February 7, 2007 – Let’s take BHP Billiton, the world’s largest, diversified mining company, to illustrate the point of this blog entry. For the past couple of months, when BHP Billiton was trading below $40 a share, and it stayed below $40 a share for a long time, I told several friends that were looking for something to buy that BHP under $40 a share was a good buy. For two months, they could have bought BHP between $37 and $40 a share, but yet I doubt that any of them did. Why? I know the mindset of most investors. Most investors want to see large increases in price before buying into a stock instead of buying it when it is beaten down in price. From a psychological standpoint, when they see a stock leap up 15% to 20% in price, they think they can hop on board and continue riding the wave higher. Sometimes this works, but the majority of times it does not.
Stocks oddly enough seem to be the one commodity that the overwhelming majority of people only buy when it is selling at extremely high premiums. If you find a person that is willing to pay $275 for a nice pair of dress shoes, if he returned next week and that same pair of shoes was now $500, 999 out a 1000 people would probably no longer buy them as its price would seem bloated compared to its value. However this is not the case when it comes to stocks. People, and this includes analysts as well, only seem to jump on board the bandwagon when the price goes up.
But back to BHP. This past week, BHP announced a $10 billion buy back of their shares on top of an already announced $3 billion buy back, a move that will benefit shareholders. Although the CEO Chip Goodyear announced his resignation and will be replaced before year’s end, his resignation, given BHP’s management depth, is not a huge concern. After an announced 41% increase in profits (just below the street’s expectations) and their massive 9% share buyback program, I saw that a couple of analysts upgraded BHP. And that’s precisely the problem. While BHP traded sideways for two full months between $37 and $40 a share, let’s say a more forward looking investor bought in at an average price of $38.50 a share.
On the news this week, BHP is now trading above $44 a share. So as the average investor waits for analysts’ upgrades to buy into a stock, buying in at $44 a share, they will be purchasing at a price 12.5% higher than a more forward looking investor. For a more volatile stock than BHP, the average investor will probably pay upwards of 25% to 50% a higher price than a forward looking investor. So if you consider the fact that average investors are paying anywhere from 10% to 15% higher prices on blue chips and 25% to 50% higher prices for mid and small cap stocks, obviously there will be a huge and marked difference in the absolute returns of the portfolio of an average investor versus that of a forward looking investor.
Although today, many investment newsletters tout value, value, value, this is not what I promote nor what I believe. When I worked for a large Wall Street firm before becoming independent, I remember during growth years in the U.S., value investment firm Sanford Bernstein performed horribly for a number of years. Companies can appear to be a great value, but may be undervalued because they deserve to be, and ultimately will only head lower. Companies can appear to be a great value, but their business may be in an out of favor sector, so they will remain undervalued for the next 12 months. Today, a forward looking investor must understand the relationship between financial institutions (and the economy), governments and corporations.
A company may be a “great value” but if there is no compelling story attached to its industry or no compelling story regarding the company on the horizon, the stock price may still languish for a long time and there may be a much better use of your money elsewhere. For example, Microsoft’s share price has languished for a long time and nobody out there would argue that Microsoft is not a well run company. But only now does a compelling story accompany Microsoft’s depressed share price which makes it a good risk/reward stock as opposed to a year ago, or two years ago.
If you think that for an investment blog that I spend too little time as compared to other investment blogs discussing P/E, P/E to growth ratios, working capital ratios, debt structure, etc., it’s not because that I believe that number crunching is boring besides the fact that I’ve never met an interesting number cruncher in my life. And it’s not even because I don’t occasionally look at these numbers, because I do. It’s because I believe that number crunching alone is a pre-historic method of picking stock winners. As I have said before, how many of you think that Heads of State and U.S. Senators that have killed every money manager out there in terms of portfolio performance are sitting at home with a calculator, happily number crunching away to determine what stocks they should buy?
There is much better predictive information of stock price appreciation than fundamental evaluation, starting with searching for and understanding government-banking-corporate relationships. Don’t get me wrong, number crunching has its place, but just as a supplemental piece to the puzzle and never as a primary driver of decisions. Just being a value stock picker is a very incomplete system to finding huge winners. While I don’t expect 60% to 80% gains in less than a year from BHP as I do from many other stocks I hold, owning stocks like BHP and MSFT that have great stories and are out of favor (or in BHP’s case, was out of favor for the last two months but no longer is) make sense as long-term core holdings to build a portfolio around. While I don’t own too many stocks that most investors have ever heard of, having a few with strong upside potential as long term core holdings is never a bad idea.
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J.S. Kim is the founder and Managing Director of maalamalama, a comprehensive online investment course that uses novel, proprietary advanced wealth planning techniques and the long tail of investing to identify low-risk, high-reward investment opportunities that seek to yield 25% or greater annual returns.
