Selling Too Early: When Focusing Too Much On Valuation Punches Back Hard

The longer you invest in the public markets the easier it is to identify your past mistakes. While these errors have cost you some money before, hopefully you can learn enough to reduce those losses in the future. Until I reach an age where my memory starts failing me, the cases where I sold too early will be a constant (positive) reminder that getting too worked up about near-term valuations for stocks with excellent long-term outlooks can result in leaving a lot of money on the table.

Back in 2011 I lived in Pittsburgh where my now-wife was getting her PhD. A short stroll from our apartment was a fellow RIA (hat tip to Ron Heakins with OakTree Investment Advisors - hope you are doing well my friend) who organized regular meetings with local investment advisors to share ideas and stay on top of an ever-changing industry. I recently came across a brief PowerPoint slide deck I shared with the group back then over a weekend breakfast meeting at Bruegger’s Bagels. In hindsight, it exemplifies how selling too early for not the best reasons can cause heartburn down the road.

You can view the 5-slide deck on AutoZone (AZO) here and I will summarize it below.

The investment thesis was fairly simple. AutoZone held a strong position in a mature, economically insensitive industry and was using its prodigious free cash flow to conduct massive share repurchases (in lieu of taking the more tax inefficient dividend route). The ever-smaller share count helped AZO turn 7% annual sales growth into 22% annual earnings growth from fiscal 1998 through 2011, propelling the stock price to 21% annualized gains during that time (to $325 per share by late 2011).

Since I thought the trend was likely to continue, it was a worthwhile idea to share with our group. Simply put, AZO appeared to be a wonderful buy and hold stock and with the economic uncertainty still lingering in 2011 from the Great Recession, the business outlook appeared quite resilient regardless of where we were in the business cycle.

I can’t recall when I sold the stock after that, but I can tell you it has been an “on again, off again” investment during the ensuing 13 years for me and my clients, largely due to peaks and troughs in the stock’s relative valuation even as the core underlying story has remained unchanged the entire time. In hindsight, that was not the right call. The correct move was to simply buy and hold.

Despite AZO stock compounding at 21% per year from 1998 through 2011, the 2012-2024 period has seen similar performance, with the shares compounding at 20% per year to the recent price of $3,100. Trying to exit when it was overbought and add when oversold not only added more work than was needed, but also undoubtedly resulted in lower returns over the long term. Lesson learned.

Full Disclosure: No position in AZO at the time of writing, but positions may change at any time

MBIA Shareholders Laugh Efficient Markets Hypothesis All The Way To The Bank

As an active manager of debt and equity investment portfolios it will come as no shock that I do not believe in the efficient markets hypothesis (EMH).

From Investopedia.com:

The efficient market hypothesis (EMH), alternatively known as the efficient market theory, is a hypothesis that states that share prices reflect all available information and consistent alpha generation is impossible. According to the EMH, stocks always trade at their fair value on exchanges, making it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices.

While there are numerous examples that clearly debunk EMH, periodically we stumble upon one so prodigious that it is worth sharing. This week that example is MBIA, an insurance comapny that is seeing its share price rise by a stunning 75% today alone:

What makes this stock, which closed yesterday at $7.38 worth nearly $13 today? A special dividend announcement from the company itself:

You read that correctly - an $8.00 per share dividend to be paid two weeks from now. You don’t see that kind of announcement every day for a $7+ stock.

Full Disclosure: No position in MBIA shares at the time of writing (unfortunately)

Why Market Timing Is Near Impossible

Ever since the meme stock revolution began on Reddit in early 2020 I have seen the same trends that everyone else has; younger investors, new to the scene, trying to day-trade their way to wealth. I would echo the same sentiments as many professionals, namely that having young people engage with the investing community is great, so long as they embark on a strategy for their money that sets them up for success based on what we know works (and doesn’t) from decades of experience.

Early in my career I thought that a modest amount of market timing made sense. After all, when you read that over the history of the S&P 500 index, there is a direct inverse correlation between the performance of stocks in each quintile of valuation (as judged by P/E ratio), or that the index itself does far better when starting from a lower P/E, you can really only conclude that having more cash when the market P/E is high and none when it is low would boost returns.

Personal experience, however, shows that it is more complicated than that. The reason is that the strategy works over, say, 40 or 50 years, but it is less reliable over 5 or 10 years. The problem lies in the fact that you don’t know which specific periods will overperform or underperform (only the end result), and if you miss out on returns due to high cash levels for an extended period, it will seemingly take forever to get back above water.

For instance, let’s say that my investment strategy was to be 25% in cash anytime the market was trading for a P/E ratio of 20x or more. Well, I would have had a ton of cash over the last five years (earning close to zero) while the market nearly doubled. If I am supposed to make all of that money back by going to 0% cash whenever the P/E ratio falls below 15x (in this hypothetical barbell strategy maybe I have 5-10% cash between 15x and 20x), I really need the market to go down soon, but what if the P/E stays above 15x for another 10 years?

Playing the “long-term averages” only works when you can be certain that you will be in the game during the highs and the lows and everything in between. If you start investing at 20 years old and stick to the strategy until you are 70 then it will probably work just as the data suggests. But if you are like the majority of people and are only use the strategy for 10-20 years, it is far less likely to work and requires quite a bit of luck (i.e. through no skill of your own you need to hit the right period where the long-term trend follows perfectly).

Okay, Chad, but what if you mix in some economic observation and forecasting into the strategy? For instance, maybe you can time the shifts in overall portfolio cash position to overall economic conditions. Try to predict when recessions are more likely, for example. Or just reduce cash during recessions to ensure you are fully invested when prices are low. It’s easier said than done.

Let’s assume for a moment that you, unlike most everyone else on the planet, have an uncanny ability to forecast when S&P 500 company profits are going to decline within the economic cycle. You surmise that the market should go down when profits are falling so you will use this knowledge to simply lose less money during market downturns than the average investor.

The long-term data would support this strategy. Since 1960, the S&P 500 index has posted a calendar year decline 12 times (about 19% of the time). Similarly, S&P 500 company profits have posted calendar year declines 13 times during that period (21% of the time). This matches up with the often repeated statistic that the market goes up four years out of every five (and thus you should always be invested). But what if you can predict that 5th year? Surely that would work.

Here’s the kicker; while the S&P 500 index fell in value during 12 of those years and corporate profits fell during 13 of those years, there were only 4 times when they both fell during the same year. So, on average, even if you knew for a fact which years would see earnings declines, the stock market still rose 70% of the time.

So the stock market goes up 80% of the time in general and in years when corporate profits are falling the it goes up 70% of the time. And so I ask you (and every client who I discuss this with), how on earth can anyone expect to know when to be out of the market?

The problem with market timing seems to be that even if you have a decent track record avoiding a high stock market allocation during times of extreme froth and overvaluation, any alpha you generate will likely be completely offset during periods when you think stocks will perform poorly (and are positioned accordingly) only to see them rise instead.

It probably took me 10-15 years of investing experience to fully understand these dynamics and greatly reduce the weight I gave to the data I saw as a young investor that shaped by views for a long time. In fact, I still have a Fortune Magazine article that got me thinking that way. Here is a chart featured nearly 20 years ago:

Note: While this data focuses on individual stock returns based on P/E ratio, the results are similar if you map out the entire index’s performance against it’s aggregate P/E (since the index is just the sum total of its constituents).

Gone are the days that I try to figure out what the market is going to do. If I have a lot of investment opportunities that I like, I will have less cash onhand, and vice versa. Sometimes that will happen to overlap with overall market conditions, but sometimes it won’t and that’s fine by me nowadays.

RIP: Gold

I find it pretty amazing that 2021 did not turn out to be “the year of the gold bug.” You know the long-standing argument for the precious metal; huge deficit spending by the government leads to surging inflation, which in turn leads to a tremendous performance for gold - cementing its place as the dominant inflation hedge. Well, the consumer price index is setting up to exceed +6% for the year, the highest inflation rate in several decades. So let’s pop the champagne for the gold bugs as their bet finally paid off in spades:

Oh. Nevermind, I guess. Couldn’t even muster a gain of any kind this year.

The nail in the coffin for that strategy, I suppose. Hopefully that moment came a long time ago for many people.

The inflation hedge argument never really made sense to me. Over my lifetime, gold has compounded at about 4% annually versus the CPI at about 3%. Store of value? Sure. A hedge against inflation? Not so much, given that its track record is roughly the same as, well, most everything. It would be like saying U.S. small caps are a good hedge against U.S. large caps (the former narrowly outperforms the latter, on average, over the long term). Not a very compelling argument.

So why hasn’t gold done well this year? Others probably have more insight into that than I do, as I neither own gold personally nor in client portfolios. But I will say that I don’t really think demand for gold has anything to do with inflation. The supply of gold is fairly stable and predictable and the same can be said for demand (fairly narrow uses that don’t shift much year to year).

As we have seen in 2021, inflation really boils down to “too much money chasing too few goods.” In other words, strong demand coupled with constrained supply. You seem to need both to be true for prices to materially move above trend. Budget deficit hawks have been predicting inflation for a couple decades now, as government spending has surged this millennium, but price increases actually decelerated (globalism has only eased any potential supply constraints, such that strong demand has been met adequately).

Only with the pandemic and its impact on supply (of materials and labor alike) have prices surged. So within the commodities market, those raw materials that have seen the bigger supply disruption, and that are simultaneously used in the manufacturing of more “stuff,” have seen the biggest price increases. If anything, those are the inflation hedges.

While I suspect the inflation hedge argument will lose steam coming out of 2021, it will remain a part of portfolios for many managers going forward. Despite a down year, the long-term track record still suggests gold is a store of value. It also continues to have a low correlation with other asset classes, if not strong absolute performance, and that will be useful for investors looking to hedge a diversified portfolio over short periods of time. Over the long term, however, allocations to gold are likely to continue to be a drag on overall portfolio performance.

Are Financial Markets Getting Even Less Predictable in the Near Term?

Earlier in my investment management career it was not uncommon for me to raise a fair amount of cash, say 10-20%, in client accounts when I thought the equity market was overheated. The idea was that I would have plenty of firepower when prices dropped and bargains were abundant. Over the years the data suggested that such a move was rewarding, at best, half the time. Too many instances, though, resulted in prices rising enough before they fell that the cash positions at best offered no alpha.

Don’t get me wrong, I have always been in the camp that market timing in the near term is difficult (hence I would never go to 50, 75, or 100 percent cash), but I learned that mean reversion, while a real thing, could not really be consistently exploited profitably even on just a small part of a portfolio. As a result, cash balances in my managed accounts now reflect the number of interesting investing opportunities I see out there, rather than overall market levels.

As I have spoken with clients this year, I think 2021 has solidified the argument against market timing even more, if that’s possible. Profits for S&P 500 companies this year are currently on track to come in roughly 30% above 2019 levels. And that result has not happened because the pandemic suddenly waned. In fact, we are seeing a lot of data that would suggest corporate profit headwinds; retail supply constraints, a lack of qualified labor, and a chip shortage - to name a few - all of which are profit margin-negative.

Despite such strong profit growth, interest rates remain very low with the 10-year bond yield hovering below 1.5%. The end result is an S&P 500 that fetches 23 trailing earnings after surging for most of the year. Who would have been able to predict that? It seems to me even fewer people than would have done so in more normal economic times.

The current inflation story reinforces the point even more; that short-term market movements are getting even less predictable than in the past. And that’s certainly saying something. We just learned today that consumer prices rose by more than 6% in October, a 30-year high. Remember how one of the main jobs of the Federal Reserve is to raise interest rates to keep inflation subdued? Would any short-term investment strategist suggest that 6% inflation would not result in higher interest rates and thus lower stock valuations? And yet, here we sit with the Fed Funds interest rate sitting at zero. Not just an average rate. Not just a below average rate. But zero.

I didn’t come into 2021 trying to predict the economy and the markets and thank goodness for that. For those who still do try that sort of thing, I think 2021 has taught us that a very tough job is getting near impossible, if it wasn’t there already.

So what to do? Throw up our hands, of course. But in conversations with clients I find myself saying “I have no idea” more often than ever. Some may find that disappointing, especially coming from an industry professional, but if my track record predicting stock prices, interest rates, or other economic metrics six months out was unimpressive before the pandemic, imagine how subpar it would be now. I much prefer to just sit back and try to invest in undervalued companies regardless of the macro backdrop and I think my clients are best served by that as well.

Suicide by Robinhood User Shows Some Folks Should Consult With Investing Pros

The stories behind the Robinhood generation of investors is getting worse:

Rookie trader kills himself after seeing a negative balance of more than $700,000 in his Robinhood account

It seems that startups bringing free trades and app-based investing to the uninformed masses might need to be reined in a bit. The narrative in recent years has been that investing can be a low-cost, do-it-yourself kind of thing, where paying professionals a fee is a complete waste of money and only eats into your returns. Of course, that is only true if the small investors have as much knowledge and experience as the professionals and therefore would get zero value from the professional advice (that caveat is rarely mentioned in the same conversation).

Now yes, I am an RIA so I have a dog in this fight and you might say I am just talking my book here. But assets managed by RIAs are growing, not shrinking, and it’s not because the professionals are taking advantage of anyone. There are simply millions of people out there who know they won’t be very successful on their own because they lack the knowledge, time, and/or ability to take emotions out of the equation enough, and therefore they would rather outsource the bulk of the investing work to a pro (and gladly pay for that service). That is not to say that everyone will, or should, fall into that bucket. But many will and if you do not, then great, by all means manage your own portfolio.

Apps like Robinhood that have turned investing into more of a game like Candy Crush are making it easier for novices to venture into waters that are too deep given their background and skill set. As we saw in the story linked to above, such services probably need to have more risk controls in place and higher thresholds for advanced trading strategies (like dabbling in options and penny stocks). Instead, the opposite seems to be happening and they don’t seem to want to take responsibility (at least not yet - maybe that will change).

It reminds me of the social media companies who have created sites where anyone can sign up for an account (without verifying their identify), and then can post anything they want to the world (even anonymously). If bad things happen, the companies claim they are only serving as a platform for free speech and can’t control what people do or say. It seems pretty obvious that such a business model could pose real societal problems, but there was no plan to deal with that side of the equation.

While I can’t control what apps like Robinhood do, I can give advice. And on that front I say that only educated and experienced investors should manage their money entirely on their own without any help. That help can take many forms and does not have to mean you hire an RIA to manage your account for you while you close your eyes and pray for good results. I know myself and many pros that would gladly serve as sounding boards for investing ideas and/or in the role of a second opinion for those who want to make the final calls and actual trades themselves. If you have others to bounce ideas off of and to give you the opposing side of an investing thesis (or explain the downside risks in more speculative waters like options or penny stocks), I suspect your returns over the long term will be higher than they would otherwise. And that is even after you account for any advisory fees you might pay for such advice.

Just some food for thought… please be careful out there everyone.

Pandemic Trading Action Reinforces Importance of Simplifying One's Investing Approach

With the stock market rallying in recent weeks over optimism for a relatively smooth nationwide reopening of the economy, and daily trading becoming a little more calm (day traders speculating in bankrupt equities notwithstanding), I am able to take a breath now that earnings season is mostly over and reflect on the past few months. Of course, a second wave of virus could quickly bring back volatility and fear, but let’s stay positive.

The tables have turned pretty quickly and I am now actually finding opportunities to lighten up on securities that I was buying during the height of the recent market meltdown. As was the case when I was bargain hunting with fresh client cash in March, I am trying to keep things simple.

Take a stock like Starbucks (SBUX). Great business. Blue chip stock that typically fetches a premium (and deservedly so). Today it trades 8% below its February 19th (market peak) level. Seems about right to me, as their business is likely not permanently impaired at all by the pandemic, but sales volumes and margins will take time to rebound to pre-covid levels. At its worst point SBUX was 45% below its $90 pre-covid print, which was most certainly irrational given that about half of their locations remained open during the stay-at-home orders. Buying SBUX in the 50’s was obvious and came with minimal risk. Paring it back in the 80’s seems obvious too.

It can be easy to get stuck in the weeds during massive market drops, but when most securities are on sale, it is best to stick with the simplest stories. Take a company like Bright Horizons (BFAM), a leading daycare provider. Sure it is financially stressing for the company when the bulk of its centers are closed, but the bearish thesis for BFAM over anything but the short term seemed odd at best and downright silly at worst; post-pandemic everybody is going to work from home, care for their children in the next room, and maintain the same level of productivity and/or sanity? I don’t think so. And yet BFAM shares sank from $175 on February 19th to the mid 60’s in March. Down by two-thirds for a leading daycare company with a strong balance sheet? These are easy and simple bets to make if we look out 6 months or a year.

One last example is Vereit (VER) a commercial landlord for single tenant buildings. While tenants like drugstores and dollar stores kept paying, VER still only received 75-80% of contractual rent payments for April and May. Should the stock have fallen on that? Of course. But how much should a REIT fall if they are collecting the bulk of rent and are still fully covering operating expenses and debt service? In this case, investors felt that 65% was the right number, as the stock fell from $10.00 to $3.50 per share at its low point. In fact, the entire real estate universe fell by 50-80% regardless of actual rent collections.

In each of these examples, the simplicity of the story should have given investors a sense of confidence when allocating capital into falling markets. The leading global coffee retailer is a survivor. Parents will keep sending their kids to daycare post-pandemic. A landlord collecting 75% of rent should not see its stock trade down by 65%.

Now, this is all easy to say and harder to do. Did I also find myself delving into more complex and riskier bets, rather than putting all of my capital into BFAM, SBUX, and VER? Yes. Consider taking the plunge into an airline, cruise operator, or hotel company and ask if the undervalued nature of the stock was as easy to see (and pinpoint to an exact figure). It is rare to be able to maintain such focus and discipline and only target the most obvious buys in a sea of bargains. But as value investors when we look back and grade ourselves a year after a bear market, it is usually the case that the simplest stories brought with them the best risk-adjusted returns.

Full Disclosure: Long BFAM, SBUX, and VER (as well as CCL, LUV, and PEB) at the time of writing, but positions may change at any time