2Q 2014 Newsletter: Avoiding Your Portfolios EnemiesLearn more about this firm
Your Portfolio’s Enemies
“Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful.”
We often hear the last part of this wonderful quote from Warren Buffett, but here at Smead Capital, we find the beginning just as instructive. We thought we would unpack the entirety of his thoughts and dissect it for our faithful investors.
Numerous studies (Dreman, Bauman-Conover-Miller, etc.) analyzing forward common stock price performance based on P/E ratio show that over both one-year and longer periods that expensive/exciting stocks significantly underperform the market averages. Today we see the excitement falling on technology/social media shares and the common stocks of those who are involved in the oil and gas business. My favorite commercial on the radio is for a business which gives you a chance to get into the oil business via OILBOOMUSA.COM. We have a long memory at Smead Capital. In the late 1970’s and early 1980’s, the US had a oil boom very similar to this one and the largest bank in Seattle, Seafirst Bank, nearly went bust because of oil drilling loans they made in concert with a bank in Oklahoma City name Penn Square. In tech, investors have extrapolated their wonder of technology and forgotten that the purpose of a business is to meet an economic need and to make a profit for the owners. We have a hard time coming up with any intrinsic value calculations for today’s tech favorites.
The great stock-picker and money manager at Fidelity Magellan, Peter Lynch, believed in finding common stock investments that could gain ten times your original investment. He called them "ten-baggers." Lynch, like Buffett, subscribed to the idea that excitement surrounding a company could cause a stock to become over-capitalized, which, for the long-duration common stock owner, can be a curse. Lynch, therefore, looked for wonderful companies which had something about them that prevented excitement and over-capitalization from occurring.
From 1977-1990, Lynch trounced the US stock market by investing in Philip Morris and Fannie Mae. Philip Morris made cigarettes and it was the most hated company of that era. It had addicted customers and unlimited pricing power. No matter how well they did as a company, many investors avoided owning the stock. Fannie Mae facilitated the mortgage market in the US and was a Government-Sponsored Enterprise (GSE). Most people couldn't understand that their assets and liabilities were matched back then and the stock never got a P/E ratio which caused excitement. We own Gannett (newspapers), Cabela’s (guns), Bank of America (a damnable bank in our opinion), and others which have been protected from excitement.
The two main expenses in investing are annual management fees and trading costs. The larger an investment company gets, the lower the annual expenses become. However, the trading costs of a firm are determined by the annual portfolio turnover. In a February, 2013 Financial Analyst Journal article titled, "Shedding Light on ‘Invisible’ Costs: Trading Costs and Mutual Fund Performance,” the actual costs of too much activity on the part of mutual fund managers was exposed. The average large-cap equity manager turns their portfolio over 62% per year and causes an average of 0.86% or 86 basis points of annual return reduction. Is it any wonder that the average large-cap manager underperforms the index which has low annual expense and low turnover?
In 34 years in the investment business, I have rarely observed anyone who gets wealthy from market timing. We assume it is a useless exercise and the huge meltdown in 2008 gives a perfect example of why. A number of investors, both institutional and individual, got a bad gut feeling during the 2007-09 bear market and bailed out of the stock market. Many of them saved themselves some money for awhile. Unfortunately, nobody rang a bell to get back in and many of them missed the terrific move in stocks over the last five years. Greg Zuckerman pointed out in a June 23, 2014 Wall Street Journal article that this included many of the largest and most highly-respected institutional investors like Harvard and the pension plans of General Motors and Ford.
Twenty-year ownership of a terrific company held through up and down markets can, in our opinion, be an easier thing on which to rely than guessing than which way the wind is going to blow or where the US stock market is going to go each year. Therefore, we prefer to dwell with the companies which meet our eight criteria for stock selection. By being very selective in the first place and avoiding excitement in the process, we can hold shares for a long time. This can automatically keep our trading costs down over the decades and filter to money in the pockets of our partners and their clients.
We believe investors have been greedy about China, oil, commodities in general, conceptual technology stocks, private equity investments and US small cap stocks. In effect, wide asset allocation has created its own over-capitalization. We are fearful of these areas and avoid them. We think faith in China's economy is misplaced and the coming recession/depression triggered by a financial meltdown for unpaid loans could cripple commodity prices like oil. We have written extensively that the excitement around conceptual tech currently is dangerous for those who wish to speculate. Lastly, we think esoteric investments like private equity have too many investors chasing too few good choices. This seems to have artificially propped up small-cap indexes making them extremely expensive compared to the Russell 1000 Index on a 35-year basis.
Investors, from our perspective, are afraid the US economy will never grow at 3% or greater per year and that China will usurp the US as the largest economy in the world. To us they seem afraid of several things. Here are just a few things we see frightening investors. They think Millennials, those born between 1977 and 1996, won't get married, won't have kids and won't succeed in the way that prior generations did. They fear that the US government has ruined the banking industry with lawsuits and regulation. Market participants are afraid that citizens won't watch TV for local news, read locally-produced news, and watch low-tech cable and network television. Investors don't seem to believe the research done by drug companies will pay off for investors and are fearful that Obamacare will kill the profit motive in healthcare.
We at Smead Capital Management believe the next ten years could be one of the greatest eras in the history of the US economy. We see a coming boom in marriages, babies, car-buying and house-buying. We see an explosion in blue-collar trades, blue-collar work and blue-collar wages.
We see lower oil and gas prices and expanded use of energy alternatives. We plan on being greedy where others are fearful without being tempted by market timing and the expense which comes with it.