Market Playground

By Rocco Huang

In a recent article in Smart Money magazine entitled “Dead Stocks Walking”, Russell Pearlman lamented the disappointing and puzzling performance of Wal-Mart Stores, Inc. (NYSE:WMT) shares, along with many other high-quality blue chips (e.g., Microsoft, Intel, Medtronic, Gilead) in the past decade.

Many asset managers, some considering themselves “value investors,” now say that WMT is a “value trap”, citing the contrast between its flatline performance in the stock market and its consistently growing earnings in the past decade.

Their explanation is a typical example of selective memory loss. Ten years ago, WMT was NOT a value stock. According to Gurufocus, WMT’s P/E ratio was above 40X ten years ago, and since has been declining steadily.

They simply paid too much for it. Buying-and-holding a glamour stock is not value investing. Over time, a glamour stock may become a value stock as its price comes down, but it doesn’t change the fact that, when they purchased WMT back then it was an overvalued glamour stock.

Of course, WMT’s share price should have gone nowhere. We are still paying for the sins of the last large-cap equity bubble of 1982-2000, more than 11 years after its collapse. Yes, it takes that long, when the two decades of accumulated overvaluation was that much.

However, WMT is not a “value trap”. A “value trap” is a stock whose price initially appears cheap based on its perceived fundamental at the time of purchase, but later turns out to be expensive when its fundamentals reveal it to be in much worse shape. In contrast, WMT in the past decade was simply an over-hyped growth stock finding its way down to its intrinsic value. Its fundamentals didn’t collapse. Quite the opposite.

Those who purchased WMT ten years ago can only blame themselves for paying too much. In investing, buying at a bargain price can hide a lot of sins. Now, after ten years, why is WMT a buy again? First of all, the Wal-Mart of today remains as high quality a company as the Wal-Mart ten years ago. Wall Street analysts back then were right about the company, but wrong about its price.

Its market price has changed. The stock market is like a pendulum. Gravity makes a clock pendulum swing back and forth. In investing, the counterpart of the gravity theory in physics is the law of mean reversion. Crowd sentiment swings between two extremes: greed and fear. Stock prices swing between overvaluation and undervaluation.

How do I know that now is the time to buy? (I am sure some of you have in your mind a clock-related joke: “A dead clock can be right twice a day.”)

My first answer is that I don’t know. A stock’s price reaches its intrinsic value from time to time, but similar as a pendulum, it seldom spends much time there. If you have ever observed a pendulum clock doing its work, you must have noticed that the pendulum spends the least time at the nadir, because its speed is the fastest there. Timing the market is difficult, if not futile.

Trading volumes are usually the lowest when a stock bottoms, suggesting that indeed very few market participants actually know they are at the bottom.

My second answer is that I do know something. Value investors believe in the laws of gravity and mean-reversion. The investing process of value investors consists of two stages. First, we wait patiently (like ten years in the case of Wal-Mart) for a stock to become cheap enough. Second, we hold our hands out in the path of the pendulum, and wait again (hopefully not another ten years) for it to return and hit us.

It may take a while. Like a pendulum, an over-valued stock usually has to become significantly under-valued first before bouncing back and passing its intrinsic value for a second time. The silver lining is that, for a high quality company that is growing just moderately every year, it pays to wait. Just imagine a pendulum bob that is growing in weight every second.

I don’t attempt to time the market, but I would like to point out that Smart Money magazine is a great contrarian indicator. (To be fair, I believe all popular magazines make great contrarian indicators.) The icing on the cake is the last paragraph of the article discussing the recent exit decision of a fund manager:

Notably, however, he did finally throw in the towel this year on one of his longtime holdings: Wal-Mart. After seven years, the manager concluded that the retailer had become a “value trap” — which is to say that while it looked like it could become a great stock, the odds weren’t  good that it ever would. “Wal-Mart hasn’t moved out of a range in 10 years,” Creech says. “When you think like that, it becomes very easy to unload.”

Recession: More Likely Than Not

Many friends ask my opinions about the economy, ostensibly because of my prior job as an economist. However, when it comes to investing, I am macro-aware but not macro-driven. I react to what happens in the economy, but I don’t forecast.

Wall Street economists like to use the term “on the other hand” when forecasting the economy just in case they are proven wrong later. It’s a good career strategy.

I am not going to beat around the bush here. I don’t need to. I am not forecasting the economy. I am just now-casting (i.e. trying to find out what has happened) and therefore my reputation should remain intact even if I am wrong.

There are a group of economic indicators that I watch closely, including the Purchasing Manager Index (PMI) (in all major economies), non-farm payrolls, PCE (Personal Consumption Expenditure), Average Weekly Earnings, etc. I also watch financial market indicators including equity market performance, yield curve, credit spreads, etc.

Based on these indicators (without disclosing my method), I believe that we are currently more likely than not crawling into a double-dip recession. Consumption is not picking up because employment and wage is not doing the push. For a consumption-based economy like the US, this is a death penalty. There are no growth engines left in the world as Europe, Japan, and China all have their own problems to deal with.

Accordingly, I continue to hold sufficient amounts of cash.

I am sure you will have a problem with my choice of words. What does “more likely than not” mean? Isn’t it as useless as “one the other hand”? And why don’t you hold 100% cash if you think a recession is coming?

Puggy Pearson, one of the greatest professional gamblers, used to say: “There ain’t only three things to gambling: knowing the 60/40 end of a proposition, money management, and knowing yourself.”

The “money management” and “knowing yourself” parts answer the “why not 100% cash” question.

(1) Money management. Very likely I can be wrong. One holds 100% cash only if he’s 100% sure that he’s got a crystal ball to see the future. I don’t, and accordingly I don’t bet the farm. What if the market rallies up?

(2) Knowing yourself. My comparative advantage is not in timing the market. Period.

The “Knowing the 60/40 end of a proposition” advice has been my favorite quote. Even the best poker players get an edge of only 51/49. Yet they turn that tiny edge into millions of dollars. It is not luck. It is simply the law of large numbers. In fact, if you make large number of bets with a 51/49 edge, you should make billions. The fact that we haven’t seen a billionaire poker player, but plenty of millionaires, probably suggests that their edge is smaller than 51/49, but greater than 50/50.

If you are disciplined enough to make a bigger bet when you feel that your edge is smaller (e.g., when you are dealt a poor hand) and a smaller bet when your edge is larger, assuming that your “feel” is, more likely than not, correct, then you can make even more money in the long run. Few are disciplined enough, otherwise there should be more than one Warren Buffett on this planet.

The quants like to say “have an edge, and bet often”. If you have an edge, you can achieve much higher a risk-adjusted return (or Information Ratio, in industry jargon) if you apply it systematically to many independent bets than if you concentrate in just one bet. There are at least 49% odds that a poker champ will lose to an amateur if they play just one hand.

How does Pearson’s advice translate into my decision to tilt my portfolio according to a “more likely than not” view about the odds of an oncoming recession?

Well, if the odds are more than 51% that we are going to have a recession, then I prepare based on this view, even if 49% of the time I will turn out to be wrong. If I stick to this strategy often enough, I will be better off.

Explaining this logic the most persuasively is a poker-related story told by Paul DePodesta (of MoneyBall fame). He’s the Vice President of player development and scouting for the New York Mets – see the story on DePodesta’s blog:

Many years ago I was playing blackjack in Las Vegas on a Saturday night in a packed casino. I was sitting at third base, and the player who was at first base was playing horribly. He was definitely taking advantage of the free drinks, and it seemed as though every twenty minutes he was dipping into his pocket for more cash.

On one particular hand the player was dealt 17 with his first two cards. The dealer was set to deal the next set of cards and passed right over the player until he stopped her, saying: “Dealer, I want a hit!” She paused, almost feeling sorry for him, and said, “Sir, are you sure?” He said yes, and the dealer dealt the card. Sure enough, it was a four.

The place went crazy, high fives all around, everybody hootin’ and hollerin’, and you know what the dealer said? The dealer looked at the player, and with total sincerity, said: “Nice hit.”

I thought, “Nice hit? Maybe it was a nice hit for the casino, but it was a terrible hit for the player! The decision isn’t justified just because it worked.”

The moral of his story is that casinos really love Blackjack customers who ask for hits when already having 17 with the first two cards, even if  the next card may be a four from time to time. In our context, it is not wise to be fully exposed to the market when the odd of a recession is “more likely than not,” even if the market may indeed goes up the other 49% of the time.

Three-month performance review

Tortoise Stock has turned in its first 3-month performance report card.

In the three months ending 10/31/2011, the model was up 4.1%, while the S&P 500 index was down 3.02%. According to Covestor’s statistics, Tortoise’s 3-month performance is #1 in the Value strategy category, and #1 in the Risk Score 1 category. Most of the model’s outperformance came from August and September. The model didn’t benefit much from October’s market rebound, and significantly lagged the market.

Controlling risk is one of my priorities as well. According to Covestor’s calculations, Tortoise’s annualized volatility in the past three months was 23.74%, and was within my comfort zone.

As Tortoise is a Risk Score 1 model, my stock selection pool is limited to U.S. domestic stocks with market cap above $10 billion. One of the stocks in the model, Dollar General (NYSE:DG), is currently replicable for subscribers with Risk Score of 2 or above only. However, as of 11/2/2011, it does have a market cap greater than $10 billion, according to Google Finance.

To reiterate my investment strategy, my goal is to own business franchises that grow (1) consistently and (2) efficiently. So long as I don’t over-pay for them in the first place, then what I care about and what I monitor every quarter is whether their earnings power is gaining, and whether they have made any stupid and undisciplined capital allocation decisions (e.g., costly acquisitions) hurting investment efficiency.

The Q4 earnings reporting season has started, and I’ve been watching the numbers closely and will adjust the portfolio if necessary. That said, if I constantly have to adjust the portfolio after new quarterly results, I am probably doing something wrong. I strongly prefer high quality stocks, because with them I am less likely to be negatively surprised during earnings calls. Yes, this approach certainly shuts me out from some potentially more lucrative deep value distressed stocks.

But I follow Puggy Pearson’s advice: know yourself.

Disclosure: Long WMT, MSFT, INTC, MDT, GILD

The above article comes from Covestor. For more information on Rocco Huang and to view his Tortoise and the Hare Covestor Model, visit Covestor.com. 

Covestor Ltd. is a registered investment advisor. Covestor licenses investment strategies from its Model Managers to establish investment models. The commentary here is provided as general and impersonal information and should not be construed as recommendations or advice. Information from Model Managers and third-party sources deemed to be reliable but not guaranteed. Past performance is no guarantee of future results. Transaction histories for Covestor models available upon request. Additional important disclosures available at http://site.covestor.com/help/disclosures. For information about Covestor and its services, go to http://covestor.com or contact Covestor Client Services at (866) 825-3005, x703.