Tag Archives: etfs

Myopia And Market Function

Benartzi defines myopic loss aversion as making “investment decisions based on short-term losses in their portfolio, ignoring their long-term investment plan.” Myopic loss aversion can arise when investors check their account balances or the prices of their holdings which thanks to technology has become increasingly more convenient to do. We know that there will be future bear markets and probably another crisis or two in most of our lifetimes. By Roger Nusbaum AdvisorShares ETF Strategist The Wall Street Journal posted an article written by Shlomo Benartzi who is a professor at UCLA specializing in behavioral finance. The article primarily focuses on the behavioral problems, like myopic loss aversion, that can arise when investors check their account balances or the prices of their holdings which thanks to technology has become increasingly more convenient to do. Benartzi defines myopic loss aversion as making “investment decisions based on short-term losses in their portfolio, ignoring their long-term investment plan.” Benartzi cites that the stock market has a down day 47% of the time, a down month happens 41% of the time, a down year 30% of the time and a down decade 15% of the time. We’ve talked about this before, going back before the crisis albeit with some different wording. Before and during the last major decline, as well as many times since then, I’ve said that when the market does take a serious hit that it will then recover to make a new high with the variable being how long it takes. While this seems obvious now, it is one of many things frequently forgotten in the heat of a large decline. Additionally, we know that there will be future bear markets and probably another crisis or two in most of our lifetimes. And those future bear markets/crises will take stocks down a lot which will then be followed by a new high after some period of time. This is not a predictive comment, this is simply how markets work with Japan being a possible stubborn exception that proves the rule. It took the S&P 500 five and half years to make a new nominal high after the “worst crisis since the great depression.” If you are one to use some sort of defensive strategy, it is hopefully one that you laid out when the market and your emotions were calm and your strategy probably doesn’t involve selling after a large decline. My preference is to start reducing exposure slowly as the market starts to show signs of rolling over. Very importantly though is that if you somehow miss the opportunity to reduce exposure, time will bail you out….probably. I say probably based on when a bear market starts in relation to when retirement is started. If a year after retiring, a 60% weighting to equities that cuts in half combined with a life event at the same time that requires a relatively large withdrawal (this is not uncommon) it will pose some serious obstacles. I think the best way to mitigate this is, as mentioned, a clearly laid out defensive strategy but not everyone will want to take on that level of engagement. In that case it may make sense for someone very close to retirement and having reached their number (or at least gotten close) to reduce their equity exposure. Not eliminate, but reduce. Back to the idea of myopic loss aversion and how to at least partially mitigate it. Knowing how markets work and then being able to remember how they work will hopefully provide an opportunity to prevent emotion from creeping in to process and giving in exactly as Benartzi describes.

Valuation Always Matters – Especially For This Cheapskate

Summary I am a cheapskate – I like a good bargain on quality merchandise. The same principle should apply to investing – why pay premium prices if we don’t need to? It is helpful to keep an eye on the value of something – since the price we pay is completely our choice, we know we got a good deal. This article provides two midcap examples where valuation mattered: those who ignored the price-to- value relationship were probably disappointed. As someone always looking for a bargain, I offer an example of a company possibly on the sale rack right now. I will confess: I am a cheapskate. There are many of us out there. For whatever reason, we like to get the best deal possible when we buy something. Name-brand clothing? Wait for a sale (“Can you believe it – $95 bluejeans for $56!”) Toothpaste and toiletries? Stock up during the in-store sales. Quality electronics? Wait patiently for holiday sales. Estate auctions are prime hunting grounds for us cheapskates. Imagine you are at a poorly-attended auction and a name-brand, 8-seat, mint-condition oak dining room table set has no buyers above $8.75 (this really happened). Even if we are not the buyer, we know that is probably a great deal. What makes it a “great deal” to us cheapskates? We know the value of something. Then we compare the price to that value. One of the subtle nuances of value investing is to apply that same mentality and behavior to our investment choices. This is often easier said than done, because investing can seem to turn things upside down: rather than wanting lower prices, we like it when prices go up. And we may not be confident in our ability to value a company. In my view, we would become better investors if we continually explore and understand this whole price-to valuation relationship. Why? Mr. Buffett, as usual, says it well: “The critical investment factor is determining the intrinsic value of a business and paying a fair or bargain price.” Objective The point of this article is to suggest that we can and should apply our same frugal mentality to our investing decisions. And this discussion assumes that historical facts on any company could serve as one piece of our investing decision-making. To support that view, two midcap companies will be offered as examples where valuation mattered over time–those who bought well above normal valuations were disappointed, and those who acted when the price fell below valuation were rewarded. Lastly I will offer an example of a company likely on the discount rack at current levels. Valuation Matters, Example 1: CEB, Inc. $2.5 billion company CEB Inc., provides ”best practices” research and analysis, focusing on corporate strategy, operations, and human resources issues. With a long-term, normal PE around 37, it is never really cheap by absolute standards. But a closer look at the company’s own history gives us a good guide toward periods where the price seemed overvalued or undervalued. Have a look at the graph below, courtesy of my F.A.S.T. Graphs subscription. Please note the orange line represents a valuation tied to the earnings per share growth rate. And also note that the blue line represents the company’s own PE over time. The black line is the market price line. You’ll see the period from 2006 to 2009 highlighted first. Note that investors who bought when the PE was well above the company’s own norms were in for sharp disappointment until the bottom in 2009. From a price to valuation perspective, in 2006 as CEB was running well above its own historical norms. In addition, a year-by-year review of high and low PE’s the company actually experienced would suggest that shares were not on sale around that time. If viewing investment decisions from a frugal, “cheapskate” perspective, the period of overvaluation would not have been enticing to bargain hunters. (click to enlarge) Historical Graph – Copyright 2015, F.A.S.T. Graphs – All Rights Reserved The picture in 2009-2010 following the Great Recession was a different story. In that period CEB was offered at a discount to its normalized valuation. Thrifty buyers paying attention to valuation may likely have recognized this period as an opportunity to buy as part of a “storewide sale” in the stock-market. Investors at that time have probably been satisfied with the purchase. (click to enlarge) Historical Graph – Copyright 2015, F.A.S.T. Graphs – All Rights Reserved Valuation Matters, Example 2: Brown & Brown, Inc. (NYSE: BRO ) $4.5B company Brown & Brown, Inc. ( BRO ) offers another example where the price to valuation situation mattered to investors. Brown & Brown operates an insurance brokerage firm that markets property/casualty products and services to commercial,professional, and individual customers. F.A.S.T. Graphs again offers a useful picture. Note in this example the orange line represents a possible valuation based on an earnings multiple of 15X, the blue line is the company normalized PE ratio over time, and the black line is the market price. Please take a look at the period beginning in 2006. In that period, we bargain-hunters would notice that the PE ratio was well above norms for this company. Those who bought near those peak levels had to watch the decline during the Great Recession and thereafter and didn’t experience a bottom until 4 years later. While in this case even those who bought in 2004 or so would have been impacted, an eye on excessive valuations may have limited the damage to those buyers. (click to enlarge) Historical Graph – Copyright 2015, F.A.S.T. Graphs – All Rights Reserved Fast forward to 2011 when it again appeared BRO was being offered at discount levels. The PE had sold off to well below historical norms and yet earnings forecasts for this quality company were intact. Those willing to wait for sale prices have probably been satisfied with the returns since that time. (click to enlarge) A Company Possibly On Sale: Bed, Bath & Beyond (NASDAQ: BBBY ) The previous two examples were offered as examples where a look at relative valuation to price may have been helpful. But those were looks at history. Looking forward and applying the cheapskate mentality, it is possible that BBBY is on the discount rack right now. At around $57 BBBY is near its 52-week lows and has been sold off to a point where it merits close review. First, Let’s Make Sure BBBY is Quality Merchandise The idea is to buy quality merchandise on sale, not the low-quality stuff. In my view, BBBY qualifies as a quality company based on, among other factors, its historical growth in per share book value, earnings, and revenue. This F.A.S.T. Graphs snapshot captures the trend graphically: (click to enlarge) Historical Graph – Copyright 2015, F.A.S.T. Graphs – All Rights Reserved Why Are Shares On Sale? BBBY sales have been a bit slower than desired, and the retail environment has been challenging. That and the entire retail sector has seen selling lately. The company itself, however, is taking steps to increase sales and has authorized a share buyback program which is favorable. Here’s Where Valuation Matters Again a F.A.S.T. Graphs summary is a useful tool. My read is that BBBY has done a very effective job of growing earnings and valuation over time (orange line). Recall the blue line represents a normal PE and the black line is price. Over a 20-year time frame the normal PE for this company is 23.6X. And note there have been times (2002-2004) when the company is actually priced at a premium and not as attractive to us frugal types. But the situation today is different: the current PE is around 12X earnings. At these levels, with solid fundamentals and earnings expected to grow, this appears to be a case where the price is now attractive. This is visible when viewing the relationship between the price I pay (which I can control) and the valuation – which includes lots of external forces I cannot control. Interestingly, as a side note, I suspect the recent range-bound price action means there is uncertainty in the market. As a patient investor, that’s no worry as long as I am confident in the quality of the merchandise: I realize I sometimes need to wait for the value to be recognized later. (click to enlarge) Historical Graph – Copyright 2015, F.A.S.T. Graphs – All Rights Reserved Recap I have noticed that it is fairly easy being a cheapskate for day-to-day life purchases: waiting for a good sale or refusing to purchase something at unreasonable prices comes fairly easily when it comes consumer goods or even larger purchases like cars and homes. It seems easier to recognize value. But often that mentality gets turned upside down when investing. The focus is price – and we always want that price to go up. The point of this article was to suggest that we can and should apply our same frugal mentality to our investing decisions. To support that view, two midcap companies were offered as examples where valuation mattered over time–those who bought well above normal valuations were disappointed, and those who acted when the price fell below valuation were rewarded. Lastly I tried to outline why and how BBBY may be a company likely on the discount rack at current levels. To a cheapskate like me, that is music to my ears. As always, thank you very much for reading. All of this is in my opinion only and intended solely to add to the investing conversation so that we all benefit.

Things Won’t Stay The Same

My kids keep growing up, and it continues to surprise me. One who was just learning to stay upright is now a constant chatterbox and a daredevil on her Strider bike. The other seems to have grown a foot this year, and has gone from quiet and reserved to confident ringleader of her friends. But the realization I’ve recently had is that it is so easy for us to assume the current state of affairs will perpetuate into the future. The little baby who was so happy to sit and play with a toy was suddenly gone, whether I was prepared for it or not. Someday soon, both of my girls will be in high school fighting over clothes and car keys. In the moment, that is hard to remember. Whether things are great and everyone in the house is sleeping and happy and playing nicely together or we’re up four times a night and separating a fight every twenty minutes, it is easy to believe that this is how things will always be. In behavioral finance, this effect is known as recency bias . It is our strong tendency to extrapolate recent events forward into the future. And investors do this all the time. I mean all the time . In March 2009, as the stock market was approaching generational lows, the most popular headlines and predictions were that the Dow Jones Industrial Average, having just passed below 7000, would continue to drop as low as 3000. And of course, the most famous example of recency bias is the book Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market . Published near the height of the stock market in 1999, when the DJIA was just above 11,000, the book was wildly wrong. But it was a perfect example of how easy it is for us to see a pattern and project it into the future. We haven’t learned much since the 2008-2009 bear market or the late ’90s tech bubble. Oil prices seem to been in a near free fall for the past few years. So guess what is being predicted? More declines! Goldman Sachs suggested that oil prices could go to $20 a barrel in September. Of course, in 2008, Goldman Sachs also predicted that prices, then over $140 a barrel, would eventually surpass $200 a barrel. Making professional predictions is fairly easy – you take the recent changes and extrapolate them into the future. Tada! And of course, it isn’t just professionals making outlandish predictions that fall prey to recency issues. Individual investors are just as bad. Emerging markets have been dismal for the past several years. Returns have been negative so far in 2015, and emerging market stocks lost money in 3 of the last 4 calendar years. In May 2015, EM stocks started a nasty slide. By September, investors assuming that the recent past would continue indefinitely had had enough, and started pulling money out of these funds. Here’s what flows out of Vanguard’s Emerging Markets ETF looked like this year. Investors love to hear and talk about what is going on in the market “right now.” We love this idea because we assume that “right now” will continue into the future. But what is true today won’t necessarily be true tomorrow. The world is a changing place, and always has been. Don’t be fooled thinking anything else.