Sunday, July 21

Week 107 - Gambling vs. Charity: How to Tell the Difference

Situation: Whether you trade stocks actively or use a “buy and hold” strategy, you’ll need to know the pitfalls of your risk profile. If you go for stocks that have a strong record of rewarding investors, you need to know that many of those same stocks are favored by short sellers. At some point, many high-flyers fall in price, fast. Sure, if you hang on to them for 10 yrs you’ll still get a nice return. But if you have to sell into a bear market, the “shorts” will pick your shares up for cheap: You have gambled and lost. On the other hand, you may get sucked into buying financial or technology stocks that are impossible to analyze, decide to hang on to those in a bear market because you're a believer, then find that your returns can’t (and won’t) keep up with inflation: You have made a charitable contribution.

Let’s start with quantitative definitions for gambling and charity. Gambling would be buying stock that historically gives returns equal to or better than the strongest definition of a “business case,” which is that you’ll very likely double your money in 10 years even after adjusting for inflation. Looking at the past 10 years, that means a total return of 7.1%/yr to double your initial investment + 2.4%/yr for inflation = 9.5%/yr. Going to the Buyupside website to check out stocks composing the S&P 100 Index, we find that 50 satisfy that requirement. However, only 25 of those had losses during the 18-mo Lehman Panic period that were no more than 2/3rds as great as the loss of the lowest-cost S&P 500 Index fund (VFINX). Investing in any of the remaining 25 companies would therefore label you a gambler, unless you’re a stolid “buy and hold” investor. Some of the “blue-chips” in that high return/high risk category are AT&T (T), Walt Disney (DIS), UnitedHealth Group (UNH), United Technologies (UTX), Caterpillar (CAT) and Boeing (BA).

Charity is easier to define: that’s where 10-yr total returns were less than inflation (2.4%/yr). There are the 9 “charity cases” in the S&P 100 Index: 
Five are financial companies
American International Group (AIG)
Citigroup (C)
Bank of New York Mellon (BK)
Morgan Stanley (MS)
Bank of America (BAC)
Two are information technology companies 
Dell (DELL)
Intel (INTC)
One is an industrial company that gets most of its earnings from loans (GE)
One is a pharmaceutical company (LLY).

You are not interested in leaving money on the table for short sellers or charity cases. So what about the remaining 66 companies in the S&P 100 Index that don’t pose those risks? Some must have a “business case” for attracting investment, as well as a business plan that limits losses during a bear market. Let’s find those by confining our attention to companies that had 10-yr total returns of at least 9.5%/yr but lost no more than 2/3rds as much as VFINX during the Lehman Panic (i.e., lost 31% or less).There are 25 such companies. Owning those stocks makes business sense and isn’t a gamble. To determine which are likely to continue to prosper, we turn to the Barron’s 500 Table that analyzes recent sales and cash flow trends. Seventeen of those companies were either in the top 200 for both 2011 and 2012, or had a higher rank in 2012 than in 2011 (Table). Three of those 17 are on our list of Lifeboat Stocks (see Week 106): COST, ABT and SO. Two companies (NKE and IBM) are on our Core Holdings list (see Week 102).

Bottom Line: Excessive risk-taking amounts to gambling, since short-sellers stand ready to buy your volatile stocks when you give up and sell them cheap. Alternatively, you can “ride out the storm” and hold onto those stocks--provided you are very confident the company will recover lost sales. But for financial and technology stocks, you’re unlikely to ever have enough confidence in future revenues to make that judgment. Holding onto those stocks in a bear market can amount to charity. For example, Intel and General Electric are former high-flyers that haven’t kept up with inflation for the past 10 years! 

"The markets can remain irrational a lot longer than you and I can remain solvent” - A. Gary Schilling, 1993.

Risk Rating: 4

Full Disclosure: I dollar-average into DRIPs for IBM, ABT, and KO; I also have stock in Accenture and Berkshire Hathaway.

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