Gallery:Step 3|Step 3: Stock Pickers

IFA's Quote of the Week - 12

Gallery:Step 3|Step 3: Stock Pickers

Step 3 - Stock Pickers

"res tantum valet quantum vendi potest."

Latin for:

"A thing is worth only what someone else will pay for it."

 

 

 

 

Many investors began their St. Patrick's Day seeing red, not green. Monday, March 17, 2008 capped the brief and very turbulent saga of Bear Stearns' (Bear's) precipitous fall which caused the company to land into JP Morgan's lap for an ultimately agreed upon price of $10.00 worth of JP Morgan shares in exchange for each share of Bear and the acceptance of their potentially large liabilities.

On Friday March, 14, Bear sold for $30/share. In an ironic twist, on Monday March, 17, the stock opened at $3.17 a share – one-tenth of the previous trading day’s value. A closed-door weekend dissection of Bear’s books revealed the disaster that bubbled to the surface and JP Morgan offered investors $2.32 a share to avoid a total loss and bankruptcy. One week later, shareholder mutiny loomed large and JP Morgan boosted their offer to $10 a share – one-third of the price at which the company traded just 10 days before. But, the story is far worse. In January 2007, Bear sold for $164/share or 16 times the March 24 offer from JP Morgan, according to MSN Money.

The specific missteps that led to the rapid-fire demise of Bear are well-covered in financial publications, and we shall leave the forensic accounting of Bear's implosion to them. We deem it significantly more meaningful at this time to focus on a far more important issue that Bear's crumble should bring to the forefront of investors' minds: Risk.

Investors of individual stocks expose themselves to concentration risk - a risk that is unrewarded and carries no increased expected return above the market's return.

Figure 8-11 depicts the reason that concentration risk has no benefit for investors. As you can see, each stock in a particular index carries the same expected return of that index. This is indicated by the Expected Return (the y-axis), which shows that an individual stock and its respective index have the same expected return. However, the uncertainty of that return (or risk) increases significantly as you shift to the right from the index to one stock. The statistical translation goes like this: over the last 80 years, an average stock in the S&P 500 had a return of about 10%, plus or minus about 50%, two-thirds of the years, while the S&P 500 index had a return of about 10%, plus or minus about 20%. two-thirds of the years. Since many studies show that investors cannot pick just the winning stocks in the index, there is a far greater certainty that you will earn the 10% by just owning the index. In other words, don't bother looking for the needle, just buy the haystack.

Figure 8-11

A part of the risk of a concentrated position in a single company is the possibility of near failure or bankruptcy. Joe Lewis, a British billionaire, lost one-third of his $3 billion fortune overnight by holding onto 11 million shares of the company when it went belly up. Bruce Sherman, CEO of Private Capital Management, a unit of famed Legg Mason, appears to have held nearly 5% of Bear when it limped into oblivion. And, Dallas money manager James Barrow would have far more money to manage now if he had known that Bear Stearns would implode and take with it the value of his near 10% stake in the ill-fated company.

“The sale price does not reflect the value of Bear Stearns" and "shareholders are being shabbily treated given that the transaction was not designed to maximize or even salvage their equity," the Police and Fire Retirement System of the City of Detroit, with 13,500 shares, said in a complaint in Delaware Chancery Court in Wilmington.

T-Shirts are now being sold on eBay emblazoned with: "I invested my life savings in Bear Stearns and all I have left is this lousy t-shirt." Looks like we have a new reason to call a drop in the market a "Bear" market.

Good companies can and do go bad and no one knows which ones will or when. Bear Stearns is not the first big company to fold and it won't be the last.

Take a look at Table 3-2. Some very big names have dissolved into obscurity after stellar runs of good fortune. As you can see by the total assets before bankruptcy, massive amounts of shareholder wealth have been obliterated. The degree to which an investor can absorb or overcome such an unlucky hit is directly tied to their portfolio's concentration in that one stock. When asked to sum up the most important investment concepts individuals should know, Nobel Prize-winner Merton Miller stated, "Diversification is your buddy."

Table 3-2

In the book Creative Destruction, McKinsey & Company consultants Richard Foster and Sarah Kaplan researched the original S&P 500, which was created in 1957. The survival of companies is similar to the survival of mutual fund managers. The Figure 3-1 shows that in the 41 years from 1957 to 1998, only 74 of the original 500 companies were still in existence and only 12 of those outperformed the S&P 500 Index over the 1957 to 1998 period. The study found that the odds of picking a winning stock that beat the S&P 500 Index was one in 42.

Figure 3-1

The moral of these stories is that today's success does not ensure tomorrow's survival. We hope that those who lost big in the Bear Stearns debacle will win a very big lesson: investors must diversify their investments, as well as their holding periods, so that these kinds of events will not destroy their portfolio.