The Third Pig

After finding my post about “lazy investing”, a reader of The Third Pig suggested following such an approach would eventually lead to financial ruin. The reader suggested to be a successful investor one had to be unnaturally gifted in analytic ability and/or spend countless hours researching and trading his portfolio. I cannot speculate on where this reader developed his point of view but what I can say is the evidence does not support him. Warren Buffett has often said that successful investing requires three things: a 5th grade understanding of mathmatics, a sound investment philosophy and the right temperament. Never does he say you have to be a genius or you have to stay up all hours a night trading your portfolio.

Legg Mason Capital Management performed a study in an attempt to find the common characteristics of mutual funds that beat the S&P 500 Index during the period of 1992 to 2002. What was found was a few common attributes of the outperformers which are strickingly similar to a lazy investing approach. Those funds were/are/have:

• Portfolio concentration: These portfolios have, on average 37% of assets in their top-10 holdings, versus 24% for the S&P 500 and a 28% median for all U.S. equity funds.
• Portfolio turnover: As a whole, this group of investors had about 30% turnover, which stands in stark contrast to turnover for all equity funds of 110%. They are truly, lazy investors (how we like to define it).
• Value Investment Style: Most if not all of the funds listed seek stocks with prices that are less than their value. These fund managers recognize that price and value are not the same, often diverge and then converge again. They take advantage of this consequence of investing in the stocks of companies.
• Off Wall Street: Only a small fraction of high-performing investors are located in the financial centers of New York or Boston. There location allows them to quiet the noise of Wall Street, dampening the temptation to trade frequently or with reckless abandon. They can take a more methodical and rational approach.

The chart below shows how some of those funds have fared against the S&P 500 in the 10 years ending September 30, 2009. As you can see, most of them beat the market and had positive returns in a period that experienced the worst economic times since the great depression. Oakmark Select in particular had a bad run as a result of owning a large piece of Washington Mutual during the subprime crisis (article) but it hardly mattered over the long term. The funds that didn't have been a little more volatile than the market and measured over different but similarly long periods, also outperformed the market. Although I cherry-picked the funds I follow most, the sample is representative of the group listed in the Legg Mason white paper.

Following this approach, our Core Model Portfolio Average has performed well over a similarly long period of nearly 7 years (ending 9/30/2009) returning an annualized 10.7% versus the S&P 500's 3.8%. Bottom line, it pays to be lazy when it comes to investing.

Disclosure: I and the clients of Brick Financial Management, LLC did not own shares in any of the the companies or funds mentioned in this post at the time of this writing. But positions may change at any time.

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Posted by Benjamin Taylor at 03:00 PM |
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Dear friend,

On September 26th, CrossFitters across the nation will unite for the fourth consecutive year to honor and support our injured service men and women and the thousands of people fighting and living with prostate cancer: Fight Gone Bad IV. One day. One workout. One Purpose.

Fight Gone Bad IV benefits Athletes for a Cure and the Wounded Warrior Project. There's no stopping us from making a difference and I hope you will support our efforts with any contribution you see fit. Last year we raised $627,000. This year, we are going for $1million. This goal will be reached one dollar at a time, in amounts ranging from $1 to $1000.

Please take a moment to give what you can to this important event. Click on the link below to connect to my personal fundraising page. http://tinyurl.com/bensfgb

I would also like to invite you join our Facebook community and come meet all of the participants who are taking part and supporting Fight Gone Bad IV. You can join us here: http://fgb4fans.org

Thank you for your support. One Fight at a Time.

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Posted by Benjamin Taylor at 09:24 AM |
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source: Cordoza Life

This past January, about the time of Obama's inauguration, Warren Buffett gave an interview to PBS corresspondent, Susie Gharib. In the interview Buffett was asked to give his greatest and most important business lesson. He responded:

The most important investment lesson is to look at a stock as a piece of business not just some thing that jiggles up and down or that people recommend or people talk about earnings being up next quarter, something like that, but to look at it as a business and evaluate it as a business. If you don't know enough to evaluate it as a business you don't know enough to buy it. And if you do know enough to evaluate it as a business and its selling cheap, you buy.

When thinking of stocks as more than just pieces of paper, but actual representations of underlying businesses, the investor is led to a more sensible approach. If as an investor you were considering buying a business that you would own, operate and would provide the majority of your income, it is likely you would not contemplate selling that business within seconds of purchasing it. Just as you would not think of buying a home in the morning and selling it in the evening, if your intent was to live in it.

A great example is Google (GOOG). Google is the dominant player in the search engine world commanding more than 64% of internet searches and is rapidly becoming a threat to longtime tech behemoth, Microsoft (MSFT). Google also produces and obnoxious amount of free cash flow and seems to grow that cash at will (see chart).

With market dominating performance and consistent operating results, it is safe to assume Google's business value is stable and steadily growing. But if you were to look at the stock price, you'd never know it. In the past 52 weeks, Google's shares have gone from a high of $510 to a low of $247 and now sit at around $430. Do these wild fluctuations make any sense given Google's performance? Nope. But for those of us who are more concerned with the underlying business, we can just sit still and only move when to buy when the market greatly undervalues our business and sell when they overvalue them. This is why I don't trade very often and prefer the "lazy" approach to investing.

Disclosure: I and the clients of Brick Financial Management, LLC owned shares of Google at the time of this writing but positions may change at any time.

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Posted by Benjamin Taylor at 06:19 AM |
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A few weeks back we introduced you to Bill Nygren, manager of the Oakmark Select fund. In the video Nygren plainly states his belief the market is presenting investors with a lot of opportunity to purchase undervalued but high quality companies. In his 2009 semi-annual letter to his fund holders, he reiterates this view. He says,

We continue to believe that today’s long-term investors will increase their capital more by investing in stocks than by investing in other assets. Further, we believe that the long-term return for stocks purchased today is likely to be higher than historical average returns. Here are a few of our main reasons for such optimism.

In his letter, Nygren sites three factors that influence his position - valuation, historically high levels of cash, and lots of skepticism amongst investors. In regard to valuation, Nygren points out that with the S&P 500 trading at about 900, and operating earnings in 2009 expected to be in the $60s, stocks appear reasonably valued with a mid-teens P/E ratio. But Nygren strongly suggests a $60 range for earnings is not normal. Nygren argues that operating earnings were nearly $90 in 2006 thus normal earnings are probably somewhere north of $60.

Nygren also talks about cash, the amount of money market balances which remain historically high. These funds have to go somewhere and the stock market is its most likely destination. The following graph illustrates this point:

In regard to the market's skepticism, Nygren says:

As value managers, we’re used to having people disagree with us. In fact, we prefer it that way. The consensus opinion, almost by definition, is usually reflected in current prices. So when we differ from consensus, we’re excited by the opportunity. We believe that today’s consensus stock market opinion is that the magnitude of the market increase since March has not been matched by fundamental improvement in the economy. The implication is that an investor should wait for the market to fall before increasing their investment in stocks. While we applaud the effort to tie stock price movements to fundamentals, we have to ask, where were these fundamentalists when the market was in freefall?

All in all, Nygren makes for a good fundamental argument to be an investor in today's market.

Disclosure: none

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Posted by Benjamin Taylor at 03:34 PM |
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Source: Flickr by timcullen

At the extremes, the bottoms of bear markets and the tops of bull markets, you will undoubtedly hear that buy and hold is dead. We find ourselves in the former market (we hope) thus that old refrain has returned. Over the last 10 year, the S&P 500 has seen a -2.5% annual yield (ending 4/30). Those who become disenchanted with the buy and hold strategy are folks generally uncomfortable with what feels like doing nothing. Alternatively they set to a course of frenetic trading at what seem to be opportune times. Unfortunately this approach leads to very little except frustrated investors.

The Journal of Finance published a white paper by two Cal Berkeley professors, Brad Barber and Terrence Odean which chronicled the folly of the active trading approach. Right from the abstract of the paper they write:

Of 66,465 households with accounts at a large discount broker during 1991 to 1996, those that trade most earn an annual return of 11.4 percent, while the market returns 17.9 percent. The average household earns an annual return of 16.4 percent, tilts its common stock investment toward high-beta, small, value stocks, and turns over 75 percent of its portfolio annually. Overconfidence can explain high trading levels and the resulting poor performance of individual investors.

So how does an investor beat the market?

Relax: The first thing to do is to simply take a chill pill. Most of what you need to beat the market comes down to your temperment. If you can keep a cool head while all the world is losing theirs you will have a tremendous advantage. Fear and panic cause investors to make bad decisions more often than not. So stay cool.

Stop trading: Transactions costs, the least of which is commission, eat away at returns. As damaging is the bid-ask spread as well as the capital gains taxes paid on any small gains made. According to Barber and Odean:

The investment experience of individual investors is remarkably similar to the investment experience of mutual funds. As do individual investors, the average mutual fund underperforms a simple market index. Mutual funds trade often and their trading hurts performance. But trading by individual investors is even more deleterious to performance because individuals execute small trades and face higher proportional commission costs than mutual funds.

Control your emotions and your ego: Consistently beating the market is difficult. For this very reason it pays to take your emotions and your ego out of it. Do you really think you will create some investment approach that is somehow smarter and more fantastical than the methods used by Warren Buffett or John Templeton? It's foolhardy to chase the latest fad in investing (or to think you'll create it) when the tried and true works like a charm.

Hold just a few positions: The investor would do well to select only the stocks of companies he understands well. By doing so he will reduce his portfolio's risk by steering clear of permanently weak companies and avoiding overpriced firms, not by excessive diversification. Increasing portfolio positions past 20 to 30 positions does very little to reduce volatility any further. Interestingly though, increasing positions past this point will continue to reduce returns. According to mutual fund manager Robert Hagstrom, concentrated portfolios of 15 securities are 13 times more likely to outperform the market than portfolios of 250 securities. In other words, excessive diversification fails to effectively reduce volatility risk yet greatly handicaps the investor’s ability of beating the market.

Buy at the right price: Even the greatest company will not make a good investment if it is overpriced. Determining the correct price for an investment is difficult as it requires many assumptions. But it is essential to a sound investment process. If bought at a price below the company's real value, all an investor really needs to do is wait until the price of the stock reflects the true value of the company. Eventually, it will.

If an investor follows these few steps, he can relax on the beach and let others worry about the ups and downs of their portfolios.

Disclosure: none

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Posted by Benjamin Taylor at 06:50 PM |
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