The Common Stock Commandments of Claude N. Rosenberg, Jr.
By Kendall J. Anderson
August 15, 2011
Last week, in the middle of the market’s roller coaster ride, I caught this remark from one of the morning show commentators as I was leaving the house: “This is not your parents and grandparents market”. I have to admit that his comment was correct, but only partially correct. He was correct in the fact that the sheer volume of transactions could not have been completed during your parents or grandparents markets. This was made possible through the technological advancements made in society over the past thirty years. He was correct in the fact that today, the vast majority of these transactions were ordered by institutional investors who are in charge of money that is not their own, unlike your parents and grandparents who believed in the value of direct ownership. He was correct in that the vast majority of these transactions were executed based on an untested economic theory or trading system that is completely detached from the fundamental value of a business’s operations. Your parents and grandparents learned from experience that investment systems and academic theories can cause more harm than good.
He is wrong in some ways. The same behavioral problems that exist today existed in your parents and grandparents generations. And just like they had to learn the hard way, today’s group of young and aggressive investment managers will also need to learn the hard way. The oldest of our grandparents learned their lesson in the mid-to late sixties. The current fad at the time was growth investing, the nifty-fifty and trading. They held a belief that a group of fifty companies could generate an unlimited amount of future cash flow that you could buy them at any price and get rich. It worked, until it didn’t. When that failed, a group of young and aggressive investment managers, the “gun slingers”, took over with the belief that rapid turnover (rapid trading) was the key to investment riches. It worked, until it didn’t. The price paid by your grandparents was a permanent loss of wealth and a deep mistrust of mutual funds and their managers. It took fifteen years or more before the market recovered the losses of the go-go years.
Our younger grandparents came into their own wealth during those fifteen years after the go-go years. It was during these years that the glitter of gold was considered by many as the only safe investment available. This safe investment worked, until it didn’t. The price of gold collapsed right before the great bull market began in the 80’s taking almost thirty years to recover. The crash of 1987 drove the youngest of your grandparents to openly state that they would never invest in the U.S. stocks again. So they quickly sent their money to Japan the world’s growth miracle. Surely they believed that the economic growth of the Japanese economy would continue forever and make them rich. Just after the peak of the Nikkei 225 in December of 1989 a survey of 50 economists and strategist published in January 1990 an average estimate that the Nikkei 225, then at 38,915.87 would produce a total return in 1990 of 15%. Of course we know the results. Twenty years later the Nikkei stands at 8926.89 down 77%.
Your parents had their own Armageddon with the great technology bubble of the late 90’s. Their belief in the unlimited future of the internet drove the NASDAQ to its all time high of 5132.52 on March 10, 2000. At 2182.05 today, it may be another twenty years to recover.
Today’s market has all the same beliefs as your parents and grandparents markets, just the players have changed. Today’s Japan is China and all other emerging markets. Today’s gunslingers are hedge fund managers and algorithmic traders. The nifty-fifty turned into the tech bubble while gold has regained its glitter and has been determined by many to be the safe investment. Advisors and consultants still believe as they did fifty years ago in failed economic theories and trading systems that are driving more and more individual investors further away from the direct ownership of common stocks.
Yet through the years of our parents and grandparents markets there were a few voices of reason to help guide them. One of these voices was Claude N. Rosenberg, Jr. whose legacy is kept fresh through RCM, formerly Rosenberg Capital Management, a global asset manager and a company of Allianz Global Investors. Over the years he shared his thoughts directly to your grandparents and parents through his writings. I have chosen to highlight a few of these ideas that he called his “Common Stock Commandments” that I consider timeless and can guide you just as he did years ago to your parents and grandparents. These first appeared in one of his many books, Stock Market Primer. His words are as follows:
Commandment: Do not make hasty, emotional decisions about buying and selling stocks.
Of all the advice given, this is perhaps the single most important for each of you to plant firmly in your mind. As he stated, “When you do what your emotions tell you to—on the spur of the moment—you are doing exactly what the masses are doing, and this is not generally profitable”. This advice is directly in conflict with “momentum” investing that drives the vast majority of investment models employed by professionals today. You have heard me say time again; Do not become a member of the buy high sell low club. It is far better to sit and do nothing than to react to your emotions.
Commandment: Do not concern yourself as much with the market in general as with the outlook for individual stocks.
This has become far more difficult given that so few individuals are direct owners of securities. Those that do, have a tremendous advantage over others. Over the past three weeks the greatest amount of insider buying by executives of S&P 500 companies has taken place since the week prior to the March 9th 2009 market bottom. They are buying because they understand the same thing Mr. Rosenberg is telling you with this commandment. Here are his words: Often times you will see a fine stock come down in price to an unquestionable bargain price, only to let your feeling about the general market sway you away from buying it. As they say, it is not a stock market, but instead a market for (individual stocks). Buy good value as it appears and do not let the general market sentiment alter your decision.
Commandment: Remember that stocks always look worst at the bottom of a bear market (when an air of gloom prevails) and always look best at the tip of a bull market (when everybody is optimistic).
How many times have you heard this? Yet knowing this and acting on it are two different things. Mr. Rosenberg says: Have strength and buy when things do look bleak and sell when they look too good to be true. I want to give you a little more firepower, courtesy of the wonderful research produced by O’Shaughnessy Asset Management.
Consider this: Following periods where GDP growth is negative (a palpable current fear)… the S&P 500 had an annualized 12.24% return over the next three years. (O’Shaughnessy) If you believe that the current decline in GDP will result in future market declines, think again!
Consider this: The level of unemployment has a small +0.12 correlation with subsequent three-year stock returns since 1929—jobs data simply has not been helpful in predicting future returns. (O’Shaughnessy) How often has it has been implied that buying today in light of the current unemployment level is the wrong thing to do. Past history has shown that the unemployment rate had little impact on future market returns.
Consider this: Consumer confidence remains very low. The Investor’s Business Daily’s Economic Optimism Index fell to al all time low of 35.8, and is down 31 percent for the year. But the best market returns since 1952 came after periods of low confidence (with an average annualized return the following five years of 11.5 percent), whereas the worst returns came after periods of high confidence (average annualized loss of -2.42 percent) (O’Shaughnessy). Buying cheap has always been the best way to protect your investments and produce future returns. When confidence is low the price you pay is generally low.
Commandment: Remember too, that you’ll seldom—if ever—buy stocks right at the bottom or sell them right at the top.
These words of wisdom have been repeated by so many of the great investors of all time that we should easily accept it, yet we continue to punish ourselves after every buy or sell that work against us for a short time. Instead of trying to find the bottom, or pick the top, concentrate on what you own and attempt to determine a fair value of your holdings based on the business itself; buying it at less than fair value and selling it above fair value. These are the only two price points you need to concern yourself with.
Commandment: Remember the public is generally wrong. Mr. Rosenberg continues: The masses are not well informed about investments and the stock market. They have not disciplined themselves correctly to make the right choices in the right industries at the right prices. They are moved mainly by their emotions, and history has proved them to be wrong consistently.
Through July of this year, Morningstar, Inc. reported the largest net monthly outflows of cash from long term mutual funds since December 2008 with the greatest outflows for funds investing in U.S. stocks. Taxable bond funds collected inflows once again. The future winners will be those who understand price and value. Here is a hint; Buy what people are selling and sell what people are buying.
Commandment: Beware of following stock market “fads.”
Do you see a pattern in Mr. Rosenberg’s commandments? As he says…”the stock market occasionally develops fads for certain industries. In almost all cases a sudden rush to buy the fad stocks pushes them to price levels which are totally unwarranted. When you buy at the height of popularity you almost always pay prices which have little relationship to value…” Today, the market is dominated by ETF’s (Exchange Traded Funds) and Gold has replaced Mr. Rosenberg’s hula-hoops and Batman as the latest fad. Combine the two and you have a disaster waiting to happen. Many of you would think twice about buying gold in physical form given the problems of shipping, storing, protecting and converting your gold to cash when desired. Yet, it is so easy to buy a gold ETF that takes these problems away. Without these problems the price of gold has separated from its underlying value just as it did thirty years ago.
Commandment: Do not be concerned with where a stock has already been—be instead concerned with where it is going. The import thing is what lies ahead, not what has already transpired…”
Over the years I have heard so many state that what goes up must come down and vice versa. This thinking leads to a belief that you can buy a stock safely because it is down $20.00 from its high, or it must be overpriced because it has appreciated $20.00 from its low. When it comes to common stocks, neither is true. Over time stocks, both individually and the market in its entirety, will reflect the underlying growth of capital that companies produce. Spend your time on how and why a company can grow its value in the future and compare that potential growth against its current market value, the price you have to pay to participate in that future growth. If the future growth potential does not warrant the current value, then be a seller, if this future growth is not reflected in the current value, then be a buyer.
Commandment: Concentrate on quality. (I am not going to add to Mr. Rosenberg’s comments on quality as they are just as true today as they were decades ago when Mr. Rosenberg put pen to paper.) Here they are:
While big profits are often made through buying and selling poor quality common stocks, your success in the stock market is far, far more assured if you emphasize quality in your stock selections. Too many investors shy away from the top-notch companies in search of rags-to-riches performers. This, of course, is fine for a certain portion of your investment dollars, since most people can afford an occasional “flyer.” But a person who starts out looking for flyers usually ends up, not with just one or two, but with a host of poor quality stocks—most of which turn out unsuccessful. These low-grade issues are certainly no foundation for a good portfolio; instead, the fine, well-managed companies should form the backbone. And don’t for a minute thing you can’t make money without wild speculations—fabulous fortunes have been made over the years in such high quality, non-speculative stocks as Carnation, Coca-Cola, Procter and Gamble, and others. In other words, place your stress on the elite, not the so-called “cats and dogs” of the marketplace. “Remember,” said one wise stock market philosopher, “if you sleep with dogs, you’re bound to get fleas.”
Some final notes
Three years ago we were able to regain control of our company. Two years ago we took the steps necessary to review all aspects of our business to align our capabilities with our operations. We completed a full review of our investment process and made the changes necessary to provide the highest quality research and portfolio management we can provide directly to you. In the past year we have taken steps to redesign our valuation model in line with our belief that buying quality at less than fair value and selling at prices above fair value can be accomplished while maintaining an acceptable level of diversification and risk control.
The gyrations of the markets in the past few weeks have allowed us to accelerate the implementation of this drive to quality. We took the extra time necessary to review all portfolios. We increased the quality where we could by purchasing companies that were never cheap enough for us to buy in the past year and selling some legacy holdings whose quality and business model were questionable. We still have a way to go, but are more comfortable with what we own today than any time in the last three years.
(c) Anderson Griggs