale often is that there will be strategic "synergies," making the combined company more valuable than the companies were worth by themselves.  There might be major cost savings from eliminating duplicative overhead.  Or there might be economies of scale, as when a broader product line can be sold with the same sales network, or higher output from existing production facilities reduces unit costs.  Even though most acquisitions involve a considerable premium over the acquired company's stock price, executives assure skeptical investors and analysts that the takeover will be "accretive," (additive to earnings per share) in the first year--or at least in the second.

But it often doesn't work out that way.  It seems that the bigger the merger, the less sense it makes.  Take yesterday's announcement by Rio Tinto, the world's second-largest mining company. The company plans a $14 billion writedown of "goodwill" that it put on the books due to acquisitions of aluminum companies, the largest being Alcan for $38 billion in 2007.  
Though the company will argue that the $14 billion loss is non recurring and "extraordinary," it still reduces Rio Tinto's shareholder equity by $14 billion.  

Rio Tinto's management has written off $29 billion of assets since 2009.  The company's stock market value is $77 billion.  So, the company has written off an amount equivalent to 40% of its stock market value.

It is for examples such as this that I emphasize actual net income, after the "bad stuff" such as supposedly extraordinary asset write downs.  Instead, Wall Street uses "operating" earnings, which excludes such losses.  Yet, the balance sheet of a company--which presents the "net worth" of a company (assets minus liabilities) , is weakened by such write downs.  

When evaluating stocks to invest in, most of Wall Street prefers to emphasize the income statement of a company's financial statements, specifically "operating" earnings per share.   Actually, it's even worse, as analysts forecast what operating earnings per share will be one or two years out--which makes earnings per share in most  cases much higher (and the price/earnings ratio lower), so stocks look cheaper than they really are.

I look at all three major financial statements--the balance sheet, the cash flow statement, and the income statement.  But I emphasize the balance sheet and the cash flow statement, which are much less subject to manipulation by companies than is the income statement.

Steve Lehman

Tuesday, January 15, 2013

More Here Behavior on Wall Street

Investing isn't easy.  And for Wall Street analysts, having public "buy," "hold," or (rarely) "sell" ratings on specific stocks is challenging--and sometimes embarrassing.  But an all-too-familiar pattern of behavior by Wall Street analysts is happening again—with likely negative consequences for investors.

There is so much career pressure on these extremely well-paid analysts that they tend to move as a herd.  (Just as fund managers often “hug” the benchmark market index they are measured against in order to produce returns comparable to the major stock indexes.) 

Unfortunately, the analysts often move after the fact, which doesn't help investors who follow their advice.  It is common for analysts to downgrade their ratings and price targets on a company’s stock after bad news is issued by the company (such as a profit shortfall).  The problem is the stock price plunges immediately when the news is announced, so it is not possible for investors to heed the advice to sell without taking a major hit to one's proceeds.  Or, after a stock has fallen steadily even without a specific news announcement, analysts often give up on it and either cease coverage of the stock or downgrade their rating.

Similarly, the "bandwagon effect" is common with a rising stock.  Everyone loves a winner, and a stock that has been a great performer attracts many fans.  The supposedly objective Wall Street analysts seem to get just as carried away on the way up--and down--as the broad investing public.  Take Apple. Just last summer, as Apple prepared to launch its latest version of the iPhone, there was frenzy interest in the company and its stock.  Only four months ago, the stock reached a record of $705 per share.  Almost all of the 50 or so analysts covering the stock rated it a "buy” (after it had risen % over the past three years).  The Wall Street stock analysts seemed determined to outdo each other with their optimistic price targets for the stock, with some exceeding $1,000 per share.  (In contrast, go back to my blog at and read my warnings about the stock at that time.)

Today, the stock has fallen nearly 30% from its peak, perhaps because of concerns about the profitability of the iPhone5, perhaps because of investors selling shares to book capital gains in advance of higher tax rates.  Who knows for sure?  The stock is simply down sharply.  But in response, today another analyst sharply lowered his price target on the stock (from $660 to $530), after the 30% drop in the stock.  Apple stock now sells at 10.5 times estimated earnings per share this year, a sharp discount to the overall stock market.  Apple remains one of the world's leading companies, and it is in superb financial condition.

I am generally not a fan of investing in technology companies for a couple of reasons.  One, I don't understand the products.  Two, technology products can become obsolete virtually overnight, so from a business standpoint, they often don't provide a "margin of safety."  But when the stock market is undervaluing a company's stock based on its asset value, earnings, or especially its generation of cash beyond what is needed for normal business operations, I'll consider investing in it.

And even though I think that stock prices in general have risen so sharply--along with enthusiasm among investors-- that makes a decline likely, relative to other stocks at the moment, I would more likely buy a stock like Apple than one like Celgene.  Celgene was upgraded to "buy" today by a Wall Street analyst after the stock rose 16% last week (and 36% in the last two months) on the basis of positive drug test results.  After all, we want to buy when there is good value in a stock, before a sharp rise in the stock price and sell when there is no longer good value, before a sharp decline in the share price.

Steve Lehman

Apple:  $501
Celgene:  $98

Monday, January 14, 2013

Stock Market Correction--Or Worse--Likely

The evidence of warning signs for a selloff in stock prices continues to build.  A spike in selling by corporate insiders and greater optimism by individual investors are the latest signs.

Selling by corporate insiders of their own company shares has spiked in recent weeks.  Individual investors, who have been net sellers of equity mutual funds and exchange-traded funds for many months, have become net buyers of stocks.  They may be right, but after a doubling in major stock indexes over the past four years, it seems to me that a more prudent course would be to reduce stock holdings now, rather than increase them.

Steve Lehman

S & P 500:  1470

Friday, January 11, 2013

Go Long Volatility

I continually search for asset classes or specific investments that are depressed in price, unpopular, or undervalued based on asset values or cash generation.

After major global stock indexes returned more than 16% (including dividends) and almost 4% more so far in January, there are few depressed assets or instruments.  Earlier this week I identified gold and gold stocks as providing such an opportunity.  

Now I think volatility is another opportunity.  There is a high level of complacency, if not outright ebullience, among investors now.  This is reflected in the extraordinarily low level of the VIX index of volatility on options linked to the S & P 500 stock index.  

High levels of the VIX Index are historically reliable indicators to buy stocks, since the expectation of high volatility in stock prices reflects anxiety (and is a contrarian indicator to buy).  The evidence supports buying stocks when the VIX Index is above 30.

Low levels of the VIX, on the other hand, do not have the same empirical support as a market timing tool (in this case as a sell signal).  Yet, the current level of 13.5 on the VIX is exceptionally low and, I think, worth "buying."  There are several exchange traded funds that are linked to the VIX Index (such as VIXY).  These instruments are not appropriate to buy and hold, as they tend to erode over time when held indefinitely.  But at current prices, I think they are a worthy speculation and a way to hedge core stock holdings against a broader market decline.

Steve Lehman

S & P 500:  1470
VIX:  13.5

Tuesday, January 8, 2013

Buy Gold and Gold Stocks

Ethical issues about gold mining aside, from a purely investment perspective gold and gold stocks look like a good buy at current levels.

The 12-year bull market in gold might have ended more than a year ago, when its price reached $1,925 an ounce.  Its current price of $1,650 is 15% below the peak, yet gold still rose in price last year (though by only 7%).  But from a tactical standpoint, both the gold price--and gold stocks--now offer the potential for a rebound.

After a year in which major stock indexes around the world returned about 15%, it is difficult to find asset classes that are depressed enough to offer an attractive return given the risks.  I think gold-and especially gold stocks--now offer this.

I do not, however, consider this a "buy and hold" situation.  The long-term bull market in gold may indeed be over.  But I think there will still be a solid move higher from here.

The prices of the metal and the stocks have fallen sharply, and are now technically "oversold" (and likely to rebound).  And key investor sentiment measures indicate levels of pessimism that historically have been followed by large percentage gains in the stock prices.  The Hulbert Gold Sentiment index, for example, is now at a level which over the past fifteen years, has been associated with annualized gains on the XAU gold stock index of 60%.

Remember, the best time to buy something is usually when few others are clamoring to do so.

Steve Lehman

Gold:  $1,650

Thursday, January 3, 2013

Uptrend, Downtrend, or What?

The idea that studying graphs of past price movements of a stock or commodity (known as "charting" or "technical analysis") can reveal its future price movements is appealing, since we can't reliably predict the future course of events. 

While there have been prominent "chartists" or "market technicians" on Wall Street who  have had successful careers, I'm skeptical of the value of technical analysis.  

We all have biases as investors.  I favor assets that are unpopular and depressed in price, rather than widely popular assets that are already sharply higher in price (regardless of whether fundamental prospects are favorable).  When selecting stocks, I favor valuation, financial strength, management quality, and contrarian market psychology, rather than business fundamentals or upcoming profit reports.

I do look at some technical indicators while favoring stocks or assets that are depressed or "oversold" (abruptly lower) in price.  However, I have a bias against pure charting, where the name of the company or the commodity is irrelevant to the decision whether to own, not own, or short the asset in question.  

My impression over nearly three decades of following markets is that for every example where charting would seem to work in predicting the future price direction, there is another that would not have worked.  

A case in point is the use of uptrends, downtrends, and "breakouts."  It typically takes so long for an uptrend or downtrend clearly to have reversed direction that by the time it is decisively reversed, the percentage move in the opposite direction is substantial--and often unreliable.  That means giving up a significant portion of profits when an uptrend has been reversed by a sharply falling price, or missing a significant gain when a downtrend has been reversed by a sharply rising price.

I noticed in this week's Barron's that as of last Friday, all three Dow Jones indexes--Industrial, Transportation, and Utility--had decisively "broken down," or fallen below the rising line that connects the daily closing prices of each index.  Given that supposedly clear signal, one should sell--or even sell short--each index.  

But in the first two trading days this week, all three indexes reversed the supposed new downtrend by rising sharply (the Dow Jones Industrials rose 4%).  Which is it?  Buy or sell?  The Dow Jones Industrials declined nearly 4% before clearly breaking down and giving a "sell" signal.  Now it has rebounded 4%--and given a new "buy" signal?

I have noticed similar results when studying moving averages, either 50-day, 100-day, or 200-day moving averages of the price of an asset.  Sometimes when the price rises above--or falls below--the chosen moving average, it signals a trend reversal.  But often it is just price fluctuations that do not indicate a trend reversal.  The result is buying and selling and buying and selling, often buying somewhat high and selling somewhat lower, followed by buying back in at a higher price and selling at a lower price.  It seem to me that the result often is to "buy high and sell lower," rather than what we're supposed to do:  "buy low, sell high(er)."

It may be unfair to assert that charting often causes investors whiplash, as they reverse positions abruptly following broken uptrends or downtrends.  It does seem that when an asset builds a "base" by fluctuating at a depressed level for some time but not falling further, it produces significant gains once it "breaks out" by rising sharply.  And I realize that dedicated "chartists" would tell me that there is much more to technical analysis than I've presented.  Nevertheless, I continue to view technical analysis with skepticism and as only a small input to my investment decisions.

Steve Lehman

Wednesday, January 2, 2013

Sell Into This Rally

The sharp gains in stock prices on Monday and so far today will lift the spirits of investors.  After months of tedium following the deadlocked fiscal negotiations in Washington, it was encouraging that the two parties were able to reach an agreement (despite having to pass it on a holiday).

Yet, I wouldn't get carried away.  I think this might be a case of the adage, "Buy on the Rumor, Sell on the News."  Last year was a solid year for investors, with mid teens returns from many stocks.  Any further rebound early this year would seem to offer a prudent opportunity for profit taking and to rebuild cash reserves for better entry points later.  

After all, one of the most important lessons in investing is, "Starting Price Matters."  And for a growing number of stocks today, the starting price facing investors is not low enough to provide a sufficient margin for error, or "margin of safety."

Steve Lehman

S & P 500:  1449