Friday, October 7, 2011

Buy Stocks, Not Economic Data

With all the focus by investors on macroeconomic data these days, I think the title of this Barron's article from last month sums things up pretty well:

Buy Stocks, Not Economic Data

That's sound long-term advice but I suspect the disproportionate role in the market of ETFs and high speed trading combined with such a macro-oriented focus likely means that mispriced individual stocks can get a whole lot more mispriced* in the short run.

In the long run, paying a substantial discount to value is what matters for an investor. That doesn't mean, for a period of time, things can't get ugly as far as near term stock price action goes.

The durability of core economics for each individual business is what matters to equity investors focused on long-term effects. The article makes the point that macroeconomic data and policies don't impact corporate performance but rarely has it gotten more attention than now.

The article also makes the point, using a study by David P. Goldman, that investors are unwilling to buy the 8% earnings yield of large cap U.S. corporations (what Goldman describes as being in the "sweet spot on the investment spectrum") when the 10-year Treasury is yielding near 2%.

Pretty much the mirror image of a decade or so ago.

The article goes on to use Intel (INTC), Microsoft (MSFT), and Abbott Laboratories (ABT) as examples of profitable businesses with strong balance sheets that "gush free cash flows".

Cash flow that can be returned via buybacks and dividends.

The current list of low price to earnings/ high earnings yield large capitalization stocks selling at a nice discount to value is a very long one.

Here's another article from back in August that makes a similar point about blue-chips selling at 10x earnings with dividend yields greater than 10-year Treasury note:

Bargain Days

It provides a bunch more examples of low multiple stocks.

Just keep in mind that, while lots of stocks seem cheap, the number of investments that most can reasonably expect to understand is not that high.

"The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it." - Warren Buffett in the 1993 Berkshire Hathaway Shareholder Letter

At this point, there are many large capitalization stocks that, at least on the surface, look inexpensive. It would be easy to make the mistake of trying to own too many of them.

It's generally just not possible to get a good understanding of what you own if the number gets too large. When buying a little bit of lots of different stocks in order to diversify it will often make more sense to consider something like an broad-based index fund (or at least maybe use a fund as a supplement to individual stock holdings).

It comes down to how much confidence each investor has in their own ability to pick individual stocks.

Adam

* Mispricing cuts both ways. What seems cheap can become a lot cheaper given the market's current structure and, even if hard to imagine now, in some future euphoric market episode the overvalued can once again become even more overvalued. Yet another bubble. Market participants increasingly focus on the macro, utilize ETFs (including some of the leveraged garbage now available), and employ high frequency trading strategies in lieu of evaluating how market price compares to an individual stock's intrinsic value. If price relative to value of an individual security takes a back seat for a disproportionate number of participants it seems almost certain mispricing will become more the norm. High speed algorithmic trading now accounts for something like 70% of volume and goes a long way toward explaining the 2.8 month average holding period of stocks...down from a holding period more like 2-4 years, historically.
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