Buffett Record is One Thing, Outlook Quite Another

Before you go out and buy a stock simply because Warren Buffett either has owned it for a long time or recently purchased it, consider the following quote from his letter to shareholders, released yesterday."

Expect no miracles from our equity portfolio. Though we own major interests of a number of strong, highly-profitable businesses, they are not selling at anything like bargain prices. As a group, they may double in value in ten years. The likelihood is that their per-share earnings, in aggregate, will grow 6-8% per year over the decade and that their stock prices will more or less match that growth."

What should investors gleam from this statement? Should they take it at face value, or just assume Buffett is being modest and trying to keep expectations low so he can exceed them more easily? If you are one of the many people who have asked me about my views on some of his larger holdings in recent months, you already know where I stand on this issue. Take what Buffett says as the truth. His days of drastic outperformance are long over.

Consider Berkshire Hathaway's performance in 2005; up 6 percent using the metric Buffett prefers. That compares with 5% for the S&P 500 with dividends reinvested. A solid year, but hardly something that one should bend over backwards to mimic. It also is right around the 7% estimated growth rate he offered in his letter.

Consider Berkshire's largest holding as of December 31st; more than $8 billion dollars of Coca Cola (KO). Coke stock has been dead money for 10 years, even as the S&P 500 has nearly doubled, as the chart below shows.

I will repeat here what I have told those who have asked. I would not expect shares of Berkshire, or Coca Cola, or Anheuser-Busch, or Wal-Mart, or Proctor & Gamble, or Washington Post, or any of Buffet's other large holdings to make you rich from here on out. They were all great buys at some point in time, say 15 or 20 years ago, but now they are richly priced, even as growth prospects have diminished greatly as they have grown into industry behemoths.

Why then does Buffett continue to hold these stocks, even if he only expects them to return 7% per year? The answer lies in the fact that he has said his ideal holding period for a stock is "forever." If I was to argue with Buffett on one aspect of his investment philosophy, that would most likely be the one I would choose. Holding a stock "forever" will ensure you own it during both the good times and the bad times. The latter is something investors should strive to avoid.

A.G. Kicks Abercrombie While It's Down

Despite today's downgrade from "buy" to "hold" by A.G. Edwards (point "B"), I still view the recent weakness in shares of Abercrombie and Fitch (ANF) as an excellent entry point for investors. As you can see from the chart below, A.G. has hardly been adept at calling the direction of ANF stock. They put the "buy" recommendation on it in June 2005 (point "A") and within weeks the shares began a freefall from over $70 to under $45 in less than two months. If I'm right that Abercrombie will rebound later this year, this will be just another example of analysts urging clients to buy high and sell low.

Intel vs AMD

Since a reader brought up Intel (INTC) in a comment on my prior post, I decided to take a closer look at the history of the Intel vs Advanced Micro Devices (AMD) battle. It seems to me that whenever AMD was successful taking share from Intel, and the stock price outperformed, it was a short-lived phenomenon. The chart below comparing Intel and AMD since 1998 does a great job showing visually the cycle I referred to in response to Simon's comment in my prior post.

AMD taking share from Intel, and the resulting stock price rally, is something have happens fairly regularly. However, the chart shows that when AMD takes off it rarely can maintain the business momentum (due mainly to Intel's high responsiveness to such events), and when optimistic profit estimates aren't reached, the stock comes tumbling back down to earth. Could history repeat itself? I tend to think it will, although the timing will not be easy to pinpoint.

WSJ Exposure and a Stock Pick

Thanks to Kevin Delaney and the rest of the team at The Wall Street Journal for featuring me yesterday in a front page story about my trading in and views on Google (GOOG). It certainly made for a fun and eventful day, most notably a full inbox and a phone ringing off the hook. If you would like to read the story, it can be accessed through wsj.com in addition to March 2nd's hard copy. I also have an electronic copy if you aren't a WSJ online subcriber, so email me if you'd like a copy.

On to the market. I have been pleasantly surprised how well the market is acting so far this year. I am tempted to take some money off the table, but the momentum is clearly strong right now. Hopefully nothing will get in the way of that. What do readers think? Feel free to comment.

As for specific stocks, I would suggest investors take a look at Abercrombie and Fitch (ANF). The stock was down $6 yesterday after weaker-than-expected same store sales for February. A lot of hot money was in the stock, so the decline may have been more than normal. Keep in mind that SSS were still up more than 5% for the month, and February is the second least important month of the year for retailers. The stock looks very cheap down here under $60 per share.

Analyst Costs Sherwin Williams Investors

If you read this blog regularly you know that I don't listen to sell side research analysts. Upon hearing this I often get strange looks from prospective clients until I explain why. It's pretty straight forward actually; analyst stock picks won't make you any more money than a monkey will throwing darts at the Wall Street Journal stock tables.

Today's example comes to us from Eric Bosshard, the FTN Midwest research analyst who covers Sherwin Williams (SHW). Collectively, Wall Street analysts were fairly bullish on Sherwin Williams coming into February. Of 9 analysts who follow the company there were 6 buy ratings, 3 holds, and no sells. Shares of SHW closed February 1st at $54 per share.

Last week, SHW and other paint makers lost a lawsuit claiming public nuisance for selling lead paint in Rhode Island in the 1970's. Shares of SHW tumbled to as low as $37.40 last Thursday, before rebounding to close at $45.55 yesterday. As the stock fell from $54 to $37, nobody upgraded the stock to "buy". Now we can say the lawsuit uncertainty prevented them from recommending the stock, but very few people could make the case that a public nuisance verdict against SHW should cost the company 31% of its market value in a single day.

There was one analyst who changed his rating. Eric Bosshard of FTN Midwest pulled his "buy" rating on Thursday morning. As you can see from the chart below, his call marked the bottom, and it quickly rebounded more than 20 percent in a matter of days. I don't want to even think about how many people sold Thursday morning after his call.

This type of story plays out all too often on Wall Street. What's worse is what will likely happen from here. Afraid of looking like an idiot, Bosshard will probably keep his "hold" rating, hoping for further downside that will vindicate his call. The stock will continue to rise and eventually get all the way back to its old highs. With the problems in the past, he'll recommend the stock citing "diminished uncertainty surrounding the Rhode Island verdict". FTN Midwest clients will have bought high and sold low.

Perhaps what's most striking about this story is the fact that on the very day that FTN downgraded the stock, Sherwin Williams insiders, including Chairman and CEO Christopher Connor, were buying shares in the open market. Pretty ironic if you ask me.

Why Large Caps Are Lagging

For years large cap stocks have been trounced by small and mid cap stocks. Coming into 2006, most experts were predicting a move toward large cap outperformance. So far though that has yet to come to pass. In fact, the Russell 2000 small cap index gained 10 percent at the outset of the year, about triple the gain of the S&P 500.

Now it is true that historically larger companies do not advance as much as smaller companies. Small caps do best, followed by mid caps, with large caps bringing up the rear. This trend though has been even stronger than normal in recent years. Why is this true, and will it continue?

Stock prices in general are richly valued today, based on price-earnings ratios. As a result, stock price appreciation has not come from multiple expansion this decade, as it did in the 1990's. Rather, earnings growth has been the only way to see outsized share price gains as multiples have either remained the same or contracted.

Common sense tells us that small and mid cap stocks will have an easier time growing earnings. After all, they are growing off a much smaller base of business. A $100 million company need only add an incremental $10 million in business to grow 10%, but Wal-Mart needs to add tens of billions of dollars in sales to reach the same level of growth.

Will small caps and mid caps continue to outperform? Over the long term, absolutely. However, the gap in performance may not be maintained at the levels seen in recent years. As you can see from the charts below, small and mid cap stocks are soaring, hitting new all-time highs

S&P Mid Cap Index (MDY) vs S&P 500 - 10 Years

Mid cap stocks have doubled the returns of large caps over the last decade.

Russell 2000 Small Cap Index vs S&P 500 - 3 Years

Small cap stocks have also outpaced large caps by a factor of two..

Equal Weighted S&P 500 vs Market Cap Weighted S&P 500

Even the smaller stocks within the S&P 500 index have outperformed the mega caps that dominate the index.

Housing Inventories Hit Record High

"The backlog of unsold new homes reached a record level last month, as sales slipped despite the warmest January in more than 100 years. The Commerce Department reported Monday that sales of new single-family homes dropped by 5 percent to a seasonally adjusted annual rate of 1.233 million units last month. That was the slowest pace since January 2005 and left the number of unsold homes at a record high of 528,000."

The housing boom is over folks. Inventory data is crucial for real estate. There is no magic formula for calculating fair value of residential housing. You can't run a discounted cash flow model, or dividend discount model. Housing prices are simply based on supply and demand. And supply is at an all-time high.

Even here in St. Louis, hardly a booming market, I am seeing more and more houses going up for sale, even though others have been on the market for months. Mortgage rates are up and millions of ARM loans readjust this year. Home equity loan rates are also on the rise. Fed Funds will hit 5% this year, which puts the prime rate at 8% and most home equity loan rates at 9%.

It's not a complex scenario. Supply is high as the inventory numbers show. Interest rates, the cost of money, are going up and will adversely affect demand. Not a good combination. Housing stocks may look attractive with low P/E ratios, but don't forget why housing stocks always have low multiples; because the cycle always ends.

It's Tough Not To Like These Guys

For those of you who follow energy companies, and Chesapeake Energy (CHK) more specifically, I highly recommend you listen to the company's fourth quarter earnings conference call that was hosted this morning.

The company's shares have been weak lately as natural gas prices have been cut in half and the company's co-founder and chief operating officer, Tom Ward, suddenly announced his retirement from the company at the fairly young age of 46 years old.

I can't recall a more impressive conference call this quarter. They even had Ward on the phone to address any concerns over his unexpected departure. You don't see that type of focus on shareholders' interest every day from management teams of publicly traded companies.

Loyalties Aside, ESRX is Bloated

Shares of my former employer, Express Scripts (ESRX), a leading pharmacy benefits manager in the U.S., are going to fall a few points this morning. Earnings reported last night were 2 cents above expectations but the momentum traders wanted more.

Express Scripts had beaten estimates by a fairly wide margin in recent periods, and bulls were undoubtedly hoping for another "beat and raise" quarter. They got the "beat", but not the "raise".

Full year guidance remained at $3.10 to $3.22 per share in earnings. ESRX rarely misses guidance, so they will be fairly conservative. They don't raise guidance often, and when they do, it's usually only once per year.

At $93 per share, the stock was trading at 30 times 2006 earnings coming into the latest report, historically an astronomical multiple for a PBM company. It's true that accretive acquisitions are boosting growth rates above competitors like Medco (MHS) and Caremark (CMX), but 30 times earnings for ESRX is too rich, in my view.

As a result, profit taking is in order, and investors have already begun that process this morning.

Rising Commissions? Since When?

I had to double check to make sure what I heard over the weekend was correct. A.G. Edwards (AGE), a St. Louis based firm with 7,000 brokers nationwide, is planning to raise their commissions by 5 percent beginning on March 15th. In addition, their postage and handling fee is jumping 10 percent to $5.50 per transaction. Yes, that is correct. The company will charge customers $5.50 to mail them each trade confirmation. BrownCo actually only charges $5 to make a trade, so you can see how out of whack these fees really are.

Amazingly, full service brokers continue to thrive, even when they are ripping off millions of investors. AG Edwards stands to bring in an estimated $50 million in incremental revenue from the price hike, as they generate $1 billion per year in commissions (40 percent of total sales). Now I understand investors take comfort in having a personal broker with whom to work with, but at what point does one think twice about paying these astronomical fees? After all, it costs next to nothing to execute trade, which is why discounters can charge less than $10 and still make a lot of money.

The statistics have shown that analysts aren't good stock pickers (sell-side research generates the investment ideas brokers in turn recommend to their clients) and the majority of mutual funds lag the market, so the buy side isn't that great either. Meanwhile, discount brokers now offer all kinds of stock research reports, the same research high-priced brokers are using.

Why then are investors content to pay a 2 percent commission to full service brokers? Think about it this way. Let's say you hold your average stock for a year. If you are paying 2% when you buy it and another 2% when you sell it, you're 4% behind the market's return assuming your stock picks are average performers.

With valuations where they are today in the U.S. stock market, the S&P 500 is likely to only average a mid-to-high single digit annual return for the rest of the decade at least. So, a full service brokerage customer is going to make about 4% per year net of commissions if the market returns 8% per year. Mutual funds will return about 7% in such a scenario, but transaction fees and loads could take that number even lower. No wonder index funds have become so popular. Compared with actively managed mutual funds and full service brokers, they are often a better option.

This current state of the investment advisory industry is exactly why I started Peridot Capital Management. The average mutual fund investor is going to underperform. The average stock broker is going to underperform. Investors who pick their own stocks often buy what they know and like, paying no attention to valuation. In doing so, they buy overpriced blue chips stocks that have done wonderfully over the last twenty years, and as a result, are set to underperform.

Unless you can earn above-average returns on your own, index funds are the best option of the four most common investment options, but by definition you can not outperform by owning them.

The answer, at least in my eyes, is pretty simple; investing with superior independent research from a personal investment manager, who is not working on commission, through an online discount brokerage account. Hence Peridot Capital was born.