Category Archives: Freezing Assets Shout Out

Catching a Buzz—Bees and Investor Sentiment

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OLYMPUS DIGITAL CAMERAOne of my joys is beekeeping. In fact, I have learned a great deal about human investing behavior from observing bee behavior. For example many people believe that bees hop from one flower to the next, be it a dandelion, snap dragon, petunia, or whatever flower happens to be around. Actually bees are very particular about what flowers they visit. They usually focus solely on what is blooming in force at the moment such as a grove of apple trees or a large field of clover. Investors, for better or worse, are very similar—“the swarm” congregates to whatever is currently blooming in the market.

Investment styles come in and out of season, much like flowers. Most investors focus on the business cycle—certain sectors work at certain times in the cycle. We believe this is true, but we also think that we can break it down even further. Since most of us have a financial background, often times how investors focus attention on certain financial statements (i.e. income, cash flow and balance sheet statements) can work better as a guide to collective investor sentiment than analyzing individual sectors.

For instance when we are in the middle of a market upturn, investors often focus on income statements as they struggle to ascertain what to pay for future growth. Cash flow and balance sheets in this phase may not tell the whole story in the short-term as increased leverage and lower cash flows as companies increase sales forces, capacity, head count and other expenses associated with potential growth. Therefore accurately forecasting revenues on the income statement in this phase may be the most crucial task especially if investors believe that operating leverage on the income statement follows.

As the market matures and goes into a downturn, usually this is when we see cash flow statements take center stage. Investors may become preoccupied with the sustainability of results. More predictable free cash flows mean more potential earnings streams, more cash flows to shareholders and likely a less volatile stock. Additionally the ability to deleverage with free cash flows not only strengthens the financial outlook of the company; it also should give it a better ability to refinance debt as often interest rates decline at this phase of the cycle.

Finally as the market bottoms, this is often when balance sheets get their love. This is when investors focus on inventory levels, working capital management, debt ratios, potential goodwill write-downs and the like to determine how well the company is positioned to come out of a downturn financially. If the company has a strong balance sheet, it should have the ability to be more nimble than its peers to make timely growth investments in the future.

Therefore we likely can learn a lesson from our furry black and yellow friends. Don’t look at what individual bees are doing (although they are fun to watch). If one wants to determine which direction the market is going, watch the swarm. It may tell you where the cycle is if “the buzz” is focusing on one particular financial statement.

If you are interested in bees and beekeeping, I recommend “The Beekeepers Lament” by Hannah Nordhaus.

Learning from our Most Painful Successes

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I think that every investor dreads the end of the quarter portfolio review—even when your quarter was successful.  Why? Because even in the best of quarters there are always the zombie stocks of your portfolio stumbling around for all to see.  We all struggle with defending these stocks to our peers and clients after they failed—even if the stocks were sold and it was the right decision to sell them at the time.  And we spend a lot of time analyzing these undead. All too often our successes go unanalyzed in these reviews because we attribute success to our intelligence, foresight and ingenuity of our investing process.  Unfortunately lots of avoidable future failures can be learned from our investment “successes”.

The Holy Grail of investing is developing a winning process that is unique, repeatable and sustainable. Achieving that goal means asking tough questions about success as well as failures. Investor hubris often comes from mistaking your intelligence for stumbling upon a bull market or your investing style coming into vogue for one’s clairvoyance. The key question, which rarely if ever gets asked, is what did you do differently this time that you did not do last time and is it repeatable? Equally as important is what insight drove you to that successful decision?  Why did others miss that insight? Will that insight continue to be overlooked? If an investor cannot answer those questions, success probably didn’t have anything to do with your stock picking skill. It probably had everything to do with luck.

Don’t get me wrong, luck is great as long as you can identify a particular success as such. It makes exiting out of a lucky position much easier of a decision. But again, achieving this takes some tough self-analysis and self-questioning, and not being afraid to admit to one’s weaknesses and misjudgments openly—even in the face of “success”.  Not always the easiest thing to do! Therefore long-term success means asking difficult questions about our winners as well as our losers. If they are truly winners, we can learn from them, incorporate what worked into our investment process and have (hopefully) even stronger results in the future.

We know how to question ourselves in our failures. They are there for all to see. Honesty is required in these situations. But good results don’t lie do they? Yes they do. Therefore brutal honesty is required here as well.

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Living on the Edge Part III: Let’s Get Small

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Last week we discussed if investors can get an edge on large cap stocks. This week is focused on smaller cap stocks (e.g. $3 billion or less).  Most investors and academic studies usually concur that one can get an edge on small cap stocks because there can be an informational advantage as smaller companies get less coverage on both the buy and sell sides.  Investors can occasionally see their money double or more as Wall Street becomes aware of these underfollowed companies.

That’s the good news. However, for every success story there are dozens of small cap stocks that will continuously languish in obscurity. The investor’s challenge is often not if you can get an informational edge on an underfollowed small cap, the challenge may be determining if anyone besides you will ever care enough about the name to purchase it. This is a major concern, especially with illiquid stocks that can take days, if not weeks, to exit a position if the stock fails to work. Therefore it is crucial to not only know a small cap company and the catalysts that theoretically should propel it higher, but also the ownership structure.

Knowing the ownership structure not only entails knowing how much of the float is owned by management (and oftentimes the management’s family) but also other investors that are currently involved in the name and activities surrounding those investors that could “loosen up” some shares of a small cap company. These activities can include things as changes in Portfolio Managers, tax needs of the investor, estate property changes or modifications, or any number of things other than valuation reasons that can influence the sell decision for an investor.

It also helps to know, or get a sense from your analysis, if there is a secondary offering coming, which improves the number of shares not held by management. Those offerings usually are followed by growth initiatives such as M&A activity, increasing the distribution channels of the company, increasing capacity, international expansion or any number of investment opportunities.

Therefore the investor can likely get an informational edge with a small cap stock, but sometimes that might not be enough. You need to know other factors quite well, such as ownership structure, for that edge to matter and happen within the investor’s time horizon as well for the stock to work.

Living on the Edge, Part II—Make Mine a Large (Cap)

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Late last month, we asked if you can get a real edge on individual equities in general. This week we ask if you can get an edge on large cap stocks in particular. We think yes. We think there are lots of ways to get an edge on large cap stocks—more ways than we can fit in here. So we’ll discuss just one of our favorites: Looking beyond the next handful of quarters in earnings estimates.

One of the toughest parts of an analyst’s job is deciding whether to use a short-term or long-term outlook as he or she develops an investment thesis. Often—perhaps too often—the shorter view wins out for less-than-the-best reasons. Because analysts usually are judged on quarterly performance, for example. Or because there are so many voices chattering about the same issues concerning a particular security.

Those short term perceptions are often what drive a stock, but in our experience, short term noise and thinking can create biases in analysts’ financial models—particularly in forecasting next year’s earnings estimates.

For instance, if an analyst is convinced that shorter-term factors are going to have a negative influence on a particular stock, chances are that perception will bias his-or-her longer-term estimates. Such a bias can keep estimates artificially low, as the analyst may have a difficult time explaining to clients a negative thesis on a stock with accelerating longer-term forecasts.

Simply being aware of the potential for such a bias can be a powerful tool, especially when an analyst believes the longer term potential of a stock outweighs the short-term risks.

So when we hear that most investors are waiting for that “one last negative factor” to subside before getting more constructive with a security, we get interested.  Usually, with well-known products and names, the negative factors are already well-known and anticipated—and factored into short-term forecasts.

But longer-term recoveries from those negative factors in subsequent year’s numbers are often overlooked. The result is a potential edge for the investor willing to cultivate the long term perspective.

There is, of course, the risk that those shorter term factors will drive down the price after one purchases a security. But if your long term investment thesis is unchanged after those events such a price dip often is a great time to add to a position.

What is Art, Besides Keith’s Guitar Work?

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We are taking a break from our series on getting an edge in the market because of what we read in an article in the Wall Street Journal about Keith Richards, the Rolling Stones, the song “Street Fighting Man” and the creative process. Some people might look at us strangely but we have always considered equity analysis as at least partly a creative process, not unlike the creation of a song, or a piece of art. Therefore we occasionally refer to our job as being a “financial poet”. Sound unusual? It really isn’t. There are two parts to our job. The first is determining theoretical asset values using well-worn financial analytic tools.

In actuality, determining the intrinsic value of a company mathematically is what we need to know to become analysts in the first place.  We all know the tools and the language. We all know what questions to ask. We all know how to read financial statements. But there is so much more. What is that? Specifically it is the art of investing. That’s the second and equally crucial part of our job.

Yes, we feel financial analysis is an art and a creative process; not unlike Keith crafting music on his guitar. Most guitar players can bang out notes and play a song, but how many can do so with emotion, feeling and originality? The same is true with the financial analyst. Feeling and originality in our case is determining value. Value is different than valuation. Valuation is an empirical term that can be measured by standard formulas and measurements. Value is much more esoteric and often cannot be measured by mere accounting measures. Accounting measures are more backward looking. How do we look forward? This is where the art comes in.

Taking a forward look means determining future values, user tastes, and various other things that are unknown. It means we need to look at needs and how the need can potentially be fulfilled. This is also how we differ from entrepreneurs and business managers. Entrepreneurs and managers try to craft an idea and make a business out of it. Financial analysts look at many ideas from entrepreneurs and managers, especially in smaller companies, and attempt to determine which one is the most viable and will succeed as an investment.

The challenge is eliminating our biases. In that regard, we need to put ourselves into the mind of the person whose problem is being solved by that new product or service and then try to determine if it is an investable concept. For instance, how many people are there that will be motivated to act by that product or service? Would, say, a Chinese citizen react differently than an American to that product or service?  How about a younger person versus an older one? Analysts essentially have to leave our experiences, biases and beliefs at the door and look at the world from a different perspective in determining value.

Once we determine value, then can we open up our financial toolbox and determine valuation. Therefore we are not unlike Keith Richards (minus the chemicals). Keith had to learn the chords and notes before he could play the guitar. However, to make the guitar tell a story he needed to determine if a concept he had was worth pursuing. That takes art.

This will be the last Freezing Assets Shout Out until after the New Year. Happy Holidays everyone!!!