Had someone warned me that my 2-year business school education would ultimately cost me more than a million dollars, I might have thought twice about enrolling at Wharton.  But, as my corporate finance professor, the late Isik Inselbag, was fond of reminding us, “a sunk cost is sunk.”  And so, instead of regretting the possibility of early retirement, I’ll continue to reflect on my initial forays into investing as an instrumental part of my secondary education.  Expensive yes, but probably worth every penny.

Within months of picking up my undergraduate degree in mechanical engineering in 1985 I was at the Dayton offices of Merrill Lynch opening up my first CMA account.  I still chuckle at the thought of running into a friend’s father, a local big producer at the firm, who inquired as to whether I was running an errand for my father.

Like many things, profitable investing is a skill acquired through trial and error.  Over the next few years I was all over the board - dabbling in stocks and mutual funds, writing covered calls on high-growth tech and biotech stocks, adding margin to the mix to leverage my insights.  In hindsight I didn’t make a lot, but learned a few key lessons that stick with me still.  Among them, covered call option strategies are “win a little…win a little…lose a lot” propositions – especially when paying pre-discount broker commissions! 

When Black Monday reared its ugly head on October 19th, 1987 I sunk with the rest of the go-go crowd, down a whopping $20,000 plus in one day.  Fortunately I had the wherewithal to hold steady and recoup a good portion of those yet-unrealized losses over the coming year.  Still, it became clear to me that investing was best viewed as a long-term proposition – there are no “free lunches”.  I regrouped and dedicated myself to looking for companies with great growth prospects that I could hold for years, not months, and set my sights on getting a business education that would teach me how to better evaluate stocks.

About this time, Dell Computer was filing for their Initial Public Offering (IPO).  I knew their business model was head and shoulders above those of IBM and Compaq and became quite comfortable that the company’s price advantage coupled with the quality of their products should allow them to continue taking market share.  Valuation?  Couldn’t tell you, as without formal financial education, it was impossible for me to compare apples (or should I say IBMs – with their steady-state profit margins) with oranges (Dell’s money-losing, yet high-growth venture).  Still, the offering looked intriguing and I decided to invest, not at the IPO, but in the secondary market after the stock had a chance to settle down.  After all, this was still soon after Black Friday, investors remained skittish, and the prospect of a company’s stock doubling during its debut was remote.

I finally took the plunge in June of 1988 (see trade confirm above), plucking down about $3,000 for 300 shares.  Happy camper that I was, I was determined to hold for the long-term.  I entered grad school in the fall and continued to follow the company’s escalating battles with IBM, Compaq and Gateway and recognized the company’s stagnant profits to be a growing pain.

Alas, even the best laid plans go astray.  While a fool and his money may soon be parted, a full-time grad student and his money likely parts quicker.  In my last semester of business school I found myself down to my last few thousand dollars and needing to pay tuition.  Looking back on things, I should’ve hit my parents up for a loan…pleaded, begged, whatever.  Instead I reluctantly sold my Dell shares, took a small loss and remained solvent throughout the remainder of my education.

Those shares – I didn’t really follow them closely over the next few years, but somewhere around 1997, I checked in again.  Suffice it to say, they did alright without me.  Went on to split a few times – alright more than a few…

Shoulda’, coulda’, woulda’…c’est la vie.

Lessons Learned

While I didn’t pocket the big change on this investment, it did provide a fertile learning opportunity.  A few thoughts to ponder -

1. Common sense is not so common.  What I viewed as obvious – that Dell’s business model was far superior to those of IBM and Compaq – wasn’t so obvious to most investors in the early days of the company.  Instead, as is often the case, public shareholders focused their attention primarily on earnings growth, largely missing the long-term, industry changing, implications of a superior business model.  In my opinion, the same is true of Google today, though I would hazard it’s pretty well reflected in the GOOG’s price.
2. When investing in an early stage company and, though public I’d suggest that Dell was early stage in 1988, look for the fundamental difference that’s going to drive success and remember that investing in growth stocks is about patience and letting the concept play out over long, long periods of time.  Buy a small stake and hold, hold, hold.
3. It’s really, really tough to resist the temptation to sell as an opportunity unfolds, especially when the initial investment is substantial.  In my opinion, this is another argument in favor of small initial positions.  You’ll sleep better as the psychological factors associated with short-term price swings should be much more manageable.
4. For mature companies, earnings and free cash-flow growth are key metrics for gauging value.  Not so for early stage, renegade companies capitalizing on new business models or concepts.  Instead keep your eyes on top-line revenue growth.  If the concept takes hold, the explosion in revenues will signal it and more likely than not, management will find a way to turn that revenue growth into profits.
5. Stock splits are extremely powerful compounding tools, let them work for you.

Wall Street teems with folklore surrounding appropriate trading strategies at various points in the economic cycle, election calendar, and calendar year.  There’s the annual “Sell in May and go away” advice which dictates that profit opportunities in the broad market are typically subdued from May until the Labor Day.  There’s the presidential cycle phenomenon, where stocks generally perform poorly in the first two years of a presidential cycle and well during the second two years.  (Further analysis by William Hester of Hussman Funds points to some interesting sub-trends likely playing into this year’s final quarter.)

Today, with long-term interest rates low, commodity prices collapsing, and economists envisioning a slowdown on the horizon due to a cooling housing market, the idea that the next Fed move is more likely an easing than a tightening is gaining credence amongst market participants.

More often than not, discussion of possible Federal Reserve interest rate easing is coupled with seemingly boilerplate market commentary noting that lower interest rates provide a positive catalyst for market returns and prodding investors to front-run the Fed and gain exposure to a stock market that’s poised to move higher.

Nice story.  Clean, intuitive. A “feel-good” outlook that’s always appealing.

But what does the data show.  We examined market returns during both Fed easing and tightening cycles to unearth the reality behind the myth.  Specifically, using S&P 500 price returns from 1954 through this month along with historic Fed funds rates, we look at how the broad market performed 2-months before a shift in Fed policy through 36-months after the initial move took place.  We note the following upfront:

• market returns for the S&P 500 series we used didn’t include dividends, so they’re a bit lower than investors would have realized
• due to the small number of sample points, eleven easing and tightening cycles, the averages aren’t statistically significant.

That said we’re after general trends, not detailed statistics, so we’re comfortable with the limitations of our analysis.

Fed Easing

Contrary to popular opinion, average returns realized following the commencement of a Federal Reserve easing cycle have been abnormally weak for the first year after the change in policy took effect.  Through the first thirteen months the stock market has generated price returns of slightly less than 1% cumulatively with a maximum of 30% (April 1995 easing cycle) and a minimum of -20% (July 2000 cycle).

Interestingly, cumulative market returns from two months prior to the beginning of a Fed easing cycle were uninspiring as well; down roughly 0.70% cumulatively.

Beyond thirteen months into a Fed easing cycle the market has generally fared well, rising 22.5% in year two (months 12-24) and 12.9% in year three.

Fed Tightening

Perhaps paradoxically stock market returns leading up to, and during, the early stages of a Fed tightening cycle have been quite robust.  From two months prior to the first Fed tightening to the start of the cycle, the market gained an average 3.8%. 

More interestingly, from the start through the first ten months of the tightening campaign the market averaged gains of an additional 10.85%, with a maximum of 35% (October 1986 tightening cycle) and a minimum of -10.7% (July 1961 campaign).  Only in the 1961 cycle did stocks post a negative cumulative return during the first ten months.

Beyond ten months into historic tightening cycles, stock market returns began to suffer.  The average second year returns (months 12-24) weighed in at -4.6%, while returns in year three recovered by 9%.  The maximum drawdown occurred between months ten and twenty-four; a cumulative -8.5%.

Easing vs. Tightening

While we stress that the numbers presented aren’t statistically significant the stock market return trends displayed in Fed easing vs. tightening campaigns is insightful nonetheless. Investor’s would be wise to keep a few ideas in mind with regards to tight versus loose money environments.

• Since 1954, stock market returns have lagged the beginning of Federal Reserve monetary campaigns by between ten and thirteen months on average.
• The first thirteen months of Federal Reserve easing campaigns have been associated with abnormally weak stock market returns.

Our conjecture - The monetary authority typically begins an easing cycle only when the economy has shown clear signs of faltering.  In the early stages of an easing campaign the economic benefits of future expected rate cuts are more than offset by the effects of a slowing economy, leading to sub-par stock returns. 

• Historically, stock market returns have remained robust up to ten months after the beginning of a Federal Reserve tightening campaign.

Our conjecture - The monetary authority typically begins a tightening cycle only when the economy has shown clear signs of overheating.  In the early stages of a tightening campaign the strength of the underlying economy more than outweigh the future effects of higher interest rates, leading to continued strong gains in equity valuations. 

While common wisdom holds that investing in stocks at the beginning of a Fed easing cycle provides investors a fantastic opportunity to capture equity market returns, it’s not clear to us that this is an optimal strategy.  More appropriate may be a strategy of maintaining an overweight in the long-end of the government bond market twelve months into an easing campaign before switching to stocks. 

Most investors approach saving for retirement, whether through taxable or tax-deferred accounts such as 401(k)'s and IRAs, similar to that of a "rainy-day" fund. Put as much as you can into your available tax-deferred investment options, invest in the either conservative stock, asset allocation and bond funds (in order to minimize the risk of losing money) or aggressive stock funds (with the goal of riding out any market downturns over the long-term), and call it a day.

But will it be enough? It's a tough question to answer due to the large number of variables that can impact your chances for success but let's see if we can simplify the problem to help derive a rough approximation of how much you'll need to sustain the lifestyle you desire well into your retirement years.

Estimate Retirement Living Expenses: How much money would you need to live comfortably for the next year, if you were to quit your job today? If you haven't spent time thinking this through, it's a good first step in gaining control of your finances. Consider only items that you would have to pay for during retirement for you and your spouse - no babysitting fees, children's clothes, college tuition, etc.

Next, let's consider taxes. Remember, any funds generated from tax-deferred retirement plans will be taxed as income when they are dispersed! In an effort to be conservative, we'll assume that all retirement living expenses are generated from taxable income. Divide your annual living expenses by 0.65 (which implies a 35% tax rate). This number represents your pre-tax living expenses

As a check, divide your pre-tax living expenses by your current income. Many experts calculate that in retirement one needs roughly 70-90% of their final pre-tax income to live comfortably. How does your calculation stack up? Of course this amount can vary depending on how active your lifestyle will be in retirement, but for our example we'll use 90% of a current salary of $111,000 as a conservative estimate.

How Long Do You Plan to Live?: Admittedly estimating personal longevity is a wildcard. Life expectancies continue to increase and a longer lifespan calls for greater retirement resources. Perhaps the best we can do to conservatively account for increasing longevity is to plan on saving enough money so that the resulting portfolio will be able to sustain itself in perpetuity, after annual living expenses are dispersed. To those in the financial industry this is known as a perpetual annuity. In simple terms the retirement portfolio must generate enough return to offset annual withdrawals and inflation each year in retirement.

When Do You Plan to Retire?: The longer time horizon you have to build up your retirement nest egg, the better. Recognize that wealth doesn't grow linearly, it grows on a compounded basis so while $100,000 returning an average 8% per year for 10 years grows to approximately $216,000 the same $100,000 invested at 8% for 20 years grows to $466,000, or a bit over $1,000,000 in 30 years. Compounding is one of the keys to investment success, so the earlier you get started the better you'll fare.

Forecasting Inflation: Inflation is one of the biggest risks to the retirement investor. Simply put, it'll take much more than $1 in 30 years to buy what $1 can buy today and savers need to be aware of this point. Assuming bank deposit rates of 1% and inflation growth of 3% per year, the real value of $1 today will be cut in half in 30 years, after taxes. Conservatively, we'll assume inflation of 3% per year over the foreseeable future.

Returns Matter, A Lot!: It goes without saying that the higher the level of returns you're able to generate, the better. Over the past decade, the stock market has compounded at roughly 10.5% per year. Going forward, that number is likely to drop a bit. We'll assume returns of 8% per year are achievable over the long-term for retirement investors. Those with astute investment skills, or skillful investment advisors, may do better.

Putting it All Together: The table below presents our estimates of the lump sum a retirement saver would need in a tax-deferred account at present in order to enjoy $100,000 of pre-tax income annually, in perpetuity, upon retirement. Inflation is assumed to be 3% per year and the $100,000 of current income increases annually by this amount, so that the retirement saver's real spending power remains constant over time. Additionally, no further investment is assumed to be made by the investor.

Readers who estimate retirement income needs differing from $100,000 per year can scale the portfolio values up, or down, to arrive at estimates that best fit their needs.

An interpretation of the table is as follows: A retirement saver with 20 years until retirement who expects to generate 8% returns annually into the future would need a current tax-deferred portfolio totaling $775,000 in order to generate a perpetual income stream of $100,000 (inflation adjusted) upon retirement.

As you can see, the benefits of saving early and/or finding a way to generate higher returns are substantial. Perhaps we can help? If you have questions on the above table, or your unique situation, please don't hesitate to call or e-mail us.

1) Focus on Long Term Trends: Now more than ever it is important that investors focus on long-term trends to harvest financial gains. In the 1990's money could be made by opportunistically buying shares in companies that missed a quarterly earnings estimate only to rebound the next quarter. Now however, quarterly earnings misses are often the sign of larger underlying business problems and buying into what is perceived to be a short-term situation often leads to long-term misery. Instead, investors should look out 5 to 10 years and give deep thought to what trends are likely to take place over this period. For example, pharmaceuticals and healthcare services are likely to grow over the next decade as the baby-boomer generation ages. Additionally, the use of credit/debit cards is likely to continue growing as is dining out.

2) Emphasize Real/Hard Assets: A corollary to focusing on long-term trends. In the 1990's most money was made buying financial assets. Companies were rewarded for expanding their businesses aggressively to reach what was perceived to be ever-increasing demand. The real cost of debt relative to equity was low and businesses were formed and financed based on nothing more than business plans. Today however, we're in an economic environment characterized by oversupply in almost every industry. Airlines, automobiles, steel, telecommunications...the list is truly massive. It is likely that returns generated in these industries will be low for the foreseeable future as companies compete by lowering prices, squeezing their margins. As an alternative, investors will likely do better by focusing on companies that own hard assets including commodities such as timber, oil and perhaps precious metals, as well as other real assets including long-term patents, exclusive licensing agreements and technological/medical research and development.

3) Buy Market Leaders at Attractive Valuations: It is no longer enough for investors to identify an attractive market sector and buy the first company that comes to mind. In an extremely competitive business climate you want to own the best companies that are profitably gaining market share from their competition, for it is quite likely that only a few companies in each industry will be left standing five years from now. More than this, you want to buy these companies at attractive prices. What is an attractive price? If you don't know, then you honestly shouldn't be buying! But read on.

4) Value Companies Using Cashflow, not Earnings: As we have all seen over the past few years, corporate earnings can be, and routinely are, manipulated to meet Wall Street expectations. Moreover write-offs, restructuring and other one-time charges that distort a company's true operating performance can significantly impact earnings. Free cash flow, in any number of forms, does not have these problems and is often a more accurate depiction of a company's operating performance. Additionally, because the numbers aren't as volatile, valuations based on cash flow tend to be more uniform across industries making comparisons more meaningful. To learn more about valuing a company using free cash flow try "Valuation: Measuring and Managing the Value of Companies" by Tom Copeland and/or McKinsey & Co.

5) Don't Be Afraid to Sell Your Winners: In our opinion, the "buy and hold" strategy preferred by many is unlikely to work well over the next ten years. The competitive environment has changed from creating and expanding markets to gaining market share from new and existing competitors. As such companies on the whole and large companies in particular, are unlikely to be awarded the valuations available during the '90s. For example, Coca-cola traded at over 45 times earnings in 1998 when their growth into emerging markets was viewed as a key driver. Even so, this was an incredible multiple for a company with long-term growth prospects of 7-10% per year! Today the company is in a fierce market share battle with Pepsico and is trading at 23x earnings. Companies go in and out of favor on Wall Street and taking advantage of this phenomenon will add meaningfully to investor returns in the years ahead.

A second related implication is that disciplined, actively managed mutual funds from research-oriented shops are likely to out-perform index funds over the coming years. In a relatively trend-less environment, astute buying and selling will make up a significant portion of the overall returns generated by skilled portfolio managers - value that was not meaningful in the up, up and away days of the late 1990's and that index funds simply cannot match today.

6) Explore Alternative Asset Classes: Whether it be emerging markets debt and equity, international small cap, long/short equity strategies or natural resource funds, alternative asset classes offer investors diversification opportunities and good prospects to outperform traditional large cap equity funds over the next few years. Each asset class has its own driving force but opportunities abound for the resourceful investor. For example emerging markets should benefit from very attractive valuations relative to U.S. large cap stocks along with growth driven by increased outsourcing by U.S. and multinational firms looking to drive down their cost structures.

Funds that look attractive to us include AXA Rosenberg Value Long/Short Equity (ticker: BRMIX), Hussman Strategic Growth (HSGFX), UAM Acadian Emerging Markets (AEMGX), Oakmark Global (OAKGX) and Royce Special Equity (RYSEX).

The next five to ten years are likely to be a difficult environment for the stock market, but if you follow the above disciplines religiously we suspect you'll come through wiser, and wealthier, for the effort.