As 2013 draws to a close, we’re approaching a time of year when market participants become increasingly susceptible to outside forces; between the “Santa Rally”, tax planning / concerns, window dressing / portfolio "cleaning", and the influx of “Best of 2014” lists, there’s an incessant prodding to do something – anything. That prodding has been intensified due to rising equity prices, as well as newspaper headlines that are implying good times ahead (the cover story for this weekend’s Wall Street Journal reads “US Economy Starts to Gain Momentum”).
I’m not sure if Blaise Pascal really said this, but he’s often attributed for having said the following: “All men's miseries derive from not being able to sit in a quiet room alone.” A few decades after his death, the South Sea Bubble would prove just how applicable this can be when (apparently) easy money is being made by swarms of individuals without doing a lick of work.
It looks like 2013 will end up being a very good year for equity investors; as of December 17th, the Dow Jones Industrial Average and the S&P 500 are both up somewhere between 20% and 25% for the year (before the 2% or so they picked up Wednesday). A quick look at the S&P 500 by individual names (as of the 17th) shows that just 10% of those companies are in the red for the year – with the majority of those in the red down low-mid single digits. With a limited number of exceptions, being in the game was all it took to win big in 2013; add in the low double digit gains for the indices in 2012, and it’s been nothing but sunshine over the past few years – an eternity in the eyes of most market participants (as long / short fund managers have found out).
Which brings me to Peter Lynch: Mr. Lynch hasn’t been in the public eye too often since stepping down from the Magellan Fund more than two decades ago, so his recent appearance on Charlie Rose caught some attention; there was also a piece in the New York Times highlighting the charitable giving that Mr. and Mrs. Lynch’s foundation has been involved in since the late 1980’s. However, this isn’t what brought Mr. Lynch to my attention; instead, it was a CNN Money article from 2003 titled “Peter Lynch: Why He's Buying Now” (that’s the kind of headline the financial press loves).
Let’s remember something before we jump in: stocks had been a real bummer in the three years prior to 2003. After increasing double digits in every one of the years from 1995-1999 (with the lowest annual increase at +19%), the market had fallen by more than 10% in 2000, 2001, and 2002; an investment of $100,000 at the start of the new millennium was worth less than $60,000 at the start of 2003 (if you think that’s bad, consider the NASDAQ – you’re $100,000 investment from 36 months ago was now worth just north of $30,000).
The financial press, as always, had an explanation – uncertainty:
“Just about anywhere investors looked this year they found things not to their liking: global tensions over Iraq and possible new terrorist attacks, spiraling oil prices, corporate accounting scandals, and an economy struggling to recover from the first recession in a decade in 2001. All of these created great uncertainty, which is what investors like least of all.”
Of course, we know in retrospect that the uncertainty would never end (events just five years later would make the “uncertainty” of spiraling oil prices seem like a walk in the park); the future is always uncertain – some people just need to lose a boatload of money before they come back to earth and remember that tomorrow will only be “certain” after it has passed.
Anyways, let’s get back to Mr. Lynch; what were his thoughts on equity investing after a few years in the gutter for the indices, economic weakness, political instability, and a growing recognition of questionable behavior in the C-suites of corporate America? You might not be surprised to hear that while others were scared of uncertainty, Mr. Lynch saw opportunity:
“I have increased dramatically all year long the percentage of my Fidelity holdings that are in stocks in general and growth stocks in particular… I've found that when the market's going down and you buy funds wisely, at some point in the future you will be happy. You won't get there by reading 'Now is the time to buy.' These things never go off that way. But this is the third straight year of market declines, and we haven't had many periods like that. I'm not a timer, but I thought I should increase my percentage in stocks. I've bought more as the year's gone on, moving cash from my money-market funds and increasing my equity bet by about a third.”
Compare this to other “wisdom” from that same period:
''The confidence that people have had in the equity market to really deliver returns over the long term has just been shaken down to their roots,'' said Jeff Knight, chief investment officer for global asset allocation at Putnam Investments, which manages $275 billion. ''It will take many years before confidence can really come back in a meaningful way.''
When Mr. Knight says years, he really means returns. Confidence wouldn’t have come back in a big way in the ensuing years if the markets had continued to dive or even stabilize; people became confident again because the S&P posted positive results in each of the next five years – starting off with a bang in 2003 with a 26% gain. It’s the same cycle again and again – people hate stocks as they get cheaper, and only become interested once again as they become more attractive (and are able to find the headlines to soothe their fears – again, see this weekend’s cover story from the WSJ).
In many ways it’s sad to see that so many individuals are helplessly doomed to a life of mediocrity – at best – when it comes to saving for their retirement; undoubtedly, that will continue to be the case (and increasingly so as the days of defined benefit plans disappear - from roughly 80% of private sector employees thirty years ago to less than 20% as of last year).
I’m not making a market call; at the same time, markets are nothing more than a collection of individual companies – and as I look at the individual companies that I can understand, almost all of them are substantially more expensive than they were just a few years ago. I have not made a single purchase the entire year; beyond a handful of stocks that I’m taking a closer look at as we speak, I would require a decline on the order of 15-20% in most of the names on my watch list before I started to get interested. Until that happens (or the valuations catch up over a number of years due to market stagnation), I will continue to build up my cash reserves.
As it stands, my cash balance is in the mid-teens as a percentage of my overall investments (I’ll provide a more precise update in the coming weeks when I write a year end portfolio review); that will continue to rise if stocks become more expensive, as savings are set aside in anticipation of future opportunities. Naturally, I will underperform by a wider and wider margin if this growing cash balance is combined with the continued double digit annual increases we’ve seen in the past few years (soon to be four of the past five).
Here’s an important thing to recognize - I’m fine with that result. If you are not concerned with matching the indices week to week, month to month, or year to year, you’re given the flexibility to abstain from new investments when opportunities appear limited; on the other hand, if you’re constrained by relative performance (or look to the market for advice on whether or not you should be a buyer or a seller), Mr. Market dictates your investment strategy.
I won’t buy unless opportunities meet a simple set of criteria: (1) can I conservatively value the business in question, and (2) is it trading at a meaningful discount to that conservative estimate of intrinsic value. If I cannot answer both of those questions, I will not invest – period. I would bet that Mr. Knight’s comment from above is reflective of how most individuals think: they are concerned with the near term outlook for equities (that’s why CNBC parades out one person after another with predictions for 2014), the “uncertainty” about what lies around the next corner, the fear of underperforming in a bull market as their neighbor makes easy money month after month in tech stocks, and so on.
(Quick side note - here’s a tech example for you: Twitter (TWTR) has more than tripled from its initially reported IPO price, to a valuation north of $33 billion as of Friday; that initial IPO price was set less than 60 days ago. Amazingly, analysts have somehow managed to double or triple their “fair value” targets – now that’s an oxymoron – and still call TWTR a buy; it's simply mind-blowing that people would hang their hats on the opinion of someone who thought the stock was worth $30 a month ago - yet continues to call it a buy with the stock currently trading at $60)
My philosophy is straight-forward: I will not let the market dictate my behavior; I will happily sit with cash earning nothing (and likely coming out a bit behind after inflation) until I find an intelligent investment opportunity. I wouldn’t pay $35,000 for a farm (or an apartment) that could reasonably be expected to produce $1,000 in after-tax income a year – and the price jumping to $40,000 would only make me less interested. Almost anybody can grasp that simple example – yet for some reason, when it comes to equity ownership in publicly traded companies, people don’t make that connection (the ability to easily check prices all day hasn’t helped).
You may have noticed in the past that I’m prone to rambling; this article is yet another example. In an attempt to bring some clarity, here’s a simple summation: when equity returns significantly outpace increases in intrinsic value, stocks have become less attractive; this can go on for a long time – until it finally stops. The most prominent example of this in recent memory came in the early 2000’s, when tech investors (using the NASDAQ as a proxy) lost nearly $0.70 of each invested dollar in just thirty-six months; people were as confident as can be paying one hundred cents on the dollar – and couldn’t be less interested when they had the chance to load up at thirty cents. If you’re paying more than 20X normalized earnings / FCF for a business but would scoff at paying 15X – after the stock fell over 25% - then it’s time to start cooling down, not speeding up. If you are making decisions based on a single factor - like the current dividend yield - you need to seriously consider if you know what you're doing.
Many have become increasingly confident as stocks have become more expensive; I’d humbly suggest that you might want to think twice about what you’re doing if you're in that group. If a 20-25% decline in 2014 would cause you to move to the sidelines once again, now is the time to rethink your approach to investing.
Happy holidays to all, and I look forward to talking again soon!
About the author:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with a handful of equities accounting for the majority of my portfolio (currently two). In the eyes of a businessman, I believe this is adequate diversification.