Investing like the rich…

While my opinion often differs from Michael James, I appreciate his perspective. I particularly enjoyed his post on investing like the rich. He makes two valid points: the rich (generally) didn’t make their money in the stock market and they aren’t necessarily successful when investing in the stock market.

This is no secret. I’ve read a number of books that have pointed this out. Think about any successful person you know. How did they make their fortune? Almost all of them made their money by owning or running a business. A single business, without diversification. That investment of time and energy, if not capital, provides an investment that is understandable and is under the control of its owner. All the information about operations and results is available, and the owner can make whatever changes he sees fit.

When the owner sells his business, the question becomes: what to do with that money now? Buying businesses makes sense and is probably comfortable for the prior business owner. Buying a share of a business is exactly what the stock market is for. The business owner is then able to put their capital to work, spread the risk across a number of ventures, and continue to collect business profits (as dividends).

The problem arises from the differences. First, ownership through shares is totally hands off. Complete information isn’t always available (although, to be fair, many companies make an effort to provide clear and complete information), and the influence of shareholders over operations is at best indirect. Once a portfolio of businesses is collected, generally more than 20, it becomes very complex to stay abreast of all the information and external conditions affecting the portfolio of businesses.

If the rich were to treat their stock investments the way they treated the businesses in which they made their fortune, they would be more successful. It would certainly go against modern portfolio theory, and the sales pitches of large financial firms. How do they hire people? They look at qualifications, experience, ability and they measure results. How do they ensure their business is on track? They are involved on a regular basis, and they set and meet targets. Finally, they don’t buy and sell their own business on a regular basis.

If we invested the way the rich run their business, I think we could expect better results. That’s why I own a small number of business, trade infrequently, read financial statements and participate in conference calls. I also don’t expect every quarter to be better than the last. The economic environment, as well as the individual company context, fluctuates over time. I expect results to deteriorate and improve over time. For this reason, it doesn’t make sense to jump in an out of a company’s shares except in response to opportunities that arise from price fluctuations.

I try to run my investment portfolio as a business, where I hire managers to function on my behalf and to be accountable to me (within reason). If I lose confidence in a company, I will sell it, and find another company I can depend on to produce results. This can be complex, since there is an interplay between the various businesses I own (they react differently and on a different timeline to external forces), as well as the impact of price movements in the marketplace.

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Market Outlook November 28, 2011

Not good. That’s basically the market outlook, summed up in two words. The fact that I’m summing up my market outlook in two words shows that I’m tiring of watching the market. But the market doesn’t care whether or not I’m ready for some good news, the bad news just keeps rolling in. I don’t see bad economic news, because corporate earnings appear to be holding up. Rather, it’s uncertainty and a lot of “what if” followed by negative scenarios. While that certainly translates into lower stock market prices, it also means that the market will turn, not on company performance improvement, but on sentiment improvement, which can be quicker, but also more volatile.

Given three weeks of negative stock market performance, stocks appear much less attractive than bonds. That was already the case, but it is even more pronounced than at any time since early October. That doesn’t mean the outlook for the economy isn’t good (it may or may not be), but that the prevailing attitude toward equity ownership is negative. A traditional portfolio should remain underweight stocks and overweight bonds. A more adventurous portfolio should focus on owning gold (IGT).

The stock market appears more undervalued now, at 7.5% below my fair value estimate, than it has in recent months. Corporate earnings are supportive of a stock market value between 9,600 and 16,000, depending on outlook. The mid-point is 12,400, with the market level at 11,500. It could always go lower, but it appears cheap at the moment.

Money

I admit, I got sidetracked. Instead of writing a blog post for today, I read everything on this chart:

http://xkcd.com/980/

It reminds me a little of an Andex chart, in that it’s packed with too much information. But in this case, the information is way more dense. The artist listed 5 (6) things that he learned in researching the chart. Here are five things I learned:

  1. A dinner at McDonald’s is cheaper than a homemade chicken dinner, or even a homemade dinner of pinto beans and rice, if you include shopping for two hours, travel, prep and cleanup (at $16.27/hr). The moral: don’t shop every single day.
  2. Between 1965 and 2007, worker compensation has remained constant, after adjusting for inflation. CEO compensation, conversely, has exploded. In 1965, a CEO earned 25x the hourly wage of a worker. In 2007, the CEO earned 275x the worker’s wage.
  3. In America (and probably across Western democracies), the government taxes the rich more than the poor, but FAR from proportionally to their income generation.
  4. The American government currently funds about 40% of its spending programs using debt. On a related note, Canada has a little more debt than the US in proportion to GDP.
  5. The combined pay at banks and Wall Street firms is about half of combined teachers’ salaries. In a similar vein, government spending on K-12 education (in the US) is less than a third of total spending (including privately) on health care.
  6. In the US, the government consumes almost 14% of GDP. In contrast, education costs 1.1% of GDP.

Market Outlook November 21, 2011

Volatility remains persistently high, closing the week at 32. I’m less concerned by the level, but more concerned by the fact that it is not trending downward. Stocks lost more than 3% this past week, moving the market valuation to a level where it appears undervalued. I had thought that stocks would continue their recovery on a fairly smooth trajectory, but that has not been the case. The market seems to be predicting corporate profit growth of less than 0% (-0.87%) over the next 12 months.

Bonds continue to have the greater momentum, and a portfolio that is balanced between stocks, bonds and cash should still be overweight bonds. Among all asset classes (that I track), gold (IGT) continues to present the best prospects. Other assets sometimes have a couple weeks of growth, only to reverse direction and give back the gains.

While I’m not ready to commit money to equities by selling gold, the market looks cheap. Investors who are patient, with a long time horizon, or who don’t mind watching their investments go down before going up, may be wise to buy now. The markets have already made a low on Oct 4 (of just under 11,200) and seem to have reversed course and begun the recovery. There are plenty of bargains, for those with the stomache for them.

Stock Market Rhythms

Ned Goodman, long-time professional investor in Canada, likes to say that history may not repeat itself, but it often rhymes. There are many views that, while history may not predict the future, we can learn from history. There is also a sense that, when investing, timing is important. Here are various perspectives on the rhythm of market movements.

Wave theory exists on a number of scales. The Elliot Wave Theory, for example, suggests that patterns exist in scales of decades, years, months, days, hours and minutes. Further, it suggests a regular up-down-up pattern.

Technical cycles suggest that the market changes direction or changes rhythm on predictable timeframes. These might be cycles of 21 days and 105 days, or it might be cycles (based on moving averages) of 50 days and 200 days. Looking at these timeframes will help a market watcher to predict how long the current trend will last, and whether the trend is likely to reverse itself.

On the one hand, these cycles may have a base in human psychology. People tend to change their mood based on their circumstances, their environment and the moods of others around them. This is demonstrated in seasonality and herding in the market. On the other hand, our human brains are basically sensitive pattern-detectors. Because we are so determined to find patterns (which easily compress, to save memory and decoding effort), it becomes easy to see patterns even in randomness. It is very difficult to know whether cycles exist, possibly due to human behaviour, or whether we are finding patterns in noise.

Another example of the rhythm of markets is trading time. I first heard this term used when reading the work of Benoit Mandelbrot. According to Mandelbrot and consistent with my experience, time isn’t experienced as a uniformly advancing phenomenon by stock traders. Certain events cause time to speed up or, rather, for more actions (trades) per minute to be effected. These may include a news item, a corporate action, such as a merger, the publication of a revised forecast or a financial document. It might also be in response to other actions in the market, such as a sudden large buy or sell order or a change in price of the shares of a competitor. Traders will review this information and (more or less) quickly decide whether or not to act based on the new information.

When a person is considering investing in the stock market, they should start small and come to understand the rhythms of the market and of their specific stock picks. Individual companies may have a unique rhythm, based on earnings reports, changes in outlook, news items and large trades or participation in the market of strong and weak traders. This is the kind of benefit that comes from experience and can help a person gain a small advantage.

Market Outlook November 14, 2011

I had hoped for better. I was really hoping that after September and October ended, the high volatility and negative stock market performance would end also. Historically, the period of November to May has been relatively strong for stock markets. That doesn’t mean that they turn on a dime, switching from negative to positive as the calendar turns from October to November. But volatility remains somewhat elevated (between 30 and 35, where 20 is normal during a bull market), likely due to uncertainty around the situation in Europe in general and in Greece in specific.

Another sign of the prevailing lack of optimism is the fact that the stock market is discounting 12 month earnings growth of just 3.1%. Remember a year ago when they were discounting earnings growth of 30% and 40%? I suggested at the time that it was possible, and a few companies have achieved it. But not all companies have enjoyed continuous economic growth, and there is still much uncertainty about what the next 12 months will bring. This translates into P/E compression, which explains why some companies, such as the banks, are trading with relatively low P/E ratios (under 12) and high dividend yields (near 5%).

Stocks ended the week lower in value than they began the week. The negative return impacted the momentum, where bonds continue to hold favour. In fact, gold (IGT) continues to offer the best momentum out of the asset classes I watch. Others continue to be positive, but gold appears the most favourable.

Per stock momentum

I’ve been watching the momentum of different asset classes, in order to determine what to own. So far, it’s worked extremely well. When stocks aren’t in favour, investors may profit from owning bonds or gold. When bonds are out of favour, and investor might do well by owning large cap stocks, small cap stocks, or emerging market stocks. Each of these asset classes tend to move differently.

Individual stocks don’t seem to necessarily move differently, in the way that asset classes do. Large cap stocks all tend to move with the market, except when news is reported that affects earnings or expected profitability. As I applied my momentum methodology to large cap stocks, I found very few stocks that moved differently enough that I could form a portfolio. When I did, the portfolio had high turnover (short holding periods) and disappointing performance.

By owning 5-8 stocks over a period of a month and a half, the large cap stocks that I picked and traded, based on momentum, have under performed the TSX by over 5%. But what was worse was noting that certain stocks moved from in favour to extremely out of favour, and then back in favour over a small number of weeks.

Perhaps the issue is the ranking formula I used. I ranked all the stocks against each other, giving equal weight to fundamental criteria (P/E and debt-equity ratios) and momentum criteria (price growth) which overweighted recent time periods. The goal was to benefit from both value and momentum styles, but the results have been disappointing. Perhaps removing the value screen and investing purely by momentum would yield improved results.