Frozen on the Bridge of the Titanic
(Guest Commentary by Rick Konrad – November 20, 2008)
Dear Subscribers and Readers,
No doubt, these are extraordinary times. In an ad hoc commentary on the Asian bond markets yesterday, GaveKal remarked that the Asian convertible bond markets fell more in September and October than during the entire Asian Crisis – when Asian sovereign governments and businesses were literally going bankrupt! Today, Asian balance sheets are generally the most healthy they have been in years. Similarly, US convertible bonds are now trading at 20% to 30% discounts to their plan vanilla counterparts – meaning that investors are not only ignoring the embedded call options, but are valuing them at negative values! Weeks of deleveraging have taken their toll. Even the options markets are now experiencing a severe decline in trading volumes – as investors' fears are now turning into apathy and as hedge funds have generally hedged their positions or forced to raise cash.
In these trying times, it is important to keep in mind why we are investing in the stock market in the first place – and most importantly, what has worked in the past and should continue to constitute investing success in the future. Our guest commentator, Rick Konrad, is no stranger to this. For those who had wanted to learn more about picking stocks, evaluating companies, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a guest commentary. Rick is one of our two regular guest commentators (besides Bill Rempel) and usually writes for us every third Wednesday of the month. We highly appreciate your investment insights and general wisdom, Rick!
In this commentary, Rick will be discussing the importance of temperament and patience in the current markets– as well as a stock market screen based on value investing concept of free cash flow. Without further ado, following is a biography of Rick:
Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator of MarketThoughts (please see “Surfing the Tsunami” for his last guest commentary). Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years. You can view a more complete profile of Rick on his blog. You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary. Rick is a very genuine teacher of the financial markets and treats it very seriously. Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been responsible for grading CFA papers.
Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice. Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.
"When anyone asks me how I can best describe my experience in nearly forty years at sea, I merely say, uneventful. Of course there have been winter gales and storms and fog and the like. But in all my experience, I have never been in any accident ... or any sort worth speaking about. I have seen but one vessel in distress in all my years at sea. I never saw a wreck and never have been wrecked nor was I ever in any predicament that threatened to end in disaster of any sort."
(Quote by: Edward John Smith, 1907, Captain of the RMS Titanic)
It seems appropriate at this time in capital markets to use this quote from Captain Smith, recorded five years before the Titanic's demise in 1912. Captain Smith had a reputation as a “safe” captain, a reputation that had him serve as the master on many inaugural voyages.
Yet, when confronted with the disaster of the collision, the highly experienced captain went into a blank state of immobility, a state of psychological trauma and complete hopelessness, resigning himself to his fate.
How many of us go into isolation and denial, “hiding on the bridge” as Smith did when confronted with a downward spiral of stock prices? Indecision is so much easier than taking a stand for most of us.
New investors who have not seen corrections before may be in the same “boat” as Captain Smith, never having been in a predicament that threatened to end in disaster of any sort.
In situations such as we are experiencing in these markets, it is very easy to lose sight of fundamentals. Focusing attention on the direction rather than the level of stock prices blinds us to measures of value and profitability.
As I had suggested last month:
“The adage of investigating before you invest is more important than ever. Pronouncements by strategists using selective data points may sound impressive but check the reliability of the data…it may not always be complete. Though the Buffett's of this world may find a price to swing the bat with fierce determination when that fat pitch arrives, most of us do not have the intellectual capital or emotional wherewithal to do so with confidence. Nibble and graze…diversify rather than feast. You will be able to concentrate your positions later as evidence mounts that you have chosen well. Cash may seem like the greatest refuge but when a market abounds with bargains, it represents the sirens' lure.”
Some years ago (1962), Claude Rosenberg published a “Stock Market Primer” with a chapter entitled “Common Stock Commandments.” Let's look at a few:
The very first commandment was, “Do not make hasty, emotional decisions about buying and selling stocks.” As he explains, when you do what your emotions tell you to-on the spur of the moment-you are doing exactly what the “masses” are doing, and this is generally not profitable.
Another valuable commandment he cited, “Do not fall in love with stocks to the point where you can no longer be objective in your appraisal of them.” A corollary to his commandment should be, “Do not hate stocks to the point…” Rosenberg explained in a politically incorrect way that “stocks are different than women.” “You'd be a fool to think of your wife all day the way she looks first thing in the morning-maybe best you think of her as she appears all dressed up.” (Please forgive me for my politically incorrectness…I realize that we men are not terribly attractive first thing in the morning…I am merely quoting) He suggests that stocks need to be thought of with respect to their worst points; you have to be brutal and unemotional in your appraisal.
“Buy a good value as it appears and do not let the general market sentiment alter your decision.” In other words, it is not a stock market, but a market for stocks.
Finally, “Remember that stocks always look worst at the bottom of a bear market (when an air of gloom prevails) and always look best at the top of a bull market (when everybody is optimistic.)” This brings to mind the Buffett quote about being greedy when others are fearful.
Temperament plays a very large role in investing. Most of us who have seen rotten markets in the past extol the value of patience, a habit that those who are not terribly patient absolutely despise. Someone has pointed out that patience has a very strange distribution among investors. Young investors who have all the time in the world to enjoy compounding and the long-term benefits of patient investing generally are the least patient. Old investors who do not have much time left and have actuarial tables working against them invest as if there are an infinite number of tomorrows. In my experience with retail clients, I find this to be quite true, my oldest client, still spry at 86 has just sent an incremental 25% to top off his account. My youngest clients, who clearly have never seen anything like this before, are quite distraught. As Rosenberg said, don't make hasty emotional decisions.
As many of you know, I am a strong believer in free cash flow as a guiding principle to investment. I think this is particularly true in a world where banks are reluctant to lend and investment bankers are stuck in a capital market that is frozen and unyielding.
Free cash flow measures cash that is generated beyond the working capital and capital expenditure needs of a business. Such cash flow can be deployed in three ways, 1) growing dividends, 2) buying back stock, and 3) reinvesting in the business, hopefully at significant returns on capital.
One measure of the quality of earnings is the conversion rate i.e. the proportion of earnings that is free cash flow.
Here is a screen using Cash Flow Analytics (http://www.cashflowanalytics.com) an institutional research provider that I have adopted in my firm. I have looked for NYSE and NASDAQ companies with decent profitability (trailing ROA above 12%), improving profitability year over year in ROA, where free cash flow exceeds net earnings and where free cash flow growth year over year was positive. The screen yields 136 securities.
Here is the screen.
One last comment. The dividend yield on the S&P 500 now exceeds that of ten year treasuries. Doug Kass, known as being a perma-bear comments on this here.
My first portfolio management role was at a life insurance company that had a rather dim view of equities. The investment philosophy that had been adopted over the years was that one should never own equities unless they yielded more than bonds. As you can see, such a philosophy would have kept the company out of stocks for 50 years, something that an investment committee would have a very difficult time explaining.
I agree that this crossing of the yield threshold suggests profound risk aversion and a market that sees no potential earnings growth. I consider this highly unlikely over any reasonable time frame. Once again, I think this demonstrates the unreasonable fear that is capturing most people's attention.