In my last article, I did a pre-mortem of my portfolio of investments. Below are the macro-highlights from my analysis.

• Discounting for where we are in the interest rate cycle, the stock market looks expensive.
• Taking into account interest rates and the inflation, markets seem fairly priced
• Unemployment is at historic lows and wage growth is finally catching up to historic norms.
• All the extra cash in the pocket will further drive consumption,and a  positive feedback loop of increased corporate profits and further gains in equity valuation

It is quite evident that atleast for 2020, I am quite bullish as far as investing in equity markets go. That said, there are several macro-indicators that are pointing in the other direction. In todays article, I want to highlight a few those of these to shed some light on where we are in the economic cycle.

Purchasing Manufacturer Index (PMI)

YCharts has an excellent definition of what PMI represents:

PMI is used as a leading indicator of economic health, given that it is a survey of industry participants into activities such as sales, employment, inventory and pricing. Manufacturing activity reflects consumer demand, growing demand leads to growing activity and vice-e-versa. It is clear from above chart that for more than a year now, we are in the down-cycle for manufacturing activity.

When would this slowdown manifest itself in the equity markets? Who knows, but may be now is the time to be cautious.

Smart-Money Flow

The table below provides a summary of fund-flow across various asset classes in the past 20 years.

It is striking to see the amount of fund outflow from equity markets in 2019. The corresponding growth in liquidity seems to suggest to me that all the smart-money seems to be sitting on the sidelines, waiting to be deployed.

Buffett Indicator

Warren Buffett suggested that the percentage of total market cap (TMC) relative to US gross domestic product (GDP) “is probably the best single measure of where valuations stand at any given moment“. The chart below shows where we are currently in the market-cycle in absolute terms and relative terms wrt to the trend line for the Buffett Indicator.

In absolute terms, the Buffett indicator suggests that the expected future growth relative to actual economic output is currently is quite bullish, a fact quite nicely highlighted by the detrended chart. The Buffer indicator is over 50 % above historic average and under the following 2 circumstances will it return back to historic average: (a) Equity markets are fairly priced and US-GDP increases by 50 % or (b) We see a stock market correction of 30 % or greater.

Noble Laureate View

In a recent New York Times article titled- Gut Feelings, Robert Shiller presents a case for why US markets are trading at premium valuations. He argues for taking into factor the very unscientific reason for the boom, “animal spirit”, sometimes called “gut feelings”. He talks about three very popular works of non-fiction, Robert Kiyosaki’s 1997 published book, Rich Dad Poor Dad, that espouses virtues of an uneducated by rich dad as opposed to the educated guy who defers to authority; Jack Welch’s (co-authored with John Byrne) 2001 published book, “Jack: Straight from the Gut” who described his management style to be intuitive as opposed to driven by expert analysis and finally 2011 book, “Steve Jobs”, by Walter Isaacson, where in he writes, “Jobs was more intuitive and romantic and had a greater instinct for making technology usable, design delightful, and interfaces friendly.”

Through these examples, he talks about how we are being inundated with narratives about young folks, who some times drop out of college, revolt and overcome the dull conformist lifestyle to become hugely successful. Folks who buy into this dream seek to mimic these folks by acting like a rich person and buying stocks. He concludes we have a less sensible markets because of the disconnect between dreams and expertise.

What ever the explanation, it is abundantly clear that we are nearing the top of economic cycle and no one really knows how long this cycle will last and how much room there still is to grow!

Let the Winners Run

My approach to navigate the waters in the current economic cycle was distilled in my last article wherein I noted that incase markets rise 10%, 20 %, 30 % or more, I will follow the strategy I adopted in 2019, which is to say, have a healthy cash buffer and wait for opportune moments to put all that money to work. 

In 2019, most of trading activity for me happened by not adding new money to my equity portfolio, but rather trading overvalued stocks in my portfolio to purchase stocks that were on sale. If the markets continue to rise into 2020, I foresee myself doing more of the same, i.e., I will continue to look to generate cash from my investments to avail dry-powder available to deploy when opportunity presents itself.

The dilemma for me now is to figure out a way to do so.  It was easier for me in 2019 to take profits into stocks that had grown in valuation quite a bit, and invest the proceedings into cheap stocks. The situation for me is somewhat different this year as all the obvious sales have happened and I now own some quite big winners and some quite big but cheap losers. The question therefore is, Should I let my winners run or consider cutting short some of my losses.

Let me take a specific example: AAPL vs. CRTO

At the end of 2019, AAPL position was at 8.6 % of my active-portfolio and I am sitting on unrealized gains of about 75 %. Contrast that with CRTO, which at the end of 2019 represented about 7.33 % of my active-portfolio and I am sitting on unrealized losses of about -18.22 %.

Let us now look at some numbers to see how these firms are doing

Metric	AAPL	CRTO
Gross Margin	37.8 %	36.3 %
ROE	55 %	8.8 %
ROIC	22.5 %	10 %
Share holder Yield	6.6 %	-7.6 %
EV/EBIT	21.4	6.4
Intrinsic Value	235.2	23.9

Clearly fundamentals for APPL are quite strong, with a healthy gross-margin at >30 %; a very well run firm with excellent capital allocation, indicative of >20 % ROIC and shareholder friendly with shareholder yield > 5 %. However, the valuation is premium. It is trading at EV to EBIT multiple of >20X and by my estimates overvalued by atleast 30 %.

On the other hand we have CRTO, which is currently trading at a discount, undervalued by atleast 25 %, with EV to EBIT multiple of 6.4 times. It also has a healthy gross margin. Management is not as savvy as AAPL with capital allocation, but still not a shabby job producing ROIC of about 10 %. The company is certainly not share holder friendly, diluting shareholder value to a point where the shareholder yield is -7.6 %.

My value oriented thinking would have said, AAPL has produced healthy gains for me, it is currently quite over valued and I do not see myself adding to my AAPL position. On the other hand, with CRTO, I have been wrong thus far, sitting on significant losses in my portfolio. I have conviction that it is quite a bit undervalued and it is simply matter of time when the markets will come around to its senses. Given it is still trading cheaply, if only it stops diluting its share base, I want to add to my portfolio. Thus, if I were to sell stocks to increase cash portion of my portfolio, I should sell AAPL and lock in gains. There is a name for this intrinsic bias, to sell winners and keep losers, the so called,  disposition effect.

A competing thought, is to let winners run. It is one of the most enduring saying on Wall Street, and  a growing body of research and empirical evidence suggests that this is a sound strategy for portfolio management. To quote from the Kiplinger article on the topic, from a decade back, A few great stocks held for many years can turn an otherwise average portfolio into a stellar one. However, our intrinsic bias for loss aversion, prevents us from acting on this age old Wall Street mantra.

I have suffered from loss aversion fallacy far too long. It is in some sense embedded in my style of investing. I tend to find contrarian value plays, which markets hate and if my timing is off, by definition the stock continues to fall and I continue to buy. My losses pile up but I am convinced that I am buying a stock at a bargain basement price. Given my investment horizon, atleast one year, before I consider selling (if it is not a speculation purchase), I am more right than wrong and stock eventually recovers but some times I am stuck with a perma-value stock, case in point CRTO.

I am therefore making a conscious effort to evaluate my portfolio and come up with a rationale strategy to get rid of perma-value stocks in my portfolio, while allowing for the winners to run.   While my thinking on this topic is still evolving and there will be a few trial and error runs, I have taken the first steps in cleansing my active portfolio of perma-value stocks, with the goal of increasing the net value of dry-powder in my portfolio, ready to get into play when market decides to offer bargains.

Below is my trading activity thus far in the new year.

Sold:

• CVS, 212 stocks, recorded a net gain of 9.15 %, the portfolio allocation now stands at 4.83 % with unrealized gains at about 3.1 %
• CRTO, 1000 stocks, recorded a net loss of 24.34 %, the portfolio allocation now stands at 3 %, with unrealized gain of 0.45 %
• LB, 500 stocks, recorded a net loss of 26 %, the portfolio allocation now stands at 2.6 % with unrealized loss of 13 %

Video/Book/Article/Audio for the Week

• Book: (Its a repeat from last week),  The greatest trade ever, by Gregory Zukerman. I have been reading this book for the past week and a half and am now proud to say, I am done reading the first book on my list of “books to read”. What did I learn, while a lot of people were aware of the impending maelstrom, a few, John Paulson being the boldest of all, acted upon it to reap insane profits from the miseries of the rest of us! These folks were not to blame however, as they were merely exploiting the loop holes in a broken system!
• Documentary: James May, Our Man in Japan, a 6 episode travelog on Japan by a entertaining british host- James May. I am a killer for these types of travelog shows. Its always fun to learn about parts of the world that I probably will never have an opportunity to explore myself.