Wednesday, June 15, 2011

In Praise of Two Troubled Sectors

Here's a recent Barron's Magazine interview with David Katz of Matrix Asset Advisors.

In it, he says financials have the potential to rise 30-50% in the next year or two.

He also point out how cheap larger tech stocks happen to be.

A long and growing list of value-oriented investors have pointed out that financials and technology are inexpensive and I happen to agree with it.

I've highlighted tech stocks as being inexpensive for quite a while.

As stocks they are going nowhere fast and I won't be surprised if that continues.

Bank stocks have also done poorly for an extended period. That's also likely to continue.

"The last time I was heavily involved with the banks, it was a five-to-ten-year period. And I'm always early, which in a way is a good thing because if you were right on day one, you'd have a much smaller position." - Bruce Berkowitz of Fairholme in Institutional Investor Magazine

With value investing, even if you get something right in the long run (defined as above market returns over the entire investment horizon that the asset is held), you'll probably be staring at red for a very long time.

"...if you are a value manager, you buy cheap assets. If you are very 'experienced,' a euphemism for having suffered many setbacks, you try hard to reserve your big bets for when assets are very cheap. But even then, unless you are incredibly lucky, you will run into extraordinarily cheap, even bizarrely cheap, assets from time to time, and when that happens you will have owned them for quite a while already and will be dripping in red ink." - Jeremy Grantham from his letter with the title: Time To Be Serious (and probably too early) Once Again

That's why I don't think someone should buy something that seems inexpensive, unless that investor has extraordinary personal conviction that the price paid provides a sufficient discount to their own conservative estimate of intrinsic value. That's also why I don't think it's wise to buy something unless it's based upon one's own analysis and conclusions. I happen to think no investor should buy something based upon someone else's opinion. Read everything possible, listen to lots of viewpoints, but reach your own conclusions. When an investor does not have high levels of conviction at their disposal, they end up shaken out before the full story plays out, in some cases, over many years.

So the norm is to be too early because an investment looks cheap not knowing that it will, at first, get even cheaper.

In a similar way, selling an investment too early also tends to happen when something starts to look expensive (only to watch it become more expensive).

It goes with the territory of making buy and sell decisions that are grounded by valuation.

"I made my money by selling too soon." - Bernard Baruch

An asset that is already cheap becoming even cheaper is just the flip side of what happened during some of our recent bubbles. Expensive stocks got even more expensive before ultimately being checked by economic reality. The forces that cause bizarre prices in either direction begin with either a real problem or real potential taken to extreme. Never expect rationality when it comes to short-to-intermediate run market prices.

The remaining true believers of efficient market hypothesis won't care much for this thinking. In the short-to-intermediate run a market price has only a loose connection to the value of a business itself.

I think the evidence in support of this view is overwhelming.

There are many short-to-intermediate term events that move a stock price in any direction that has little to do with what the intrinsic value of an asset will be over the long haul.

When volatile short-term price movements morph into persistent downward selling pressure many, especially those lacking conviction in what the asset is ultimately worth, will just bail out.

Financials stocks, in particular, are probably not the place to be for those seeking a straightforward investment (I'm not sure there is such a thing, but, for example, a proven consumer staple franchise is certainly less tricky to own than a bank). Many things can go wrong with even a good bank that is beyond management control. As we've seen recently, confidence in and stability of the financial system as a whole is bigger than any one bank and can dramatically impact future intrinsic value per share.

There will likely be many twists and turns before things like the regulatory, legal, and mortgage clouds are put mostly in the rear-view mirror for financials. Future regulatory risks are especially difficult to predict.
(I say that as someone who wants further limits on speculation by banks, far beyond the so-called Volcker Rule, substantially reduced use of derivatives, and significant changes to bank executive compensation systems so leaders of the key financial institutions have more skin in the game...more to lose longer term.)

The problem? It's just as likely that poorly focused regulatory over-reach will occur that just adds complexity and costs but does little to address those things that lead to systemic instability (many didn't listen to Brooksley Born in the 1990s and I'm not sure we making enough wise moves now).

Still, the highest quality financials over ten year horizon should do just fine even if the ride will likely be very bumpy. There are many difficult to understand risks in the short-to-intermediate term. During that time, again, I'd expect many investors to just get tired of all the noise and for prices to go nowhere. There are easier ways to get results.

As far as technology stocks go, many larger tech stocks have been cheap for quite a while yet continue to get even cheaper. Who knows how long this persists. Unlike financials, it would seem the biggest risks are unknowable technology shifts and new competitors that out of nowhere threaten the economic moat of a franchise.

That's the nature of tech.

How long do these two sectors struggle? In my experience it is always longer than one expects. Long enough for most who have had their money tied up in a dead money stock (or worse) for a long time to get frustrated, annoyed, and just sell.

Adam

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