Monday, March 12, 2007

Ignore The "Noise"

"If a business does well, the stock eventually follows." Warren Buffett

The past two weeks have been the perfect example of why, as an investor you must ignore the market action as it pertains to your existing portfolio and focus on the reason you bought shares of the companies in it in the first place. I am going to use my favorite and largest holding in the ValuePlays Portfolio, Sears Holdings (SHLD) as an example.

We first have to remember the reasons why we bought Sears:
1- Retail operations improving
2- Increasing cash hoard for Eddie Lampert to invest (this is a large part of the "value" in SHLD, his 16 yr. track record of 28% annual returns)
3- Reducing debt and shares outstanding
4- Growing profits

Now we have to look at the past two weeks and follow the events of them. We will then see why we were wise to ignore those events and then what that did for us. Feb 26th saw the S&P (.INX) begin what would end up being a 5.2% decline over the next two weeks (it should be noted we added another 1.7% to our lead over the S&P during this slide). If you picked up a paper or watched CNBC you were inundated with dire prognostications.

We had Alan Greenspan aimlessly wandering around the Asian continent incoherently mumbling to any innocent bystander who would listen the US had a "1/3 chance of recession by the end of the year". It was only after officials found him, reminder him that he no longer was the head of the Fed and that all economic indicators point to the opposite, he changed his statement to, "it is possible we could get a recession toward the end of this year, but I don't think it's probable." Right, and it is also possible your reporter wife Ms. Saywer was first attracted to your chiseled looks, not your decades long access to Washington's inner circles, but not probable. Alan, its over buddy, go home, take a bath, read a book, do whatever, just please shut up, Ben's the guy now. Your predecessors where classy enough to be quiet and let you do your job, lets try to exhibit the same to Mr. Bernake and let him do his.

In Asia, the Bank of Japan raised rates 1/4 of a point. This set off a chain of events as people who had borrowed (we are talking billions of dollars here) money in Japan where it was cheaper to buy stocks here no longer enjoyed the lower rate (the "carry trade" you have heard about). This caused them to to then have to sell the stocks they had bought with that money to have to pay off those loans, putting downward pressure on the market.

We then had a sub-prime (these are mortgages given to the most risky prospects) mortgage implosion which, for some reason seemed to make everyone panic. They were actually surprised that when you give as person with a marginal credit history a mortgage you know they probably will eventually not be able to afford, they default on it. The only surprise was that it did not happen 6 months ago. The fear was that the defaults "would spread into the prime market". Right, so because my neighbor bought a house he could not afford with financing he was not really qualified for and invariably defaulted on his loan, now I should on mine? This is the type of logic we are dealing with folks...

To top it off we had a home builder executive telling us in no uncertain terms that "2007 is going to suck". An important note here: January 2007 home figures were the 3rd highest in history (despite the declines), this "sucks?" What he really should have said was "look we are fools, we bought way to much land because we thought the party would never end and now it is time to pay the piper." Real estate has been in a bubble phase for 5 years now and just because they got stuck with their pants down does not mean it will suck, it just won't be as good. Nothing goes up at a record rate forever and home-builders bought land and started building homes like it would. These guys are like a lottery winner who, after getting his winnings sprints into the nearest bar yelling "the drink are on me". He then proceeds to fill up the bar with booze, turn around and only then realizes he is at an AA meeting.

All these events, when looked at individually were probably not enough to cause the problem but when you consider the S&P had not had a significant drop in almost a year (remember nothing goes up uninterrupted) you had the mix for panic. We got it.

In the middle of this mess Sears released 4th quarter and full years results. On March.1, the day of the earnings report, shares opened at $180.25 a share. What happened?

Profits- Increased 27%
Debt- Reduced by $815 million
Shares Repurchased- $429 million
Cash On Hand- $4 billion
Retail Margins- Improved 25%

On every metric we bought shares in the company on, it has improved. Would anything you saw make you think about selling your shares? Me neither. But lots of people, listening to the noise above and ignoring these results did as shares dropped $4 that day to $176. Those of us who sat tight and laughed at the panic stricken hoards watched as shares not only climbed out of the hole, but finished this past week at $180.38.

"Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years" says Buffett. If the market was shut down and you looked at Sears last earnings report you would be thrilled, do not let to those who trade pieces of paper and do not "buy pieces of companies" affect your outlook of an investment, let the investment itself do that. The past week and a half saw a ton of "noise" and ton of panic but, those of us who stayed calm and focused came out just fine.

To quote Jesus (of the traders), "They know not what they do...."

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