2007-Novemeber-Archive

Ockham Universe of Coverage Getting More Positive
November 27, 2007

Following an upbeat initial Black Friday report, the market continues its slide into more reasonable valuations this week.  We are increasingly seeing the negative pressure on our outlook in the short term, while valuations are naturally improving overall.  This week was the first time in years that the Price-to-Peak earnings ratio reached 16.  Remember, 15 would be considered historically normal, so we are still not there yet in the short run.

Additionally, we have spent some time reviewing our ratings break down over the last several days between the positive recommendations and our negative ones (shown in the chart to the right).  On Friday, our ratings reached a milestone of more than half of the 2700 companies followed by Ockham received a "buy" rating or better.  This is a very strong indication that stock prices are reaching appropriate levels for the long term investor to begin buying again.  However, some historical context is necessary and would demand some additional caution.  Back in 2002, just prior to the market bottom, our percentage of stocks receiving a "buy" rating in our universe topped above 80%.  Looking back, this seems to be an incredibly high number, however, the market bottom was not far behind.  See our Ratings History Chart to get a picture of where we are in the cycle.

Continued Credit Concerns & Recession Possibilities
November 13, 2007

Looking at the market this past week, we continue to see the credit crunch as the market's main focus, and for good reason.  Perhaps even more unnerving to our investors is that the marketplace continues to ignore much broader signs for concern, namely that the underlying securities and CDO's causing the financial sector meltdown have not yet begun to unveil their true potential nor the extent of their reach.  What is clear to us is that while only some economists are beginning to discuss the possibility of a recession, many expect continued stability.  Consider the facts: (a) the market has reached a several year high; (b) the current Price to Peak Earnings indicator (created by John P. Hussman of Hussman Funds) while falling given the recent market pullback is still above acceptable levels, with it at 16.3 this week; (c) and corporate earnings are continuing to deteriorate (even with Wal-Mart net income rising 7.9% today).

No one likes to stand up and yell "recession!" in a crowded theater, especially when Goldilocks is playing, but it is necessary to review one's portfolio when many signs of a slowdown or recession are visible.  Not that we advocate an immediate realignment of one's portfolio, but at times like this, the identification of real value opportunities with strong balance sheets and sustainable ROE through the next few months is very important.  More analysis and stock selection to follow in this week's Enterprising Investor's Guide...

OCKHAM & GRAHAM (Reposted from November 2006)
November 10, 2007 

Although William of Ockham and Benjamin Graham lived roughly 600 years apart, their work shares a common thread---and it’s to this idea that Ockham Research is dedicated.

Benjamin Graham is remembered as “the Father of modern financial analysis”. His value investing approach, one of the most popular and successful investment styles, continues today as the basis for nearly every professional money management program. Value investing has been reshaped over the years into a multitude of approaches, however the guiding premise remains the mathematical study of a company’s financial ratios and the attempt to identify undervalued companies at reasonable prices.

William of Ockham’s pioneering principle -- that the most direct explanation of any problem is the preferred explanation---has become known as Ockham’s Razor. This concept, sometimes referred to as the Law of Parsimony, has been a defining characteristic of scientific theory, philosophy, and many other fields of study. Ockham’s Razor removes excess assumptions from explanations and cuts to the truth of whatever is being questioned.

In many ways, in its simplest forms, value investing is the Ockham’s Razor of equity analysis. Benjamin Graham’s principles have proven time and again to provide the best answer to the investor’s ultimate question, “What securities should I invest in?”

Ockham Research, formerly Financial Market Management, Inc., has been producing equity research for over a decade guided by the principles of value investing and Ockham’s Razor. As equity research has evolved to incorporate thousands of inputs, firms, and methodologies, the approach taken by Ockham Research is straightforward and specifically devoid of needless variables.

In investing, equity research needs to be clear and based upon sound arithmetic. The inclusion of countless factors within an investing approach only tends to corrupt conclusions. This is the problem currently facing most research departments and firms. Analysts today juggle fundamentals, technicals, company meetings, earnings estimates, corporate disclosures, pipeline forecasts, insider trading, quantitative studies, forensic accounting, trading algorithms, sector analysis, market forecasting, and thousands of other factors in an attempt to arrive at a “Buy”, “Sell” or “Hold”.

After years of studying different equity research approaches, it has become clear that with investing, unlike speculation, Ockham’s Razor is vital. Ultimately, all investment is designed to produce alpha. This means that the question that all financial research is trying to answer is the same. Therefore, according to this guiding principle, the most preferred answer must be simple, direct, and efficient.

This is why Ockham Research produces its straightforward analysis which incorporates the efficient study of a company’s price to cash earnings and price to sales ratios as the razor with which our clients may cut to the answers.

This is Ockham Research.

Short-term market timing is always extremely difficult to do well. It has a nearly universal reputation for being a fool’s game. Many of the world’s great investors have not only given up trying to improve their own portfolio return with this complicated tool, but have also repudiated publicly anyone who advocates its use. Their major argument against market timing has always been the general lack of ability to find consistent results in forecasting market turning points ahead of time. Market timing “experts” have been right part of the time but wrong enough to cause most listeners and readers of their forecasts to distrust their opinions at a minimum.

While I generally agree that consistency in picking future market peaks or troughs in a market index is virtually impossible, I do think it is possible to use a logical approach in trying to improve investor return. I am certainly not alone in this pursuit and there are other tacticians who are actually quite good at this. What separates those with a good reputation from those who are less reliable is usually an inverse correlation with consensus. For an extreme example, one only has to recall the excitement and confidence shared by almost all investors in March of 2000 when the S&P 500 traded at its all time high. That March 2000 level has not been exceeded since. When the last bears threw in the towel in 1999 and joined the exuberant throng, they had capitulated to what appeared to many of them to be inevitable above average returns forever. This psychological stage is categorized as capitulation.

Their capitulation followed a period of discomfort that the market was going up while they were invested defensively, and in some cases invested in such a way as to take advantage of a market decline. After all, a 20 to 25 P/E ratio on the S&P 500 and a 50 to 75 P/E ratio on the NASDAQ might suggest the probability of a bear market in the short run. I can generally categorize that uncomfortable feeling as a suspicion that you might be invested the wrong way but lack the conviction to switch your expectation and portfolio structure. The psychological stage of suspicion always precedes capitulation.

There is a third psychological stage to the market movement that is notable both for its ability to affirm an investor’s strategy while at the same time experiencing returns that run counter to expectations. I call this stage denial. Denial is popular with investors immediately following a market turn to the downside after a large advance or to the upside after a large decline. In both of these circumstances many investors had only recently capitulated and joined the big crowd, having finally given up fighting their suspicion.

So we have summarized the basis for a market timing tactic that tends to be more consistent than trying to forecast short term market movements: watch for capitulation and make sure you don’t capitulate too. When the market peaked in 2000, bullish sentiment according to every survey available was running extremely high and the best selling books of the day talked about fabulous stock market returns for years to come. Clearly, almost all market participants were positive about future prospects. For some months following the peak, the average investor was in total denial about the possibility of a bear market. My suspicion that a bear market could actually be underway was evident during the volatility of 2001, but then as 2002 unfolded capitulation began in earnest.

Bull and bear markets are a good deal more obvious with the benefit of considerable hindsight, but each are composed with periods of rally and correction. Bull markets have more of the former and bear markets have more of the latter.

In an extended period of advance/decline, or a relatively shorter term rally/correction, investor psychology plays an important role. As the current minor correction begins to move from the stage of denial to suspicion, I find watching the headlines and interviews in the financial press fascinating. This morning, one strategist said he saw no reason to change his bull market forecast at this point but said to call him in a week and he’ll tell investors whether to become more defensive. He would be a good one to watch through the week because, unless I miss my guess, what will make him capitulate is another several percentage point decline. He was clearly suspicious this morning that he might need to change his bullish opinion, but he had none of the confidence in the denial stage that he did when the market was rising several weeks ago.

So, my advice is not to forecast what level or what day the market will reverse course, but rather to watch the pundits carefully for a capitulation and do the opposite. This is one of those things that you can’t forecast with specificity but more often than not you will know it when you see it.