Contravisory Blog

Facebook IPO

“In seeking to avoid the dangers of crowd action, remember that a majority opinion can be sustained.  Unanimity of opinion is more vulnerable to a contrary surprise.”

The quote above is from Contravisory founder Ed Noonan’s 10 Rules for Investing.  Considering the record amount of anticipation and speculation surrounding the recent Facebook IPO and the subsequent disappointment, this seems like a particularly good time to revisit this rule. 

For the past several months, the buildup to the Facebook IPO has been the rage with investors and media alike.  The coverage has been non-stop.  The speculation surrounding the IPO centered not on whether the IPO will be successful, but how successful.  Will it break the record for the largest technology IPO in history? How high will shares trade on day one? $50? $60?  Will Facebook save the stock market?  The possibility of a disappointing Facebook IPO never factored into the minds of investors.  The most novice and seasoned investors wanted a piece of the most anticipated IPO in history.  Recognizing the unprecedented demand, Facebook raised the asking price from a range from $28-$35 to $34-$38 in the days leading up to the IPO.  All the elements of a speculative bubble were in place and the stock hadn’t even gone public yet.  There was unanimity of opinion that the Facebook IPO was destined for success.       

And then Facebook went public.  After a NASDAQ glitch delayed trading, the initial reaction was tepid as the stock moved higher from $38 to $42.  Those who couldn’t participate in the IPO snatched up what shares they could in the secondary market as volume reached record IPO levels.  With the last retail investors getting on board, demand subsequently dried up and the stock declined to close at $38.   And that decline has continued as Facebook is now trading at $28.  As is typically the case in the post-bubble aftermath, the finger pointing has begun.  Lawsuits and allegations are being filed against everyone from Facebook to NASDAQ to Morgan Stanley and beyond.  It’s getting ugly and investors are not happy.

Human nature makes it hard for us not to get swept up in a speculative bubble, but let this be another lesson that unanimity of opinion is more vulnerable to a contrary surprise.  Thanks Ed.

-David Canal

 

Contravisory Q1 Letter to Investors

Today we share with you an excerpt from our Q1 letter to investors, recapping the first quarter and providing some insight to our current market thinking for Q2 and beyond.

The equity markets continued their winning ways in the 1^st quarter as all major indices pushed higher during the period.  In fact, this was the strongest opening quarter for U.S. stocks in 14 years.  The S&P 500 Index rallied 11.8% while the Dow Jones Industrial Average increased 8.1%.  

Investors' appetite for equity assets continue to outweigh concerns about the debt crisis in Europe and faltering attempts to deal with budgetary issues at home.  Global political leaders are using regulatory, fiscal, and monetary policies to address the overhanging government debt problems without driving their economies back into recession.  Meanwhile, in the U.S., the economy has been growing moderately with improvement in the unemployment rate, albeit modest.  Overall corporate earnings have been healthy and should continue to improve.

Despite these positives and the enthusiastic response to this modest improvement, we continue to pursue a cautious approach when managing portfolio risk.  This prudence is manifested in defensive holdings within the Consumer Staples, Healthcare and Utilities sectors.  While this defensive posture has been a drag this quarter, our research continues to signal that some conservative holdings are warranted in an environment in which many economic uncertainties remain unresolved.  The crosscurrents of good and bad news challenge us to react but not overreact.  This highly disciplined approach has rewarded our investors over the long term and is the basis of our methodology.

Frank Thoughts: The Bigger Story

Imagine resigning from a $500,000 a year job with an open ended future, on principle.  Greg Smith, a young Goldman Sachs derivatives salesman, did just that and wrote an OP-ED column published in the New York Times.  The next day the story was on the front page.  But there is an even bigger story.

Greg Smith said about Goldman, “I can honestly say that the environment now is as toxic and destructive as I have ever seen it.  To put the problem in the simplest terms, the interests of the client continue to be sidelined in the way the firm operates and thinks about making money.” There is an old Wall Street proverb that describes the inherent conflict.  “The job of a broker is not to make money for a customer, but to make money from the customer.”  And Goldman Sachs is, after all, a brokerage firm.

In 1982 there was a paradigm change in the investment business.  Paul Volcker, then Fed Chairman, after years of fighting inflation with rising interest rates, cut interest rates.  That policy change, inadvertently, created a seminal change in the brokerage industry.  The business moved from a client-focused business to a transactional customer business, overnight.  The transactional business quickly dwarfed the relationship business.  And that’s when the trouble began.  Goldman was hardly unique.

Wall Street was originally dominated by large, privately owned, investment banks.  But after 1982 these firms went public.  When they were private the partners owned all of the profit, but they also owned the risk and liability, including possible personal bankruptcy.  Once public, only stockholders were at risk.  This created what became known as the privatization of profit and the socialization of loss.

The real issue is the distinction between a customer and a client.  A customer is one who buys goods or services from a business.  A client is one who pays a fee for professional service.  The issue is realizing which you are, a customer or client.  In the arcane world of the investment business, there is a huge distinction!  A brokerage customer has only to be treated with the issue of suitability.  Example:  You cannot sell a 90 year-old a speculative technology stock with high risk.  But you can recommend a “suitable” stock that you hold in inventory and hide a generous commission in an opaque trade, which Goldman and other brokerage firms routinely do.  A registered investment advisor is held to a different standard - a Fiduciary Standard.  The advisor must always act in their clients’ best interest, always.

Most brokerage firm’s customers do not understand this, or even know this difference exists.  Naively, they think their stock broker is acting in their best interest.  But as Mr. Smith, formally of Goldman Sachs, scathingly points out, that is often not the case.  The Fiduciary Standard applies only to the investment advisor, the money manager charging the CLIENT a fee.  Of course, brokerage firms continue to call their customers “clients.”  It sounds classier.

Contravisory Q4 Letter to Investors

Today we share with you some commentary from our Q4 letter to investors as we recap 2011 and look forward to 2012.

The year 2011 was a challenging one for your equity investors as most market indices underperformed their historical averages.  Fortunately, U.S. stocks ended the quarter on a positive note as most major indices posted double digit gains for the period. 

It seems investors continue to focus on the three-ring fiscal circus in Washington and the European sovereign debt crisis.  These uncertainties continue to weigh heavily on investors and until there is some resolution on both fronts, the markets are signaling that a more defensive posture is in order.  However, despite these two negatives, corporate earnings in the U.S. are healthy and equity valuations are considered depressed by historical standards.  Eventually, we would expect the excessive cash invested in fixed income assets to be redirected into equities once interest rates finally begin to rise.  Moreover, with low expectations for stocks, modest improvement in the above factors could produce above average gains for equities in 2012.  

Evidence of leadership change continued to evolve during the fourth quarter of 2011 for both market capitalization and sector selection.  The shift away from more volatile asset classes such as small-cap and emerging market stocks into “safer” blue chip stocks (typically offering higher dividend yields) has become more prevalent.  With this shift comes a narrower list of “theme” opportunities within sectors such as Consumer Staples, Healthcare, and Utilities.  More than usual, we expect industry and stock selection to be a key ingredient in obtaining above average results in 2012.  

Dividend Stocks Drawing a Lot of Interest

It should be no surpise considering today's uncertain economic and political environment that investors have been flocking to dividend-paying stocks.  Historically, stocks that pay steady dividends tend to perform better during challenging market environments.  As the European debt crisis continues to rattle markets and fears of a global economic slowdown persist, investors have been finding safety in predominantly large-cap, defensive stocks with attractive dividends.  Additionally, with interest rates at historic lows, dividend stocks offer a much higher yield versus short-term debt instruments for investors who are willing to accept some equity market risk. 

We have been hearing the pundits praise the benefits and appeal of dividend-paying stocks for over a year now but it hasn't been until recently that we have seen it manifested in the actual price action of the stock market.  We conducted our own analysis by examining the performance of all S&P 500 stocks with a dividend yield of greater than 2.75% versus the overall performance of the S&P 500.  From August 31st through November 30th, the 140 stocks in the S&P 500 with a dividend yield greater than 2.75% had an average return of +3.64%.  The average return for the S&P 500 during that period was +2.30%.  And that performance is price appreciation only, so including dividends will only make the relative returns of the 2.75%+ dividend-paying stocks even more impressive.   

To illustrate this, we have generated a chart of these higher paying dividend stocks Download Dividends.  An examination of the relative price action (the bottom line in the chart) shows the surge in performance since September.  With such a disparity in performance, it looks like the pundits are finally putting their money where their mouths have been as dividend stocks have become a leadership segment of the market.