Friday, May 12, 2006

May 2006 Desert of the the Real Newsletter


Welcome to the Desert of the Real—
Real Investment Returns in a Dry Season
May 2006 Copyright Robert C. Feightner

Welcome to the Desert of the Real.[i] (Author’s Note: This Desert of the Real Newsletter will mark the return of the newsletter. And the velocity of the Author’s blog posts is increasing. The Author will attempt to keep up a reasonable pace. The Author is still looking for entrepreneurial opportunities in the motorcycle business, but the right move is still illusive.)


A sign that the Author has been drinking in the financial genius of GMO principal Jeremy Grantham is when the headlines get truly bizarre. Mr. Grantham is not a bizarre dude. He is an accessible genius. Rather, the brilliance of Mr. Grantham’s insights requires that the Author grab the readers by the lapels and share Grantham’s insights.

The April 2006 “Letters for the Investment Committee VII”[ii] by Jeremy Grantham is entitled “Risk and the Passage of Time: The Extreme Importance of a Long Time Horizon”. But don’t let the statement about the “extreme importance of a long time horizon” move you off a momentum based, relative strength investment approach. First, few investors have enough time on earth to hold investments through Secular Bull and Bear cycles that typically average 16-18 years per cycle. Also, you need all of your capital at the beginning of the time period for the compounding effect. The time period Mr. Grantham refers to is more akin to geologic time, not investor lifetime. Only the idle rich, who are rich because their grandparents were rich, can put these time horizons on their indolent sides.


The economy grows at about 3.5% per clip per year. And two-thirds of one-year periods in the economy were within 1%, plus or minus[iii]. By this measure, the American economy chugs along. Also, as Grantham points out, the “fair value”[iv] of the S & P 500 spends most of its time within a range of 1%, plus or minus, of fair value. Just like the turtles, snails and tectonic plates. But then it gets interesting. Really interesting.

The actual S&P 500 spends 2/3’s of its time within 19%, plus or minus, of its fair value. This means that the S & P 500 is 19 times more volatile than its underlying value. Why is the S&P 500, and other equity indexes, so volatile? And what does this mean for the momentum based, relative strength investor?


Grantham ascribes this short-term volatility (and inefficiency) to portfolio manager “career risk” and the across-the-board tendency of most analysts to extrapolate future growth (or future losses) from the same, and usually incorrect, estimates. Long sentence. Lots to look at.

Lord Keynes’s frequently quoted investment management career advice is “never be wrong alone.” If your accounts lost money (or earned) money in general parity with the industry average, you keep your job. But if everyone else made money and you pursued a different, losing, strategy, pray for severance pay. This human tendency to want to stay employed encourages groupthink generally correlated activity, and occasional willful ignorance.[v]

If the consensus estimates for ABC stock says earning will grow by 8%, you are unlikely to forecast 4% or 12%. Stick with an 8% estimate (don’t stick your neck out) and not much bad will happen. Maybe to your clients or to ABC stock. But not to you.


If everyone is extrapolating (projecting future stock price movements) from the same estimates, you can guess what happens. Analysts will recommend buying or selling the same stocks at or about the same prices. But in comes price means regression, along comes a Secular Bull or Bear market, and these consensus estimates become consistently wrong. Why and how does it happen?

Two reasons:
Overvalued earning estimates will be multiplied by historically high price/earnings ratios. This will estimate a price for the stock that far exceeds its objective value.
Undervalued earning estimates will be multiplied by historically low price/earnings ratios. This will result in estimates that are below a stock’s objective value.

This effect, combined with the Secular Bull and Bear markets, drives prices insanely high or ridiculously low. It is a reason that markets typically overcorrect.


It is May 1982 and we have just discovered MTV. England has taken back the Falkland Islands from the Argentines. Bill Gates is reading about the lives and business tactics of John D. Rockefeller and J.P Morgan. Our analyst has just started as a stock analyst at R.K. Maroon Investments, LTD. He follows ACME, Inc., storied purveyor of anvils, rocket engines, and portable holes to cartoon characters. The current price/earning ratio of ACME, Inc. is 8. And a P/E of 8 is the average S&P P/E in 1982. The stock market is at an historical low. It is at the end of the Secular Bear Market and poised for the Secular Bull Market that ended in 2000.

ACME, like many companies, has struggled of late. Its revenue growth and earnings growth have been weak. The consensus estimates for ACME’s earnings in 1983 is $3 per share. The stock currently trades at $24 per share ($3 per share forward earnings * ACME P/E ratio of 8=$24). So it appears fairly valued. But it is not.

Historically, ACME has grown earnings at 9%. Using this historical 9% growth rate would give us an earnings estimate of $3.50, not $3.00. So if we used $3.50 as the earnings estimate instead of the consensus estimate of $3.00, ($3.50 per share forward earnings * ACME P/E ratio of 8=$28). So if we use a longer-term earnings growth estimate for ACME, we would determine that ACME is 16% undervalued. ACME now looks like a buy.


Rather than spend time researching Secular Bull and Bear Markets, our new analyst spends most of his time listening to Flock of Seagulls cassette tapes on his brand new Sony Walkman machine. If he had considered that fact that the stock market was at an historic low, he might have determined that a Secular Bull Market was just beginning. Remember, ACME’s P/E ratio, like the S&P average is at an historically low level of 8. The historical average P/E ratio of ACME and the S&P is 16. Let’s refigure this.

ACME CONSENSUS ESTIMATE FOR 1983: $24 ($3 forward earnings * P/E 8)
BETTER 1983 ESTIMATE FOR ACME USING HISTORICAL AVERAGES: $56 ($3.5 forward earnings * P/E 16)

By only using recent history and estimates as his guide, he missed the fact that ACME, as well as other S&P 500 stocks, is undervalued. And guess what mistakes he will make when he prepare his 2001 estimates for ACME. At the peak of the Secular Bull Market, when prices are poised to revert to the mean valuation, he will use overly generous earnings estimates and historically high P/E ratios. Lose-Lose. But he will keep his jobs because nearly his entire cohort is similarly in error.


The Author is not using this newsletter as a promotion for fundamental investing or value investing styles (But if you use these styles, this is important advice.) Instead, he is using these examples to demonstrate how the short-term nature of market analysis, along with the tendency of analysts to run with the herd, create short-term volatility and inefficiency.

As momentum and relative strength investors, we use this short-term volatility to magnify our gains and avoid losses. If it is gong up, buy it and ride it up. When the market overcorrects to the downside, we keep our gains by bailing out early. Our methodology works not because we are quicker and slicker, but because we listen to what the market is telling us and move accordingly.

Welcome to the Desert of the Real!

IMPORANT DISCLAIMER: This newsletter is offered for informational purposes only. Sources of information provided are believed to be reliable, but are not guaranteed to be complete or without error. Opinions and suggestions are provided with the understanding that readers acting on information contained herein assume all risks involved. The Author may or may not buy or sell securities discussed in this newsletter.

[i] The title of this Newsletter, “Welcome to the Desert of the Real”, comes from the 1998 film “The Matrix”. The world in the Matrix is a Simulacrum, a computer–generated illusion. It only “looks” and “feels” like the late 20th century. Instead, human beings are enslaved in tanks of fluid, wired to the Matrix. Also, readers steeped in post-structuralist philosophy may recognize the title as a paraphrase of a quote in Jean Baudrilliard’s 1981 book, “Simulacra and Simulacrum”.

One the subject of cinema, the Author reviewed the film “Lonesome Jim” for the Ligonier, Indiana newspaper Advance-Leader. “Lonesome Jim” was shot in and around Ligonier and was written by an area native. A copy of the review is posted at:
[ii] Registration is required, but it is free.
[iii] “Letter to the Investment Committee Part VII”, p. 1-2.
[iv] ”The "fair value" quoted on TV refers to the relationship between the futures contract on a market index and the actual value of the index. If the futures are above fair value then traders are betting the market index will go higher, the opposite is true if futures are below fair value.”
[v] "It is difficult to get a man to understand something when his salary depends on his not understanding it." Upton Sinclair.
[vi] The “WABAC” machine was a time machine used by Mr. Peabody, a professorial dog, and his boy, Sherman, on the Bullwinkle and Rocky cartoon show. The Author has frequently commented that one does not need an investment advisor (or even a strategy) to get rich, just a time machine. Shoot yourself back in time and buy 1000 shares of IBM, Microsoft or Genentech. Return to the present rich.

Another dream strategy recommended by one of my investment mentors is to get a copy of the Wall Street Journal from 10 years in the future. This strategy has merit, but the Author, in homage to numerous Twilight Zone episodes, would likely get one from a day after a Stock Market holiday, an edition of the paper where there would be no prices quoted.