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Kendall J. Anderson, CFA
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Kendall J. Anderson, CFA is the founder and President of Anderson Griggs Investments. Anderson Griggs manages equity only and balanced separate accounts from Rock Hill, South Carolina. Kendall was recognized by Money Manager Review as the number 1 large cap growth manager for 2004. His... More
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  • Regression To The Mean

    I often hear from many of you that you know very little about investing. However, I find that most of you understand investing quite well. Many of the concepts and theories thrown out by those of us who claim to be professionals can be restated into words and phrases you use regularly. For instance, when you say, "what goes up must come down," or, when you are going through a particularly tough time, "don't worry, things will get better," you are showing your knowledge of regression to the mean.

    We have a deep conviction that things will return to normal with time. It is the driving force behind our security selection and portfolio management decisions. Because of that, I thought I would share some information on "regression to the mean" with you. Once again, I have sought a little help with this from my library, and am sharing with you an excerpt written by H. Bradlee Perry, CFA in 1987.

    At that time, Mr. Perry was employed by David L. Babson & Co., Inc. Babson was known as an excellent investment counselor and manager specializing in equity investments. The company published The Babson Staff Letter, which at the time was one of mine and many other investors' favorite source of investment insight. The company still publishes the staff letter and it is freely available through the company's website, www.babsoncapital.com. Although their business has changed substantially since the earlier days of the company, they are still highly regarded in the investment community. Of local interest, the company announced in May of this year that they are considering moving their headquarters to Charlotte, our neighbor city a few miles up the road.

    From The Babson Staff Letter, August 14, 1987, H. Bradlee Perry, CFA

    Regressing to the Mean

    Golfers and baseball players often talk about being "in the groove", having their swing following the particular pattern which has been successful for them. Different businesses also have a "groove", a mode of performance that is typical for them, and individual stocks tend to have a normal valuation "groove".

    However, athletes, businesses and stocks deviate from their typical performance from time to time, doing better or worse for a while. Such periods obviously are very significant to sports fans and investors.

    Because of aging and other human frailties, golfers and ball players don't always get back into the groove. However, due primarily to competitive forces, businesses and stocks usually do. Statisticians call this "regressing to the mean". Understanding the process and observing it carefully can be very rewarding for investors.

    Industry Patterns

    Most types of businesses are influenced by specific factors that give them distinctive characteristics, and all the participants in those particular businesses tend to perform in somewhat similar fashion. When one doesn't, history shows that eventually the "outlier" usually falls back in line with the industry pattern.

    Banking is a good example. This is a very homogenous business. All banks deal primarily with money; it is a commodity because one bank's money is just the same as another's. Through various means they all gather deposits primarily from individuals and businesses and lend those funds to other individuals and businesses.

    Some banks are better managed than others so they operate a little more effectively. But in the long run there are rarely major differences in performance in such a homogenous, competitive industry- especially within the geographic areas where economic conditions are similar.

    Over the years when a particular bank has been growing faster than its competitors, it has usually been more aggressive in lending. Eventually that leads to greater loan losses and in turn, a reining in of its rapid growth. Occasionally when a bank goes bonkers on profit expansion, it gets into such deep trouble that it has great difficulty regaining its position. Continental Illinois is a recent example and previously First Pennsylvania experienced the same fate (for somewhat different reasons).

    However, in most instances overly aggressive banks do regress to the mean. Notable cases are Citizens & Southern many years ago and Chase Manhattan in the late 1970s.

    Conversely, banks which go through a period of slower than normal growth and are tagged as "sleepy" usually wake up and get back in the groove. Wells Fargo, First Interstate and State Street Boston are good illustrations.

    The same process has occurred in just about every industry: Texaco declining from superiority in the 1970s while Exxon was moving up the scale; Union Carbide losing its position of preeminence in chemicals while Hercules rose from a subpar position to a very good one; Borden and Nabisco waking up in the food business while General Foods was sinking to mediocrity; Pfizer developing much greater strength as Upjohn slipped into the average category; Federated Department Stores sliding from its very strong position while May Department Stores was advancing from the rear of the pack; etc.

    The record is clear that more often than not in a business heavily influenced by a few basic forces, companies rarely perform way above the industry average or way below it indefinitely. There is a constant tendency to regress toward the mean….

    This is illustrated in Figure 1 prepared a few years ago by Merrill Lynch. Covering a broad universe of over 1,5000 corporations, it shows how those in the top quintile of profitability in 1966 gradually experienced a decline in their return on equity from way above average to moderately above average over the next 14 years - and how those at the bottom of the scale in 1966 improved to just slightly below average….

    (click to enlarge)

    Stock Market Performance

    One lesson we need to remember constantly is that stock prices tend to reflect quite fully the most recent performance of companies. When a business has been going extremely well, almost invariably that fact has already been factored into the stock - because everyone has seen the good reports from the company. Similarly, when the recent results of a company have been poor, the stock is usually depressed.

    Then when the news on the "good" companies becomes even slightly less favorable - or perhaps merely fails to get more favorable - their shares are likely to underperform the market. On the other hand, even a slight improvement in the news on a "bad" company can park a major upswing in its stock….

    Conclusion

    Many years ago we knew a person outside this firm who had developed a very simple-and very effective-method of selecting stocks to buy. He kept careful records of the returns on assets earned by different companies. He would only buy a stock when the firm's profitability was below its historic norm-and he would only sell the stock when profitability had risen above that norm. This gentleman was an extremely successful investor and his commonsense approach (which predates the general understanding of regression to the mean) works just as well today as it ever did.

    The reason it does is that most investors take a relatively short-term view and assume that what has happened most recently will continue. They fail to recognize that economic and market forces are always working to press companies (and whole industries) back toward their respective grooves. Furthermore, there is a human element in the equation. As with athletes, it is difficult for management to play over their heads for long. Nor does any management want to continue performing badly. And if they do for very long, the directors (or an outside buyer) usually step in and replace management.

    Appraising where a company is in relation to its normal pattern of performance and how its current status has affected its stock prices is a very useful process. Like any other investment technique it doesn't work all the time because exceptions do occur, but clearly this type of analysis can improve one's portfolio batting average.

    While it is easy for us to understand the concept of regression to the mean, it can be difficult for us individually to use this powerful force when we are investing our own money. We often do not want to sell when everything seems perfect, nor do we consider buying when things look bleak. Even if we do buy low, we often do not have the patience to wait and allow the business to make the changes needed to correct and improve their operations. Yet I know that if we can overcome these instincts, we will, as Mr. Perry states, improve our batting average.

    Until next time,

    Kendall J. Anderson, CFA

    _______________________________________________________

    Anderson Griggs & Company, Inc., doing business as Anderson Griggs Investments, is a registered investment adviser. Anderson Griggs only conducts business in states and locations where it is properly registered or meets state requirement for advisors. This commentary is for informational purposes only and is not an offer of investment advice. We will only render advice after we deliver our Form ADV Part 2 to a client in an authorized jurisdiction and receive a properly executed Investment Supervisory Services Agreement. Any reference to performance is historical in nature and no assumption about future performance should be made based on the past performance of any Anderson Griggs' Investment Objectives, individual account, individual security or index. Upon request, Anderson Griggs Investments will provide to you a list of all trade recommendations made by us for the immediately preceding 12 months. The authors of publications are expressing general opinions and commentary. They are not attempting to provide legal, accounting, or specific advice to any individual concerning their personal situation. Anderson Griggs Investments' office is located at 113 E. Main St., Suite 310, Rock Hill, SC 29730. The local phone number is 803-324-5044 and nationally can be reached via its toll-free number 800-254-0874.

    Jan 05 9:37 AM | Link | Comment!
  • The Evaluation Of Common Stocks

    "Stocks are not always worth what they sell for. Sometimes they are carried too high, sometimes too low, by mass excitement. Sooner or later, though, they move into line with value."
    Arnold Bernhard

    I have met many financially secure families over the years. Most earned this financial security by working hard, while saving as much as possible, for a very long time. Some inherited a safety net, some married into wealth, and a few lucky people just did everything right at the right time. What I have not come across is anyone who gained financial security quickly in a short period by investing in the capital markets. I know there are a few of these wonder kids somewhere on the planet, but I haven't met them. And of course, being human and carrying a little bag of envy around with me every day, I would not have believed they accomplished this feat on skill alone. There had to be a great deal of luck involved.

    Knowing full well that luck passed over me about the time I was born, I followed the lead of the majority on the road to financial security by working hard and saving as much as I could. It helped that I chose to work in the investment field. This opened up the door for gaining some element of skill in minimizing my number of investment mistakes, which we all make at some point.

    I began my career as a financial intermediary: a registered representative better known today as a financial advisor. Basically, I was one of those guys who would talk with you and then advise you to buy a mutual fund or some other product designed and managed by someone else. Selling mutual funds was fine for a while, but I wanted to increase my investment skill, so I purchased a one-year subscription to the Value Line Investment Survey which included weekly updates. It was my introduction to a systematic method of the evaluation of common stocks. Some years later, I obtained a copy of Arnold Bernhard's 1959 book, The Evaluation of Common Stocks. I remember I purchased it from the local library's annual book sale for less than a dollar. What a bargain!

    For those of you not familiar with Arnold Bernhard, an introduction is appropriate. Mr. Bernhard was born in 1901 in New York City. He grew up in Newark, DE and Rutherford, NJ, and graduated from Williams College. After graduating in 1925, he began a career as a reporter with New York newspapers. The great bull market of the late 1920's enticed him into the investment business. He began his career as an employee of Jesse Livermore, one of the most widely known stock speculators of the day. It took just a short time for Mr. Bernhard to recognize that Livermore's trading was completely indifferent to any standard of value, so off Mr. Bernhard went again, landing at Moody's Investors Service, where he worked as an analyst and account executive. However, the effects of the great crash found him out of a job in 1931. At this point, he started Arnold Bernhard & Company, an investment counselling firm.

    Five years later he published the first edition of the Value Line Investment Survey. It was duplicated on a mimeograph machine and mailed to a few interested parties. What I find so special about the survey is that it is based on the assumption that there is "a standard that can signal when stocks are overvalued, and when they are undervalued, a standard that would not give way to emotionalism" (valueline.com). This idea, that prices can be over or undervalued, directly conflicted with the efficient market hypothesis which holds that all information is reflected immediately in stock prices, so that any attempt to outperform the market is wasted effort.

    Because of this, the survey includes years of data that is produced consistently, and thus it is easy to compare one company to another. For an analyst, this is one of the most difficult, not to mention boring, parts of the job, having to adjust data from multiple sources so that all final numbers are produced in identical fashion.

    The inside flap of The Evaluation of Common Stocks states: "The key to Mr. Bernhard's book is to be found in his statement, 'If all the deviltry of all the crooked stock market riggers of all time were raised to the hundredth power, it would count as nothing compared to the desolation wrought by deluded crowds [of investors] whose imagination knows no discipline.'" Here we are fifty-five years after publication, with more than one crooked stock market rigger spending his or her days in federal prison for dirty deeds committed in the past, and still the primary reason individuals fail as investors is because of an undisciplined approach to investing.

    Mr. Bernhard did his best to correct this during his lifetime. His book is a transcript of a series of presentations he gave at the Bernard M. Baruch School of Business and Public Administration of the City College in New York. He discussed a widely held but fallacious generalization about stock evaluation, quality and appreciation potential, and current valuation and whether stocks are cheap or dear to their own intrinsic value. In his final presentation, he gave a method for building and maintaining a portfolio of individual companies.

    Price/Earnings (P/E) Ratio as a Measure of Value

    Most of you know that the P/E ratio is the current price of a stock divided by the company's earnings per share. This ratio is one of the most widely used statistics to determine whether a market price is high or low. I came under the P/E spell early on. Initially I believed the lower the P/E the better, but Mr. Bernhard's little book enhanced my understanding and my use of the P/E ratio in our own determination of value. Because of this, I want to share with you some statements he makes in his book about the P/E ratio.

    · One cannot generalize that stocks are worth 10 times earnings, which is a common assumption. The truth is that each stock has its own characteristic price/earnings ratio.

    · Yet it would also be misleading to assert that an average, or typical, price/earnings ratio is a reliable criterion of the value of a stock in all phases of its business cycle.

    · The price/earnings ratio, if taken at the highest and the lowest prices of the year, would fluctuate even more [than the annual average price/earnings ratio].

    · When the earnings rise, the price/earnings ratio tends to fall. But when the earnings fall, the price/earnings ratio tends to rise [on cyclicals].

    · …the fact that the price/earnings ratio of a cyclical stock normally goes down as the earnings rise.

    · Each stock has its own individual price/earnings ratio…

    · …the price/earnings ratio of the individual stock normally varies at different levels of earnings.

    · …in determining how a stock should be valued in relation to earnings, or dividend-paying ability, we must discard the idea of a general price/earnings ratio for all stocks, for we have found that each stock has its individual price/earnings ratio.

    · We must discard the idea of a fixed price/earnings ratio for the individual stock at all levels of earnings, because we have found that the price/earnings ratio of even the individual stock varies-and normally varies-at different levels of earnings.

    (Bernhard, The Evaluation of Common Stocks, pgs. 26-36)

    I have chosen to highlight Mr. Bernhard's comments on the P/E ratio for a very important reason. It is the season for forecasts. Invariably, many firms and individuals will forecast a level for the Dow Jones or the Standard and Poor's 500 index based on a multiple of estimated earnings; a P/E ratio for the entire market. One of the easiest mistakes we can make is to assume these estimated market P/E ratios are normal and can be relied upon to estimate the fair value of an individual common stock. Mr. Bernhard reminds us that each company has its own individual price/earnings ratio and we must discard the idea of a general price/earnings ratio for all stocks.

    Market forecasts are fun to read. Some will prove to be accurate, most will not. More importantly for us is that we understand that a market forecast is just an educated guess and should not be used to estimate whether an individual company is a bargain or if it is fully valued.

    Until next time,

    Kendall J. Anderson, CFA

    ___________________________________________________

    Anderson Griggs & Company, Inc., doing business as Anderson Griggs Investments, is a registered investment adviser. Anderson Griggs only conducts business in states and locations where it is properly registered or meets state requirement for advisors. This commentary is for informational purposes only and is not an offer of investment advice. We will only render advice after we deliver our Form ADV Part 2 to a client in an authorized jurisdiction and receive a properly executed Investment Supervisory Services Agreement. Any reference to performance is historical in nature and no assumption about future performance should be made based on the past performance of any Anderson Griggs' Investment Objectives, individual account, individual security or index. Upon request, Anderson Griggs Investments will provide to you a list of all trade recommendations made by us for the immediately preceding 12 months. The authors of publications are expressing general opinions and commentary. They are not attempting to provide legal, accounting, or specific advice to any individual concerning their personal situation. Anderson Griggs Investments' office is located at 113 E. Main St., Suite 310, Rock Hill, SC 29730. The local phone number is 803-324-5044 and nationally can be reached via its toll-free number 800-254-0874.

    Dec 02 9:59 AM | Link | Comment!
  • John Templeton's 22 Maxims For Investors And 6 Factors For Analysts

    John Templeton was one of the greatest mutual fund managers of the 20th century. The Templeton Growth Fund was established in 1954. From then until Mr. Templeton sold the fund in 1992, a $10,000 investment with dividends and capital gains reinvested would have grown to $2 million.

    Much of what Mr. Templeton shared through his writings and interviews found its way into my own approach to portfolio management. He paid very little attention to the markets, concentrating instead on buying companies throughout the world that were bargains. If bargains were not available, he would hold as much as 50% of his portfolio in cash, knowing that opportunities to invest would become available in the near future. He held on to companies for an average of four years. If his analysis was right, he would earn a "double play" profit from both increased earnings and a higher multiple of those earnings.

    Mr. Templeton died in July 2008 at the age of 95. His wisdom and guidance deserves to be remembered. In 1983, William Proctor published The Templeton Touch and provided us with Mr. Templeton's maxims for individual investors.

    John Templeton's 22 Maxims for Investors

    1. For all long-term investors, there is only one objective - "maximum total real return after taxes."
    2. Achieving a good record takes much study and work, and is a lot harder than most people think.
    3. It is impossible to produce a superior performance unless you do something different from the majority.
    4. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.
    5. To put "Maxim 4" in somewhat different terms, in the stock market the only way to get a bargain is to buy what most investors are selling.
    6. To buy when others are despondently selling and to sell when others are greedily buying requires the greatest fortitude, even while offering the greatest reward.
    7. Bear markets have always been temporary. Share prices turn upward from one to twelve months before the bottom of the business cycle.
    8. If a particular industry or type of security becomes popular with investors, that popularity will always prove temporary and, when lost, won't return for many years.
    9. In the long run, the stock market indexes fluctuate around the long-term upward trend of earnings per share.
    10. In free-enterprise nations, the earnings on stock market indexes fluctuate around the replacement book value of the shares of the index.
    11. If you buy the same securities as other people, you will have the same results of other people.
    12. The time to buy a stock is when the short-term owners have finished their selling, and the time to sell a stock is often when the short-term owners have finished their buying.
    13. Share prices fluctuate much more widely than values. Therefore, index funds will never produce the best total return performance.
    14. Too many investors focus on "outlook" and "trend." Therefore, more profit is made by focusing on value.
    15. If you search worldwide, you will find more bargains and better bargains than by studying only one nation. Also, you gain the safety of diversification.
    16. The fluctuation of share prices is roughly proportional to the square root of the price.
    17. The time to sell an asset is when you have found a much better bargain to replace it.
    18. When any method for selecting stocks becomes popular, then switch to unpopular methods. As has been suggested in "Maxim 3," too many investors can spoil any share-selection method or any market-timing formula.
    19. Never adopt permanently any type of asset or any selection method. Try to stay flexible, open minded and skeptical. Long-term top results are achieved only by changing from popular to unpopular the types of securities you favor and your methods of selection.
    20. The skill factor in selection is largest for the common-stock part of your investments.
    21. The best performance is produced by a person, not a committee.
    22. If you begin with prayer, you can think more clearly and make fewer stupid mistakes.

    John Train, in his excellent book The Money Masters, shared Mr. Templeton's advice on stock selection.

    John Templeton's Six Factors for Security Analysts

    1. The price-earnings ratio.
    2. Operating profit margins.
    3. Liquidating value.
    4. Consistency and growth rate of earnings.
    5. Flexibility.
    6. Don't trust rules and formulas.

    I want to draw your attention to these because I believe they have important implications for investors today. Although we can learn from each one, I particularly want to discuss the sixth factor, "Don't trust rules and formulas." Mr. Templeton employed these maxims and factors before the average person had access to a computer. Today, however, due to the low cost of computing power, formulaic investing has become a norm that is broadly promoted by brokers, investment advisors, and of course those on-line companies who assure you that a computer can manage your money better than any individual. In The Money Masters, Mr. Templeton shares a story that his former partner, from his original investment firm Templeton, Dobbrow & Vance, presented in lectures about investing. In the story, Vance warns the audience about relying upon formulas to select securities.

    Templeton's sometimes partner Vance, then an elderly man, used to enjoy lecturing about investments. Part of his kit was a huge chart plotted on a roll of wrapping paper. It was so big that during his lectures he would have to get a volunteer from the audience to help him unroll it and put it on the wall. This chart plotted the market for the previous twenty years. Then there were different squiggly lines representing the various factors that influence it - industrial production, money supply and so on. One squiggly line was best of all. It worked perfectly. Year after year if you had followed it you could have known where the market was headed and made a killing. When the audience, fascinated, demanded to know what it represented, Mr. Vance told them. It was the rate his hens were laying, in the chicken coop in back of his house.

    Virtually every formula I have ever seen is based on some historical relationship between one or a multitude of factors that proves, without a doubt, if you had just made your investments according to that formula, you would be rich today. Of course, in order for you to get rich based on these past relationships, the future would have to unfold identically to the past.

    It is rare for an investment advisor to work directly with an individual to build and maintain a portfolio of individual securities based on fundamental analysis. As rare as it is, we assure you that we will continue to offer this personal service to each of you for as long as we can.

    Until next time,

    Kendall J. Anderson, CFA

    ___________________________________________

    Anderson Griggs & Company, Inc., doing business as Anderson Griggs Investments, is a registered investment adviser. Anderson Griggs only conducts business in states and locations where it is properly registered or meets state requirement for advisors. This commentary is for informational purposes only and is not an offer of investment advice. We will only render advice after we deliver our Form ADV Part 2 to a client in an authorized jurisdiction and receive a properly executed Investment Supervisory Services Agreement. Any reference to performance is historical in nature and no assumption about future performance should be made based on the past performance of any Anderson Griggs' Investment Objectives, individual account, individual security or index. Upon request, Anderson Griggs Investments will provide to you a list of all trade recommendations made by us for the immediately preceding 12 months. The authors of publications are expressing general opinions and commentary. They are not attempting to provide legal, accounting, or specific advice to any individual concerning their personal situation. Anderson Griggs Investments' office is located at 113 E. Main St., Suite 310, Rock Hill, SC 29730. The local phone number is 803-324-5044 and nationally can be reached via its toll-free number 800-254-0874.

    Sep 30 12:49 PM | Link | Comment!
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