Surprise Anticipation

[6/29/07] Schwab research has found that companies that subsequently perform better or worse than current consensus expectations have some distinct traits. As the "Surprise Anticipation Matrix" graphic below illustrates, stocks with low, but rising expectation levels tend to report positive surprises. To identify these opportunities, we look for stocks with traits such as:

• Low price multiples (e.g., low price-earnings ratios and low price-to-book ratios).
  
• Management that is returning cash to investors (e.g. dividends, share buybacks, debt repayment).
  
• Buying by corporate insiders and short sellers (i.e., "smart money" investors).
  Growing free cash flow (definition: cash from operations less capital expenditures and dividends).
  
• Sales growth exceeding asset growth (i.e., improving operating efficiency).
  
• Recent reported earnings above consensus forecasts.
  
• Recent positive analyst earnings-per-share (EPS) forecast revisions.
  
• Recent stock price outperformance vs. overall market.

Conversely, stocks with high but falling expectations tend to report negative surprises. These are often firms with great reputations stemming from strong past performance or firms perceived to have good future growth prospects, but these alluring attributes typically cause investors to bid up stock valuations to levels that leave no room for disappointment. To identify stocks likely to report negative surprises, we just flip the parameters of the criteria listed above.

[5/30/07] Professional stock analysts focus much of their time attempting to forecast companies' future earnings growth. Clearly, perfect foresight of future earnings would be valuable information, but that brings us to our third research principle: The fact that a correct forecast could have value is not sufficient reason to attempt such a forecast—one must also be able to make correct forecasts at a rate higher than chance alone.

To quantify the value of accurate EPS forecasting, a few years ago, Schwab measured the potential returns an investor could have earned with perfect foresight of EPS growth one year into the future. If it were possible in advance to buy the 20% of stocks with the highest subsequent one-year EPS growth, your portfolio would have grown an average of 38.7% annually from 1986 to 2004 vs. only 14.3% annually for all stocks included in our study. By contrast, a portfolio of the 20% of stocks with the lowest EPS growth (a negative growth rate in most cases) would have lost an average of 10.4% annually.

Clearly, accurate EPS forecasting could have a large payoff, but what's the probability of actually making accurate forecasts? Unfortunately, accurately forecasting EPS is extremely difficult. Schwab research has found historically that only 15% of quarterly EPS forecasts are within 1% of actual reported EPS. If at the beginning of each year, you bought the 20% of stocks with the highest consensus one-year EPS growth forecasts, your portfolio would have slightly underperformed the average stock included in our study. In other words, our findings have shown that analyst forecasts have historically been so inaccurate that basing stock purchase decisions on one-year EPS growth forecasts has been a completely futile approach to outperforming the stock market!

Forecast "surprises," not earnings
So if forecasting EPS isn't viable, what should you forecast? It's critical to understand that a company's stock price is based not just on its current fundamentals, but on all expected future cash flows, discounted back to the present according to anticipated risk. In other words, today's stock price reflects consensus expectations of future fundamentals. Consequently, meaningful stock price changes occur only when investor expectations change. And since expectation changes are triggered by the unexpected, a key element to a market-beating stock selection strategy is "surprise anticipation."

Successful equity research must be able to identify stocks that perform better than the expectations embedded in their stock prices at the time of purchase. If your stock picks experience positive surprises more often than negative surprises, you have a good chance to outperform the market in the long run. Unfortunately, investors often fail to appreciate the importance of expectations. For example, they cling to the notion that great companies will be top-performing stocks, forgetting that such greatness is generally already reflected in stock prices.

Surprise anticipation sounds nice, but is it actually possible to forecast the unexpected? The good news is that what is a surprise to most investors doesn't have to be a surprise to you! Behavioral finance researchers have discovered that investor expectations tend to err in two predictable ways.

First, investors seem to believe that successful companies will continue to succeed and that struggling companies will continue to struggle. This tendency to extrapolate past trends drives expectation levels to extremes for many companies. Yet research has shown that the forces of competition typically lead to long-term business success being more likely to reverse than to be sustainable. Therefore, one powerful way to anticipate surprises is to bet on what statisticians call mean-reversion, which is the tendency for high or low values to return to the mean, or average. When investor expectations are extremely low for a stock, you should anticipate future surprises to be positive as the company does better than pessimistic expectations. And when investor expectations are extremely high for a stock, anticipate future surprises to be negative as the company does worse than optimistic expectations.

The second way investor expectations err predictably reflects investors' reluctance to change held beliefs. For example, if a company reports a positive earnings surprise, investors typically notch up their future expectations, but they seek further confirmation by waiting to see if the company can do it again next quarter. Behavioral finance researchers have shown that this "anchor-and-adjust" process creates a tendency for short-term expectation changes to lag behind fundamental reality. Therefore, a second powerful way to anticipate surprises is to bet on systematic underreaction to newly reported information. If recent expectation changes have been positive for a stock, you should expect more positive changes in the near future as expectations play catch-up, but if recent expectation changes have been negative, expect more negative changes in the near future.

We have created a Surprise Anticipation Matrix that encapsulates these general tendencies. As the graphic below illustrates, stocks with low but rising expectation levels tend to report positive surprises while stocks with high but falling expectations tend to report negative surprises.

Schwab Equity Ratings: a surprise anticipation tool
If applying all of these research principles sounds like a lot of work, consider using Schwab Equity Ratings as a time-saving shortcut. Schwab Equity Ratings are, in essence, a sophisticated surprise anticipation tool. Indeed, since the ratings were launched in May 2002, through March 2007, A-rated stocks have reported quarterly earnings above consensus forecasts 74% of the time, while F-rated stocks have beat consensus forecasts only 41% of the time. We believe surprise anticipation is a key reason why A-rated stocks have outperformed the average rated stock by over 5% per year on a 52-week buy-and-hold basis since inception, while F-rated stocks have underperformed by a similar margin.

So in conclusion, successful equity research must be a process of discovering relevant information. When you buy a stock, you are implicitly forecasting that you know something material that other investors don't know. It seems to us that professional analysts who focus their research on EPS forecasting and investors who use those forecasts haven't accepted the fact that earnings forecasts have historically been too inaccurate to be the basis for a successful stock selection strategy. Fortunately, we believe there is a more reliable forecasting strategy available to investors called surprise anticipation.

by Greg Forsythe, CFA, Senior Vice President, Schwab Equity Ratings®, Schwab Center for Investment Research®

[6/14/07] See also Forsythe's article "Are Stocks With High Earnings Growth Good Investments?"

A recent academic paper showed that firms with above-average EPS growth in the previous five-year period were no more likely than chance to deliver above-average EPS growth in the five years that followed.2 Furthermore, since stocks with above-average historical growth tend to have above-average P/E ratios, investors in these stocks often get double-whammied: Not only does expected future EPS not materialize, but P/E ratios contract as investor expectations are adjusted downward to the new reality.

and his article in the Summer 2007 Charles Schwab OnInvesting

Investor expectations of a company's future earnings growth tend to be highly correlated to its past growth. Yet researchers have found that historical earnings growth rates have little ability to predict future earnings growth. Nonetheless, analyst forecasts reflect excessive extrapolation of past growth trends and influence investors to award high (low) price-to-earnings (P/E) multiples to stocks with high (low) EPS growth forecasts. Reflecting this overreaction tendency, research has shown that high P/E stocks tend to underperform as actual results fall short of optimistic forecasts, while low P/E stocks tend to outperform as actual results exceed pessimistic forecasts.

Death, Taxes, and Short-Term Underperformance

Research from Brandes Institute on Death, Taxes, and Short-Term Underperformance. This research focuses on the performance results of a wide range of U.S. mutual funds over the last decade. Observations suggest that underperformance in shorter time periods - such as one quarter, one year, or even three years - is to be expected, even for portfolios that perform strongly over the long term.

DivestTerror.org

What can you, an average citizen, do to help defend America against terrorists sworn to our destruction? How about not investing in them?

A campaign to cut off such investments is gaining momentum. The Center for Security Policy, a Washington think tank, has organized a “Divest Terrorism Initiative” — a campaign to persuade pension funds, college endowments, 401(k) plans, retirement account managers, and individual investors to make sure their money is not used to support regimes that underwrite terrorism.

Highest on the priority list: Iran, Sudan, Syria and North Korea. These countries have been sanctioned by the United States government as sponsors of terrorism, said Sarah Steelman, the Treasurer of Missouri, the first state in the nation whose pension fund has divested from companies doing business with terrorist masters. Investing in terrorist countries is not acceptable to the citizens or the public employees of Missouri.

After the record

According to Standard & Poor's Chief Technical Strategist Mark Arbeter, the technical picture for the S&P 500 indicates the benchmark will probably eclipse its record closing high of 1527.46, set on March 24, 2000, sometime in May or June of this year.

If Arbeter is right (and he usually is) what will that mean for future market action once the adrenaline rush has subsided?

If history can serve as a guide (but remember past performance is no guarantee of future results), we will likely see sub-par price performance in the first month following the setting of a new high, and then find above-average price appreciation in the three and six months after. In addition, the next market top usually occurred around three years after the setting of a record high.

Common Sense buying and selling

James B. Stewart explains his Common Sense guide to buying and selling in his column in the June 2006 SmartMoney.

My traditional focus on buying is one of the reasons that I introduced the Common Sense guide to buying and selling, which has been the underpinning of this column since its inception. At periodic intervals, this system forces me to be disciplined and take some profits when stocks are high. As I've explained in previous columns, my goal is simply to buy low and sell high. When the market drops, I add to my holdings at intervals of 10% declines in the Nasdaq composite index, my preferred barometer. During rallies, I sell some of my stocks at intervals of 25% advances. These numbers aren't arbitrary. They're the midpoints of average bear market declines (20%) and bull market rallies (50%).

Ten Stocks for the Next Ten Years

[SmartMoney Magazine, May 2007] For our 15th-anniversary issue, we've taken what we've learned over the past decade and a half to create another 10-year portfolio. To identify our top-10 stocks this time, we also demanded a demonstrable history of sales growth. Then, as in past years, we sorted through the remaining stocks one by one, looking for common themes that were likely to play out over the next decade. In the end, we identified four themes: clean water, health, wireless technology and global growth.

WATER SERVICES
Fresh water is becoming an increasingly important commodity. Water-infrastructure and water-treatment companies will clean up as emerging and developed economies build and rebuild their systems.

Tetra Tech (TTEK) is a consulting firm specializing in water-resource management and environmental cleanups.

At first glance, you might not think a company that invented a hot-water valve in the early 1900s would be a high-growth prospect for the next decade. But Watts Water Technologies (WTS), which supplies water-control, purification, safety and flow devices to the construction industry, should see strong gains in the years ahead.

HEALTH
Demographics favor medical-equipment manufacturers, from dental equipment to respiratory care to imaging systems. Natural foods, too, will continue to grow as Americans adopt healthier lifestyles.

Sirona Dental Systems (SIRO). It may be that no one enjoys a visit to the dentist, but health- and appearance-conscious baby boomers are sure going.

Viasys Healthcare (VAS) is a cluster of high-technology medical-equipment and diagnostic companies that focus on respiratory care and neuro diagnostics — the monitoring of the brain and nervous system.

OSI Systems (OSIS) is a hybrid medical/defense company, with half of its revenue from medical equipment and half from scanning and inspection equipment and optical gear used by the defense and aerospace industries.

Wherever you run into organic produce, chances are it got there thanks to United Natural Foods (UNFI). The company is the largest national distributor of organic and natural foods, offering more than 40,000 products from 17 distribution sites nationwide.

WIRELESS TELECOM
As broadband-like speeds come to wireless communications, demand for ever more sophisticated handsets and the infrastructure that powers them will drive the industry's next leap forward.

Powerwave Technologies (PWAV) makes the amplifiers, antennas and other equipment that enable wireless phones and handheld devices to transmit and receive voice and data.

Brightpoint (CELL) is the middleman for the wireless industry and should be ideally positioned to profit from its continued growth.

GLOBAL GROWTH
Globalization is creating new opportunities in areas as disparate as market research and global air transport. Our two picks give investors worldwide reach as the global economy grows.

Best known for its Harris Poll, ubiquitous during American election campaigns since the 1950s, Harris Interactive (HPOL) is one of the top 15 market-research firms worldwide.

Atlas Air Worldwide (AAWW) offers an unusual opportunity to profit from growing global trade, a trend we expect to intensify in the coming decade.

Mason Hawkins

Mason Hawkin's six principles than any true investor must have in order to succeed in the long-term:

1. You need a sound philosophy
2. Good Search Strategy
3. Ability to value businesses and assess management quality
4. Discipline to say no.
5. Patience
6. Courage to make a significant investment at the point of maximum pessimism

-- via brknews

Seth Klarman pulled it off

Manager Frets Over the Market, but Still Outdoes It

By GERALDINE FABRIKANT
Published: May 13, 2007

EARNING 22 percent on your investments while holding half of your portfolio in cash is no easy trick, but last year Seth A. Klarman pulled it off, and it was not the first time.

Mr. Klarman, a 49-year-old hedge fund manager, has turned in market-beating performances since 1983, while perpetually warning that the markets were dangerous and that investors should minimize risk.

What is his investment approach? He will not spell it out, although lots of people would like to know. On the Web, the price for his out-of-print 1991 book — “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor” — has gone for $1,200 on Amazon and $2,000 on eBay.

At a time when hedge fund managers seem to be grabbing headlines with stories about their homes, hobbies, philanthropy and outsize compensation, Mr. Klarman keeps a low profile, and is reticent about the investments of his $7 billion Baupost Group of hedge funds, which has been closed to new money for the last seven years.

But his book, his letters to investors and other fund documents provide some clues about his thinking, and he added to the picture in a telephone interview. Mr. Klarman clearly sees himself as a deep value investor, in the mold of Warren E. Buffett or Benjamin Graham, the Columbia professor who pioneered value investing.

He is also a world-class worrier. In one letter, Mr. Klarman said, “At Baupost, we are big fans of fear, and in investing, it is clearly better to be scared than sorry.” In an earlier note, he wrote, “Rather than ratchet up risk, our approach has been to hold cash in the absence of opportunity.”

Last year, the cash holdings of his hedge funds amounted to 49.8 percent of assets, an enormous proportion for actively managed investments, but not an anomaly at Baupost: a year earlier, the cash holdings amounted to 45.8 percent. To add safety to his portfolios, he said that he usually eschews leverage, or debt, in his funds, using it only in some real estate investments. Instead, he has profited handsomely from investing in the debt of other companies, particularly those in financial distress.

Mr. Klarman, who is based in Boston and works with a team of 24 people, does not make bets on the overall market. Instead, his funds look for specific opportunities that he deems worthy. But he warns that Wall Street often tries to sell customers overvalued assets. For example, he said that he is wary of new issues because in the pursuit of large fees, banks may underwrite overpriced or highly risky securities.

Mr. Klarman’s record has generated intense loyalty from investors. Since he began Baupost in 1983, it has posted an average annual total return of 19.55 percent, according to data provided by the hedge fund group. Declines have been posted in only 11 of the total 97 quarters since Baupost’s debut.

In 2006, Baupost’s portfolio held an array of assets, including United States, European, Asian and Canadian equities, which accounted for 17.1 percent of the portfolio; debt and real estate, which each made up 10 percent; and 4.7 percent in private equity funds. And there was that big dollop of cash.

“Seth has a remarkable record, and even more so when you realize that he has achieved it by holding significant amounts of cash,” said Jack R. Meyer, who until 2005 ran Harvard’s endowment, which has been a longtime investor in Baupost.

“In other words, his risk-adjusted numbers are spectacular. What is unusual is the high return and the high cash levels,” added Mr. Meyer, who now runs the investment fund Convexity Capital.

Mr. Klarman grew up in Baltimore, where his father was a health economist. After graduating from Cornell with a degree in economics in 1979, he worked for Max Heine and Michael Price at Mutual Shares for a year and a half, then went on to Harvard Business School, where he graduated with an M.B.A. in 1982. Immediately afterward, four wealthy families, including those of two Harvard professors, put up $27 million for Mr. Klarman to manage.

While his actual compensation has not been disclosed, years of high returns have made him wealthy. Baupost charges a 1 percent management fee on investments in its funds, as well as 20 percent of annual profit. It was managing roughly $6 billion at the end of 2005 — which would mean a $60 million management fee for Baupost. In addition, its 22 percent return on investments last year would suggest profit of about $1.3 billion — generating a 20 percent share for Baupost of about $260 million. The only leverage Mr. Klarman said he used was on the 10 percent of holdings in real estate, where the leverage was one to one.

Despite more than two decades of smart choices, Mr. Klarman seems to obsess continually about potential crises. In his most recent letter, he said that while investors had been upbeat because of relatively low market volatility and inexpensive credit, he was worried about trade imbalances and high levels of consumer debt, which he said could set off market declines. Writing about the stock market rally in 2006, he said: “There was nothing about this party that would have made you want to leave early, unless you were a value investor. The only adverse trend was the scarcity of mispricing opportunities.”

One place in which he said he had found some mispricing was in the shares of News Corporation stock, which rose 37 percent in 2006. While Baupost sold 1.8 million shares last year, at the end of December, it still owned 4.19 million shares, according to company filings. Last week, Mr. Klarman said he believed the stock was still undervalued. He added that he was not concerned about Rupert Murdoch’s bid for Dow Jones & Company, at a price many have described as extremely generous, because it would be a relatively small transaction for a company the size of News Corporation.

Other Baupost equity holdings include Home Depot and Posco, a Korean steel manufacturer, two stocks that happen to be held by Berkshire Hathaway, Mr. Buffett’s company.

Figuring out which distressed bonds Baupost owns is more difficult. For competitive reasons, Baupost does not name the companies, but last year Mr. Klarman told investors that its second-largest single annual gain came from an holding in NationsRent, a company that rents equipment to builders. NationsRent filed for bankruptcy in 2001. The next year Baupost invested about $100 million in the defaulted bank debt.

A year later, NationsRent reorganized. Baupost put in about $50 million in fresh capital in exchange for stock and ended up with a total of more than two-thirds of the stock. Last year, Sunbelt Rentals bought the company for $1 billion in cash and the assumption of debt. Mr. Klarman said that Baupost more than doubled its investment.

In the interview, Mr. Klarman said that he found bankruptcy investing appealing because the process of bankruptcy itself can help unlock the value of an investment.

“There is a catalyst,” he said, “because the way you make money is dependent on specific situations; the bankruptcy process itself will deliver you securities in the reorganized company.”

DESPITE Baupost’s stellar returns, Mr. Klarman’s team continues to take out what he calls “disaster insurance.” Last year it emphasized gold, which would appreciate if the dollar and other currencies declined in value. Although Baupost did not indicate the size of its wager, it did tell investors in one of its funds that 2.87 percentage points of about 20 percent in total fund profit came from a bet that the precious metal would rise. He wrote that gold was underpriced because investors in this “goldilocks” era have not worried enough about currency devaluation.

Baupost has had its setbacks. In 2006 it lost money on an investment in TRM, which operates automated teller machines. “It seemed cheap on cash flow, but its business deteriorated after Hurricane Katrina,” Mr. Klarman said. “It did not turn out to be as stable a business as we thought.”

Baupost has done better with real estate. Last year, Coastal Management Resources, a company in which Baupost has an equity stake, bought the neighboring Cojo and Jalama Ranches north of Santa Barbara, Calif. Although neither the size of Baupost’s investment in Coastal Management nor the purchase price of the ranches is known, the asking price was $155 million.

The ranch purchases may reflect Mr. Klarman’s passion for horses. He has owned racehorses, and even at the track his penchant for details is manifest. One of his horses, now retired, is named Read the Footnotes.

[4/8/08] Klarman can clearly be an active seller of stocks. He sells when a stock reaches fair value, but he also replaces current holdings with better opportunities as they come along. It's not rocket science, but it isn't a strategy most investors follow.

Chasing Performance

Know When to Hold ... and When to Fold

New research turns conventional wisdom - a buy-and-hold strategy is best - on its head.

ANY GAMBLER will tell you never fold with a winning hand. And yet all investors know not to buy a fund simply because it has been doing well. That's called chasing performance, and that's bad. We've said it ourselves countless times. The thing is, though, that advice may be wrong.

No, we're not suddenly advocating jumping on any enticing investing bandwagon. But Dan Weiner, founder of AdviserInvestment, which manages $1.1 billion primarily in Vanguard and Fidelity funds, has quietly shared some interesting research positing that strategic buying and selling of top performing funds can beat the market.

Simply purchase the top-performing diversified equity fund (pick domestic or international, but avoid sector funds) in the past 12-month period. Hold it for one year. Sell it and purchase the new No. 1 fund. AdviserInvestment backtested the strategy on Vanguard funds and found it delivered average annual returns of 20 percent over 10 years, compared with an average of 13.7 percent for the Standard & Poor's 500. Jim Lowell of the Fidelity Investor newsletter, came up with similar results based solely on Fidelity funds. Morningstar found the strategy worked best with domestic stock funds showing a 23 percent annualized return over 20 years, handily beating the broad market's 11.6 percent.

The reason for the phenomenon is simple: Trends don't confine themselves to any given 12-month period. Interestingly, some months seem to be stronger than others. Buying the top funds in June or October worked better than buying and selling in February. If the top-performing fund is closed to new investors, go ahead and buy the second best.

So what might work now? Based on our preliminary look, two good options appear be Fidelity International Small Cap Opportunities (FSCOX) and AIM Trimark Endeavor (ATDAX), a midcap fund.

-- Dyan Machan, SmartMoney, May 2007, page 33

Spike Higher?

[5/1/07] Major stock market tops are characterized by elation, ecstasy, and euphoria - not the fear of falling prices. We believe the combination of a fairly vibrant stock market and rising levels of fear is bullish for stocks, as sentiment gauges are best read from a contrarian perspective. We would use the bear's misguided feeling to our advantage.

One way to gauge market sentiment is to watch the short-interest ratio on the New York Stock Exchange. First, the short-interest ratio is the number of shares sold short divided by average daily volume. This is often called the "days-to-cover ratio" because it tells - given the stock's average trading volume - how many days it will take short sellers to cover their positions. Short sellers are, of course, betting on a price decline.

Since 1994, the NYSE short-interest ratio has oscillated between 3.7 and 7.5. The higher the ratio, the more investors are betting on a market decline. The lower the number, the more investors are looking for a rise in stock prices. The average ratio over this period has been 5.4. We view readings of 6 and above as bullish and readings of 4.6 and below as bearish. The current NYSE short-interest ratio is 7.4, or right near the top of the range since 1994 and just below the all-time high of 7.5 in October 1996.

With the ratio very high once again, and the market doing relatively well, the bears must have a case of severe indigestion and will, in all likelihood, be forced to cover their mistakes at even higher prices, adding more fuel to the fire.

* * *

[4/4/07] Mark Arbeter, S&P Chief Technical Strategist, sees a higher market.

It's not often we predict a spike higher. That fraternity of market mavens who, among other non-bull's-eyes, have called nine of the last six recessions is just not where we'd care to be.

That said, certain technical measures we follow suggest higher prices could be in store later this year.

We're talking about the put/call ratio, which tracks options contracts purchased on the Chicago Board of Options Exchange. Puts are, of course, options to sell; calls are options to buy. The ratio is used widely as a gauge of market sentiment. When there are more calls than puts, Mr. Market is bullish. More puts than calls, and Mr. Market is bearish.

Recently this measure hit an all-time high, suggesting Mr. Market had just taken a room at the Bates Motel — a glut of fear, in other words. Interestingly enough, this occurred during what was by historical standards a relatively modest pullback. This excessive fear is, we suggest, bullish.

And so on.