Thursday, April 23, 2009

Staples vs Cyclicals

According to Jack Meyer, who managed the endowment, pension, and other assets as President and CEO of the Harvard Management Company from 1990 to 2005, investors wrongly think they'll be able to identify money managers that will deliver above average results:

"Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 percent to 90 percent of managers fail to match their benchmarks. Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value. The investment business is a giant scam."

Now, buying -- ideally when very cheap or, at least, a plain discount to value -- then owning long-term the shares of some high quality businesses like Coca-Cola (KO), Pepsi (PEP), Procter & Gamble (PG), Philip Morris International (PM), and Diageo (DEO) offer a more simple (if not easy) alternative.* Their likely long run advantages, especially adjusted for the risk of permanent capital loss, aren't small. As it stands right now, the shares of these businesses seem to be selling at very reasonable recent prices relative to current per share intrinsic value. How long the window remains open -- where a margin of safety exists -- is naturally impossible to know. I've mentioned before that, even if shares of businesses like this do not outperform over the long haul going forward (and they may not, of course), the sheer simplicity of the approach compared to alternatives needs to be considered.

So does the reduced likelihood of permanent capital loss and more narrow range of outcomes. In fact, if the quality franchises produced merely market returns they'd still win in my book. The reason is that, if bought well, the same return will have been arguably achieved at less risk of permanent capital loss (not temporary paper losses).

Though each franchise has its own unique risks, these generally have, give or take, attractive business economics and future prospects. The durability of their advantages is more understandable than most other businesses in my view.

It is a totally different situation for market participants who's primary focus is the trading of price action.

Anyone buying the higher quality stocks expecting them to outperform during the next bull market is likely to be disappointed. That is, in part, how they have earned the reputation of being defensive. Yet, this reputation is verifiably incorrect when you look at the historic returns of these stocks over the longer haul (a full business cycle or two). Over shorter time frames, it's easy to see why these are perceived to be defensive investments. They generally don't go down as much when the market crashes, and they don't go up as fast during bull markets. It's over a number of bull and bear markets that their merits -- especially if adjusted for risk --  become more obvious. And when I say adjusted for risk I don't mean beta. I mean the risk of permanent capital loss (not near-term paper losses).

They tend to just quietly work out okay in the long run with little or no trading required. Of course, buying with a margin of safety is still very important. As I've said, what's sensible to buy at a plain discount to intrinsic value won't make sense at some materially higher valuation.

What really matters is, of course, how these businesses and ultimately their shares will perform going forward. Getting that at least mostly right still requires plenty of work.

In other words, just because something has done well in the past guarantees nothing.

Also, attempting to trade them based upon market conditions seems very likely to only hurt long-term results between the added frictional costs and mistakes that get made.

So look elsewhere for exciting stock market price action.

Some of the more cyclical sectors that are down 70-80% will outperform during the next bull market. Just keep in mind that you are taking more risk and, ultimately, many of these more economically-sensitive businesses are inferior in the long run.

That doesn't mean shares of all economically-sensitive businesses are inferior. There are some good ones. LOW, WFC, and AXP are examples I've mentioned in the past that I like for my own portfolio.
(As always, I never have an opinion on what others should or should not own.)

I've said previously...

Some commentators seem to suggest it's possible to jump in and out the shares of a high quality business based upon whether a defensive posture is warranted or not.

Well, correctly doing this without making mistakes (and creating unnecessary frictional costs) seems like a good idea mostly in theory, less so in practice.

As Jack Meyer points out above, a number of professional managers -- though certainly not all -- will perform poorly against benchmarks like the S&P 500 in the long run. Defensive stocks, on the other hand, tend to do just fine if bought cheap enough and held for a longer time period.
(Over the shorter run -- less than five years or so -- anything can happen as far as relative performance goes, of course.)

At a minimum, I'd argue this deserves more attention than it gets.

That doesn't mean no one can successfully time the market. I'm guessing there are some who effectively do that sort of thing. It's just that the evidence suggests the odds are not good when you include all the frictional costs involved and seemingly inevitable mistakes (every additional move isn't just a chance to improve's a chance to make a mistake and hurt results). Also, identifying the managers who will actually do well long into the future is difficult at best.

Buy great companies at a fair (or better than fair) price. Otherwise, try to ignore the near-term -- or even intermediate-term -- market fluctuations and stock price action.

Finally, if someone is able to spot the next Google, Apple -- the next big thing -- they should go for it.

I have no idea how to do that without making costly mistakes.


Related posts:
Best and Worst Performing DJIA Stock
Defensive Stocks?

Long positions in KO, PEP, PG, PM, and DEO. My preference happens to be PM and DEO but consider each of these long positions to be worthy investments when bought at the right price. 
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
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