Investing: The Madness of Crowds

When I run into people, they often ask me “what have you been up to?” Usually, I end up saying something like, “acting, directing, and looking at my stock portfolio.” And that gets a bit of a chuckle out of people. Now my guess is that for most, the combination of acting, directing and stocks is just a bit, well, let’s say a bit of a twist.


And believe you me, no one feels it more than I do. I live in a world of opposites. On the one side, there are the actors and artists. Usually, the last thing they want to know about is business and logic. You want to put an actor to sleep? Be logical. It’s quite simple, really. On the other side, I have my friends from business. While they find Hollywood and entertainment interesting, asking them to live like actors is a whole other thing. Rationality is a much bigger part of their lives, and believe me, I think there are a lot of good reasons for that.

I believe in life, you have to face both. And – “ you know where I’m going with this – “ it’s true about stocks as well. Moreover, we often don’t realize how strong our bias is one way or another. I attended (arguably) a top business school, and looking back, I don’t think we ever really talked about integrating business fundamentals and market psychology. The classes were decidedly analytical. To understand investing, you have to have a basic handle on both.

The topic is timelier than ever. If you’re a student of stocks, it’s critical to understand what’s going on in the markets right now.

To give you some background, this last week, the Dow just touched the record 14,000 level. Predictions of the “goldilocks economy” and Dow 15,000 or even 16,000 are common. And record highs have been set all summer. On the bear side, fears of slowing corporate earnings, weakening consumer spending, inflation, subprime fallout and market skepticism (as evidenced by high short selling) have been hanging over the markets.

For most of the summer, the bulls have managed to overcome the bear onslaught. At each dip, the bulls have said, hold on, the market will come back. Subprime is contained, they argued; the consumer is still alive, interest rates are historically low, and deal making will continue. But this week, there was a change. Selling in certain sectors was so severe that the bulls just disappeared. No reassuring messages, no calls for patience. Just silence. And some are now taking the other side. Some are saying the “mojo” might be over. Even Cramer, of Mad Money fame, was saying that you can’t fight the bears. And for those who are stressed about their portfolios, he’s begun to say, “if you can’t take it, maybe you shouldn’t be in stocks.”
Case Study: Goldman, Sachs & Co.

To be fair, if you own aerospace, minerals, mining, infrastructure, oil, construction or agriculture, you’re probably okay. But even then, a miss by Caterpillar (the construction company) on Friday, July 20, has put thrown some doubt on those sectors. And if you owned the brokers, banks, lenders or homebuilders, your stocks have been brutally punished this week (and that’s not an understatement). In all likelihood, there’s more pain to come. As an example, let’s take a look at one of my favorite companies, Goldman, Sachs & Co.

For those of you not familiar with Goldman, it’s considered the premier investment bank. Driven by record M&A deals and record profits in principal investments, the stock is up nearly 300% since 2003. The company is a money making machine. Take a look at Goldman’s 5-year chart:

But recently, fears of subprime spillover and an end to the merger boom have been a drag on the stock. On Tuesday night, Bear Stearns, another major investment bank, announced that two of its funds with subprime exposure were essentially worthless, and Bernanke followed by announcing that “credit losses associated with subprime have come to light and they are fairly significant.”
Reaction in the markets was swift and harsh.

Take a look at Goldman’s stock through the week:

And to show you how negative the market is, the week had positive earnings from Merrill Lynch, JP Morgan, Bank of America, and Citigroup, and the market still sold off these stocks.

The Market Mood.

Now notice something. I haven’t mentioned anything about Goldman Sachs’ earnings. That’s because there weren’t any announcements. In fact, there was no news specifically about Goldman this week. We have no evidence that anything has changed at the company; only fear that 1) subprime will have a bigger impact than previously expected; and 2) that future earnings will decline because of reduced liquidity in the markets (roughly, that subprime problems will reduce the amount of money available for deals).

Someone once said, “with financial stocks, the action is to sell first and ask questions later.” And that’s exactly what’s happening. That’s the “madness of crowds”.

The Fundamentals.

But what about the fundamentals, you say? Funny thing, I would argue that the fundamentals aren’t nearly as bad as the market is making them out to be. In terms of the subprime, these guys aren’t stupid; they’re assessing their risk every day. They spread their risk out to other banks and spend every day thinking about how to reduce their exposure. You’ll remember that after the first round of subprime problems this summer, the banks were looking to buy. If they had serious problems, they would have been looking to sell.

And there’s another little-noticed point made by Bear Stearns when their funds floundered. If you’ll remember, when the two Bear Stearns funds got into trouble a few weeks ago, Bear was refusing step in and support its two funds with cash. Eventually, they agreed to lend one of the two funds $1.6 billion, and refused to extend credit to the other. Now, the media was saying, “it’s so bad, even Bear won’t extend credit to their own funds.” Bear’s response was, “we’re not extending credit because these funds are higher risk than the risk we take for our own book” [paraphrased]. In other words, Bear knew that these funds were risky, and to them, these funds were a spec play, not an investment. They might throw a little money at these funds, but they weren’t going to stake the firm on them. They hadn’t misjudged the risk; they knew exactly how high risk the funds were and had planned to contain that risk by letting them collapse if necessary.

As for the end of the merger cycle, I think that will come, but its still a good half-year or year away. I think it’s a medium term process. True, fewer deals will get done, and the most speculative or the mostly highly leveraged deals will not get done, but there’s still more M&A to come.

So I don’t think the market fears are all that justified. In fact, I think Goldman is beginning to look pretty inexpensive. It trades today at a 9.6x PE, when normally it would trade at a 10-11x PE. But you know something? I can’t tell you to buy.

What I’m Doing. So first, I have to tell you that I bought Goldman at the following prices: $69.95, $74.60, $78.45, $88.85, $149.05 and $202.28. I sold all of my Goldman stock on Friday, July 20, 2007 for $208.23. I’m also long Merrill, Morgan Stanley, JP Morgan and Citibank, and I am holding on to those positions.

Okay, am I confusing you? I mean, why sell Goldman (one of my favorite all time stocks, and oh, I have to mention, I used to work there) and still hold on to the others? First, let me repeat, I still believe in the fundamentals of these companies. It’s the market sentiment that’s negative. And the truth is, sometimes, that’s something you can’t fight. Goldman is one of my larger positions, and although I would have liked to sell it at a higher price, I can still sell it, take the profits, and call it a day. I sold it because it could very possibly go down more, and although I’m sure that it will eventually go up, that may very well not happen any time soon. I can almost guarantee that there will be more subprime and liquidity scares that will put pressure on the stock.

In a previous article, I recommended that you stay away from Whole Foods because there wasn’t enough of a margin of safety in the stock price. And that’s where we are today with Goldman. I can’t tell you to buy today (even though I think it’s getting to be cheap) because there may still be downward pressure on the stock.

The odd thing about this situation is that I still like Goldman long-term. But keep in mind, worst case, I buy back the stock. It’ll still be there tomorrow, or next month. I actually think there might be a good entry point in the near future, but today, as of this writing, I can’t tell you when, or at what price, that will be.

And what about the others? Goldman happens to be one of my larger positions, so it doesn’t hurt to close a chapter on it. Goldman was also closer to it’s high ($233) than the others and has fairly high volatility, so there’s more downside to Goldman in this environment than for the other banking stocks that I own. I’m holding the others because I believe they’ll do well longer term, and because I’m willing to ride it out.

The Conclusion

So what’s the point of all this? I think there’s a lot to learn and think about from a situation like this:

Separate Fundamentals from Market Psychology. That means, as in this case, you can still believe in a stock and sell. Likewise, you can still believe in a stock and not buy. How the market is looking at a stock or industry can be a big factor in the buy/sell process.

Market Confidence Can Deteriorate before Fundamentals. With certain industries, and especially with financials, market confidence can fall apart before the fundamentals actually do. That’s because financials are, to a certain extent, a bit of a black box; people don’t really know what’s on the books. So the fear of the unknown can cause market to be very quick on the sell trigger.

Oh, and I have to remember one last reason to sell Goldman. You sleep better. And remember, it’s all about making money while you sleep.
Stock Update

In previous articles, I’ve mentioned Boeing, Whole Foods and Altria (I’m long Boeing and Altria). Here’s an update on the these stocks:

Boeing.

When we looked at Boeing on April 10, 2007, it was trading at $90.84. As of 7/20/07, Boeing was at $103.86. I will continue to hold Boeing, its Dreamliner continues to sell well and the cycle is not over. The plane was unveiled this month, and first deliveries are scheduled for early 2008. We won’t know for sure whether it’s on schedule until then, but there is no reason at this time to expect a disappointment.

Whole Foods.

In May, when we reviewed Whole Foods, the stock was at $45.84. I thought the PE was too high, and as of 7/20/07, the stock was at $39.32. During the last month, it’s been revealed that Whole Foods CEO has been blogging online under a pseudonym. In his statements, he trashed the competition and pumped up Whole Foods. Also, the CEO has made statements in internal emails saying that the Wild Oats acquisition was necessary to knock out a competitor. The SEC is investigating and the process will impede Whole Foods acquisition of Wild Oats. Finally, expect the other grocery chains to stock up on organic goods, increasing competition. I continue to believe Whole Foods stock is vulnerable to further declines and would avoid the stock.

Altria.

When we looked at Altria on 6/15/07, Altria was at $72.67 and I recommended buying Altria on a pullback. As of 7/20/07, Altria was at $69.80. Although Altria might still fall $1 or so in this market environment, it’s a buy in this range. Expect not much to happen until Altria announces a spin off of its international and domestic divisions. In the meantime, collect a 3.9% dividend.

Thanks for reading, and until the next time, sleep well.

This article was written July 21, 2007.
Ming Lo is an actor, director and investor. He has an A.B. from Harvard College, Cum Laude, and an MBA and an MA Political Science from Stanford University. Prior to going into entertainment, Ming worked at Goldman, Sachs & Co. in New York and at McKinsey & Co. in Los Angeles.