Take Your Losses Early and Often

With market volatility picking up this past week, now is as good a time as any to review why it’s important to take your losses early.

Portfolio LossGain Required to Break Even
(10%)11%
(20%)25%
(30%)43%
(40%)67%
(50%)100%
(60%)150%
(70%)233%
(80%)400%
(90%)900%
(97%)3,233%

If you lose 10%-20% in a trade, it’s not that hard to recover. It only takes 11% – 25% to get back to where you started.

But if you lose 50%, you need 100% returns to get back to break even. Or if you lose 97% — as Bill Ackman recently did in Valeant Pharmaceuticals — you’d need a ridiculous 3,233% on your next trade just to get back to zero.

I have a select few stocks in my portfolio that I’m truly willing to buy and hold, tolerating whatever volatility the market throws at me. As an example, I own some shares of Realty Income (O) that I will never sell. I’m reinvesting the dividends and letting them compound, and I’m willing to sit through a significant drawdown.

But for the lion’s share of my portfolio, I take my losses early. I’ve taken enough losses over the years to learn that lesson the hard way…

 

 

This article first appeared on Sizemore Insights as Take Your Losses Early and Often

Looking Beyond the 60/40 Portfolio in an Era of Low Returns

I wrote earlier this year that the 60/40 portfolio is dead. Well, rumors of its death were not greatly exaggerated. The 60/40 portfolio that served retired investors so well over the past 30 years is gone… and it’s not coming back any time soon. As investors, we have to move on.

Rest in Peace 60/40 Portfolio

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While it’s true that a simple 60/40 portfolio of the SPDR S&P 500 ETF (SPY) and the iShares Core US Aggregate Bond ETF (AGG) is actually enjoying a nice run in 2016, up a little more than 3% for the year, don’t get used to it. The math simply doesn’t work out going forward.

Let’s play with the numbers. Back in 1980, the 10-year Treasury yielded a fat 11.1%, and stocks sported an earnings yield (calculated as earnings / price, or the P/E ratio turned upside down) of 13.5%. This implied a back-of-the-envelope portfolio return of about 12.5% per year going forward, and for much of the 1980s and 1990s that proved to be a conservative estimate. Both stocks and bonds were priced to deliver stellar returns, and both most certainly did.

But what about today? The 10-year Treasury yields a pathetic 1.6% and the S&P 500 trades at an earnings yield of just 4%. That gives you a blended portfolio expected return of an almost embarrassing 2.8%. [Note: The usual disclaimers apply here. These are not intended to be precise market forecasts.]

You know the refrain: past performance is no guarantee of future results. There is no guarantee, at least with respect to stocks, that expensive assets can’t get even more expensive. It’s possible that the great bull run in stocks could continue indefinitely, however unlikely it might be.

But I can’t say the same for bonds. Starting at a 1.6% yield to maturity (or even the 4% you might find on a mid-grade corporate bond) you cannot have returns going forward that are anything close to the returns of the past several decades. Bond yields would have to go negative, and I don’t mean the (0.15%) we see today on the Japanese 10-year bond. I’m talking (5%) or (10%) or even more.

That’s not going to happen. Or if somehow it did — if investors got so petrified that they piled into bonds to the extent that yields went negative to that degree — then I would assume the stock portion of your portfolio effectively fell to zero at that point.

The bottom line here is that even under the most optimistic scenario, investors are looking at disappointing returns in a standard 60/40 portfolio.

So, what are investors supposed to do about it? They can’t just stuff their cash in a mattress for the next 5-10 years. Most of us actually need to earn a return on our money.

I’d offer the following suggestions:

Consider taking a more active approach to investing.

To the extent you invest in traditional stocks and bonds, don’t be a buy and hold index investor. Yes, low fees are great. But the fact that you paid Vanguard only 0.09% per year in management fees won’t really matter if you’re returns are still close to zero.

Instead, try a more active strategy, perhaps focusing on value or momentum. Or perhaps try a dividend focused strategy. With a dividend strategy, you can realize a cash return even if the market goes nowhere for years at a time.

Consider investing outside of the market.

If you’re willing to get your hands dirty, consider starting your own business or investing in a cash flowing rental property. Yes, there is more work involved, and there is the risk of failure. But there is also risk in trusting your savings to a fickle market when both stocks and bonds are both expensive by historical standards.

Consider a truly alternative asset allocation.

This final point is really my specialty. To the extent I can, I am eliminating traditional bonds from the portfolios of most of my clients and replacing them with non-correlated (or at least minimally-correlated) alternative investments. A standard 60/40 stock / bond portfolio might instead become a 50/50 dividend stocks / alternative investments portfolio.

Alternative investments” is a generic term that can mean just about anything. In practice, for me it has meant a combination of long/short strategies, options writing strategies, absolute return hedge funds, and liquid alternative portfolios.

Will a non-traditional portfolio like this outperform over time?

Frankly, I don’t know. No one does. We’ve never seen a market like today’s.

But to me, it’s the only move that makes sense. Taking the traditional path is a virtual guarantee of disappointment. Incorporating alternatives into the portfolio at least give us the potential for solid returns.

Charles Lewis Sizemore, CFA is the principal of Sizemore Capital, an investments firm in Dallas, Texas.

Photo credit: Pheonix149

In Defense of Hedge Funds…

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Photo credit: Sean Davis

Hedge funds don’t get a lot of love these days. They’ve underperformed for years, and their fees — the standard is 2% of assets and 20% of profits — make them a pariah in the age of indexing and low-cost robo advisors.

Hey, I get it. The high fees and lousy performance of competing hedge funds was a major reason that I started a liquid alternative robo advisor with my partner, Dr. Phillip Guerra. We run a suite of risk parity portfolios that hold their own against comparable hedge funds… and we do it at a fraction of their fees.

Yet let’s not throw out the baby with the bathwater. While many — perhaps most — hedge funds add no real value and certainly don’t justify their fees, there are plenty of hedge funds that absolutely do add value and deserve every last cent. But how do you separate the wheat from the chaff?

Ask yourself the following questions:

Does the fund do something unique that realistically cannot be replicated in a cheaper and more transparent vehicle, such as an ETF, mutual fund or managed account?

Really dig deep here. If the fund is a long-only large cap fund, you should be skeptical as to whether the hedge fund structure is necessary. If the fund employs sophisticated hedges that would be hard to implement in a smaller managed account, then the hedge fund structure is probably justified.

Does the fund deal in illiquid securities that would justify the lack of liquidity of the fund itself?

Years ago, a hedge fund in the DFW area made a fortune buying idled planes from the major airlines. Needless to say, that sort of thing would be impossible to replicate in a mutual fund, ETF or managed account. It’s virtually impossible (or at least impractical) to securitize an airplane. On a similar note, in the past I have placed accredited investor clients in a fund that finances medical accounts receivable that might take two years or more to pay off. It’s hard to see a strategy like that working in a mutual fund that promises daily liquidity.

Does the fund have a strategy that would be fundamentally undermined by investor redemptions?

Think about corporate raiders like Daniel Loeb or Carl Icahn. These guys are known for amassing massive stakes in companies and then using their clout to force change, including booting out management that is underperforming. That only works if you have a stable pool of capital. Imagine Loeb attempting to take over a company and then having to back away with his tail tucked between his legs because he had a wave of shareholder redemptions.

When your advisor pitches you a hedge fund, you shouldn’t necessarily recoil in horror. I regularly incorporate hedge funds into the portfolios of my accredited investor clients when they fill a specific niche I’m trying to fill. And to date (knock on wood), I have yet to have a major disappointment on this front. I’ve lost plenty of money for myself and clients in low-cost ETFs and mutual funds, though I’ve never lost money (again, knock on wood) investing in a good alternative manager or hedge fund. I probably will at some point. You know the drill, past performance is no guarantee of future results. But I can credibly say that it hasn’t happened yet.

Before you invest a single red cent in a hedge fund, ask yourself the questions above. Hedge funds are certainly not for everyone, but if utilized correctly they can reduce portfolio volatility without sacrificing returns.

Charles Lewis Sizemore, CFA is the principal of Sizemore Capital, an investments firm in Dallas, Texas.

This article first appeared on Sizemore Insights as In Defense of Hedge Funds…

Why Dividends Matter

Feel free to use this image, just link to www.SeniorLiving.Org
Photo credit: www.SeniorLiving.Org

I like getting paid in cold, hard cash. And frankly, who doesn’t?

But stock dividends are more than just a quarterly paycheck. They are a way of doing things. I would go so far as to argue that they are a philosophy of life (or at least of business).

That might sound a little kooky at first, but hear me out.

In the Wolf of Wall Street, Jordan Belfort (or at least Leonardo DiCaprio playing Belfort) says that money does more than just buy you a better life; it also makes you a better person. That’s certainly debatable. But I can credibly say that paying a dividend makes for a better kind of company. And here are a few reasons why:

  1. Dividends are an outward, visible sign of who the real boss is. Remember, the SEO in the suit running the company isn’t the owner. He’s an employee, no different than a common assembly line worker other than for his larger paycheck. You, the shareholder, own the company. And management shows that they understand and respect that by regularly paying and raising the quarterly dividend.
  2. Dividends dissuade fruitless empire building. Corporate CEOs really aren’t that different from politicians. At the end of the day, they spend other people’s money and often times waste it on useless projects or on mergers that add no value. Why? Because growth – even unprofitable growth – gives them more power and control. Well, paying a regular dividend forces management to be more disciplined. If you’re paying out half your profits as a dividend, you have to be more selective about the growth projects you choose to pursue with your remaining cash. They focus on the most profitable and worthwhile and, by necessity, pass on the marginal ones.
  3. Dividends foster more honest financial reporting. At one point or another, many (if not most) companies will… ahem… perhaps be a little less than honest in their financial reporting. Outright fraud is pretty rare. But accounting provisions allow for a decent bit of wiggle room in how revenues and profits are reported. Even professionals can have a hard time figuring out what a company’s true financial position is if the numbers are fuzzy enough. Well, while revenues and profits can be obfuscated by dodgy accounting, it’s hard to fudge the numbers when it comes to cold, hard cash. For a company to pay a dividend, it has to have the cash in the bank. So while paying a good dividend is no guarantee that the company isn’t being a little aggressive with its accounting, it definitely acts as an additional check.
  4. Share buybacks – the main alternative to cash dividends – never quite seem to work out as planned. Companies inevitably do their largest share repurchases when times are good, they are flush with cash, and their stock is sitting near new highs. But when the economy hits a rough patch, sales slow, and the stock price falls, the buybacks dry up. And another (and frankly insidious) motivation for buybacks is to “mop up” share dilution from executive stock options and employee stock purchase plans. The net effect is that a company buys their shares high and sells them back to employees and insiders low. Call me crazy, but I thought the whole idea of investing was to buy low and sell high, not the other way around. A better and more consistent use of cash would be the payment of a cash dividend.
  5. And finally, we get to stock returns. I’m not particularly excited about the prospects for the stock market at today’s prices. Based on the cyclically adjusted price/earnings ratio, the S&P 500 is priced to deliver annual returns of virtually zero over the next decade. But if you’re getting a dividend check every quarter, you’re still able to realize a respectable return, even if the market goes nowhere. And that return is real, in cold hard cash, and not ephemeral like paper capital gains.

Hey, not every great company pays a dividend. And certainly, a younger company that is struggling to raise capital to grow has no business paying out its precious cash as a dividend when it might need it to keep the lights on next month. But for the bulk of your stock portfolio – the core positions that really make up your nest egg – look for companies that have a long history of paying and raising their dividends.

Charles Lewis Sizemore, CFA is the principal of Sizemore Capital, an investments firm in Dallas, Texas.

 

How to Become a Financial Blogger

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My financial practice is an interesting creation of the internet era. I don’t do a lot of face-to-face networking, and I very rarely host dinners or live events. It’s not that I’m against doing these things but rather than they are expensive and time consuming, and I’m not very good at them. If these things were required to build a practice these days, then I would have never gotten off the ground.

I really don’t go out looking for clients. Most of my clients end up finding me after reading an article I wrote that made sense to them. In addition to my own blog, I regularly publish on Yahoo Finance, Forbes and Kiplinger’s, among other sites, so I manage to get in front of a lot of eyeballs.

I often get asked how I got into financial blogging. And my answer is always the same: I have no idea. It just sort of happened.

It was an odd experiment in trial and error, which means that I made every mistake there was to make before finally exhausting them all and managing to do a few things right. For any aspiring financial bloggers out there, I’m happy to share a little of what I’ve learned the hard way. This is by no means an exhaustive list and by no means a guaranteed path to success. There is always an element of being in the right place at the right time, but perhaps this list can better your chances of getting to that right place at the right time.

So with no more ado, here are my tips for cutting your teeth in financial blogging.

1. Use your real name and face. I have a simple policy on Twitter and StockTwits. If a person has a ridiculous handle (“KickassTrader47”) and uses a picture of a Star Wars character as their profile picture, this is not a person I take seriously. And the same goes for bloggers. First off, using your real name and face creates accountability. You can’t hide from your opinions or past recommendations. You own them, for better or worse.

And remember, as a writer you are building a relationship with your readers, even if you never meet them in person. Using your real name and face make you more personal and allows readers to identify with you and bond with you. That builds loyalty, and you need that.

There are exceptions here. One of my favorite bloggers goes under the pen name Jesse Livermore because his employer won’t allow him to write under his own name. And of course, there is “Tyler Durden” of Zero Hedge, who has created something of a cult following as a doom and gloomer. But these are the exceptions and not the rule. And if you’re wanting to build a brand around yourself, you need to use your own name and face. And don’t forget to smile in the photo.

2. Produce a ton of content. I’m always surprised by which posts of mine really get traction… and which ones flop. Thoughtful posts I’ll spend hours researching might barely get noticed… yet some hatchet job I threw together while watching Battlestar Galactica reruns might go viral. There is really no rhyme or reason to it. It seems to be totally random.

But that’s the nature of the internet. On any given day, a piece you wrote might get lost in the shuffle. But the very next day, an opinion maker might happen to stumble across an article you wrote and post a link to it. So the key is to simply get as much content out there as possible. It’s a numbers game. Put enough good content in front of enough eyeballs, and you’ll eventually get traction. It’s a marathon, not a sprint, and you shouldn’t expect instant success. Just make sure that you consistently publish content that readers will find useful or insightful.

Not every post has to be a masterpiece. I’m published blog posts that were nothing more than an embedded StockTwits tweet or a YouTube video. Just publish something that conveys an idea, even if it is a simple one.

3. Find publishing partners. SeekingAlpha might be the single best thing that ever happened to the aspiring financial writer. Anyone can submit an article. Now, not every article gets prominently published, of course. That’s up to the editors. But anyone that has a good idea to share can share it. Writing for SeekingAlpha got me noticed by InvestorPlace, which in turn got me noticed by other publishers. All of this is part of building name recognition and your personal brand.

You should also reach out to other bloggers and quote posts that you like. And when you do, make sure the blogger knows about it. Find their Twitter or StockTwits handle and post them the link. That can lead to retweets and to more eyeballs for your post.

4. Optimize your posts for search. “Search engine optimization” sounds complicated. It really isn’t.

Sure, you can get really scientific about it, but you don’t necessarily have to. Following a couple basic steps will get you most of the way there. First, you should obviously include the terms that would be relevant for search. If you are writing a piece about Walmart’s earnings release, you should probably include the terms “Walmart earnings” and “WMT earnings” somewhere in the post. You should also try to include those terms in the title of the post and the URL if possible. Second, include relevant outbound links… and if possible, get others to link to you. The more embedded you are in the web, the more you matter to Google.

Along the same lines, if you write about individual stocks, regularly post your pieces to StockTwits and include a cashtag. For example, if writing about Walmart, include “$WMT” in your tweet. This will get your tweet in the message stream for that stock… and get you on the Yahoo Finance page for that stock too under Market Pulse.

5. Have fun. And finally, have fun with it. If you enjoy what you do and your personality comes out in the posts, people will gravitate to you. If your posts read like a lifeless Reuters press release generated by a computer, they won’t. People crave human interaction and want to read the work of a real person, typos and all.

I try to keep it somewhat professional though certainly not formal. Basically, this means that I avoid profanity and personal insults and try to avoid industry jargon (no one wants to read about EBITDA). But importantly, I try to make it lively.  You don’t have to have the writing skills of Ernest Hemingway. You just need to have something a interesting to say.

And finally, I would add that superficial touches can make a big difference. Add a stock photo from Flickr or Google Images to add a little color to your post. And stock charts from BigCharts or any number of other sources make for a nice effect too.

Best of luck. The pool of quality financial bloggers gets bigger every day. There is no reason why you can’t be one of them.

Charles Sizemore is the principal of Sizemore Capital, a wealth management firm in Dallas, Texas. 

Photo credit: Mike Licht

 

Blast from the Past: Walmart Dividend Letter from 1985

I was digging through an old file cabinet that had belonged to my grandfather, and I found this little blast from the past: a Walmart (WMT) letter to shareholders from 1985, signed by Chairman and company founder Sam Walton.

As a child in the 1980s, I actually remember my grandfather proudly showing me a paper certificate for his shares of Walmart stock, and I remember the day he went electronic by handing the paper certificates to the trust department at the bank. He wasn’t sure he trusted the system and made sure to photocopy his certificates before handing them over…just in case.

Paper stock certificates seem so anachronistic today in this age of online trading and instant liquidity. It makes me wonder how different the world of trading and investment will be when my future grandchildren are going through a drawer of my personal effects.

1985 Walmart Dividend Letter

The truth is, I’m not sure how beneficial instant liquidity is in building long-term wealth. In fact, it’s probably downright detrimental. When my grandfather bought his shares of Walmart, the high cost of trading discouraged him from short-term trading. As a result, he was a de facto long-term investor, which ended up working out to his benefit as Walmart grew into one of the largest and most successful companies in history. Long after my grandfather passed away, the cash dividends from the Walmart stock he accumulated in his lifetime continued to pay for the retirement expenses of my grandmother–and for my college tuition! Had my grandfather had access to the instant liquidity of today, he might have been tempted to sell far too early.

My grandfather also practiced his own version of Peter Lynch’s advice to invest in what you know long before Peter Lynch became a household name. He was an Arkansas boy–born and raised not far from Fort Smith–and he liked to invest in local companies that he could observe firsthand. Walmart was one of those local companies; its headquarters in Bentonville is less than an hour and a half from Fort Smith by car.

I remember fondly my grandfather taking me to Fort Smith’s Walmart and buying me an Icee at the snack bar. He liked to walk the aisles personally to see what Mr. Walton was doing with his money. That might seem a little old fashioned today, but then, it’s still the approach taken by Warren Buffett and by plenty of long-term value investors. If done right, it works.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.

Worthless: Thoughts on Investing in Collectibles

My favorite historical anecdote—and one that every investor should be forced to acknowledge reading before opening a brokerage account—dates to the era of the South Sea Bubble. A charlatan whose name is lost to history, published a prospectus forA company for carrying on an undertaking of great advantage, but nobody to know what it is.” 

Yes, some 18th-century two-bit hustler launched an IPO for a company with a “top secret” business plan, and British investors actually gave him money.  If contemporary accounts are true, he took the money and fled to Europe, never to be seen or heard from again.

As a student of market history, I’ve come away with one enduring observation: investors can be phenomenally stupid.  Whether it is profitless social media stocks, Miami condos, or, if you want to go old school, decorative tulip bulbs, there seems to be no limit to the force with which otherwise sane people will suppress rational thought in order to throw away their hard-earned money.

But as crazy as stock market bubbles can be, they really don’t compare to collectibles crazes. A share of stock represents a claim of ownership in a business that, however implausibly, could someday generate real profits.  A collectible’s value, on the other hand, rest entirely on your ability to someday sell it to a greater fool.

In some cases—think Renaissance paintings—collectibles have maintained their value over time and proven to be fantastic investments.  Others…well, let’s just say that Star Wars Happy Meal toys might not be as good of investments as Old Masters.

Let’s take a look at two high-profile collectible bombs of recent decades, and then I’ll offer a little guidance on how not to fall victim to the next collectible fad.

Baseball Cards

I’ll start with one that I myself fell victim to in my late childhood: baseball cards.

I loved baseball as a boy and would subject my poor father to hours of inane player statistics. (He showed remarkably patience…a virtue I hope I can repeat when my own sons get old enough to badger me with meaningless statistics from the hobby of their choice.)

In the days before the internet, baseball cards were the perfect way to access years’ worth of player statistics, and I legitimately enjoyed organizing my cards into albums…and spending hours thumbing through the albums.

Then, somewhere around the late 1980s, it all got adulterated.  Baseball cards ceased to be a little boy’s objects of adoration and become “investments.” I stopped touching my “valuable” baseball cards for fear of degrading their mint condition, choosing instead to encase them in hard-shell plastic cases. I subscribed to Beckett Baseball Card Monthly, the authority on baseball card prices, and read it religiously.  I also stopped buying packets of cards as prices rose, choosing instead to buy individual cards of the most valuable players.  Not my favorite players, mind you, but rather the players whose cards were the most valuable at that time.

In Mint Condition, Dave Jamieson tells the story of the Great Baseball Card Bubble of the late 1980s and early 1990s, and The Slate published a fantastic excerpt here, which I quote below.

By the ’80s, baseball card values were rising beyond the average hobbyist’s means. As prices continued to climb, baseball cards were touted as a legitimate investment alternative to stocks, with the Wall Street Journal referring to them as sound “inflation hedges” and “nostalgia futures.” Newspapers started running feature stories with headlines such as “Turning Cardboard Into Cash” (the Washington Post)…

Precious few collectors seemed to ponder the possibility that baseball cards could depreciate. As the number of card shops in the United States ballooned to 10,000, dealers filled their storage rooms with unopened cases of 1988 Donruss as if they were Treasury bills or bearer bonds. Shops were regularly burglarized, their stocks of cards taken as loot. In early 1990, a card dealer was found bludgeoned to death behind the display case in his shop in San Luis Obispo, Calif., with $10,000 worth of cards missing.

It was a full-blown speculative mania.  And like all speculative manias, it didn’t end well.  High prices encouraged a massive increase in supply of the “investment,” no different than in the internet mania of the 1990s or the South Sea Bubble I mentioned at the beginning of this article, when companies couldn’t dilute their stock fast enough to meet investor demand .  As Jamieson continues,

Unfortunately for investors, each one of those cards was being printed in astronomical numbers. The card companies were shrewd enough never to disclose how many cards they were actually producing, but even conservative estimates put the number well into the billions. One trade magazine estimated the tally at 81 billion trading cards per year in the late ’80s and early ’90s, or more than 300 cards for every American annually.

At some point, something just clicked in my mind and collecting baseball cards lost its appeal. There was nothing enjoyable about having to elbow my way past sweaty, bearded, middle-aged men to bid for a piece of cardboard encased in glass.  The massive influx of new “premium” card series were hard to keep track of and, in any event, out of my price range.  And frankly, as I entered my teenage years, I discovered girls and pretty well lost interest in anything related to baseball statistics. The baseball card bubble crashed soon thereafter, and my “valuable” investments became all but worthless.

New baseball card sales were a $1.5 billion industry in 1992.  Today, the number is closer to $200 million, a drop of nearly 90%, and that does not include the effects of inflation.  The number of baseball card shops has shrunk from over 10,000 to less than 200.  And the value of all of those premium Upper Deck baseball cards?  You’d be lucky to get a couple cents for them.

Beanie Babies

I was thankfully too old to have ever played with a Beanie Baby and too young to have ever purchased one for my kids.  But I remember the Beanie Baby Bubble well, and it is as baffling to me today as it was in its mid-1990s heyday.

Beanie Babies were adorably cute bean-bag toys for babies and small children, and I understand their appeal—as toys for children.  How this became an investment fad for otherwise sane adults is something sociologists are no doubt still studying, but one family famously lost $100,000 when the bubble burst about 25 years ago.  And that’s $100,000 in late 1990s dollars.  Tack on another 30%-40% to get an estimate in today’s dollars.

John Aziz gives a nice telling of the Beanie Baby Bubble story here.  Beanie Babies were originally marketed as affordable toys for children, usually priced around $5.  But because they were originally sold at smaller stores and had a certain aura of exclusivity about them, they quickly became an object of speculation.  And the enabling tools of speculation soon followed: baseball cards had Beckett Baseball Card Monthly; Beanie Babies had Mary Beth’s Bean Bag World, which at one point had a circulation of 650,000 readers.

What made people believe that Beanie Babies had value?  Part of it was artificially constrained supply.  The manufacturer intentionally kept production down to create an air of exclusivity (yes…in a beanbag toy). Beyond this, it was a case of rising prices begetting rising prices.  The high prices attracted new speculator, who in turn sent prices even higher.

At some point, there were not enough new buyers to keep prices rising, and the bottom fell out.  Today, “investment grade” Beanie Babies that once sold for hundreds or thousands of dollars can be had for less than $10.  Which, after all, is a fair price for a cute toy made to be played with by young children.

So, how can you know ahead of time if a collectible is an enduring masterpiece or a ridiculous fad that will make you an object of ridicule among your closest friends and family?

There are no hard and fast rules here, but I would give two broad guidelines to consider:

  1. The rarity of the object in question, and
  2. What drives its perception of value.

I’ll start with rarity.  Rarity is not a guarantee of high prices, but it is definitely a precondition.  The mass-produced baseball cards from the late 1980s are all but worthless, but truly rare baseball cards have actually held their value surprisingly well.  A 1909 T206 Honus Wagner card can be expected to clear well over $1 million at auction.

This brings me to perception of value.  Rarity alone does not make the Wagner card valuable; there has to be something that makes the object special.  Among baseball aficionados, Wagner was considered to be one of the all-time greatest players.  And there is a mystique about the card itself because Wagner ordered its production stopped; he was uncomfortable with the fact that his image was being used to sell tobacco to children.

The same is true of paintings.  And Old Master is priceless because of its rarity but also for its beauty, the quality of the artwork, and legendary status that the painters have acquired with the passing of time.

So, before you consider investing in collectibles, ask yourself: Is the object sufficiently rare, and has its perception of value withstood the test of time?

But beyond this, I would offer one last piece of advice.  Don’t view a collectible as an investment at all or you lose that “special something” that make it valuable to begin with. Buy it because of the way it makes you feel, with the assumption that, even if its monetary value fell to zero, it’s still something you’d proudly display in your home.

 

 

The Biggest Mistake of Warren Buffett’s Career

Warren Buffett is a hero to many investors, myself included.  His record speaks for itself: 18.3% annualized returns in Berkshire Hathaway’s ($BRK-A) book value over the past 30 years compared to just 10.8% for the S&P 500.  And his returns in the 1950s and 1960s, when he was running a much smaller hedge fund, were even better.

Mr. Buffett is also quite generous with his investment wisdom, sharing it freely with anyone who cares to listen.  But as with most things in life, failure is a better teacher than success.  And Mr. Buffett has had his share of multi-billion-dollar failures.

You want to know the biggest mistake of Buffett’s career?

By his own admission, it was buying Berkshire Hathaway!

Everyone assumes that Buffett’s decision to buy Berkshire Hathaway was a typical Buffett stroke of genius.  Nothing could be further from the truth.

We like to think of Warren Buffett as the wise, elder statesman of the investment profession, but Buffett too was young once and prone to the rash behavior of youth.  And Berkshire Hathaway was not always a financial powerhouse; it was once a struggling textile mill.

Buffett had noticed a trading pattern in Berkshire’s stock; when the company would sell off an underperforming mill, it would use the proceeds to buy back stock, which would temporarily boost the stock price. Buffett’s strategy was to buy Berkshire stock each time it sold a mill and then sell the company its stock back in the share repurchase for a small, tidy profit.

But then ego got in the way.  Buffett and Berkshire’s CEO had a gentleman’s agreement on a tender offer price.  But when the office offer arrived in the mail, Buffett noticed that the CEO’s offer price was 1/8 of a point lower than they had agreed previously.

Taking the offer as a personal insult, Buffett bought a controlling interest in the company so that he could have the pleasure of firing its CEO.  And though it might have given him satisfaction at the time, Buffett later called the move a “200-billion-dollar mistake.”

Why?  Because Buffett wasted precious time and capital on a textile mill in terminal decline rather than allocate his funds in something more profitable—in his case, insurance.

By Buffett’s estimates, had he never invested a penny in Berkshire Hathaway and had instead used his funds to buy, say, Geico, his returns over the course of his career would have been doubled.  Berkshire will still go down in history as one of the greatest investment success stories in history, of course.  But it was a terrible investment and a major distraction that cost Buffett dearly in terms of opportunity cost.

What lessons can we learn from this?  I’ll leave you with two quotes from Buffett himself:

“If you get into a lousy business, get out of it.”

“If you want to be known as a good manager, buy a good business.”

In trader lingo, cut your losers and let your winners ride.  Holding on to a bad investment wastes good capital and mental energies that would be better put to use elsewhere.

Thank you, Mr. Buffett, for sharing your failures with us.  Your willingness to do so is one of the reasons we love you.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.

Is Sears the Next Berkshire Hathaway?

I originally penned this articled in December 2011.  Given Sears’ stock action in the year that has passed, it’s worth another read.

A well-respected value investor buys an old American company in decline, promising to restore its fortunes.  Alas, the recovery never comes.  The economics of the industry have changed, and the company cannot compete with younger, nimbler rivals.  The company ceases operations, but the value investor holds onto the shell to use as an investment vehicle.

Could this be the future of Sears Holdings (Nasdaq: $SHLD) under Eddie Lampert?  Maybe; maybe not.  But it was certainly the case for Warren Buffett’s Berkshire Hathaway (NYSE: $BRK-A).

Unless you’re a history buff or a dedicated Buffett disciple, you might not have known that Berkshire Hathaway was not always an insurance and investment conglomerate.  It was a textile mill, and not a particularly profitable one.  It was, however, a cash cow.  And after buying the company in 1964, Buffett used the cash that the declining textile business threw off to make many of the investments he is now famous for, starting with insurance company Geico.

So, when hedge fund superstar Eddie Lampert first brought Kmart out of bankruptcy in 2003, the parallels were obvious.  With its debts discharged, the retailer would throw off plenty of cash to fund Lampert’s future investments.  And even if the retail business continued to struggle, Lampert could—and did—sell off some of the company’s prime real estate to retailers in a better position to use it.  Lampert sold 18 stores to the Home Depot (NYSE: $HD) for a combined $271 million in the first year.

That Lampert would use Kmart’s pristine balance sheet to purchase Sears, Roebuck, & Co.—itself a struggling retailer—seemed somewhat odd, but his management decisions after the merger seemed to confirm that his strategy was cash cow milking.   Lampert continued to talk up the combined retailer’s prospects, of course.  But his emphasis was on relentless cost cutting, and he invested only the absolute bare minimum to keep the doors open.  Sears Holdings didn’t have to compete with the likes of Home Depot or Wal-Mart (NYSE: $WMT). It just had to stay in business long enough for Lampert to wring out every dollar he could before selling off the company’s assets.

The strategy might have played out just fine were it not for the bursting of the housing bubble—which killed demand for the company’s Kenmore appliances and Craftsman tools—and the onset of the worst recession in decades.  With retail sales in the toilet (and looking to stay there for a while), there was little demand among competing retailers for the company’s real estate assets.

It’s fair to blame Lampert for making what was, in effect, a major real estate investment near the peak of the biggest real estate bubble in American history.  But investors  frustrated by watching the share price fall by more than 80 percent from its 2007 highs have no one to blame but themselves.   Anyone who bought Sears when it traded for nearly $200 per share clearly didn’t do their homework.  They instead were hoping to ride Lampert’s coattails while somehow ignoring the value investor’s core principle of maintaining safety by not overpaying for assets.

Lampert is a great investor with a great long-term track record, and there is nothing wrong with paying a modest “Lampert premium” for shares of Sears Holdings.  If you like Lampert’s investment style but lack the means to invest in his hedge fund, Sears may be the closest you can get.  But at $200 per share—or even $100—the Lampert premium had been blown completely out of proportion.  The same is true of Buffett, of course, or of any great investor.  As the Sage of Omaha would no doubt agree, there is a price at which Berkshire Hathaway is no longer attractive either.

This brings us back to the title of this piece—is Sears the Next Berkshire Hathaway?

I would answer “yes,” but not necessarily for the reasons you think.

Everyone assumes that Buffett’s decision to buy Berkshire Hathaway was a typical Buffett stroke of genius.  Nothing could be further from the truth.  In fact, Buffett revealed in an interview last year that Berkshire Hathaway was the worst trade of his career.



If you cannot view the video above, please follow this link: “Buffett’s Worst Trade
 

We like to think of Warren Buffett as the wise, elder statesman of the investment profession, but Buffett too was young once and prone to the rash behavior of youth.  He had been trading Berkshire Hathaway’s stock in his hedge fund; he noticed that when the company would sell off an underperforming mill, it would use the proceeds to buy back stock. Buffett intended to sell Berkshire Hathaway its own stock back for a small, tidy profit.

But due to a tender offer that Buffett took as a personal insult, he essentially bought a controlling interest in the company so that he could have the pleasure of firing its CEO.  And though it might have given him satisfaction at the time, Buffett called the move a “200-billion-dollar mistake.”

Why?  Because Buffett wasted precious time and capital on a textile mill in terminal decline rather than allocate his funds in something more profitable—in his case, insurance.  Berkshire Hathaway will still go down in history as one of the greatest investment success stories in history.  But by Buffett’s own admission, he would have had far greater returns over his career had he never touched it.

So, in a word, “yes.”  Sears probably is the next Berkshire Hathaway.  And investors who buy Sears at a reasonable price will most likely enjoy enviable long-term returns as Lampert’s plans are eventually realized.   But Mr. Lampert himself will almost certainly come to regret buying the company—if he doesn’t already.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.