Do Your Own Research

If we had a motto here at “Trust funds for kids” I am sure that part of it would be “Do your own research” and another element would be “Don’t believe the so-called experts”. This was put on amazing display recently in a Bloomberg article (really, if you just look to one place for financial information and analysis, it probably should be Bloomberg) titled “Equity Analysts Prove Hazardous to Returns As Contrarian Stocks Rise 165%“. From the article:

Following the advice of equity analysts may be perilous for your profits. Companies in the Standard & Poor’s 500 Index that analysts loved the most rose 73 percent on average since the benchmark for U.S. equity started to recover in March 2009, while those with the fewest “buy” recommendations gained 165 percent, according to data compiled by Bloomberg.

The equity analysts are “professionals” that rate a stocks’ prospects using a variety of mechanisms, including modeling their financial results into the future to determine if the stock is over or under valued. In the past the analysts had blatant conflicts of interests (i.e. they would recommend that customers purchase a stock in print while they were privately telling other customers via email that it was a piece of sh*t or while selling their own or company’s stake) but this has mostly been fixed; now they are just terrible in their collective recommendations.

Analysts use a scale from “sell” to “hold” to “buy”. If the analysts are generally bullish on a stock and most of them recommend purchasing that stock to investors than this stock is favored. Analysts usually review and recommend stocks that are already moving up.

In a recent post I described the massive run-up in equity values in the US market from the nadir in 2009; if the analysts were going to prove their mettle an excellent time would have been to provide advice when markets were at their (in hindsight) low point.

Instead, from that critical moment, the Bloomberg article proves that the analysts were almost completely WRONG from that point forward. If you BOUGHT the stocks the analysts told you to SELL, then you did well, and if you followed their recommendations and loaded up on those stocks you actually did WORSE than the benchmark.

Remember this as you pay for advice or read through the detailed analyst reports. From the nadir, when the analysts’ advice would have been most valuable, they have been virtually, completely, wrong. It is as if someone predicted the Buffalo Bills to win the Super Bowl at the start of the 2010 season; they could not have been wrong-er.

Like Anything Else, It Isn’t Easy

Back on Dec. 13, Barry Ritholz penned a great article about the ten lessons learned from the Madoff implosion.  You can see that article here.

I have been thinking about some of the things that Ritholz said and would like to make some comments on a few of the points.

5. Know What You Own: Do not invest in anything you do not understand: How does this make money? What makes this unique? What is the basis for this investment? What are the risks? If you cannot answer those questions, you should not be risking your capital.

Boy can I relate to this one.  About six or seven years ago when everything was going up, up, up I got talked into buying a large position in a fund of hedge funds.  I knew absolutely nothing about the investment, but trusted my FA and took the leap.  Several years later I told my (now new) FA that I wanted out of that fund of funds.  It took four months for that position to unwind.  I recovered my principal (lucky) and learned a terrific lesson.  From that day hence I vowed to never invest in any instrument that I did not understand.  I have stuck with that to this very day.

6. No Outsourcing: Do not outsource your thinking or due diligence. Do not rely on 3rd parties, fund of funds, lawyers, advisors or consultants. We have learned that most are worthless. What is the value add does this fund manager provide? What are they doing, and should I be doing that myself? This is true for consultants, economists, strategists, traders, and managers.

My FA is a good guy and he brings me a lot of good ideas.  Some I like, others I don’t.  In the end, if any investment I make takes a dump, it is MY PROBLEM.  FA’s are just that – ADVISORS.  When push comes to shove, if something that I have my money in takes a dump it is my fault and I am the one that bears the brunt of the consequences.

This opens up a discussion about FA’s in general.  Do I really need one?  Probably not.  But he has brought me interesting ideas and products that I would have no clue existed if he were not there.  If I had to run my complete portfolio myself I think it would just be a plain ‘ol mix of stocks and bonds, rather than the diverse and varied investments that I have now.  I am not even sure I would have access to many of the products that I own without a FA, but I don’t really know.  In the end, I think he is worth the money I pay him.

7. You must not keep all of your money with one manager: I was astonished how many people had all their money with Madoff. If the worst happens, this is a recipe for disaster. Diversify your holdings across several professionals in unrelated firms.

I am not so sure that I agree with this one 100%.  I get the drift of what Ritholz is saying.  But in the end, my accounts with (insert large broker here) are owned by me.  So if you have ALL of your money in Merrill or B of A or whoever it really is your money.  You own the stocks, bonds and all the rest.  Madoff, being a private entity was different.

The only way this could fail in a bad way would be if (insert entity here) was printing and emialing you bogus statements that said that you owned xx shares of company abc.  I have a hard time believing that this could happen in any of the large, publicly owned companies that are reputable.  That said, I do not have all of my eggs in one basket.

I would like to add one that I read somewhere else.  Nothing is free.  I don’t like seeing those quarterly withdrawals from my account that my FA gets, but you gotta pay the man.  If I don’t like it, I can always close the account.  Plain and simple.

If They Are Making the Call, I Am Going The Other Way

Carl and I really are chumps in the world of which we speak, which is mostly the stock market.  I heard someone say that the stock market was the bond markets idiot little brother.  I have to agree.  Sometimes the best researched purchases end up being dogs, and dartboard hail marys work out.

Barry Ritholz has a very interesting column today at the Big Picture.  His main thesis is that if someone who has a ton of money (namely Mark Cuban in this example) makes a call that the stock market is going to tank, it is probably for the better that you are on the other side of that trade.  Ritholz freely admits that he is in a large cash position right now, but outright worries about it while wondering aloud wrt the Recency Effect:

I don’t doubt the business acumen of either of these gentlemen; Each is wildly successful in their chosen fields. However, I cannot help but note that neither of their fields involve analyzing the data that goes into determining economic or market collapses. Indeed, it smells more like a case of Recency effect than anything else.

Note that I am not talking my book: We have been mostly cash since May 5th (as much as 100% then, 50% cash in June). We are now over 80% cash, and are looking for a move down towards 950 on the SPX. So what both of these commentators are saying actually matches both our positioning and our perspectives (as well as this AM’s futures).

What I am pointing out is the unusual perspective of two businessmen discussing a crash that is so far outside of their expertise, following a 55% drop from the market top, and a 16% drop from the April highs. Perspectives such as this would be more valuable before, rather than after, a huge crash. (We will revisit this in 6 months).

It reminds me in some small part of the parade of sports figures and celebs on CNBC in late 1999 discussing their equity trades, or the Playboy bunny turned RE Agent in 2005 (also on TV) just as that market peaked. These were all late cycle momentum calls, as opposed to insightful analysis based on new data, fresh perspectives, or creative research.

I doubt this rises to the level of full contrary indicator, but it makes me nervous to be on the same side of the trade of what can be described as “scared” or “dumb” money.

Oddly, I base a lot of my market research on contrarian indicators and it appears Ritholz (who is a baller to be sure, unlike me) does as well.  Most of my contrarian indicators consist of me hearing someone who I think to be a dunce (Paul Kru#man, Mark Cuban, others) and going the opposite way.  Yes, this is simple and is certainly not a recommended way to invest as opposed to thoughtful research, but it works for me.

Contrarian Investing

I have been blogging for a long time at several other sites.  Back in the day I used to fisk articles by Pa*l Krugm*n.  After doing this a few times it was very apparent that Krugm*n was just another partisan hack, and he really wasn’t worth me wasting time on.  In other words, I am better than that.  This doesn’t stop legions of people from picking apart Krugm*n all the time, and some of them do a pretty good job.

He recently came out with some sort of “another depression” deal in a column, and that was my signal to immediately jump in and buy stocks.  Pretty much everything PK says is wrong, so my intent is to go 180 degrees and do the exact opposite of what he predicts.

Barry Ribholz put up this post the other day that got me laughing.  It is about the Lex Team over at the FT.  Here is the money from the letter:

“Dear Investor,

It has been a profitable first half for Contrarian Partners. Our core investment strategy remains unchanged: to mine the research produced by investment banks every six months to establish consensus trading strategies. Then trade against them . . .

In general, though, the advice was reassuringly poor. The markets continue to reward us for listening to the experts – then doing the opposite.”

I don’t have access to the full letter since I don’t subscribe at FT (Maybe Carl can post) but all in all, this is probably a pretty good strategy.  Just like betting against PK, betting against big banks and their “research” can, I imagine, pay pretty good dividends.  Could they make any worse calls than in the last half decade or so?  I think not.

Regression to the Mean

A recent Wall Street Journal titled “Rebound of the Losers” from July 6, 2009 described how some specific actively managed mutual funds with large losses recently booked better performance. From the article

Ninety-four diversified U.S.- stock funds that finished 2008 in the bottom 10% of their peers are now performing in the upper 25% of their categories

The article then described their reasons why these specific managers were able to “rebound”. They included:

– purchased shares of better-performing foreign companies (the markets in China and Russia, for example, fell further and later rebounded better as a % than US markets)
– commodity markets improved, so stocks with a commodity footprint like energy benefited
– some managers described their own “guts”

“It’s funny how quickly things can change,” Mr. Soviero says, “but I’m glad I had the level of conviction and stuck with a concentrated strategy.”

– others used terms like “discipline” and said they were looking for companies with a “sustainable advantage”

But the journalist on the article missed the simplest, and most obvious answer –

REGRESSION TO THE MEAN

What this means, in practical terms, is that stocks or sectors that have the largest rise now are likely to fall later, and vice versa. One financial magazine I read had “Chicos”, the clothing store, as the “worst” performer over the last year, and the “best” performer over the prior decade, in back to back pages.

Something to watch for, especially when people describe their recovery in personal terms, rather than ascribing it to typical market “bounce”.

What I’ve Learned About the Stock Market

Anyone who has a retirement fund or personal investments has an interest in the stock market.  I have an additional interest because I am the fiduciary in charge of trust funds and describe at this site.

When the stock market started cratering in 2008, I didn’t take immediate action, for the most part (I was going to say didn’t do anything “rash” like sell off, but in hindsight of course probably that would have been under the category of “smart”).  I did sell off financials (owned ICICI, an Indian bank, and GE, which is essentially a giant financial conglomerate with a few businesses stuck in there) immediately, and although my exposure to that sector was limited in those funds, those stocks had not done well.

Now I am trying to re-visit the stock market and do some research to consider what to do next.  I am starting out with what I’ve learned from this debacle.  As always, do your own research, this is just my 2 cents based on my experience and body of knowledge.

1.  Watch the level of debt, and the timing of debt – for many years there was an absence of a risk premium, which meant that newly emerging (risky) companies could raise debt very cheaply, such as only a couple of points above the treasury rate.  Today, it is unlikely that these types of companies can raise any money AT ALL, and if they did it would be at a rate perhaps 10 percentage points above Treasuries (i.e. if Treasuries are at 4%, they would pay 14% for financing).  Companies are moving into bankruptcy rather than try to refinance at these rates – companies like Charter Communications, for example.  Even if bankruptcy is avoided (or deferred) the company would have to be highly profitable to earn enough to cover that level of interest payments – and most companies can’t profit when their cost of capital is that high.  I won’t even comment on the 33-1 leverage used by investment banks because we all know how that turned out

2. Guessing the actions of the US Government is important – during the cold war, “Kremlinologists” attempted to divine what was occurring at the top levels of the Soviet government, since it had a direct bearing on our policies.  For example, the Feds let Lehman die and saved AIG, although in both cases their equity value evaporated to the point that a 100% equity loss and a 98% equity loss were a toss-up either way.  The subtle way in which by saving AIG they benefited Goldman Sachs (since AIG was a major counter-party to Goldman Sachs) would be something worth understanding, for example.  The Feds also didn’t bail out Fannie Mae and Freddie Mac preferred shares, which caused whole ranks of smaller institutions to fail.  In general, if you are investing in an industry that looks likely to need government help, you should get out now, because whether or not you have a few equity crumbs or go to zero is a Hobson’s choice you don’t want to face

3. Correlation between asset classes is higher than you expect – Basically unless you were 100% in gold or treasuries you were likely hurt badly in this market.  Foreign stocks, US stocks, many debt instruments, preferred stocks, real estates and most commodities (excluding gold) all dived together.  One of the “core” beliefs of “modern portfolio theory” is that if you spread your investments across classes with lower correlation to one another, you will do better over time.  Modern portfolio theory basically didn’t save anyone in the time frame we are talking about here

4. Liquidity can evaporate, and if you depend on liquid markets, you are in trouble – Not only did the risk premium (see #1 above) go up quickly, liquidity in the market evaporated, meaning that if you counted on liquid markets, you were in big trouble.  Illiquid markets mean that you can’t “roll over” debt and if you do have to sell, you will receive a distressed price for those assets (a big loss, in real terms).  One of the first items to fail were the “auctions” in the municipal area which were a sign of bad tidings to come

5. Real estate is no bulwark – For individuals, there was often an assumption that real estate is a “safe” investment, but real estate values have proven to be anything but.  Real estate losses for individuals were semi-spared because the government has set a very low rate for mortgages and nationalized Fannie and Freddie – without that floor mortgages would be illiquid and subject to #1 and #4 below.  Now, however, the mortgage market is basically subject to government fiat – see #2 above.  If the government decides that condominiums are too risky and pulls back on guaranteeing mortgages on half built condominiums, those investments will fail.  For real estate companies that specialize in building new homes, those stocks are basically dead, since demand won’t catch up with supply for years.  The government is definitely working to prop up the home market, with tax incentives for the new buyer (and likely no more talk about not making home interest deductible)

6. Complexity is dangerous – Another early warning sign was the fact that Citicorp and others had to bring in “off balance sheet” entities onto their balance sheet when liquidity failed (see #4 above).  Those companies were incredibly complex, and their financial statements were incomprehensible even to me, a financial professional.  These counter-parties, off balance sheet entities, and WAY too much leverage made a toxic stew.  In general, companies that have a very complex “story” will likely have a harder road to travel when trying to show their value to the equity community, since people have been burned by what they don’t understand

7. Dividends provide little shelter – over time a significant portion of the total “return” from stocks is driven by dividends paid to stockholders.  Many companies paid dividends at a steadily growing rate for decades, and constantly re-emphasized the importance of dividends to their strategy (giving investors confidence that these dividends would continue in the future).  However, virtually everyone gave up on their dividends, from the financial companies that are sliding to the edge of oblivion to GE (who really is a financial company anyways) to many other industrial companies.  There are exceptions to the rule (companies that are not facing dire straits) but the fact is that strong companies can pay dividends and weak companies cannot, so betting on a dividend independent of the underlying financial structure is a fools errand.  The dividend is nice to have (and starting from a solid one is better), but counting on it in the future has proved to be devastating

8. For the most part, no one (who talks) knows anything – yes you can point to the occasional seer who cried doom and certainly many, many smart and rich (and tight lipped people) made tons of money shorting the entire market all the way down, but for the most part the conventional wisdom was completely and utterly wrong.  There are people or firms that understand the market well and can profit in down times, but you aren’t getting their thoughts from Jim Cramer on CNBC or in the WSJ or Barron’s or anywhere else, much less the popular magazines like Time, Money or your local paper columnist.  Look at how their stock ratings performed, and generally it was terrible.  A lot of this is institutional bias because those magazines and paper can’t just tell you to short everything and get out of the market because those same companies buy advertising and those sorts of negative messages frankly sound un-American when explained out loud.

9. Timing IS important, as is re-investment risk – I resisted timing in favor of “buy and hold” for years but then I moved into selling stocks when I thought that they had peaked on the upside, or they had huge down side risk (financials).  Buy and hold really hasn’t done anything for anyone in the last decade or so except rack up huge losses.  That doesn’t mean that I have a better strategy, but it is a fact that the central issue is timing.  Tied to timing is re-investment risk – which basically hits you in that even though you sell at a gain, you have to re-invest in something else that has increased in price (due to strong correlation) and you don’t mitigate your risk that much by selling one overvalued stock for a gain and trading it for a new one.

10. If it seems too good to be true, it probably is – I am not a seer but I think that all these people piling into municipal bonds for the tax benefits and historically low default rates are in for a rude awakening when bad things start happening to the states.  I know that there are many ways to bail out a state including the Federal government but it just seems like the municipal financing is going to fall apart and I don’t want to be holding the bag.  This applies to “free lunches” everywhere…

Now with all these “lessons”, what is a forward looking investor to do?  The stock prices are down, and this could be an historic time to “buy in” to the market, rather than sitting on the sidelines licking your wounds.  I am trying to figure that one out now, but thought it made sense to take stock of what, if anything, I learned so far.

Cross posted at LITGM and Chicago Boyz

One of My Favorite Investing Books in Context

I was reading a Wall Street Journal column by James Stewart recently. He has a column called “Common Sense” which outlines his approach to selecting stocks and investing.
His strategy involves buying when the stock market drops 10% and then selling when the stock market rises 25%. This type of investing (which looks at relative market levels) is a type of “technical analysis” as opposed to “fundamental analysis” which looks at the merit of individual stocks relative to financial metrics. To be fair, Mr. Stewart’s model is a mix of technical and fundamental analysis, but the “buy”and “sell” signals are pure technical analysis (in my opinion).
The headline of the article really caught my eye, however:

When bad times get worse, it’s best to stick to a system

That quote reminded me of a line from one of my favorite investing books titled “A Random Walk Down Wall Street” by Burton Malkiel. On p146 he discusses his opinions of technicians which rings eerily familiar:

I personally have never known a successful technician, but I have seen the wrecks of several unsuccessful ones. Curiously, however, the broke technician is never apologetic. If you commit the social blunder of asking him why he is broke, he will tell you quite ingenuously that he made the all-too-human error of not believing his own charts

In my mind, sticking to a system and not believing his own charts are one and the same.
As far as the book by Malkiel, I like to pick it off the shelf from time to time and read it again. The book is 30+ years old (it has been updated), but the main thesis is the same; a broad basket of stocks, best in an indexed fund, will typically beat active management when fees and taxes are considered. While this idea is pretty much accepted as common sense nowadays, when this theory first came out it was seriously attacked by the investment community, since it undercut their validity and high costs (relative to indexing, which can be done cheaply in a transparent manner).
I also like the book because the author acknowledges the thrill of individual stock-picking, and allows that some people are good at it, and that it can be “fun”. While he doesn’t recommend it for the whole portfolio, he notes the lure and that doing it with part of a portfolio or not “rent money” is also understandable. This to me sums up my plan in the funds I run for my nieces and nephews; I invest in individual stocks because the funds are relatively small and not needed immediately to pay for rent and food, and because investing in individual stocks allow for much greater interaction and teaching opportunities about the market relative to a simple index fund (or ETF).

I heartily recommend Malkiel’s book and am a bit worried about the normally staid and on-point Stewart… don’t ride that system to the end.

Cross posted at Life In the Great Midwest