Identifying Red Flags and Acting When an Outlier Happens

Virtually every time you see a news item about a public company that has either fired their accountants or announced that their accountants or auditors have resigned, it is time to sell that stock.  In this regard, a few examples come to mind, Enron, Lehman Brothers and, while not “accounting” related, the BP Gulf Spill.

It’s important not to second-guess or “re-analyze” the decision to sell, just sell it immediately.  When it was announced that there was an oil rig explosion off the Gulf of Mexico and that oil company BP operated the platform, some traders sold the stock immediately, causing it drop by as much as 10% in that session.  BP stock went from a glittering $62.38 per share to crude-oil-black $26.75 in a matter of weeks!  Of course, this is a dramatic example, but if I were to back test similar occurrences in the past, the conclusions would be nearly the same across all industry.

Going back to accounting woes in a company, it has been my experience that the numbers are almost always suspect in assessing companies’ prospects.  Companies can do amazing things with their books.  When the auditors leave, or when the CFO exits, more bad news usually follows.  Eventually, the stock may be a buy (since BP bottomed to $26.75 per share, it has traded in the $40s range), but in the time it takes to straighten out the mess, you could be using your money in much more profitable directions.

Back-testing Annual Stock Predictions

It’s always fascinating to me when major magazine publications such as Money or Forbes issue their annual “Investor’s Guide” in the beginning of the year.  Assuming that most investors rebalance their basket of stocks around the holiday season, let’s take a look at the predictions from Money Magazine for 2010 and see what investors would have made if they followed the advice. 

There are two things to note in this observation.  One is, at the time of this writing it is, October 6th, 2010.  Not even a full year has gone by since these picks were made, so I am merely observing the progress year-to-date.  And two, they cover nearly 200+ stocks, bonds and ETFs in the entire issue and to list them would be too tedious (for both reader and writer).  So, I am simply including those picks with the most “conviction” – that’s when they feature fund managers who have done exceptionally well in the past year.

 Top Picks From Top Pros

That’s the headline for the top five of 2009’s most successful funds.  Now, let’s see how they do this year thus far. 

Bruce Berkowitz/Fairholme (FAIRX):	Money Magazine	Current Price	Gain/(Loss) %	Total Return
Humana (HUM)	$42.04	$50.50	+20.01%
WellPoint (WLP)	$57.43	$55.11	-4.03%
Pfizer (PFE)	$18.32	$17.24	-5.89%
Forest Laboratories (FRX)	$31.19	$31.31	-0.38%
Total Return				+9.71%

David Herro/Oakmark International (OAKIX)	Money Magazine	Current Price	Gain/(Loss) %	Total Return
Toyota (TM)	$83.42	$71.25	-14.58%
Richemont (CFR.VX)	$32.35	$47.70	+47.44%
Publicis Groupe (PUBGY)	$40.21	*$49.70	+23.60%		*Split Adjusted
Total Return				+56.46%

Eric Ende/FPA Perennial (FPPFX)	Money Magazine	Current Price	Gain/(Loss) %	Total Return
Varian Medical Sys. (VAR)	$46.07	$61.81	+34.17%
Signet Jewelers (SIG)	$24.78	$32.62	+31.64%
Total Return				+65.81%

Diane Jaffee/TCW Dividend Focused (TGIGX)	Money Magazine	Current Price	Gain/(Loss) %	Total Return
Packaging Corp. (PKG)	$42.04	$50.50	+20.12%
J.P. Morgan (JPM)	$57.43	$55.11	-4.04%
Pfizer (PFE)	$18.32	$17.24	-5.89%
Total Return				+10.19%

John Rogers/Ariel Appreciation (CAAPX)	Money Magazine	Current Price	Gain/(Loss) %	Total Return
CB Richard Ellis (CBG)	$12.05	$18.03	+49.62%
CBS (CBS)	$13.81	$16.66	+20.63%
McCormick (MKC)	$18.32	$41.73	+127.78%
Total Return				+198.03%

Money Magazine’s Average Total Return: +68.04%  Vs.  S&P 500 Year-to-date:  +2.341%  (Wowza!)

Now, before you fire your stock broker to jump on these hot stocks, there are a few things you should know.  These stocks are coming off of exceptional bottoms from the 2007/2008 housing collapse and have not yet surpassed their peak prices (with the exception of one or two on the list).  While approximately 75% of the total stock market are currently in positive territory year-to-date, only a handful of them have reached back to their 2007 highs.  Obviously, this is only a small sample of those stocks and may not necessarily suit your needs.  But, aside from the technical details, a return of +68.04% in a year is extremely rare, if not impossible only because there are strong psychological forces at work that prevents from achieving that.

By the way, if you’re wondering, here are the figures for each funds’ five year annualized return.

Fairholme (FAIRX): +7.7%
Oakmark International (OAKIX): +6.6%
FPA Perennial (FPPFX): +2.1%
TCW Dividen Focused (TGIGX): -1.8%
Ariel Appreciation (CAAPX): +1.3%

Fundamental Analysis and Corporate Earnings

When we invest in a company, we invest in its potential to make more products, more profits, to continue to grow, and add value to the price of each individual share. 

A share of stock represents one unit of ownership in that company.  All shares of that stock in circulation, multiplied by its value per share (share price) make up the market’s estimate of the value of that company – that is, the market capitalization. 

The more profits a company makes and the faster those profits are growing and are projected to grow, the higher the company’s value in the longer term at least.  History tells us that consistent growth in sales and earnings lead to a higher stock price in the longer term…and vice versa. 

So, if you choose to be primarily a fundamental investor you would look to corporate profits to determine your entry and exit points.

Money and Your Purpose in Life

I thought I’d start the week with something fun (talking about money), and some of you may be wondering what purpose in life has to do with money.  Because purpose is a strategy that we use to express our important values, it follows that our use of money is one of the important ways to express these values.  Money is very, very flexible, with an infinite ways to earn it and spend it.  Your wealth at any point is the end result of millions of earning and spending decisions.  If you live in an industrialized nation, you will probably earn more than $1 million in your lifetime.  The decisions about how you earn this fortune, and spend it, are determined by your purpose in life.

Most often, people who are living paycheck to paycheck have an unconsciously chosen purpose for money that is something like “Money is to live on” or “Money is to buy the things I need.”  Because money responds to the commands of the mind, the external financial experience of these people confirms to their internal thinking about it.

If you are living paycheck to paycheck, then the decisions about how to use your money are made by the bills you pay each month.  This situation makes it impossible to take charge of your money.  You have unintentionally turned over your prerogatives as your own financial manager to your creditors and to your letter carrier who delivers the bad news each month.  Additionally, when bills exhaust all of your income, you are protected from making a mistake, perhaps unconsciously, thinking something like, “I used all my money to pay my bills.  That’s the best thing to do with it.”

For many people the prospect of dramatically increased income is frightening.  As they lack a clear purpose for their life or their money, the possibility of greater income usually brings up anxiety about loss or making mistakes.  Having a noble and consciously chosen purpose provides you with a framework for making decisions about the effective use of your growing income.