Persuasion Time

I am not a big fan of roller coasters.  Perhaps it’s my age.  Maybe it’s the meaningful volatility I face each day in the capital markets.  Whatever the reason, I am not a big fan of roller coasters.

Imagine my family’s surprise then, when I agreed to join them on the “California Screamin’” coaster in Disneyland.  As you can see in the picture above, this roller coaster is not the most extreme coaster in the world, but it is well above my comfort level.  So why did I agree to this self-inflicted terror?

It was simple misunderstanding.  At the entrance of the ride there appeared to be two rides: one small, non-scary looking thing and the other big, scary “California Screamin’.”  I truly thought we were going on the smaller ride, until we got on board.  The ride began with a massive acceleration followed by a rather high peak and subsequent plunge.  At this point, I knew I was in big trouble, because up ahead I saw the big peak of the ride.  Did I mention that I’m not a big fan of high places either?

So faced with this double whammy of phobias I did what I always do to combat stress, I began generating alpha waves.  In college I underwent some biofeedback training and learned how to generate alpha waves to improve my meditation skills and to deal with stress.  So, as I approached the apex of Mickey’s torture machine, my eyes were lightly closed, my breath deep and smooth and my face of picture of meditative serenity.

The rest of the ride was inconsequential.  I recall many loops and twists, ups and downs; we even went upside down at one point.  All the while, my little brain just kept on pumping out those alpha waves.  At this point, the reader might be wondering if this is some kind of “Tall Tale” with a jokey punch line.  I assure you, it is not.

At the end of the ride, a camera snapped a picture of our family as we neared the end of the ride. My wife looks like she’s having the time of her life – hair blowing in the wind with a huge smile on her beautiful face.  Behind us are Ben, whose eyes and mouth are wide open in mock terror (like his dad, he is a big fan of irony) and Matt, whose face is all scrunched up from laughter.  He too looks like he’s having the big time ever.  Then there’s me.  Face calm, lips pursed into a slight, knowing smile, eyes peering steadily into the camera as if to say “Ha ha – you did not scare me!”  [Disney copyright rules prevented me from sharing the photo, but trust me – it is a classic]

So what does this have to do with investing?  For one, I think I now understand why I can maintain a reasonably stoic demeanor in the face of market volatility.  Back in 2008-2009 when everyone seemed to be panicking, I was able to provide perspective, comfort and useful advice to our clients and my colleagues.  I may not have been aware that I was using biofeedback to maintain my composure during those challenging days, but I guess I was.

Second, amusement park ride volatility is by design fun (for most), but capital market volatility is fun for no one.  We like a good scare every now and then, whether it be at a horror flick or a roller coaster ride, and this is probably healthy and cathartic.  Being afraid that you will not be able afford retirement due to market volatility is a scare no one should have to face.  In my view, market volatility in and of itself is not that damaging (no fun, clearly); it is our response to it that can have lasting effects to our detriment.

Selling at the bottom and buying at the top are two strategies guaranteed to reduce one’s ability to reach long-term financial goals.  We saw a lot of selling in late 2008 and early 2009.  Some of those people may still be hoarding cash either waiting for a pullback or some other signal that “all is clear.”  Now, we are hearing about a lot of people wanting to increase equity exposure.  I have no idea whether we are close to the peak or not, but I do know that increasing one’s equity weighting based on how one feels about the market is probably an unwise move.  Asset allocation, in my view, should reflect the intersection of one’s risk tolerance and need for portfolio growth, not one’s views on the stock and bond market.  Changing one’s asset allocation based on feelings may be recipe for selling low and buying high.

For the record, I am still fully invested in equities and am still able to find individual stocks which seem substantially undervalued relative to my estimation of fair value.

I’ve been writing this blog for about 5 years now, and anyone who has had the endurance to follow me for this long probably can identify my overarching theme – Investing is not as easy as it looks – do your homework before investing or get professional help.  In this era of 24/7 news coverage of the financial markets, it might appear tempting to conclude that all one needs to do is listen to the free advice offered by the “experts” quoted in the media to make a killing in the markets.  As I often suggest, there is nothing as potentially costly as free advice…

A quick check of some of today’s postings on Seeking Alpha (a popular financial markets website) yielded the following investment recommendations:

1)   Buy master-limited partnerships

2)   Sell bonds

3)   Buy U.S. treasury bond exchange-rated funds

4)   Buy the yen

5)   Buy single family houses

6)   Buy companies selling SUVs in China

7)   Buy gold

8)   Sell gold

9)   Buy emerging market debt, but only in local currency

10)Buy uranium

Without commenting on the merits of any of these “recommendations,” I would submit that a portfolio based on all of these ideas would be a messy hodge-podge indeed.  This is the key problem with most bits of free investment advice – no context.  Successful investing, in my view, starts with a plan or a goal.  Investing in something just to make money may be an acceptable notion, but it is unlikely to lead a person to his or her long-term financial and life goals.  In addition to having a plan, being adequately diversified in one’s investments and having some program for risk management are other necessary components of a successful investment approach.

Way too much of the capital markets commentary I see out there feels like snake oil sales.  Laying aside the possibility of pure humanitarian altruism, why would someone give you valuable, actionable and profitable investment advice for free?

Thus was my surprise so great when I heard something I deemed to be very valuable offered for free to everyone listened.  The source was David Einhorn, a very vocal (and quite successful) hedge fund manager, whose public pronouncements can often impact stock prices.  In my opinion, his motivation in speaking publicly about stocks seems obvious – he wants others to join with him in the trades he has already made.  People seem anxious to play along, and we can often see a stock move up or down based on Mr. Einhorn’s views on it.

So, it was very refreshing to hear him say at a recent conference, “It doesn’t make sense to blindly follow me or anyone else into a stock.” He added, “Do your own work.”  I couldn’t agree more.  I see too many individual investors trying to invest as a sideline or a hobby with limited resources and limited understanding of the principles involved.  I hear countless stories of someone buying a stock because of a newspaper or Internet article, a “tip” from a relative or friend, or the compelling comments of a “guru” on television.  This ought not to be.

Find a plan, diversify and monitor risk.  Absent this, hire a professional.  If you still want to “invest” like Jim Cramer, open up a small account (one that will have no significant impact on your net worth) and as my son often says, “Follow your heart.”  Actionable or not, I’ve heard much worse advice…

Now that most major indices have breached their old highs (sorry, gold), the negative chatter immediately appears with many “experts” calling for a major decline in stock prices.  This chatter is as predictable as it is likely to be wrong.  Just because the market reaches a new high is no reason, by itself to become negative.  There may be reasons to be negative (I don’t see a lot right now), but the pattern of a stock or market chart rarely compels me to action.

I can only presume that the intent of its creator was to show that the S&P 500 only moves in this “no win” saw-tooth pattern and that the next direction must be downward, perhaps all the way to the old 2009 lows.  In my view, this is the lowest form of stock market “prediction” – one that uses a simple chart pattern to scare people into doing something that is probably not in their best interest.  When I first looked at this, I was surprised that its creator included the P/E values at each peak and through.  My first impression was “Wow, look how cheap the S&P 500 is now compared to past peaks!”  If it could trade at 2000’s valuation (*not a prediction*), we could see the S&P 500 move to 3,000, or up 100% (* not a forecast*).  Yes, valuation does matter, as do earnings, as do interest rates, as do many other things beside the chart pattern.

Allow me to show you a long-term chart for the S&P 500 to illustrate another major problem with the “saw-tooth” pattern chart.

It’s not exactly easy to see, but if you can find 1997 on this chart, you can see that it was not a trough of any kind, but simply a point on the huge upward trek the market experienced in the 1990s.  I suppose that some people in 1997 were wondering if the market was overvalued and overbought – it was reaching new highs, after all.  The market continued rising for another three years after 1997.

I am not trying to say that charts are “bad” or that patterns are not useful – I use technical analysis in all my investment research/management.  No, what is useless and potentially dangerous is cherry picking a chart pattern to support one’s opinion about the market or a stock.  In my experience, the chart pattern alone is rarely a reason to make a big decision about investing.  Most charts only “prove” their point well after the fact.  “See, the chart told you that you should have bought/sold back there!” Thanks a lot, Sherlock…

Taking a look at the long-term chart for the S&P 500, I did see one interesting pattern way back in the 1960s and 1970s.  The 1960s was a great time to invest in stocks.  The market was strong and valuations rose steadily until 1968 when both peaked.  This was the era of the so-called “Nifty Fifty,” where the 50 largest stocks commanded huge valuation premiums.  After 1968, everything fell apart and the market didn’t find its bottom until 1970.  The rally was short lived, however, as economic stagnation, oil shocks and government policy missteps pushed the market down again.  Even after 1975 when the market bottomed again, it struggled to surpass its old mid1970s high.  It wasn’t until early 1980 that the market reached its old high.  I suspect that some joker out there at that time probably produced a saw-tooth pattern chart showing that the market only moves sideways (after all, that is what it did for 12 years), and was predicting another big decline.

The rest as they say is history.  Those who might have sold stock in 1980 fearing a decline could have missed the greatest twenty-year bull-run of the century.  Now I’m not saying we are the cusp of another great bull market (we could be), but the chart pattern of 1968-1980 looks suspiciously like the chart pattern of 2000-2013.

I’m a big fan of looking at the past in order to put the present into perspective.  In my opinion, the inability to do this well may be a key factor limiting the average person from being a good investor.  Too many people focus only on the present and/or the recent past and then extrapolate the current situation into the future.  This tendency can explain the irrational exuberance of the late 1990s and the morbid pessimism during and following the “Great Recession” of 2008-2009.

It is obvious to most people now that we are in a U.S. equity bull market.  Yet, during each of the corrections the market experienced during 2010, 2011 and 2012, there were many who were quick to “predict” that the bull market was over and that stock prices were “doomed” to revisit the old recession lows.  Much of the “analysis” touted in the media, appears to be little more than extrapolating the current trend, whether it’s up, down or sideways.  Why do people think this way?  One possibility is that many trends will persist for a while.  The likelihood of being “right” goes up when one expects the current trend to continue.  Everyone who likes to hear the sound of his/her own voice will want to be right and to be quoted often in the media.  Going with flow will assure this, at least for a while.

Another possibility for this tendency is that calling inflection points is very difficult.  Think back to how many people you can remember suggesting that October of 2007 was the peak in the stock market.  Naturally, some who had been bearish for a while before then took credit for calling this cyclical peak in the market, but very few actually did.  Ditto for the bottom of stocks prices in early 2009.  Many smart investors were buying stocks in late 2008 and early 2009, but very few of the “expert” commentators were calling the turn when it happened.

I guess this my roundabout way of saying that predicting the future is hard.

But, here is where the past can be helpful in trying to understand what might be coming down the road.  We all know that a typical economic recovery (as measured by the time from the trough in GDP growth to its peak) lasts about 5 years.  We also know that few recoveries are “typical,” and that knowing the average duration only gives us a general guideline for the current cycle.  We also know that U.S. equity bull markets last, on average, a little over 4 years.  Here too, the mean does not define each and every bull market.  Yet, these two historical measures can be helpful in determining where we are now in our cycle.

Near the end of a normal economic expansion, corporate profits and profit margins tend to be high, and tend to peak near a cycle’s end.  Interest rates are usually trending upward as the cycle nears its apex.  Capacity utilization, employment growth and other cyclically measures of economic activity will also show higher than average numbers as the cycle peaks.  Often, we will see banking lending very strong near the end of a business cycle – many times the recovery/expansion will be fueled by this lending.  Inflation is usually trending higher near a cyclical top.  Corporate balance sheets may show more debt and less cash as companies use borrowing as well as their own cash flow to expand their business growth.  More often than not, some kind of excesses in a sector or industry may be obvious near the peak of broad economic cycle (tech in the late 1990s, real estate in 2007-2008, for example)

As equity bull markets mature, they also can show tell-tale signs of their own demise.  Somewhat ironically, stronger-than-trend line economic growth is often a harbinger of the end of a bull market.  Strong profit growth if accompanied with expected higher profit growth can often signal the end of the bull market.  Stock valuations almost always reach their highest levels at the peak of the bull market.  Perhaps the most telling sign of the end of a bull market is sentiment.  In my career, each bull peak was accompanied by widespread enthusiasm of stocks.  Most people you would meet at these peaks were fully invested in stocks and wholeheartedly expected the markets to continue to rise further.  Cash on the sidelines will usually be very low at the peak in stock prices.  As with the economy, some sort of excess may accompany a bull market top (tech and telecom stocks in the late 1990s, for example).

Which of these “typical” cycle-end factors do we see today?

Only a small number.  Corporate profits and margins are high. Sentiment has improved from the bottom.  But mostly everything else suggests anything but a business cycle peak or bull market top.  Debt levels are low and cash levels are high.  Bank lending is tepid.  GDP growth has been below trend most of this recovery.  Employment trends are not robust.  Equity valuations are closer to cycle averages than peaks. The evidence supporting a top in the economy or the U.S. stock market is quite scant.

This leads me to believe that this time around the business cycle and by extension the bull market will be longer than average.  I see very little of the excesses I normally associate with market tops.  The Fed is likely to keep short-term rates low for a long time yet – this should provide some kind of support for the stock market.  We have seen some rotation into stocks by individual investors in recent weeks, but I would submit that sentiment is far from ebullient.

One of my favorite equity market strategists, Liz Ann Sonders, published this wonderful graphic:

Where do you think we are now in the cycle?  I think maybe just above the “optimism” line.  We still have three E’s to go before we can call the bull market over – here’s to the coming Enthusiasm, Exhilaration and Euphoria!

So how much longer can the bull market last?  I’m not sure (I don’t make predictions, remember?), but I think that anyone who hears someone say that “stocks are expensive” or that “another crash is coming around the corning”  should take a look at the important data (as I suggest above) and draw your own conclusions.  The “best” time to lighten up on stocks is when everyone you meet is telling you to buy them.  I don’t think we’re there yet…

The historic resignation of Benedict XVI is certainly newsworthy.  Something that hasn’t happened in 600 years usually is.  Now the cardinals have gathered at the Vatican to select the next global leader of the Roman Catholic Church, the world’s largest Christian Church.

I am not an expert on this, but as I read about it, I was fascinated by the details of the selection process.  As I learned more about the process, I was struck by the many challenges facing those who must make this decision, and by the ramifications this choice will have on the church, if not the entire world.

As I pondered on this, I realized that most people would not view this process akin to picking a stock.  Clearly, the selection of a new pope has global important far beyond anything stock pickers might do, nonetheless, I found a few points of similarity and contrast worth exploring a bit.

Selection by Committee.  The new pope will be chosen by a committee, the College of Cardinals.  Although committees often receive much criticism (the old joke that a camel is a horse as crafted by a committee is but one example…), I suspect they do well in this kind of big decision.  A committee, especially one made up of diverse individuals, can bring a breadth of experience that can make the collective decision much smarter than any one member of the committee might make.  Most places where I’ve worked used a committee to discuss the particulars of stock selection.  This kind of committee work is sometimes more time consuming than working by oneself, but the outcomes, in my experience are usually smarter than the decision of one person.

Following Proper Procedure.  The cardinals will be required to gather in Rome and follow strict guidelines for picking the new pope.  The details are too numerous for the scope of my note today, but a couple caught my eye:  1) No recording devices of any kind are permitted in the discussions.  2) The ballots for each vote are hard written in secret but tallied in public.  3) It’s considered bad form for a cardinal to vote for himself.  In the investment decision process it’s very good to have some kind of procedure to follow.  Too many people tend to select a stock based on a media report, comments from a well-intended friend or neighbor, or (horrors!) from somebody trying hard to sell them something.  There are many valid investment styles, but to be a successful investor requires one to learn, understand and follow the procedures associated with that investment style.  My process in simple terms starts with a screening process to find stocks which look attractive simply by the numbers, then uses qualitative analysis to determine the attractiveness of the stock (some stocks which look good simply by the numbers can be horrible investments…), then looks long and hard at the stock’s valuation, then a dash of technical analysis and then the final decision.

Deliberation.  I suspect that many outsiders would love to be a fly on the wall during the discussions which attend the selection of a new pope.  I’m sure that the cardinals, in trying to find the “right” person who will lead the church over the next several years, consider many factors, including age, health, race, nationality, geography, etc.  In picking a stock, I look at a large number of factors such as cash flow, valuation, profitability, quality of management, insider transactions, sentiment, size and so forth.  I will also consider how the new stock might fit into the portfolio I am managing.  Well-constructed portfolios do not simply contain my “favorite” stocks. Balance, diversification, and risk measures are as important to a portfolio as is the attractiveness of any one stock.

Final Decision.  The new pope will be selected with a 2/3 majority of the votes.  Each time the votes are cast and tabulated, the paper ballots used for voting are tied together and burned in a special stove which sends out smoke from the Sistine Chapel.  Black smoke indicates an inconclusive decision and that more deliberation and voting will be needed.  When a final decision is reached, the smoke from the chimney will be white, signaling to the world, a new pope has been chosen.  Whenever I approach a new stock, I really hope that the decision will be easy.  Most often, however, my initial feeling is mixed – some good, some bad, some questions remain.  I will then go back, dig up more data, ponder a bit more, discuss the issues with my colleagues and try to reach a final conclusion.  There is a great deal of satisfaction and relief in those “aha” moments when the conclusion is obvious.  Alas, my final decision on stock picking never approaches the drama of a puff of white smoke – I just buy the stock and look forward to good things in the future…

“Value Investing is pain, Highness. Anyone who says differently is selling something.”

-– The Dread Pirate Roberts

“The Princess Bride” is one of my family’s favorite movies.  At any point during the last decade or so one could hear someone in the Goodson household quoting any of the famous lines from it.  From random shouts of “Inconceivable!” to a heavily accented, “Hello. My name is Inigo Montoya,” the lines from this charming film would fill our home with warmth, humor and much laughter.  Even now whenever I hear someone end a sentence with “mean it,” I reflexively think to myself, “Anyone want a peanut?” In my opinion, it’s one of most entertaining movies of my lifetime.

The original quote from the Dread Pirate Roberts in the movie is “Life is pain, Highness.  Anyone who says differently is selling something,” which is, in my view, an amazing quote worthy of a philosophy textbook.  My alteration of it was inspired by a quote from a famous value investor, Jean-Marie Eveillard.  He was cited in a recent Wall Street Journal article saying, “Most people aren’t cut out for value investing, because human nature shrinks from pain.”  This is something I have been trying to articulate for years.

Conceptually, most people understand buying something at a discount, or when that something is on sale.  Yet, when it comes to stocks, this notion is much harder to implement.  Most value stocks trade below fair value exacting because they have something “wrong” with them.  These “flaws” usually turn off the average person (“Why not buy something better?” they would argue), and often turn on the value investor.  This is why most people loved Apple (AAPL) at $700 (“The company could do no wrong” was the consensus view), and loathed Avon Products (AVP) at $14 (ousted CEO, bribery scandals, dividend cut, etc.).  As shown below, AVP has outperformed AAPL by near 60 percentage points over the last six months.

AVP was a classic value stock.  But what about the pain of value investing?  Let’s suppose that AVP’s share price had gone down over the last six months.  Anyone holding it or recommending it would look doubly foolish. Not only did you lose money, but you lost money on a stock that was “obviously” troubled and deemed likely to disappoint.  This is why the average individual investor is likely to bail on value investing at the first sign of trouble.  The average person cannot tolerate the pain of owning something that looks ugly and is losing money.  In some perverse way, it feels better to lose money owning Apple than in some other less quality name.

Studies have shown that value stocks have outperformed growth stocks by an average four percentage points per year since 1926.  Yet, most individual investors who buy mutual funds specializing in value investing tend to do much worse than this. Why?  They tend to bail on these funds whenever they underperform.  Human nature is averse to pain.

My favorite value investing story comes from John Neff.  In the early 1980s he began buying metal stocks – gold, silver, nickel, iron, etc.  He felt that all of these stocks were incredibly cheap relative to his estimate of fair value.  He continued to buy them while his fund lagged the broad market for about 3 years.  Then, all of sudden, the market found favor in these names and they went up something like five-fold in a short period of time.  For years he was tagged as being “wrong” on his metals call, when he was just “early,” something we often see with value investors.  His long-term track record is a clear testimony of his approach to value investing.

I consider myself a value investor, and have had my fair share of feeling apart from the consensus view.  For those willing to stick to the game plan and ride out the hard times, I believe value investing can be a very rewarding way to invest.  Maybe value investors should adopt a new slogan, “No pain, no gain.”

During the course of my career, I’ve a heard a lot of Wall Street stories.  Not surprisingly, some of the best ones have to do with investing.  One of my favorites is about the junior trader who bought something like $60,000 worth of leveraged puts on the S&P 500 in the middle of October 1987.  I worked at the same firm at the time, so this fellow’s fame quickly spread.  He closed out his position a few days later, took his $7 million profit and retired from the business!

Another one features a “little grey-haired nun.”  One of my colleagues, who was a seasoned investor, served on the board of some endowment fund for a non-profit organization.  Also on this board was in his own words, “a little grey-haired nun.”  As the board met and began to consider the fund’s asset allocation, the “little grey-haired nun” argued strongly for a higher exposure to stocks because, in her own words, “everyone knows the stock market is going up.”  My colleague concluded that this was a classic signal of a market top and argued to reduce equity exposure.  His views were overridden, but he was able to make a tidy profit by buying some puts in his personal account following this meeting.

Another time in the late 1990s, I spoke at a huge regional conference of stock brokers in Atlanta.  My discourse on the Asian markets was met with polite, but mostly indifferent attention.  The most popular speaker was the young fellow who preached with great enthusiasm the merits of buying tech and telecom stocks.  The crowd was electrified.  One could have mistaken him for Elvis or the Beatles in their heyday.  The next speaker was our biotech specialist who had the best line of the day, “The best TECH stocks are biotech stocks!”  He too had the brokers going bonkers.  The final speaker was the oldest person in my group, someone (unlike the previous speakers) who had actually seen a bear market and understood the concept of valuation (something that was quite out of favor in the late 1990s).  He spoke of the merits of stocks with low betas and high dividend yields.  I thought his remarks were very sensible and intelligent.  The crowd all but ignored him.  I thought this very ironic when after only a few quarters all the tech, telecom and biotech names touted at this conference were down 50-80%, the stocks recommended by the last fellow were all clear winners in a relative sense.  This experience highlighted to me the idea that it is easier to sell someone a stock that “makes sense” than to sell them something that will make them money.

Just recently I heard someone remark that they were buying stocks because they were “the only game in town.” That is to say that the alternatives (cash, bonds, commodities, etc.) were much less attractive.  In my opinion, this is a very tepid reason to buy any investment.  I’ve been of the opinion that stocks have been very attractive relative to bonds, cash and commodities for many years.  There have been times when I felt very much like a voice in the wilderness for my opinion.  There have been occasions when my confidence was nearly shattered by the bearish gyrations of stock prices.  Yet, to this date, my bullishness has been well rewarded.  The stock market has been able to recover from its “Great Recession” lows and have provided healthy returns to investors over the last four years.

Only now, after the market has risen over 100% am I hearing comments like “I’m buying stocks now because they are the only game in town.”  I’m reminded of Sir John Templeton’s oft quoted saying, “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” Perhaps we are seeing this bull market shift from its “skepticism” phase into its “optimism” one.  One can also make the case that individual stories/companies are driving the market more than macro factors.  It’s become more of a “stock picker’s” market.  I still see good upside in stocks from here, but I am keeping a careful eye on retail investor sentiment for signs of euphoria.

I studied Japanese in college.  I’m not sure if it’s this way with all languages, but the Japanese language and the Japanese psyche are deeply intertwined.  In common speech, the Japanese rarely use the pronoun “I.”  It is a language very good at art, poetry, and subtlety.  Directness and absolute pronouncements are harder to come by, both culturally and lexically.  The Japanese use of “hai” (which translates as “yes” in English) to acknowledge understanding instead of marking agreement is one classic subtlety many Westerners have experienced in Japan.

It is no wonder to me that Buddhism took root in Japan.  There is a certain “Zen-ness” I that I always felt whenever I was there.  Studying Japan is where I first came across the notion of a “koan.” According to the dictionary, a koan is a “non-sensical or paradoxical question to a student for which an answer is demanded, the stress of meditation on the question often being illuminating.”  The classic one is “the sound of one hand clapping.” The Western mind will sometimes struggle with this notion.  It may seem to be a waste of time to the action- or outcome-oriented way of looking at the world.

Oh yes, back to the stock market.  My question today (trying my hardest to create a new koan) is “If the stock market rises but no one seems happy about it, can we really call it a bull market?”  In my career, I have never before seen a stock rally so normal, both in duration (four years) and magnitude (up over 100%) that was so badly celebrated.  Take a look at the chart to see what a “normal” bull market looks like…

For nearly the entire duration of this bull market (there, I’ve answered my own question!), retail investors have been net sellers of stocks.  Three of the last four years, the S&P 500 has posted double digit returns.  Every year, there have been corrections; this is normal for bull markets.  This time around, however, each correction was met with vociferous “doom and gloom” pronouncements telling everyone that another global financial collapse was just around the corner.  Meanwhile, corporate profits kept growing and companies continued to make investor-friendly moves (buying back stock, increasing dividends, making strategic acquisitions, etc.) that helped move stocks higher.

Each of these pull backs was a chance for investors who had been sitting on the sidelines with their cash to enter the market.  But most often, the negative noise associated with these corrections was usually sufficient to scare them into inaction.

So how do you feel about stocks now?  I suspect that many people are feeling better about the stock market now.  There are still lots of challenges out there – Europe is still in recession, the IMF recently lowered its estimate of global economic growth for 2013, social and political unrest continues in Mali, Egypt, Afghanistan, Syria and other places, U.S. government debt levels remain high, etc.  One could find ample reason to be bearish now.  Paul Krugman was quoted today saying that the U.S. is still suffering “depression conditions.”  Yet, the mood regarding the stock market seems to have brightened quickly maybe just because the stock market is up.  Retail investors have actually been net buyers of stocks so far this year, reversing a multi-year trend.

So what do I think?  I think it’s a great time to have a well-designed, long-term investment plan, which includes an asset allocation that reflects one’s risk tolerance, and to stick to that plan.  The research clearly shows that the worst returns retail investors can generate involved market timing.  The stereotypical retail investor sells when things look bad (early 2009, for example) and buys when all is clear (now, perhaps?).

Most of the indicators I follow suggest that 2013 could be another pretty good year for stocks.  I would be surprised if we don’t see some kind of correction sometime during the year.  I can still find many stocks trading well below my estimate of intrinsic value.  I even think that lots of retail investors piling into the market now could also provide a tailwind to stocks.  Yet, when everyone starts to like something, my contrarian spidey-sense starts tingling.  Caveat emptor, perhaps?

Last year at this time, I made a number of tongue-in-cheek “predictions,” aimed primarily to poke fun at anyone who makes serious (or takes serious) predictions for the year ahead.  Through this exercise I discovered that I am really quite good at making predictions regarding topics of very little importance.  In this entry I will revisit my “bold” predictions for 2012 and maybe offer a few more for the nascent year.

Here are my predictions for 2012 and my analysis of their accuracies:

1)     The World will not end on December 21^st.  We have a winner!  Did anyone really think that the Mayans (who, by the way, died out long before their calendar did) had any kind of special knowledge about the end of the world?  Easy one…

2)     The U.S. will either re-elect a Democrat or elect a Republican.  Right again!  History does show us that re-electing a Democrat president tends to be good for the stock market.  Time will tell…

3)     A politician will become embroiled in a scandal.  Another bull’s eye!  David Petraeus, Shirley Lasseter, Todd Akin, Eric Holder, Susan Rice, Jesse Jackson Jr., Tim Cahill, Herman Cain – just to name a few.  If Benjamin Franklin were alive today maybe he’d say “There is nothing certain in life but death, taxes and political scandals.”

4)     The markets will continue to display volatility.  Yep – stock prices moved around in 2012.  This chart proves it:

5)     The S&P 500’s return for 2012 will not be 10%.  Most professional equity strategists (who get paid a lot more than I do) predicted a return around 10% for 2012.  I didn’t.  I was right.  The S&P 500 rose 13.4% in 2012.

6)     Most of the predictions about the S&P 500’s returns this year will be wrong. I recall no one predicting a return of +13.4% for the S&P 500 in 2012.  Most forecasts were well below this.  Only a few were above this.  Nearly all of them were inaccurate, in the most precise sense of the word.  To be fair, capital market strategists are paid to create scenarios and offer probabilities for these scenarios.  Serious consumers of their research understand this and use it accordingly.  Casual users (who don’t pay for their research) just look at the year-end target and try to assess the strategist’s worth based on this simple, and somewhat beside the point, data point.

7)     Nouriel Roubini will find a compelling reason to be negative.  He had a couple of real zingers in 2012.  “I think Greece will leave the Eurozone in the next 12 months…” – January 28, 2012.  “… Super-Fiscal Drag in 2012 that ensures double dip (recession)” – November 23, 2011.  There are many more, but so far his “perfect storm” doom and gloom scenarios have not come to pass.  Better luck this year, Mr. Roubini…

8)     The Kardashians will completely shun all media and effectively disappear from our view.  With Kim’s recently announced pregnancy, there is little hope this prediction ever happening.  One bit of good news on this front was an excellent article about a MIT tech guru inventing a new measure for keeping track of how much attention a person, place, thing, or concept garners in the media.  Ethan Zuckerman, the director of MIT’s Center for Civic media, dubbed this unit a “Kardashian.”  Clever idea. You can read all about it (if you dare) here:  http://news.cnet.com/8301-17938_105-57440599-1/measuring-the-tech-world-in-kardashians/

It seems I’ve just about hit my word limit for the day.  I guess I will just leave you all with one prediction – 2013 will be another year full of challenges and opportunities.  It will be a year with various surprises, heartaches and happy times.  But regardless of the outcomes for the year, many of us will find great joy in the journey – just like every year.  Safe travels to all!

It’s a bit of a mystery to me that many people still find value investing so mysterious.  At its very heart is the notion of buying something for less than its true value.  Almost everyone I know likes to buy things when they go on sale, except for stocks.  When stock prices are down, that is to say they are “on sale,” the natural tendency is to sell, not buy.  Funny old world, isn’t it?  Buying in the face of bad news seems to be the most difficult of investment disciplines to acquire.  This is one reason perhaps why so many individual investors, armed only with their common sense and the information flow from the media, tend to perform poorly versus the major indices.

This year, we (my investment colleagues and I) invested in a stock that nicely explains our investment philosophy and practice.  Not every stock we buy will follow this pattern (which is actually a good thing for my blood pressure), but I think sharing this one with the reader may help understand better how we invest.

Sometime in April of this year, I was running my usual screens looking for attractive investment candidates. I use a number of data sorts that can identify stocks that look cheap on a number of measures such as price-to-earnings, price-to-book, price-to-sales, price-to-free cash flow and so forth.  The output from these screens is our starting place in the stock selection process.  Not every stock that looks cheap (inexpensive) should be bought.  Some cheap stocks truly deserve a low valuation.

So in April, I found a company that I had never heard of before.  It was a mid- to small-cap company that looked cheap on a number of the ratios we use.  It operated in a competitive industry, but seemed to have a solid handle on an attractive niche in that industry.  The balance sheet seemed ok and sentiment on the name was mixed.  We usually find these things to be positives as we analyze a stock.

One of our investment policy committee members, ran the numbers, wrote up the report and we discussed the name at length, trying to fully assess the pros and cons of the stock.  In the end, we decided to buy the name, somewhere between $8 and $9, and thought that its “fair value” was around $12.

We started to buy the name with the expectation of making an attractive return.

Very shortly after we started buying the stock, it released a disappointing earnings announcement.  The company was having trouble with pricing, was losing market share and had a couple of other technical issues that were troubling.  Wall Street analysts began to cut price targets and earnings estimates.  Sentiment on the name quickly turned very negative.

We reconvened and reviewed our investment thesis in light of this new information.  After much discussion, we concluded that the news was not a deal breaker and continued to buy the stock.

From early May to early June the overall market struggled and this stock (perhaps because of its now perceived higher risk profile) moved down sharply with the market.  Each week we review the numbers and our investment thesis on this name.  Each week we concluded that the fundamentals continued to suggest a “fair value” much higher than where the stock was trading.

By early July the shares were down about 30% from where we started to buy them.  Although we felt a bit troubled by this move, we continued to buy the stock.  We noted in one of our discussions that the stock, when it was trading below $6, was actually cheaper than the cash on its balance sheet.  The market was practically giving away the stock for free.  And yet, sentiment continued to be very negative and some “experts” were even starting to question the viability of the company as an on-going business.

This was the time that the great investor Sir John Templeton would call the “point of maximum pessimism,” the place that separates good investors from average ones.  Investors who can look this pessimism in the eye and conclude (as we did this time) that the stock should be bought are generally rewarded for their contrarian (and perhaps courageous) stand.

By the middle of July, the market had turned around a bit and so did our little headache.  In late July, we began hearing talk that another company might be interested in acquiring our stock.  The stock moved quickly higher and by September there was an actual bid on the table to take over the company.  Although the deal was a bit complicated, we found it interesting that a bid from a strategic buyer drove the stock price to the exact level ($12) that was our “fair value” estimate back in April.

The chart below shows the trajectory of this stock’s price action.

So here are a few of the key issues about this investment I wish to stress:

1)     No one recommended this stock to us.  We found it on our own, did our own research on it and reached a conclusion that was a bit contrary and wholly our own.

2)     The stock looked cheap in April, but got a lot cheaper before the market (and the strategic buyer) could see its upside potential.

3)     It would have been much easier to give up on this name in May, June or July than to keep liking and buying it.  This would have been a big mistake.

4)     This stock rose to our estimate of “fair value” much faster than usual. This is why I thought it would be an interesting case study, exactly because the time frame was so compressed.

5)     Contrarian investing is not intuitive or easy, otherwise everyone would do it.

6)     We made a very attractive return in this stock.

7)     Your results may vary.

8)      Past returns are no guarantee of future results.

Each month I continue to use my screens searching for the next undervalued and unloved stock.  Each week our committee meets to look at new names and discuss new developments on the stocks we already own.  Every day, I wake up and wonder what new events will affect the markets and my stocks.  It may seem like a volatile and uncertain business to the average (normal?) person, but I really enjoy the entire process with all of its many ups and downs.