I recently published an article and in many ways the article was a great success and generated a lively comment thread containing approximately 500 comments and growing. Moreover, the article generated at least two rebuttal articles that I know of. One by Adam Aloisi and the other by Kevin Wrotenbery. However, and with all due respect to both of my fellow Seeking Alpha authors, I don't feel that either of their articles were actually a rebuttal of what I was postulating. On the other hand, and in all fairness to my colleagues, I must admit that I might not have made my true position clear enough.
Therefore, I would like to try to rectify my lack of clarity with this follow-up to my original work. In my original article I intended to discuss how to handle assets that retirees and/or those investing for retirement were earmarking to be invested in equities. But since I didn't make that clear enough, many comments were offered in support of holding cash reserves and/or holding cash for other asset allocation purposes. However, I was not talking about cash in that context. My primary objections were related to holding cash earmarked for stock purchase for fear of a correction, which I consider attempting to time or predict the market. Most importantly, since I don't believe it is possible to predict or time the market, I consider that a mistake.
Therefore, what I was truly recommending in my article was to ignore worrying about the stock market, or even the economy for that matter, in favor of focusing on great companies that you wanted to be shareholder partners in. Additionally, I pointed out a couple of other critical facts that I believe support my thesis. Best-of-breed companies produce long-term performance records that are in many cases multiples of what the general stock market produces. In other words, I don't believe in investing in average companies, I believe in investing in above-average companies. I presented several examples illustrating that fact in my original article. Therefore, if I own above-average companies, why would I worry about what the averages are doing or might be doing in the near future?
I also pointed out that strong businesses can often perform successfully in most any economy. I also offered several examples illustrating that point. Here, I'm talking about business results to include a steady and rising dividend income stream from those companies that pay a dividend. Furthermore, although I will admit that a falling tide may initially sink all ships, the cream of the crop will inevitably float back to the top. Once again, it is a market of stocks and not a stock market. Therefore, I choose only to research, analyze and invest in what I consider to be the strongest and best.
In his article, Kevin Wrotenbery attempted to counter based on his view that the market is overvalued. I might agree that common stocks in the general sense might not be cheap today, but I do not see anything resembling bubble territory in the aggregate. Based on the actual level of current earnings, the S&P 500 might be fully valued and even moderately overvalued. However, I don't believe in investing in the stock market, I believe in investing in carefully selected above-average businesses that I feel are capable of meeting my specific goals and objectives.
But even more importantly, I will only invest when the valuation on the specific business I am studying makes economic sense. Because, when I invest in a business, I understand that I am buying its earnings power, which I strive to purchase at the most reasonable or low price I can. As I said in the article, I don't believe in overpaying for even the best companies. Consequently, I build my portfolios one business at a time based on my belief in its future earnings power and the current valuation of its shares. It does not matter to me if the market is high or low, the only thing that matters to me is the valuation of the specific business I am contemplating investing in.
After more than 40 years of following this investing philosophy, I have yet to find a market environment where good values could not be found. Therefore, I consider it a mistake to sit on cash that I want to invest for growth and/or growth and income when there are perfectly sound and attractive opportunities at hand. I have learned that one in the hand is truly worth two in the bush, therefore, when I can get my hands on a solid opportunity I take advantage of that opportunity.
The Foundation of My Thesis
I've spent my entire working life, and the better part of my adulthood, analyzing and trying to learn how to properly invest in common stocks. From the very beginning it seemed only logical to study and learn all that I could from the greatest investing masters and legends that came before me. Consequently, over the past 40+ years I devoured every book, article or paper that I could find that was either written by, or on, the most acclaimed and best investors and teachers that ever walked the planet. Today I continue that process, even after all these years, on the principle that every day I can learn something is a great day. Because, as my wise and beautiful wife is so fond of stating: "if you're not growing you're dying." I choose to live, learn and grow.
My primary teachers comprise numerous legends of investing to include Benjamin Graham (I keep a copy of "The Intelligent Investor" sitting conspicuously on my desk), Warren Buffett, Charlie Munger, T. Rowe Price, Peter Lynch, Larry Tisch, Marty Whitman, Bernard Baruch, William J. Ruane, Paul Cabot and Philip Fisher, to name just a few. Now, I can't say that I agree with each and every principle or theory that each of these money masters preached, but for the most part everything I learned and feel I know, was taught to me by paying attention to the principles these investing greats espoused. Perhaps the only original idea that I had was developing F.A.S.T. Graphs™ the Fundamentals Analyzer Software Tool that allowed me to study their teachings in graphic form.
But even more importantly, I do believe there was one common theme or principle that each of these gurus believed in and preached. They believed in investing in good businesses with the stock market representing simply the store they shopped at. Consequently, at least for the most part, they also eschewed worrying about trying to time the market and preferred positioning themselves as long-term investors in fine businesses instead.
Lessons from Phil Fisher
Regarding the two articles referenced above that were offered as a rebuttal to mine, there were really two common arguments that I identified that were offered supporting their position for holding cash that was ultimately earmarked for equity investments. Both of these authors presented arguments that made reference to the stock market. Adam Aloisi talked about long periods where the stock market performed poorly, and Kevin Wrotenbery argued that the market was currently overvalued based on certain academic theories. And both authors argued for the benefit of having cash available to exploit the incredible opportunity to invest at or near the impending market bottom.
I will acknowledge that these arguments appear logical or even rational at first glance. However, I will also state with great confidence gained after more than 40 years' experience dealing with investors, that often what might sound good in theory rarely occurs in real-world applications. More clearly stated, with human nature being what it is, most people with cash to invest in a bad market will not do it. After a large fall in the price of a stock, whether as a result of a Great Recession like we saw in 2008 or simply an isolated example, after a price drop people are more likely to avoid stocks than become encouraged to invest in them.
My own personal experience during the recent Great Recession of 2008 supports the above statement. No matter how hard I tried to convince people that the high quality companies they owned were in fact healthy and strong, it took all the encouragement and even cajoling I could muster to convince them to stay the course. During that horrific period people wanted nothing to do with stocks, all they wanted to do was get out, and some even went as far as to say they wanted forever out. In truth, people generally are not in a buying mood at the bottom of markets.
Here is what Phil Fisher had to say on the subject in his book 'Common Stocks and Uncommon Profits.' This first excerpt deals with Phil's view on investing for the long term:
At this point the critical reader has probably discerned a basic investment principle which by and large seems only to be understood by a small minority of successful investors. This is that once a stock has been properly selected and has borne the test of time, it is only occasionally that there is any reason for selling it at all.
This next excerpt corroborates my contention that it is a mistake to postpone investing based on a fear or belief that a market crash may be forthcoming:
Most frequently given of such reasons is the conviction that a general stock market decline of some proportion is somewhere in the offing. In the preceding chapter I tried to show that postponing an attractive purchase because of fear of what the general market might do will, over the years, prove very costly. This is because the investor is ignoring a powerful influence about which he has positive knowledge through fear of a less powerful force about which, in the present state of human knowledge, he and everyone else is largely guessing. If the argument is valid that the purchase of attractive common stocks should not be unduly influenced by fear of ordinary bear markets, the argument against selling outstanding stocks because of these fears is even more impressive.
This next excerpt corroborates my experience that people will not buy stocks during a bad market:
There is another and even more costly reason why an investor should never sell out of an outstanding situation because of the possibility that an ordinary bear market may be about to occur. If the company is really a right one, the next bull market should see the stock making a new peak well above those so far attained. How is the investor to know when to buy back? Theoretically it should be after the coming decline. However this presupposes that the investor will know when the decline will end. I have seen many investors dispose of a holding that was to show stupendous gain in the years ahead because of this fear of a coming bear market. Frequently the bear market never came and the stock went right on up. When a bear market has come, I have not seen one in 10 when the investor actually got back into the same shares before they had gone up above his selling price. Usually he either waited for them to go far lower than they actually dropped, or, when they were way down, fear of something else happening still prevented their reinstatement.
United Technologies Corp. (NYSE:UTX): A Graphic Illustration of My Thesis
Within this article I am going to only offer one simple example to illustrate the points I've been trying to make in both of my articles on why I believe that holding cash earmarked for equity investments is a mistake. Frankly, I could offer hundreds of examples, and in the past I have had a penchant for offering example after example. Hopefully, through the simplicity of one quintessential example I might get my points across to some.
First, I offer a price only graph on United Technologies going back 20 years to 1994, or as far as I can with my F.A.S.T. Graphs™ research tool. Nevertheless, I believe that this particular timeframe is relevant because it includes both of our most recently severe recessions of modern time. Consequently, this period of time allows us to carefully examine what truly occurs before, during and after a recession and the stock price drops that accompany them.
I feel this is important because in my experience, a large majority of investors base their decisions almost exclusively on price action. When the price of a stock is going up, many will contend that it is a good stock. Conversely, when the price of the stock is dropping, many will automatically contend that it is a bad stock. This attitude is created with an almost total disregard about the fundamental strength of the underlying business. In my opinion, this is mostly a function of emotion overriding reason. But even more importantly the price drops associated with recessionary periods instigate emotional havoc.
With the above said, let's analyze the price history of United Technologies since 1994 in order to put price action into perspective. I have circled the most severe price drops on the graph for focus. There is clear evidence on this 20-year price graph that corroborates my positions. First of all, even the largest and most severe drops in price recover in a reasonably short period of time. However, it's also important to point out, as I will in a moment, that this is functionally related to United Technologies' underlying business strength.
In this and my previous article I also contend that not only will the price of a strong business inevitably recover from large losses (again, as long as the business remains sound), but that it will predictably move to even greater heights. Adam tried to counter this point in his article by arguing about extended periods in history where the general stock market did not recover. And, I will acquiesce that he may be correct when talking about the general stock market. However, my contention is not about the stock market, instead it is about what happens with great businesses. I argue that United Technologies Corp. is a representative example of a great business, as I will illustrate with my next graph.
My next graph looks at United Technologies over the same 20-year time frame, however, this time it only shows earnings and dividends. Here we see that United Technologies is a great business that has produced solid earnings even during recessionary periods (The orange line on the graph). Moreover, we see by examining the dividends (the pink line on the graph) that United Technologies has offered their shareholders an increase in pay every year to include both of the recessions.
Consequently, I believe this speaks to my position that large price drops are simply periods of time when United Technologies' stock has become temporarily illiquid. There are no losses to be had over the long run, unless of course investors become frightened enough by the price drops to panic and sell. However, for those wise enough to stay the course, they eventually, and I argue inevitably, recover unrealized losses and move on to even higher gains.
I believe this also refutes the arguments that were made referencing how many years it would take dividend increases to cover losses. In the United Technologies' example at least, there are no losses unless they are taken. The key is that I believe it's more important to focus on business results and dividends than it is to freak out over price volatility. As long as business is strong, price will take care of itself. Therefore, unless I specifically intended to sell a great business like United Technologies, there is no motivation to do it just because the price was down.
Next, by combining the above graphs into an earnings and price correlated graph, my points become crystal clear. The company's stock price (the black line) clearly tracks the orange earnings justified valuation line, with only an occasional deviation. Price follows the company's earnings in the long run. Temporary short-term bouts of the emotional responses of either fear or greed inevitably succumb to business results (earnings and dividends). Therefore, it should be clear to those willing to examine the evidence that it is really the strength and quality of the business that matters most and that should be what we focus on. Trust business results; distrust the often irrational price volatility.
If the evidence presented above has not convinced you that it is a market of stocks and not a stock market, perhaps a comparison of United Technologies' historical performance compared to the S&P 500 over the past two decades will. An initial $10,000 investment in United Technologies on December 31, 1993 would have grown to over $130,000 representing a 13.8% compound annual rate of return from capital appreciation. In contrast, the stock market, which so many are so obsessed with, would have only turned that same initial $10,000 investment into $38,000 representing a 6.9% compound annual return from capital appreciation. Respectable, but nothing compared to what United Technologies generated for its shareholders.
The significant difference seen from the dividend income between United Technologies and the general stock market is also quite profound. United Technologies' shareholders received over $21,000 in dividend income, compared to the S&P 500 which only generated slightly more than $8,000 in dividend income. The simple conclusion that should be gleaned from this comparison is: as a long-term shareholder of United Technologies why should I pay any attention to what the overall stock market has been doing or might do in the future? Frankly, it just doesn't make any sense to me.
Have You Considered that Your Negative Opinions About the Stock Market and/or the US Economy May Be Wrong?
Based on numerous comments posted on many of the articles I have authored recently, it is obvious to me at least, that many investors have a negative and even cynical view of our economic future. In many ways, this is understandable because it's rare to find positive offerings from mainstream media. However, serendipitously I came upon one as I was writing this article. Barron's magazine published an article in Wall Street's Best Minds by Diana Choyleva titled U.S. Economy May Be "Only Game in Town" found here. I offer the following short excerpt as an illustration that not everyone has a jaundiced view of America's future:
Good news is still at a premium in the global economy. But America's outlook for 2014 is decidedly positive. The U.S. economy has made tremendous progress correcting its underlying imbalances, well beyond the claims of some commentators that it has merely been 'printing money'. The U.S. recovery is set to take output growth well above trend to average 3%-4% over the next few years. It will be a production-led recovery, not a consumer-led recovery i.e. America will import less of what it consumes.
Growth should also prove durable, as inflation will not be a concern for some time. The economy continues to have significant spare capacity, while faster GDP growth could also pull up the economy's potential growth rate. Energy prices and the U.S. dollar will exert downward pressure on inflation, thanks to shale fracking and America's relative-growth outperformance. Subdued inflation is likely to keep policy rates ultra low for some time. Importantly, even when the Fed decides to raise interest rates in response to a sustained revival in growth, this will not derail the economy because it is no longer plagued by excessive levels of debt.
Frankly, I don't believe any of us can really know for sure what the future holds. However, I have long held that optimism trumps negativity in the long run. For example, upon announcing my desire to enter the financial services industry in 1970, well-meaning friends and family vehemently recommended against it. After all, they theorized America's economy could not possibly survive under the enormous weight and burden of our national debt and our government's reckless spending habits. I shudder to think what my future would have been like had I heeded their warnings and advice. After all, it's been more than 40 years and America's economy continues marching onward and upward.
Almost two years ago (Jan 5, 2012), I submitted an article for publication that was rejected. Even though I had permission from the author to publish it, the editors were not comfortable because it contained a long dissertation in its entirety by a financial planner who was frustrated by all the doom and gloom he was encountering from his clients. Although I respected the editor's decision, I felt the information was important enough to publish it as an instablog and on my own website's Blog. It can be found here.
Although some of the specific information and situations have become dated, I feel that the underlying message remains valid even today. Therefore, I offer it again now for anyone interested in examining a more positive view. The following is an excerpt from my introduction:
Let there be no confusion about the purpose and intent of this article. It is intended to present a positive and enthusiastic defense and a reasoned support of our great country and its economic strength and promise. There are far too many that want to criticize and denigrate our economy and the very system within which it operates. Not only do I believe we live in the greatest country on earth, I also believe that our economy is the strongest and most prolific that has ever existed. And as such, it is the most benevolent and generous provider for the population it serves than any other on earth.
Yes, we face economic problems from time to time, and we always have and always will. But the indomitable American spirit has met every challenge we've ever faced, and I believe will continue to do so for a long time to come. The late great American economist Milton Friedman said it better than I:
"So that the record of history is absolutely crystal clear. That there is no alternative way, so far discovered, of improving the lot of the ordinary people that can hold a candle to the productive activities that are unleashed by a free enterprise system. "
Summary and Conclusions
The most important messages that this article, and my previous article, were intended to deliver are as follows. Once an investor has committed an appropriate portion of their portfolio or assets to investing in common stocks, I believe it is more prudent, practical and intelligent to focus on the specific investments they are considering. As Philip Fisher suggested, I believe it makes more sense to examine what we can know something about, over worrying about something that we cannot possibly know about with any certainty. Forecasting the economy or the stock market is an exercise in futility, in my humble opinion.
Furthermore, regardless of what your views about the macro may be, my long experience suggests that sound and attractive investments exist in each and every economic or market environment. Therefore, since we cannot predict the economy or time the market, I believe it makes more sense to find good companies that are also available at sound valuations, and invest in those for the long run. I provided examples of good dividend-paying companies at sound valuations on David Fish's CCC lists in three previous articles found here, here and here. Time in your investments has proven to be more profitable than attempting to time getting in or out. Intellect over emotion seems to be a better course of action. May we all have a happy and prosperous New Year.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.