Sunday, May 22, 2011

The Crowd Roared and Investors Cringed: Be Careful of Crowded Trades

Saturday night, my wife Ruth and I heard Mahler's Symphony No. 3, with the marvelous Jacques Lacombe conducting the New Jersey Symphony Orchestra in its concluding classical concert for the season. (Ruth is an indefatigable Co-chair of the NJSO.) When the last note was sounded, the nearly sold out audience at the New Jersey Performing Arts Center (NJPAC) exploded in a loud and enthusiastic roar of approval. (I am very pleased to see full houses at the NJPAC, where I am a trustee and chair an investment committee with very impressive co-members.) Though the Mahler symphony was composed over 100 years ago, being amidst Saturday night’s large and vocal crowd reminded me that one of the most valuable skills of some of the best investment managers that I have known and studied over the last half century, is to avoid crowds, especially early crowds.

Bond buyers and inflation

Last week bond buyers purchased between $40 to 50 billion dollars of securities, depending on which sources one used. Most of these issues were of high perceived quality and therefore relatively low yields. The yields were below many actuarial assumptions for pension plans, were below endowment fund expectations, and certainly did little to resurrect the retirement capital accounts of investors. Why the rush? The answer may well be that there is too much un-invested money sitting around earning next to nothing. The pressure to “do something” at times becomes unbearable. In the week, we saw the issuers take full advantage of the crowd; including Google raising $3 billion in addition to over $30 billion in cash on its balance sheets. Perhaps the buyers will be rewarded with interest rates dropping further (if that is possible) and therefore pushing bond prices up.

The two largest middle class populations outside of the US are in India and China. Both countries are experiencing reported and less-reported inflation at an accelerating rate. These populations are relatively unschooled in high finance, but are living through an inflationary experience and are acting smartly. Both are buying gold in all forms. In the first quarter of 2011, the purchase of gold by the Chinese was $40 billion, or about the same amount as its weekly bond buying surge. Often ordinary people are more correct than well-schooled experts, and therefore I am expecting an increase in the rate of inflation.

Gold buying is not the only defense against inflation. On Friday I attended the annual Investors’ Day for the Sequoia Fund, a mutual fund that has been held for many years by some of our investment advisory accounts. In discussing inflation, the president of the fund stated that ownership of well-managed corporations that have protected pricing power is an effective inflation-defensive strategy. I tend to agree.

Lack of Historic Perspective by Equity IPO Buyers

LinkedIn recorded a doubling of value on its first day of trading, a modern record. The key facts are: The company had no earnings, and at the initial prices it was selling at eleven times sales. By the end of the first day therefore, it was selling at more than twenty-two times sales. Assuming that full taxes are paid and that the after-tax operating margin is 50%, the potential price/earnings ratio would be a minimum of forty-four times earnings, if there were any earnings. When I was learning security analysis at a trust bank, there was a rule that senior investment management would not accept a terminal P/E valuation in excess of 25x. Further, there are very few companies that have a history of growing operating earnings with low double digit growth rates over a decade. A rare, exceptional company might be able to grow operating earnings in the mid to high teen range over a ten year period. I am not conscious of a company growing operating earnings 20%+ over ten years on a fully taxed basis. History would suggest that the first day closing price for LinkedIn was a function of undisciplined price behavior or aggressive shorting pushing up demand.

Lesson of The Week

Stand up and cheer great performances, but stay away from participating in crowded trades. This principle is applicable to bonds, stocks, or for that matter, anything that trades. Some of the biggest gains in the hedge fund that I manage have come from buying stock after an IPO price ran up, and subsequently collapsed well below the initial price. I doubt that I will buy into LinkedIn soon, (the stock, as distinct from the service). My early training at the bank requires publicly traded securities to have earnings.

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