Saturday, March 26, 2011

We get rich when Efficient Market Hypothesis fails

Not only David Dreman is disagreeing with Efficient Market Hypothesis (EMH) and Modern Portfolio Theory (MPT). In 1960, Eugene Fama was one of the strongest advocates of EMH, but irony of ironies, in the 1990s, he and Kenneth French showed that the data did not support EMH. Who says that a scientific theory only becomes obsolete when its leading proponent dies?

Maybe it is the fact that investing is not a science that gave Fama the courage to review his opinion? Maybe in the world of investing, nothing is more costly than hanging on to improper tools? Or maybe in the investment world we care about the results rather than explaining those results with grand theories. After all, successful investors are pragmatic.

It is EMH that forms the basis of many investment strategies. It is in particular the EMH notion that market price reflects all facts and news about an investment that prevents us from reaching financial freedom. EMH states the price is unemotionally set by the market consensus of well informed investors. But if that was true, then nobody can outperform the market and the only thing that counts is the expenses you incur to acquire a basket of diversified investments. It is true that many mutual funds underperform the stock markets by the amount of their MERs (management expense ratio) and the buy and sell commissions. The only thing many of those mutual funds deliver is less volatility than the overall market. Only a select few of fund managers outperform the market – the most famous of those is Warren Buffett. Here in Canada we have Peter Cundill and John Templeton that are shining examples of investors that disproved the principals of EMH.

Between 2008 and 2010, Warren Buffett made some of his largest investments yet. Barely 2 years later, the wisdom and profitability of those investments cannot be denied. Lately we're talking more about black swans and Justin Fox's 'The Myth of the Rational Market'. But this is no real news, Ken Fisher and many other investors, ridiculed by the academic investor establishment, were for years telling and showing us that markets are much more complex. Markets are an amalgam of numerical logic and consensus emotionalism plus… That is why on this blog, we're talking about a diversified portfolio COMBINED with the breaks in your life.

Those breaks or investment opportunities come from many directions and it is your job as a successful investor to recognize these opportunities and grab them. But how can you take advantage of these opportunities if you don't have the skills to deal with them and optimize your profits? It takes a lifetime of learning and studying to be ready to take advantage of our breaks. Some luck out or are gifted with the talent to recognize 'breaks' at an early age. Warren Buffett claims that it is his luck to have those talents and to live in a country where he can take advantage of his talents. As Warren himself states, if he ever got shipwrecked on an uninhabited island Warren would undoubtedly perish because of his lack of survival skills while others would prosper (Tom Hanks and Robinson Crusoe come to mind).

Less than 4% of all real estate transaction involve investors with rental properties; most of us invest in paper securities. This is partly because investing in real estate requires a lot of work. Some of it can be delegated to rental pools and property managers, but then you still have to sit on condo and rental pool boards. Many real estate investors prefer this kind of control and the higher work load is reflected in part in the real estate returns; the higher level of control also allows the real estate investor to use leverage increasing profitability even more.

Most of us prefer paper securities and a hands-off approach. Only our money works (to some degree). Whether you are big in real estate or not, most successful investors own a diversified stock and bond portfolio. The returns of such a diversified portfolio are limited; we may become 'well off' but never wealthy. Also, in today's investment climate, fixed income instruments like bonds may help combat portfolio volatility, i.e. short term valuation risk, but over the longer term stocks clearly outperform. This may change when the government cycle of high deficits and high inflation peaks as it did in 1982 but that is probably still another 10 years away if not longer.

Therefore, we should aim for a diversified stock portfolio and be ready for a 'break' in the stock market or in our employment (company savings plan and/or stock options). For small investors creating a diversified portfolios is easiest achieved through buying a set of Exchange Traded Funds (ETFs) that reflect the Canadian stock market, the U.S. market, the European market and Emerging markets or better the BRIC countries. Alternatively, a larger investor could buy a portfolio of individual stocks. Don't own more than 30 to 40 companies. For more diversification, you could buy preferred shares, common shares and even some debentures for one and the same company.

The reason to buy not more than 30 to 40 companies is simple. Keeping track of them is going to be a full time job! In the meantime you have no other control over those companies than buying or selling their investment paper. We are typically not Karl Icahn who owns enough of a stock to force him onto the board gaining a measure of control that way.

For many of us, building a diversified portfolio is all we achieve. To become wealthy however, we need our 'breaks'. With sufficient experience, funds and knowledge we should position ourselves for the 'breaks' like buying individual companies during a market downturn and to make it into a lifetime opportunity that increases our net worth with leaps and bounds. Those are the investments where EMH is out of whack, a Black Swan opportunity you can take advantage of. So, it is kind of odd, but it is when EMH no longer works, when blood runs through the streets of the investment world, during the low tide when the naked investor is exposed that true wealth is created. We're making most of our money when the Efficient Market Hypothesis fails and is swept away by the emotions of market consensus. We all, even non-investors, know this already intuitively, but many of us don't have the stomach to take advantage of it. With increased knowledge and experience we should overcome our fears and grab the 'breaks'.

Friday, March 25, 2011

Steady as she goes

The 'correction' in the stock market augmented by the Middle East crises and Japan's Earth Quake was not really much of a correction. It suggests that this bull market has still a lot of 'umph'. U.S. fourth quarter GDP was just upgraded to 3.1%. In Alberta, retail sales are on the rise while interprovincial in-migration and foreign immigration as well as job creation are accelerating. All this bodes well for the Alberta and for the Canadian economy.

However, potential rising interest rates, political uncertainty regarding the coming Federal election and uncertainty regarding Alberta's political leadership detract from the good news. Coming May a new Federal government will be sworn in. Who will win? Your guess is as good as mine, Canada's electorate has proven to be easily distracted by side shows such as the poor communications skill of a federal minister or cuts in cultural subsidies. But...

How likely is it that the Liberals and their potential coalition partner(s) will increase their seat count to the level that they can form a minority government kept alive by Block support while opinion polls suggest that Liberal support has fallen as low as 24% of the popular vote?  If, as the Globe and Mail claims that 'thrustworthyness' is the Tories' Achilles heel, than how about the lingering anger over the Liberal AdScam?

In my mind it is more likely that we end up with another Conservative minority government, so what is the real reason that this election was called?

My guess is that Mr. Ignatief is running out of time as a Liberal leader. If he does not make good progress his days are probably numbered. This election is likely his last shot at becoming Canada's Prime Minister and if he does not make it, it will be 'goodbye Iggy!".  Jack Layton is also running out of time. These gentlemen are the ones to loose this election, while Stephen Harper is in a position to finally reach majority status.

Will Iggy and Jack be able to fire up the masses? I doubt it, more likely they will be running out of fuel. Fiscal hawks may be getting what they are asking for: "Fiscal restrained and debt reduction", if Harper gets his majority or even with a strong minority government complemented by two nearly politically dead opposition leaders.

That is my forecast (which will likely require a lot of updates over the coming months). It explains the tame budget because how would you expect the Conservatives to win their majority if they announced severe budget cuts and possibly even a tax increase?

Economic leadership in the coming month will be from the U.S. while Canada will be drifting rudderless going from spring into early summer. Then everyone is on vacation which is not good for the Canadian stock market either. So expect extended summer doldrums with here and there a little boast from a recovering U.S. economy.

The real power of this stock market will likely be unleashed after the summer and in the 4th quarter. I don't see many well priced investments in the stock market right now. Valuations in the U.S. are somewhat more attractive.
Typically, real estate markets lag stock markets and I expect that here we may see some hot action over the summer. With in-migration picking up its pace and vacancies already low, expect rent increases and a hot rental market over the spring and summer, especially in Alberta.

If you have not bought your Alberta real estate yet, this is time to take action because we're about to turn from a buyers to a sellers market. In the mean let the stock market ride don't buy expensive stock investments. Just sit back and count your increasing net worth. It is not yet time to start significant profit taking and cash building; yet the buying opportunity for stocks is over for now.

Wednesday, March 16, 2011

Emotional Investing

The Japanese crisis is upon us and I would not want to discount the human tragedy and the suffering of the Japanese people. But the stock markets are reacting as if the worst case scenarios are fact rather than possibility. Initial damage estimates in Japan are approaching $180 Billion - huge! But the markets have lost all their 2011 gains; worldwide stock market losses are reaching a trillion or more. As usually, we are overreacting in crises.

You may disagree, but statistics show differently. Here is a tabulation of crises in the last century and subsequent stock market performance in the U.S. as compiled by David Dreman:

Crisis EventDate of Market LowAppreciation
after 1 year
After 2 years
Berlin Blockade07/19/1948-3.3%13.3%
Korean War07/13/195028.8%39.3%
1962 stock market break06/26/196232.3%55.1%
Cuban missile crisis10/23/196233.8%57.3%
Kennedy assassination11/22/196325.0%33.0%
Gulf of Tonkin08/06/19647.2%3.1%
1967/1970 stock market break05/26/197043.6%53.9%
1973/1974 stock market break12/06/197442.2%66.5%
1979/1980 oil crisis03/27/198027.9%5.9%
1987 crash10/19/198722.9%54.3%
1990 Persian Gulf War08/23/199023.6%31.3%
Average appreciation25.8%37.5%

According to Dreman, "these were eleven crises since World War II, ranging from the Berlin Blockade (when we stood eyeball-to-eyeball with the Soviets on the brink of war) to the crash of 1987 (the worst crash of the twentieth century). Of the 11, 6 were political; and the other 5 were brought on by economic, investment or financial factors. The figures measure the Dow Jones Industrial Average at the bottom of each crisis when experts predicted prices could only tumble lower, along with the subsequent 1 and 2 year performance."

So if you have cash, this may be a good opportunity to buy stocks at a 'discount' and the table shows that on average, you would likely be ahead 25.8% in one year and 37.5% 2 years from the bottom. Of course, picking the bottom of the crises perfectly is not possible (unless very lucky), but still when you buy during this crises you will probably profit handsomely a year from now.

If you feel bad about profiting while others are suffering, why don't you make a donation to the Red Cross in anticipation of your profits? The markets will go up and down regardless of your investment actions, but your donation will certainly help the victims of this disaster.

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.

Friday, March 4, 2011

When will high oil prices affect economic growth?

Oil is starting to play the role of interest rates when it comes to determining economic growth. A lot of things are 'chicken and egg' situations. For example, if inflation increases, then interest rates tend to increase, which would increase the financing costs of government debt (amongst others). This would result in increased deficits, which politicians tend to fight not by cutting spending but by raising taxes.

Next thing you know, the increased tax rates pervades the economic prices of labour and all kinds of products. In other words it fuels inflation. Simultaneously, higher inflation fuels higher commodity prices which includes the price of oil. So it is a vicious cycle that leads to ever increasing taxes, government debt service costs, inflation and asset value increases.

 People with fixed income will suffer most. Pensioners and other retirees are prime targets. They will first be forced to reduce their lifestyle especially due to the fact that the combination of inflation and high taxes will kill not only their spending power but also the real value of their nest eggs.

So just like the Bank of Canada can control, to some degree, economic growth so does the price of oil. It will force consumers to cut back their purchases and lifestyle expectations. If less product is bought, then the economy will cool and eventually slip into recession.

That is why the WTI Crude Oil price chart at the head of this blog is so important. It helped me make a very simple price extrapolation and predict that oil prices would likely exceed $100 per barrel in the first quarter of 2011. Apart from the Middle East unrest, we would have reached this price level anyway. The WTI prices may not be truly representative of world oil prices for now because of oil pipeline issues in the U.S. Mid West (Cushing). The Oil Drum website has an excellent review on this issue if you are interested: Why are WTI and Brent Oil Prices so Different?
Some authors such as Jeff Rubin ascribe the cause of the 2008 not only to the Subprime mortgage crises and overvalued real estate markets of Europe and the U.S. but also to the fact that the economy had no longer affordable oil to fuel the economy. A perfect storm! The bubble peak on the WTI graph in March 2008 with a WTI above $125 per barrel would seem to be the danger point.

So to forecast the oil price for the next 6 months or so (barring Middle East price shocks) suggest that oil prices should reach $105 per barrel over the next 6 months for WTI while the Brent Price may be closer to $115. By then some clouds may start to form along our economic horizon. BTW the chart below is from the aforementioned Oil Drum article.

Everything goes well in the world of investing

Well, not necessarily perfect. There are always issues looming at the investment horizon but as far as possible in this world things have been going pretty smoothly. The U.S. economy is clearly picking up; the panics about marginal EU economies have been pushed aside by the Middle East turmoil. This will provide authorities time to find remedies away from the spotlight.

Since last September we have enjoyed a big rally, but now we enter a somewhat slower moving part of the year culminating in May - "When in May go away" is the saying. So for the next six months things may slow down, i.e. a flatter stock market.

In the meantime, spring is good for real estate and that combined with an ever improving Alberta economy bodes well for the real estate markets and rental property markets of Edmonton and Calgary. Eastern Canada enjoyed excellent real estate appreciation last year, but now with higher oil prices and a Loonie above par as well as with the potential of rising interest rates in the second half of this year, this may change. Expect a more subdued Eastern Canadian economy and a cooler real estate market, especially after the spring.

 Don't get caught up by the herd and start buying stocks with them - all or nearly all five traffic lights are on green and a lot of cash is moving back into the stock market. After having experienced the buying opportunity of a lifetime (or at least a decade), finding well priced stocks in today's market may become more difficult. Also, with rising interest rates avoid buying long term fixed income. Unfortunately, inflation adjustable interest bearing bonds and preferred shares are 'priced for perfection'. Safest is to put your short term cash in variable rate short term GICs and money market funds that will not lose too much in capital value when yields go up with interest rates.

 Unless you really know your stocks, do not buy "hot stocks", or extremely low priced stocks. Hot stocks tend to underperform and you usually pay too much. Extremely low priced stocks have likely hidden problems. In this market, if you do want to buy a bit more in stocks, stick to our perennial favourite: XIUs or better ETFs for the U.S. stock market indexes (S&P500 and Dow). Canadian markets are at least 'fairly' valued while the U.S. economy and markets are in 'catch up mode' especially with the Loonie so high this is a place where you could make money.

 Finally, always invest for the long term; leave day trading and special opportunities to the experts and the gamblers.