Cutting Off The Ends?
Cover Story, by Mark Robertson, Managing Partner November 1st, 2009
Thanksgiving is a time to honor traditions with the courage to question long-held beliefs.
As Thanksgiving approaches, we honor traditions and celebrate Community and family. We also give thanks for freedom and the innovation that comes with liberty. While honoring tradition, we also seek new approaches that remain faithful to our core principles and philosophy. Have you noticed the epidemic of curved shower curtain rods while seeking lodging on the road? It appears that the patent is as recent as 2006? What took so long? What psychological, traditional or behavioral barriers had to be conquered to finally keep the shower curtain at bay?
During a recent stay at a Hampton Inn, we discovered that the hotel chain is actually using their curved shower rods as a promotional feature for marketing. The increase in space (particularly for those of us afflicted with larger body volumes) at the shoulder level is a welcome innovation.
And a haunting question is rendered, “What took [us] so long to come up with this?”
Thanksgiving is the perfect time to honor, yet question, traditions.
I like the story of the young couple preparing their first Thanksgiving meal together.
The bride’s family had always included a ham with the feast so she embarked on preparing it as her mother had always done. She carefully removed it from the package and sliced both ends until the ham was approximately 18 inches long. Seasoning was added and her mother’s recipe was carefully followed.
Her mother arrived and helped with getting things in order. The young couple asked the bride’s mother why they’d sliced the ends of the ham off as part of the recipe. “I really don’t know why … it’s the way my mother, uhhh … your grandmother, always did it. We’ve always done it that way. She’ll be here in a few minutes, let’s ask her.”
When Grandma arrived in the kitchen, they asked about the recipe. Grandma smiled and laughed, “Heavens! When your grandfather and I were first married, neither our pan nor oven were large enough for the full ham, so it had to be trimmed to make it fit the pan.”
Two generations later, the ham was getting trimmed whether it needed it or not!
During an SSG-based stock study, a forecast range is calculated between a “worst case scenario” (potential low price) and an optimistic “best case scenario” – a potential high price over a five-year time horizon. This range is divided into segments to provide buy/hold/sell guidance. The position of the current price within these ranges provides the advisory opinion. (The zoning configuration on the right should be used, IF you continue to use zoning after reading this article.) What if we don’t really use price volatility as our definition of risk? Why shouldn’t we instead use relative potential return as one of the better navigational tools in our quest?
Zoning Out
During a fairly recent stock study on Meredith Corporation in the MANIFEST Forum, I admitted that I’ve placed less emphasis on zoning (buy, sell and hold) and Upside-Downside ratios since approximately 1995, dating back to the investment club days well before I joined the staff of Better Investing at the National Association of Investors (NAIC).
During the Meredith study, I took a “present day” look back at a published stock study from 1998, performing the study again with the historical data and exploring whether I’d do anything different or reach different conclusions based on lessons learned over the last ten years or so. The study inspired the following questions:
1. Why did the zoning recipe exist in the first place?
2. How do we define risk? How does that reconcile with the recipe?
3. Are some aspects of the recipe a buggy whip — and if so, even if they’re a really good buggy whip, what is their present contribution to our quest?
It’s ‘About’ The Data
George Nicholson, Jr. is regarded as the grandfather of the modern investment club movement. He is also credited with the development of the original Stock Selection Guide (SSG), a tool for studying and understanding the most important fundamental components of stock analysis.
Why did the design include this component of zoning?
To discover the answer, we have to think about the prevailing conditions at the time. It was 1940 or 1950 … computers were vastly different and calculators were still 25-30 years in the future. Fundamental information was difficult to obtain and S&P reports could be quite dated by the time they were delivered.
Doing an SSG by hand was time-consuming and relatively laborious.
Under these conditions, Nicholson sought a remedy that would have to be responsive to the myopia — the harsh reality was that it wasn’t reasonable or feasible to expect to complete a large number of studies (for comparison purposes and “shopping”) on a continuous basis.
The answer, the NAIC Stock Selection Guide, was and still is, ingenious. The design parameters meant that a buy/hold/sell outcome had to be generated from the results of a single analysis.
All of this made it necessary to build a myopic tool and the zoning architecture was absolutely ingenious in its day. The zoning made it possible to render a buy/sell/hold characterization on the basis of a single study.
That said, we fully believe that Mr. Nicholson would be inclined (today) to base buy/sell decisions on the basis of relative comparisons of projected returns. Build expectations. Shop among the leaders.
Relegating, Reconciling Risk
What is risk?
How do we really define it?
The rhino definition of risk is short-term price volatility. Warren Buffett suggests that “real risk is not knowing what you’re doing.” In a series of narratives on risk, Ron Muhlenkamp defines risk as lost opportunities. Muhlenkamp equates mattress-stuffing with maximum risk due to the certainty of inflationary erosion.
I really don’t think we define or see risk as short-term price volatility. In fact, some of the most successful long-term investors in our community have pointed out that short-term price volatility is the place where outsized returns are born.
Look no further than our letter to the President a year ago. You may recall that our answer to the legislative studies aimed at the replacement of defined contribution plan with 3% guaranteed return funds was, “Nuts!” Take a look at the unit value of our Tin Cup model portfolio (page 7) over the last 18 months or so.
The zoning and upside-downside calculations are based on the foundation that the risk component of a reward-to-risk analysis is based on a low price (worst case scenario), a concept that is consistent with the belief that short-term price volatility and risk are related.
We’ve launched and will continue to explore the role of short-term price volatility when it comes to the realm of strategic portfolio design and management - but it’s not a primary consideration in our stock selection “recipe.”
The bottom line is that if we don’t see price volatility as a meaningful measure of risk, then the section 3 and 4 calculations on an SSG become either moot, obsolete or at most, questionably informative relative to return expectations.
Microsoft (MSFT) Scorecard. When we chose MSFT for Solomon Select back in October 2005, our expectation was for a projected annual return of 17.5% based on reaching a stock price of $57 over a 5-year time horizon. And we’d expect the price to attain those levels during a “normal” period in the market. But the market has actually decreased 11.3% since October 2005. This is where the relative advantage kicks in … because while MSFT hasn’t quite attained that “forecast trajectory” it has managed to outperform the general stock market by 29.4% since selection. “No, Virginia, we don’t expect the stock price to follow the straight line, ever.”
Asymptotically Arbitrary
One of the challenges associated with the SSG-based practice of establishing a projected low price is that the process can be pretty arbitrary.
An asymptote is a mathematical condition where a curve approaches a straight line. The most common condition is when we divide by a number approaching zero. When this happens, the result approaches infinity. We see this whenever the current price during an SSG-based stock study approaches the projected low, and the difference between the two approaches zero, delivering an upside-downside ratio headed for infinity. In my work with investment clubs and individual investors, I think “arbitrary” is actually pretty generous when it comes to either the selection of the low price or the understanding of what the design intentions were. There’s very little consensus or consistency and frankly, I’ve discovered great “refuge” in the reality that if risk isn’t about stock price volatility … it just doesn’t matter. Moot.
The Math: Keep It Simple
“… in 44 years of Wall Street experience and study, I have never seen dependable calculations made about common stock values, or related investment policies, that went beyond simple arithmetic or the most elementary algebra. Whenever calculus is brought in, or higher algebra, you could take it as a warning signal … of substituting theory for experience … or to give speculation the deceptive guise of investment.” - Ben Graham, The Intelligent Investor.
Yes, we’re repeating part of last month’s cover story. I once participated in an academic and professional review of the SSG process. The distinguished panel came to the conclusion that the concept was on target in Sections 1 and 2, but the “lug nuts loosen and some wheels are lost in Sections 3-5.”
Occam was right about his razor.
This is the prevailing thinking behind our emphasis on (1) top-line growth, (2) profitability and (3) reasonable and considered forecasts for P/E ratios … and the math behind it all is relatively simple.
The myopic design requirements disappeared with the first data CD issued by NAIC. Unfortunately, Mr. Nicholson passed away at that time also … precluding his advice on the transformation. With no horse involved, and the advent of internal combustion, the buggy whip became a lot less relevant. We can leave the ends on the roast beast, now. Happy Thanksgiving, everybody!
Mark Robertson
Mark Robertson is founder and managing partner of Manifest Investing, a source for research and portfolio management focusing on strategic long term investors.