Fluctuating Conviction

This is just a thought I have been mulling over the last couple days that relates to investing.

I read about a third of "Reminiscences of a Stock Operator" before I lost it, but even what I read had a big impact on me. The young men in the book would be in a flurry of activity and excitement. They would often ask a particular older gentleman if he thought the specific stock they were talking about would go up. His repeated response was "It's a bull market", which really annoyed the younger traders because they didn't think he was answering the question. I'll come back to this in a second.

I played golf with my brother the other day and we were talking about the markets. I mentioned that many of my recent purchases had gone up dramatically and that I was really enjoying being an investor right now. He made that comment that maybe I should just trade for myself rather than keep trying to find a job working for someone else. His suggestion forced me to verbalize something I already knew; We have been experiencing an unusually good time to be an investor and these times don't last. This rally off what I think was the bottom has been violent and very profitable if you were lucky enough to get involved at the right time. Picking doubles and triples will not be as easy once we get into a more normal bull market.

My recollections about "Reminiscences" and my conversation with my brother are the catalyst for this post. I think that as an investor, the level of conviction I have should vary over time as the circumstances of the market change. Having worked as an analyst at an investment firm, I can tell you that there is unspoken pressure to maintain a high level of conviction; all the time. How do you get a portfolio manager to buy your stock recommendation? You "pound the table"! But as the old man in the book pointed out, the back drop really matters. Will XYZ stock go up? If we are in a bull market, then it most likely will. In mid-march, my conviction level was very high that I should buy a basket of beaten-down stocks because I was convinced that those types of stocks had explosive upside potential. I mentioned the stocks I bought in the last post, but my point here is that my success in that case had less to do with the five stocks I picked than with matching my purchases to the environment I thought we were in. I'm sure there are hundreds of other stocks I could have bought that would have matched or outperformed the five I purchased.

What are the current implications? As I have been thinking about this, the key point is that I think the environment is shifting. We were in an environment where the most beaten down stock could really bounce off the bottom. I think we are entering a phase where investors are still looking for pockets of extreme pessimism to play the bounce, but in general the environment will start focusing on longer term growth and earnings power. As such my level of conviction probably needs to be reigned in to match a less extreme environment.

I occasionally catch a show on CNBC called "Fast Money" which is basically a show for traders. One of their favorite lines was "everyone is a trader now". I think they were picking up on the environment we were in. The environment was a traders market, but I really think that is changing as I write.

I have not seen the job numbers yet this morning, but the number of data points that look good continues to build. Things are getting better and money on the sidelines will start pouring back into equities driving a bull market.

Let me be presumptuous and give you my formula for prices (this applies to stocks and the market broadly). P=(IV*S)+T. Price equals the product of intrinsic value and a sentiment multiplier, plus the impact of technicals. Intrinsic value is theoretically what a financial instrument is actually worth if we could all agree on what discount rate, and growth rates to use. As you know, sentiment pushes prices around that intrinsic value. The price of a dot.com stock in 1999 was largely driven by the sentiment multiplier, not calculations of intrinsic value. I am using the term "technicals" to describe unusual imbalances of buyers or sellers, such as if the top share holder starts liquidating their position, or if pension funds in aggregate start reallocating away from US stocks and into international stocks. The distinction between sentiment and technicals can get blurry so don't over-think it. The formula is really just a mental framework, not a calculation tool.

Using that framework, I would argue that intrinsic value has not changed much, but sentiment and technicals have been overwhelmingly negative until mid March. Now that I am convinced both factors will be a tailwind, I want to own equities. "It's a bull market."

Some recent buys and sells

In mid-march, I bought a mini-portfolio of beaten-down risky stocks with the thought that any of them could triple or go bust, but were more likely to triple (PFG, IBOC, SKX, SFLY, and ARGN). I should have talked about it in this blog, but I was buying stocks that I considered either very risky or that I didn't know very well, so I chickened out. That is behind us. Now I have some new decisions to make and I decided I should share them. The five stocks in my "beaten-down" portfolio are up between 42% and 172% so I have started to trim these stocks to take some profits. However, I am still bullish overall, and have been trying to decide how to invest that cash.

Basically, I took the view that the markets were dramatically oversold and that the best near-term performers would be the "junk". I think the "junk rally" is in the 6th inning, so I want to start buying some higher quality stocks in addition to more beaten down stocks that I still think have a lot of upside.

Here are the five stocks I have purchased in the last week with an explanation (limited as they may be):

Duckwall-Alco (DUCK): I wanted some consumer exposure, but more importantly, I like this investment thesis. Duckwall is a micro cap with a market cap of only about $50 million which makes it very tough for institutional investors to get in and out. Basically, I bought the stock because I wanted consumer exposure, they brought in a new management team a few years ago to modernize an old business model, they operate in markets with limited competition, and management appears to be doing a good job because they have been showing same-store-sales growth for the last three months. In the middle of horrendous employment trends and a bad recession, they have had positive same-store-sales. If this can continue, the stock is too cheap and as it moves up it could start to attract institutional investors again. My price target is $30-$45 within two years. I'm in at $11.34.

Ryland Group (RYL): This is a homebuilder and falls into the beaten down bucket. The stock has come off its lows like everything else, but I don't think sentiment has really turned for the home builders yet. The thesis here is that we are getting close to a housing bottom. As housing prices bottom, sales will pick up and we will start to burn through our excess housing inventory very quickly. Therefore, when investors decide housing has bottomed, they will naturally start thinking about inventory levels, and that will lead them to start buying the homebuilders in anticipation of renewed building. I don't have a price target on this one, just the thesis that the stocks will do very well over the next two years. I'm in at $20.70.

Partner Re (PRE): Over 40% of my portfolio is in financials because that is what I know best, but I didn't own any insurance and this is one I have wanted to own for awhile now. Of all the reinsurance managements I have met, this one impressed me the most. Their risks are very well diversified all around the world, which I think is critical for a business model that essentially short black swan events (read The Black Swan if you can). I think the recent environment has allowed them to write business that will be very profitable over the next few years as it seasons, and as such I will be able to exit this position at a multiple of 1.5x book (currently about 1.2x). So the thesis is that I expect book value to grow, the multiple to expand, and I get a modest dividend as well. I'm in at $66.34.

UnderArmor (UA): This is a high-flyer and that is the risk. I guess I am starting to believe that this really could be the next Nike. They grew revenue by 27% last quarter in a recession. I know they added running shoes; but we are in a recession! What would that number have been in a normal economy. The stock is expensive and expectations are high, which generally would keep me away. At $24.50, the stock trades at 30x 2009 consensus estimates and the street is building in 21% EPS growth from 2009 to 2010. This is a growth stock and I think the growth can continue which will actually allow the multiple to expand in the early stages of a bull market. The most likely bear case is that they post good growth, but don't really exceed expectations and the stock flatlines as the multiple fades. I'm in at $24.78.

Clearwire (CLWR): According to industry observers, Clearwire owns some of the best spectrum in the US and is trying to roll out WiMax based telecom service. They have powerful backers, like Google, and I guess I just really like the WiMax idea. This stock is dangerous for me, because I don't understand the technical issues that will play a big role in determining whether they succeed or fail. The biggest obstacle appears to be improvements to technology using existing cell-phone spectrum. Realistically, I'm still getting to know this stock and probably wouldn't encourage anyone to follow my lead on this one. I think I'm falling back on the idea that even if they don't succeed, they still have valuable spectrum which should limit my downside as long as they maintain modest leverage. I'm in at $5.90.

I clearly don't know these stocks as well as the financials I cover, but I decided to let you know my thought process before I know whether they were good buys or not. (I may never have told you about my mini-portfolio if it had not worked out and I decided that isn't really what I wanted this blog to be)

As an aside, ADP came out with an employment report today that estimated the US economy lost 491k jobs in April. This would be a big improvement over the last four months, although clearly still a bad number. So far, I have been wrong on employment trends. I thought the improvement would have started sooner and was surprised by how uniformly bad the prior four months were. This data point is very positive in my opinion and I think the market will get really excited if next month can show losses of 300k or better. Remember that employment is a lagging indicator, so the markets will move long before employment really looks good.

JP Morgan's Debt Offering, Goldman still makes me nervous

As I have reflected on the last week, one news item really sticks out in my mind. JP Morgan raised $10 billion in debt the day they announced earnings, but they did it without the FDIC backing that is available for large financial institutions right now. I don't follow the debt markets closely enough to know if other firms have raised similar amounts without a government backstop for investors, but I don't remember hearing about it. I think this is yet another very good datapoint. The debt markets are starting to function without the need for government help. The cynics will argue that I shouldn't be excited about the strongest bank in the country being able to raise some debt financing; of course they should be able to. They would say that my excitement only proves how bad things are. My point is simply that I don't expect JPM to be the last bank to be able to do this. The trend is bullish.

There were also a string of better than expected earnings from Wells Fargo, Goldman, JP Morgan and Citigroup. As I have said before, things get less bad before they really get better. Despite my bullishness, I as still a skeptic on Goldman Sachs. Don't misunderstand me, I admire their culture and the caliber of the the people they attract. These are very good things. But as an investor I am staying away. At the end of the day, this is still a highly leveraged company that makes money in a very opaque way. People who buy this stock (I fell into this mindset in the past so this is also a confession) will shrug their shoulders and say "Yes, but these guys are REALLY smart and will figure out how to make money like they always have." That's right; very highly paid investment professionals will use this as their investment thesis.

I have learned quite a few things over the last three years and here is one; if the business model is flawed, whole industries can be wiped out. It wasn't that long ago that mortgage originators were darlings of the investment community. They are simply gone now. The leveraged investment bank industry almost followed suite; we lost Bear and Lehman, Merrill was forced to sell, UBS is still in trouble, Goldman and Morgan had to convert to bank holding companies so the Fed could keep them from the same fate. My point is that Goldman may be full of smart people, but I can't even begin to predict how much money they will make next year and I no longer think the business model is attractive. And yet the stock was at $130 the other day. This is a cult stock and I'm going to find better models to invest my money in. For the sake of the broader market, I hope Goldman does very well but I'm willing to miss that gain.

Market in Transition and Equity Raises

I have been thinking and realizing over the last week that the market is at a tough spot. For some perspective, I remember hearing a lot of investors say things like the following: "I can't call the bottom so I won't try. I'm willing to miss the first 15-20% of the next bull market so that I have confirmation that it IS a bull market." My conversations with people lead me to believe that these same people are now very uncertain about what to do. They had the 20% rally off a bottom, but they are still hesitant. I have noticed my own tendencies are to want to buy on a pull-back when the markets are going up, but being afraid to buy when the pull-back is actually occurring. If I am bold enough to extrapolate my tendencies on the market, it implies that there are still a lot of potential buyers that are still waiting to buy. All this to say, we just had a rally but I don't think investors are convinced we are in a bull market, despite their comments prior to the rally. And for those who bought on the way up, or are just still holding old positions, it is tempting to lock in some of the recent gains. I still think we are in a new bull market, but these pauses make sense to me.

What I was really excited to see was some equity raises. Everyone saw that Goldman Sachs raised $5 billion yesterday, but unless you cover the financial sector you may easily have missed three other equity raises (First Niagara and Fidelity National yesterday and Chimera today). Seeing four financial sector equity raises in two days was a bit of a surprise; in the pleasant sense. The capital markets are normalizing under our noses. I'm still leery of Goldman's business model, but from a broader perspective, I'm very happy that other investors are willing to give them more capital.

And finally, I little aside. I was thinking about one of my favorite internet ideas again yesterday; Prosper.com. They are currently in a quiet period while they go through a registration process to sell promissory notes, but this is fine because I wouldn't lend money through Prosper.com quite yet. This website allows people to borrow and lend from each other through Prosper.com. As a lender, you are making an unsecured loan to a stranger based on their write up and some standardized data they have to provide. When the US economy loses less than 75k jobs in a month, I think it will be time to put some money to work here, based on the assumption that the most likely reason the loans won't be repaid is loss of income. At about -75k jobs, I expect loan performance going forward to be good, but interest rates still attractive.

Greenhill on a roll

Greenhill (Ticker GHL) announced another MD hire today, bringing the YTD number to five. My projections were for them to hire ten in 2009 so they are already half way there. For those that own it, I would start to think of the position as a source of funds if it goes above $85 within the next month or two. The stock can go higher, but I think you can find better risk/rewards in other stocks at that point. I wouldn't initiate a new position at these prices, but I am sticking with my position for now.