Archives For Active Investing

Quiz!

Which of the following is the most promising investment?

  1. A company that is losing money and is priced low reflecting the losses.
  2. A profitable company that is underappreciated and priced low.
  3. A company with phenomenal profitability, that you shop from every day, and can’t live without.

Sales up 27%, Profits up 47%, Stock Down 7%! What Gives?

On 7/29/2021, Amazon reported spectacular Q2 sales growth of 27%. Profits grew even faster, at 47%. Yet, the stock declined 7% after the announcement. This is could be unsettling for investors that chose Amazon, given it’s amazing profitability.

What happened? These growth rates were below prior growth rates and the expectations. Stock prices move in response to changes in the company’s performance – a relative measure, as opposed to the absolute company performance. Once the bar is set very high, gains could be tough to achieve, and declines can be very rapid.

Did we get any warning signs? Yes, glaring ones. It’s P/E (stock price relative to earnings) was 69, and it’s P/B (stock price relative to company value or liquidation value) was 17. These numbers are huge, and reflect a company that is 100%’s better than other companies.

An extra difficulty: Stocks of successful companies sometimes go up far above their intrinsic value. It is partly the result of people choosing a company based on its success or even solely based on recent stock growth, while ignoring the stock price. You can do the same, and do well for some time, as people do in various pyramid schemes, or you can join at the peak and experience steep declines. The peak may come during a phenomenal quarter for the company.

How can you use this information? Whenever analyzing whether to buy a stock, look for companies that are underpriced relative to their performance. These include phenomenal companies that are underappreciated, as well as mediocre companies that are priced too low. If you find a company that you love and believe in, analyze how much of its value is already reflected in the stock price, before investing.

What is the future of Amazon’s stock? This question is outside the scope of this article. There are many positive and negative factors, and it’s not a trivial task to combine them to reach an answer. Here is a sliver of the factors: Will the company manage to revert back to its phenomenal growth of prior quarters, or even beat it? Will enough investors continue to bid up the price because they love the company, or because the stock price went up in recent years? Will competition eat into Amazon’s market share, or will Amazon gain even greater market share? Will interest rates in the US go up, hurting Amazon’s borrowing costs? The full list is very long.

Quiz Answer:

Which of the following is the most promising investment?

  1. A company that is losing money and is priced low reflecting the losses.
  2. A profitable company that is underappreciated and priced low. [Correct Answer]
  3. A company with phenomenal profitability, that you shop from every day, and can’t live without.

Explanations:

  1. If the company is priced appropriately, the next step is to check the odds of a turnaround towards profitability. Trusting a turnaround can be risky, and should be done with caution, based on strong evidence.
  2. The combination of profitability & underpricing is the ideal one. Underpriced profitable companies have the potential for extra returns compared to the average company.
  3. A phenomenally profitable company is a great start. If you can’t live without it, and others feel the same, it’s another positive sign. The missing part is whether the stock price reflects more or less of all these positives.

See article for more explanations.

Disclosures Including Backtested Performance Data

Quiz!

During a big decline, is selling stocks until the storm passes conservative?

  1. Yes.
  2. It is conservative at the moment, and likely riskier beyond that.
  3. No, it is risky to sell low.

2 Hidden Risks of Selling Stocks Temporarily Now

It may seem appealing to sell stocks now, and buy lower, when seeing signs of the end of the coronavirus damage. There are two hidden risks in such a strategy:

  1. Hidden Risk #1: A decline never comes, so you buy 10%+ higher. After the gain, the portfolio turns much lower. Now your investments bottom at an even lower point than without the temporary selling.
  2. Hidden Risk #2: Fast forward to the next peak. Another big decline follows. During the entire decline – from peak to bottom – you have less money.

A variation is to sell stocks now, and wait to buy until we are completely done with the coronavirus impact. This is likely to eliminate Hidden Risk #1, but it makes Hidden Risk #2 far worse. By the time we are completely done with the coronavirus impact, your investments could potentially be 100%+ higher. The impact on all future declines can be devastating.

You may be desperate for some relief from the stress of staying invested at a low point, and are still tempted to sell. The relief is an illusion:

  1. If you are stressed now, imagine the stress after selling, reinvesting higher and then going to the bottom with less money.
  2. You may be tempted to sell and not buy until far into the future. As strong as it is at relieving the current stress, it is devastating at the depths of the next decline – lowering its bottom dramatically.

By holding onto your investments, you ultimately get the portfolio returns. While stocks may face long periods with poor returns, it is much better than risking making future declines deeper and longer.

Mirroring the risks above, if you still have income and are able to invest at today’s low levels, you can boost your financial security in future declines for the rest of your life.

Quiz Answer:

During a big decline, is selling stocks until the storm passes conservative?

  1. Yes.
  2. It is conservative at the moment, and likely riskier beyond that. [Correct Answer]
  3. No, it is risky to sell low.

Explanation: See this month’s article.

Disclosures Including Backtested Performance Data

Quiz!

Which are good ways to reduce your risk after 10 years of poor returns for a diversified investment? (There may be multiple answers.)

  1. Diversify and include some lower risk investments that performed well in the past 10 years.
  2. Lower your risk by holding some bonds.
  3. Lower your risk by holding some cash.
  4. Don’t make any change.
  5. Increase your allocation to the investment.

5 Rules of Thumb to Avoid Making a Painful Investment Change

Have you ever seen your diversified investments perform poorly for an extended period of 5-10 years, and felt that it would be prudent to diversify to reduce your risks? Have you moved money to an investment that felt much safer based on those years? In most cases, such activity would increase your risk – the opposite of your intended action. In some cases, the results could be painful.

How can a shift to reduce risk end up being painful? Diversified investments tend to be cyclical. The risk of a tough decade following a tough decade is lower than typical, not higher. Furthermore, the risk of a tough decade after an exceptional decade is higher than typical. Here is a case that may be familiar to you: In the late 1990’s US Large Growth stocks seemed like the safest stocks in the world. A switch to these seemingly safe stocks could have led you to losing 30% of your money over the following 10 years (total returns, including dividends, starting 3/1999). If you would have switched away from the seemingly risky Value or Emerging Markets stocks, your pain would have compounded, by missing phenomenal growth.

How can you avoid making a flawed change? Here are a few rules of thumb:

  1. Compare your investment performance in the past 10 years to the long-term performance (ideally 30+ years). If the past 10 years were below average, the investment is likely to be less risky than usual, not more. Don’t make a change!
  2. Do the same for the target investment you want to diversify into. If the past 10 years were above average, the investment is likely to be more risky than usual, not less. Don’t make a change!
  3. Do the same when comparing valuations, as presented by Price/Book. If the change would increase your Price/Book, you would sell low and buy high, something that can hurt you.
  4. Imagine living through a period with the opposite recent performance – would you still feel that you are reducing your risk with the intended change? If not, the alarm bells should be ringing.
  5. Say that someone urges you to diversify your portfolio, given the risk of your current portfolio, as presented by recent performance. Check how diversified your current portfolio is. If it includes 100’s or 1,000’s of stocks, split over many sectors in many countries, you are probably already diversified. The phrase: “You should diversify”, is a disguise for the real intent: “You should buy the recent winners, no matter what it does to your diversification.”

How can you use the information above today?

  1. Just like in the 1990’s, US Large Growth stocks performed far better than their long-term average. They averaged about 13% per year over 10 years, compared to a 10% long-term average. You should realistically expect the returns in the next 10 years to be much lower, not just below 13%, but far below 10%. In addition, the P/B of these stocks is far above average, another warning sign for poor upcoming returns.
  2. The reverse is true for Emerging Markets stocks. They grew far below their average. For example, the portfolio Extended-Term Component grew by a mere 2% per year in the past 10 years, compared to 9.3% 22-year average. In addition, the valuations of this portfolio are far below average. Returns above the 9.3% average in the next 10 years are the likely outcome.

A few words of caution: cycles don’t have a fixed length. Returns that are better or worse than average can continue longer or shorter than expected. In addition, long-term averages can fluctuate. While no result is guaranteed, the information above can help you work with the odds, and not against them.

Quiz Answer:

Which are good ways to reduce your risk after 10 years of poor returns for a diversified investment? (There may be multiple answers.)

  1. Diversify and include some lower risk investments that performed unusually well in the past 10 years.
  2. Lower your risk by holding some bonds.
  3. Lower your risk by holding some cash.
  4. Don’t make any change.
  5. Increase your allocation to the investment. [Correct Answer]

Explanations:

  1. Answers 1-3: Diversified investments tend to be cyclical – selling after 10 tough years, is likely selling low. Buying an investment that performed unusually well at the same time, is likely buying high. This will likely increase your risk.
  2. Answer 4: While future returns are likely to be above average, and risks below average, no change will keep your risk profile at the same reduced level.
  3. Answer 5: Buying extra at a very low point may reduce your risk, if valuations (Price/Book) are far below average and the investment is diversified.
Disclosures Including Backtested Performance Data

How would you like to choose mutual funds that will outperform benchmarks of the stock market? This is an ongoing pursuit of millions of people. Up until recent decades, people intuitively believed that if you pay professionals to spend hours every day researching stocks, they would outperform a brainless benchmark. It was only a matter of how big the outperformance would be – at least that was what people believed. Since then, multiple studies compared the performance of actively-managed mutual funds with benchmarks, and found out that it is not as trivial as intuitively seemed.

The task: This article reviews an academic study that tried to find out what portion of actively-managed mutual funds outperformed benchmarks due to skill, as opposed to random luck. This can help you decide whether you want to pay someone to try to outperform the benchmarks by picking the right stocks or by timing the market.

The study is by Russ Wermers, a professor of finance at the University of Maryland, Laurent Barras of the Swiss Finance Institute, and Oliver Scaillet of the University of Geneva. It observes returns of actively-managed mutual funds over the 32-year period of 1975 to 2006. It avoids short-term biases by including only funds with at least 60 months of returns, and is free of survivorship bias, by including funds that existed at any time in the period observed.

How do you decide? Given the alternative of passively managed funds that track diversified benchmarks, combined with the fact that globally diversified stock investments recovered from all declines in hundreds of years to achieve handsome long-term averages, you have to make a good case for trying to beat benchmarks, while risking doing worse.

You may choose to use an actively managed mutual fund if the odds of outperforming the benchmark are substantially higher than the odds of underperforming it. A smart speculator would do so given any chance of success over 50%, while a more risk-averse individual may want much higher odds.

The results: Can you guess what the chance for success was based on this study?

During the 32 year period studied, from 1975 to 2006, only 0.6% of funds delivered higher returns than their benchmark through skill (not even counting sales loads).

Feel free to reread the number above – the number is indeed less than 1%.

The decision: Based on these results, choosing actively managed funds seems unlikely to make you excess money while adding the risk of one person making wrong predictions. Neither the conservative investor nor the smart speculator should see any benefit in taking this chance.

Accepting the results of passively managed funds may sound boring, without the excitement of trying to “beat the market”, and plain “average”, but when compared to the dismal results of actively managed funds, it seems like the more sensible approach. It may be average compared to the benchmarks, but outstanding compared to most investors that still use actively managed funds.

What can you control? By narrowing it down to passively managed funds, you can avoid the risks of stock picking and market timing. Instead you can focus on things you can control such as minimizing costs, minimizing taxes and maximizing diversification. By using such criteria for selecting mutual funds you can peel off the speculative layer, turning yourself from a speculator to an investor, with a more direct link to the productive capacity of the world.

Disclosures Including Backtested Performance Data

This article reviews an article published by the Journal of Financial Planning: The Difficulty of Selecting Superior Mutual Fund Performance * [February 2006]. This is one of many research projects that compare actively managed mutual funds with passively managed funds and past performance with future performance.

First, let’s explain the two types of mutual funds:

Actively managed mutual funds tend to select stocks individually and time the market with the hope of outperforming the average market.

Passively managed mutual funds try to replicate the returns of the market, or a certain asset class, and are usually called index funds.

Several important results are presented:

  1. 90% of Large Cap Active Managers underperformed Indexes, over a 20-year period .
  2. 97% of Mid Cap Active Managers underperformed Indexes, over a 20-year period .
  3. Past Winners became Losers . Actively managed funds that outperformed indexes over the first 10 years, underperformed the indexes in the following 10 years. Past winners became losers, hampering the chance of predicting outstanding fund managers.
  4. Higher Taxes . The results were magnified when considering taxes: active managers lost 0.89% more of the returns to taxes, when compared to index funds (1.51% loss compared to 0.62%).

What can we conclude from these results? If you are looking to get the highest returns on your investment, you would not want to settle for average. You would like to find a superior fund manager that can beat the market.

Unfortunately, most fund managers underperform the market. When going to smaller companies, it is nearly impossible to find a fund manager that is better than the average market (3% chance!)

Even if you managed to find the rare fund manager who beat the market for many years, s/he is likely to do worse than the market in the future.

You are at a dead-end. Ads focus on recent returns of mutual funds. Returns of indexes that have a consistent investment allocation and that are measured over periods of 25+ years may be more reliable. The ads tend to focus on periods no longer than 10 years. Even Morningstar gives significant weight to returns over the past 3, 5 and 10 years. The whole mutual fund industry focuses on ratings that do not provide you with helpful information.

The good news! It turns out that if you settle for “average”, you end up outperforming most investors. Once you are settled on average, you can focus on things you can control and measure very well: diversification, minimization of taxes and all other investment costs. You might think that you settled for average, but at this point, very few people, including most sophisticated money managers are doing better than you.

* Referenced with permission.

Disclosures Including Backtested Performance Data