Investing in 2010: The Opportunity Continues

Let me begin with my best prediction for 2010: I will not match last year’s picks!

In
my preview last year I suggested that the market had a gift for
investors. There was too much negative sentiment about bailouts and the
economy. It took some time to prove out, but it was basically accurate,
and for the right reasons.

I named four stocks. The worst of
these was up 40% (from the date I wrote the article through the date I
am writing this). The average return, without dividends, was up over
85%.

When everyone was worrying about having missed the rally, and many were calling a market top at the end of August, I did a review of these picks indicating more room to run.

The four stocks gained an average of 18.7% after this article, in the last four months of the year.

I emphasized this with a debunking of the “Sell in September” calendar theory.

Obviously,
my clients were not exclusively in these four stocks, but we had a
great year and have had a nice run for the eleven-year history of our
investment program.

The Opportunity Continues

This
year’s story is more complex. While the opportunity is no longer “a
gift”, it is still very strong. In this article I will discuss the
right attitude to take, some mistakes to avoid, and some winning traits
that are especially important right now.

Next, I will consider
some key themes for the year and the opportunities I see as a result.
Finally, I will show what this means for the individual investor.

The
investment landscape is as challenging as ever. A survey article like
this cannot anticipate everything that will happen during the year. It
can provide a starting point, and emphasize what to watch. It will pay
to monitor data and developments, remaining objective at all times.

The Winning Perspective

The objective for 2010 is to find successful investments. This requires three things:

1. Identifying companies where business prospects are better than most expect.

2. Finding an attractive stock price to establish a position.

3. Waiting for the market to recognize what you have already seen.

You
are not rewarded for being accurate in economic forecasting, since
stocks are not GDP futures. In particular, you are not rewarded for
confusing your political opinions with investing.

Three Mistakes to Avoid

False Comparisons

Where You Finish Depends on Where You Started

There
is a popular methodology that is very expensive. The analyst finds some
time in the past that he thinks is comparable. So this recession is
like the 70’s. Or the yield curve is like Japan. Or here is the path of
job recovery in the last several recessions.

This is all
completely bogus, and you should ignore it. There are not enough cases
and there are too many dissimilarities. Any disciplined researcher
would reject this approach. So why is it so popular? Most writers are
not experts in research methods, but they are wordsmiths. And by the
way – adding a chart or two to the article does not make the analysis a
solid quantitative piece. It usually invites the reader to become an
“instant expert” by looking at a misleading chart.

Most people
these days are aware of the dangers of computer models that “post-dict”
by looking at all of the old data. The human mind is the most powerful
computer, with plenty of imagination.

Why are these comparisons so bad?

I’m
going to state this in very simple terms. Most recessions were mild,
this one was deep. Trying to compare the other paths to this one is
sloppy work. There is a chorus of pundits and fund managers stating
that the 2009 market rally from the bottom was not justified by the
fundamentals. They see plenty of problems. The rally is greater than
that from other recessions. Ergo, the rally has moved too far. The
problem is the failure to recognize the starting point. The March
bottom was not the low from a normal recession, but a “death warmed
over” bottom. It was 25-30% lower than expected by most bottom-calling
methods (including ours).

Ignoring Data

There
is a powerful movement encouraging people to ignore data. Many pundits
find something wrong with every report. At the extreme, the government
reports are characterized as political and manipulated. The private
reports are often viewed as biased as well. This is a powerful leveling
force for those who have limited methodological skill.

In a world where anecdotes rule, everyone can tell a story.

Getting Political

The
investment discussion became highly partisan early in 2009. We can
expect another year of the same. It is a serious investor error to
confuse political opinions with forecasts about the economy or the
market. Even a program that we do not like – a wretched compromise –
will have some impact. It is better to identify the winners and losers.

I call it political agnosticism – a willingness to make money no matter what party is in power.

Winning Ways

Find Solid Forecasting

Predicting
the economy is not easy. It is easy to criticize economists, saying
that they are all foolish. Successful investing does not require
perfect economic forecasting, it only requires an edge. In 2008 those
making the most extreme calls got a lot of notoriety. I recommend
taking a longer viewpoint. The consensus of economists is an
interesting piece of information. Some of the respondents in these
polls have their own macro-economic models. Most are interpreting the
work of others.

I emphasize that we are all consumers of data
and forecasts. I find the forecasts from the Economic Cycle Research
Institute to be very valuable. The ECRI makes public some general
information, including this article written for an audience of investment advisors.

Conclusion: The ECRI is bullish on the economy

Mid-Course Adjustments

No
matter how well a forecast is prepared, things change. When the
circumstances change, you must be willing to adjust. In 2008, the fall
of Lehman was a game-changer for the economy and all related forecasts.
No one knew for sure what would happen. We now know what occurs when
there is a complete cessation of normal lending.

In 2009, many
pundits expected a complete economic collapse. They underestimated the
combined force of massive government interventions. This was also a
game-changer, and it called for a revised forecast.

Ignoring the Political Debate

The
GOP is headed for major gains in the mid-term elections and will make
things seem as bad as possible. This is good strategy. The Democrats
will try to show economic progress. Many of the arguments – measuring
the number of jobs created or saved is a good example – depend upon
sophisticated methods, assumptions, and conclusions where there will
never be agreement.

Investors should focus on data, not the
political spin. In 2009 the political argument became an economic one,
just as it did in 2004 and again in 2008. We can expect much more of
the same in 2010.

Focus on real measures of progress, or the lack thereof.

My Major Themes

Pulling this together, I see several key themes. These observations are the background for winning investments:

• Market
  valuation is quite attractive. We have not yet hit the initial target
  of pre-Lehman market prices, even though the depression-like scenarios
  are off the table. The market has traded in line with corporate bond
  rates (based upon forward earnings). The rates still reflect elevated
  risk, and bonds also carry the risk of increasing rates. The market is
  attractive by comparison. This is a stronger approach than the
  backward-looking methods that give excessive weight to the post-Lehman
  earnings.
• Economic growth is looking brisk. There is
  plenty of additional running room. The mere removal of negative
  factors, like the decline in housing, adds to economic prospects. Many
  critics ignore the natural economic tendencies – using slack resources
  and adding productivity.
• Corporations are starting to invest. Recent earnings reports from Research in Motion (RIMM), Micron Technology (MU), and Oracle (ORCL)
  show that business investment is beginning a rebound. This is only a
  start, with room to run. The Windows 7 launch creates a business
  upgrade need. Delaying investment was an easy choice during the
  recession. It can be a driver as it is reversed.
• Government
  stimulus continues. Many do not realize that the stimulus package is
  spread over three years, with most of it still to come. The Fed remains
  accommodative.

What to Watch

There are several data themes to observe closely.

• Housing
  sales and prices seem to have stabilized with the help of various
  programs. With continuing mortgage resets and high foreclosure rates,
  this bears watching.
• Credit growth. Everyone understands
  the problem of excessive lending. The economy depends upon what I call
  normal and sensible lending. So far, credit is still tight, especially
  for many emerging businesses.
• Employment must start to come around. Job growth lags the economy and the market, but we need to see improvement.

My Themes

I
see several strong investment themes. My standard is the expectation of
25% appreciation, a double in three years. It does not pay to be greedy
and swing for the fences. Obviously, I do not hit the target with every
pick, but using this guideline helps to find a balance of winners.

Technology:
This will be an early move for businesses and it should have legs.
Investors can look to the big names in the group to get appropriate
exposure. I like and own Microsoft (MSFT) and Intel (INTC).

Growth: Every portfolio needs some growth stocks. There are several choices, but I continue to like Apple (AAPL).
If you back out cash holdings and look at forward earnings, you see an
attractive price-to-earnings growth (PEG) ratio. You can play
technology and growth more conservatively via XLK.

Health:
The year-long cloud over health stocks has lifted. Investors can look
to the sector for choices in managed care, big pharma, hospitals, and
information technology. I am looking for a basket of these stocks for
client accounts, but you can play the sector effectively with an ETF – XLV.

Cyclical Stocks:
As the economy improves, some companies are poised for exceptional
profit growth. I look for stocks with exceptional leverage on operating
earnings. This is a work in progress, but my current favorite is Allegheny Technologies (ATI). I bought this in the mid-30s for clients, but there is still plenty of potential.

Energy:
This is a special case. There is slack in energy markets, but it could
be taken up quickly. I am less enthusiastic about energy as an
immediate play, but we could find ourselves back to the tipping point
as the year progresses. I have de-emphasized energy at this point, but
I could revise my opinion rapidly if the global economy comes around.

Emerging Markets:
I expect more stability in the dollar, but a continuing secular growth
story in emerging markets. There is plenty of news in individual
countries so investors can play this via ETFs including EEB or EEM.

Summary

There
is a widespread feeling that the “easy money” was made last year. In
fact, we actually just got back to square one. The many skeptics set up
a traditional environment for a rally. As corporate profits and revenue
growth prove out, the relevant stocks will react.

Investors have
trouble buying stocks that are well off of the lows. This is a mistake.
Few people call an exact bottom in any stock. At some point, the
fundamental story becomes attractive. Some of my biggest successes came
after I waited for real evidence – not buying the bottom, but picking a
time of lower risk. Many stocks are now in that range.

Individual Investor Implications

For
the investor who has “missed the rally”, there is still time. I do not
see the market rally as in the “late innings". Well-chosen specific
stocks can do very well—gains of 20%+.

For those with a negative
world view – suppose you think that the Fed, the President, and the
Congress are all blundering. You do not need to be “all in” on this
viewpoint. Consider allocating some investments to stocks with great
potential. A few big winners can help you if your overall political
viewpoint is incorrect.

For those who are worried about risk –
consider a program with a built-in asset allocation method. There is a
demand for this. We have developed such a product, and so have others.
It allows you to dip in, with a limit on possible losses and attention
to increased risk. Our approach shifts to other assets based upon
quantitative methods.

Each investor is different. You need to
consider your investment goals, your full range of assets, your risk
tolerance, and other factors. If you do not know how to do this, you
might consider getting some professional advice.

Most new
investors I talk to are under-invested in stocks, ill-prepared for
retirement, and have nothing to combat inflation. A general rule is to
determine your “normal” stock allocation and increase it by about 10%
to reflect the current opportunity.

[We own most of the stocks mentioned in both personal and
client accounts, and we are shopping for positions in the others.   The article originally appeared a week ago as part of Seeking Alpha's series where
ten managers were invited
to provide their thoughts about 2010. 

I really appreciate Seeking Alpha's kind invitation to participate in this series.  Seeking Alpha has become much more dynamic and important in the last year, drawing contributions from many strong sources.  Readers of "A Dash" will find many good
ideas in the series, which is refreshingly different from the MSM
approaches.]