Ignore the data at your own peril

How rare this week is

From The Big Picture:

Markets have just lived through 4 consecutive 90% Trading Days. That is a session where 90% of the stock trading volume and the number of advancers versus decliners is to one sided. These 90% Days are defined by their extreme intensity. They are typically associated with panic selling and on occasion, panic buying.

Four consecutive 90% Days is extremely rare, and according to Lowry’s Technical service, this week was “only the second time since 1940 that four consecutive 90% Days have been registered.” Floyd Norris of the NYT found 3 instances of consecutive 4+% swings.

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Intelligence - better for the individual or the collective (answered below)

I thought this was so great I am going to reprint the Marginal Revolution post in its entirety (which is attributed elsewhere.

A recent line of research demonstrates that cognitive skills—IQ scores, math skills, and the like—have only a modest influence on individual wages, but are strongly correlated with national outcomes [emphasis mine]. Is this largely due to human capital spillovers? This paper argues that the answer is yes. It presents four different channels through which intelligence may matter more for nations than for individuals: 1. Intelligence is associated with patience and hence higher savings rates; 2. Intelligence causes cooperation; 3. Higher group intelligence opens the door to using fragile, high-value production technologies, and 4. Intelligence is associated with supporting market-oriented policies. Abundant evidence from across the ADB region demonstrating that environmental improvements can raise cognitive skills is reviewed.

The paper is here and the slides are here.

So fascinating.

Haiku - Motivation

What motivates me?

Respect via money.

Am I good enough?

-JDW

(Alternative last line: Do I have enough?)



Supporting my post on doing nothing as an OK response

Two weeks ago I wrote on the topic of not reacting to our feelings to act. Today I believe that is more true then ever. I'll offer up an example:

Today, some low-level know-nothing in my company decided to send a simple request to a distribution list that she didn't really understand. We've all been there. We know what happened. It set off a torrent of reply-all messages saying "take me off this distribution" and, helpfully, "stop hitting reply-all". Except they hit reply-all themselves. You see, it's a catch-22. Everyone who replies thinks to themselves "after I send this email where I specifically say 'stop hitting reply-all' then these emails will 100%, definitely stop". Except they don't, because nobody listens to you if you're not a head honcho like Steve Jobs. If Steve Jobs said STFU the email traffic would stop. That instant. No question.

But they're not Steve Jobs. None of us are. We're all anonymous cogs that are just trying to become bigger and bigger cogs so eventually we can be on top of the machine and get access to the controls. The truth is that we only have influence over our cog neighbors. Nobody else listens to us. Or respects us, because they don't know us. These response emails people write are generally short and to the point. They would be effective if people read them. But no one ever does. Unbeknownst to them, they are just further spreading the virus that was the original email. (Aside: scary when you contemplate extrapolating that example to actual and harmful germs. I could easily imagine how an epidemic is spread quickly. "Aw geez I'm not sick")

Inaction is an appropriate response to this type of situation. I can understand someone's impulse that "I'm going to get this to stop myself and everyone will thank me for it". If that's you, maybe your best option is to sit on your hands. Or if you really have to be pro-active, create a filter that automatically takes emails with that subject line or distribution list to the trash. But, for God's sakes man, don't hit reply all.

*I'm going to continue to document situations where it's best to do nothing. I think this is really interesting.

You don't have to act on every impulse

I got on the elevator this morning after buying my Cherry Coke Zero, the lifeblood of my workweek, at the canteen store in the sub-basement. Another woman gets on. I'm standing in the elevator operator position so I say ask her which floor she wants to go to. She says "lobby". Because our building's elevator software is programmed to always stop on the first floor, instead of pressing the 'L' button, I said "oh, ok. We'll hit that on the way up."  All of the elevators are programmed that way. It is inconvenient, but everyone knows the deal. I think she felt slighted that I didn't act on her request, so instead of just trusting me that the elevator would stop where she wanted, she reaches over to push the button. But it was too late, we were already there, the doors were already opening. Just as I said they would. I think it was less about being correct than it was that my response didn't meet to her expectation that I would act on her request.

This interaction got me thinking - a lot of people demand action. The economy's bad, do something! $787 billion stimulus didn't work, do some more! Oh shit, my portfolio is down 30%, these stocks are no good, I need to sell them!

But that's not the case. When things are happening, you don't have to participate, especially with investing. Sometimes the best course is inaction. If the pain is too unbearable, don't log into the accounts, throw away the monthly statements unopened. By all means, know what's going on with the companies you invest in, but ignore Mr. Market. You don't have to trade with him.

The point is, if you become aware of some of our tendencies as people that you can correct those behaviors. So don't automatically call for something to be done just because you perceive there to be a problem. A lot of the time, things resolve themselves.

The problem with overreliance on models

In finance, they call it data mining

Source: the wonderful xkcd.

Ira Sohn Investment Idea Contest

On Friday, I completed my entry to the Ira Sohn Investment Idea Contest, a major investment contest with many heavy-hitters among the list of speakers. They include: Bill Ackman, Seth Klarman, Carl Icahn, David Einhorn, Joel Greenblatt, and Steve Eisman. On Monday, I was delighted to find out I was chosen among the semi-finalists, which means I will be able to attend. Included below is a copy of my entry.

 

Stay tuned, I will be posting my notes from the conference later in the week.

 

In the interest of full disclusure, I am long HPQ.

 

Your Investment Idea

Company Name: Hewlett-Packard Company (HPQ)

 

Market Capitalization: $78.1B

 

Is this a Long or Short Idea? Long

 

Position Type: Equity

 

Shares Out (in millions): 2,164

 

Price (Friday, May 20): $36.07

 

52 Wk High: $49.39

 

52 Wk Low: $35.91

 

Net Debt (in millions): $22,918

 

Last 12 months EPS: $4.08

 

Last 12 months revenue (in millions): $127,158

 

Target Price and Rationale: $44.00; I believe HP's lowered third quarter guidance has led to a market overreaction and will lead to an earnings surprise. After they beat concensus estimates later in the year, investors will value HP on a comparable basis to the industry. With even a conservative valuation (11x earnings) this would place HP in the mid-$40s.

 

Relevant Comps: Companies engaged in the diversified computer systems industry such as IBM, Dell, Cisco, and EMC Corporation.

 

Catalyst - Please explain what action, event, situation or future realization will cause the market to recognize the value discrepancy that you observe. I expect to wait until the third or fourth quarter results are announced, which I fully expect to top the dampened expectations. In other words, I believe that their continued profitability will prove to investors they have overreacted to a nonfactor like guidance.

Investment Thesis

Hewlett-Packard issued a second quarter press release before the opening of the market on May 17, 2011. In the release, HP reported beating the consensus second quarter earnings estimates ($1.24 vs $1.21), but went on to lower their guidance for the full year citing a tough PC market and weak consumer demand. Investors punished the stock and it opened 6% lower than the close. It has since shed 10% since before the announcements. HP is now trading near its 52-week low at a P/E of 9.2. The market has vastly overreacted.
I believe that the lowering of expectations is setting up an earnings surprise situation because, fundamentally, the public has a misperception of HP's business model and in turn value the company inappropriately. The investing public believes HP is a commodity company yet 63% of its 2010 operating earnings came from recurring revenue streams such as services, networking, and software. Aside from the PC group, none of the other business lines have seen any decline since CEO Leo Apotheker took the helm after Mark Hurd's exit in November. In fact, servers, storage, and networking revenues were up 15% year-over-year, software revenues were up by 17%, and financial services revenues increased by 17% as well. A decline in consumer demand may lower the top-line revenues, as these are HP's most competitive business lines, but it will tend to increase their margins. It will not have the devastating impact on their business that people expect; rather, it will be a symptom of the continued evolution of their business model into a higher margin company.

Investors are discounting the steadiness of HP's earnings stream, not to mention their continued growth in their more profitable services business line. I think it's paradoxical for second quarter GAAP earnings to grow 15% year-over-year and increase gross margins by 1%, and have the market reaction to be to knock 10% off their market cap.

HP is still massively profitable and throwing off enormous amounts of cash which they are using to reward their shareholders. They generated $4 billion of cash in the second quarter and a 22% return on equity. They only paid out $182 million in dividends, but they returned $2.7 billion to the shareholders by repurchasing approximately 64 million shares of stock. They have authorization to repurchase another $8.6 billion in stock and the cash to do it with ($12 billion, or around $6 a share); at present prices this could pull an addition 237 million shares off the market and have a significant impact on their future earnings results. Not to mention the secondary affect it will have on their market price. All of these factors combine to add to the margin of safety of this trade.

Despite being in the tech industry, which doesn't lend itself to value plays very often, HP passes even Ben Graham's stock screener. Their earnings yield (10.9%) is many multiples over the two times the AAA-bond yield (2.8%) criterion. Their total debt ($23 billion) is well less than the 2/3 tangible book value ($68 billion) needed to pass. They do, however, fall short of having a dividend yield (0.9%) of at least two-thirds of the AAA-bond yield, but this is only a crude measure. If we take into account the large stock buybacks that dwarf the declared dividends, we can be sure they are returning a large amount of earnings to their shareholders.

I believe Ben Graham's requirements for purchase of a "bargain issue" from chapter 7 of The Intelligent Investor exactly fit HP's current situation. For one, HP has reasonable stability in its earnings, not only in consistent profitability but also in topping expectations. Even through the financial crisis, HP did not take the large writedowns that plagued other firms. They had only profitable quarters. In HP's worst quarter, Q2 of 2009, it still earned $0.86 a share. According to Graham, a potential investment should have significant size and financial strength. With a $78 billion market cap and $12 billion in the bank, HP does. The $23 billion in debt may be troubling at first glance, but nearly 40% of this figure are short-term borrowings on which they are paying very little (roughly 2% weighted average interest rate), by historical standards, in interest expense. Beyond the $1.75 billion in debt that becomes due this month, there will be no other due dates until March 2012 so the financial risk in the near term is minimal. As already determined, HP is trading well below both its average price and a reasonable P/E valuation based on either its industry position or its prospects. HP passes every Graham requirement to be considered a suitable investment for a defensive investor.

When Hewlett-Packard beats expectations in the third or fourth quarter, Apotheker will emerge from Mark Hurd's shadow and HP will again be a Wall Street darling. Within the next year, as Apotheker's HP proves itself, investors will value the stock closer to the industry average of 14.8. (For comparison - its closest competitor, IBM, which is three times as large, trades at a multiple of 14.3) I've cited my price expectation at 44, which represents a 22% premium to today's market value and covers my required rate of return (which I borrowed from Warren Buffet) of 15%. I believe this is a conservative estimate which provides the investment with a wide margin of safety. Even if HP were to earn exactly what it did in the third quarter last year (which would actually be a decline in total earnings based on the continuing repurchase of shares) and was only valued at 11 times the trailing twelve months earnings, then it would still rise up to the mid-40s. Were it to trade at the industry multiple previously cited, HP could easily trade into the mid-50s. To the best of my ability, I believe Hewlett-Packard represents an excellent risk-reward tradeoff: downside protection based on their industry position and financial history with significant upside potential based on their investment in higher margin and growth industries. This is a classic Graham-type value trade with an embedded option on cloud computing.