The Peloton Position / 4th Quarter 2011

Mastering the Basics

Quickening financial markets agitate investors’ natural impulses to act. Rather than discount these impulses or downplay their persuasiveness, we offer alternatives to the notion that “action” — as it pertains to investing — involves only the acts of buying or selling. Rather, “pulling the trigger” is the easy part. The transaction itself is merely the outward expression of the careful consideration (hopefully) that led to the decision to buy or sell. Warren Buffett’s investment approach embodies the essence of fundamental securities analysis. The Oracle of Omaha and his lieutenants are constantly evaluating new investment opportunities as well as the holdings that comprise Berkshire Hathaway’s monolithic portfolio. From quarter to quarter, Berkshire gurus tweak its portfolio by initiating/accumulating or reducing/divesting stakes in various public companies, but seldom does Buffett engage in transformative transactions like Berkshire’s $34 billion purchase of Burlington Northern Sante Fe (BNSF) in 2009. Few companies could swallow the likes of BNSF, and no one can invest precisely like Buffett because no one else has a triple-A-rated, $150 billion balance sheet at his or her disposal. Thankfully Mr. Buffett has almost as much investing advice to offer as he has dollars — much of which can and should be heeded by investors of any means. (Buffett’s quips of wisdom are highlighted in orange throughout.)

“You do things when the opportunities come along. I’ve had periods in my life when I’ve had a bundle of ideas come along, and I’ve had long dry spells. If I get an idea next week, I’ll do something. If not, I won’t do a damn thing.”

In periods of violent stock market swings, and also during long, sustained advances or declines, the urge to buy or sell stocks can become practically irresistible. Inactivity, if defined by few transactions, comes to be viewed as imprudence, indecision or neglect. Like Buffett, we believe these are times when (like all other times) fundamental analysis is the most important investing activity, and that savvy investors only “…do things when (fundamental) opportunities come along.” If an investor understands a company and has valid reasons for owning or not owning it, the short-term actions of the markets should not prompt trading reactions either way.

“You ought to be able to explain why you’re taking the job you’re taking, why you’re making the investment you’re making, or whatever it may be. And if it can’t stand applying pencil to paper, you’d better think it through some more. And if you can’t write an intelligent answer to those questions, don’t do it.”

Unfortunately financial markets are offering stockholders plenty of reasons for day-to-day consternation. Thoughtful fundamental analysis of individual companies is being overshadowed by macroeconomic concerns, particularly of the European variety. Stock price correlations have risen to extremely high levels and prompted many to adopt an in-or-out mentality regarding stocks. Simply put, seemingly all individual stocks have been moving lockstep with the broad market indexes, and by the same percentages — day, after day, after day. In these climates, “trading” strategies always gain popularity, and holding periods longer than a week are categorically dismissed as outdated “buy and hold” approaches.

“Nothing sedates rationality like large doses of effortless money.”

“The Stock Market is designed to transfer money from the Active to the Patient.”

While I couldn’t find any Buffett-isms to precisely convey my next point, I believe he would endorse Peloton’s overall approach and our recent “activity.”In short, we are focusing on the specific aspects of investing which we can control:

  • Asset Allocation: We make tactical adjustments to ensure that each client’s portfolio remains risk-appropriate. When necessary, we trim stock positions to rebalance toward bonds. Portfolio structure is more important than short-term performance. When constructed properly, portfolios handily tolerate elevated day-to-day volatility. On this Buffett says, “Anything can happen in stock markets and you ought to conduct your affairs so that if the most extraordinary events happen, that you’re still around to play the next day.”
  • Buy/Sell Discipline: Having the right asset allocation allows investors to sell stocks when their own analyses lead them to the decision, not because markets are in turmoil. Buffett: “I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for ten years.”
  • Specific Portfolio Needs: Peloton buys stocks for clients because we understand the fundamentals and because they fulfill specific needs or objectives as an investment. Dividends are important where cash flow is a near-term focus, and long-term growth is necessary to prolong accumulated wealth throughout retirement and to benefit heirs. Our understanding of each company and/or our thesis for the investment does not always pan out, but we always know why we own what we own, where we think it is headed, and why we sell it, if and when we do. Buffett: “Risk comes from not knowing what you’re doing.”

Even when we are not trading much, behind the scenes we are actively “working the portfolios.” Each quarter, as companies report earnings results, we get a fresh look at their recent operating performance. We use this information, together with forward looking statements from management and a large grain of salt, to update our assumptions, company models and investment theses. (Mr. Buffett would probably say he doesn’t bother with short-sighted quarterly results, but I’m guessing someone at Berkshire very quickly gains a deep understanding of the causes if operating margins, at say Coca-Cola, suddenly fall short of their expectations.)

If management is executing, and if the current stock price still offers attractive return opportunities relative to the target, the stock remains in the portfolio. If earnings or cash flows are growing or if margins are expanding, the fundamentals force us to re-evaluate the price target. Recently Peloton raised price targets on standout performers MasterCard (MA), Home Depot (HD) and Qualcomm (QCOM). Sometimes a stock performs so well that its price level significantly surpasses the value our research has derived for the company, and the position is sold. Recently we sold Nike (NKE) across the board and realized solid profits. At any given time, a number of stocks are approaching or have exceeded targets and must be re-assessed in light of a new stock price and new fundamental data. At the time of this writing, targets are under review for American Tower (AMT), McDonalds (MCD), Ecolab (ECL) and railroads Canadian National (CNI) and Norfolk Southern (NSC).

All fundamentally-driven decisions depend on “valuation,” which lies at the intersection of the stock price and the underlying operating metrics. There are subjective components to assessing value, and even the most thorough analysis often leads to a non-tradable conclusion. “Valuing a business is part art and part science.” Peloton’s director of research, Steve Carr, agrees, “It’s remarkable sometimes how much work goes into a ‘hold’ recommendation.”

Investing is also always a capital allocation decision. At any point there are investments you do not own but could choose to buy. Accordingly, there are always stocks on Peloton’s radar screen that we evaluate side-by-side with stocks already in the portfolio. Some new names that we have recently approved or are watching closely include Deere (DE), Boeing (BA), Hasbro (HAS), Nuance Communications (NUAN), Starwood Lodging (HOT), NextEra Energy (NEE) and Hyundai (HYMTF).

The (New) Global Basics

The basics of valuing a security have not changed since Graham and Dodd literally wrote the book on it in 1934.1 However, the operating environments facing companies are always in flux. Short-term market gyrations are often driven by short-term issues. Traders quickly make or lose a lot of money betting on the changing odds of a European solution, or on the varying degree of dysfunction in Washington (which, in our estimation is stuck in a narrow trading range between “really, really dysfunctional” and “unbelievably dysfunctional”).

Some of the “art” of investing that Buffett mentions is vision — that is, recognizing a secular demographic trend or transformative new technology and preparing to profit from it before it is obvious to everyone. If a surfer could predict where the biggest wave in a set would begin to swell before others perceived anything, he would have an advantage. By the time the wave actually develops, it is too late to position for it or too crowded to enjoy the ride. Being able to identify good waves early would be a neat skill, but in order to be truly beneficial, the surfer has to also know how to surf.

Peloton’s research has identified a significant secular trend which is relatively early in its development, and we are employing strategies to profit from specific opportunities. The world is rapidly becoming a global marketplace for goods and services of any origin. National trade borders are disappearing, and all manner of capital is flowing more freely that at any time in history. As national economies and whole geographic regions become interconnected, living standards rise in developed and developing economies alike. In the next several decades, billions of people will have discretionary income for the first time, and they will consume goods and services made anywhere in the world. As we’ve said many times, a company’s “nationality” is not nearly as important as the end markets it is accessing.

The big three consumer economies — United States, Europe and Japan — together are massive but are already established and not growing very quickly. The exciting opportunity is elsewhere, especially in Asia. The emerging Chinese middle class alone is roughly the size of the entire population of the United States! The coming growth in global consumerism is staggering (more than $30 trillion in new consumer spending):

Forecasting is essentially free, but without a stake in the ground, there is no benefit from being right (and no cost of being wrong). Warren Buffett was perhaps already contemplating this trend when Berkshire first bought a stake in Coke in 1988. Unquestionably, some variation of this graph factored into Berkshire’s recent decision to buy $10.7 billion of IBM stock. Coke and IBM, two iconic American brands, are already much more “international” than they are American.2

Investing in emerging markets, particularly the “BRIC” economies, is hardly a revelation. But the consumer wave is deeper than popular infrastructure and commodity- based trends. It is also wider geographically than the big four: Brazil, Russia, India and China. The timing of this opportunity is also unique in investing history. Investors remain fearful after the last market crash, and European banking uncertainties are holding would-be stockowners resolutely on the sidelines. Ironically, heeding the following Buffett axiom will cause many to miss the great opportunities he outlines in so many other adages:

“Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.”

Once a macro trend is identified, sharpened pencils help Peloton decide how to invest in it. Table 1 identifies 14 attractive stocks in a variety of sectors that are poised to help clients surf the wave of emerging consumerism.

Basically No Upside

As a comprehensive wealth manager, Peloton is an asset allocator. We build and manage custom portfolios comprised of both stocks and bonds. We don’t get paid any more to own one asset class over the other, so our advice is always what we believe to be the best for each client, given unique circumstances and objectives. The only time that decision becomes uncomfortable is when equity markets make clients nervous — which has been almost always.

Warren Buffett is a great lover of equity investing. Owning pieces of companies and their operating profits is a tremendous way to build wealth — if you know what you’re doing. Stocks are often the most talked about because, quite frankly, if you use bonds the right way in portfolios, there shouldn’t be many surprises. Having the right bond allocation allows investors to take calculated risks in stocks, achieving higher returns when well-reasoned hypotheses play out.

Peloton is continually buying stocks, bonds and Exchange Traded Funds (“ETFs”). Our disciplines force us to keep them in proper balance for each client regardless of a bias towards one class or the other at any given time. That said, our general bias is more heavily skewed towards stocks (including the EM consumer stocks mentioned) than at any other time in our careers. The fear keeping investors out of stocks is driving them irrationally into safe havens like bonds and cash. The trick is, inflation, at just 2%, is already eroding purchasing power and creating negative real rates of return. A forthcoming white paper will illustrate the gapping valuation disparity between Treasurys which are 30 years into a bull run, and equities, which have run in place for more than a decade.

We like to quote Warren Buffett (and it is easy). Mr. Buffett has a wonderful knack for elegantly wording many allegories that match our philosophies. We don’t agree with everything he says, and I for one have never attended the Berkshire shareholder meeting in Omaha. We respect his success and admire his investing discipline and patience, but our approach is our own. I imagine he would respect that:

“You’re neither right nor wrong because other people agree with you. You’re right because your facts are right and your reasoning is right — that’s the only thing that makes you right. And if your facts and reasoning are right, you don’t have to worry about anybody else.”

1 “Security Analysis,” by Columbia Business School professors Benjamin Graham and David Dodd, was first published in 1934 and provided the foundation for modern “value investing.”

2 In 2010, Coca Cola and IBM derived 68% and 57% of total sales from non-US markets, respectively.

The Peloton Position is a compilation of original insights and writings by Peloton Wealth Strategists. This issue features articles by Matthew K. Bradley, Executive Director and Chief Investment Officer.