August 2014

“If not now, when?”

- Hillel the Elder, 110-BCE-10 CE

Hillel the Elder doesn’t come up much in conversation these days—and 2000 years ago his quote had absolutely nothing to do with investing.  Still, we thought it fitting today because it goes to a key investing point….when do we sell? 

If not now, (as we enter another correction after a recent high) when?  And conversely, when should we buy back into the market?—otherwise known as market timing.

The common chatter for the last two years has centered on “the markets being too high.”  We, like you, read and hear about national and global issues such as war, drought, unemployment, social unrest, and so on.  And while we care about macro-economics and global geo-politics, we do not base our investment decisions on the crisis de jour. 

It may seem counterintuitive, but the overall market has far less to do with the performance of individual stocks than most people think.  For example, while the S&P 500 (SPY) has risen by over 300% in the past 20 years, that upward momentum hasn’t helped former Dow giant Kodak one bit.  During that same 20 year period, Kodak’s share price fell from over $60/share to about 3 cents a share before it delisted and reformed into a dramatically smaller company with high-energy management. “The market” did not tank old-Kodak.  Kodak did!

By the same token, when the S&P 500 (SPY) fell 34% in the first 18 months of the dot com bust in 2000, Exxon stock (symbol XOM) barely moved at all.  XOM shares went up slightly from $40.62/share to $40.92/share—all the while trading within a small 10% range.  If you owned Exxon, because of a combination of product mix, a well-run company, and a strong balance sheet, your investment did not fall prey to the dot com bust.

So putting the two stocks together, imagine if you had owned an Exchange Traded Fund (ETF) that owned only Kodak and Exxon.  No matter how well Exxon did, Kodak doomed your returns.  Granted, no ETFs own only 2 stocks, but the absurdity of the example is not as far off as you may think.   Let’s use an analogy to view this simple concept a little more broadly.

Let’s say, someone came to you and said, “You can own the local mall.”  What would you say?  It would probably depend on what you thought of the mall’s prospects.   But, suppose someone else said, “You can pick and choose which tenants in the mall you want to own.”  Wouldn’t you be more likely to answer yes?  After all, now you could build your “mall portfolio” with only the busy and profitable stores and dismiss the ones that have the “liquidation sale” signs in the windows and dis-interested store managers.  Admittedly, they key here is a good store picker!

Owning “the market” (via ETFs or mutual funds) is akin to owning “the mall.”  If you invest in exchange traded funds and mutual funds you certainly get diversification; but like the mall, that philosophy saddles you with investments you might otherwise have avoided had you gleaned through the fundamentals of each individual company.

But the issue goes deeper than that.  What happens when the time comes to sell?

If you own a market ETF or mutual fund, selling requires proportionately exiting everything inside the fund.  You lose much of your ability to tax manage….and total returns (after tax) are what matters.  Many times, it’s not about what you “make,” but rather what you “keep.”  (the noted exception here would be IRAs or 401Ks)

So, again, when is it time to sell?   And once you’ve sold, when do you get back in?  In our minds, the signs show up in the companies’ metrics, not the market’s sentiment-swings. 

For instance…..

Has revenue growth slowed or stalled?  If so, why---and will it rebound?  What does management say about future projects?  Is tangible book value still growing at a nice pace?  Is free cash flow solid?    Are costs in line and improving as a percent of sales? 

What about the dividend levels within our portfolios?  Have dividend increases been slowed, stopped, cut?  Are net cash flows needed to pay future dividends still healthy? 

What about the management teams?  Have there been quiet (or noisy) exoduses of key leaders?  During earnings calls, are management teams saying things that “just don’t sound right?”  Have new disruptive technologies appeared on the scene—and are executives dismissing their importance?  (Think Kodak again and the emergence of digital cameras and smart-phones.)

None of the above questions requires a degree in physics to answer….and, in fact, can be related back to our fictional shopping mall owner.  Picking the right shops to fill your space (read:  your portfolio) is critical to long term investment success.

So where are we today?   As we pen this blog in early August, a correction has begun. At this point, doing a “look-back” can sometimes help weigh the odds of what might happen going forward.  Since the equity markets are so liquid, much of the day-to-day volatility can be attributed to “market sentiment” and not fact-based macro-data changes.

We don’t see the “facts” of the latest earnings seasons supporting a long-term downturn in the value of our holdings.  With S & P 500 Q2 earnings now mostly in the books, sales are up overall around 4.3% and earnings up approximately 6%. So, top and bottom lines are growing. That is a solid quarter.  Plus, jobs are being added and energy costs are falling.  Energy is more dependable than ever. Even retailers are showing some life in their sales numbers.  And the backdrop to all this is that combined S&P PE ratios have fallen from 17 to under 16—mostly because ‘E’ has risen (earnings).

In the last five years, by our count, there have been 13 “corrections” similar (or more pronounced) than the one that is currently in motion.  Without fail, within months, these corrections have been followed by 13 new highs.  So the problem we have with aggressive selling (against the fundamentals of what we believe to be present inside our companies) is that we would then be betting on following market-sentiment.  It then becomes very difficult to know when to re-engage and buy back in.

Then, assuming asset sales, these assets would end up sitting in cash—an asset that for all intents and purposes is earning zero.  Alternatively, the money could rotate into bonds, but with interest rates at historic lows, the concomitant risk associated with volatile (or worse, steadily rising) interest rates isn’t very attractive. 

So to answer Hillel the Elder’s “If not now” question, the answer is….we will more aggressively sell when we see the value proposition and risk/reward ratio becoming less in what we hold vs. other asset classes available for our hard-earned investment dollars.  When that occurs, we will not hesitate to make adjustments.  We’ll bet Hillel wasn’t expecting that answer.

Happy Investing!



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