Stocks, Forex and Other Money Matters

WHAT JOHN NEFF AVOIDS

John Neff was in charge of the Windsor Fund for 31 years. It beat the market for 25 of those 31 years. He took control in 1964, and retired in 1995. Windsor was the largest equity mutual fund in the United States when it closed its doors to new investors in 1985. Each dollar invested in 1964 had returned $56 by 1995, compared with $22 for the S&P 500. The total return for Windsor, at 5,547% outpaced the S&P 500 by more than two-to-one. In this article, instead of focusing on what stocks Neff purchased, let us focus on what he avoided, most of which relate to bull-markets.

1. High Transaction Costs

Few mutual funds can claim to have such low expenses as the Windsor had– a mere 0.35% per year. The portfolio’s turnover was kept to unusually low levels. This saving on dealing costs is complemented by the low level of operating expenses for activities such as information gathering and analysis. One of Neff’s guiding rules is to keep things simple. The most important element determining stock value can be understood without the need for expensive sophisticated equipment or people. By holding for the medium term and not going for short-term profits he reduced both transaction costs and taxes.

2. Excessive Diversification

While all would agree that ‘some’ degree of diversification is necessary, if this is taken too far investment performance is hobbled. Neff said: ‘Why own, for instance, forest products companies if the market has embraced them and you can reap exceptional returns by selling them?’ He generally ignored market weightings and bought in areas of the market where under valuation was evident. Some sectors would be unrepresented in the portfolio, whereas others would be ‘over-represented’ (according to conventional logic). Normally the vast majority of the S&P 500 were not held, at any one time, by Windsor. Generally a mere four or five of these well known stocks fulfilled his requirements for inclusion. When the fund was valued at US$11 billion it still only had 60 stocks. Furthermore, the largest ten accounted for almost 40% of the fund. Windsor would often have 8 or 9% of the outstanding shares of companies. ‘By playing it safe, you can make a portfolio so pablum-like that you don’t get any sizzle. You can diversify yourself into mediocrity’, he said.

3. Technology Stocks

These were generally avoided for three reasons: (1) they are too risky; (2) they do not pass the total return to PE ratio test employed by Neff; (3) Neff admitted that he had no ‘discernable edge’ versus other people in the market place (Buffett’s circle of competence lesson). Neff believed it is essential to have some informational and analytical advantage.

4. Forgetting the Lessons of the Past

The memory of stock market participants is notoriously short. Markets are continually foolish, being condemned to invite catastrophe by forgetting the past. A knowledge of history is essential to give the required perspective. Neff, writing in 1999, believed that speculators in 1998 and 1999 were merely the latest in a long line of amnesiacs. In the late 1990s anything ending in a .com generated great excitement. In the 1950s firms merely had to put ‘tronics’ on the end of their name to attract attention and to drive their share prices higher. In the 1960s it was the go-go stocks. In the late 1960s and early 1970s to be labelled one of the Nifty Fifty was to see your stock prices soar. In the 1980s oil companies were in vogue. Before these bubbles you had the new era stocks of the 1920s, and so on.

Each generation believes that a few magical companies have an almost infinite capacity to grow, that the rules of economics have been rewritten and that you have to jump aboard before it is too late. The 1990s fervour was more dangerous than most because many, if not the majority, of the companies which lured the speculative dollar had no profits. They could not be called growth stocks in the traditional sense of the term. Speculators were premature in conferring growth status on companies that had good prospects only if you made massive assumptions regarding the likelihood of the entry of competitors, or the prospect for another change in technology, and, the willingness of consumers to join the revolution rather than continue to do things without the new technology. ‘Windsor’s critical edge was nothing more mysterious than remembering the lessons of the past and how they tend to repeat themselves,’ said Neff.

5. Getting carried away with Bull Market Hype

Markets go through cycles over time. There are occasions when investors are very risk averse. There is a phase when the emphasis is on quality. Later as confidence grows, investors look for stocks with a more speculative taint. After a period of growth the speculators fall over each other in their buying panic as the market runs well ahead of its fundamentals. ‘The capacity of investors to believe in something too good to be true seems almost infinitive at times,’ quips Neff. As the fad gathers pace, people who have little familiarity with stocks get swept along with the drumbeat of the prevailing wisdom. People find the urge to ‘hop on the line that moves fastest’ as they try to take short cuts to riches. The siren song of positive beliefs in the future drowns out the argument for a rational investment strategy based on a fundamental evaluation of stocks. Traders buy and sell on the basis of tips and superficial knowledge. The visions of overnight fortunes blind them to the logicality of investing without sound information and calm reflective thought.

People come to believe that there is gold enough for all in the same streams that earlier adventurers panned. Most of these followers go home empty handed as the wild expectations of the individual members of the mob one by one receive a slap in the face with a dose of reality. Eventually, it dawns on the masses that some players have already taken their money, as they figured things had already gone too far. Group panic begins, as everyone tries to exit at once. Predicting when these inflection points will occur is impossible so the best advice is to stay clear of stocks and markets that have lost touch with fundamentals. Don’t try to play the greater-fool game — you might just end up being the biggest fool.

6. The Technical or Momentum Game

Neff considered it ill-advised to try and predict market movements. His approach: ‘amounts to hitting behind the ball instead of anticipating market climaxes six to eighteen months ahead of the investment crowd. Poor performance often occurred as a consequence of a technical orientation that tried to predict peaks and troughs in stock charts. It assumed that where a stock has been implies where its going.’

7. Growth Stocks with High PE Ratios

The problem with stocks showing fast earnings growth is that their potential is likely to be well recognized. Indeed, on too many occasions, stocks that have attracted a market buzz have their price driven up to unrealistic heights as investors get carried away. This was clearly evident in the mania for business-to-consumer internet stocks in the late 1990s. A combination of over excitement, small free-float and the obligation of index tracker funds to purchase high capitalization stocks drove prices to ridiculous levels, especially for those with an untested business model, no profits and without enough time having passed to be able to analyze the possibility of market entry, competition and the introduction of substitute products.

Even well established growth companies such as General Electric, Gillette, Coca-Cola and Procter and Gamble can be poor investments. Yes, they are good companies with excellent financial performances based on strong competitive positions and good management. Yes, their businesses are broadly-based, sound and global. Yes, they are safe and, almost inevitably, will be around in 20 years’ time. But, no, they will not produce good returns to the stock buyer if they are purchased at a time when everyone knows these are great companies and the price is bid up to reflect this common belief. The slightest hiccup in growth or expectation of growth for these companies will see the stock sent reeling as the crowd becomes disillusioned. The lesson is that even great companies have a price ceiling. Neff says, ‘You can’t up the ante forever. Eventually, even great stocks run out of gas.’ Believing that Coca-Cola is a buy at a PE of 55, because it might go to 70 times earnings is battling against the odds. Value investors always keep the odds in their favor.

8. Being a Simple Contrarian

Neff is an individual who makes up his own mind about a situation or a stock. His willingness to argue with a signpost has paid off handsomely when it comes to going against the whims and fancies of the stock market. And yet, he was never obstinate, ego-driven or simple minded in his opposition. He did not assume that the market was always wrong. He was prepared to listen to the views of others. Most importantly he did not unthinkingly and automatically take a contrarian line.

Neff says, ‘Do not bask in the warmth of just being different. There is a thin line between being contrarian, and being just plain stubborn. I revel in opportunities to buy stocks, but I will also concede that at times the crowd is right. Eventually you have to be right on fundamentals to be rewarded… Stubborn, knee-jerk contrarians follow a recipe for catastrophe. Savvy contrarians keep their minds open, leavened by a sense of history and a sense of humor. Almost anything in the investment field can go too far, including a contrarian theme.’

By Curtis of Wallstraits.com

Credits: This article is modified from a summary of Neff’s investing style provided by Glen Arnold in Valuegrowth Investing, 2002.

Popularity: 23% [?]

Warren Buffett is the most influential invesment mind of the late 20th and early 21st centuries. He is the most successful pure investor in history and, along with Microsoft’s Bill Gates, one of the two wealthiest people on the planet.

Buffett and his partner, Charlie Munger, have become legendary for their savvy stock market investing and the management of a portfolio of wholly-owned businesses under their NYSE-listed holding company called Berkshire Hathaway.

From 1965 to 2003, Buffett and Munger beat the S&P500 Index in 35 of 39 years with an annual compounding rate of return close to 22% over nearly four decades! Buffet’s overall return from 1965 to 2003 was over 250,000% compared to 4,000% for the S&P 500.

Popularity: 34% [?]

Peter Lynch essentially created the Magellan Fund. After he took charge in 1977, it became the largest mutual fund in history, which it still was twenty years later. It had over a million shareholders, and during his tenure paid Fidelity, its managers, some US$60 million a year in management fees and several hundred million in sales commissions. (The 3% sales commission goes straight into the pocket of the owners of the management company; there are no salesmen.)

Lynch attended Boston College on a golf caddie scholarship, and happened to caddie for Fidelity Investments president D. George Sullivan, which helped him land part-time summer work with the firm. He started full-time with Fidelity in 1971 and by 1974 became director of research. In analyst meetings, Lynch would urge his colleagues not to tear down each other’s ideas, but rather to explain why their own ideas are good ones.

Lynch says that he has an edge because a lot of people he competes with are looking for reasons NOT to buy: The company is unionized; GE will come out with a competitive product that will kill them; or whatever. There is a whole list of biases that scare most investors away from studying the situation at all, so you miss a lot. To make money, Lynch says, you must find something that nobody else knows, or do something that others won’t do because they have rigid mind-sets. He also points out that it’s all right to make mistakes as the price of catching huge winners: The stock that doubles from 10 to 20 pays twice over for the one that falls in half from 10 to 5.

Lynch’s cardinal advantage over the legion of his competitors, besides his basic talent, is simply the enormous dedication he brings to the task. Lynch tries harder. In twenty years of marriage he took two proper vacations. A stockbroker who accompanies him on a trip mentioned that in a country where things barely get going at ten o’clock in the morning, Lynch insisted on starting to see companies at eight, and was quite grumpy that none could be found to talk to him at six! When at the end of the day the idea of dinner was raised, Lynch begged off, saying, ’I gotta read four annual reports by tomorrow.’ This broker said he had never seen anyone so well prepared for a company visit.

Lynch’s basic objective is to catch the turn in a company’s fortunes, which might be described as the time-efficient technique of deploying capital. Often, there is a one-to-twelve-month interval between a material change in a company and the corresponding movement in its stock. That’s what Lynch wants to capitalize on.

Lynch believes in an old trader’s rule: If you buy a stock because you hope something will happen, and it doesn’t happen, sell the stock. Wall Street has a sardonic expression for this idea: ’An investment is a speculation that didn’t work out.’ You had an idea, based on an expectation; you were wrong. So now you really have no reason to hold on to the stock and should sell it cleanly and quickly. Lynch says he often sells too soon. But you don’t get hurt by things that you don’t own that go up. It’s what you do own that kills you.

Of the stocks that I buy, says Lynch, three months later I am happy with less than a quarter of them. So if I like to look at ten stocks, it’s better for me to buy all ten, and then go on studying and researching. Perhaps I won’t like a number of them later on, but I can keep the ones that I do like, and increase those positions. And companies keep changing as you look: Competition may intensify; a problem plant may be sold off or closed; a competitive plant may burn down. So if you stay tuned, you can find that the fundamentals are changing.

Or even if they don’t change, the stock may go from 20 to 16. Perhaps I bought 10,000 at 20, and then I’ll buy 100,000 at 16. If I look at ten companies, I may find one company that is interesting. If I look at twenty companies then I may find two. If I look at forty, I may find four. If I look at a hundred, I may find ten. If other people saw as many companies as I do, I think that nine out of ten of them, when they heard the same story, would say, ’Wow,’ just the way I do, and be able to make the same buyin’ decision. You have to be a good listener in this business. And of course you may not be able to decide on the first visit. It may happen a year later or two years later.

Lynch thinks the worst traps is to buy exciting companies that do not have earnings. He can remember buying dozens of companies– where had the story come true– he would have made 1,000% on his money, and losing every time. And yet, and yet…! Wonderful new stories appear– ’the sizzle, not the steak,’ as he says– and again he will bite, and again he will lose.

The very best way to make money in a market is in a small growth company that has been profitable for a couple of years and simply goes on growing, says Lynch, who further observes that it is easier to make big percentage gains in stocks of small companies than in those of big ones. It is much harder for a stock in the Dow Jones Industrial Average to triple than it is for a stock in little NASDAQ companies. He is not strictly a value investor by any means, noting that if you get the facts right, you can be justified paying a high PE ratio for a rapidly growing company.

Lynch also discourages market timing. Starting in 1954, he has written, an investor sticking with the S&P for the following 40 years would have made an annual return on his investment of 11.4%. If he was out of stocks for the ten most profitable months, usually as the market bounced sharply from a bottom, the return fell to 8.3%. If he missed the 40 most profitable months, his return collapsed to 2.7%! Lynch is a fanatic about the stock market. Delight in his craft is Lynch’s secret to success!

Credits: Much of this article was extracted from Money Masters Of Our Time (John Train, 2000). Lynch has written two bestselling books, including One Up on Wall Street, since his retirement in 1991.

Popularity: 19% [?]

Philip Fisher began his investing career with a San Francisco bank, but in 1931 ventured out on his own confident that all investors would be looking for a new advisor with the 1929 Great Depression crash still fresh in their minds. Fisher built his early portfolio around just four stocks: FMC, Dow Chemical, Texas Instruments, and Motorola. He didn’t want a lot of investments, just a few outstanding ones.

Fisher’s general feeling about investments that are of interest to him is that the company in question should combine outstanding business management with a strong technological lead in most of what it does. Fisher’s key idea is that you can make a lot of money by investing in an outstanding enterprise and holding it for years and years as it becomes bigger and better. At the end your share in the enterprise is worth a great deal more than at the beginning. Almost certainly the market price of your share will rise to reflect its higher intrinsic worth. And certainly you should concentrate on growth in intrinsic worth: without that there’s no reason for the stock to go up at all.

He ridicules short-term thinking. Pursuing short-term goals Fisher regards as almost the worst possible mistake for a company. He therefore insists that management must first and foremost be working to build the company over the long-term. Growth happens because management is profoundly dedicated to bringing it about and directs all its activities to that objective, and as long as it does this successfully, the investor can stay on board.

One of Fisher’s most notable utterances is on this subject: If the job has been correctly done when a common stock is purchased, the time to sell it is– almost never. He gives two exceptions: first, if it turns out that you made a mistake in your original appraisal; second, if the company ceases to qualify under the same appraisal method. The old management may lose its drive or newer management may not be as able. Alternatively, a company may get so big in its own market that it cannot do much better than its industry, or indeed than the economy as a whole.

A third exception, which Fisher considers rarely valid, is that you discover a particularly attractive new opportunity– such as a company with great promise of a sustained 20% annual earnings gain– and, to buy it, you decide to cut back on a holding with lesser growth prospects. However, you probably know less about the new company than the old one, about which you have been learning more and more for years, so there is a risk of making a mistake. You cannot, after all, know almost everything that could be important about more than a few companies. Those years of progressively greater familiarity, Fisher urges, should not be thrown away.

He also argues that you should not sell because you think that a stock is too high-priced– has gotten ahead of itself– or because the whole market is due for a slide. Selling for either reason implies that you are clever enough to buy the stock back more cheaply later. And in addition you have the capital gains tax to pay. After all, if you have chosen the company properly in the first place, with a reasonable prospect that in ten years, say, the stock will have tripled or quadrupled, is it so important that it’s 35% overpriced today? And there’s always the possibility that the stock price reflects good news you don’t know about yet.

Silliest of all, says Fisher, is selling out just because a stock has gone up a lot. The truly great company– the only kind he is interested in buying– will grow indefinitely, and its stock likewise. That it has advanced substantially since purchase only means that everything is going just as it should.

Fisher redefines the word conservative around this concept. To him, a conservative investor is one who makes his capital grow in a practical, realizable way, not in a way that can’t succeed. People often describe large, well-known companies as conservative investments. But for Fisher, old and famous companies that have passed their prime and are losing ground in the jungle of international business are by no means conservative holdings. Rather, the conservative investor is one who owns winners: dynamic, well-managed enterprises that because they are well situated and do almost everything right continue to prosper, grow, and build value year after year. The owners of such companies don’t have to worry about market fluctuations, since the underlying assets are building: Things are going the right way. Market recognition will follow.

Fisher’s first substantive chapter in his classic text, Common Stocks and Uncommon Profits dwells on the importance of scuttlebut– which he also calls the business grapevine– in investing. The theme recurs throughout his writing. In fact, Fisher suggests no other source of information for a number of the points he says a prudent investor must consider, such as management integrity, long-range planning, cost controls, and the effectiveness of a company’s research program, all of which are hard to determine from the public figures.

Outstanding Companies

In his first book, Fisher describes fifteen characterists of an outstanding company, and in his second he touches on several more. I think one can discern about 20 in all, depending on what is considered a separate category. Though not presented consistently in Fisher’s two books, his criteria can be grouped under two main categories: qualities of management and characteristics of the business itself.

Characteristics of an attractive business include growth from existing products and from new ones; a high profit margin and return on capital, together with favorable trends for both; effective research; a superior sales organization; a leading industry position giving advantages of scale; and a valid franchise– proprietary products or services.

Management characteristics include integrity, implying conservative accounting; accessibility; an orientation toward long-range results, if necessary at the expense of this quarter’s bottom line, without equity dilution; a recognition of the pervasiveness of change; excellent financial controls; multidisciplinary skills where appropriate; the special skills associated with particular industries; and good personnel policies, including continuing management training.

In discussing profit margins, Fisher makes a point that investors sometimes forget: Exceptionally high profit margins can be a honeypot to attract hungry competitors. The safest position may be to have only a small edge on the competition in profit margins, plus a higher turnover, because that leaves little incentive for new competition to move in on you. Fisher ridicules the notion, sometimes put forward by brokerage reports, that a statistically cheaper number two company may be a more attractive investment because it has greater possibilities. A fully installed dominant company– a GE or Merck– is exceedingly hard to displace, as long as management remains alert.

Fisher insists on integrity in management. Insiders have any number of opportunities to benefit themselves at their shareholders’ expense, both in material terms and by deceiving them about the prospects for the company. A greedy management’s most common abuse is issuing itself overly generous stock options when the company’s stock happens to be at a low point– selling below book value, say. Time passes, the stock returns to a normal level, and through no merit of its own, management has extracted millions of dollars of value from the shareholders.

Fisher’s investing technique will be very difficult for most investors to emulate. He proposes three successive phases in analyzing a company properly: absorbing the available printed material, triangulating through business sources, and finally visits to management. Once convinced of the quality of the business and its management, Fisher further advises three buying points to accumulate shares: first, buy when the start-up period of a substantial new plant–which sometimes lasts for months and includes a special sales effort for the new product involved– has depressed earnings and discouraged investors. Second, is on bad corporate news: a strike, a marketing error, or some other temporary misfortune.

The third opportunity to buy on favorable terms arises in a capital intensive industry, such as chemicals, where an unusually large investment in plant is required. Sometimes after a product has been in production for a while engineers figure out how to increase their output substantially by spending a relatively modest amount of additional capital. This may produce a significant improvement in the company’s profits. Until the stock advances to reflect this prospect there should be a buying opportunity. Fisher also mentions that one should not hesitate to buy on a war scare. During this century, almost every time American forces have become engaged somewhere in the world, or there has been a serious danger that they would, the stock market has fallen, and every time it has recovered. Perhaps the same applies to a SARS scare.

Credits: Much of this article was extracted from the book, Money Masters of Our Time (John Train, 2000).

Popularity: 16% [?]