In Price There is Knowledge: Medtronic Edition

June 30, 2011

Medtronic has been in the news lately for allegedly hiding side effects of one of its treatments.  According to Bloomberg:

Studies funded by Medtronic Inc. (MDT) failed to disclose serious side effects associated with the company’s Infuse bone-growth treatment, misleading doctors about its safety and causing unnecessary use of the product, a series of articles reported.

No side effects were reported in 13 clinical trials funded by Minneapolis-based Medtronic, while data provided to U.S. regulators showed as many as half of patients had complications including infections, pain, cyst formation and cancer, a review in The Spine Journal found. The report said financial ties between Medtronic and researchers weren’t clearly disclosed.

Doctors began raising questions about Infuse shortly after its approval in 2002 for spinal fusion when patients started experiencing unanticipated side effects, said Eugene Carragee, chief of spinal surgery at Stanford School of Medicine near Palo Alto, California, who led the review.

2002 was a long, long time ago in medical technology terms and the information is just now coming to light.  Or is it?

Below is a relative performance chart of Medtronic compared to the S&P 500 from the end of 2002 to the current time.  Over that stretch, Medtronic has had very poor relative strength and has underperformed the market by more than 50%!  In 2002, Medtronic reported earnings per share of $1.40.  Value Line projects that Medtronic will earn $3.60 in 2011, an increase of more than 150% from the 2002 level.

Yet Medtronic’s stock price is actually down more than 5% from the end of 2002.  There are a lot of smart people making decisions with large amounts of money in the market.  If a stock is performing terribly on a relative basis, more often than not there is a good reason for it.  Ignore relative strength at your peril.

Earnings up 150%, price down 5%


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Surprise, Surprise, Surprise

June 30, 2011

From Trader’s Narrative comes an interesting piece on Citigroup’s Economic Surprise Index:

The Citigroup Economic Surprise Indexes are a clever concoction that measures the variations in the gap between the expectations and the real economic data. The input consists of the actual econometric data that moves foreign exchange markets – the bigger the data moves forex markets, the more significant its weight in the index.

For a visual, the index is below:

Surprise, Surprise, Surprise!

Source: Citigroup, Trader’s Narrative

Everyone hates the economy right now—and that often means we are close to a bottom.  Our own sentiment survey indicates that investors remain deeply concerned about the market.  I don’t know whether the indicator will pan out this time around, but it’s interesting and certainly non-consensus.  Trader’s Narrative points out:

The important take away point here is when economic data is absolutely horrendous – as it is getting to be now – important lows are close at hand. When everything is sunshine and lollipops, you better run and find a good bombshelter!

Gomer Pyle couldn’t have said it any better.

Source: www.

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Value Trap: Eastman Kodak

June 30, 2011

Bill Miller at Legg Mason Value Trust had one of the longest mutual fund outperformance streaks in history, 15 years through 2005.  His record may end up like Joe DiMaggio’s longstanding consecutive game hits record—never equalled and rarely even approached.  Yet even superstar fund managers may occasionally have feet of clay.  According to a Bloomberg article, his fund has had a rough time with Eastman Kodak:

Legg Mason Capital Management Value Trust (LMVTX), run by Miller since 1982, disclosed in a semi-annual report last week that the fund sold 18.2 million Kodak shares late last year and during this year’s first quarter for about $3.89 each on average. The fund realized a $551 million loss through the divestiture, according to the report.

Miller, 61, began loading up on Kodak shares in 2000 and, by the end of 2005, his firm owned as much as 25 percent of the Rochester, New York, company. Value Trust, one of several Legg Mason funds and accounts to hold Kodak stock, kept the bulk of its stake for more than a decade, only to sell after the film company had lost more than 90 percent of its market value.

Someone took the Kodachrome away


One of the challenges that value investors must take on is the value trap.  A value trap is a stock that looks cheap, but turns out to be cheap for a reason.  EK didn’t necessarily hold Bill Miller back; he had quite a number of years of market outperformance with Kodak included in the portfolio.  Other selections did pan out and more than offset the problem stocks.  The problem with value traps is psychological.  The Bloomberg article goes on:

“Part of it was just this mentality that this was just a temporary setback and Kodak would be able to get quickly back on track,” said Bridget Hughes, an analyst at Morningstar Inc., a Chicago-based stock and fund research firm. “It was not only a mistake, it was also causing a lot of client angst.”

I put the psychological problem in bold.  It drives clients crazy to see a big loser in the portfolio quarter after quarter, year after year. Even when buying cheap stocks is obviously part of the investment philosophy and when patience is required to get good returns, clients sometimes struggle with it.

Portfolio management using a systematic relative strength process has different strengths and weaknesses.  Clients are less likely to see a big loser sitting in the portfolio quarter after quarter, but are more likely to see more numerous transactions that result in small or moderate losses.   I suspect clients are no happier about a string of small losses, but they often seem to be able to let it go.  On the plus side, when using relative strength, most of the big winners will be retained in the portfolio for an extended time.

No investment approach is perfect, and every investment methodology will have its fair share of mistakes.  Still, clients choose to stick with some investment managers and bail on others, even when their long-run performance is comparable.  The client’s choice is often made primarily on the basis of emotion—sometimes just how they feel about how things are going.  All other things being equal, why would you elect to have your big losers show up on client statements for an extended period of time?

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Fund Flows

June 30, 2011

The Investment Company Institute is the national association of U.S. investment companies, including mutual funds, closed-end funds, exchange-traded funds (ETFs), and unit investment trusts (UITs). Members of ICI manage total assets of $11.82 trillion and serve nearly 90 million shareholders. Flow estimates are derived from data collected covering more than 95 percent of industry assets and are adjusted to represent industry totals.

Domestic equities continue to lose money as investors flee perceived risk for perceived safety.  Taxable bonds continue to out-sell all others by a huge margin.  More of the same!

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