Friday, January 6, 2012

Strategy for Making 20% in 2012

First off - find me on Twitter! I'll be feeding all my research and article updates through there. Second, just a reminder that I'm no longer updating this site (with the occasional exception obviously).

Strategy for Making 20% in 2012


20% is a magic number for me. Jim Collins talks about the "20 Mile March" that great managers use to perform well in good times, bad times, and in chaos. Buffett always said his goal was to return 20% (and if you look he has done it...20.2% on average since 1965 to be exact). Many money managers are suggesting that with a delevering global economy, we should lower our expectations for returns in the capital markets.

These guys are wrong.

I mean, technically they are right. Bond yields are at historic lows, and at most we'll get another 2 or 3 years of rallies in treasuries and other short term high credit fixed income. After that the risk premium in ultra low interest rates kicks in and those are dead money. Equities, by comparison, are where you have to be.

But they're still wrong.

Money managers are just not flexible or ballsy enough to capitalize on opportunities in this market. You have to trade and not get married to ideas or theses. Here's what I'm thinking: a euro-crisis, potential US munibond crisis, potential gold bubble, and a slowdown in commodities - none of that will effect short term equity returns. Here are the 3 things that will drive sentiment in the first half of 2012:
  1. US Housing Market Improvements
  2. Outperformance of US Financials (driven by better than expected GDP growth and less exposure to sovereign debt than currently priced in)
  3. Demographics of North American Retail Investors
The first two points speak for themselves. I think a major trend the market isn't considering is the future demand to be expected by aging baby boomers with nothing to retire with who are forced to overweight equities over fixed income paying nothing. They should not be buying commodities or gold, it should be Coke and McDonalds. As institutional investors moved into large cap US in a big way, we'll see that trade disseminate to the perennially late to the party retail investors in 2012.

I believe this sentiment gets you to 1420 at the maximum.

When this trade runs its course, and I do believe we will see 1420 at some point this year, then it's time to go mostly cash for all the obvious reasons:
  1. Euro debt could take 10 years to get to ideal levels (<60% of GDP) assuming ideal interest rates, gdp growth and inflation. Look at Argentina as a good precedent of this. Read GMO and Jeremy Grantham to help inform your long term view.
  2. Income Inequality in the US - the next wave of prosperity will have to include the redistribution of capital. Less billionaires but far more millionaires? Perhaps less millionaires, but also less people living in 'tent cities'.
I think China concerns are overblown - there are definitely problems but a keen look into the housing situation reveals something much more stable than the US MBS collapse. They are ahead of the pack on raising rates and bank reserve requirements and will outperform in my view. It is, however, still a tail risk.

Target For the S&P 500 is 1175

People keep disregarding the Shiller 10 Year P/E and saying we're in a new normal. I agree with those that say we are in a new normal for profit margins, but definitely not to this extent for the multiple. A multiple of 16.5 for the Shiller P/E implies a current market price of about a 1000. I ran a comprehensive DCF for the companies that compose 75% of the weight of the S&P and found that if every sector returns to fair value the index is worth 1175. That assumption includes big haircuts for financials and conservative growth estimates for most other sectors, and I trust it. In between those two figures is a cheap market. This is where bets should be placed, and I think we'll get at least one opportunity in 2012 to see these levels. Instead of being scared into gold or treasuries, buy common stocks.

S&P: Buy Common Stocks Below 1175 and Sell Them At 1400

Selection Criteria For Individual Equities

I'm looking for companies with a large margin of safety and good catalysts, that I can swing trade in and out of throughout the year.
  1. Average Volume >1MM
  2. Market Cap > 2B
  3. P/E < 12.50
  4. P/FCF < 15
  5. P/B < 2
  6. 5 Year EPS Growth > 5%
  7. 5 Year Revenue Growth > 10%
  8. Preferably a Dividend Yield > 2.5%
  9. No Financials, No Commodity Businesses, Preferably no Cyclicals
I cut some of my 2011 holdings and have been implementing this strategy since middle of December to some good success. Keep in mind that this is trading, not value investing. I'm stepping out of my comfort zone as I believe we are in a sideways market. I'm shortening my time horizon. I would only recommend this strategy to active money managers and would still recommend buy and hold to the majority of people I meet on the street.

Disclosure: As of writing this I am in Dolby (DLB), Eli Lilly (LLY) and Staples (SPLS)

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