Some sound investment advice at Morningstar
JOSE BAILEN
Seven Different Investing Perspectives
Paul Larson is an equities strategist with Morningstar and editor of
Morningstar StockInvestor, which seeks to purchase shares of quality
companies at a discount, and sell them after the market has come
around to our view. StockInvestor features two market-beating
portfolios: the Tortoise and the Hare. Meet Morningstar's other
investing specialists.
Some of what we do here at Morningstar is perfectly aligned with
common thinking and what is taught in business schools. For example,
there is little debate about the mechanics of how to value and
discount a stream of future cash flows that a company is going to
generate.
Yet some of my strategies in managing Morningstar StockInvestor's
Tortoise and Hare portfolios are definitely not in sync with academia
or conventional wisdom--including those listed below:
1. Focus on the next decade, not the next quarter.
(Or, why I hold Home Depot and First American , despite real estate
being in the tank.)
Most Wall Street analysts who publish research for public consumption
spend an inordinate amount of time trying to figure out what companies
are going to do in the next couple of quarters. Witness all the
attention given to analyst estimates around any given quarterly
earnings release. This means analysts spend a lot of their energy
focusing on near-term tax rates, weekly inventory trends, and so on,
which really do not matter in the long term.
The army of analysts on Wall Street are then serving an exploding
number of hedge funds, entities whose investors demand
performance--and demand it now--given the exorbitant fees usually
being paid. Many hedge funds cannot afford to think about the long
term, because if they suffer even a little in the short term, they
might not be around for the long term.
Luckily, those willing and able to take a long-term perspective can
gain an edge in this short-term-focused world, and that's exactly what
I and our analysts do here at Morningstar. We spend a lot of our time
thinking about where a company is going to be many years from now,
because this is what drives intrinsic value. We try to minimize the
short-term noise to pick out the secular trends that will really
matter.
For instance, say the value of a large SUV goes down 10% in a quarter
because gas prices go up, and CarMax had a slug of SUVs in its
inventory. This might cause the company to miss its quarterly earnings
estimate by $0.10 in one quarter, likely causing a bloodbath of Wall
Street downgrades on the stock. At Morningstar, we'd likely view this
event for what it is: a short-term headwind that will be tomorrow's
tailwind. Meanwhile, we wouldn't forget that CarMax still has a large
competitive advantage in sourcing and pricing used cars and that it
still has yet to expand into most of the country. One might say we try
to look at the forest, and any given individual tree (short-term
trend) is only part of the picture.
2. Price volatility does not equal risk.
(Or, why I think common sense and proper temperament are more
important investing skills than advanced math.)
If you go to business school, you are likely to be taught that risk in
the stock market can be defined as the historical volatility in a
stock's price. Risk is usually thought of and measured in terms of
beta, a statistical measure that represents a stock's past volatility
relative to an index. Frankly, I just do not understand the relevance
of beta when thinking about ways I might lose money. Not only is it
backward-looking, but its connection to intrinsic business value is
tenuous at best.
Let's say we were walking into a store and there on a table were two
things for sale--sticks of dynamite and bananas. The bananas
periodically go on sale for 50% off, while the price of the dynamite
never changes. Assuming both the bananas and the dynamite have the
same intrinsic value, what do you think is the riskier asset to buy
and own? A finance academic would probably say a banana is riskier,
since its price fluctuates so much. Me, I'll let the dynamite explode
somewhere other than my hands.
When thinking about a stock's risk rating, Morningstar analysts do not
focus on the past stock price movements of a company. Rather, we focus
on the fundamental business factors--competition, litigation,
financial leverage, and so on--to try to figure out what sort of
margin of safety to apply to a company before buying it.
Lately we've been thinking about our risk rating in terms of our own
forecasts. Namely, what are the chances our fair value estimate is off
the mark, and how far off could we be if our thesis and projections do
not play out? When doing our cash-flow projections, are we throwing a
bowling ball in an alley with solid bumpers in the gutters, or are we
playing wiffle ball in a tornado? The wider the "cone of future
possibilities," the greater the margin of safety should be, all else
equal.
3. Price volatility is a good thing.
(Or, why I get grumpy when the market steadily goes up for weeks on end.)
Not only do I think stock price volatility is a silly way to measure
risk, but I actually like volatility. When stock prices whip around,
it creates more opportunities to buy things when they go on sale.
Moreover, volatility can fling stocks well above their intrinsic
values, creating selling opportunities.
I think two of the more famous Warren Buffett nuggets of wisdom apply
here. (Though Buffett is as mainstream now as he has ever been, he is
still seen as a heretic in many academic circles.) According to
Buffett, one of the cornerstones of his strategy is, "Be fearful when
others are greedy, and greedy when others are fearful." The other
Buffett quote that backs up my favorable opinion of volatility is:
"Look at market fluctuations as your friend rather than your enemy;
profit from folly rather than participate in it."
Although many of the stocks we own in the Tortoise Portfolio tend to
not be volatile, I would welcome having them go on "clearance sale"
again in the future, as long as the businesses remain intact. Over the
long term, the market should reflect intrinsic value and growth of the
businesses.
4. Concentration has its benefits, overdiversity its downfalls.
(Or, why I've sold some of the Tortoise's and Hare's holdings to buy
more of what I already owned.)
It seems that whenever I hear financial advisors speak, they are
always preaching the benefits of diversity. While I agree every
portfolio should have some level of diversity to prevent any single
mistake from causing financial doom, I do not think the downside of
diversity gets enough attention. Specifically, the wider you spread
your portfolio around, the less you will know about any single
investment, and the greater the chance you will miss something that is
wrong. Call it the risk of ignorance.
In other words, I agree that it is good advice to not put all your
eggs in one basket, but do not forget about the risks of trying to
carry too many baskets. Or, to use our "fat pitch" metaphor, don't
swing at the marginally decent pitches, because then your swings at
the truly fat pitches will be diluted.
5. Bottom-up is better than top-down.
(Or, why I buy stocks and not the market.)
There are two basic ways to look at stocks. The first way (and what we
do here at Morningstar) is to look at an individual company--its
competitive positioning, profitability, growth prospects, and so
on--to come up with an intrinsic value estimate for the business. We
then compare this fair value estimate with the current stock price to
come up with our Morningstar Rating for stocks (the star rating). We
do this for each and every company in our coverage universe of nearly
2,000 stocks.
The other way is to try to pick out macroeconomic trends and generate
investment ideas from these trends. Some examples might include ideas
regarding the aging population, interest-rate movements,
global-warming regulations, changes in consumer-spending patterns, and
so forth. Some investors might choose to overweight or underweight
their portfolios in certain sectors based upon their views of some of
these trends.
The problem I see is that there are often too many logical links
between the ideas and the actual stock investments. Even if your idea
is correct, you could still select the wrong stock for that idea.
Another pitfall of looking top-down is forgetting the importance of
valuation and paying too much for a stock.
For instance, say it was the late 1990s, and you thought the Internet
was going to explode in popularity. Your idea would have been correct,
but many of the investments you might have made would have had
terrible returns, either because the companies were poorly positioned
or their stocks were exorbitantly expensive.
When looking at any individual company, our analysts obviously have to
be aware of the larger trends that might affect that company, but
these trends are not the end-all, be-all. It is fair to say that our
views on the larger economy are already baked into our fair value
estimates and star ratings.
I also do not try to "fill the box" when managing the Tortoise and
Hare. What I mean by this is deciding on some sort of asset
allocation--either by sector or stock style--and then picking stocks
to try to fit my target allocation. To me, this is putting the cart
before the horse.
What I do instead is look at each stock on a case-by-case basis, and I
then let the cards fall where they may with respect to the sectors and
styles of my holdings. Only at the extremes might I get worried (such
as having more than half a portfolio invested in a single narrow
industry). At the moment, neither portfolio is near what I would
consider an extreme concentration.
6. Increased portfolio activity does not create higher returns.
(Or, why the Tortoise and Hare had turnover of only 8% in 2006 on a
combined basis.)
In the real world, the more activity you have in a given area, the
greater the return in that area, in general. For example, the more you
exercise, the more weight you lose. The more you play golf, the better
your swing will get and the lower your handicap will go, and so on.
But when trading stocks, the exact opposite is true. In general, the
more you trade, the lower your returns will be.
There are the frictional costs of taxes, trading spreads, and
commissions that will eat into your capital every time you trade. Of
even greater importance in my mind is the amount of thought that goes
into each trading decision. It seems that the greater the
thought-per-transaction ratio, the better our results should be, all
else equal. I spend hours upon hours considering each transaction in
the Tortoise and Hare, but spend mere minutes interacting with our
broker doing the mechanical transactions, worrying about nickels and
dimes. I get the impression that too many investors have this ratio
reversed.
7. Focus on value, not price.
(Or, why I don't use charts or stop-loss orders.)
It strikes me that many in the market know the price of everything and
the value of nothing. I will admit that there are scores of companies
for which I know what the stock price has done, but have no clue about
the value of the underlying business. But before I invest in
something, there is no way I would put a single penny in without
having some idea what the underlying business is worth. Knowing price
without knowing value means knowing nothing.
I recently was asked if I had in place any stop-loss orders for
positions in the Tortoise and Hare. The answer is a resounding "no."
Making decisions based on historical prices makes no sense to me.
Moreover, assuming that the intrinsic value of a business is
unchanged, when its stock price goes down, that is the time to get
more excited and consider buying more, not time to cut bait.
Of course, the key phrase is "assuming the intrinsic value of a
business is unchanged." We are continually questioning our theses and
projections for the companies we cover, always digging deeper for
pieces of confirming or contradictory evidence. These fundamental
factors--not stock prices or ideas about future market sentiment--are
what drive our fair value estimates.