Friday, September 14, 2012

Its Time to Buy Blue Chip Stocks

If, like me, your eyes glaze over with boredom every time one of the financial media channels wheels out Jeremy Siegel in order to argue that equities look cheap relative to bonds, you would be entitled to view the following article with great circumspection. Yes, stocks do look inordinately cheap on a relative basis but no, that is not my point. The aim of this article is to demonstrate that stock prices and evaluations really are moved around by sentiment rather than any strict adherence to relative evaluations.

The Equity Risk Premium

I’ll start this tortuous discourse by looking at a long term chart of the equity risk premium as defined by comparing E/P (for the S&P 500) versus long term interest rates (US 10 year treasuries).

A few things are immediately apparent. Equities certainly look relatively cheap right now but then they spent a large part of the 50’s looking even cheaper. Similarly, there is a long period in the 70’s where equities looked cheap. There is also a remarkable period from 1980-2000 where this relationship holds in sync. In fact I am going to contend that it was this period that contributed so much to the structure of the financial crisis.

What happened from 1980 to 2000?

In order to demonstrate this relationship between equity evaluations and interest rates, I am going to perform a regression analysis on the data. Now, hold on, before you run off! It’s not really that complicated.

Essentially, it is just a way of measuring correlation (or rather R^2) between two data series. Simply speaking, the closer the R^2 gets to 1, the closer the two data series move with each other. Here is what happened between 1980 and 2000.

The x-axis is the interest rate and the y-axis is the E/P ratio. Note that the R^2 is remarkably high here.  In addition the best fit equation is suggesting that if long term interest rates are say at 5% the correct E/P ratio should be .9894*5-1.6431=3.3 and the P/E is then likely to be 30.

Granted some of this data is skewed by the nutty period in the late 90’s but nevertheless the relationship is quite accurate over those 20 years.

A graphical depiction of those 20 years here.

This wasn’t just a chart; it was a way of life. A 20 year bull market in which any objector was swept aside in the rush to get long. Not only were they swept aside, but the guys who took on the most risk were the ones rewarded the most. There are a lot of heroes in bull markets.

Unfortunately, this is likely to have caused a concentration of uni-directional ‘punters’ who don’t really understand risk at the higher echelons of the financial services industry. And, boy, did the financial services industry do its best to prove this theory right!

What About From 2000 to Now?

I chose the phrase ‘uni-directional’ carefully, in order to express that this is not just about someone who wants to be long only equities. That game went out of fashion in 2000, as we can see from a chart of the equity risk premium during the period.

Equities start off the decade being expensive, then the crash comes and they are historical cheap from '04-'08. The recent recession definitely wasn’t caused by equity overvaluations, but it was caused by the self same people who had been promoted in the 20 year bull market. They took their ‘skills’ and knowledge of risk and applied them to the next investment fad, in other words housing. The truth is that no one wanted equities post the dot-com crash and everyone wanted commodities, China and housing. Some of that has changed now.

However, the key point for this article is that the relationship between bonds and equities did break down in this period, and it is a fallacy to regard this relationship as something inevitably mean reverting. In addition, the equities that did outperform in this period were small caps rather than large caps.

Where to Next?

Having established that the bonds/equities relationship is nothing set in stone and really a ‘marker’ of investor sentiment and asset class preference, I am now going to argue that good old fashioned blue chip equities could be the way forward!

Purely by way of example here are some current PE ratios and dividend yields for some of the largest cap stocks in the US.

Now if investors can take a long term view then these sorts of stocks look like good value right now. You don’t even have to rely on the equity risk premium to justify these valuations. Wal-Mart $WMT is likely to have its long term growth rate align with the US economy. Coca-Cola $KO arguably has good long term growth prospects within emerging markets and people won’t stop drinking soda anytime soon.  The market may fret over the patent cliff and future reimbursement issues but Pfizer $PFElooks like good value and has a few very exciting drugs in its pipeline.

Another company experiencing short term worries recently is McDonald’s $MCD as the market concerns itself with its European exposure. So what? In the long term the company has a great brand and lifestyle changes (single parent families, trading down etc) are favoring it.  Everyone hates the banks –me included- but as we’ve seen the politicians bend over backwards to keep these guys afloat, perhaps it’s better to look at JPMorgan $JPM and conclude it will get over its short term trading difficulties?

Over the last decade or so we’ve had an emerging market bond bubble, a gold boom, localized housing booms all over the world, small caps outperforming, a commodities boom, a boom in leverage etc. In other words, investors have wanted anything but large cap equities.

Perhaps it’s time for blue chips to make a comeback in sentiment? And if they do, it will be sentiment rather than anything that Jeremy Siegel and the equity risk premium enthusiasts tell you about it.

Monday, September 10, 2012

How to Diversify Your Portfolio

Very few professional investors would advocate a portfolio of equities without insisting diversification. It is certainly a worthy aim, but what is puzzling is that so few seem to understand it or at least make the effort to think in non-conventional terms about. In my humble opinion the conventional and consensus opinion on the subject is plain wrong and investors with even a rudimentary understanding of the underlying issues can better generate diversified portfolios.

In this article I will briefly focus on two ideas.  The first is the concept of beta (derived from the modern portfolio theory beloved of unintentional index hugging fund managers) and the second relates to mechanical based investment systems. In turn, I’ll share a few thoughts on what investors might do to better achieve diversification.

Beta in Investing

The concept of beta is wonderful in principle. Theoretically all an investor has to do is put together a portfolio of stocks whose average beta works out to one and he/she has a portfolio thaqt approximates market risk.  Bingo he is diversified! Furthermore, when he wants more risk, he just buys more stocks with a beta more than one. When he wants less, he just buys stocks with the opposite property.

Unfortunately, it is not that easy. Beta is- by definition- based on historical data. It tells you what was a high or low beta across previous market conditions. I’m not saying that this isn’t useful. It is. If market conditions are the same going forward then the concept of beta is highly applicable. Alas, markets are not that compliant.

In the last 20 years or so, we have been through a technology boom, a housing market boom, a banking boom, a commodities boom, a banking bust, a housing market bust, a boom in emerging market bonds, boom in Gold, a China housing boom and so it goes on. The fact is that market conditions constantly change and deluding yourself that you can obviate the necessity to think about how macro-conditions are evolving by just relying on some backward looking data like beta, is a recipe for trouble.

Consider, a stock like Intel (NASDAQ: INTC) and then look at Caterpillar (NYSE: CAT). Yes, during the dotcom boom the former was likely to have been a high beta stock as the market priced in every ‘Blade Runner’ technological fantasy whilst Caterpillar would have been a lot less beta. After all, they just provide machinery to the boring housing, mining and construction industries. Fast forward a few years into the dotcom bust/low interest rate era and suddenly housing, mining and anything China are (literally) hot property and no one wants tech. Guess who is high beta now?

This sort of example illustrates that beta changes with market conditions and cannot be relied upon. In a brief aside, I will also note that fans of Soros’ reflexivity would also point out that self reinforcing feedback loops also create investment bubbles (i.e. high beta stocks or sectors) and they can come from origins such as sheer sentiment or regulatory changes. How anyone can think that these factors will be expressed in the historical beta of a stock is beyond me.

Ultimately, if the beta moves around with conditions then structuring a portfolio based on this approach will not lead to diversification because the portfolio will do the same.

Mechanical Based Strategies Lead to Unintentional Style or Sector Biases

Another instrument of self-delusion is the seductive idea that investors can achieve diversification by investing based on a set of mechanical metrics which attempt to capture some sort of attribute or other. Again, I am not completely decrying this idea because I use such metrics to quantify stocks and I think they are useful. What I am saying is that if they are applied without consideration of the macro-conditions or overall portfolio direction they will lead to an unintentional style or sector bias.

In plain English –I can use it in occasion, I promise- if a portfolio is constructed purely using a metric such as , say dividend yield or PE ratio or Price/Assets etc, it will end up manifesting an unintentional market view. To give you an example, consider that in 2008 the highest yielding stocks tended to be banks, insurance companies and house builders. Guess what happened next?  The dividend did not exactly provide a floor to the share price, especially when it had a tendency to disappear as earnings collapsed. Investors can look at the stocks like Citigroup (NYSE: C) as a classic example of this trap.

Another example of a pitfall with this approach can be seen if investors focus on only investing in say an earnings or cash-flow basis. This sort of approach has a tendency to immediately disqualify certain sectors like biotech or oil & gas exploration. No one invests in Vertex Pharmaceuticals (NASDAQ: VRTX) or other such stocks because their growth prospects are all about future cash flows and earnings. If you wait for them, you will be too late to capture the upside.

Putting these two examples together begs a key question. How can a portfolio be truly diversified if it overweights one sector and/or it ignores whole swathes of the market?

An Alternative Approach to Risk Management

I’m going to conclude this article by suggesting another approach. Namely, to try and actively diversify the profit drivers in a portfolio and/or select stocks that have upside drivers which are relatively non-correlated with the macro economy. An example of the former approach would be to say balance an oil services company (which you think is undervalued) with say a company that has a high proportion of its fixed costs in oil or energy. Another example would be to buy a fertilizer company and balance it out with a food producer.

In other words, what you are trying to do is pseudo-hedge away macro risks and create a diversified portfolio that isn’t over exposed to anyone sector of the economy. Of course such an approach requires a lot of forethought into stock selection, but hey, no one said investing is easy!

As for the non-aligned approach, I think special situations investors tend to cross over a lot into this camp. It is all about finding stocks with almost hidden upside potential.  I think an example of this now is Johnson & Johnson (NYSE: JNJ). It isn’t the sexiest stock out there but its growth prospects are mainly about execution. If it sorts out its production difficulties within consumer products, integrates the Synthes acquisition and successfully develops sales of its new drug products then the stock price can appreciate irrespective of the economy.

Investing is more of an art than a science and there is no reason for fund managers to try and bamboozle private investors with the idea that they have the secret formula for diversification. They don’t. In truth it is much more about understanding why stocks move in the way they do and trying to balance the overlying risk. There is no reason why private investors can’t do this just as well as institutional investors.