Monthly Archives: May 2012

Fiscal Cliffageddon

In my mind, it’s a virtual tie as to which scenario is more likely – the end of the world as “predicted” by the Mayan calendar, or the U.S. economy falling off the “fiscal cliff” as “predicted” by just about every economic and capital markets commentator.

If the reader is unaware that the world will end on December 21, 2012 (according to many who claim that an ancient Mayan calendar suggests as much), then congratulations!  Your life is obviously filled with meaningful and interesting activities.  Predictions about the end of the world are just about as old as civilization itself.  They tend to make headlines due mostly to their audacity, but so far, they have all proven to be wrong.  As an aside, I find it somewhat ironic that anyone would trust the Mayans’ ability to predict anything far into the future – they certainly did not see their own end coming…

So what about the “fiscal cliff?”  This is what the pundits are calling the expiration of many tax breaks and other “temporary” factors coupled with another congressional tussle over the debt ceiling.  A report from the Congressional Budget Office this month warns that without any action from Congress, the expiration of the Bush-era tax cuts, the ending of the payroll tax cut, other automatic spending cuts, and changes in tax treatment for dividends and capital gains could severely impact U.S. economic growth.  Some are suggesting that all of these items may shave off 3-4 percentage points from GDP, and given that current economic growth is around 2%, this would “plunge” (to use a favored word of the pundits) the U.S. economy into recession.

The sincerity and gravitas with which the commentators report on the “fiscal cliff” are quite amazing.  We all know that the media (and maybe all of us) loves to see a train wreck.  At the human level, we are repulsed by the tragedy of such events (“Oh, the humanity…”), and at the same time, something deep in the feral part of our brains makes us want to gaze at the scene of destruction.  As Don Henley so tellingly said, “It’s interesting when people die (“Dirty Laundry” – 1982).”

This “fiscal cliff” is not only a train wreck, but one where we know the timing, the location, the magnitude and nearly every gory detail (body count?) long before it happens.  This, in my view, is why it’s getting so much press.

The “fiscal cliff” notion is a classic example of a ceteris paribus (all else held constant) analysis.  All of the commentary on this starts with the word “if.”  “If Congress fails to act…”  “If the President and the Legislators cannot find a compromise…” And so forth.  In my view, these are pretty big “ifs.”

I am not a political expert, but I find it hard to imagine that the U.S. President (whoever he/she may be) or the Congress would want to be responsible for creating a recession simply by fiat.  The more likely outcome, in my opinion, is some sort of compromise that prevents recession, kicks the bigger sticking points down the road and ultimately pleases no one.  Welcome to American politics, my friends!

In all seriousness, if the “fiscal cliff” were a genuine and likely threat to the capital markets, Mr. Market would be saying something about it right now.  So far, I see little evidence that the markets are concerned about this possibility at all.  They are a bit concerned about how Greece will leave the EU – kicking and screaming or head held high.  Either way, the June election there will likely give us all the information we need.

If the markets respond badly to the result, I would view it as a buying opportunity.  On the other hand, the markets may be already discounting this probability.  That’s the tricky thing about predicting the future – it’s so uncertain =)

It’s much easier in my view to buy cheap stocks…

My Take on IPOs

Last week, the capital markets gave birth to the largest initial public offering (IPO) in history.  Although I have no opinion regarding this newly-public company, I do have an opinion about the merits of investing in IPOs.

At the outset, let me disclose that I am not an IPO expert.  I did work for a number of investment banks over the years, but only have direct experience on a few deals.  I actually have more experience as a professional portfolio manager buying IPOs than as a banker issuing them.

Here is a simple rundown of the process.  The management of a private company decides they want to “take it public;” that is, to issue shares to the investing public.  Why would they want to do this?  First, it allows the owners of the private company to sell their firm to the public and actually monetize its value.  A second option would be to only sell a portion of the company.  This would establish a market value for the entire company.   This is what happened last week – the owners of the company were able to maintain a large ownership position in the company, but now they know exactly how much it’s worth.

The company then contacts an investment bank to explore the best way to go public.  The company shares with the investment bank all important financial information to help both parties determine how valuable the company really is.

After this conclusion is reached, they take the company’s management on a “road show,” where big institutional investors (those most likely to buy the shares of the new company) can hear the company’s story, meet management and try to assess the merits of owning the shares of this company.

Investors will submit to the investment bank how interested they are in owning the shares at the IPO price (they actually specify how many shares they want).  The investment banks will determine who will get these shares and then the deal is priced.

Consider that there are three key parties to this transaction – the company, the investment bank and the investor.  Two of these parties have perfect knowledge about the company (they have seen all the important numbers), one (the investor) is allowed to see only a few of them.

Now imagine yourself in a game of poker with two other individuals who have X-Ray vision.  How likely are you to win at this table?  I view investing in IPOs akin to this.  There are two ways I see investors making money in IPOs: 1) The issuing company and the investment banker like you and want you to feel good about them, and thus underprice the deal.  This is one possible reason some IPOs perform very well in early trading – a mispriced deal; the seller was willing to share some of the wealth with investors.  2) The investment bankers simply made a mistake in pricing or assessing true demand for the deal.

I’m not sure I want to rely on either the kindness or mistakes of others to make money in an investment!  I much prefer looking at a company with a long track record and financial data going back a long ways.  I like to see how a stock trades in a variety of macro environments.  I like to see what Wall Street analysts are saying about a company before I invest in it (analysts are prohibited from offering opinions about an IPO).

Every investment contains an element of uncertainty.  In my view, IPOs contain much more uncertainty than a stock that has been public for a while.  As a general rule, I do not invest in IPOs and do not recommend them for my clients.  For the individual investor, it is easy to get caught up in the “story” of the company and ignore critical elements such as valuation, management quality, sustainability of business model, barriers to entry, and so forth.

I wish the newly-public company and all of its investors all the best.  I also applaud the system that allows the creation of an enterprise that has enriched so many hard-working people and provided fun, entertainment and personal utility to millions of its customers.  Bravo!

Why Index (When You Can Pick Stocks)?

I received a call last week from a friend who used to actively help me invest my money.  Because our skills were different, but complementary, we were actually able to help out each other quite a bit.  Time moves on, circumstances change and we find ourselves not working together as before.  As he was looking through some old records, he found a list of stocks I had owned when we were working together.  To the best of my recollection, this list comprised of stocks I owned back in 2007.

During our call he noted the prices of these stocks I’d owned then and their prices now:

Stock              Old Price       Now Price    Percent Change

“A”                 $33                 $69                 +109%

“B”                  $20                 $25                 +25%

“C”                 $12                 $9                    -25%

“D”                 $31                 $39                 +26%

“E”                  $47                 $66                 +35%

“F”                  $44                 $57                 +30%

“G”                 $58                 $87                 +50%

The average return for these stocks is around 35%, which sounds great by itself.  The real kicker was when he mentioned the market’s return over the same period:

S&P 500         $1411             $1388             -1.6%

This last bit of information changed the returns from the stocks mentioned from “good” to “exceptional.”  This simple exercise re-enforced a fundamental and critical idea which lies at the heart of all that I do as a professional investor – “You can beat the market!”

Too many people (in my opinion) have bought into the notion that the efficiency of markets precludes ANYONE from doing better than market returns.  Support for this idea usually comes in the guise of aggregate returns for mutual funds.  Yes, according to these data, the “average” return of all mutual funds can lag the market from time to time.  There are a number of reasons for this (which are beyond the scope of today’s note), but nowhere do the data support the conclusion that NO ONE can ever beat the market.  In fact, these studies show that nearly half of the funds measured beat the market in any given year.

“But”, the skeptic may say, “can anyone beat the market consistently?”  Here too, the data seems to lead one to this conclusion.  The trouble is that most studies will look only at annual or quarterly returns.  I will readily admit that it is nigh to impossible to beat the market each and every quarter and year.  If one is suggesting that “beating the market” means only to outperform it each and every year, then, yes, no one can do that.  But, if it means to have above-market returns for a long period of time, then many, many people do this on a regular basis.

Bill Miller, who worked at Legg Mason, had an epic record of beating the S&P 500 for 15 years in a row.  Many other mutual fund managers and hedge fund managers have 5-, 10- and 15-year records well above the markets’ return.  Saying that NO ONE can beat the market because the AVERAGE mutual fund doesn’t, is like saying no one can make it into Harvard, because the average applicant doesn’t.

So why would anyone want to invest in an index fund that is designed to provide market returns?  First of all, it seems easy.  Stock picking is hard work and not everyone has the time, skill or energy to do it.  Buying an index fund allows one market exposure without having to worry about individual stock selection.
Second, it can be a more inexpensive way to invest.  Index funds usually have lower fees than mutual funds.  An actively managed portfolio, whether it’s a mutual fund or a group of individual stocks, may have higher fees and commissions attached to it.

Third, it seems less risky.  Here is where the water gets a bit muddy.  True, owning an index fund is less mathematically risky than owning one or two stocks, but it may not be less risky than owning a mutual fund or a well-diversified portfolio of individual stocks.  This is simple math.  In the case of my stocks from 2007, owning the market was the more “risky” option.

So what’s wrong with index investing?  In my view, it guarantees that you will not beat the market.  It locks one into a return no better than the broad average.  In a decade like the 1990s, this would have been fine.  For the last ten years, much less fine.

Also, the way an index fund is managed assures that it will constantly buy high and sell low.  That is, it will always be buying more of the stocks which do well (and have become a larger part of the index) and selling some of the stocks which underperform.  To the value investor (like me) this seems exactly wrong.

Now a lot of smart people invest in index funds.  And another bunch of smart people spend millions of ad dollars each year trying to convince the public that index investing is the “best” way to do it.  It may be well beyond my power to “prove” that index investing isn’t a good way to invest, but I am pretty sure that it’s not the best way for EVERYONE to invest.

I don’t do it.  My clients don’t do it.  And maybe, just maybe, everyone who is doing it should make sure they’re doing it for all the right reasons.