Warren Buffett, arguably the most famous investor in the world, believes there are only two rules to investing: 

• Rule #1: Don’t lose money, and
• Rule #2: Don’t forget rule #1.

These rules serve as the premise for a new book by Phil Town entitled “Rule #1” (Crown Publishers, 2006). Town, a former Green Beret and river guide turned investor, believes that individuals can follow Buffett’s Rule #1 of investing by investing in wonderful companies at attractive prices. Following the principles of Rule #1 Investing, Town claims to have turned $1,000 into $1 million in five years.

AAII has developed a new screen based on Town’s methodology as outlined in his book. The screen is part of the AAII Stock Screens series. On a monthly basis, AAII.com lists the companies passing the AAII Stock Screens, and tracks their performance in hypothetical portfolios. [If you are interested in a detailed discussion of developing this screen with a computerized stock screening service, especially with Stock Investor Pro, you may wish to read the article in the September/October 2007 issue of Computerized Investing.]

The Philosophy

Town believes that many individuals have been “scared off” from investing their own money. Instead, they choose to invest their money with professional money managers, typically in the form of mutual funds.

According to Town, this has come about because the financial services industry perpetuates three myths to protect their business:

1) You have to be an expert to manage money;
2) You can’t beat the market; and
3) The best way to minimize risk is to diversify and hold for the long term.

However, Town feels that the Internet “has changed everything,” and that today individual investors can find accurate and timely information on-line, often for free, which eliminates the need for a professional money manager. In addition, he feels that individual investors are better equipped to react to the market, given that they do not influence the market with their buys and sells.

Town points out the profound impact mutual fund managers have on the overall market and on individual stocks: With trillions of dollars under their control, they effectively are the market.

As a result, in Town’s opinion, investing in a large, diversified mutual fund actually increases an individual’s investment risk: If the market were to fall sharply, investors would start withdrawing money from mutual funds, which, in turn, would force the managers of these funds to sell stock to cover withdrawals, adding further downward pressure on the market.

Given these circumstances, Town believes that individual investors following the Rule #1 Investing approach-buying a few choice businesses in different sectors at attractive prices-should be able to outperform with reduced risk.

Wonder Businesses at Attractive Prices: The 4 Ms

In order to conform to Buffett’s Rule #1 of investing-don’t lose money-Rule #1 investors buy “wonderful businesses at attractive prices.” To find these wonderful companies, Town follows the “Four Ms”: meaning, moat, management, and margin of safety. Meaning Town believes that companies that hold “meaning” for an individual are those that you are willing to make your sole means of financial support for the next 100 years. In order to make such a significant commitment, it is vital to do your homework regarding the company so you feel comfortable with what the company does.However, this does not mean you need to have intimate knowledge of the company’s business model. Instead, Town borrows another page from Buffett and suggests investing in companies you already know-consider what you enjoy doing, what you are good at, and where you earn or spend your money. Moat The term “moat” has gained in popularity in the investing lexicon over the last several years. Simply put, a moat is a barrier to entry for would-be competitors of a company. A wide moat, in general, protects companies in some way from competition. Because of their wide moats, such companies also tend to be well-known and among the top companies in their industries.In addition, wide moats tend to insulate companies from inflation, meaning they can raise their prices as costs go up without fear of losing market share to lower-priced alternatives.Town identifies five moats: brand, trade secrets, tolls, switching costs, and price.Companies with strong brands offer products that consumers are willing to pay a premium price for because they know and trust the company. Town cites Apple and eBay as examples of companies with strong brands.Trade secrets can also create moats for companies-they prevent companies from competing against them because the ingredients of the product, or the means of production, are secret. These secrets can include, for example, the secret recipes of Coca-Cola or Kentucky Fried Chicken. Drug companies with patent protection are another example.Town describes “toll-bridge” companies as those with exclusive control of a market-in effect, a monopoly. Therefore, companies can collect a toll from those wishing to use their products or services. Town cites utilities and advertising and media companies as examples of toll-bridge companies. Some companies have moats because the costs of switching to competitors’ products or services are just too high in terms of time, money, and aggravation. Town offers Microsoft as a prime example. Despite the well-publicized problems with the Windows operating system, it still enjoys overwhelming market share over the more stable and secure Mac OS from Apple. For most, this is because of the cost and hassle involved with switching operating systems. Finally, a company has a price moat when it can price its products so low that no other companies can compete. Given its massive purchasing power, Wal-Mart is a well-known example of a company with a price-based moat. To find companies with wide, sustainable moats, Town uses the “Big Five” numbers (see below). Management Beyond finding companies that hold meaning to us, we also want people we can trust and respect running them. This is where the third M, management, comes into play. Here, Town looks for owner-oriented leaders. In Town’s view, an owner-oriented CEO has his personal interests directly aligned with the owners of the company-the shareholders. As the Internet bubble illustrated, company-issued stock options can sometimes create a divergence between shareholder interests and executive interests. Therefore, all else being equal, Town believes that CEOs who do not accept stock options as part of their compensation package are more apt to be owner-oriented. Town offers another easy way to learn about the person running a company-read their annual letter to shareholders. While not every chief executive is as candid in his annual letter as Warren Buffett, Town doesn’t want a CEO to sugarcoat what happened with the company over the last year. He believes that owner-oriented CEOs are willing to step up and tell us what went wrong over the last year, whose fault it was, and what they hope to do about it. Another item Town mentions during his discussion of management is insider trading. While insider-trading statistics are, at best, an imperfect indicator of company troubles, investors can glean some potential insight from them. Corporate executives can sell their shares for a number of reasons, most of which are completely innocuous in nature-tax purposes, estate planning, portfolio rebalancing, etc. Therefore, it’s not a good idea to sell your stock in a company just because some insiders are selling theirs. What is much more important is the magnitude of the selling. Town warns that if you see several executives selling a large portion of their holdings, it may be time to head for the door. Keep in mind that you may need to go back several months to piece together a pattern of insider selling. If a company executive is defrauding the shareholders, it is highly unlikely she would sell all of her shares at once, especially if she has substantial holdings in the company. Margin of Safety Just because a company is a wonderful business doesn’t necessarily make it a wonderful investment. While Town points out he is not a value investor, he stresses the importance of buying a company with a margin of safety-his fourth M. According to Town, this means buying a dollar of value for no more than 50 cents, a common practice of the father of value investing, Benjamin Graham. Such a margin of safety, in theory, serves as a safeguard in case your wonderful business turns out to be not-so-wonderful. In order to arrive at Town’s margin of safety (MOS) price, an investor must first determine the “true” value of the company-the “sticker price.” From there, the MOS price is merely one-half the sticker price. It is important to note that a number of assumptions go into deriving this sticker price. The most significant is that the growth the company is currently experiencing will continue for the next several years. This is another reason why Town looks to buy when the current stock price is at least 50% lower than the sticker price. This provides some protection in case the underlying assumptions used in calculating the sticker price do not hold up. Our screen looks for companies with a current stock price that is no more than 50% of the sticker price (see the box on page 10 for an example of how to calculate sticker price).

Rule #1 Investing Criteria

In “Rule #1,” Town outlined several specific guidelines to follow when trying to identify wonderful businesses with attractive prices:

1) The “Big Five”: Town believes in searching for companies with wide moats (see sidebar above), but it is important that the wide moat be sustainable going forward. To find companies with wide sustainable moats, Town looks for the Big Five, which should all be equal to or greater than 10% per year for the last 10 years:

 

• return on invested capital (ROIC);
• equity (or book value) per share);
• earnings per share growth;
• sales growth; and
• free cash flow growth.

2) Manageable Debt: Rule #1 investors are trying to find stable, predictable companies. For companies saddled with a high debt load, a downturn in the economy or any other “blips” could force the company to sell off assets to cover its debt obligations, which could have a negative impact on the company’s future. Ideally, Town would like companies to have no debt, but he is more interested in whether a company can pay off its debt quickly. As a rule, then, he feels that a company has a “reasonable” level of debt if its current annual free cash flows can pay off its long-term debt obligations within three years: In other words, long-term debt divided by annual free cash flow is less than or equal to three.

3) Margin of Safety: After finding wonderful companies, the next step is to find those that offer a sufficient margin of safety. Town does not want to pay more than 50 cents for every dollar of a company’s value. He estimates a company’s fair value by calculating what he calls the “sticker price.” Town then only buys those companies whose stock price is no more than 50% of its sticker price.

4) Adequate Liquidity: Town warns against attempting to buy or sell illiquid stocks. Ideally, he would like to see a stock have an average daily trading volume of at least 500,000 shares.

Monitoring & When to Sell

Once Town finds a wonderful company with an attractive price, he does not immediately buy its stock. He also uses charting and technical analysis to determine the right time to buy. In addition, he uses these same tools to trade his Rule #1 stocks-selling when they become overbought and buying when they become oversold.

Ultimately, however, he believes that there are only two instances when you should abandon a Rule #1 company for good:

1) When the business ceases to be wonderful, or
2) When the market price is above the sticker price.

Town believes that the biggest reason why a once-wonderful business ceases to be wonderful is when its moat is threatened. The other reason, according to Town, is when the CEO stops being on the shareholders’ side. Over time, problems with the company will appear in the Big Five numbers. When they do, it is time to sell.

When the stock price reaches the sticker price, it no longer provides a margin of safety and it is time to sell. However, it should also mean that you have a nice gain since you bought it at less than 50% of the sticker price. For Rule #1 stocks, Town sells because their price reaches the sticker price, but he does allow for a violation of his 50% margin of safety. Assuming all of the other numbers pass muster, he will buy back in when it drops 20% below the sticker price.

The AAII Screen

For the AAII screen, we used AAII’s Stock Investor Pro fundamental stock screening and research database program. Stock Investor Pro covers a universe of almost 9,000 NYSE, Amex, and NASDAQ stocks.

Figure 1 reports backtesting results that show the Rule #1 Investing screen outperformed the S&P small-, mid-, and large-cap indexes since the beginning of 1998. However, it only has a slight advantage over mid-cap stocks and has greatly underperformed the typical exchange-listed stock over the same period. Between January 1998 and the end of August 2007, the Rule #1 Investing screen returned 164%. By comparison, the S&P 500 index gained 51.9% over the same period.

Figure 1. Performance of Rule #1 Investing Screen CLICK ON IMAGE TO SEE FULL SIZE.

Profile of Passing Companies

Table 1 presents the characteristics of the companies passing the Rule #1 Investing screen as of September 7, 2007. The Rule #1 Investing screen looks for companies with strong income statements and balance sheets that are also trading at a discount to their fair value or sticker price. Therefore, it may not be surprising that the current group of passing companies has a median price-earnings ratio (11.7) that is significantly lower than the median price-earnings ratio of 18.5 for all exchange-listed stocks.

The current passing companies, as a group, have no problem exceeding the requirement that the average annual growth rate in earnings per share be 10% or higher. The median earnings growth rate of 79.3% easily surpasses that of all exchange-listed stocks, which is 15.4%. Looking forward, analysts expect robust growth from the current Rule #1 Investing companies, as they have a median forecasted earnings growth rate of 21.2% versus 14.6% for all exchange-listed companies.

In order for a company to pass the Rule #1 Investing screen, its current price must be no more than 50% of its sticker price-an estimate of the company’s fair value. The current passing companies have stock prices, which, on a median basis, are only 25% of their respective sticker prices. In contrast, the typical exchange-listed stock has a current price that is almost 66% of its sticker price.

Lastly, the companies currently passing the Rule #1 Investing screen have not fared very well relative to the overall market over the last year. The companies have underperformed the S&P 500 on a median basis by 11.5% over the last 52 weeks, while the typical exchange-listed stock has underperformed the S&P 500 by 4% over the same period.

Table 1. Rule #1 Investing Portfolio Characteristics
Portfolio Characteristics (Median)	Rule #1 Investing Stocks	Exchange-Listed Stocks
Price-earnings ratio (X)	11.7	18.5
Price-to-book-value ratio (X)	3.93	2.03
Price-to-sales ratio (X)	3.05	1.84
Dividend yield (%)	0	0
EPS 5-yr. historical growth rate (%)	79.3	15.4
EPS 3-5 yr. estimated growth rate (%)	21.2	14.6
Price as % of sticker price (%)	25	65.8
Market cap. ($ million)	1,542.80	464.1
Relative strength vs. S&P (%)	-11.5	-4
Monthly Observations
Average no. of passing stocks	13
Highest no. of passing stocks	35
Lowest no. of passing stocks	2
Monthly turnover (%)	26.7

Passing Companies

Table 2 lists the eight companies passing the Rule #1 Investing screen as of September 7, 2007. We ranked these companies in descending order by their five-year average return on invested capital (ROIC). Town says that if he were to choose only one of the Big Five numbers, it would be ROIC, since in his opinion it indicates how well the company is being run.

Odyssey Re Holdings, a casualty and property insurance provider, barely cleared the 10% hurdle for average ROIC at 10.6%. For 2005, the company had a return on investment of -5.5% after suffering significant losses from hurricanes Katrina, Rita, and Wilma. In 2006, however, the company was able to rebound to post its highest ROIC over the five-year period of 19.6%.

Northwest Airlines owned Pinnacle Airlines Corporation, the parent company of Pinnacle Airlines and Colgan Air, until 2003, when Pinnacle went public with an initial public offering. Prior to Northwest’s transferring control, it entered into two non-cash transactions whereby Pinnacle “paid” Northwest $215.5 million in dividends. As a result, Pinnacle’s retained earnings fell from $476.9 million in 2002 to a deficit of $133.6 million at the end of 2003. In turn, the company’s shareholder’s equity was deficient $48.4 million. However, the company’s earnings performance since 2003 has allowed it to expand its equity to the point where it meets the growth requirements for this screen.

While not part of the actual screen, we did include the 10-day average trading volume of each of the passing companies in Table 2. Town says he would like to see average daily trading volume of at least 500,000 in stocks he is looking to buy. However, many daily trading volume statistics, including those in Stock Investor, tend to be erratic because they only cover the last 10 trading days.

Based on Reuters’ data in Stock Investor, Travelzoo has the lowest average daily trading value among the passing companies at 176,000 shares. However, Google Finance lists Travelzoo’s average daily trading volume at 335,000 shares and Yahoo! Finance has it at just over 182,000 shares. For this reason, it is a good idea to consult multiple sources for this information.

We also list the number of insider sell transactions over the last six months for each of the Rule #1 Investing companies, although we did not use this in the screen either. Town warns against investing in companies where insiders are selling significant portions of their holdings, and the data in Table 2 tells us whether there is need for additional investigation.

First Marblehead has had the highest number of insider sells, with 43. However, a single director made the vast majority of these sales. Among key executives, the CFO sold 1,548 shares in August but still holds over 93,000 shares. In addition, between May and August of this year, the company’s chief administrative officer exercised options for 12,000 shares and sold 3,810 shares. These were the first shares she had held over the last two years, so these sales do not appear to be significant.

Finally, in order to provide what he considers to be an adequate margin of safety, Town only initially buys company’s whose current stock price is less than or equal to 50% of its sticker price. See the box below for an example of how to calculate the sticker price.

Table 2 shows the current stock price as a percentage of the company’s sticker price. These values range from a low of 2.1% for First Marblehead to a high of 45.9% for Odyssey Re Holdings, just below the 50% cut-off.

Conclusion

Town’s approach of finding companies with solid income statements and balance sheets trading at a perceived discount has been the cornerstone of numerous successful investment strategies.

However, even if a company meets all of the Rule #1 Investing requirements, it does not mean you should automatically buy it.

Stock screening is only a starting point in the investment process. Ultimately, you want to identify stocks that match your investing tolerances and constraints before adding them to your investment portfolio.

What It Takes: Rule #1 Investing Criteria

Include only companies listed on the New York, American, or NASDAQ exchanges Exclude foreign companies trading as ADRs on U.S. exchanges The average return on invested capital over the last five years is at least 10% The average annual growth rate in equity over the last five years is at least 10% The average annual growth rate in earnings per share from continuing operations over the last five years is at least 10% The average annual growth rate in sales over the last five years is at least 10% The average annual growth rate in free cash flow over the last five years is at least 10% The ratio of current long-term debt per share to current annual free cash flow per share is no more than three The current stock price is no more than 50% of the company’s “sticker price,” an estimate of fair value

Calculating the Sticker Price: An Example

1) EPS-Continuing 12m ($/shr)           3.94 2) Rule #1 Growth Rate                        36.1% For sake of conservatism, Town uses the lower of the historical equity (110.0%) and estimated EPS (36.1%) growth rates. 3) Future EPS (in 10 years)          $85.92/share EPS 12m × [1 + (Rule #1 Growth Rate ÷ 100)]^10 = 3.94 × [1 + (36.1 ÷ 100)]^10 = 85.92 4) Estimated future PE (X)                     72.2 For sake of conservatism, Town uses the lower of the default P/E (72.2) and the average historical P/E (na). Default P/E = (Rule #1 Growth Rate × 2) = 72.2 Avg. 5-Yr Historical P/E = na (Company has not been trading for five years.) 5) Future Market Price                   $6,203.42 Future EPS × Estimated future P/E = 85.92 × 72.2 = $6,203.42 6) Sticker Price                                $1,533.39 Future Market Price ÷ [1+ (Minimum required annual return on investment ÷ 100)] ^ 10 $6,203.42 ÷ [1 + (15 ÷ 100)]^10 = $1,533.39Current Stock Price (9/7/2007 close) $32.19 Current Price as % of Sticker Price 2.1 Must be 50% or less to provide adequate margin of safety in order to buy.

Wayne A. Thorp, CFA, is financial analyst at AAII and editor of Computerized Investing.

© 2009 AAII Journal PRINT

Reprinted with the permission of:

American Association of Individual Investors (AAII)
625 N. Michigan Ave.
Chicago, IL 60611
(800) 428-2244
(312) 280-0170
(312) 280-9883 fax

www.aaii.com

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

 

There is a common notion that stocks, at least if held for a long-time, usually outperform other assets, so that stocks should be the cornerstone of any long-term portfolio.

If, when this idea is presented, you protest: “Wait a minute. Stocks are also risky!” the reply is either, “Stocks have done well in the past and so they will probably also do well in the future,” or “If you have a long time horizon, you’ll do well in stocks.”

However, the thoughtful investor must also wonder: “But what if stocks don’t do well? What happens then to my retirement?”

And in this self query, the more appropriate approach becomes clear: It makes more sense to think first about what risk you are able and willing to bear, and then to think about what potential investment returns you might be able to capture.

So, let’s take a step back and before thinking about potential portfolio return, think through the factors that determine a person’s ability and willingness to take investment risk.

Time Horizon and Risk

The big fallacy abroad in the land at the moment is that time horizon is a reliable and sole proxy for risk preference. In this paradigm, the longer you intend money to be invested, the higher is the appropriate risk level (i.e., stock allocation) of the portfolio.

Typically, the data used to support the purported link between one’s time horizon and optimal stock allocation shows that for successive holding periods starting in 1926 and ending in 2003, the annualized rate of return in the domestic stock market has on average been positive, and the range of annualized returns gets smaller as the holding periods rise, implying less risk as time lengthens.

But this does not tell the whole story. Stocks can be risky, even in the long run.

The fact is, lower than expected returns could happen-even for many years in a row-which is exactly what makes stock ownership a risky investment, not a certainty. Lower-than-expected returns that last for a long time and/or that are severe in nature would have the impact of dramatically lowering the ending value of your portfolio, and thus could significantly threaten your ability to meet financial goals. While the probability of such an event is low, the consequences are potentially devastating and so are worthy of careful consideration. What the current reasoning omits is the fact that as the investor’s time horizon lengthens, the range of possible ending values for the portfolio also increases, and that these widening ranges include the low, but still positive possibility of a whoppingly low actual versus expected portfolio ending value.

For the mathematically inclined, proof positive of how stocks are risky even in the long run is that if you try to insure a portfolio against a shortfall, you will find that the premium rises as the time horizon lengthens, exactly as would the price for a put option on the termination value of the portfolio.

Uncertain Returns

In sum, the uncertainty of returns is an often-underestimated risk factor for investors.

This risk is particularly daunting for investors who are moving money into or out of their portfolio. In that case, the order of the returns also becomes critically important, as Table 1 illustrates.

 

 

The order of returns-whether high returns appear early or late-makes a big difference in determining a portfolio’s termination value when money is going into or out of the portfolio during the investment period.

Table 1 shows that, regardless of the order of your returns, a particular sum (one with no additional deposits or withdrawals during the investment period) will grow to the same amount: The ending values for the No Deposits or Withdrawals columns are identical no matter the order of returns.

But look what happens if an additional $10 per year is saved (deposited). In this case, Table 1 shows how getting high returns late in the period creates a much higher portfolio termination value, in this case $328 versus $198.

Not surprisingly, the order of returns also impacts the portfolio termination value when regular withdrawals are being taken-Table 1 shows that termination value is higher when high returns come early.

Thus, one reality of investing is that when moving funds into or out of the portfolio, the actual order of returns that you experience during your time period will greatly impact how well you will meet your investment goals.

For investors then, risk considerations include not just expected return and time horizon, but also one’s ability to withstand the risk of loss created by the uncertainty of returns, and by the order of returns when cash is moving into and out of the portfolio.

Risk Tolerance

There are several factors that influence one’s ability, need, and willingness to take investment risk.

Personal Circumstances
There are times when the receipt of an extra $100 feels like a life-changing event. At other times, an extra $100 is not even noticeable in the flow of daily financial life. The same pattern occurs with millions of dollars. The first $1 million changes your life. So arguably does the second million. But at some point even an extra $1 million doesn’t change the way you think and feel about your financial goals. Once you already have sufficient wealth for your lifetime, it is often true that your interest and willingness in taking investment risk declines. It is not unusual for the very wealthy to store a large fraction of personal wealth in conservative portfolios of tax-exempt bonds.

But the converse is not necessarily appropriate. For the not-yet-wealthy, ramping up risk (i.e., the stock allocation) in order to address a compelling lifetime need for more wealth is a slippery concept when evaluated from the point of view of protecting the ending value of the portfolio. (In some sense, the same circumstances that lead to a need to build portfolio wealth are the same circumstances that lead to an inability to withstand a downturn in the markets.) But ramping up risk commensurate with one’s ability to handle losses is a reasonable way to try for an increased standard of living.

For example, a worker who can work more hours, and so earn more money, has more financial resiliency than does, for instance, an older person living on a fixed income who has little or no ability to increase income. Similarly, a family that maintains a spending level far below its regular, reliable income stream is better able to withstand portfolio losses than its more free-spending neighbors.

On the other side of the coin, workers whose income is highly correlated to the stock market, or that is highly uncertain in some other way, are not as well positioned to take investment risk as are their peers in jobs with more predictable compensation.

This interaction between one’s labor income, spending patterns, and investment wealth is of fundamental importance. But there are also other factors determining a person’s ability and willingness to take investment risk.

Investment Knowledge
Experienced financial advisers know that individuals sometimes present themselves as being highly risk-averse, but as the conversation unfolds it becomes clear that really they are simply averse to taking risk in areas in which they are not familiar. As their knowledge of investments increases, so does their willingness to take investment risk. The converse is also true. Individuals who present themselves as being highly risk-tolerant sometimes become less risk-tolerant as their understanding of investments grows.

Personal Background
Investors whose families went through the Depression or some other extremely challenging financial event tend to shy away from investment risk. In contrast, investors whose first experience in investing includes the recent extraordinary bull market are at risk for thinking that stocks aren’t in fact very risky.

Personal Preferences
Psychologists will tell you that people differ in the pleasure they take from investment gains versus the pain they feel from investment losses. But most people are asymmetric: Losses tend to hurt a lot more than gains give pleasure.

Risk vs. Return Considerations

This cursory review of the factors behind a person’s risk preference as reflected in the allocation of his or her investment portfolio highlights the fact that when managing personal investments, it’s not just about return management. It’s also crucially about risk tolerance.

And once risk tolerance is taken into account, there are instances in which even long-term investors will not choose to put a substantial portion of their portfolio into stock investments.

In sum, rather than reaching for a high stock return because it might come true, the goal of investing is better expressed as having enough cash on the day a bill comes due-for example, for college tuition for your children, and/or enough cash to maintain or improve your standard of living throughout retirement with minimal chance of having to go backward in your daily standard of living. These are the typical actual concerns of individual investors.

Against this standard, beating one’s peers or surpassing the market averages, or achieving a particular targeted rate of return all pale in comparative appeal. As the investment saying goes: “You can’t eat relative returns.”

These considerations may lead certain investors away from using stocks as the foundation layer for their portfolio toward using more stable investments-in particular, inflation-indexed bonds-as the foundation layer.

Inflation-indexed securities are increasingly and readily available to the individual investor. They include the U.S. Treasury Series I Savings Bonds and U.S. Treasury Inflation-Protected Securities (TIPS) (http://www.savingsbonds.gov). The advantage of inflation-indexed securities is that they allow the investor to protect purchasing power reliably, with minimal transaction costs and also (if purchased appropriately) with high tax efficiency. With inflation-indexed securities as the foundation layer of a portfolio, it is much safer to then take investment risk with more volatile securities such as stocks.

Inflation-indexed investment products will likely become more popular as individual investors become more aware that they can protect purchasing power with investments that are less volatile and more certain than are stock investments.

In the meantime, as you continue to be inundated with information about how much you can earn in the investment markets, remember that when determining the optimal allocation for your portfolio, it’s best to focus first on how much you are able and willing to lose.
Zvi Bodie, Ph.D., is a professor of finance and economics at Boston University School of Management. He maintains a Web site at www.zvibodie.com.

Paula Hogan, CFP, CFA, is the founder of Hogan Financial Management, a comprehensive fee-only planning firm based in Milwaukee, Wisconsin. She also maintains a Web site at www.hoganfinancial.com.
PRINT   

 © 2010 AAII Journal

Reprinted with the permission of:

American Association of Individual Investors (AAII)
625 N. Michigan Ave.
Chicago, IL 60611
(800) 428-2244
(312) 280-0170
(312) 280-9883 fax

www.aaii.com

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

By March 2009, most U.S. and international stock indexes had lost at least half of their value in the current financial crisis.

Since that time, some indexes have managed a small rally, but all remain substantially below their peak levels. In addition, banks are in lousy shape, and governments around the world are running huge deficits and trying, seemingly in vain, to cure the financial ills that beset the world economies.

There has been a litany of articles trying to lay the blame for the crisis. We do not propose to add to this literature. Rather, our primary aim is to discuss the investment lessons from the crisis, and to make positive suggestions for investors today.

As a background, we begin with a brief discussion of a few of the factors that contributed to the financial crisis. Then we progress to the discussion of investment lessons that can be learned and what investors can and should do going forward.

Contributing Factors

While this article is not intended to “point fingers” of blame, it is helpful to understand some of the factors that contributed to the current financial crisis. This is an impartial list that is included because these factors will be part of the later discussion of lessons learned and advice to investors.

Lowered Lending Standards

First, a major factor in the crisis was the government-sponsored push to vastly broaden the availability of mortgages. In this, we concur with Nobel-laureate economist Harry Markowitz who, in a major article in the Financial Analysts Journal (January/February, 2009), stated: “[A] basic cause of the current financial crisis was the mandate by the U.S. Congress for the Federal National Mortgage Association (Fannie Mae) to vastly increase its support of low-income housing. This mandate required a lowering of lending standards.”

Overly Complex Investments

Second, the lowering of lending standards resulted in an enormous number of questionable loans that were packaged into complex pools of mortgages (collateralized mortgage obligations, or CMOs). These pools were then sliced up into various combinations of principal and interest repayments, with various maturities, and then sold; the result, in many cases, was that bits and pieces of each original mortgage were spread around various mortgage pools.

In some cases, CMOs were sliced up and wrapped up into other complex and exotic pools, such as collateralized debt obligations (CDOs). For example, one slice of CDO B may contain CMO C. A major problem today is that it is virtually impossible to look inside these opaque investments to determine their value.

Excessive Leverage

Third, many investments and investment banks used excessive leverage, and thus incurred excessive risk. Due to this leverage, a small decrease in assets’ value could and did wipe out the equity at many financial firms, including the government-sponsored enterprises of Fannie Mae and Freddie Mac, and the investment banks Lehman Brothers, Bear Stearns, Merrill Lynch, and others.

Lessons From the Crisis

What should investors learn from the financial crisis? This section presents five major lessons that every investor should heed.

Lesson 1: A mix of high-grade bonds and stocks moderates portfolio risk.

Does history repeat itself?

After the last financial crisis, one of the authors (Reichenstein) wrote the article “10 Lessons You Should Learn from Recent Market History” (February 2003 AAII Journal; available at AAII.com). In the first lesson, he wrote: “High-grade bonds and stocks are fundamentally different assets. Bad years for bonds are sometimes good years for stocks. Bad years for stocks are sometimes good years for bonds.”

At the risk of sounding like a broken record, that same lesson is repeated here as the first lesson to be learned from this most recent crisis.

A key qualification is that only high-grade bonds are fundamentally different assets than stocks. And the higher the credit quality, the greater the difference.

Consider a highly rated 6% coupon ExxonMobil bond. It promises $60 in interest each year, plus the $1,000 principal at maturity. When crude prices rose to $145 a barrel, the bond holders were not promised more than $60. When crude prices fell to $40 a barrel, bond holders were still promised the same $60. The changes in crude prices affected ExxonMobil’s stock price, but not their bond prices because of the lack of default risk.

In contrast, consider low-rated Ford bonds. Due to default risk, Ford’s existing junk bonds will rise and fall in value, just like the stock value, as the firm’s prospects change.

Junk bonds behave like stocks, while high-grade bonds are fundamentally different assets than stocks, and thus provide good diversification benefits.

In the book “The Only Guide to Alternative Investments You’ll Ever Need” (Bloomberg Press, 2008) authors Larry Swedroe and Jared Kizer emphasize that high-yield [junk] bonds, convertible stocks, emerging market bonds, and preferred stocks all have stock-like characteristics that can provide some growth benefits during rising markets. Unfortunately, during bear markets, these assets still behave more like stocks than bonds. Therefore, these assets do not provide investors with protection during bear markets. For diversification purposes, the authors recommend that individuals invest in Treasury securities, government agency debt, or FDIC-insured bank deposits (for amounts within the insurable limits).

Another approach, recommended by Prof. Reichenstein, would be to limit bonds to Treasuries or high-grade bonds.

Lesson 2: Avoid complex investment products.

Wall Street likes to create complex products that appear desirable, but are designed to separate capital from investors.

David Swensen, the portfolio manager of Yale University’s endowment fund and author of the popular investment book “Unconventional Success” (Free Press, 2005), may have expressed it best:

“When a sophisticated provider of financial services stands toe to toe with a naïve consumer, the all-too-predictable conclusion resembles the results of a heavyweight champion and a ninety-eight-pound weakling. The individual investor loses in a first-round knockout.”

These complex investments may combine $97 worth of assets, but are sold for $100. Recent examples include Accumulators, Booster-plus Notes, Buffered Notes, Principal Protected Notes, Reverse Convertibles, STRATS, and Super-Track Notes.

Author Larry Swedroe has studied these products for more than a decade. In that time, he concludes that every single product that he reviewed was meant to be sold, but never bought. Investment bankers are not in the business of playing Santa Claus.

Another example: On a Saturday morning radio show in Dallas, brokers encourage individuals to attend their seminar where they will reveal the wonders of equity-indexed annuities. These assets, which were discussed in our November 2007 AAII Journal article ["Investment Products: If It Has to Be Sold, Don't Buy It!"; available at AAII.com], have hidden costs, complex features, surrender penalties, a lack of a secondary market, and more. But they pay huge commissions, and are aggressively sold.

In “An Overview of Equity-Indexed Annuities,” a 2006 working paper by the Securities Litigation and Consulting Group, authors Craig McCann and Dengpan Luo conclude that the “net result of equity-indexed annuities’ complex formulas and hidden costs is that they survive as the most confiscatory investments sold to retail investors.”

If it sounds too good to be true, it probably is.

Lesson 3: Insist on simple, transparent investments.

Individual investors can create prudent portfolios by combining stocks, bonds, mutual funds and exchange-traded funds. They do not need to resort to non-transparent products like CMOs, CDOs, hedge funds, and funds of hedge funds.

The markets for CMOs and CDOs have frozen because no one knows what is in these opaque investments.

Some hedge fund managers refuse to reveal their strategy because, they claim, they do not want other investors to learn about the market inefficiency that they are allegedly exploiting.

Bernie Madoff had a history of providing consistent stable returns before his $50 billion Ponzi scheme collapsed. Allen Stanford, head of Stanford Financial Group, and also accused of running a Ponzi-type scheme, also had a strong record allegedly built on secret strategies before the fraud was discovered.

Investors should not trust opaque strategies that seem to offer returns that are too good to be true.

Buying simple investment products provides a degree of safety against fraud that is not available in complex and opaque investments.

Lesson 4: Avoid leveraged investments.

It should be clear that there is plenty of risk in traditional stocks, bonds, mutual funds and exchange-traded funds. We suspect few, if any, individuals feel the need to leverage up their risk beyond that inherent in stocks and stock funds.

However, many hedge fund managers use substantial leverage. Hedge funds’ cost structure, where managers typically charge 2% of assets under management plus 20% of profits, encourages this risk-taking. After all, when leverage increases returns, it magnifies the managers’ profit-sharing returns, while when leverage decreases returns, the investor bears all the risk. This is a classic example of “heads” the manager wins and “tails” the investor loses. It makes sense for the manager, but not for the investor.

 Table 1. Annual Index Returns: 2003-2008

	2003-2008 Return (%)
Hedge Fund Index
HFRX Index*	-0.7
Domestic Indexes
S&P 500	2.4
Russell 2000	5.8
Russell 2000 Value	6.8
Russell 2000 Growth	4.7
Wilshire REIT	5.9
International Indexes
MSCI EAFE	7.5
MCSI International Small	9.8
MSCI International Value	8.6
MSCI Emerging Markets	14.9
Fixed Income
1-Year Treasury Notes	3.3
5-Year Treasury Notes	5.3
20-Year Treasury Bonds	8.8
Barclay’s Aggregate	4.6
*The HFRX index is an index of hedge fund returns.

Table 1 shows the 2003-2008 returns on an HFRX index of hedge funds [HFRX indexes are published by Hedge Fund Research Inc.] and several stock and fixed-income indexes. The HFRX index indicates returns “as reported by hedge fund managers.”

These returns may have several upward biases. First, the returns are “reported” but not necessarily audited.

Second, they likely included returns from hedge funds run by Madoff and Stanford that looked good, but were fraudulent.

Third, there may be survivorship bias. Several hedge funds in existence in 2003 did not survive through 2008. When a fund dies, it usually has poor returns, and most indexes delete the historical records of these non-survivors at their death. The survivorship bias reflects the fact that the average return of investors in surviving funds exceeds the average return of investors in all funds, including those that survived and those that failed.

Despite multiple upward biases in this hedge fund index, Table 1 indicates that hedge funds had negative returns for 2003-2008, while domestic stocks, international stocks, and high-grade U.S. bonds had positive returns.

The dramatic failures of Fannie Mae, Freddie Mac, Lehman Brothers, and Bear Stearns would not have been possible without the use of excessive leverage. Fannie Mae, Freddie Mac and Lehman Brothers had leverage ratios of about 30, meaning they borrowed about $30 for each $1 of their money. (Counting off-balance-sheet obligations in the form of guarantees made the real leverage at Fannie Mae and Freddie Mac much higher, perhaps 100 to 1). So, it took less than a 4% drop in the underlying asset’s value to wipe out their equity positions.

With this level of leverage, investment bankers could not be right just some of the time. They had to be right all the time.

Lesson 5: There is no “smart money,” or investors who are consistently smarter than others.

There is the myth that there exists so-called “smart money” and “smart investors,” and if you only had access to that smart advice, you could consistently earn market-beating returns.

If only it were true!

This financial crisis, perhaps more so than any other, should dispel the myth that “smart money” and “smart investors” exist that individual investors can tap into and earn higher-than-most-anybody-else’s rates of return.

For 15 straight years from 1991 though 2005, Bill Miller’s Legg Mason Value Trust mutual fund beat the S&P 500, and he was considered by many investors to be “smart money.” However, his fund has dramatically underperformed since 2005. According to Morningstar, as of year-end 2008 his fund’s returns were in the bottom quartile of one-, three-, five-, and 10-year trailing returns among large-cap blend stock funds.

Investment banking firms have long corralled the best and the brightest. Just ask them. Indeed, they have long cherry-picked the brightest minds from universities. If ever there was a group of smart investors, they would be at investment banks.

In early 2007, Merrill Lynch had a market cap of $86 billion. In fall 2008, they were rescued by Bank of America after gaining certain Federal Reserve guarantees. Recent estimates suggest losses at Merrill might cost the government in excess of $100 billion.

Lehman Brothers is bankrupt.

Bear Stearns was rescued in the face of certain failure.

AIG, an insurance firm with a large investment arm, has been rescued from failure, and the cost of the government rescue continues to rise.

Where, then, is the smart money?

Where are the investment managers that can consistently produce market-beating returns?

Because markets are highly efficient, investors are best served if they assume that (or invest as if) there is no smart money and there are no smart investors. The reason is that, while it is easy to identify investment managers with good performance after the fact, no one has yet found a way to identify the good performers before the fact.

That is why the SEC requires the disclaimer about past performance.

What Should Investors Do Now?

The first and foremost step investors should take is to have a plan: They should have an asset allocation strategy, and they should stick to it.

Be Broadly Diversified

Investors should stay with the tried-and-true strategy of building a broadly diversified portfolio containing U.S. stocks, international stocks, and U.S. high-grade bonds.

In addition, you may want to (but do not have to) allocate a small portion of your portfolio to alternative assets such as real estate investment trusts (REITs, which own income-producing real estate such as office buildings, shopping centers, and apartments) and commodities.

The U.S stock market already contains a small exposure to REITs, so if you have investments in a broad-based stock market index, you are already invested in REITs. However, most real estate is privately owned, so if the idea is to construct an investment portfolio that mirrors the portfolio of all existing financial assets, you could easily justify a higher exposure than the one you are getting in the stock indexes-perhaps a 5% exposure to REITs beyond that already present in a stock index fund.

The same philosophy applies to commodities.

Keep It Low Cost and Tax Efficient

Since markets are highly efficient, individuals should invest in passively managed, low-cost, and tax-efficient index funds and exchange-traded funds (ETFs).

Since markets are efficient, it is unlikely financial analysts can consistently find mispriced assets and thus add to investors’ returns-especially after paying the costs of the effort. So, it does not make sense to pay the higher fees needed for an army of financial analysts to try to find such assets.

Rebalance Periodically, and Don’t Try to Time the Market

One good strategy is a fixed-weight strategy.

Suppose a couple has a target asset allocation of 60% stocks and 40% bonds. Unless circumstances change dramatically (for example, one spouse loses a job, or there is a death in the family) then periodically-perhaps once per year-they should rebalance the portfolio back to these original fixed weights, since changes in market valuations will cause the portfolio to stray from the original allocation.

There are other perfectly viable asset allocation plans. However, the main point to keep in mind is that you should resist the common practice of trying to “time” the stock market-substantially changing your exposure to the stock market based on the direction you think it may be headed. Substantial research shows that many investors enter the stock market or increase their stock exposure after the market has risen and exit or reduce their exposure after stocks have fallen-the most inopportune time for either move.

It is tough to be tenacious in bear markets and stick to your stock market holdings at a time when the valuations seem unbearably bleak. But history suggests that investors will hurt their returns if they listen to their gut and bail out, instead of listening to their mind and “bearing” with it.

Have a Plan B

In the financial community, historical returns are often used to help estimate what the future might bring.

For example, at the turn of the century, estimates might have been generated from analyses of thousands of possible 30-year scenarios, based on randomly drawing 30 yearly returns from the 1926-1999 distribution of historical returns.

These procedures are used in the hopes that they can provide some guidance about the probable distribution of future returns.

But the 1926-1999 distribution would have predicted only an extremely small chance of two separate 50% decreases in the real value of the S&P 500 this decade.

Perhaps this very small predicted chance is what actually occurred. More likely, however, the simulations underestimated the range of future possible 30-year returns.

This should serve as a cautionary reminder that there is a difference between the risk that is implied from a known probability distribution (one that has already occurred, like the 1926-1999 returns) and the risk from an uncertain probability distribution.

Unknowable factors-like 9/11 and this financial crisis-remind us that the future comes from an uncertain distribution. While past returns are often used for some guidance, don’t be fooled into thinking that “improbable” bad events can’t happen.

Since “unexpected” things can happen to good people and good plans, it is important to have a Plan B: If things turn out worse than expected, how will you respond?

• If you are still working, you may be able to delay retirement.
• If retired, you may be willing and able to return to work.
• You may have to eliminate one or more goals from your wish list.
• You may have to reduce or eliminate discretionary spending for travel and dining out.
• You may have to move in with a family member.

We all need to remain flexible in the face of an uncertain future.

For Further Reading

Link to these past AAII Journal articles for more on the topics discussed in this article.

• § Balance & Diversification in Your Portfolio
• § “The Real-World Lessons From Investment Theory,” by William Reichensten and C. William Thomas, January 2006
• § “10 Lessons You Should Learn From Recent Market History,” by William Reichensten, February 2003
• § “Basic Truths About Asset Allocation: A Consensus View Among the Experts,” by William Reichensten, October 1996
• § Complex Investments
• § “Due Diligence: 10 Steps to Avoiding Ponzi Schemes and Financial Fraud,” by Karen C. Altfest, April 2009
• § “Investment Products: If It Has to Be Sold, Don’t Buy It!,” by William Reichensten and Larry Swedroe, November 2007
• § “Hedging Your Portfolio With Mutual Funds,” by John Markese, June 2006
• § “What Are You Really Getting When You Invest in a Hedge Fund?,” by William Reichenstein, July 2004
• § Investing With Margin
• § “Margin Accounts: A Double-Edged Sword,” by John Gannon, May 2005

 

William Reichenstein, CFA, holds the Pat and Thomas R. Powers Chair in Investment Management at Baylor University in Waco, Texas. He can be reached at Bill_Reichenstein@baylor.edu.

Larry Swedroe is director of research and principal of Buckingham Asset Management in St. Louis, Missouri. He is also author of six books on investing, including “Wise Investing Made Simple” (Charter Financial Publishing Network, 2007), and can be reached at lswedroe@bamstl.com.

 

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© 2009 AAII Journal

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I have frequently been asked, “What is the one thing an investor should monitor in order to gauge the health of the economy and the direction of the stock market?”

My response is “interest rates.” The mandate of the Federal Reserve is twofold: to promote economic growth and to keep inflation under control.

Think of it this way. If the economy were a car, the Fed’s responsibility as a driver would be to maintain a safe speed. If the Fed wanted to speed things up, then they would step on the gas by lowering interest rates. To slow things down, however, the Fed would need to tap or even slam on the brakes by raising interest rates and reducing the availability of capital.

The biggest challenge for the Fed is that our economy isn’t a little red sports car that reacts nimbly to the application of the gas pedal or the brakes. Instead, the economy is more like a supertanker whose response time is remarkably slow. It usually takes between six and 12 months for the economy to feel the stimulation effects of lower rates. It also takes quite some time for the economy to slow down as a result of higher rates.

In the current market environment, the equity market’s response time has been even slower than normal, despite the Fed’s rate reductions and unprecedented stimulative actions. One reason could be that the recession and bear market were the result of higher energy prices, a worldwide credit crisis and a general crisis of investor confidence, not the result of higher interest rates. As a result, lower rates alone haven’t reversed the damage done to the economy and equity markets in the past 18 months. However, the Fed’s unprecedented efforts to loosen credit markets, support teetering financial institutions and stimulate economic growth will eventually take hold-if one applies enough lighter fluid to their charcoal briquettes, they will eventually ignite.

Interest Rates and Earnings

So how do the raising and lowering of interest rates affect stock prices?

Investors buy stocks because they “want a cut of the action.” In the case of a stock, the “action” is price appreciation through earnings growth.

Earnings typically increase as a result of company-specific factors and economic considerations.

Company-specific factors include the desirability of the product or service the company offers, the markets it sells into, the quality of the management, and so on.

The economic considerations hone in on expected growth in the overall economy. As the economy rises, more and more goods and services are being produced, and an increasing number of people are finding jobs and receiving raises. These people, in turn, can then afford to purchase more goods and services. So when the economy expands, so do overall corporate earnings. This growth is frequently the result of the Federal Reserve having begun a rate-cutting program many months earlier.

After a cycle of interest rate increases, however, the reverse is true. Higher rates typically lead to slower demand. In addition, unemployment rises and corporate earnings growth contracts.

Substitutes and Present Values

An equity investor is concerned about rising and falling interest rates, not only because of how they affect the growth of the economy but also for reasons of substitution and present values.

Rising short-term interest rates also usually push up longer-term bond yields. If bond yields rise too much, however, investors begin to consider the possibility of selling their stocks in order to purchase typically less-risky bonds that now offer very attractive yields. This “substitution effect,” therefore, puts additional pressure on stock prces.

Interest rates also impact the valuation of earnings. When equity analysts evaluate the intrinsic value of a stock, they use a discounted cash-flow model. First, they estimate the future stream of cash flows that a company will produce. Second, they estimate the current worth of this future stream by discounting the future streams by the current interest rate. The higher the interest rate with which one discounts these future streams, the lower the present value of these streams.

Lastly, interest rates also have a direct impact on companies-particularly those that continuously borrow money by issuing bonds in order to operate and grow. For these debt-heavy companies, higher interest rates will likely cause their interest expense to increase. As they retire old debt at lower interest rates, they will need to take on new debt at higher interest rates. This rising interest expense, which is paid to bond holders, will take an increasingly large chunk out of their overall earnings.

Therefore, the direction of interest rates is extremely important in projecting economic growth, earnings changes, substitutability, and present values-all things analysts and investors look to when forecasting the attractiveness of stocks in general, and sectors in particular. You don’t want to ignore, or underestimate, the impact that future interest-rate policy could have on the economy, corporate earnings, and your investments. You want to adjust your portfolios accordingly.

Returns After Rate Changes

How does the market respond to the start of these rate-hiking and rate-cutting cycles?

Figure 1 shows the results of a study that examined the effect of interest rate cuts and hikes on the S&P 500 from 1946 to 2008 both six months and 12 months after the initial move.

The S&P 500’s average six-month price rise after the start of each rate-hiking cycle was only 2.6%. This abnormally low price advance was likely the result of investors being their old, anticipatory selves. They expected stock prices to suffer from the oncoming rate increases. And 12 months after the first rate hike, the story wasn’t too much different. Stock prices rose an average 6.2%, 200 basis points below the longer-term average annual price change. In other words, rate increases, and the prospects of even higher interest rates, have traditionally kept a lid on stock market price advances.

Cuts in interest rates, however, are a different story. Over that same time period, six and 12 months after the Fed started cutting interest rates, the S&P 500 soared an average 10.2% and 15.5%, respectively. In other words, Wall Street tends to get very excited whenever the Federal Reserve begins a new rate-cutting program. History shows, but does not guarantee, that when interest rates have started to decline, the S&P 500 has risen in the following six- and 12-month periods by much more than it normally does in six or 12 months.

Long Term: Don’t Fight the Fed

Since 1946, the Federal Reserve has initiated 13 rate-cutting cycles. Yet not all investors were convinced early on that lower interest rates would help overcome their investment woes. In other words, the stock market advanced fewer than two of every three times in the six months following the first rate cut. That 62% conviction level is not very encouraging, in my opinion. I think it is safe to say, therefore, that an investor could have been justified in not responding to the Fed’s actions during the first six months of an interest-rate easing cycle.

However, the market rose 85% of the time in the 12 months after the first rate cut. I believe this statistic is the most compelling for why you don’t want to wait too long in responding to the Fed’s actions. Eventually the Fed will get it right.

The S&P 500 failed to rise only twice in the 12 months following initial rate cuts: 2001-2002 and 2007-2008. In 2001-2002, the Fed’s swift action actually resulted in the shallowest recession since World War II. It failed to move stock prices up, however, as quickly as previous cuts. The U.S. equity markets had to deal with the bursting of the technology bubble, as well as endure the shock of the terrorist attacks domestically on September 11, 2001. These factors contributed to the S&P 500 suffering through the deepest bear market since the Great Depression.

In the 2007-2008 period, the U.S. equity markets had to adjust to the deflation of housing after the housing bubble burst. In addition, markets have had to account for the most severe credit crisis since the Panic of 1907.

Digging a Little Deeper

Now that we know that equity prices have typically risen more rapidly than normal after the start of rate reduction cycles, how can we leverage this knowledge from a sector standpoint?

Equity prices as a whole have jumped after initial rate reductions because of the projected beneficial impact on the economy, corporate earnings, substitution, and present values. So, it will probably come as no surprise that the more cyclical, “growth-oriented” sectors have posted superior price performances and outperformed the market more often than the more defensive “value-oriented” sectors during the six and 12 months after the first rate cut.

Cyclicals Lead the Way

Table 1 shows, in descending order, the average price changes for the 10 sectors in the S&P 500 in a 12-month period after the Fed started a rate-cutting program since 1946. The table also shows how frequently these sectors beat the S&P 500 during these 13 rate-cutting periods.

Table 1. Sector Performances and Rate Cuts
Sector Performances and Frequencies of Beating the Market 12 Months After the First Rate Cut, 1946-2008
S&P 500 Sectors	Average % Change	Frequency of Beating S & P 500 (%)
Information Technology	28	77
Consumer Discretionary	27	69
Industrials	24	69
Consumer Staples	23	77
Health Care	21	62
Average of All Sectors/Industries	19	53
Financial	17	54
Materials	14	38
Energy	11	31
Telecommunications Services	5	17
Utilities	5	15
Source: Standard & Poor’s Equity Research Services. Past performance is no guarantee of future results.

 

Twelve months after the first rate cut, investors’ interest in cyclical sectors has been pronounced. The consumer discretionary, industrials, and information technology sectors have posted superior average price gains. In addition, they have shown above-average frequencies of beating the overall market. The average sector/industry has posted an average annual return of 19%, which is more than twice the average annual increase of 8.2% for the S&P 500 since World War II. In addition, the average sector/industry has beaten the S&P 500 53% of the time. Yet these three sectors have recorded price gains in excess of 24% each. What’s more, each of them has beaten the S&P 500 at least two out of every three times.

Surprising Strength

The consumer staples and health care sectors have also posted above-average returns and frequencies of beating the S&P 500. Initially I was surprised by this strength, since these groups are traditionally regarded as defensive. That’s because the demand for their products and services is fairly static. This strong showing by consumer staples and health care may be due to the reluctance of investors to dive into cyclical equities with both feet. Many probably prefer to hedge their bets in case the economy and stock market do not respond so favorably to interest-rate cuts.

Weeding Out the Weaklings

The pronounced underperformers 12 months after the first rate cut were the energy, materials, and utilities sectors, which gained between 5% and 14% and recorded frequencies of beating the S&P 500 that were anywhere from a high of 38% to a low of 15%. The energy and materials sectors possibly lagged the overall market since they were the groups that had already seen their day in the sun. These two groups historically have done well during the latter stages of a prior economic expansion. Investors have traditionally gravitated toward “real-asset” sectors as inflation has crept higher. Once the Fed started cutting rates, however, investors likely engaged in a bit of sector rotation. They shifted away from those areas of waning strength and toward those that were projected to do better. Utilities likely lagged the market as these income-oriented issues were bypassed in favor of higher-octane groups.

I purposely avoided talking about the results for the telecommunications services sector, since this group has been around only since the late 1980s. As a result, it does not have enough history under its belt, in my opinion, to make its average results a helpful guide to possible future performance. This might be a good time to remind you that I don’t think history is ever gospel, but I do believe it makes a pretty good guide.

Higher Rates = Lower Advances

While it is the least of most investors’ concerns right now, too much of anything is not good, especially if it has to do with partying. After a series of interest-rate cuts, the economy and stock market have typically been partying, so it’s the Federal Reserve’s responsibility to bring this party to an end. The Fed attempts to do this in a controlled fashion by taking away the punch bowl through a gradual rise in short-term interest rates. However, once the Fed starts hiking interest rates, the market’s returns suffer, over both a six- and 12-month timeframe.

Sector Standouts and Slackers

Table 2 shows the average price changes for the 10 sectors in the S&P 500 and the frequency of beating the S&P 500 12 months after the Fed has started raising interest rates. The data is sorted in descending order by average percent change.

Table 2. Sector Performances and Rate Hikes
High E/P ratio (earnings yield)
S&P 500 Sectors	Average % Chg	Frequency of Beating S&P 500 (%)
Information Technology	20	69
Health Care	13	54
Telecommunications Services	10	67
Energy	10	46
Average of All Sectors/Industries	9	44
Consumer Staples	7	46
Industrials	7	23
Consumer Discretionary	7	38
Utilities	5	38
Financial	4	38
Materials	3	31
*An estimate of the stock market’s equity risk premium based on predictions from Value Line Investment Survey.

 

Historical sector performances 12 months after the first rate hike offer less helpful or convincing investment guidance, in my opinion, than they did after the first rate cut. They tell a less clear story this time around as to which sectors are typically helped or hurt by rising rates. Is it because investors don’t believe that the party is really ending, or is it because the reasons behind the Fed beginning to raise rates are more varied than the reasons to lower them? The truth could contain a little of each.

At first, I would have expected to see a reverse listing of winners and losers after rate hikes than after rate cuts. This was apparently was not the case.

I have studied all bear markets since 1945. (A bear market is defined as an S&P 500 price decline of 20% or more from the peak of the prior bull market.) In a bear market, there typically is no place to hide-all 10 sectors post average price declines. The lowest price declines, however, have historically come from: 

• consumer staples,
• health care, and
• utilities sectors.

That’s because in good times and bad, people still eat, drink, smoke, get sick, and heat their homes. As a result, I frequently say that “when the going gets tough, the tough go eating, smoking, and drinking. And if they overdo it, they go to the doctor.”

As a result of my prior work with bear markets, I thought I would see the likes of information technology on the bottom and utilities on the top. Obviously, I was mistaken. My assumption is no doubt incorrect for two reasons. First, remember that investors are always anticipating events. Since the Fed typically begins raising rates an average 12 months after their last rate cut, maybe investors have rotated into those sectors that are expected to be shielded from the effects of rising rates well before the first rate hike.

Another reason could be that in a rising-rate environment, one has to be aware of the impact not only on the overall economy but also on the specific industries and companies.

Why Tech Was on Top

Information technology stocks have done well after initial rate hikes for two possible reasons. First, investors may rationalize that as the economy will likely slow because of rising interest rates, companies may begin to spend more on technology in order to improve productivity.

Another reason information technology companies have continued to post strong price gains after the Fed has started raising interest rates could be that most technology companies have little debt on their balance sheets. As a result, because these firms don’t frequently borrow money in order to operate, their interest expense will not go up as interest rates rise. This situation will help their earnings growth on a relative basis.

Utilities, on the other hand, are big users of debt and typically feel the pinch of higher interest rates on their overall earnings. So, investors may shy away from these big borrowers. In addition, many investors who own utilities do so for their dividend yield. As a result, utilities are frequently referred to as “bond substitutes, or proxies.” Utilities, therefore, may feel the effects of “substitution” more acutely than do other sectors.

In conclusion, the data show that investors aren’t very sure where to turn when interest rates are on the rise. While some defensive sectors, such as health care, have held up well, others, such as utilities, have not. And although some cyclical sectors, such as financials, have taken it on the chin as interest rates have begun to rise, others, such as information technology, have not because of the absence of interest expense.

Takeaways

This article was written to help you understand how the S&P 500 has been affected by rising and falling interest rates. It should help you to gain the conviction to “stand your ground” when rates are falling, yet pare back your exposure to equities if the party is still going strong.

As you have seen in the resulting data, the response by sectors within the S&P 500 has not been overly consistent, particularly when the Fed starts raising rates.

I think this reaction is mainly the result of trying to put too much faith in one indicator, namely, interest rates. While I believe the direction of interest rates is the most important criterion in evaluating the direction of equity prices, it is by no means the only one. Many times the direction of sector prices may be influenced by the concentration of more minor, sector-specific factors.

I am more encouraged by the magnitude of sector price returns and frequencies of beating the market after the beginning of rate cuts than I am after the start of rate hikes. In my opinion, the data provides convincing evidence that a move back into equities, particularly into cyclical groups, is more in order after a rate cut than after a hike.

That doesn’t mean that the data surrounding sector returns after the start of a new rate-hiking cycle is unhelpful. On the contrary, I think the data show that investors are well advised to tread very carefully after a rate hike, as stocks in general haven’t performed up to par at that time. And from a sector standpoint, I advise you not to assume automatically that those sectors that went up the most when interest rates fell will be the ones to go down the most when interest rates rise.

Where Things Stand Today

Where does the economy, and the stock market, stand today after the combined actions of the Federal Reserve and Treasury?

In the 60 weeks from the start of 2008 through the end of February 2009, the S&P 500 fell in price 60% of the time, as compared with an average 45% in the preceding 10 years. Yet the S&P 500 rose in six straight weeks from March 9 until April 17 this year. What a relief.

However, investors continue to ask, “When will this bear market end?,” with the intention of simply waiting until the fundamentals start to improve before getting back into equities.

While this mindset might serve investors well in the near term, it might also cost them in the longer term. Since 1949, bear markets bottomed a median of five months before recessions have ended and eight months before corporate earnings hit a trough and unemployment peaked. And while history is never a guarantee, it often serves as a guide. Why should one even consider the early March low as a possible turning point in this bear market?

Because bear markets don’t last forever, and investors clearly should remember how strong the advances can be in the first year of a new bull market: The average gain for the S&P 500 in the first 12 months of a new bull market since 1932 was 46%. While it may be prudent to look upon this recovery with a skeptical eye, investors should acknowledge that sooner or later a new bull market will emerge.

Investors should also keep in mind that price declines will likely end before fundamentals start to improve. Of course, prices need a catalyst in order to bottom, and investors typically don’t want to look more than six months into the future before committing capital.

One catalyst for share-price recovery would be the expected end to the current U.S. recession. S&P Economics sees this recession ending by the start of the fourth quarter of 2009, after registering a peak-to-trough decline of 3.9%-the deepest since the 1930s, and at 21 months the longest since the 1950s.

Should this equity market recovery be similar to prior recoveries-and there’s no guarantee it will-the cyclical consumer discretionary, financials and information technology sectors may lead the pack, at the expense of the more defensive consumer staples and utilities groups. Indeed, information technology was the best-performing sector in the first quarter of this year, and the only one to post an advance.

A rotation into such early cyclical sectors as technology and consumer discretionary would be consistent with a potential bottom. But only time will tell if they do so this time as well.

Sam Stovall, chief investment strategist of Standard & Poor’s Equity Research, serves as chairman of the S&P Investment Policy Committee, where he focuses on market history and valuations. He is the author of the book “The Standard & Poor’s Guide to Sector Investing” and Stovall’s Sector Watch, a column featured on www.spoutlook.com. Sam Stovall will be a speaker at the AAII Investor Conference this fall in Orlando. For details, please see the ad on page 9 of this issue.

This article is adapted with permission from Mr. Stovall’s new book “The Seven Rules of Wall Street: Crash-Tested Investment Strategies That Beat the Market” ($21.95), published by McGraw-Hill Companies, 2009.

 

© 2009 AAII Journal

Reprinted with the permission of:

American Association of Individual Investors (AAII)
625 N. Michigan Ave.
Chicago, IL 60611
(800) 428-2244
(312) 280-0170
(312) 280-9883 fax

www.aaii.com

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

Where is the stock market heading? Has the rally that started in early March been exhausted? These are the key questions on all investors’ minds as financial markets remain caught between the frantic actions of central banks to get the cogs of the credit system and economy turning again on the one hand, and a still shaky economic and corporate outlook on the other.

It is therefore no wonder that even so-called “pop analysis”, including some legendary axioms, is resorted to in a quest for direction. And besides “buy low and sell high” few other axioms are more widely propagated than “sell in May and go away”. A Google search revealed an astounding 127,000 items featuring this phrase.

As equities have seen a particularly strong six-week rally, followed by what looks like the start of a consolidation/retracement of some of the recent gains, investors are justifiably questioning the market’s next move. And they nervously wonder whether this May will not only herald longer days in the Northern Hemisphere, but also live up to its reputation as the advent of a corrective phase in the markets.

The important issue, however, is whether this axiom actually has any scientific basis at all. Analyzing historical returns, the figures vary from market to market, but long-term statistics seem to show that the best time to be invested in equities is the six months from early November through to the end of April of the next year (”good” periods), while the “bad” periods normally occur over the six months from May to October.

A study of the MSCI World Index, a commonly used benchmark for global equity markets, reveals that since 1969 “good” periods returned +6.5% per annum while investors were actually in the red by -1.0% per annum during the “bad” periods.

“Sell in May and go away” also holds true for the US stock markets. An updated study by Plexus Asset Management of the S&P 500 Index shows that the returns of the “good” six-month periods from January 1950 to March 2009 were 7.9% per annum whereas those of the “bad” periods were 2.5% per annum.

A study of the pattern in monthly returns reveals that the “bad” periods of the S&P 500 Index are quite distinct, with five of the six months from May to October having lower average monthly returns than the six months of the good periods. Interestingly, May - the first month of the bad patch - is the only exception.

Historical average returns from May to October in emerging markets also tended to be weaker than those from November to April, as shown in the graph below (hat tip: US Global Funds).

But what exactly does this mean for the investor who contemplates timing the market by selling in May and reinvesting in November? Further analysis shows that had one kept the investment in the S&P 500 Index only during the “good” six-month periods, and reinvested the proceeds in the money market during the “bad” six-month periods, the total return would have been 10.5% per annum.

These calculations do not take tax into account. And, of course, every time one switches out of and back into the stock market there are costs involved, which would also reduce the returns for the market timer.

How did the good and bad periods stack up during the past two years? The results are as follows.

 

• May 2007 - October 2007: +4.52%
• November 2007 - April 2008: -9.62%
• May 2008 - October 2008: -30.1%
• November 2008 - April 2009: -5.1%

 

Some you win, some you don’t! It seems that the axiom “sell in May and go away” in itself is a rather doubtful basis for timing equity investments. However, it may serve a useful purpose as input, together with other factors, to otherwise rational decision making.

Reprinted with the permission of:

Prieur du Plessis

Investment Postcards from Cape Town

http://www.investmentpostcards.com/

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

Human capital is something we all have, and it’s becoming a front of mind issue in the press and in the field of financial planning.

What’s up with that?

What Is Human Capital?

For economists, there is a very specific definition for human capital. They say it is the value of future earned income expressed in today’s dollars as if it were a lump sum.

That’s an idea that makes conceptual sense, but is hard to specify in a practical sense. Who really knows what the range and pattern of their future earnings will be?

But even if you don’t know the exact value for your human capital, it is possible to develop a sense of its character-and that’s important for investment planning. You would manage investments differently depending on how high and how secure your earned income is likely to be, how long it may last, and how correlated it will likely be with financial markets.

For you personally, “human capital” is simply your God-given gifts. From a financial planning point of view, the implied planning issues are: How will you use these gifts and how will society financially reward you for doing so?

Why It’s a Hot Topic

People are living longer, and we are beginning to understand the implications of that. Protecting against the risks of longevity and inflation are coming into focus for baby boomers as the key retirement planning goals, especially in light of declining pensions and job security.

As a result, we’re seeing more personal investment products and services that incorporate academic theories-in particular, the theory of life-cycle saving and investing.

Life-cycle theory, first developed in the 1970s, points out that each person has both human and financial capital, with the former usually being the most important. [The theory of life-cycle investing discussed here should not be confused with the target-date or age-based life cycle asset allocation process, adopted by many mutual funds and that is a common investment choice in many 401(k) plans.]

It seems like a small change to focus more centrally on human capital than on financial capital, but it has major planning implications. So let’s take a closer look at the theory of life-cycle investing.

Life-Cycle Investing: The Theory

In life-cycle investing, a person’s total wealth is defined as the sum of their current financial wealth and the present value of their human capital-that is, what their labor will earn during their lifetime.

Under this theory, there is a key assumption that, in general, people like to smooth consumption across their lifetimes and that they especially want to avoid big downward swings in their standard of living. Using this approach, financial planning consists of transferring consumption across time and across contingencies, throughout the entire life cycle of the individual.

How does this work?

As an example, the act of saving for retirement shifts consumption from high earning years to years when the individual is no longer in the workforce. Student loans and mortgages, on the other hand, allow individuals to shift in the other direction, consuming more in the present by borrowing against income expected in the future. And health insurance is a vehicle for transferring purchasing power across contingencies-that is, from “good” times of robust health to “bad” times when medical care is needed.

From a life-cycle investing point of view, preparing for retirement thus requires investing savings in safe investments to the extent that is appropriate for one’s personal circumstances, and insuring or otherwise addressing the risk of catastrophic losses, such as from poor health or challenging longevity. Then and only then does one consider how to capture the upside potential of volatile investments with an acceptable level of risk.

An additional tenet of life-cycle investing is that the source of labor income must be taken into consideration when making investment choices in order to avoid having the investment portfolio move in a highly correlated manner with labor income.

For example, if you are a stockbroker, you may think that because you are familiar with investment trends, you would be a good candidate for investing in stocks. Yet if your income rises and falls with the market, a more sensible strategy would be to manage financial capital as a counterpoint to earned income. Thus, as a stockbroker, you would keep portfolio volatility low in order to avoid having investment wealth plummet at the same time labor income sinks in a market downdraft. So, odd as it may sound to modern ears, not investing in stocks at all is a reasonable default choice for someone whose income goes up and down in lockstep with the stock market.

A Different View of Risk

In this context, “safe” investments are investments such as annuity-based products, inflation-indexed savings bonds, Treasury inflation-protected securities, and targeted savings accounts (for example, a college savings plan where the promise to the investor is a payment of tuition instead of a payment of a specific dollar amount).

In fact, a key implication of life-cycle investing is that there are safe investments, and further, that safe investments are appropriate as the base layer of personal wealth, an idea that is quite different than the notion that stock investing should be the mainstay of an individual’s portfolio.

For example, financial planners frequently focus on an individual’s time horizon: “If you have a long time horizon, invest in stocks because you have time for everything to work out OK.”

However, from a life-cycle investing point of view, this statement doesn’t work. There is no reason to think that time softens market risk. The long-term average return is likely to be a positive number, perhaps a number even above inflation. But the range of possible ending values grows rapidly as the time horizon expands. This means that you might earn a nicely positive average annual return over your lifetime, but on the day that you need to start drawing cash from the portfolio for living expenses, your portfolio could be a fraction of total deposits-not a good outcome, and not financially safe.

Using a life-cycle investing planning perspective, the more correct statement would be that, rationally, you can consider increased investment risk to the extent that you have resiliency in your labor income. Thus, a young professional at the beginning of his career, everything else being equal, can consider ramping up investment risk, not because he has a long time horizon, but because he has resiliency in his labor income. If something goes wrong in his investment portfolio, he can ramp up lifetime labor income by working harder or longer.

In contrast, consider the situation of a 60-year-old. Given current longevity trends, he has a long time horizon, and so according to current popular lore, might consider investing heavily in stocks. But, if the 60-year-old is not able by preference or personal skills to ramp up lifetime labor income by working longer or harder, then he cannot really afford to take considerable investment risk. To the extent that he needs portfolio income for daily expenses, he also cannot afford to have anything go wrong in his portfolio and so must keep investment risk commensurately limited.

The Outlook

As the life-cycle theory of investing washes into daily financial life, you can expect to see an increased focus on safety first in investments as well as increased attention to coordinating investment policy with human capital.

Human capital is something that we all have and there is tremendous choice about what to do with it.

The financial planning implication is that what you do with your God-given gifts has a lot to do with personal happiness and your mark on the world-and everything to do with how you manage your investment portfolio.

Paula Hogan, CFP, CFA, is the founder of Hogan Financial Management LLC, a comprehensive fee-only planning firm based in Milwaukee, Wisconsin. She also maintains a Web site at www.hoganfinancial.com. This article is based in part on Ms. Hogan’s article “Life-Cycle Investing Is Rolling Our Way,” which originally appeared in the May 2007 issue of the Journal of Financial Planning.

 

© 2009 AAII Journal

Reprinted with the permission of:

American Association of Individual Investors (AAII)
625 N. Michigan Ave.
Chicago, IL 60611
(800) 428-2244
(312) 280-0170
(312) 280-9883 fax

www.aaii.com

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

Philip Fisher got his start in investments in 1928 as a “statistician” for a bank underwriting securities-and quickly lost a significant amount of money in the 1929 stock market crash.

Soured by the experience, he started his own investment counseling firm in the early 1930s, following an investment philosophy of selecting deeply researched companies with strong long-term growth prospects and holding them through the gyrations of the economic cycle.

Fisher stood out as one of the first money managers to focus on qualitative factors instead of quantitative ones. He examined factors that were difficult to measure through ratios and other mathematical formulations: the quality of management, the potential for future long-term sales growth, and the firm’s competitive edge.

Although Fisher focused on the qualitative characteristics of a company, he was first and foremost a growth stock investor. He felt the greatest investment returns did not come from the purchase of stocks that were undervalued, since a stock that is undervalued by as much as 50% would only double in price to reach fair market value. Instead, he sought much higher returns from those companies that could achieve growth in sales and profits greater than the overall market over a long period of time. Furthermore, Fisher did not seek companies showing promise of short-term growth due to cyclical events or one-time factors. He felt that the timing was too risky and the promised returns too small.

Over the years that followed, Fisher penned three books regarding his investment philosophy. They were republished as a single work: “Common Stocks and Uncommon Profits and Other Writings” by Philip A. Fisher (Wiley, 2003).

Fisher Screen

Even though qualitative factors were high on Fisher’s list, his writings provided enough detail to establish some basic quantitative screens. AAII’s Philip Fisher screen seeks to highlight growth stocks meriting further in-depth analysis with:

• Consistently strong profitability;
• Consistent sales growth;
• Growth exceeding industry norms;
• Little or no dividend payout; and
• Reasonable price compared to future growth prospects.

You will find the exact screening criteria for the Philip Fisher Screen at the end of this article.

Screen Performance

Each month, the AAII.com Web site provides a list of the companies passing the Philip Fisher screen and tracks the performance of these stocks in a hypothetical portfolio.

Figure 1. Performance of the Philip Fisher Screen CLICK ON IMAGE TO SEE FULL SIZE.

Figure 1 illustrates the erratic performance of the Philip Fisher screen over the period from January 1998 through the end of August 2008. Despite its gyrations, the stocks passing the screen have produced price gain returns that have outpaced the S&P 500-over the test period, the Fisher screen gained 133.5% while the S&P 500 is up 32.2%. Over the 10 complete calendar years that make up the testing period, the Fisher screen saw an equal number of up years as down. Year-to-date, the screen has gained 5.2%.

Overview of Passing Firms

Table 1 highlights some of the characteristics of the companies currently passing the Philip Fisher screen compared to the typical exchange-listed stock, while Table 2 lists the stocks passing the screen as of September 5, 2008.

Table 1. Portfolio Characteristics of the Philip Fisher Screen
	Philip Fisher Portfolio	Exchange-Listed Stocks
Portfolio Characteristics (Median)
Price-earnings ratio (X)	12.2	16.4
Price-to-book-value ratio (X)	2.12	1.54
Price-earnings-to-EPS-est.-growth (X)	0.5	1.2
EPS 5-yr. historical growth rate (%)	38.3	13.6
EPS 3-5 yr. estimated growth rate (%)	24.4	14.0
Market cap. ($ million)	729.1	367.8
Relative strength vs. S&P (S&P=0) (%)	–17	–5
Monthly Observations
Average no. of passing stocks	22
Highest no. of passing stocks	82
Lowest no. of passing stocks	0
Monthly turnover (%)	32.5
Data as of September 5, 2008.

 

While Fisher was not in favor of merely seeking “undervalued” stocks, he advocated buying “outstanding” companies when they were out of favor because the market has temporarily misjudged the true value of the company. He also wasn’t against buying “outstanding” companies at fair value, but cautioned investors to expect lower, albeit respectable, returns.

AAII’s Philip Fisher screen looks for “outstanding” companies-firms with strong growth opportunities that are also trading at undervalued levels. At 12.2, the median price-earnings ratio for the Fisher stocks is lower than the median for the typical exchange-listed stock. In contrast, the price-to-book ratio is above the median for exchange-listed stocks.

The screen also looks for stocks with positive sales growth over each of the last three years and a three-year average sales growth rate that matches or exceeds its industry’s median sales growth rate over the same period.

The stocks currently passing the Fisher screen have shown an average increase of 38.3% in earnings per share over the last five years, while exchange-listed stocks have seen earnings grow at a median rate of 13.6% over the same timeframe. While, looking forward, earnings growth is expected to slow to 24.4% a year for the next three to five years, this still exceeds the expected earnings growth rate of 14% for exchange-listed stocks.

The median market cap for the Fisher stocks is just over $729 million, almost twice that of exchange-listed stocks, which have a median market cap of almost $368 million. The stocks currently passing AAII’s Philip Fisher screen have underperformed the S&P 500 by 17% over the last 52 weeks. By comparison, the typical exchange-listed stock has underperformed the S&P 500 by 5% over the last year.

Currently, 23 companies pass the Fisher screen, which is slightly above the monthly average of 22 over the last 10 and a half years.

Table 2 ranks the passing stocks in ascending order by their ratio of forward price-earnings ratio (current share price divided by the consensus earnings per share estimate for the current fiscal year) to the estimated earnings growth rate (PEG ratio). Fisher believed that the only value in looking at historical price-earnings ratios was to help gain a perspective on the base valuation over time. Comparing the price-earnings to the earnings growth rate is a common valuation technique. Companies with higher expected earnings growth should trade with higher price-earnings ratios. Stocks with a price-earnings ratio half the level of the earnings growth are considered attractive.

Click the link below to view Table 2 Companies Passing the Philip Fisher Screens

http://www.aaii.com/journal/200810/stockscreens_table2.html

Republic Airways Holdings (RJET) has the lowest forward price-earnings ratio of 4.5, based on the consensus earnings per share estimate for the current fiscal year. The company also has the second-lowest forecasted earnings growth rate for the next three to five years at 15%. This translates into a forward price-earnings to estimated earnings growth value of 0.3. The company’s net profit margin is slightly higher than the average for the airline industry, but its sales growth over the last three years is significantly higher than that of the industry. Given the woes of the airline industry in the face of record-high oil prices, it is probably not surprising that the company has underperformed the S&P 500 by 39%over the last 52 weeks.

Sohu.com (SOHU), a Chinese Internet media firm, has the highest forward price-earnings ratio of 19.2 among the Fisher stocks. However, its forward PEG ratio is 0.4 due to the company’s high forecasted earnings growth rate of 48.5, which is also the highest among these passing companies. Sohu.com’s net profit margin of 28.5% is well ahead of the typical computer services company, which is currently losing 1.2 cents for ever dollar of revenue it collects. The company’s sales growth over the last three years is only slightly better than its industry-24.9% versus 17.1%. Over the last 52 weeks, SOHU shares have outperformed the S&P 500 by an impressive 131%, despite having fallen almost 20% between the close on July 24 and the close on September 5.

Conclusion

Philip Fisher was a strong believer that the market is not efficient. Occasional fads and styles in the market may produce distortions in the relationship between existing prices and real values. With the same set of facts, the market may reach different conclusions depending upon its physiology of the moment. Realities not only terminate these distortions, but also often cause the emotion to swing to the opposite extreme.

To succeed in investing, you must be able to see through the market opinion and discover the actual facts. Do not blindly accept or reject the market opinion. You must be knowledgeable, exhibit good judgment, and have enough courage to act based upon your conviction.

As the saying goes, nothing is worth doing unless it is worth doing right. While the rewards of investing in growth stocks are tremendous, the penalties for making judgments based upon superficial analysis are equally large. Fisher felt that making some mistakes is an inherent cost of investing for major gains. He said that the key to long-term success is to do your homework, recognize mistakes as soon as possible, and learn how to keep from repeating the same mistakes. Luck tends to even out in the long run.

What It Takes: The Philip Fisher Screen

Net profit margin for the last 12 months and each of the last five fiscal years is greater than the industry’s median net profit margin for the same period Sales have increased on a year-to-year basis over each of the last three years and over the last 12 months The three-year average growth rate in sales is greater than or equal to the industry’s median average sales growth rate over the same period The company is not expected to pay a dividend in the next year (indicated divided is zero) The ratio of the forward price-earnings ratio (based on the consensus earnings per share estimate for the current fiscal year) to the estimated growth rate in earnings (PEG ratio) is greater than 0.1 and less than or equal to 0.5

Reprinted with the permission of:

American Association of Individual Investors (AAII)
625 N. Michigan Ave.
Chicago, IL 60611
(800) 428-2244
(312) 280-0170
(312) 280-9883 fax

www.aaii.com

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

Over the years I have given a lot of thought to a market timing strategy. I first wrote about it here in July 2007 when I demonstrated that the stock market was overvalued and warranted a reduction in equity exposure. Since then I have also blogged about the results I have achieved with market timing, which have ever so slightly cushioned some of the blow from the recent market declines.

In subsequently thinking about this topic and discussing it with friends I have come to realize that what I refer to as market timing or hedging can just as easily be thought of as frequent portfolio rebalancing. I wanted to see how the results of rebalancing compared to what I’ve been doing for the last 8 years so I decided to test it. I ran analyses of two different portfolio rebalancing strategies under a scenario where the market declines steadily over the course of 14 periods, where a period is defined in terms of a 5% drop in market value from the previous level - much like my buy and sell thresholds. At the end of 14 periods the market is at approximately 50% of its original level - not too different from where we are today. Under each strategy I started with a portfolio that was 70% equity and 30% cash - $1MM total to make it easy - and rebalanced the portfolio at the end of each period.

The first strategy is based upon maintaining a constant 70% equity exposure and is demonstrated in the table below.

As you can see, over the course of time each subsequent stock purchase becomes smaller as the portfolio shrinks and smaller purchases are sufficient to offset the market declines. At the end of the 14 periods the total portfolio is down to a bit less than 61% of its former self and the cash position is down to $182K from $300K originally. Of course, I would argue that with the market at a lower level the portfolio is well positioned to benefit from any recovery, which is the basis of my market timing strategy.

The second strategy is much closer to the approach that I have been taking and is based upon maintaining constant dollar stock purchases - initially matching the stock purchases in the first strategy - and is demonstrated in this second table.

Surprisingly, at the end, the total portfolio value isn’t that much different than under the first strategy but cash is about $30K less. The main difference with this strategy is that at the end the portfolio is almost 75% equities, up from an initial 70%. This seems reasonable, and might even be too conservative. If one believes that 70% is an appropriate equity allocation at one level of the market wouldn’t a higher allocation be reasonable when the market is 50% cheaper?

I draw a couple of conclusions from this exercise. First, when faced with a rapidly changing market, I believe it makes sense to frequently rebalance the portfolio to take advantage of higher or lower valuations. Why should you wait until the end of the year when things might be a wash? Second, given the numbers from the second strategy, I think I have been too conservative in the magnitude of my incremental investments as prices have gone down. Of course, I’m waiting for the market to drop another 50% to really pick up the bargains.

Reprinted with the permission of the American Association of Individual Investors

Why is it that bright, educated people who come across stocks that could make them wealthy for life, so frequently fail to capitalize on golden opportunities—not enough brains or education?

No, not even close.

Two things are responsible: Beating ourselves, and a lack of knowledge. Beating ourselves is mainly emotions, meaning too much fear or greed. Normally those things take control when investors lack knowledge—they do not know what they own and why they own them in enough depth.

Investing is actually common sense along with a focus on the key factors that drive the greatest stocks.

In fact, investors need focus on only four factors that seem to be common, identifying traits of the greatest companies and stocks, in my experience. I have termed these four factors BASM:

• Business Model: How the company plans to grow, be profitable and protect itself from competitors.
• Assumptions: The key assumptions the company makes about their markets upon which they then develop the business model.
• Strategy: This is simply the plan the company develops to implement the business model.
• Management: These are the actual people who create the great business models, assumptions, execution and all the rest. Great management is also needed, over time, to adjust business models for competitive situations.

One item not mentioned here is earnings. So, what about earnings, you ask?

Earnings are part of the metrics you use in evaluating a company—gross margin, net margin after taxes, and return on capital are just some examples of other metrics. These tell you a lot about the competitive position and how well the company is managed. But these are report-card issues. While you do learn something about management from them, the report card does not tell you about vision and fixing problems.

In short, earnings are the golden eggs that drive stock prices, but BASM is the golden goose that lays those golden eggs—it is the engine of earnings.

The Business Model

The business model is the core of how a successful company operates. But most investors cannot tell you much or anything about their best investments and the business models. So let’s start here—on the first big element in BASM.

A good company normally describes and discusses their business model in several places including what they file with the Securities and Exchange Commission when they go public or have successive stock offerings, and the annual reports, all of which are easy to access from the company and the Internet. Here are the three elements of a strong business model:

1) The company describes how they are going to make a lot of money (or why they already are). If they are young and embryonic, they describe the specific path to get to great profitability.

2) The company describes how they will grow for a long time in the future, and how they will retain great profit margins and overall profit growth.

3) The company describes how it will protect itself from the competitors that want to get a piece of their markets and profits. They must talk about competition and how they will compete, protect and win—in other words, how the first two things in the business model will stay that way and not fall prey to strong competitor companies that may come along.

That’s it, and as simple as this is, it is amazing how many companies overly complicate it or write a poor business model and show us that they may not be going great places.

Thus, if an investor does not see anything of a clear, straightforward business model in filings or the annual report, he or she will have spent five minutes wisely, but then can move on and not bother with anything else.

One of the best examples of a great business model is Home Depot. When Home Depot came public, many people said it was just another big discount retailer. Many others challenged Bernie Marcus’ (co-founder) plans to pay workers in his stores more and spend more than competitors on training. Bernie understood that discount retailing was going to be dog-eat-dog competitively, and yet there could be ways other than price to differentiate between companies.

The big thing for Home Depot was a business model that was designed to attract customers on the basis of customer service while being price competitive. Low prices often meant that people felt adrift and could not get enough help to purchase anywhere near what their potential might be.

Well, paying help more than the minimum wage and the extra spending on training as part of the do-it-yourself business model concept of Home Depot did bring them the customers, and that eventually was reflected in the stock price.

Assumptions

Any strategy that a company settles upon to achieve its business plan is built on a set of assumptions, or projections, about how big a market is for a company or a product. Assumptions also must be made concerning anticipated competition and demand over the next year or three years. The assumptions part of BASM is best illustrated with an example.

Bill Gates came into the software spreadsheet market facing skeptics who told him that, since Lotus Development had 70% of the spreadsheet market, he could do nothing, and it was already “game over.” (“Game over” is one of the great syndromes of ordinary investing that ignores the elements of BASM.) So Lotus ran the hot product race without any real worries about Microsoft.

But Gates made huge assumptions about the way people and companies would buy and use software.

His biggest assumption was that customers would have a critical need for standard software—in other words, consumers were looking for uniformity and continuity in software so they would not have to relearn everything from ground zero when new products came out.

Gates also assumed that consumers would stay with one company’s products cycle after cycle if those products met their needs and were competitive in new technologies.

Setting standards and achieving early domination flowed from those assumptions as the core company strategy was formulated.

Eventually, Lotus lost, and Microsoft (need I add?) won. Now it really is “game over.”

Strategy

Management may have a great business model, but it has to have a strategy to execute the details of its plans.

Operational differentiation and excellence are concepts that apply to many great companies.

For instance, Intel has excelled over the years by continually coming out with the best new microprocessor chips to serve as the brains for personal computers. But aside from great product research and development, Intel spends a fortune on research and development in production methods and systems.

To reach back a bit further, McDonald’s is one of the truly great companies. And it is clear the core secret to McDonald’s great management success was operations. In fact, the McDonald’s business model went into great detail about how consistency and quality would flow from great operations management, and those factors would bring in the customers and control costs—and it did work, just as the company said.

Management

The best management demonstrates that it can envision a great future for the company and articulate a cohesive and logical strategy for getting there. The strategy cannot be pie in the sky—it has to be based on resources—human, financial, technological—within the grasp of the company.

Management also has to show it can execute the details, so you must watch carefully.

Great managers make promises and projections to you, the stockholder, that they can deliver on. They are driven to stay ahead of the pack and understand how to lead. While they truly want to win, they are realists in terms of the goals they can execute.

Lastly, great managers admit mistakes early and move aggressively to fix them.

Investing for the Big Money

Most investors spend too much time chasing the wrong information.

Focus is the key, and the simplicity and focus of BASM really has worked to develop some of the greatest all-time investment records and wealth for many people. They do not always call it BASM, but they concentrate on what the golden goose is that creates the golden eggs of earnings.

Great Business Model Descriptions: eBay vs. Google

How does eBay differ from Google?

They are both the darlings of our time, very successful, and both household words.

But eBay has a great business model in which—instead of concentrating on the powerful technology that was making them the best—they concentrated on a way to build true community and bring in all the customers and retain them. That was all spelled out in the prospectus they printed when going public. Google, on the other hand, was fuzzy about their business model. We know it was a great buy on the technology lead and popularity. However, they are now experimenting with so many things at once, and yet still derive almost all of their revenues from search engines that will be further assaulted by competition.

These differences could be seen by investors who scrutinized the public offering documents. eBay had great business model descriptions when it went public; Google did not.

Here is how eBay described their strategy at the time of the initial public offering (IPO):

“The Company’s objective is to build upon its position as the world’s leading online person-to-person trading community. The key elements of eBay’s strategy are:

“GROW THE EBAY COMMUNITY AND THE EBAY BRAND. The Company believes that building greater awareness of the eBay brand within and beyond the eBay community is critical to expanding its user base and to maintaining the vitality of the eBay community.

“Although the Company’s historical growth has been largely attributable to word-of-mouth, the Company intends to build its user base and its brand name aggressively…

“BROADEN THE EBAY TRADING PLATFORM. The Company intends to pursue a multi-pronged strategy for growing the eBay platform within existing product categories, across new product categories and internationally. The Company will target key vertical markets in its user programs and marketing activities.”

There are many more details and components of the business plan, but the key thing was that they all held together logically. They described in straightforward terms how they would grow and make money, and they presented something of a roadmap for both the company and its investors. This is what you want to find.

Google, in contrast, seems to have a good model for generating advertising revenues on its search pages, and it is very profitable. Moreover, the marketing and mind share aspect of its ubiquity, such that people use “Google” both as a verb and a noun—“googling” is a part of the language these days––means that Google has some major assets as it strives to become a dominant leader.

So, Google does have the first part of a good business model, the profitability. But it lacks the second and third parts of a great business model—a plan for growing the profits into the future and protecting them from competition. On these parts there is a blank slate.

Interestingly enough, the filings from its 2004 public offering contain language that concedes that Microsoft will be a competitor to contend with. But also very important is that those filings—unlike eBay’s filings—have very little in them about competitive strategy and the details of the business plan.

Even in late 2005, Google was still adding to what their core service had been. This only makes it a bit tougher for management to define their ultimate strategy and business plan.

The stock has done well, but the jury is out—and based on the BASM yardsticks, the clarity of strategy when they went public is lacking.

Fred Kobrick managed mutual funds for Wellington Management and State Street Research & Management before founding his own firm in 1998. Under his management, the State Street Research Capital Fund was ranked by USA Today as one of the top five performing funds over a 15-year period. He currently provides investment advice to nonprofit institutions and lives in Sudbury, Massachusetts. His book, “The Big Money” (Simon & Schuster, 2006), provides case histories, written to teach the simple guiding principles from which his investment record was generated.

Reprinted with the permission of:

American Association of Individual Investors (AAII)
625 N. Michigan Ave.
Chicago, IL 60611
(800) 428-2244
(312) 280-0170
(312) 280-9883 fax

www.aaii.com

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

Reprinted with the permission of the American Association of Individual Investors

What can you learn from three decades of monitoring investment newsletter performance?

Plenty.

It was nearly three decades ago that the Hulbert Financial Digest (HFD) began independently monitoring the performance of investment advisory newsletters. I’m devoting this column to a couple of the most important investment lessons that emerge from the list of newsletters that dominate the rankings of top performers.

The investment world today couldn’t be more different than the world that existed when the HFD set out to track newsletters, in mid-1980, at least on the surface. Back then, for example:

• The Dow Jones industrial average stood below 900—lower than where it had stood in 1966, 14 years earlier;
• Gold bullion, on the other hand, was just coming off a high of just under $900 per ounce—a record level that remains unbroken today, more than 27 years later (though gold is getting close);
• Inflation was in the double digits, as was the interest rate on long-term government bonds.

Given this stark contrast, it would seem that caution should be exercised in drawing any investment lessons based on which newsletters have performed the best since 1980. Why should anyone think that strategies appropriate to the investment world in 1980 would be appropriate today?

But I would argue that a closer look shows that, on average, the period encompassing the nearly 30 years since 1980 is not really all that different than what came before.

Down Memory Lane

Imagine, if you will, that you have traveled back in time to the early 1980s, and you are perusing the data in the 1980 Ibbotson Associates yearbook. This firm was created in 1977 by Professor Roger Ibbotson, and its yearbooks of historical data have become a must-have for financial planners and advisers. Those yearbooks, of course, contain the year-by-year performances back to 1926 of stocks, bonds and Treasury bills, and inflation rates.

What conclusions would you have reached? Here are two:

• Over the period of 1926 through 1979 (the period that would have been covered in the 1980 yearbook), stocks provided a handsome return, in both nominal and inflation-adjusted term;
• In addition, there was a healthy equity premium—that is, stocks outperformed bonds, compensating investors for the additional risk associated with investing in stocks.

But these same conclusions hold for the period since 1980, as is illustrated in Table 1.

To be sure, stocks in recent decades have produced higher returns (both in nominal and inflation-adjusted terms) than the returns they produced before 1980. But the real difference is not stock performance but rather bond performance—bonds did much better after 1980 than they did before. Because of this, the equity premium since 1980 has actually been less than the longer-term average, despite stocks themselves providing better overall returns.

This stock/bond relative performance difference between these two long-term time periods indicates, to me, that any “lessons learned” from the list of long-term top performers would have questionable relevance to the future if any of those top performers were highly ranked because they were heavily invested in bonds.

However, this is not the case—none of the newsletters at the top of the HFD’s rankings for performance since 1980 (see Table 2) derived a significant portion of their investment earnings from bonds.

All of which leads me to be fairly confident in drawing the following lessons.

Lesson 1: Long-term investors need not lose sleep over the markets’ short-term gyrations because the markets’ long-term patterns will eventually assert themselves.

To be sure, I am under no illusions that my drawing of this lesson will change many investors’ behaviors. For whatever psychological reasons, many are obsessed about the short-term and therefore can’t imagine not paying it the closest of attention.

What my data show, however, is that investors need not focus on the very short term to perform very well over the long term, thank you.

Consider The Prudent Speculator, the newsletter in first place on the HFD’s ranking for performance since mid-1980. Of any of the newsletters I monitor, this service has been the most buffeted by short-term market gyrations. And yet, none surpasses it in its willingness to either ignore or tolerate those gyrations.

Consider what happened to it in the crash of 1987, which just celebrated its 20th anniversary. On that day, according to the HFD’s calculations, the newsletter’s model portfolio lost 57%. And yet, far from panicking, Al Frank (the newsletter’s editor at the time) maintained his fully invested (and heavily margined) posture, patiently faithful that the stock market’s long-term uptrend would eventually win out. The newsletter’s long-term top ranking is a testament to that faith.

Lesson 2: Worrying about the short term can work against you.

Another lesson that emerges from my tracking of investment newsletters is related to the first: Constantly monitoring your investment performance can cause you to unnecessarily reduce the amount of risk you are willing to incur, causing your long-term performance to suffer.

According to behavioral finance researchers, constantly looking at how your portfolio is performing is not a benign act. It leads you to focus more of your attention on the short term than you would otherwise, leading you in turn to miss the veritable forest for the trees.

One researcher who has extensively studied this behavioral pattern, Richard Thaler of the University of Chicago, calls it “myopic risk aversion.” He hypothesizes that the more frequency with which an investor re-evaluates how he is doing, the more frequently he will experience loss, since any risky asset will not infrequently be exhibiting a short-term losing streak. No investor (except the occasional masochist) enjoys the experience of loss, and most investors prefer to avoid losses; therefore, this greater frequency of re-evaluation will tend to cause investors to own less risky assets and avoid stocks.

To test this hypothesis, Professor Thaler and fellow researchers several years ago constructed an elaborate simulation that imitated the many decisions that investors make over their lifetimes. One group was able to look at how they were doing every month, another group every year, and the third group got to take a look just once every five years. Just as Professor Thaler hypothesized, the investors who re-evaluated their portfolio every month had the lowest average equity exposure.

So, why does my own newsletter that reports investment newsletter performance come out monthly?

It’s a good question. The problem, of course, is that I wouldn’t be in business if I had a subscription product that came out infrequently. But the tension exists nonetheless.

One way I try to resolve this tension is by focusing my monthly newsletter on long-term performance. For example, none of the performance rankings in my monthly newsletter cover periods of less than five years. And most of my scoreboards cover much longer periods.

My hope is that, in the very act of responding to investors’ desire for constant re-evaluation, I can get them to focus on the long term. After all, a ranking covering performance over the last five years, or especially the last 10 or 20 years, doesn’t change that much from month to month.

Conclusion

If investors nevertheless want to obsess about the short term, they can be my guest.

But these short-term traders shouldn’t fool themselves into thinking that this obsession is necessary to build long-term health. On the contrary, it is probably standing in their way.

Mark Hulbert is editor of the Hulbert Financial Digest, a newsletter that ranks the performance of investment advisory newsletters. It is published monthly and is located at 5051B Backlick Rd., Annandale, Va. 22003; 703/750-9060; www.hulbertdigest.com. This column appears quarterly and is copyrighted by HFD and AAII.

Reprinted with the permission of:

American Association of Individual Investors (AAII)
625 N. Michigan Ave.
Chicago, IL 60611
(800) 428-2244
(312) 280-0170
(312) 280-9883 fax

www.aaii.com

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.