Bull market thinking

In 1999 I was in college, I had the world at my finger tips.  I was studying computer science, which was a perfect degree for the time.  I had stars in my eyes, some friends who were graduating said it was easy to snag a $60k a year job where everyone sat on giant exercise balls, played foosball and built the new economy.  There was palpable excitement in the air.

In 2001 I was looking to change my major, I considered either psychology or a business degree.  I wanted something with a job attached to it when I graduated, which tech didn't have at the time.  I eventually decided to completed my initial degree but added a minor in sociology.  I also got to work at a startup, right out of school.  Except that instead of the heady optimism of the 90s everyone had a bunker mentality.  No one was concerned about IPO-ing, or stock options.  We wanted to generate revenue, earn a profit and stay in business.

Sentiment in the market changes quickly.  Sentiment in the workplace takes longer to change, but when it does it's abrupt.

In a bull market it's hard to differentiate skill verses luck.  The market rewards those with guts, anyone who had the cash and a iron stomach who invested in the fall of 2008, or in March of 2009 has been rewarded with significant gains.  In the midst of a market bottom and recovery academic finance seems to make sense, those who took on the most risk realized the biggest rewards.  Investors in index funds or blue chip companies might only have doubled their money, but those who had fortunate timing and bought highly levered companies on the verge of bankruptcy earned many multiples of their money in 2009 and 2010.

A strong market can lead one to faulty conclusions.  I recently received a comment on a post that buying any company with a high ROE, even at a high multiple is a recipe for investment success.  Maybe that's true, but how did those Nifty Fifty companies work out for investors in the end?  When the market is soaring buying anything and holding seems to work well.

The problem isn't figuring out how to make money, it's figuring out how to keep it.  If an investor is up 80% one year and then down 65% the next it requires a 25% gain just to break even.  I know that in the past five years it seems like 25% or 30% gains are par for the course, but in the context of history gains like that are extremely hard to achieve, especially repeatedly.

In my view the secret to investing isn't hitting grand slams, it's avoiding large losses.  An investor who never has incredible returns can still do very well if they keep their losses to a minimum.  An investor who has outsized gains and outsized losses is really no different from a streaky gambler.  It might be an enjoyable wild ride, but in the end they'd probably be better off investing in an index fund.

Most investors fixate on success.  They want to know what makes a successful investor, or why a company was successful.  Then they work to replicate that success, either with the investments they choose, or how they invest.  Success is multi-faceted and usually due to a variety of factors, most of which are situational and not repeatable.  For every entrepreneur who credits their success to hard work there are five entrepreneurs who worked just as hard and failed.  The same is true of any factor of success.

Unlike success failure is easily replicated.  Whereas hard work isn't always a formula for success a company with high leverage that ignores customers in a downturn is a recipe for failure.  Failure is so repeatable there are failure patterns that can be spotted in companies and in people.  If you spot a failure pattern at an investment it's worth considering whether it's time to sell.  If you spot a failure pattern at your own company it's either time to try to correct it or find another job.

Strong earnings alone are no safeguard against losses in a downturn.  I was discussing this with someone a few months back within the context of banks and he said "There were many banks with 15% ROE's until the day they failed in 2008."  In the investment world returns aren't strongly linked to one specific factor.  Great earnings and a high ROE can sometimes mean a stock appreciates, but not always.  A bad balance sheet will always have the potential for failure.  A company with sizable reserves can weather a severe drop in revenue for a prolonged period of time.  A highly levered company operating in the same environment will either fail, or will be hunting for credit at loan shark rates.

A company's balance sheet is what determines whether they survive or fail in a market downturn.  Earnings come and go, but the strength of the company resides in their balance sheet.  A company with a strong balance sheet can take advantage of a downturn by purchasing distressed competitors and bargain prices.  They can use their strength to attract customers who are scared of losing a valuable service.

When the market is racing higher not many investors are thinking about balance sheets.  But downturns happen quickly.  What was a roaring market one day is a correction the next.  By the time the market is starting to correct it's too late to be thinking about safety.  An investor needs to keep the safety and strength of a company in the back of their mind during the entire bull market run. One never knows when the wind will change and a portfolio's result will be determined by the strength of each holding's balance sheet rather than their earning power.

7 comments:

  1. Hi Nate, a timely post and a thought-provoking one as always.

    However I do have some interesting news about the Nifty 50.

    You ask how they got on in the end? The answer is they matched the market, despite their high valuations -- at least to the latest 1990s, according to Jeremy Siegel, as recalled by one of (vanishingly few) favourite fund managers, Nick Train in this paper:

    http://www.lindselltrain.com/~/media/Files/L/Lindsell-Train/Attachments/investment-insight/A%20New%20Nifty%20Fifty%20Bring%20It%20On.pdf

    "Let’s be clear what Siegel is saying. A collection, however arbitrarily selected, of “great” companies outperformed the broader market over 25 years (for the likely average investor), even from the point of its highest relative valuation and despite the list containing more than several that turned out to be real clunkers. In short, 42x earnings turned out not to be expensive."

    It'd be interesting to see that data recomputed to 2014... :)

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  2. Up 80%, down 65% and then 25% compounds for me @ 21.5% down?

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  3. Another great article. Thank you.

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  4. I have done well with several strategies. One is holding good companies forever. That has worked well with Gilead Pharmaceutical (GILD), the midstream MLP's that raise their dividends quarterly (MMP< EPD, WES), and buying what I know. Colgate is an example. One can also use, and I love this strategy-buying leveraged ETN's on margin, expecially the MLP's. In theory, one can goose the yield beyond 20%. I also like the idea of using Interactive Brokers with its 1% margin. If I buy a decent yielding firm of 10% or so, on margin, and pay 1% margin rates, that can lead to tremendous long term gains, depending on the asset. I just don't care for classic portfolio theory, because that is simply a way to disguise ignorance in investing. One can beat the market with leverage and low margin rates, and do so consistently. If one holds long term dividend payers, such as Colgate, over time, the shares will reinvest at various high and low prices, leading to compounding gains over time. I use Bigcharts.com to find the best industries, the best performers with the best growth within those industries over time, and go from there. That is a simplistic approach, but in any market, there is always an investment.

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  5. Do you have specific values of balance sheet ratios such as the current ratio, debt to equity, etc. in mind when you analyze the strength of a balance sheet? Or do you just look for a sizeable moat without any absolute cutoffs? Thank you for the insightful post.

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  6. Nate,

    Why don't publish a few articles and educate your readers on which constituents of the balance sheet make or break the business? It could be a balance sheet walk-through of a few current businesses.

    Thanks!

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  7. i concur with what anonymous before has said. Just buying good companies with moats (Visa, Colgate, Coca-cola) and using a little bit of leverage through Interactive Brokers at 1% is an easy way to destroy the market :)

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