Concentrated Portfolio

In order to have consistent success in outperforming the market, you must have a concentrated portfolio. If you are a good stock picker then it makes sense to have high positions in your highest conviction stock picks. Having a diversified portfolio where you have stocks in every industry just makes not sense to me. If you are going to go that route or have someone run your money that goes that route you would be much better off simply buying an index like the S&P 500.

Bruce Berkowitz, manager of a very successful hedge fund, puts it best when he says something to the extent of, "why put money in your 35th or 36th best idea when you could put money in your first and second best ideas." I would argue that if you are an outstanding stock picker that having a concentrated portfolio could actually lower your risk. If you buy stocks that are so drastically undervalued, when the market goes down, chances are those stocks will outperform. It is important to note that you have to still own a fair amount of stocks, say five or six, in order for that to work. If you run too concentrated a portfolio then you could really get caught if one of your few stocks faces an unforeseen or unlikely event.

If you are looking to beat the market year after year then make sure that you have a concentrated portfolio made up of stocks that are so undervalued that you have a large margin of safety. My next post I will talk about how to find stocks that are undervalued.

Always keep Cash on Sideline

It is important for an investor to keep cash on the sidelines just as it is vital for a police officer to carry around with him extra ammunition. Many investors think and act counter intuitively when it comes to how much cash to hold on the sidelines. During the peak of bull markets, it is well characterized, that most investors hold very little cash on the sidelines. This is ludicrous as the risk/return ratio works against you when stock prices are high. Just like clockwork, at the end of a bear market, most investors hold too much cash on the sidelines out of fear.

I would argue that having cash on the sideline can only improve the risk part of the risk/reward equation. Sure, it is quite possible that you may regret holding the cash when equity prices rally. This is part of the logic as to why when stock prices appear undervalued one should hold less cash on the sidelines. Sure enough when stocks appear overvalued one should hold more cash on the sidelines.

Most investors don't see the benefits that holding cash has to the reward part of the risk/reward equation. However, having cash on the sidelines can be a huge asset to aid in your returns. Nobody is smart enough to time every stock move so having that extra cash as ammunition allows you to add to positions as a stock drops. Therefore, as that cash gets put to work, you are automatically investing in a stock that has better risk/return characteristics.

Average Investor Always Gets Screwed

The average everyday investor has and will continue to earn below market returns. It is ingrained in his mind just as it is ingrained in the mind of a dog to sit when he sees a treat. Human nature will easily defeat logic inside the battle of the average investors head. Throughout history, during boom and bust cycles, the average investor got whiped out during inflection points at bull and bear market cycles.

The past real estate bubble is a perfect example. I remember during the heat of the bubble a friend of mine wanted to buy a second house as an investment. I thought to myself, does he really expect to earn a return on this property when real estate prices had already ran so high and were in severe danger of collapse. Yet the feeling of being left out of probably the greatest real estate bull market in American history was too tough of an idea for my friend to comprehend. He just had to get in. Unfortunately, he did buy that house, and now that house has been foreclosed upon.

There are countless other examples such as the tech bubble bursting at the turn of the millenium and the most recent bear market that the average investor gets screwed. The stock market has rebounded substantially since the market lows of March 2009. Yet the average investor was on the sidelines during this rally. Now consequently, surveys are showing that the average investor is feeling more comfortable about investing in the stock market. However, the time to be fully invested in stocks was at Dow 6600 not Dow 11000.
For an average investor to make above average returns, he simply must be contrarian when it comes to market timing. Buffett sums it up best by saying, "be fearful when others are greedy and greedy when others are fearful."

China Debate

Two of the greatest economic minds of our time have two different views on the Chinese economy. First, Jim O'Neill chief economist at Goldman Sachs who famously coined the term BRIC. He is bullish on the Chinese economy and feels that the global crisis helped China. The other economist is Nouriel Roubini famously called Dr. Doom, who is a little more skeptical of China and possibly rightfully so.

O'Neill feels the global crisis helped the Chinese economy. His main point is that with the global economy coming to a halt, China's export led economy took a hit. But it caused the Chinese to look inward and become less reliant on the American consumer. The number one long term problem for China is getting their consumption rate up. The Chinese sooner rather then later because of the crisis have been forced to become more reliant on there own domestic demand.

Nouriel Roubini on the other hand has the view that the jury is not out on the Chinese economy. During the global recession of 2009, the Chinese managed to grow 8 percent. This astounding growth rate did not come from their usual export growth because the global consumer was no where to be found. More troubling is the fact that consumption as a percentage of GDP stayed the same at a very low 35 percent. Therefore it appears that the bulk of the growth came from fixed asset investment and easy monetary policy. The first is just not a sustainable way to grow the economy. Just ask the leaders of the old Soviet Union. The latter, easy monetary policy, could possibly have lasting implications through inflation and asset bubbles.

These are two of the most original thinkers in economics having pretty much two opposing view points. I think if you look at this from a micro perspective one would tend to want to sign with Roubini and the raw data he provided signaling the consumer in China is still not ready to spend. However, if you look at it from a more macro view, O'Neill's thesis about the crisis helping China is very persuadable.

I tend to feel that there will be many bumps and bruises over the next decade in China. However, the long term growth story in China is intact as the hundreds of millions of rural Chinese start urbanizing and becoming more productive and consumer oriented. The Chinese policy makers are very bright and are beginning to form programs that will instill consumer confidence. Safety nets have to be put in place in order to get the consumption rate up in China. Time will tell which economist is right.

Stuck on an Island- FREE CASH FLOW

Everybody remembers the question if you were stuck on an island and had to bring a movie, what would it be? If someone were to ask me if I were stuck on an island and had to bring one financial document, what would it be? In a heartbeat, I would reply the Cash Flow Statement. It incorporates the income statement and the balance sheet together.
The Cash Flow Statement provides the investor with a clear picture of its operating performance in a truly accurate way. The Net Income on the Income Statement could be somewhat manipuulated by using accounting gimmicks. Yet just as important, the Cash Flow statement also supplies the investor with how that newly formed profit is being put to work.
The best companies in the world are not only the ones that generate tons of cash, but they are the companies that generate high returns on that cash. The cash flow statement illustrates whether that cash is being invested back into the company or returned to investors via dividends or share buybacks.
When it comes to determining the true financial health of a company nothing is a subsititute for the balance sheet. However, the cash flow statement does an excellent job of previewing what that balance sheet will look like. A talented investor can usually take an educated guess about the company's financial health by simply looking at the Cash Flow statement. This is because if a company is generating a lot of Cash, then they can fund their expansions internally, without having to access finances externally.
So if for some wierd reason you are stuck on an island and are only allowed one financial statement to make an investment, make sure it is the Cash Flow Statement! You never know, maybe that investment will earn you enough returns to be able to pay for a private plane to find you and fly you back home!

High Margins and Stock Picking

I am of the opinion that a stock with high margins does not make it more valuable then a company with lower margins. Lets assume that company A has margins of 20 percent and company B margins of 10 percent. If both companies double there sales, company A and company B both have identical growth in profit. Margins play a vital role in making an investment decision, but for other reasons then a company simply having high margins.

The best scenario when dealing with margins is that a company is growing there margins. However, it is important to distinguish whether the margin increase is more of a cyclical or fundamental nature. If the growth in margins is coming cyclically, then it is more of a temporary increase because of the business cycle. The optimal choice for margin growth is that it is of a fundamental nature. This is when the higher margins come about from some sort of operational improvement in the business. The reason why the fundamental margin growth makes for a better investment because the increase in margins has more of a sustainability and did not just come from the whim of the business cycle.

I have to stress that if you are dealing with a company that has consistently had high margins, you should look at the company skeptically. Because you could see a reverse in margin growth and of the fundamental nature. One of the first things you learn in Economics 101 is that companies with high margins will not keep them for long because it invites other companies to compete and mimic the product/service. The only way a high margin business is sustainable is if the company has a gigantic moat to protect against competition. Coca Cola for example has such a strong brand name that it would be very difficult for a start up to compete and chip away at margins. However, Abercrombie and Fitch has a much better chance of seeing margin deterioration in the future.

Back Blogging---Stock Market appears fairly valued

The stock market appears at the moment to be fairly valued. However, if the economic recovery appears to be sustainable it could very well go much higher. This current enviornment is great for stock pickers like myself. Over the last year, a monkey could have returned in excess of 50 percent by simply throwing a dart at a random list of stocks. In fact, it was the "junky" companies that rose the highest. These are the companies with horrific balance sheets and murky operating prospects.
A great deal of stocks to me seem to be fairly valued or even over valued by the market. But when you dig deeper there are many bargains throughout many industries. So this is the time when the stock picker really shows his true value.