Headline: Earnings don't collapse

For the past few months, bears have been warning that investment prices are dangerously overvalued. In spite of the fact that the P/E ratio of the broad US stock market is near historic lows, doomsayers have argued that the market is still overvalued, because the bulls are too optimistic about future earnings and earnings are set to collapse.

We are now about one-fifth of the way through earnings season, and not only are earnings giving no indication of imminent collapse, but they are generally blowing past Wall Street estimates (the same estimates that the bears say are "too bullish").

Yesterday, machinery maker Caterpillar* reported income of $2.32 per share, well above analyst expectations of $1.73 per share and up 58% year-over-year. Revenues were up 35% from the year-ago quarter and beat analyst estimates by over a billion dollars.

A couple days ago, Apple* reported earnings of $13.87 per share for their most-recent quarter, demolishing the consensus estimate of $9.87 per share and representing 118% growth since the year-ago period. Revenue grew 73% to $46.3 billion, with quarterly iPhone sales more than doubling year-over-year to an incredible 37 million. iPad sales grew 111% year-over-year to 15.4 million sales during the quarter, well ahead of Wall Street estimates of 13.9 million.

We have been cautioning our readers to be wary of the constant barrage of negativity that has been coming out of many financial media outlets recently. Back in November, for instance, we said that:

the dire predictions of many media pundits and market commentators are overblown and overly pessimistic. Pessimism is in vogue right now, and optimism is out of fashion. However, we believe it is very important for investors to tune out the financial media and focus on actual business measurements. In fact, we have always said that trying to time economic ups and downs is folly anyway and that investors should focus on business fundamentals rather than economic predictions.

Going into this earnings season, you could still find plenty of bearish prognosticators saying things like, "As earnings season wears on, other executives might find it more difficult to put a smiley face on disappointing results" (from this article dated January 11), or arguing that the broad US stock market is between 20% and 40% overvalued (as this lengthy piece dated January 8 suggests).

We would advise our readers to try to tune out those who think they have a formula for detecting where in the "economic cycle" we are, and instead to focus on deploying their investment capital into well-run businesses with good prospects for future growth. As this earnings season has revealed so far, there are plenty of companies that meet this description, for those who care to look.


* At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by Apple, Inc. (AAPL) and did not own securities issued by Caterpillar (CAT).

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Fifth Anniversary of the founding of Taylor Frigon Capital Management

Today is the fifth anniversary of the founding of Taylor Frigon Capital Management, founded on January 19, 2007.

Since that inception date and through the end of 2011, the Taylor Frigon Core Growth Strategy has returned a cumulative 28.07% net of fees, versus a cumulative return of -2.18% for the S&P 500 for the same period of time (see full performance details and important GIPS disclosures here).

While we have often cautioned that short-term performance "horse-races" are not good ways to evaluate an investment philosophy, we believe that longer periods become more significant and that the five-year history tends to validate the investment convictions that we have employed since founding this firm and for many years prior to the founding of Taylor Frigon Capital Management.

These are the same investment principles that we share with you here on the "pages" of this blog as well.

We would like to thank all of our clients over the years (past, present, and even future) and look forward to continued success on their behalf.

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Happy New Year!

We wish all of our readers and clients a very happy and prosperous New Year!

2012 is sure to be a very interesting year for investors with much to look forward to and many opportunities for those who stay patient and disciplined and look to take advantage of owning great businesses at values not seen in decades!!

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Seasons Greetings and Warm Wishes

Seasons Greetings and warm holiday wishes from all of us here at Taylor Frigon Capital Management!

Above, a wreath at the General Grant tree in Sequoia and Kings Canyon National Park rests in the snow. The General Grant tree was designated "The Nation's Christmas Tree" by President Calvin Coolidge in 1926, after a little girl visiting the tree was overheard to remark, "What a lovely Christmas tree that would be!" at the sight of the massive sequoia. The story of how that came about is related on the home page of the Sanger, California Chamber of Commerce here.

The tree is also the only living, federally-designated monument to U.S. military men and women who have lost their lives in service to their country.

We wish all our readers a very safe and happy holiday season this year.

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The fantasy world of modern portfolio theory

The calendar year of 2011 will soon come to a close, and active managers will be watching to see how the performance for the year will turn out.

Many who hire active managers will also be watching closely, and will be judging whether or not they should continue to keep their investments with this or that manager based upon the outcome when the market closes on Friday, December 30.

Others, who disavow active management, will be watching in order to see how many managers failed to "beat the market" (or beat their benchmark) so that they can declare that "active management doesn't work" and that everyone should "just index."

While we believe that keeping score is important in investment management, we don't agree that the emphasis placed on a calendar year is the best way to determine whether any particular manager is doing a good job, nor is it the best way to determine the broader question of whether active management is better than (so-called) passive management or vice versa.

For starters, we have argued that investors often have far too short-term of an attention span when it comes to committing capital to businesses, much the way that the Ents in J.R.R. Tolkien's Lord of the Rings criticize hobbits for being too hasty. Would anyone select a money manager based upon whether or not his overall portfolio of investments went up or down on a single day? That would be ridiculous. How about based upon whether or not his portfolio outperformed "the market" or some other benchmark during a single day?

If you had a friend who told you that he moved his life's savings from one manager to another based upon which one did the best the day before, you might (like Treebeard) advise him, "Don't be so hasty."

The same could be said for jumping to conclusions about whether active management is better than passive management. It would be ridiculous for financial commentators to publish reports declaring "Several prominent active managers underperformed the market yesterday, leading to the conclusion that active management may not be the best way to invest."

We would argue that, while better than a single day, a single calendar year is not the most useful time period to select, but that investors should instead focus on longer periods, and should consider start and end points that are less arbitrary than the annual calendar but which correspond instead to major economic events (such as from one recession to another).

More importantly, the broader question of active versus passive management should not be decided based upon arbitrary and short periods of time. If active managers beat the market or their benchmark in one year or even in two or three consecutive years, some critics will always be waiting to pounce on them in a year that they do not, in order to declare that the mathematics are irrefutable and that nobody can beat the market in the long run. More precisely, these critics will often argue that anyone who does beat the market for a few years does so by taking "excessive risk" which could have been avoided by owning more securities. Since no one can really beat the market without undue risk, the passive advocates argue, then it is best to just buy the market -- that way, you will get the best possible return for the amount of risk that you take.

The mistaken idea that passive management is the best way to invest is one outgrowth of a much larger academic theory called "modern portfolio theory" which has slowly expanded its influence in the investment world, beginning in 1974. We have written about its problems numerous times in the past, such as in this previous post. The distinctive concept at the core of this theory is the idea that risk can be captured in mathematical formulas, and that because it asserts that risk is mathematically linked to potential returns, its advocates believe that mathematical analysis and diversification can point investors to the optimal level of risk and return for their investment profile (the so-called "efficient frontier" is an example of this concept).

This seemingly harmless idea manifests itself in many different ways in the investment industry, one of them being the idea that owning indexes with hundreds or even thousands of individual securities provides better "risk-adjusted return" than owning a smaller number of carefully-selected securities. If you think about it carefully, you will be able to see that this idea (which is at the heart of the "just index" or "passive investing" argument) was also behind the construction of the various structured investments and synthetic vehicles full of sub-prime mortgages which banks and other financial institutions bought under the illusion that enough diversification and the right mathematical models would make the analysis of the individual loans unnecessary. This fantasy led directly to the disastrous financial meltdown of 2008 and 2009.

In this regard, modern portfolio theory resembles the kung fu seen in certain martial arts movies like the one above -- it's a nice fantasy, but it is completely divorced from the real world. Thinking that its mystical precepts will keep you from ever getting cut in a real knife-fight could have disastrous consequences.

It is our conviction that in the real world of investing, there will be times when good investments are out of favor and therefore perform "worse than the market," whether for a day, a month, or even a year. The idea that owning a small number of good investments (even if they sometimes go in and out of favor) is "risky" but that owning a huge number of unexamined investments mitigates risk is actually a dangerous fantasy, and one that unfortunately is pumped out to viewers and readers daily by the financial media in video, magazines, and books. Investors who are tempted to buy into this fantasy should be cautioned that modern portfolio theory's vision of investing is as divorced from reality as mystical movie kung fu is from real fighting.

For investors who want to practice real investing, we would advise that finding quality businesses is not as difficult as they might think -- we have discussed criteria for doing this and provided several examples in previous posts (a list of some of them can be found here). They should then plan on owning those companies through the inevitable ups and downs of the market for long periods of years (this does not mean holding them forever -- we discuss sell discipline in other posts such as this one -- but rather owning them until the business signals that it is no longer the kind of business you want to own, instead of relying on the market signals that so many investors and pundits focus on).

Take a look at the kind of returns an investor could have experienced if he had purchased shares in Wal-Mart in 1982 and owned them through 1992*. Look closely at the chart and you will see that there were plenty of ups-and-downs along the way, including some sudden and rather severe drops: what would that investor have missed if he had been listening to what all the pundits were saying or if he had the mistaken idea that owning a tiny piece of a truly great company could be done without ever taking some hits and receiving some bruises?

Understanding this perspective is the first step towards building a strategy that is based on principles that investors should be focused on, instead of building one that is based on the fantasy of modern portfolio theory and its quest for "risk-adjusted return." It will also enable investors to see most of what appears in the financial media for what it really is -- entertainment that might offer an enjoyable escape into a fantasy world, but which should not be confused with reality, and actually isn't even as fun to watch as a good old-fashioned kung fu flick.


* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Wal-Mart Stores, Inc. (WMT).

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