The Great Humiliator

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This story was first published two days ago in the form of an email sent to registered FNArena readers.

By Rudi Filapek-Vandyck, Editor FNArena

The share market works according to very simple, easy to understand, basic principles. If a company is doing well, it will become popular and thus its share price will rise. Popularity has a price in that expectations will rise too and since the share market is all about "anticipation" and less about "facts", this more often than not translates into a further rise for the share price.

If a company is not doing well, usually the opposite process takes place. A loss in popularity sees the share price coming under pressure, which usually leads to a further reduction in popularity. Next thing to happen is expectations will drop and before we know it this company's share price is in for prolonged weakness. The price for unpopularity is fewer buyers and reduced expectations, hence a weaker share price.

Once you've figured out these basic principles, it doesn't take a degree in physics to work out some of the consequences. Conclusion number one is be careful when joining the bandwagon for popular stocks. They may look good for a quick trading profit, but not so good for longer term strategies depending on how much exactly has already been anticipated and priced in. Conclusion number two is to be careful in not treating all share price weaknesses as an instant buying opportunity; there might be a whole lot more to come and it might only manifest itself through a gradual, grinding process.

The third conclusion is the most dangerous one: if you're after better than average investment results, there's little value in sticking with the herd. Let's face it: popular stocks become too expensive and unpopular stocks too cheap, which means that if you get your timing right you should be in for much better results than Joe Average. Easier said than done. It requires you jump on board before the rest of the herd does, or at the very least with the early jumpers in the case of popular stocks and when dealing with unpopular stocks you jump on board after everybody's left, just before the herd starts realising more attention should be paid.

Both scenarios make a lot of sense and, certainly, backward looking price charts prove this is the most optimal way to maximise one's potential from the share market. Alas, this is also where most market participants delude themselves. "Perfect timing", it turns out, is a very good friend of Harry Hindsight but an active investor's worst enemy. We all wish we could buy the stocks we want near the bottom and let the share price ride all the way close to the ultimate top, but in practice we seldom manage to do so. This is why, over time, active fund managers are unable to stay ahead of the pack and of the index. Just ask Vanguard's John Bogle; he made a successful career out of promoting the inability of active managers to continue timing their entries correctly and ahead of others.

What about legendary funds manager Peter Lynch (he who gave the world PE ratios and their follow up, PEGs) who remains convinced that those who are really, really good in his business get it right six times out of ten  – in other words: a little more than 50/50, which is equal to flipping a coin. This is not a condemnation to all who try managing their own investments, as small investors don't have to copy all the waste and the short term pressure that characterise the industry, but it does plead against investment strategies that are too much based on continuously making the correct adjustments and decisions.

Active investment strategies work best when trends are long and strong. These are also the times when errors and mis-timings are most forgiving. Everybody who looks back in time can see that buying BHP Billiton ((BHP)) shares at $9 was an absolute steal and would have generated returns that go beyond the wildest imaginations, but even if we missed that bottom and bought at $20, more than 100% later, we would still have made an absolute motza. Alas, when trends are less clear and volatility and uncertainty rule with a vengeance, our self-declared talent for picking winners and shedding losers is usually quickly demystified.

Sure, we picked that one correctly, and got away in time with another one, and maybe we managed to do it four, five, eight, eleven times. But can we do it 33 times? 88? 434?

There's always the tyranny of the backward looking price charts. BHP Billiton shares bottomed in May last year at $36.77 for a gain of 15% today ($42.30). How many investors bought the shares at higher levels in between? And those who managed to "time" BHP well, did they equally buy Woodside Petroleum ((WPL)) below $40 and Newcrest below $39? Santos ((STO)) below $13 anyone? What about Wesfarmers ((WES)) below $29?

More than seven decades ago Benjamin Graham, widely considered the father of modern day analysis and structured investment strategies, observed: "It is fortunate for Wall Street as an institution, that a small minority of people can trade successfully, and that many others think they can." His observation still stands today. Moreover, were we to replace "trade" with "time" we'd probably cover about 99.99% of all market participants today.

Since the rampant bull market of 2004-2007 morphed into the bear market since, I have been advocating investors should "adapt". One of my favourite slides during presentations to investors contains the core conclusion that once upon a time defined the theory of evolution by Charles Darwin: "“It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is the most adaptable to change.”

In the early days of the bear market, I wrote the same base characteristics defined both bull and bear markets, it was just that the latter was less forgiving and will generate losses where the first would have generated disappointing, but probably still positive results. Now that I am a few years older, and wiser, I know that any successful long term investment strategy starts with the admission that we, the people in this process, are imperfect, which is why experienced investment legends such as Peter Lynch argue investors spend too much time on trying to figure out where interest rates are heading, what the bond market is trying to tell us and whether governments will come to their senses or not.

Let's face it: the fastest growing industries do not necessarily generate the highest corporate profits; the healthiest economies do not harbour the best performing equities and the cheapest stocks on offer are not necessarily a bargain. What remains is that, no matter what we do, making sure we don't lose too much money on our mis-timings and mistakes should always remain the prime consideration. Within this context it is probably apt to refer to George Soros, legendary market timer who last week decided it is time to wrap up and quit while the halo is still high and dry. Probably the best advice Soros ever gave was: "It's not whether you're right or wrong that's important, but how much money you make when you're right and how much you lose when you're wrong."

Shares of dividend paying companies beat non-dividend payers on average in two out of every three years. This probably explains why 55% of the Australian share market's long term return (9%-something) stems from steadily accumulating dividends. Above all, once we accept "perfect timing" belongs in the same category as "super food" and "the man in the moon", we automatically come to appreciate the true value of solid, accumulating dividends. Cheap dividend paying stocks bought a few years ago today pay out double digits in annual dividends, often fully franked (meaning no further taxes). In the same vein, solid dividend paying stocks bought cheaply today will yield double digits in about five, six years to come (could be sooner, could be not).

I am not saying it's not possible to beat those returns with growth stocks, at the right timing, or with temporary micro cap high flyers, but what I am saying is that you'll have to be at least as good as George Soros in his halcyon days to achieve this on a consistent basis. This is why Vanguard's Bogle can make a living out of the failure of active managers to consistently beat the relevant index. So by all means, have some cheap BHP Billiton in your portfolio, and a few "punts" on the side, but don't overestimate your human abilities. The long term average return for Australian equities is less than 9.5% – INCLUDING dividends which, on average, yield between 4.5-5% in Australia (and grow as you continue owning the shares).

I have since late last year continuously written about how the best value, and the best returns, are to be found among dividend paying industrial stocks. However, many of the stocks I mentioned are today trading at prices that are lower than 6-9 months ago. Think McMillan Shakespeare ((MMS)), Fleetwood ((FWD)), Woolworths ((WOW)), Ardent Leisure ((AAD)), Transfield Services ((TSE)) and all the major banks. I have continuously questioned whether expert expectations for super-returns this year with the ASX200 index projected to rise to 5500 and beyond were realistic, but little did I know that only a handful companies, such as Campbell Brothers ((CPB)), Monadelphous ((MND)) and a few others, would actually put in a strong, positive performance that would less depend on "perfect timing".

Which is why today's story carries as title the phrase coined by legendary funds manager Ken Fisher in 2006: "The Great Humiliator". The underlying dynamic of the share market, explains Fisher in his best seller "The Only Three Questions That Count", is to prove as many people wrong as possible, and to take as much money away as possible during the process. I remain of the view that most of the companies I mentioned in my analyses (see above) will prove solid investments, generating solid investment returns with rising dividends if given time (like a good wine).

I also mentioned media companies APN News & Media ((APN)) and Southern Cross Media ((SXL)), which both looked ridiculously cheap a few months ago, but have continued selling off since. This might well make both at today's prices an absolute steal, but only Harry Hindsight will be able to tell us, at some point into the future. In the meantime I prefer to act like the famous cat of Mark Twain who once sat on a hot stove; better to avoid getting burnt again. I hope investors who've jumped on these stocks didn't make the mistake George Soros warns about, as it will take a lot of dividends to turn these mis-timings around.

As reputed market trader Dennis Gartman would say: the market is indicating my assessment is likely to have been wrong and who am I to argue against it? Better to spend my time on more profitable endeavours.

Final conclusion: dividends come in handy when our timing is off, and once we accept that our active approach cannot sustainably pick all the right winners at the right time, but it doesn't compensate for the true errors. Something to keep in mind, at all times.

(The story above was written on Monday, 1st August, 2011. It was sent in the form of an email to paying subscribers at FNArena that same day).

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Come and say 'Hello' to Your Editor in the weeks ahead

FNArena Editor Rudi Filapek-Vandyck will be presenting at the upcoming Trading and Investing Expo in Sydney, and you are all invited to attend and say 'Hello' and have a chat after scheduled presentations on Friday and Saturday (3.45-4.15pm) this week.

In case you do have the intention to attend, there's the opportunity to get free tickets:

http://www.tradingandinvestingexpo.com.au/special-offers/rudi-filapek-vandyck-offer/

Promo code = Rudi

For more info about programming and the event, see www.tradingandinvestingexpo.com.au

Your Editor will be talking about how to establish when shares are too expensive

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The following week, there's a presentation in Newcastle, on behalf of members and guests of the ATAA.

The ATAA presentation will take place at the Kahibah Bowling Club, 63 Kenibea Avenue, Kahibah (near Charlestown) between 11.30-3pm (luncheon break in between) on Saturday, August 13.

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Further, a reminder that Your Editor will also present at the AIA National Investors Conference – Wealth Creation Opportunities – to be held at the Sofitel Sydney Wentworth Hotel from 1 to 3 September 2011. An early bird discount applies for this event.

Details are:

Event: AIA National Investors Conference (http://www.investors.asn.au/events/national-conference/)

Date: 1 to 3 September 2011

Venue: Sofitel Sydney Wentworth Hotel

Includes: Lunch & refreshments for 3 days; satchell; speakers’ papers; happy hour coupons

To register: Call 1300 555 061 or register online (http://www.investors.asn.au/events/national-conference/program/)

This conference is aimed at individual investors across all asset classes. Have a look at the comprehensive conference program (http://www.investors.asn.au/downloads/events/2011/Conference/20110901_Conference-Program.pdf).

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