Friday, August 19, 2005

fast grower or low p/e?

In seeming contradiction to some of the "value vs. growth" studies noted elsewhere here, Peter Lynch (in his book One Up On Wall Street) states it is preferable to purchase a business at a higher P/E that grows earnings at a higher rate than a lower P/E business that grows earnings at a slower rate.

However the example, as presented in the linked ticonline article (an excellent site by the way), does not demonstrate full [or any] understanding of the issue. Naturally the 15% grower would outperform the 10% grower if the p/e doesn't change! The very reason for buying a low p/e stock is the value investor's expectation that the p/e will rise as the value of the stock is discovered. And the danger of a high growth, high p/e stock is that the p/e cannot be sustained over time.

Let me adjust the example. Let's say the fast grower starts with a p/e of 25 and ends up with a p/e of 20 ten years later. And the low p/e stock starts with a p/e of 8 and ends with a p/e of 12. The 4.05 performance of the fast grower would be cut to 3.24. And the 2.59 performance of the low p/e stock would be boosted to 3.89. In this example, the low p/e stock would outperform the faster grower.

That said, if you can get a high enough sustained growth rate, the faster grower will outperform even with a shrinking p/e ratio. Lynch's actual example is located in the "Some Famous Numbers" chapter, in the section called "Growth Rate". He compares a 20% grower to a 10% grower. The 20% grower handily outperforms the 10% grower even if the p/e shrinks from 20 to 15.

In any case, this interplay between the growth rate and the multiple (p/e here) is at the heart behind the bulk of my investment decisions. The performance of any investment is a function of both growth and value.

Beware of Perfect Earnings

[7/12/05] Another good article referenced from Fat Pitch Financials

I like to look for companies that grow earnings year after year, but earnings can be manipulated. That's why I also like to look at sales and I think I'll start looking more at free cash flow (provided by morningstar). But the point is even those trends don't last forever.

The conclusion: "there are very few really great businesses".

[8/8/05] Gaming a financial statement to meet earnings expectations has its own colorful nomenclature: cookie-jar accounting, channel stuffing and "the big bath."

[8/18/05] Earnings can be manipulated -- and even when they aren't, they can be unintentionally deceptive. No single measure of corporate performance or stock value is perfect or totally tamper- proof. That's why many professional investors look at stocks using several different measures.

a piece of pi from Google

A year after its blockbuster debut as a public company, Google Inc. said Thursday it plans to offer another 14.2 million shares, currently worth about $4 billion, as competition heats up with rivals Yahoo Inc. and Microsoft Corp.

But here's what I found interesting interesting. The exact number of shares to be sold -- 14,159,265 -- happens to be the eight digits beyond the decimal point in the mathematical value Pi. Google's founders, Sergey Brin and Larry Page, were raised by math teachers and studied computer science at Stanford University. (I liked it, but fuddy duddy Kudlow didn't. 8)

Monday, August 15, 2005

Don't Invest Like Peter Lynch

What? Peter Lynch is one of the great investors of all time. And much of my investing philosophy is based on his books. But you shouldn't invest like him says FatBoy. Why? Because Lynch is now investing in (gasp) penny stocks!

One of the his picks is Rainmaker Systems. When I look at the numbers, revenue has slid from 61m in 1999 to 15m in 2004. Net income has never been positive. Accordingly the stock has slid above 3 last year to like a quarter earlier this year. It would seem to me that this is a stock to avoid.

So maybe I should be saying, "I don't invest like Peter Lynch" in this situation. But I'd venture to say it's OK to invest like Peter Lynch -- if you're Peter Lynch (or Gordon Gekko)!

Thursday, August 11, 2005

Unexpected Returns (what drives stock market returns?)

What's the one main driver for stock market returns? It's got to be economic growth, right? Growth is paramount to the increase in stock prices. After all, that's what we're told every single day by the financial media.

Actually, according to a new book by Crestmont Research's Ed Easterling, that's basically wrong. The single biggest determinant of stock market gains is the trend in inflation. His new book, Unexpected Returns: Understanding Secular Stock Market Cycles, is destined to be an investing classic.

Reading further into Bill Mann's review, this book is a follow-up to Mauldin's Bullseye Investing. And if you replace the term "inflation" with the term "p/e" it all becomes a little clearer. The bull market from 1980 to 1999 was driven by a p/e expansion from 7 to 23.

What about now? As expected from a follow-up to Mauldin, the premise is that the current p/e of 20 is still high historically which would would mean a bear market is mathematically likely to follow.

My take is that though the p/e of 20 is high, the current interest rate is still low and so the market isn't all that overvalued if at all. But with the rates still in a general uptrend, that thesis is slowly eroding.

For more, see the article on Vandeberg.

[8/28/05] An article in Barron's makes the same case that "the major determinant of stock-price returns
isn't growth in corporate profits, but rather changes in price-
earnings multiples". I'm trying to verify my own statement above that the p/e expanded from 7 in 1980 to 23 in 1999. The only 23 in the article I see now is that it was the p/e in 1965. Maybe I was confused. Looking at Barra, I see the p/e for the S&P 500 at the end of 1999 was 34. In 1980, it was 9.40. In 1979, it was 7.58. Barra's data goes back to 1977.

[2/23/05] Vitaly Katsenelson looks at Unexpected Returns

Wednesday, August 10, 2005

How reliable are earnings estimates?

[John Mauldin pointed out that] David Dreman pointed out in a study that he conducted from 1982 through 1997 analysts were ON AVERAGE wrong by 200%. (Forbes, July 8, 2002)

Dreman tells us, "Earnings performance for 2002's first half was a sorry one. Company after company was forced to lower expectations or restate past results downward. How can the consensus justify such a healthy-looking multiple for the year as a whole? By forecasting a second-half profit boom that gushes up from nowhere: a 48% gain (from a year earlier) in the third quarter and a 45.7% one in the fourth, according to S&P analysts' forecasts. Included in the forthcoming profit explosion, as reported in First Call, are a 127% income increase in technology stocks in the third quarter and a 73% jump in the fourth and a hardly modest 19-fold rise in transportation earnings in the third quarter (mainly airlines), with an even larger gain forecast for the fourth."

Another longer-term study published by the National Bureau of Economic Research shows that analysts typically overstate earnings by at least a factor of 2. From the report: "Analysts predicted a five-year growth for the top 20% of companies to be 22.4% which turned out to be only 9.5%. [The researchers also pointed out the actual return rate should be lower because many companies actually failed over that period.]

They created sample portfolios based upon analysts' forecasts. Predictably, the top portion of the portfolios actually returned only about half of what the analysts predicted: 11% actual versus 22% predicted. "These results suggest that in general caution should be exercised before relying too heavily on long-term forecasts as estimates of expected growth in valuation studies."

Anecdotally though, it seems to me that the majority of estimates are pretty close. It's fairly rare that an earnings surprise is way out in left field. [Just look at the InvestorGuide reported vs. expected earnings for example.] In some cases it happens, so that would skew the averages. Five year estimates may be something different though. It's pretty hard to forecast accurately five years out. For example, a few years ago they were probably forecasting CSCO to earn 40% a year. Now it's more like 15%.



[9/5/08] Dreman studied and wrote a good deal about analysts and their predictive powers (or lack thereof). In his book "Contrarian Investment Strategies," he wrote: "There is only a 1 in 130 chance that the analysts' consensus forecast will be within 5 percent for any four consecutive quarters. . . . To put this in perspective, your odds are ten times greater of being the big winner of the New York State Lottery than of pinpointing earnings five years ahead."

... [Dreman] used it as a reason to invest in beaten-down stocks. For highflying stocks, a good earnings surprise doesn't help that much, because the stock is already riding on great expectations. A negative surprise, however, can send its price plummeting.

Beaten-down stocks, on the other hand, have such low expectations that a negative earnings surprise won't hurt them too much, while a positive earnings surprise can send them soaring. The message for Dreman: Since analysts are often wrong and earnings surprises are frequent, it makes sense to focus on beaten-down contrarian plays.

Sunday, August 07, 2005

The Case for (and against) Investment Newsletters

[10/29/05] Here's another view of investment newsletters performance. The takeaway? They ain't so hot.

Don't invest in newsletter model portfolio
Special to Coloradoan
Fort Collins Coloradoan
October 23, 2005

I first learned of mutual funds in 1956, as a beginning accountant working for a CPA firm in Hammond, Ind.

One of the firm's clients was Dow Theory Forecasts, founded by LeRoy Evans and publisher of Dow Theory Forecasts investment advisory newsletter. Evans wanted to start a mutual fund using his stock-picking skills. He did - the Dow Theory Mutual Fund. Trouble was, in its short life the fund posted a dismal record. Evans retained financial doctorate degrees from Northwestern University to fix the problem. They couldn't and the fund was eventually sold and merged out of business.

Many readers will recognize the name Mark Hulbert, founder of the Hulbert Financial Digest. The digest begin tracking advisory newsletter performance in 1981 and has 25 years of newsletter history.

Hulbert recently conducted an experiment to determine if some newsletter writers really have special stock-picking skills.

He chose newsletter model portfolios at Jan. 1 of each year based solely on their performance in the previous year.

The experiment revealed that if an investor had followed this strategy beginning in 1992, as of the end of August 2005 (14 years and eight months), the investor would have lost an astonishingly 24 percent annualized.

The total nonannualized loss exceeded 98 percent.

What if the investor chose the best performing newsletter model portfolio over five years?

Hulbert says the investor's portfolio would have gained 5.5 percent annualized compared with the 3.9 percent annualized return the investor would have earned by investing in 90-day treasury bills.

Maybe 10-year model portfolios would show better results. They do, returning 9.4 percent annualized, according to Hulbert. "Not bad," you may think. But the Wilshire 5000 index gained 11.9 percent annualized over the same 10-year period.

Hulbert continued his experiment to see how the best performing newsletter model portfolio in 2004 has performed.

That newsletter is published by Hager Technology Research and Hulbert calculates its model portfolio is down 80.3 percent from Jan. 1 through Aug. 31.

I logged onto the newsletter's Web site. The 20-point type headline reads: "It's official. According to the independent audit of the Hulbert Financial Digest, Fredhager.com has the No. 1 performing investment newsletter of 2004, up 154.8 percent."

Now that is impressive. If my math is correct, a $10,000 investment in the fund at the beginning of 2004 was worth $25,480 at year-end 2004. As of Aug. 31, the value had declined 80.3 percent or $20,460 and the $10,000 investment reduced to $5,020. That is some model.

If instead of picking the one-year best performing newsletter model portfolio you chose the best five-year performing model portfolio, Corcoran's Chronicle, you would have been down 10.7 percent at Aug. 31. The Wilshire 5000 index was up 3.1 percent.

The best 10-year model portfolio with an annualized gain of 11.5 percent was recorded by The Prudent Speculator. Its model portfolio, in my opinion, is only for those who would get into a craps game with strangers. Its volatility is unchallenged.

Come to think of it, many investors might do better in a craps game than investing in a newsletter model portfolio.

Personal financial specialist James L. Watt, CPA/PFS, is a fee-only, NAPFA-registered financial adviser. Reach him at jimwatt100@msn.com or 225-1440.

* * *

[8/7/05] Even though newsletters traditionally underperform the market, I was suprise to learn that individual investors subscribing to newsletters outperform those that don't subscribe. Well, I guess the Motley Fool folks would be happy to hear that.

Shortly after the dawn of the stock market, the investment
newsletter industry was born. Today industry sources believe
there are over 2000 investment newsletters (including online
versions) with total annual revenues in the billions. Below we
will discuss the benefits of investment newsletters and how to
find one that best meets your needs.

Benefits of Investment Newsletters

At the end of the day, the reason to subscribe to investment
newsletters comes down to performance. Studies show that
investors who subscribe to newsletters outperform the average
investor. Unfortunately most investors left to their own
devices follow a scattered approach that leads to sub-par
returns. Whereas investors that subscribe to newsletters are
in affect subscribing to a time-tested investment philosophy.
The philosophy is usually based upon sound investing principles
and gives clear buy and sell signals. Most important are the
sell signals since most investors have difficulty selling
stocks at the right time. If their stock picks are down, then
investors will hold on until the price returns to breakeven
(which almost never happens). Or investors try to ride winners
too long and do not lock in profits. Investment newsletters
provide the holistic approach needed to help investors succeed.

Another benefit of newsletters is value. Consider that
investors keep vast amounts of their wealth in mutual funds.
Unfortunately, as most of you already know, 85% of the funds
underperform the market. And for this sub-par performance,
investors pay mutual funds 1.5% of assets. Even a modest sized
portfolio of $50,000 pays $750 in mutual fund management fees
to underperform the market. Note the average newsletter costs
only $250 per year and provides superior results.

-- Zacks, Profit from the Pros, 1/19/05

I'm not sold on that last paragraph. Though newsletters outperform the average investor and mutual funds generally underperform the market, it does not logically follow that newsletters outperform mutual funds.

[6/1/14 reply to roy]  Most newsletters (and mutual funds and individual investors) don't outperform the market.

Question: Recently I've been reviewing a few financial newsletters that provide market advice. I don't trust most of them but have been intrigued by some. Would I just be wasting my money ($200 or $300 a piece) or could I actually see some better than average returns? How does the current downturn in the economy affect the advice offered by these newsletters?

The Mole's Answer: This is an easy one. You'd be much better off just throwing the money in the nearest dumpster than buying these newsletters and risking a big chunk of your nest egg in following the newsletters' advice.

[6/1/14 update] Consider the 51 advisers out of more than 200 on the Hulbert Financial Digest's list who beat the market in the decade-long period that ended April 30, 2012, as measured by the Wilshire 5000 Total Market index, including reinvested dividends.

Of that group, just 11—or 22%—have outperformed the overall market since then.

***

The Reserve Bank of New York also did a broad-ranging study in 1998 which looked at investment newsletters. This paper analyzes the recommendations of common stocks made in the HFD database from 1980 to 1996. They found that newsletters typically recommend 10-16 stocks. They tend to recommend growth rather than value stocks, smaller than the value-weighted average of market capitalizations. They generally encourage much higher turnover of holdings than found among mutual funds.

In terms of performance, they concluded that:

1) Newsletter recommendations do not on average outperform benchmarks based on market capitalization, book-to-market and stock price. Including trading costs (and newsletter costs), newsletters likely underperform.

***

The Hulbert Financial Digest is a monthly newsletter that serves as an impartial, independent reviewer of all the leading stock and mutual fund newsletter services (publications that recommend and advise on what to invest in). Run by editor Mark Hulbert for more than 20 years, over 180 stock recommendation letters are tracked each month, with data going back as far as 1980 for services that have been around that long. Hulbert's tracking and research shows that 80% of these professional stock pickers can't beat the market indices -- which might make you think twice before paying their subscription fees and following their investment advise.

***

Where's my book on newsletters?  Here it is.  The Wall Street Gurus by Peter Brimelow (1986).  Chapter four is on Hulbert.

"At the end of June 1985, after five years of rating the letters, Hulbert's results looked like this (see pages 68 through 75).  It would be easy to say that these results were devastating.

Saturday, August 06, 2005

How Buffett spends his day

[7/30/05] How does Warren Buffett spend his day? Reading, talking on the phone, and thinking. <!- what do I do? look up these stupid links 8/6/05 -->

"All intelligent investing is value investing - to acquire more than you are paying for. Investing is where you find a few great companies and then sit on your ass.
- Charlie Munger at Berkshire Hathaway's 2000 Shareholder Meeting

[8/31/14 - a slightly different version of the quote:  "If you buy something because it's undervalued, then you have to think about selling it when it approaches your calculation of its intrinsic value. That's hard to do. But if you buy a few great companies, then you can sit on your ass. That's a good thing."]

[8/5/05] Buffett succeeds at nothing (also linked at the temperament entry)

[8/5/05] "Lethargy bordering on sloth remains the cornerstone of our investment style" - Berkshire Hathaway 1990 annual report <!- quoted by Jason Yee in the Janus Worldwide 2005 semiannual report -->

[8/13/05] "You make more money sitting on your ass," Marty Whitman indelicately explained to Jim Grant recently.

Five Steps to An Organized Financial Life

[1/19/09] What records can you really throw away?

[5/25/06] How long you should keep your financial records

[8/6/05] Advice for keeping your financial documents in order

Dump trash-worth documents

Friday, August 05, 2005

Baidu!

Baidu (BIDU) the Chinese Google opened for trading today. It was up 95.54 to 122.54. (Sell-sell-sell?) How did GOOG do on its first day? On 8/19/94, it was up 15.34 to 100.34. How sad.




[8/10/05] three lessons

Still Bubbling (says the Fed Model?)

Using the median p/e, Arnold Van Den Berg asserted (over a year ago) there is little upside to the market.

When the article was written, the median p/e was 19.5 compared to the highest peak ever at 20.7. So he's saying there is little upside and substantial downside.

However Arnie is using a bond rate of 6.75% in his model which would translates to a 15 p/e. If you take the 10-year tnote rate of 4%, you'd get a p/e of 25. [Today's Schwab Alerts says the 10-year bond yield is now up to 4.4%, the highest in four months. That works out to a p/e of 23.] [Here's one guy, Ed Keon, who interprets the Fed model as being bullish.]

I don't have answers for his other bearish arguments though. The market cap / GNP ratio chart looks especially scary.

In any case, even if the market is high, money can be made in individual situations. As Cramer always says, "there is always a bull market somewhere."

Monday, August 01, 2005

Orphan Stocks

According to a study that tracked more than 5,000 orphan stocks (stocks that trade under $5) over the course of 11 years, these unloved babes have less than a one-in-eight chance of recovering to above $10. Ever.



how to calculate your return

[8/1/05] follow-up




[1/8/05] Here's how to calculate your annual return.



And here's how the mutual funds do it (part 1 and part 2)

Is the run in Small Cap stocks over?

[7/31/06] The latest reign of small-cap outperformance peaked at 85 months in March, closing in on the longest run of outperformance (small caps for 88 months from 1983-1990) since the creation of the Russell indices in 1978. As a result of the weakened relative performance, and not at all surprising, mutual fund flows have followed suit. The Leuthold Group estimates a $3.3 billion net outflow from small-cap equity funds in June, compared to a $1.2 billion net outflow in May.

[7/30/05] Maybe so. But Mauldin may have been a little early as he was writing about it three years ago.