Saturday, March 12, 2011

Joining the few ‘truly successful’ investors

Efficient Market Hyphothesis (EMH) and Modern Portfolio Theory (MPT) state that as soon information is known about a stock, knowledgeable investors will immediately adjust their buying and selling prices to reflect the new information. Consequently, stock prices nearly instantaneously reflect the true value of these investments and outperforming the markets is theoretical impossible.

Investors such as Warren Buffett who have consistently outperformed the markets for years at a time are statistically impossible. But like with any science, reality shows EMH and MPT are not the final truth – there are many other investors that outperform the average market than fans of investing in market index ETFs and funds would like you to believe. If theoretical models and risk theories were right, the Great Recession 2008-2009 would never have happened! David Dreman's mutual funds would not have outperformed the markets with his contrarian investment strategies.

What is becoming clear though, and what will likely stay this way for a long time, is that great companies are not necessarily great stock market investments and that the lowest quintiles of stock market valuation tend to outperform the markets consistently. These observations by Dreman and others have been proven true since the days of Benjamin Graham, one of the earliest pioneers of value investing.

Companies may be superbly run, but that does not mean that their shares are priced right on the stock market. Take Starbucks, a well-run coffee marketing machine with stores worldwide. All data is from GlobeInvestorGold. Starbucks (SBUX-Q) was the big success story of the 1990s, it grew explosively and so did its earnings and stock price. Initially investors didn't recognize Starbuck's potential and the stock traded at moderate valuations as expressed in terms of Price/Earnings (P/E), Price/Cash flow (F/CF) or P/Book Value (P/BV). This was like buying growth at a reasonable price. But soon thereafter everybody had heard about Starbucks and earnings were expected to grow until the end of times and the stock valuation went up faster than its earnings. The share price peaked in 2006 – 2007 at $40 while it earned only $0.71. That was a P/E/ of 56. In terms of cash flow (profits before depreciation and interest costs) the company made $1.22 per share and its book value (net assets per share) was only $2.95. That meant that at the peak, an investor paid $14 dollars for $1 worth of assets in Starbucks.

The stock was set up for failure and that is exactly what happened. The company had grown too fast, new stores were less profitable and with the on-set of the Great Recession, sales for existing stores did not grow any longer either. The company still grew in 2007, but in 2008 earnings fell from a peak of $0.87 per share in 2007 to $0.43 in 2008. Duuh!! So there was a management change; they eliminated poor stores and with the onset of recovery performance of the company grew. But alas, the stock…

 As Dreman points out in his book: "Contrarian Investment Strategies: The Next Generation", investors had overpaid for Starbuck shares for years and even if earnings had kept up with expectations the company's stock would have a hard time providing the same returns as the stock market in general. On top of that, financial performance was disappointing in 2007-2008 and the stock crashed with a vengeance! In December 2008 it had fallen to $ 9 dollars per share. Looking back this was the time to buy. But would you have the stomach to have done so?

Investors who bought at the peak had lost $31 per share by December 2008 or over 77% of their investment! At that market bottom the P/BV was 3, in other words you paid 'only' $3 for each $1 of Starbuck assets. The P/E was still high at 21, but P/CF was 'only' 8. In other words, the restructuring of the company resulted in a lot of write-downs but profits from operations were still higher than in 2006 and 'only' 20% below those at the peak of the economy. My son and I still loved buying coffee at Starbucks; thousands of people were still drinking their morning lattes and once things in the world improve it will hard to imagine that Starbucks doesn't grow again.

Cash conserved from profit taking and dividends collected when the economy boomed were put to work and we bought some Starbucks. Yes, it was a leap of faith expecting that the world would NOT end durig the panic of 2008-2009. Thankfully(?), I have experienced enough economic panics by now to know that sooner or later this Great Recession or the New Depression (which never materialized) would end.

Today in 2011, earnings have indeed improved and things look better at Starbucks and the investor herds have gone again bananas. Starbucks is now trading at a high P/E of 29 and you pay $7 dollars for $1 dollar of Starbucks assets. We made just over $27 of profits with our $9 investment. Unfortunately, we bought for my son's 'practice' account and he bought a whopping 10 shares; I 'should'!

I should have had the stomach to buy Starbucks for my main portfolio. Unfortunately, my stomach wasn't strong enough at the time – I was affected by the panic too! Besides, there were other buying opportunities. When nearly everybody panicked EMH was certainly not at work and there were bargains everywhere. Even with a less strong stomach, just holding on to your existing portfolio and using your cash to buy some more stock should have proven very profitable. This 'should' I achieved and hopefully you did as well. 2008-2009 was the buying opportunity of a lifetime, or maybe better of a decade! The successful investor will feel his stomach churn; against instinct he will buy during the down turn. He/she may not time the bottom perfectly – that is often impossible. But the successful investor will buy at a discount, when EMH is forgotten and panic rules the day.

Many cannot invest like this – just holding on may prove too difficult; that is why investing is hard and although 'buy low and sell high' sounds easy, it is tough to do in real life. Still, here was one of those other breaks in your life that could make you wealthy rather than 'financially OK'. Train yourself and your stomach to see downturns and crises as buying opportunities and you will join the ranks of truly successful investors.

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