Use Stock Volume to Your Benefit

So how can you use volume to your advantage?

1.  Remind yourself that traders only determine the short term price not the value.

2.  Use the volume to help predict the right time to buy more assets or change into a better position.

Large volume (relatively speaking) means the price is at a peak or valley.  You are either at the top or the bottom of the chart, you need to determine this.



What is Stock Volume?

Summary
In this lesson, we learned the importance of stock volume. Although volume won’t help intelligent investors learn the intrinsic value of a company, it can be used as a tool to help predict market behaviour.

Many times investors can be fooled into believing that the market price of a stock is determined by all the shareholders. This idea is false.

When we look at the volume of a company on an given day, we can quickly get a sense of how many traders are actually determining the price of a stock when we compare this number to the shares outstanding.This ratio, volume/shares outstanding, provides a good idea how many traders are moving away from the company and how many are coming into the company.

• When the company trades at a very low volume, we can generally say that the shareholder agreewith the market price. 
• Likewise, if the volume is very high, we can generally say that shareholders disagree with the market price.

We demonstrated this principal with Wells Fargo (WFC). When we looked at the historical market price for WFC, we learned that on the day where the volume was the highest in ten years, the market price was at an all time low.This idea of shareholders disagreeing with the market price when volume is relatively high is an important point that stock traders can use to their advantage. 

Always remember, volume can mean that the stock is over priced or underpriced. The peak or valley is for you to discern.

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Warren Buffett's Investment Objectives

Goals

     Our long-term economic goal is to maximize the average annual rate of gain in intrinsic business value on a per-share basis.  We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress.  We are certain that the rate of per-share progress will diminish in the future - a greatly enlarged capital base will see to that. We will be disappointed if our rate does not exceed that of the average large American corporation.

2.     Charlie Munger and I can attain our long-standing goal of increasing Berkshire's per-share intrinsic value at an average annual rate of 15%. We have not retreated from this goal.  We again emphasize that the growth in our capital base makes 15% an ever-more difficult target to hit.

3.     What we have going for us is a growing collection of good-sized operating businesses that possess economic characteristics ranging from good to terrific, run by managers whose performance ranges from terrific to terrific.  You need have no worries about this group.

4.     The capital-allocation work that Charlie and I do at the parent company, using the funds that our managers deliver to us, has a less certain outcome: It is not easy to find new businesses and managers comparable to those we have.

Comments:

1.  Maximise growth in net worth over the long term.

2.  Aiming for average annual growth rate of 15%.

3.  Collect a group of great companies run by great managers.

4.  Re-allocate the funds generated by these great companies.

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Uncertainty: Love it or Hate it?

Uncertainty is like a fin you see cutting through the water – many people are uncertain whether the fin sticking out of the water is a great white shark or a dolphin? Uncertainty generates fear, and fear often produces paralysis. This financially unproductive phenomenon has also reared its ugly fin in the investment world, which has led to low-yield apathy, and desensitization to both interest rate and inflation risks.

The mass exodus out of stocks into bonds worked well for the very few that timed an early 2008 exit out of equities, but since early 2009, the performance of stocks has handily trounced bonds (the S&P has outperformed the bond market (BND) by almost 100% since the beginning of March 2009, if you exclude dividends and interest). While the cozy comfort of bonds has suited investors over the last five years, a rude awakening awaits the bond-heavy masses when the uncertain economic clouds surrounding us eventually lift.

The Certainty of Uncertainty

What do we know about uncertainty? Well for starters, we know that uncertainty cannot be avoided. Or as former Secretary of the Treasury Robert Rubin stated so aptly, “Nothing is certain – except uncertainty.”

Why in the world would one of the world’s richest and most successful investors like Warren Buffett embrace uncertainty by imploring investors to “buy fear, and sell greed?” How can Buffett’s statement be valid when the mantra we continually hear spewed over the airwaves is that “investors hate uncertainty and love clarity?” The short answer is that clarity is costly (i.e., investors are forced to pay a cherry price for certainty). Dean Witter, the founder of his namesake brokerage firm in 1924, addressed the issue of certainty in these shrewd comments he made some 78 years ago, right before the end of worst bear market in history:

“Some people say they want to wait for a clearer view of the future. But when the future is again clear, the present bargains will have vanished.”

Undoubtedly, some investors hate uncertainty, but I think there needs to be a distinction between good investors and bad investors. Don Hays, the strategist atHays Advisory, straightforwardly notes, “Good investors love uncertainty.”

When everything is clear to everyone, including the novice investing cab driver and hairdresser, like in the late 1990s technology bubble, the actual risk is in fact far greater than the perceived risk. Or as Morgan Housel from Motley Fool sarcastically points out, “Someone remind me when economic uncertainty didn’t exist. 2000? 2007?”

What’s There to Worry About?

I’ve heard financial bears argue a lot of things, but I haven’t heard any make the case there is little uncertainty currently. I’ll let you be the judge by listing these following issues I read and listen to on a daily basis:

• Fiscal cliff induced recession risks
• Syria’s potential use of chemical weapons
• Iran’s destabilizing nuclear program
• North Korean missile tests by questionable new regime
• Potential Greek debt default and exit from the eurozone
• QE3 (Quantitative Easing) and looming inflation and asset bubble(s)
• Higher taxes
• Lower entitlements
• Fear of the collapse in the U.S. dollar’s value
• Rigged Wall Street game
• Excessive Dodd-Frank financial regulation
• Obamacare
• High Frequency Trading / Flash Crash
• Unsustainably growing healthcare costs
• Exploding college tuition rates
• Global warming and superstorms
• Etc.
• Etc.
• Etc.

I could go on for another page or two, but I think you get the gist. While I freely admit there is much less uncertainty than we experienced in the 2008-2009 timeframe, investors’ still remain very cautious. The trillions of dollars hemorrhaging out of stocks into bonds helps make my case fairly clear.

As investors plan for a future entitlement-light world, nobody can confidently count on Social Security and Medicare to help fund our umbrella-drink-filled vacations and senior tour golf outings. Today, the risk of parking your life savings in low-rate wealth destroying investment vehicles should be a major concern for all long-term investors. As I continually remind Investing Caffeine readers, bonds have a place in all portfolios, especially for income dependent retirees. However, any truly diversified portfolio will have exposure to equities, as long as the allocation in the investment plan meshes with the individual’s risk tolerance and liquidity needs.

Given all the uncertain floating fins lurking in the economic background, what would I tell investors to do with their hard-earned money? I simply defer to my pal (figuratively speaking), Warren Buffett, who recently said in a Charlie Rose interview, “Overwhelmingly, for people that can invest over time, equities are the best place to put their money.” For the vast majority of investors who should have an investment time horizon of more than 10 years, that is a question I can answer withcertainty.

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John Bogle: "The Silence of the Funds"

John Bogle had the following to say in this Morningstar interview:

"I am appalled by what has happened in our industry."

Here's why. Bogle says that back when he was doing his Princeton thesis in 1951, the mutual fund industry owned a small percentage of stocks. Now, mutual funds are the biggest owner of stocks. In fact, according to Bogle, large institutional money managers of all kinds now own about 66% of stock.

 "...a big turnaround over the last half century. And they are silent."

 Bogle has a chapter with the title "The Silence of the Funds" in his new book The Clash of the Cultures. 

In the interview, he also said this about Benjamin Graham:

"...in his first book, about a third of that book was dedicated to the role of stockholders and corporate governance, and it's hard to find a word about that in any other book, except, of course, the Bogle books.

But we have a responsibility. We have the rights of corporate ownership; we better exercise the responsibilities of corporate ownership. There is a lot at stake here because the corporations have the same agency problem and those managers want to put their interests before those of their shareholders. I mean this is not black and white, I can see that. But they get too much room to run without any oversight, and you always need oversight. And if the shareholders want the best oversight, the government can only do so much, regulatory bodies can only do so much."

Bogle adds that owners could do much more yet, for a variety of reasons, simply do not. The largest institutions are certainly in the best position to do so considering all the stock that they now own.

In the interview, he talks about some of the reasons why they do not but, to me, a good bit of this comes down to the increasingly short-term focus by participants in the capital markets. Fewer long-term shareholders. More interest in near-term price action. When, in general, a large proportion of participants do not intend to own pieces of a business -- shares of stock -- for very long, it's likely they'll expend far less time and energy carefully thinking about long-term effects and outcomes. Unlikely they'll put much into assuring that responsible governance is in place. Certainly less than a true long-term owner.
(Consider how the average person tends to treat a rental car versus a car they own. Well, maybe too many of our corporations are receiving what's equivalent to the "rental car" treatment.)

In this part of the interview, Bogle points out that the average turnover of a mutual fund portfolio is nearly 100 percent.

"...and that means they hold the average stock for one year. That is unequivocally speculation, and it costs money."*

Those frictional costs are very real. Yet the "silence", as Bogle describes it, by large institutional money managers (those who control roughly 66% of the stock) may actually be far more expensive even if in difficult to measure ways.

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To many ICap's shareholders , TTB is their Oracle

Perhaps you have heard of the Oracle of Omaha, the namesake accorded to Warren Buffett. I was at the AGM this morning, my first attendance and the thing I can say is that Tan Theng Boo ("TTB") is like the Oracle of Malaysia for many of these shareholders.

In fact, the presentation provided by TTB himself is loaded with Warren Buffett's quotes, such as - "Rule No 1: Never Lose Money, Rule 2: Never forget Rule No 1" and "Price is what you pay, value is what you get" and many more. I would say that much of TTB's investments philosophies and actions is trying to resemble Buffett's. He even claimed that to save costs, his prospectus and Annual Reports are in black and white (as color printing is more expensive) - resembling the same careful spending trait that Buffett had on his vehicle, Berkshire Hathaway.

However, few differences that tell are Buffett's Chairman's statement to shareholders consists of more than 50 pages each year and spends a lot of time explaining his investments rationale and why he invested in some of the portfolio companies. TTB is much stingier in his Annual report statement ditching out less than 2 pages each year. I think that the iCapital newsletters subscription would probably be where he is concentrating on his write-ups.

Another difference is that for of Buffett's hardcore believers, they would be willing to buy just 1 share of Berkshire Hathaway to be able to attend his AGM. (Berkshire Hathaway's A share costs USD127,000 by the way) Well, TTB is still far from that, but there are still some hard core supporters (I would think 500+ or maybe many more) as shown in the majority who supported him during the AGM.

In fact, some of them complained that the AGM this time around is time consuming and non-beneficial as most of them were there in most of its previous AGM's to obtain their annual tips from their Oracle, not to really vote. This time around, their presence are to support their oracle as the threat of resigning was too much for them to absorb. One came out to actually say, "No Tan Theng Boo, No ICap." - and its the end of the world?

I did not stay to learn about the results of this unusually extended AGM as I had to rush off to another event, but I can guess that judging from the support provided to TTB - rightly so - many of them would stay thick and thin with him - to the extent that he has become "Godly".

I would have to say, at the end of the day, I am impressed and despite the initial thoughts of voting in some of the so-called non-friendly Directors to Capital Dynamics', at last I changed my mind. However, I doubt that I can be so attached and would still be looking for opportunities to sell whenever the fund is close to its NAV - unless some of the issues that I have mentioned before are really addressed.

Whatever it is, I guess I am a different type of investor anyway, as I am the type who is hoping to control my own destiny, than relying on another to do so for me. Err someone said that already, and that someone is Jack Welch.

And hah! hopefully this is my last article about ICap for a while as some readers would be bored with these articles already. I would just concentrate on researching something else myself.

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Buffett on Banks: CNBC Interview

CNBC's Becky Quick interviewed Warren Buffett yesterday.

Interview With Warren Buffett: CNBC Transcript

Earlier in the interview, Buffett said that:

"I think the stock market generally is the best place to have money..."

Then he added:

"...there's no question that worldwide there is some slowing down going on."

He also made the following comments about Wells Fargo (WFC), U.S. Bancorp (USB), and banking in general:

"In the last week, I bought some Wells Fargo."

Then he later said...

"But we only have 430-something million shares, so I didn't feel we had enough."

Here's his explanation why banks won't be as profitable (and basically shouldn't be if you want a safe and sound financial system) as they were (or at least seemed to be) going forward.

"The profitability of banking is a function of two items. Return on assets and assets to equity.

And return on assets is not going to go up particularly. USB has done the very best on that. They're at about 1.7 percent. Wells is between 1.4 and 1.5 percent. But most banks are lower. Now, if you have 20 times leverage and you're getting 1.5 percent on assets, you're making 30 percent on equity.

And that was not lost on people a few years back. And they pushed balance sheets, and they're still pushing them in Europe. But they've cut back on that here. So they will not be having the leverage in the banking system. It'll be even more restricted among the bigger banks as part of the new rules, and you won't be able to earn more on assets than before, and so with less leverage in the same return on assets, you will have a lower return on equity. Banks were —banks were earning 25 percent on tangible equity not so many years ago. And really, that's kind of a crazy number. You know, for a basic semi-commodity business, you really don't want to allow that."

Yet it was allowed. Then we all had the great misfortune to see what happens when huge leverage is combined with the use of other people's money guaranteed, explicitly or not, by the government and a lack of sensible oversight. More from Buffett:

"...people got to push and push it and push it, and then the government says, 'Listen, we got a vested interest in this. You're using our credit, in effect, and if you want to play, you're only going to have 10-to-1, or some number like that.' So the returns on banks have come down. It's still a good business."

A well run bank can still be a good businesses. He added that"...Wells is very well run. And it's a good business."

A bank with 10x leverage* that can generate 1.4 or 1.5 percent return on assets (ROA) naturally has a mid-teens return on equity (ROE).

That math is simple but I think it is fair to say investing in most banks is far from easy to do. A bank that has mid-teens ROE bought near book value should**, in the long run, produce something like mid-teens returns for shareholders.

Should, that is, if (and it's a big IF) the bank can keep itself from getting into trouble down the road (unstable funding sources, insufficient liquidity, unwise investments/trades, dumb lending practices, foolish use of derivatives, etc.) that ends up wiping out all or part of the bank's per share value for common shareholders.

With leveraged institutions, an awful lot value can be destroyed in a very short amount of time (as we saw not all that long ago).

One of the weaknesses of some banks is that they lack the core earnings capacity of a Wells Fargo or U.S. Bancorp.

Wells Fargo's ROE in the most recent quarter was 13.4 percent.

U.S. Bancorp's ROE in the most recent quarter was 16.5 percent.

Whether they'll earn those kind of returns over the long haul can't really be known but it does provide some indication of relative capacity to earn.

In contrast, with similar leverage, some other banks seem likely to, post-financial crisis, have persistent below double-digit ROE (this starts with having inherently inferior ROA then not being able amplify with leverage as much). To me, that's generally an insufficient return for what are still, even if less so than before the financial crisis, by their nature rather leveraged institutions.

The problem isn't just that the returns are subpar considering the risks.

The problem is more that banks with lower returns have less capacity to absorb credit and other losses (lower pre-tax pre-provision earnings for every dollar of assets).

Once the next inevitable economic downturn or financial crisis occurs, those banks generating lower returns, all else equal, are likely the less durable institutions (from a common shareholder perspective that is). It takes less stress to begin weakening their balance sheet and more easily results in the need to raise capital (or worse). Since stressed financial institutions usually have to raise capital when the share price is quite cheap, it usually ends up being materially dilutive, and very expensive, for existing shareholders to say the least.

The returns of a bank should be considered in the context of their ability to withstand potentially severe economic and systemic stress. Like any investment, buying common shares of a bank requires a  margin of safety. Yet, with a weaker bank, simply adjusting the estimated intrinsic value lower by some percentage or buying with a bigger margin of safety to arrive at an appropriate price to pay is usually not enough. Eventually, it's more a go/no go decision. There's a threshold where it's just better to avoid the common stock of weaker banks altogether no matter how cheap they may seem.

A higher quality bank, though selling at a seemingly more expensive share price, may be intrinsically well worth the additional multiple of earnings or book value that must be paid.
(Only up to a point, of course. Margin of safety is still all-important.)

The bottom line is reduced earnings capacity relative to assets can significantly increase the risk of permanent capital loss for the common shareholders of a financial institution. Like any commodity/semi-commodity business, it's better to own the one's that will still be profitable in tougher environments when their weaker competitors are struggling to do so. The stronger banks are not just less likely to destroy intrinsic value during periods of economic stress (when credit losses are at their highest). The one's in a position of strength should also be able to make strategic moves that actually increase intrinsic value while weaker competitors are in retreat.

So it's not just that Wells or U.S. Bancorp generate higher returns, it's that they should be able to do so at less risk. It's their relative and absolute capacity to absorb losses from loans/ investments/ trades that go sour (and other liabilities that may arise). Ultimately, they earn superior returns (via various fees, gains, interest income) on their deposits (generally lower cost stable funding) than many competitors.

To a certain, but limited, extent those comfortable reading financial statements should be able to figure out if a bank has an advantage in this regard. Yet, annual/quarterly reports and other filings is unlikely to tell the whole story. Unfortunately, investing in any bank requires a subjective judgment (some might say a leap of faith) about the quality of management and the culture of the institution. In other words, there's no way that all the possible troubles a bank may get into will be obvious just from reading SEC filings. That's true of any enterprise but, considering the leverage involved, misbehavior or stupidity has the potential to be much more expensive for a bank shareholder.

Wells and U.S. Bancorp may not be as complex as some other large banks, but they are still hardly simple to analyze.***

Later in the interview, Buffett added this on the European banks:

"The European banks still are leveraged to an extraordinary extent... But they aren't earning 1.5 percent on deposits either."

Some European banks not only still have too much leverage but also don't earn nearly as much on their deposits (and some have funding that's of lesser quality). So they are not just riskier investments because of the excessive leverage. They are also riskier because their inherently inferior earnings provides them with less ability to absorb losses before the balance sheet, and eventually per share intrinsic value, takes a hit.

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Budget 2013: Becoming the Next Greece

Consistently persistent fiscal deficit is the best description I have for long time ruling coalition government. Fiscal deficit happens when a government's total expenditures exceed the revenue that it has collected (this excludes money from borrowings). An accumulation of yearly fiscal deficits is our national debt. Fiscal deficit is not always a bad thing. However, persistent deficits even during times of economic growth shows a major lack in spending discipline. When the economy is doing well, a balanced budget strives for a surplus so in times of recession a government can meet its debt obligations. This is the exact opposite in Malaysia, the persistent fiscal deficits are adding more and more to our total national debt further burdening future generations with ballooning national debt.

Practically when drafting a national budget, the most likely number the government looks at is the country's economic growth via Gross Domestic Product (GDP) which is how much recognized goods and services a country can produce in a given year. When GDP grows, revenue is expected to go as more tax is collected and other revenues go up as well. There is an increasing risk of a double dip global recession and slower economic growth projected for 2013/2014 due to sapping demand from Eurozone, India and China. Given the path we are currently on (as you will see below later), higher deficits will happen. Worse come if we do enter into a recession, we will definitely see record level deficits and national debt levels. By the time, as the government cannot fulfill it's debt obligations through any mathematically possible resolution, we will be the "Greece of Asia".

It is worth to highlight that the country has been running fiscal deficits for the last 14 years since the financial crisis of 1999 and is expected to continue unless we cut unnecessary spending. Where do we spend our money then?

Operating expenditure has now hit a high of 80% of our national budget allocation leaving a highly disproportionate % left for development spending. The reason of increase spending under the "operating" tab can be attributed to reckless handouts/promises of bonuses. What are the implications of such irresponsible spending?

The country is built up around amassing more and more debts. The country's national debt (domestic debt + foreign debt) is just short of its self-imposed ceiling of 55%. There is no political will to dismantle our humongous bureaucracy, a stage of over-governance. Yet we have someone in parliament playing the role of "Santa Claus" year after year. Now you will ask me, who funds the government then? We can't just print money like the United States so the Malaysian government funds these yearly deficits by borrowing, welcome to Malaysian Govt Securities (MGS). People often refer them as Malaysian bonds.

As much as RM120 billion is official invested in MGS by the EPF, this comes from their latest 2011 Annual Report. EPF also lends money under loans/bonds to others. It is surprising to see that the category "Others" is deemed as "SOCSO, nominee and trustee companies, co-operative societies, foreign holders and other entities" from our National Economic report. EPF on loans/bonds == Others? Let's assume yes, and give a 10% error tolerance which makes up to 50% of our national debt is owed to the EPF!! The investment size of EPF is RM469 billion as of year 2011. Effectively this means our government has already spent ~50% of all your savings in the EPF. If say I take just the MGS figures, it's still a staggering 25.5%!. One very big egg in a basket. 

Let me paint a bleaker picture. The EU central bank back in 2011 agreed to extend financial aid to the Govt of Greece on the condition they adopt massive austerity measures and that the lenders take a haircut of 50% of all outstanding loans. After all, they continually lent to a borrower that absolutely shows NO commitment whatsoever to cut expenses in order to service their debts. Just imagine if the EPF was in the same situation and asked to take a 50% haircut of their debts from the Malaysian Govt. You will only have 70% of your retirement money back (factoring the exposure % of EPF as EPF invests 30% of money into equities as well)!!!

It's no use digging deeper or reading line by line of Budget 2013 transcripts. It the same thing all over again for the past 14 years. How much public money has been lost through corruption? How much of it has been used to subsidise big corporations instead of the people? How much of it has been used to pay for ‘commission’ for big business deals involving the government? We may never know how much, but we do know that it is one hell of an amount, it's now well over RM500 billion! Malaysia is so fucking rich to this extent that the C4 has not exploded. But how much longer can we take this? There's a timer to every bomb.

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Sector Watch: Spotlight on Defensive Strategy

About four and a half years ago, Folio Investing launched an equity (e.g. stock) portfolio that focused on reducing the impact of market volatility.  So-called defensive stocks are those which tend to be fairly insensitive to the mood of the market as a whole.  Conventional wisdom suggests that demand for band-aids, electricity and paper does not go up when the market is exuberant, but neither does it collapse when the market swoons.  The conventional wisdom also suggests that these stocks will tend to under-perform the broader market during rallies and, over the long-term, that a portfolio of these stocks will deliver modest returns.  Our research suggested, however, that it was possible to create a portfolio of defensive stocks that would provide returns to keep up with rallies in the broader market, while still substantially reducing the impact of market volatility.  Folio Investing launched theDefensive Strategy Folio that incorporated this research on February 28, 2008.

Performance

From February 28, 2008 through September 5, 2012, the Defensive Strategy Folio has provided an annualized return of 6.28% vs. 2.72% per year for the S&P 500 (including dividends).  The Defensive Strategy Folio has performed well over a 4.5-year period during which the S&P 500 has struggled.  This is what we expect for a defensive strategy.  What is truly notable, however, is that the Defensive Strategy Folio has kept up with the robust rally in the S&P 500 over the past three years as well.  The chart below shows the total return for an investment in the S&P 500, assuming dividends are reinvested, from August 31, 2009 through August 30, 2012.  Over the period, the S&P 500 has returned a cumulative 46.7% (annualized return of 13.6% per year).  Over the same three-year period, the Defensive Strategy Folio has slightly out-performed the S&P 500 with a total return of 48.3% and has done so with less volatility.  As the chart below illustrates, the Defensive Strategy Folio has followed the broad rally but has not swung up or down as much as the S&P 500 during short-term rallies and drops.  The chart of the Defensive Strategy performance is for funded performance for an account maintained at Folio Investing.

Defensive Strategy Folio vs. S&P 500 (8/31/2009-8/31/2012)

There are a number of possible explanations for the substantial out-performance of the Defensive Strategy since it was launched in February of 2008.  Certainly, there is an element of chance.  This Folio was introduced shortly before one of the worse market crashes in history and defensive industries tend to thrive in these conditions.  Our research in 2007 suggested that the Defensive Strategy would out-perform in down markets but also would out-perform the S&P 500 across a range of market conditions.  The fact that the Defensive Strategy Folio has slightly out-paced the S&P 500 during its impressive three-year rally supports our conclusions.

Strategy Overview

The Defensive Strategy Folio is not simply a collection of stocks picked from defensive sectors.  A key part of our analysis was to combine securities in the Folio that provided effective risk offsets.  In other words, these stocks were selected both on the basis of their individual attributes, and on how well they worked together to mitigate risk.  This was accomplished using a sophisticated statistical analysis that accounts for the correlations and risk levels of each stock on a trailing historical basis and using forward-looking Monte Carlo simulations.

On an individual basis, the stocks that comprise the portfolio tend to have low Beta, a statistical measure of how much the returns on a stock are driven by the broader market.  Defensive stocks tend to have low Beta.  The current Beta for the entire Folio is 73% as compared to 100% for the S&P 500.  There is a growing body of research that finds that low-Beta stocks out-perform their higher-beta counterparts (which are often ‘growth’ stocks) over the long run.  This research supports our own findings, albeit on the basis of a different line of reasoning.

Commentary: The Case for the Defensive Strategy

There are a variety of reasons why the type of strategy used in this portfolio may be attractive in the future.  First, while the economy is recovering from a deep recession, the economic growth as we emerge may continue to be modest.  In addition, the overhang of consumer debt may substantially limit the rebound of discretionary consumer spending.  For these reasons, companies which provide necessary basic products and services are quite likely to out-perform relative to stocks of companies that sell discretionary products.  While this narrative is plausible, any type of economic forecast is fraught with uncertainty.  The Defensive Strategy Folio allows investors to participate in economic recovery and growth, as we can see by the performance over the past three years, as well as providing some protection from market volatility.

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The Cost of Complexity

In [Donald] Yacktman's view, businesses with both low capital intensity and low cyclicality (Coke: KO, Pepsi: PEP, and P&G: PG are the specifics mentioned) are likely to earn the highest returns.

The benefits owning shares in quality businesses long-term (especially if bought when occasionally selling at a fair or better than fair price) comes down to potential returns relative to risk.

Simple to understand? Certainly. Easy to implement as a core investing approach? A bit less so.  

The evidence to support the merits of owning shares in these kinds of businesses long-term isn't hard to find nor is it particularly complicated. A simple insight can sometimes trump details and complexity. When it occasionally does, use it. What's simple can beat the complex and, in fact, often does.

Yet simple isn't always better. It is just that what is used should be neither more simple nor more complicated than it need be.

It's possible, of course, to make things too simple.

Science views complexity as a cost. That additional complexity must be justified by the benefits. 

"In science complexity is considered a cost, which must be justified by a sufficiently rich set of new and (preferably) interesting predictions..." - From the book "Thinking, Fast and Slow" by Daniel Kahneman

Well, investors ought to view complexity in a similar way. 

Investing is always about getting the best possible returns, at the lowest possible risk, within one's own limits. Since it is already inherently enough of a challenge, there's no need to make it more so by adding unnecessary complexity. Don't use calculus when arithmetic will do the job. Save the more powerful tools for when they can actually add value (and especially avoid some of the worse-than-useless overly complex theories taught by modern finance).

Now, just because something is relatively simple doesn't mean lots of homework isn't necessary.

There absolutely is lots of hard work involved. 

The reason for and advantage of owning shares in some of the quality franchises -- superior returns at less risk if bought well -- is clearly not all that difficult to understand. Having enough discipline, patience, and the right temperament to stick with it is the tougher part. 

Well, that and maybe not becoming distracted by the various forms of investing alchemy cloaked in incomprehensible faux sophistication: 

"...most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising 'Take two aspirins'." - Warren Buffett in the 1987 Berkshire HathawayShareholder Letter

Quality stocks. Less drama. Little mystery. Effective. 

Think of them as the "two aspirins" of investing. 

I'm sure that many will still choose to own shares of the highest quality stocks primarily for "defensive" purposes. I doubt that changes anytime soon. Somehow, the thinking goes, they'll jump in and out while not having mistakes and frictional costs to subtract from total return. Sounds good in theory. I'm sure there are even some who can make that sort of thing work for them. There are likely even more who incorrectly think they can.

So, despite the evidence, investing in high quality businesses long-term remains an approach that's still not frequently employed.*
(I mentioned in the previous post that Jeremy Grantham has described these high quality businesses as the "one free lunch" in investing.)

It's a subject I've covered many times on this blog (okay...maybe too many times based upon the number of related posts I have listed below) because it just happens to have been and remains a cornerstone of investing for me.

Unfortunately, investors need more patience now compared to when valuations were quite attractive not too long ago (though at least it's not nearly as bad valuation-wise as it was a decade or so ago). Most of the best quality enterprises are rather fully valued right now.
(Over the shorter run -- less than five years -- anything can happen as far as relative performance goes. It's the longer time horizons -- more like twenty years or so -- that the "offensive" merits of high quality businesses become more obvious. A full business cycle or two. I realize that some, or maybe even many, market participants consider five years to be longer term these days.)

Still, it makes sense to embrace any simple, understandable, yet effective method of delivering above average risk-adjusted returns while generally avoiding the esoteric.**

Finally, the assessment of risk is necessarily imprecise and is certainly not measured by something like beta. Real risks does not lend itself to the all too popular quantitative methods. What can be measured, should be, but much of the important stuff can't be measured all that well. It requires a mixture of both quantitative and qualitative.

"You've got a complex system and it spews out a lot of wonderful numbers that enable you to measure some factors. But there are other factors that are terribly important, [yet] there's no precise numbering you can put to these factors. You know they're important, but you don't have the numbers. Well practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that." - Charlie Munger in this speech at UC Santa Barbara

When it comes to managing risk (and many other things), it's often a mistake to allow the less important but easy to measure stuff to triumph over what's more meaningful if tougher to measure. 

Adam

Long positions in KO, PEP, and PG established at much lower than recent market prices. No intention to buy or sell shares near current valuations.

Related posts:
The Quality Enterprise: Part II - Aug 2012
The Quality Enterprise - Aug 2012
Consumer Staples: Long-term Performance, Part II - Dec 2011
Consumer Staples: Long-term Performance - Dec 2011
Grantham: What to Buy? - Aug 2011
Defensive Stocks Revisited - Mar 2011
KO and JNJ: Defensive Stocks? - Jan 2011
Altria Outperforms...Again - Oct 2010
Grantham on Quality Stocks Revisited - Jul 2010
Friends & Romans - May 2010
Grantham on Quality Stocks - Nov 2009
Best Performing Mutual Funds - 20 Years - May 2009
Staples vs Cyclicals - Apr 2009
Best and Worst Performing DJIA Stock - Apr 2009
Defensive Stocks? - Apr 2009

* To me, the shares of many of these businesses are not especially cheap these days even if they have been at times over the past few years. It's worth waiting for a good price then acting decisively when valuation is attractive. Since each is unique, the necessary homework to build some depth of knowledge and understanding can be done while waiting for the right price. These may be lower risk but they're certainly not no risk. Margin of safety still matters. There's no way around the preparation and patience required in investing. After figuring out what's attractive at a certain price lots of waiting is inevitably necessary.
** Some may become bored by the straightforwardness. A few may even choose more complicated, high risk journeys just to enhance the challenge. Long-term Capital Management (LTCM) comes to mind. Charlie Munger said it best in this 1998 speech:

"...the hedge fund known as 'Long-Term Capital Management' recently collapsed, through overconfidence in its highly leveraged methods, despite IQ's of its principals that must have averaged 160. Smart, hard-working people aren't exempted from professional disasters from overconfidence. Often, they just go aground in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods." - Charlie Munger's 1998 speech to the Foundation Financial Officers Group

Uncomplicated, understandable, yet effective ways to produce attractive risk-adjusted returns should be embraced. Sophisticated or esoteric methods, especially those involving leverage, should not. Best to be wary of overconfidence in any profession. It can get even the most talented into trouble.

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