RISK! A Reader’s Question

Long-Term

The view from Grant’s (Mar. 20th, 2015) is that risk can usually be found where you aren’t looking for it. You get to thinking, for example, that government bonds are perfectly and unconditionally safe. You would so conclude after 33.5 years of a bond bull market. Yet, the same asset struck many as perfectly and unconditionally unsafe at the 33.5 year point in the preceding 1946-81 bond bear market. Nothing in investing is for certain or forever, “Many shall be restored that now are fallen, and many shall fall that are now in honor,” wrote Horace (65 B.C. to 8 B.C.).

 

download

A reader asked about the 

sharpe_ratio.asp. I think any metric that uses volatility as risk is absurd. The video below will give you a better understanding of what REAL risk is–permanent loss of life! I know some may disagree–see: FAJ My Top 10 Peeves and a value investor’s view: Risk Revisited

 

A Reader’s Question

I’m a value investor from Italy, and I’ve been following your blog since a few months ago. I appreciate a lot your work and the way you share your knowledge with the others. I’ve been doing my own research in American stocks, and create a portfolio that I think is doing well.

I’m a retail small value investor with no MBA, or any especial degree in accounting.

How can a “middle class working hero” approach the world of finance? Do you think any money manager be interested in my research, or I’m only wasting my time?

My advice: First, you can post this to the deep-value@googlegroups.com because there are many smart, experienced investors who may offer another perspective.

First, why American stocks (especially now since many are high-priced?) versus Italian or Greek stocks? Can you develop an area of expertise NEAR where you are?  In other words, what makes YOU unique where you can add unique value? Where can you find the biggest edge. Do you have expertise or experience in a particular industry?   Have you spoken to or research Italian Money Managers? Send your write-up to a few of them. The worst that can happen is they give you a thumbs down but you obtain feedback/and learn.

Not having an MBA is no big deal, but you should learn accounting up to the intermediate level so you can translate the financial information into information useful for an investor.  GAAP earning don’t always equal owner’s earnings. Study online for free or attend a class or grind through a textbook but do ALL the problem-sets.

If you know your portfolio is doing well, keep good records that you can show to potential investors or employers. Do you have a clear investment process that you can follow?

Ask further questions in the comment section.

Good luck!

How Markets Work; A Case Study in Pundits: Savaged by the Truth: Jim Cramer

How Markets Workusd1

Bull-market-top-in-for-the-u-s-dollar/ (Video-Market Psychology)

3-DXY-CoTs-1024x645

Jim Cramer at his best

 

https://www.deepcapture.com/jim-cramer-is-a-complicated-man/

In short, Maier is contending that advice Cramer was giving the public under the guise of helping them manage their savings (“SmartMoney“) was actually being driven by Cramer’s need to dump his own positions without cratering the market. When a trusting public acted on Jim’s tip and bought shares, he dumped his shares onto the public. The only lesson Cramer learned from the “four orphans” incident, Maier claims, was that he, Cramer, had the power to move stocks through the press.

And: https://www.deepcapture.com/how-cnbc-becky-quick-jim-cramer-and-joe-kernan-can-solve-its-collapsing-viewership/

The link above has an amazing article written by Patrick Byrne on the slimy sleaziness of Jim Cramer.

Ignore pundits!

 

Shareholder Maximization-The Dumbest Idea in the World; Is Skill Dead?

CRB 2015 long term

JM_The Worlds Dumbest Idea_1214

Video: http://eic.cfainstitute.org/2014/10/23/shareholder-value-maximization-the-dumbest-idea-in-the-world/

Excellent video on Austrian economics and entrepreneurship:

http://mises.org/library/entrepreneurship-austrian-economics-and-cryptorevolution

Advice

I am a first year MBA student in XXXX. I am from a background of (being) a software engineer and an equity researcher in China. I was very interested in Value Investing and tried to apply it to personal investment in past 8 years. Currently, I am exploring career opportunities in the Investment Management area and see that you have been working and teaching in this area for a long time. I would learn more about your experience in this area and get some advice from you.

I would write-up investment ideas within your circle of competence to show fund managers your critical thinking skills and approach to investing.  Or if you have a great understanding of a particular industry or company that is public you can present your ideas to the fund managers who own the company.   Show your past investment results. Why did you make the decisions you made?  Try to sell your ideas to the appropriate money managers.   But only you can determine what your strengths particular interests.   Your reports should meld your interests with your skills.

Icahn

Our activist friend, Carl Icahn’s High River LP, Icahn Partners LP and Icahn Partners Master Fund LP collectively bought 6.6 million Chesapeake shares on March 11 at $14.15 each, bringing the investor’s total stake in the company to 11 percent, according to a filing on Monday. Prior to the purchases, Icahn controlled about 9.9 percent of Oklahoma City-based Chesapeake. That compares with an 11.11 percent stake owned by Southeastern Asset Management Inc. as of Dec. 31, the largest holding according to the latest filings.

The Forgotten Depression (Video)

Forgotten-depression-1921-crash-cured-itself

Commodities Carnage; Reversion to the Mean and the Growth Illusion; Net/Nets

Reuters

CRBSearch Strategy: Go where the outlook is bleakest (John Templeton). Keep his wisdom by your side: Sixteen Rules for Investment Success_Templeton

Commodities (CRB Index) fall back to a 40-year support zone ($185/$205)

while:Commodities-Sentiment

As global commodities prices plummet, it’s incredibly convenient to pronounce the commodities super-cycle dead, isn’t it?  Yet banks from Goldman Sachs to Citigroup to Deutsche Bank are on record as saying it’s over.   http://www.wallstreetdaily.com/2014/12/08/jim-rogers-commodities-interview/

The point is not to follow the “experts” but search where there is carnage. I am looking at Templeton’s Russian and Eastern Europe Fund TRF Semi Annual Report because:

  • Hated Countries (Russia, Ukraine)
  • Currencies Down,
  • Commodity Exporters and
  • trading at a 10% discount so the 1.4% management fee is covered for six years.
  • Poor performance for the past few years

Things can and will probably get worse. So please don’t follow the blind (me) off the cliff. This is meant as an example of a SEARCH STRATEGY.

More on Reversion to the Mean and the Growth Illusion

We are beating this subject to death but you can’t understand how investing in bargains works without grasping these concepts.

Contrarian Strategy Extrapolation and Risk  Abstract: Value strategies yield higher returns because these strategies exploit the sub-optimal behavior of the typical investor and not because these strategies are fundamentally riskier.  Yes, this is an academic paper, but worth reading to understand WHY and HOW value (buying stocks with low expectations/and low price to business metrics like earnings, cash flow, EBITDA, etc.) provide better returns.

Growth Illusion

The Two Percent Dilution It is widely believed that economic growth is good for stockholders. However, the cross-country correlation of real stock returns and per capita GDP growth over 1900–2002 is negative. Economic growth occurs from high personal savings rates and increased labor force participation, and from technological change. If increases in capital and labor inputs go into new corporations, these do not boost the present value of dividends on existing corporations. Technological change does not increase profits unless firms have lasting monopolies, a condition that rarely occurs. Countries with high growth potential do not offer good equity investment opportunities unless valuations are low.

value-vs-glamour-a-global-phenomenon (Brandes Institute)

Thick as a Bric by Efficient Frontier

Does the Stock Market Over React

Discussion of Does the Stock Market Over React

Criticism of the Over Reaction Theory

The above is meant to supplement your reading in Deep Value Chapter 5, A Clockwork Market

 

Ben Graham’s Net-Net Strategy Revisited

Ben Graham Net Current Asset Values A Performance Update

R-T-M, Gross Profitability, Magic Formula

Our last lesson was in Mean Reversion (Chapter 5 in Deep Value) discussed http://wp.me/p2OaYY-2Ju  View this video on a very MEAN Reversion.

We must understand full cycles and reversion to the mean.  Let’s move on to reading Chapter 2: A Blueprint to a better Quantitative Value Strategy in Quantitative Value.

Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas. -Warren Buffett, Shareholder Letter, 2000.

A WONDERFUL BUSINESS

Greenblatt defined Buffett’s definition of a good business as a high Return on Capital (ROC) – EBIT/Capital

Capital is defined as fixed asses + working capital (current assets minus current liabilities) minus excess cash.

ROC measures how efficiently management has used the capital employed in the business. The measure excludes excess cash and interest-bearing assets from this calculation to focus only on those assets actually used in the business to generate the return.

A BARGAIN PRICE

High earning yield = EBIT/TEV

TEV + Market Cap. + Total debt – minus excess cash + Preferred Stock + minority interests, and excess cash means cash + current assets – current liabilities.EBIT/TEV enables and apples-to-apples comparison of stock with different capital structures.

Improving on the Magic Formula?

ROC defined as Gross profitability to total assets.

GPA = (Revenue – Cost of Goods Sold)/Total Assets

GPA is the “cleanest” measure of true economic profitability.

See this study Gross Profitability a Better Metric and see pages 46-49 in Quant. Value. (the book was sent to deep-value group on Google)

The authors found GPA outperformed as a quality measure the magic formula.  Note on page 48, Table 2.3: Performance Stats for Common Quality Measures (1964 – 2011) that most simple quality measures do NOT provide any differentiation from the market!

FINDING PRICE, Academically–Book value/Market Price

The authors found that analyzing stocks along price and quality contours using the Magic Formula and its generic academic brother Quality and Price can produce market beating results 

The authors: “Our study demonstrates the utility of a quantitative approach to investing. Relentlessly pursuing a small edge over a long period of time, through booms and busts, good economies and bad, can lead to outstanding investment results.”

Ok, let’s come back to quality and avoiding value/death traps in the later chapters (3 and 4) in Quantitative Value.  We are just covering material in Chapter 2. 

INVESTORS BEHAVING BADLY

Investors and the Magic Formula

Adding Your Two Cents May Cost a Lot Over the Long Term by Joel Greenblatt
01-18-2012  (Full article: Adding Your Two Cents

Gotham Asset Management managing partner and Columbia professor Joel Greenblatt explains why investors who ‘self-managed’ his Magic Formula using pre-approved stocks underperformed the professionally managed systematic accounts.

So, what happened? Well, as it turns out, the self-managed accounts, where clients could choose their own stocks from the pre-approved list and then follow (or not) our guidelines for trading the stocks at fixed intervals didn’t do too badly. A compilation of all self-managed accounts for the two-year period showed a cumulative return of 59.4% after all expenses. Pretty darn good, right? Unfortunately, the S&P 500 during the same period was actually up 62.7%.

“Hmmm….that’s interesting”, you say (or I’ll say it for you, it works either way), “so how did the ‘professionally managed’ accounts do during the same period?” Well, a compilation of all the “professionally managed” accounts earned 84.1% after all expenses over the same two years, beating the “self managed” by almost 25% (and the S&P by well over 20%). For just a two-year period, that’s a huge difference! It’s especially huge since both “self-managed” and “professionally managed” chose investments from the same list of stocks and supposedly followed the same basic game plan.

Let’s put it another way: on average the people who “self-managed” their accounts took a winning system and used their judgment to unintentionally eliminate all the outperformance and then some! How’d that happen?

1. Self-managed investors avoided buying many of the biggest winners.

How? Well, the market prices certain businesses cheaply for reasons that are usually very well-known (The market is a discounting mechanism). Whether you read the newspaper or follow the news in some other way, you’ll usually know what’s “wrong” with most stocks that appear at the top of the magic formula list. That’s part of the reason they’re available cheap in the first place! Most likely, the near future for a company might not look quite as bright as the recent past or there’s a great deal of uncertainty about the company for one reason or another. Buying stocks that appear cheap relative to trailing measures of cash flow or other measures (even if they’re still “good” businesses that earn high returns on capital), usually means you’re buying companies that are out of favor.

These types of companies are systematically avoided by both individuals and institutional investors. Most people and especially professional managers want to make money now. A company that may face short-term issues isn’t where most investors look for near term profits. Many self-managed investors just eliminate companies from the list that they just know from reading the newspaper face a near term problem or some uncertainty. But many of these companies turn out to be the biggest future winners.

2. Many self-managed investors changed their game plan after the strategy under-performed for a period of time.

Many self-managed investors got discouraged after the magic formula strategy under-performed the market for a period of time and simply sold stocks without replacing them, held more cash, and/or stopped updating the strategy on a periodic basis. It’s hard to stick with a strategy that’s not working for a little while. The best performing mutual fund for the decade of the 2000’s actually earned over 18% per year over a decade where the popular market averages were essentially flat. However, because of the capital movements of investors who bailed out during periods after the fund had underperformed for a while, the average investor (weighted by dollars invested) actually turned that 18% annual gain into an 11% LOSS per year during the same 10 year period.[2]

3. Many self-managed investors changed their game plan after the market and their self-managed portfolio declined (regardless of whether the self-managed strategy was outperforming or underperforming a declining market).

This is a similar story to #2 above. Investors don’t like to lose money. Beating the market by losing less than the market isn’t that comforting. Many self-managed investors sold stocks without replacing them, held more cash, and/or stopped updating the strategy on a periodic basis after the markets and their portfolio declined for a period of time. It didn’t matter whether the strategy was outperforming or underperforming over this same period. Investors in that best performing mutual fund of the decade that I mentioned above likely withdrew money after the fund declined regardless of whether it was outperforming a declining market during that same period.

4. Many self-managed investors bought more AFTER good periods of performance.

You get the idea. Most investors sell right AFTER bad performance and buy right AFTER good performance. This is a great way to lower long-term investment returns.

Luck-versus-skill-in-mutual-fund-performance by Fama

….We will finish the chapter with a study of checklists in the next post.

Interesting reading: The Crescent Fund (note reversion to the mean)  Oil Crash Pzena and http://aswathdamodaran.blogspot.com/

Go-where-it-is-darkest-when-company.html (Vale-Brazilian Iron Ore Producer).   Prof. Damordaran values Vale and Lukoil on Nov. 20, 2015.  I am looking at Vale because they have some of the lowest cost assets of Iron Ore in the world.  They have good odds of surviving the downturn but where the trough is–who knows. 

Valuing Cyclical Companies:

Valuing Cyclical Commodity Companies

CS on a Cyclical Business or Thinking About Cypress Stock

Letter to Cypress Shareholders about Price vs Value

download_t_j__rodgers__cdc_2002_keynote_presentation

CY_VL

39_studie_value_creation_in_chemical_industry

vale

I think the author at least knew of the risks, but underestimated the extent of the cycle due to massive distortions caused by the world’s central banks.  It did get darker..as iron prices fell another 10% and still falling. 

Month Price Iron Ore Change
Aug 2014 92.63 -
Sep 2014 82.27 -11.18 %
Oct 2014 80.09 -2.65 %
Nov 2014 73.13 -8.69 %
Dec 2014 68.80 -5.92 %
Jan 2015 67.39 -2.05 %
Feb 2015 62.69 -6.97

vale

Damodaran: I have not updated my valuation of Vale (as of Feb. 20th), but I have neither sold nor added to my position. It is unlikely that I will add to my position for a simple reason. I don’t like doubling down on bets, even if I feel strongly, because I feel like I am tempting fate. 

Prof. Damodaran is responding to a poster who is asking about Vale’s plummeting stock price.  If you are a long-term bull you want declining prices to bankrupt weak companies in the industry so as to rationalize supply.

HAVE A GREAT WEEKEND!

Extremes

CRB-Index

An early sign of a turn: Gold vs. the Commodity Research Bureau Index (CRB). Since gold is commodity money it is much more sensitive to changes in financial conditions than consumable commodities.

gold crb

wtic

Offsides?

Commodities-Sentiment

IUS-Dollar-COT

cnbc

Rate of change of dollar

usd1

I like to take note of extremes. However, the amount of central bank monetary distortion is so huge (note negative interest rate on government debt, huge deficits, QE, etc.) that extremes can go to new levels but when investors are on one side of the boat–be careful.

Also, visit www.hussmanfunds.com

PS: Once I clear my backlog, I will return to our lessons in Deep Value and Quantitative Value.  Plus post the links to the videos of valua investing classes.

Can the Piotroski F Score Improve Your Investment Strategy?

Bar

We will be looking at accounting metrics to screen out value traps, so I thought some may wish to read: Can-the-piotroski-f-score-also-improve-your-investment-strategy

As an example, if you want to invest with more (RELATIVE) safety in the cyclical oil service business, you would want a company like this: RPC Inc (RES)

Note balance sheet and good operating metrics.  It doesn’t mean that RPC, Inc. can’t go materially lower in price, just that the company has a high probability of surviving through this down cycle compared to competitors.

 Market Psychology

Silver-to-$60 (video during 2011 Silver Mania)

Dollar to Euro Parity (video during 2015 Dollar Mania/Panic)

Beware of “experts.”

Dollar Panic; Valuation Ratios; Buyback Mania, CEFs

USbills_3228903b

If you think nobody cares about you, try missing a couple of payments.- Wright.

Long-term view of the Dollar (DXY)

Oil service, oil producers, mining companies etc. are being hammered by a dollar “shortage.”  Opportunity may be knocking. Remember what Klarman said about forced selling.

An overview of the situation: Dollar Shortage. With money supply rising in the US there is no dollar “shortage”, but there is a fear of inter-bank lending.

Dollar Leverage BIS Report

Dollar Crisis 2009

JPM-dollar-shortage funding

A Guide to the Swap Market

Now the “experts” say confidently cnbc Dollar Euro Parity. Perhaps a bit late in a trend!   If you are to follow a trend then The Whipsaw Song

A Reader’s Question on Valuation Ratios.  This sheet may be good as a guide to go through an annual report, but none of those ratios means anything without context.   Is growth good? It depends. Only profitable growth within a franchise.  How about asset turnover?   For some companies like Costco asset turnover is critical but not for Boeing (gross margin).   Why not take those ratios and work through the financials of these trucking companies.  Which company is doing the best? Why? Follow the money!   Those ratios may help you structure the information you pull out from the financials. But first focus on how does the company provide a service to its customers and then trace the financial effects back to your returns as an investor.

  1. HTLD VL
  2. JBHT VL
  3. KNX_VL

Buy-Back Mania (a yellow light of caution)

davidstockmanscontracorner.com-February Stock Buybacks Hit RecordTotal 2 Trillion Since 2009

Emultate Henry Singleton

Case Study in capital allocation: Dr. Singleton and Teledyne A Study of an Excellent Capital Allocator (must read!)

Gold is in a hyper bubble……………….

Gold Bubble

But now not so much…………………Gold Bubble Not Quite as much

Gold is stupid-cheap compared to all the money out there…………………Gold hyper undervalued

What determines the price of gold

2010-06-21 IE Special Report GOLD

A Case Study in investing in Closed-End Funds

Prof. Greenblatt once said that sometimes people just go crazy.

A Lesson in CEF Investing TRF

trf

Investors ran to pay a 90% PREMIUM to NAV AFTER a six-year boom and now after a seven-year decline they sell at a 10.5% DISCOUNT. Go figure.

http://www.cefconnect.com/Details/Summary.aspx?Ticker=TRF

Interesting video on China–a country brimming with centrally planned mal-investment. Is China Already in a Hard Landing?

Read more at reality-check-how-fast-is-china-growing.

We will get back to Deep Value next week and I will post links to valuation class videos.  Have a great weekend and if you do try to emulate someone, then:

Kyle Bass Interview

Kyle

Kyle Bass Interview (good interview!)

SorosThe investing rules of George Soros Soros Investing Rules and MCCM 4Q2014_Market Review & Outlook

Time-out: A Case Study in Pigeons

Pigeons-pigeons-27537154-741-1095

Case Study in Pigeon Investing

Times are hard.  Your family has been struggling to make the mortgage payments on your farm since the 50% decline in corn prices.

corn

Your lucky day! You get a call from a friend’s neighbor that he (The Pigeon King) desperately  needs breeders for his growing pigeon business. With a $125,000 investment financed with a second mortgage against your farm you can buy 360 pairs of pigeons at $165 a pair.  Then he offers to buy back the newly bred pigeons for $40 each (pigeons breed prolifically) with a ten-year contract.  He says these pigeons are for racing.  Then he gives you a list of five farmers in your state who are breeding pigeons for him.  Take your time and do your due-diligence, he says.

You check his credit ratings–all good.  No criminal or civil complaints. He owns his farm free and clear–he is a farmer like you!  After meeting with three of the pigeon farmers who confirm with check stubs that he has been paying them on time and as promised. The returns are good–in excess of 80% to 100% in terms of food and overhead to raise the chicks. Considering your time to look over your pigeons, you figure you can net a 50% pre-tax return on your capital. Plus, your contract allows you to sell whatever you produce at the stipulated price, so growth will be profitable.

Also, you hire an investigator to interview the Pigeon King. She sends you this video interview: Making Fowl into good fare—it this a good idea and A successful pigeon farmer

Times are hard. What do you do? Before you decide, you are inspired by

You gotta have dreams and the will to believe!

Pedgeon King

You remember what you learned as a deep value investor over at csinvesting.org and you_________? Why? What INVESTING/BUSINESS principles help you in your decision?

Please write them down now.  Then read on.

Many years later, you notice in the paper:

the-pigeon-king-and-the-ponzi-scheme-that-shook-canada.html

This article, The Pigeon King (same as the link above but with additional commentary for easier reading) is one of the most amazing stories–a farce, a tragedy, a comedy AND chock full of lessons for the investor.  You may think you are too smart to be a pigeon or a bird-brain (sorry!) but ANYONE can be blind.  What checklist items stop you (besides it’s too good to be true?).

What did YOU learn?

Money for nothing and your chicks for free