Model Dictates

The results of my modeling generally dictate my attitude toward investing in a company. This makes sense because presumably your best guesses about the future of that company go into your models.

The problem is that in general when I model a growth stock, I generally model a contracting multiple and when I model a value stock I generally model a stable to expanding multiple.

It doesn't take a rocket scientist to work out that usual outcome there wrt recommendations.

The Systemic Mistakes Of Bias and How It Infuses A Process (Disposition Bias)

As a value oriented analyst I find that 'disposition bias' infusing my whole process.

Whether it is using a higher discount rate than appropriate, or discounting growth and margins more than is likely.

I have found myself over the years moving from a 12% discount rate (or expected rate of return) to a 10% discount rate to recently using an 8% discount rate.

I have found myself moving from a normalized PE of 18x down to 15x and contemplating moving it up to 18x. I use the normalized PE to base relative PE's off for each stock. 

As a value investor with the implicit cautious nature of that disposition, I tend to use growth rates and margins less than what is embedded by the current consensus.

I am sure the reverse goes for a growth oriented analyst. They are likely to use lower discount rates and higher growth rates and margins than what the current consensus has embedded into the price.

What does this all mean? It means (1) You need to know the bias of your analyst, and (2) You've got to compare your assumptions with the consensus.

Note: In a world where the current WACC or discount rate is probably somewhere around 5%, growth is king. If you use a normalized discount rate of 8%-10%, then current stock prices are not going to look so bueno. But if the game is played using a 5% discount rate, rightly or wrongly, shouldn't you get with the system and play the game the way it is currently being played? Ans. No. Because when the discount rate normalizes, then stock prices will be re-rated to a normalized discount rate.

Philosophical Predilections

Was thinking. They teach you to be an analyst in college. Or at least they provide you with the tools to be an analyst. Everyone comes out with the same tools. But you take on an investment perspective/philosophy when you join a firm. Investment management is unique in that there are literally many ways to skin the cat - many paths to market beating nirvana (sadly none of them guarantee success). Some basic principles are essential, but after that you can seek to beat the market in any number of different ways. One reason for this is because there is no unified theory of investing. There is no one empirically correct way to beat the market.

And so, how important is the philosophical predilection of a shop? and, What effect (or bias) does that predilection have on the analyst's analysis?

Does a value oriented analyst in a value shop overly discount everything? Does a growth oriented analyst in a growth shop overestimate everything? [do they even do any analysis!!! my little joke]

Does it make any difference if you have a value-oriented analyst in a growth shop or a growth-oriented analyst in a value shop?

I would say Yes to everything.

Variant Perception and Edge: Value vs Growth

There are only two possible options for variant perception for both value and growth investors.

Both investor types are forecasting either higher growth rates or higher margins or a combination of those two factors compared to the market consensus and what is baked into the stock price today.

It is as simple as that. One other possible variant perception relates to the realm of undervalued/hidden/latent assets which occurs more on the value side of the divide (although effectively that is the implied assumption also on the growth side).

So for a growth investor when they come across a growth company trading at 30x forward earnings, implying 30%pa 5 yr growth and 20% operating margins, to have a variant perception they are either forecasting growth greater than 30% and/or operating margins greater than 20%. Implicitly they are also forecasting the future multiple to be 30x or greater. Lots of moving parts in that equation and lots of hope (the future) embedded in todays price. As long term holders the odds are usually not in their favor. Although if they hit the jackpot and get a genuine emerging leader that turns into a market leader then all their misses are likely to be made up by that one single hit.

For a value investor, looking at a company trading at 10x forward earnings with consensus growth of 0%pa for 5 years and operating margins of 5%, the variant perception hurdle does not appear all that great. The risk in this space is a company going the way of the dinosaur.

Growth Is Confusing

In the world of investing the word 'Growth' can mean different things and sometimes it is hard to know what meaning is meant.

Growth can be a reference to an investment philosophy, ie. they are a growth manager.

Growth can also be a reference to the characteristics of an asset class, ie. equities and real estate are growth assets.

Secular Cycle vs Cyclical Forces

The secular cycle portends the positivism of growth, expansion and rising productivity. It also increasingly includes certain headwinds from changing demographics over the next 50 years.

Cyclical stimulus (monetary and fiscal) has managed to delay, defer and extend the full impact of the prior cycle's contraction. The question is whether such actions have got us over the hump or whether there will be a price to be paid? and if so, what the price will be?

The price is likely to be a rebalancing of labor/capital wealth distribution (probably through taxes) and lower growth. To some extent we have already seen some of those factors playing out: higher taxes and lower relative growth.

Skepticism vs Cynicism

Skepticism yes. Cynicism no.

Skepticism in moderation is healthy, just as most foods in moderation are healthy. You need to be skeptical when evaluating companies, management and claims about the future.

Skepticism when it is overdone descends into cynicism. Cynicism is harmful because it is a static state of mind. It is unyielding, unbending and prone to dogma. Cynicism tends to be overwhelmingly negative, and as such distorts the bigger picture of positive growth, development and improvement.

The Conceit of Value Investing

Value investors rightly argue that if you focus on acquiring undervalued assets, ie. assets trading below intrinic value (whatever that is...certainly no objective measure...a post for another day), then the market will eventually come around to recognizing the firm is worth more than what it is currently and start bidding up the price.

The irony or conceit of value investing is that it is generally in a bullish (positive growth) economic environment that either the company's fortunes turnaround or the market has pushed the value of growth and momentum names so high that it is now looking for valuation arbs and comes down to the value end of the market to find those opportunities. A positive economic environment gives the market the confidence to take a punt on a distressed asset and time is the healer of all things (which is why value performs best at the end of a cycle - it is playing catch-up).

Value investors will also argue that value investing works in down markets because you have purchased assets at depressed prices and that provides a cushion (margin of safety) relative to the high priced (multiple) growth and momentum names that have led the market. That has not generally been my experience. In a large market pullback all names seem to fall together.

Value names tend to outperform at the beginning (inflexion point) in a market cycle and toward the middle-end of a market cycle. Growth and momentum names dominate (or lead) the market through the middle of a cycle. 

A Phenomena

There is a phenomena I have seen over and over again. It usually manifests itself as follows:

Company appears to be doing well via the numbers. Sales are growing, margins are expanding and the multiple is huge (too expensive for me). BUT...

I can't work out why the company is doing as well as it is. THEN...

It disappoints the street and the multiple shrinks enormously even as profits are substantial and it seems to the company is doing a lot more things right.

Case in point today is Coach (COH) which reported another disappointing quarter and is in Wall Street's doghouse.

The same could also be said for Apple.

Why The Market Pays Up for Growth

Great comment from Jason Cohen.

"The market rewards growth over profit ONLY WHEN the market also believes there's a lot more growth ahead of the company AND when the other mechanics in the company are sound, eg. good gross profit margin and high long term value: CAC. Once a company is large and simple market expansion isn't how it will grow, they're betting on the development of stronger business models. This is the current bet on FB, P & TWTR."

I had always intuited this and so liked when I saw it articulated. Not rocket science, but sometimes stating the obvious is good. 

Implications of Momentum Investing

Trend following, aka momentum investing is probably the weakest part of my investing DNA. I am a natural contrarian with a strong value tilt. I have learned the value of growth and the importance of sentiment and momentum, but they are still both hard for me to fully commit  to.

Over the past 10-15 years research has vindicated and validated trend following strategies as a way to add alpha. Consequently, and in conjunction with the increasingly quantitative/algo driven basis of the market, I believe trends, predicated upon more momentum investors and trend followers, will be longer and of greater magnitude that previously. The nature of momentum is that it feeds upon itself. It is self perpetuating, self replicating. There are three major implications. First, you need to incorporate momentum into your investment strategy. Second, a momentum based market leaves opportunity for fundamental based value investors. Because the trend goes longer and for a greater duration than fundamental value would indicate, it creates an opportunity for a fundamental based value perspective. Third, turns in the market or changes in trend will trip up a lot more investors. Trend followers, quant or qual, always get burnt by the turns in the market. The length and magnitude of trends will be greater on boths sides of a trend. Significant alpha will come from picking a change in trend. Incorporating a market reversal component into an investment process (albeit incredibly difficult) will be very rewarding.

The old adage, go with the flow will be the dominant characteristic of future markets.

Megacap Tech on Sale

Hard to really understand why the megacap techs trade at such a large discount to the market, their history and their fundamentals in an environment where everything else (with the exception of materials/cyclicals) are going through the roof.

The market is essentially saying that it thinks these pseudo monopolists are essentially dead men walking. It sees the young upstarts as the future, and the old lions as history.

The contrast is stark and amazing:

MSFT v CRM
ORCL v N
SAP v WDAY
INTC v LNKD
AAPL v ARMH
CSCO v RAX
HMC v TSLA

Making Heads 'n Tails of GDP Components

Refer: https://twitter.com/cullenroche/status/327874531551232000/photo/1

The interesting thing is that it has been a fairly mixed bag quarter to quarter.

If I had to eyeball trends, I'd say that Gross Private Investment has been the dominant factor lifting us out of the 2009 pit, with nice support from Personal Consumption. Strong mean reversion.

Govt is now dragging on the economy and I would expect that to continue into the future, but normalcy is returning.

A Philosophy on Investing

I look for good companies with attractive stock prices.

Some may call it growth at a reasonable price. I don't like to think of it this way. First, because it is jingoistic and fails to take account of the nuances in my approach. And second, because a good company may not necessarily have great growth prospects per se, but still have a very attractive stock price (from a long term equity ownership perspective). The beauty of a good company is that it has products, a market footprint and market opportunity that is sufficiently attractive (could be large market, could be niche positioning, could be something else) and competent enough management to continue to steer the firm along a productive path.

Now there are two other associated perspectives that are worth bearing in mind. The first is that I don't want to invest in a good company with an unattractive stock price. This would be the case where the market has bid up the price of the stock (ie. it trades at a substantial premium to a reasonable estimate of its long term intrinsic value) to the point where there is little margin for safety. The second perspective is that I am leary of investing in lousy companies with what appear to be highly attractive stock prices, ie. value traps.

There are two other areas where you can make a lot of money. The first is in buying cyclical stocks at the bottom of the cycle. The second is in identifying what were previously lousy companies that are turning into good companies and have a highly discounted stock price. Those are attractive investment opportunities also. If you fish in either of those areas, then you need a framework to understand and analyze the dynamics of both of those situations.

Major unwritten rules underlying investing are patience, structure, discipline and courage.

Let the Good Times Roll

Sort of as a contra-note to the previous post*, I want to remind myself of recovery mathematics.

The economy is bottoming and beginning the process of healing.

There are two points to make. First, the damage inflicted by the severity of the recession means it will take a long time to regain previous economic highs. Second, the YOY and MOM change numbers will look real good going forward.

The great thing (if you can call it that) is that asset prices were re-set when the economy imploded. As such, expected returns going forward will probably mirror the rate and extent of recovery.

In an environment where systemic risk factors and secular headwinds are in play, however, it is hard to see equity markets getting too exuberant, even as positive economic numbers come in. There again, that might be ascribing a level of rationality to the market that it does not warrant.

Depending upon how you look at it, it will be both a lost decade and a growth decade.

*The post was really about risk factors. Always got to keep an eye on the downside.

And now for something completely different

When I look back over my posts, there is a lot of negativity.

Am I that much of a sadsack? I guess so, and yet, it ain't all bad.

We may be heading into a slow patch, but the future is known. Progress, development, and economic growth are in the long term forecast.

Not only that, but I'm hopeful culturally and generationally we are learning some valuable lessons.