After the market dip, we’ve had the past two weeks, Eli Lilly (LLY) is the stock Wayne Himelsein, who has more than doubled the S&P 500’s return for over 18 years, says to buy. That Wayne has recommended Lilly before, at higher prices, shows you that even great managers do not expect to time the market with precision. Still, he would not have outperformed the market by such a wide margin for so long if he wasn’t making the right calls most of the time. This weekend, Wayne explains his Lilly recommendation and answers a reader’s question.
Ken Kam: This week we have a reader who sent in some interesting questions that he, and I’m sure many others, would like to know. Are you open to answering questions from readers?
Wayne Himelsein: I am happy to discuss whatever is on the mind of readers because the pursuit of understanding is the best tool to become a better investor. There is no such thing as a bad question.
Kam: The reader asks: “since you are looking at stock prices and volumes does this mean your assessments will always lag the news that drove the trading?”
Himelsein: That’s a great question. I far prefer to be asked, more so challenged, than for readers to dismiss or turn elsewhere because something either doesn’t make sense to them or bothers them. So, thank you for the opportunity to respond!
As to the question, does the study of price/volume behavior necessarily require a lag. The answer is positively and absolutely yes, albeit with a bit of contextual reshaping. What I mean is that the purported “lag” is not really a lag. It may be a lag to the news, certainly, but it’s not a lag to the processing of the news, which in my experience matters more than the news itself. In other words, it doesn’t matter what happens, it matters what the market thinks about what happened, and how future expectations change based on that happening.
Kam: That’s interesting, so you are saying that, yes its a lag to news, but the news is not the thing that matters, so in reality, there is no lag? Did I capture that correctly?
Himelsein: Yes, that’s it. If you consider the quintessential news event, the earnings announcement, there is often a gap up (or down) on an earnings beat (or miss), which happens concurrent to the news, but thereafter, there comes the processing of this information, where every major institution that follows that stock, or is already invested in it, must re-calibrate their analytics.
If earnings are higher, what does this mean to all existing projections? If more cash flows, will this translate to more R&D dollars. Maybe yes, and if we like R&D because it fosters additional growth, should we then modify (to the better) our growth multiple? The list goes on. And during and throughout this processing, are brainstorms, and research reports, and discussions, and maybe even department meetings, where analysts and portfolio managers get together to decide on upping (or downsizing) their allocation.
The point is, all of this processing takes time, and with that time, comes trades across the institutional spectrum, laddered, in part, by the timelines and bureaucracies of each of them; the agile small hedge fund can move faster than the portfolio manager for a mega-billion mutual fund. In fact, there is tremendous research around this area of the market, and in relation to the rates of information dissipation; how long does it take for good/bad news to infuse itself into a stock price given all the moving parts behind the institutional backbone of the economy?
There is, in fact, a well documented “earnings lag” wherein ample evidence has shown that the outcome of earnings surprises drifts into stocks for far longer than the announcement day. It’s safe to say that the higher the earnings “beat” the longer that news will carry itself into the performance of that stock.
Kam: I was familiar with that concept, though your explanation really helps. As a follow up to that, the same reader asked: “If so, does it follow that you can never buy at the lows since you will need to see some uptick on some volume to be confident the low has been put in place?”
Himelsein: I will happily answer that question, and at the same time, bring in my recommendation for Eli Lilly. The reason I am able to combine two objectives into one answer is because my Lilly recommendation is based on precisely the double answer to this question; which is both yes and no. In fact, my pick of Eli Lilly, which I first talked about back on April 7th, is more than perfect in demonstrating both the yes and the no.
The no side of things aligns with the recommendation I made on April 7th. At that time, Lilly’s prior high had been struck on March 26th at just over $132, after which it began retracing. When I discussed LLY on April 7th, it had retraced to reach about $125, or about a 5.3% decline from its last “show of strength.” Was this the bottom? I didn’t know, nobody knows, but that didn’t matter to my decision to recommend it on that day. I liked the stock for its behavior over prior days, weeks, months and years, so a few days of pullback was simply a luckier buy point. No need to wait for an uptick.
Kam: So if I’m hearing you correctly, you are saying that when you want to own a stock, you don’t mind buying on a down, as the decision to get in has already been vetted?
Himelsein: That’s exactly right. And that is completely differentiated from when one is assessing the drop as a part of the decision to enter. In other words, it’s one thing if you are buying (or adding to a position) because the stock is down to a nice lower level, and quite another thing if you want to own that stock based on an already established reason, and are just happy to get it a few bucks cheaper. The drop is a happy accident.
And that, as a matter of fact, leads me to why I re-up my recommendation on Lilly right here and right now. Going back to the question, when a stock is dropping, it’s greatly beneficial to wait to see what I called “basing”, which is the demonstration of the stopping of a fall, with the forming of some sort of base from which a turnaround is more probable. Decades ago, when I sat on a trading floor in Manhattan, the common adage that used to circulated (from the older and wiser crowd) was “don’t try to catch a falling knife, it’ll cut you.”
The logic is that we never know where the bottom is, so we have to see at least something that tells us it may be nearby. Even a solid base building is not necessarily the final stop on a fall, but it’s certainly a better place than trying to catch the falling knife.
Kam: I get it. So is that where we are with Lilly? Has the knife stopped falling?
Himelsein: You read my mind. About ten days after my first recommendation, it fell a little bit, causing me to not only survey but to re-assess. Especially after it demonstrated a few days (April 16th and 17th) of sharp falling. I had to decide if it was time to stop loss out of it or hold it, or at the extreme, buy some more. So I did as I have described here today, I watched it basing.
Once it found a low on April 18th, it proceeded to have a few days of run-up, then another little gap down on April 30th, but beautifully, not to its low point on the 18th. After another few weeks of bobbing up and down in this general region, it tested yet another low on May 13th that again didn’t surpass the prior. In viewing these aspects as well as a few other nuances which generally reveal the way in which it is building its base, the future has become clearer to me; it’s done falling. And it’s ready to climb again.
All in all, I like it as much here, if not more, than I did on April 7th. With that, I complete my response to my reader’s question, and built into that response, further recommend Lilly for the foreseeable future.
My Take: I have found that volatile markets are often when the best managers make their best investments. I think it is because the best opportunities are created when stocks are down in spite of improving company fundamentals.
However, it is hard to tell the difference between a stock that is falling because of the market, and one that is falling because something has gone wrong with the company. It takes years to develop the judgment to tell one situation from the other, and even then, no one gets it right 100% of the time.
While I can’t say for sure that Wayne has made the right call on Eli Lilly this weekend, I can say that for more than 18 years, he has been way more right than wrong on similar calls.
Wayne’s Logica Focus Fund (LFF) has an 18+ year track record at Marketocracy. Over that period, Wayne’s model averaged 11.82% a year which compares well to the S&P 500’s 5.83% return for the same period.