Tag: portfolio theory

Beware of Anecdotal Evidence when Investing…

There’s one thing I can’t stand when I hear an argument: Anecdotal evidence.

I think humans are inherently story tellers and perhaps a good story provides some comfort. And that’s why anecdotal evidence creeps into our investment processes.

To me, though, it is no different than someone saying, “well my Dad smoked a pack of cigarettes a day and he lived to be 90!” Ok, so is that actually good evidence for me to smoke? Or should I trust the troves of actual, scientific evidence that says I should not smoke? (yes, I know I just wrote an article about “sin” stock out-performance)

Equally, when I hear a stock pitch or reason for investment, I hate to hear anecdotal evidence as a real justification. Here are some examples:

  • Media: I just cut the cord and hear all my friends are too. Cable companies like Comcast are going to face pressure
  • Transportation: I hear millennials are all about traveling compared to buying new products. I am buying airline stocks that will benefit from this.
  • Healthcare: My grandma needs a lot of medical attention. As the baby boomer wave hits retirement, the amount spent on healthcare is undeniable going up.
  • Retail: I only shop at Amazon now. All other retail / distribution is essentially un-investable.
  • New Technology: I read an article on how this [new technology] was able to do [something in a novel way]. There’s going to be a paradigm shift in the way we do things.

I think this type of investing is popular for a few reasons. For one, it is easy. You can just identify something you know and think of a company that will benefit from a trend. Second, Peter Lynch often wrote in his books that his children would talk about something they liked, he bought the stock, and it ended up being a 5-bagger or something.

I do think it is extremely important to be aware of trends, but this sort of investing has led to a lot of trouble. You also have to know “what is priced in”. For example, look at the return of Comcast since cord cutting really starting about 10 years ago — it is up 300%+ compared to the S&P return of ~170%.

Sure Netflix is up more, but do you think many people analyzed whether or not growth in other Comcast businesses would offset the traditional cable model? Or that this was a lower margin business so therefore it didn’t impact earnings as much as one would expect? Also think about how much people complain about Comcast… yet it still prints a lot of money. That is a testament to its business model!

On the flip side of that negative outlook, look at something in the technology sector like 3D printing. It used to be all the rage where people would discuss how the industry would change the world after they saw it in action. However, that would have been a disastrous long-term investment decision, as shown below:

3D Printing stocks

These types of situations often allow a contrarian investor to profit. All asset prices reflect people’s expectations of future growth. By analyzing what investor expectations are compared to the price today, we can see whether an investment makes sense and is particularly undervalues. That’s often why in my model I run a “worst case” scenario for industries in which people believe are in secular decline as well as a “what do you need to believe” in the case of booming, hot technology stocks.

I like to invest in stocks where the expectations are really low. I’m critical of using GAAP net income and the P/E ratio for valuing a business (I prefer FCF), but for simplicity, let’s look at this example.

If you value a business on 1) current steady state part of the business and 2) the future growth of the business.  For number 1, we should assign a multiple equal to the cost of equity. If that cost is 10%, that is a 10x multiple. If I buy the business for 10x and those earnings are sustainable, then any future earnings are complete upside for me. If I can pay a low multiple then for a company that has a history of value creation, then I can get the business for value + the upside for free.

I think I should also mention one other thing: a secular declining business can last a lot longer than people think, but it has to have the right capital structure.

For example, the yellow pages are still around! And the business actually throws off a lot of cash because the managers don’t need to reinvest in the business. However, YP has also been overlevered in the past, which has led to cases of bankruptcy. If someone had acquired the business for cheap, ran it with conservative leverage, then it might have been an attractive equity return.

Is it time to buy consumer staple stocks? (And a digression on interest rates)

Consumer staple stocks had a great run following the Great Recession. It makes some intuitive sense. Bond yields were forced to at or near zero, which meant investors had to push out into the risk spectrum in order to hit their prior return thresholds. If you can’t get a 5%-7% return via bond yields, then maybe buying very stable high dividend stocks makes more sense. As a result, utilities, REITs, and consumer staple stocks all enjoyed high returns.

We should review how consumer staples stocks perform under a variety of scenarios though.

Bond yields rose following the passing of the Tax Plan in 2017, which was a strong form of fiscal stimulus. Yields on the 10yr moved from their stubborn below-2.5% band and finally topped 3%.

This 3% threshold number doesn’t necessarily mean anything,  but the market tends to focus on round number (e.g. DOW 30,000! – new market top!).

The quick rise (or fall in bond prices since they move inversely) was really more of a sign to investors that the era of ultra low interest rates may be coming to an end.


As a result, investors extrapolated the recent news into the future and sought to get out of the way of rising interest rates. They also sold off the bond proxy sectors.

They also may have moved back into some fixed-income investments that became more attractive. As shown in the next chart, it is interesting how similar the charts are for these sectors when compared to the 7-10 year treasury stock chart shown in the bottom.


Was this warranted? Is it time to step into one of these sectors?

I argued it was at the time, mainly consumer staples. As an update in 2020, I’d probably say they’ve run their course as people hoard food in response to COVID 19.  Utilities seemed just too expensive to me and they remain that way. These are highly regulated industries that obviously provide stable cash flow and high dividends, but little opportunity for upside. I also just find the yields offered by REITs just isn’t that great for what you get for a cyclical industry (although admittedly the spread between REIT yields and treasuries is wider than average).

There is one thing I’d like to address before we get to consumer staples stocks: 1) No one can predict interest rates and 2) investors should separate what the Fed is doing with what long-term interest rates are doing.

I’ve been hearing interest rates are “definitely going up” for about 10 years now. Even pre-crisis, people were saying interest rates were too low (relative to long term history).  But in recent memory, remember at the end of 2013 when the yield on the 10 year ended at 3% (following the “taper tantrum”) and subsequently went as low 1.6% in 2016? Rates really haven’t gone up that much despite the fiscal deficit and inflation fears.

If you had to guess, no, if you had to invest your portfolio on it – where do you think long-term interest rates will settle at? 4%? 5%? Higher? What do you think the long-term rate has actually been? I’d actually like for you to guess that in your mind before reading further….

The long-term average from 1900 is…. 4.69%. But that also includes some significant outliers, so when we look at the median, its actually 4.02%. BUT… that also includes the 1980’s. Really when you look at the long-term, it actually just seems like the 1980’s and ’90s were the outliers… but either way, do you think 4% vs. 3% changes the calculus much for equity valuations? Probably some, but not as dramatically as I’ve heard pundits call for (I actually did a simple DCF of a 0% growth company. The equity valuation moved lower by about 8% when the discount rate went up 1%, to 11% from 10%. However that could already be priced into a stock / stocks).

10 yr treasury

This all brings me to my second topic on interest rates, that I hear quite often as well: “The Fed is raising interest rates so rates are definitely going up.”

Well, hold on now. Didn’t I just mention the 10 year was at 3% in 2013? At that point, the Fed was still buying $85 Billion in bonds each month and its balance sheet swelled to $4.5 trillion (from $0.8 trillion pre-crisis) and kept the fed funds rate at zero in order to stimulate growth. And yet, here we are with that bond buying spree over and the Fed raising the Fed Funds rate and as of today the 10 year sits at 2.88%.

So what gives? One, NO ONE can predict interest rates. And the Fed generally signals very clearly what is planning on doing, so don’t think additional rate rises aren’t priced into the market.

So many factors come into play with interest rates. The main reason pointed to these stubbornly low interest rates has been stubbornly low inflation. That why the Fed has been doing what its doing. However, demographics and even technology play a role in inflation. As noted in an ECB report,

“When the working-age population shrinks and life expectancy increases, the number of wage earners relative to the total number of consumers is expected to decrease. The longer retirement period incites households to save more to smooth out consumption in the future. This puts downward pressure on the equilibrium real interest rate.”

This could be one reason why our inflation and interest rates remain low in the US as the baby boomers age. Another topic I want to make clear is that the Fed impacts the Fed funds rate. This is different than the long-term treasury rate.

The Fed Funds rate is the rate at which banks will lend to each other overnight, so it is very short term. Therefore, it effects other short-term rates as well, like T-bills, since they are substitutes for lenders. That can have an impact on similar tenors of bonds. The Federal Reserve of St. Louis describes it as such:
Fed Funds

“Given that movements in the fed funds rate are closely linked to movements in short-term interest rates, but less so to movements in long-term interest rates, changes in the policy rate are likely to impact the yield curve.”

If the past is any evidence, the projected increase in the fed funds rate will successfully raise short-term interest rates but have a limited impact on long-term interest rates. This will imply a reduction in the term premium for bonds and loans.

These observations rely on the Fed not letting inflation stray significantly away from its annual target, which has been set at 2 percent. It is thus likely that, despite the continuing rate hikes, the government, firms and households will all continue to enjoy historically low interest rates on their long-term liabilities.”

That leads us to the current situation, where the yield curve is very flat. That is, the difference in yield between the short-term rates and long-term rates is pretty low. This has historically preceded recessions in the US, though is not perfect. And to be clear, I don’t think we are going into a recession this year.

Yield Curve - flat

Unemployment is low which imply less slack in the system, so why do long-term rates refuse to move? No one knows for sure, but one reason could be that long-term investors are not convinced inflation will be a strong as people suspect. In fact, if inflation moves to 3%, holding a 3% 30-year treasury bond would be a real-yield of 0%

So quickly back to consumer staples stocks. Is it time to move back in? I will try to address that in future, company-specific write-ups, but if you are thinking of avoiding the sector now because of interest rates, I hope this write-up challenges your assumptions.

These are generally high-margin sectors that grow very consistently and generate good FCF. There is some disruption going on, but its nothing in the context of the tech sector. At ~15x forward earnings, the sector now appears cheap and I’m thinking of adding to the sector, but will be avoiding more challenged names. For example, before Campbell Soup’s sell off, it was clear that they’re organic trends were challenged and consumers are avoiding high sodium foods. There’s chatter that they may be bought out by Kraft-Heinz, a name I will be doing work on, but for now I’ll pass on Campbell.

Anyway, I digress. Let me know what you guys think