Waiting for the Fat Pitch
(Guest Commentary by Rick Konrad – January 22, 2009)
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 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 extend his thoughts (first discussed in his November 20, 2008 commentary) on his timeless investment philosophy to take – a philosophy that tends to be the most useful during times of market dislocations (on the upside as well as on the downside). Rick will also offer his thoughts on the custody banks, as well as on US Bancorp. 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 “Money for Nuthin” 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.
Happy New Year!
After 2008 provided us the third worst year ever, many investors remain shell-shocked and “frozen on the bridge.” Where to go…what to do?
The sub-prime crisis that had begun to emerge in 2007 evolved into a widespread financial collapse for 2008. The last few months showed incredible volatility as the Dow Jones Industrial Average suffered four of its 20 largest single day declines in history. Global commodity demand collapsed as developing economies slowed and basic material companies succumbed to a rapidly shrinking revenue line as well as, in many cases, a leveraged balance sheet that was a creation of an acquisition-driven strategy. Other than Treasury bonds, which provided a miserly, paltry return, there was no place to hide.
This year too has suffered from a lack of confidence, a feeling that government in general, and a somewhat hapless Mr. Paulson, were as confused and even powerless as the rest of us. The financial sector in particular, even after today's 15% bounce, these stocks has given up 26% of their value since the beginning of the year as measured by the XLF (Financial Select Sector SPDR.) The sector's drop in market cap relative to everything else brings its weighting in the S&P 500 to below10%, still significant but far easier for a portfolio manager to avoid as a diversifier than when it represented 22% of the total. Yesterday's collapse of State Street Bank represented the “last straw” for many investors. State Street (STT), Bank of New York Mellon (BK), and Northern Trust (NTRS) were demolished after STT's extremely poor quarterly results. Following the release of much less scary results for BK and NTRS, these stocks rallied, though not entirely reversing the prior day's losses.
The seemingly bipolar nature of some investors is as spectacular as I have ever witnessed and frightening to new clients. Investors are willing to swing for the fences in anticipation of earning huge returns. Fear of nationalization causes the same investors to dump and run. Note the huge volumes in National City (NCC) prior to its ultimate takeover (demise?) in the safe hands of Jim Rohr's PNC at $2.23 per share (the chart below is courtesy of Decisionpoint.com). The volume patterns in Allied Irish, Citigroup, and Bank of America suggest that these stocks are in the hands of the gunslingers, perhaps those who trade from the gut. I think Shakespeare described this behavior best when he described a tale full of sound and fury, told by an idiot, signifying nothing. For most banks in my opinion, the efforts to uncover the skeletons and problems can be far too arduous for the average investor.
A great example of this is the Royal Bank of Scotland (RBS) and the recent actions of the British government. RBS is set to redeem £5bn of preference shares and replace them with new common stock. This move replaces one form of capital with another resulting in little improvement in capital ratios. However, the removal of the onerous preference coupon repayments also allows RBS to boost its lending capacity by accepting significant dilution. With 70% of the stock held by government, there clearly is a new sheriff in town.
The extreme uncertainty is causing a lot of emotional trading. Keep in mind the first Claude Rosenberg commandment we offered a few posts ago:
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.
I believe that niche banks such as the custody banks are worth the analytical effort. Very well-capitalized banks, ditto. For example, we used weakness in Bank of New York Mellon (BK) to build a position on Tuesday. Yesterday, at a 13% yield, I was pleased to buy US Bancorp (USB). Though people reached for sell tickets this morning after the “disappointing” earnings, upon deeper consideration and some analysis, the stock came roaring back. And why not? Here were the results versus the recent guidance:
- Expected net charge-offs of $600 to $650 million - reported $632 million actual
- Provision to exceed NCOs by 90% to 110% - reported actual 100% coverage
- Non Performing Assets expected to be 1.14% to 1.18% of loans - reported 1.14% on core basis
- SIV/securities impairment charge of $200 to $300 million - reported $253 million
Credit problems will abound in this deep recession and reserves will continue to mount. The rich dividend could well find itself getting reduced. Yet, in looking at the relatively unsurprising operating results, it seemed there was little to warrant the initial reaction. Sure, continued credit losses will deplete equity…that's how it works in this business, yes, in every business. Nevertheless, it is my belief that USB holds up analytically much stronger than most large size regionals.
A few years ago, at a Berkshire Hathaway meeting, Charlie Munger described a terrific way to categorize investments:
"At Berkshire we have three buckets, yes, no and too hard."
Rather than just sling money at whims, remember that you don't have to investigate everything, or have an opinion on everything. Some investment ideas are just too hard, too difficult, and way too complex to forge a sound and strong investment opinion. When capital structures become byzantine and it is difficult to penetrate the black box, it should tell you something. On these difficult questions, the investor always has the ultimate safeguard: Walk away!
Harbingers of doom will continue to frighten you this year. Nouriel Roubini, the brilliant NYU professor who forecasted this credit mess and the “technical” insolvency of the UK has been recently labeled a “clairvoyant.” There is no clairvoyance in dealing with capital markets or economies. Sound judgment and dealing with probabilities and likelihoods will serve you much better than being a disciple to a prophet, especially one now christened with clairvoyance by the media.
Most forecasters expected a January that would anticipate the popularity of President Obama. Whatever your politics, the steady decline of the credibility and the power of President Bush dragged international sentiment regarding the U.S. off a precipice in recent months. I half expected that the new president might pull out the Gerald Ford comment, “My fellow Americans, our long national nightmare is over.”
Yet in the inaugural address, we were reminded of some painful realities as Washington Post's David Ignatius points out:
“The new president opened his inaugural address by reminding us how bad things are. He spoke not of sunny skies and amber waves but of "gathering clouds and raging storms."
“And he told us that it was partly our fault. The economic crisis wasn't just a result of "greed and irresponsibility on the part of some" but a consequence of ‘our collective failure to make hard choices and prepare the nation for a new age.' “
“We all know the Pogo line about how "we have met the enemy, and he is us." Obama implicitly seemed to embrace it. We have been an immature country; we want things that are in conflict. We favor lower taxes and more services; we want balanced budgets and more spending on entitlements. We want progress, so long as it doesn't threaten the status quo”.
Like President Obama describe, “immobilism” doesn't work in the stock market any more than it works in any other aspect of life…"Our time of standing pat, of protecting narrow interests and putting off unpleasant decisions -- that time has surely passed."
There are hard truths in this market that one can and must avoid. Don't kid yourself by guessing! But simple screening techniques can provide some edification and returns.
In my November 20th Marketthoughts post, I provided a screen of companies which were selected on the following criteria:
“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.”
Let's review what has happened in that very brief two-month period. We were fortunate to be able to post at a time when investor sentiment was horrific and the markets were near what turned out to be at least an intermediate bottom.
Of the 136 stocks, 114 provided a positive return measured to today's market close about 84%. When we look at an advance/decline line for the market, which is barely up for this interval, we think that is a satisfying result.
The S&P 500 provided a return for this period of +11.67%. The Russell 3000, a broad-market index returned +6.17% for this interval. The median market cap for our screen was $1 Billion as compared to the S&P 500 at $44 Billion, so the Russell is a more representative benchmark.
Fully 114 of the stocks outperformed the Russell 3000 for a batting average of 84%. Even though only three of our selections reached the median S&P 500 market capitalization, 64 of the stocks beat the S&P 500 or about 47%.
We continue to find many of these names of interest and will continue to monitor them going forward as well as provide new screens.
There have been other times in history that there has been deep-seated distrust of stock investing at times of economic turmoil. Given a ten-year record for the S&P that looks like the EKG of a cadaver brings much skepticism regarding even being involved in stocks. Rather than wondering what stocks to buy, many are wondering should we buy stocks at all??
In David Dreman's, Contrarian Investment Strategies: The Next Generation, Dreman found that the market was 25.8% higher one year after bottoming following a crisis and 37.5% higher two years later.
Abandoning stock investing at this time is a little like the life companies which following forty years of rotten fixed income returns preceding 1980, chose to reduce durations at the very bottom. I was nearly fired as a portfolio manager in July of 1982 because I was “reckless” for suggesting and executing an increased equity allocation for my firm for that year. Our august board of directors' Investment Committee chairman wanted my head, if not other aspects of my anatomy! Fortunately, the beginning of a new bull market in August of 1982 saved my bacon.
The market will turn, it always does. Crises that are going to destroy the economy and the markets come and go…we somehow manage to survive and indeed thrive. An economic recovery is not a prerequisite to the market doing better. Stock markets have done very well right in the middle of recessions and this should be no surprise…the markets look forward…the markets look to future value. Hence, the recovery takes place in the stock market before it hits Main Street.
The rotten news will likely continue. Obama will enjoy a honeymoon period that may or may not end before the economy turns. But while most investors are reluctant to open their month-end statements, let alone look at stock fundamentals, it's a great time to be looking at the numbers. Downturns prompt fear and a complacency to enjoy a cash cushion. According to Steve Leuthold, recently quoted at Bloomberg.com, cash, bank deposits, and money-market funds now total close to $9 Trillion, about 74% of the value of U.S. stocks. Hopefully, with Henry's help, we can employ some discipline, some fundamental research, and some insight gained from many battering experiences to share some decent stock picks.
This reporting quarter will provide some ugly readings in both the financial results and management guidance. Remember, that management is just as afraid as you are about deteriorating sales, falling prices, building inventories, and failing customers. Their behavioral instincts are no more refined than ours. Over-reaction is not exclusive to investors. Regulatory requirements and a compliance-driven need for conservatism tend to push optimism aside.
Success in investing is not unlike Woody Allen's prescription for success…80% of it is just showing up. Stocks are on a half price sale compared to their previous peaks, in many cases, well below 50% corrections. Lots of cash seems to be poised on the sidelines waiting for “the right moment.” None of us really knows when that right moment will occur. As I have suggested before, nibble rather than chomp, diversify rather than concentrate. A Buffett temperament and ability allow massive swings at fat pitches…few of us can muster that courage or commit capital that well.
I continue to believe that disciplined investing will put the odds of success in your favor. I encourage you to keep swinging that bat, finding a few fat pitches in a stadium where most spectators are watching the out of town scores. Keep your eyes open and don't blink! Rallies of massive proportions come out of the swampy sludge of low expectations. I hope that my friends, Henry and Bill Rempel, and I can help you find some investment success and happiness this year! We all look forward to it.