Category Archives: Investor Psychology

Buffett’s 2014 Letter to Shareholders

buffett

Decades ago, Ben Graham pinpointed the blame for investment failure, using a quote from Shakespeare: “The fault, dear Brutus, is not in our stars, but in ourselves.”

Comments on the Berkshire Hathaway 2014 letter,  Part 1

Note the plug (page 6) for Where Are the Customers’ Yachts by Fred Schwed. That along with the Money Game by Adam Smith will teach you the ways of Wall Street. Also, see:

Intrinsic Value: Buffett reiterates that it is not a precise number for Berkshire nor, in fact for ANY stock.

GEICO delivers savings to its customers because it is a low-cost operation (source of structural competitive advantage).  The company’s low costs create a moat—an enduring one—that competitors are unable to cross.  Note Buffett’s comment on the animated gecko, a LOW-COST spokesperson.

TESCO

Here’s how he explained it:

“In 2013, I soured somewhat on the company’s then-management and sold 114 million shares, realizing a profit of $43 million. My leisurely pace in making sales would prove expensive. Charlie calls this sort of behavior “thumb-sucking.” (Considering what my delay cost us, he is being kind.)

“During 2014, Tesco’s problems worsened by the month. The company’s market share fell, its margins contracted and accounting problems surfaced. In the world of business, bad news often surfaces serially: You see a cockroach in your kitchen; as the days go by, you meet his relatives.”

Buffett said the dawdling resulted in an after-tax loss of $444 million by the time Berkshire was no longer a Tesco shareholder. That, he added, is about 0.2% of Berkshire’s net worth. Only three times in 50 years has Berkshire recorded losses from a sale equal to more than 1% of its net worth.

Unfortunately, we don’t learn what exactly caused the loss. How did Buffett miscalculate intrinsic value?    Did management worsen, but if so, then how can an investor sidestep that?   I believe the economics changed as customers had more in-home deliveries and other choices coupled with poor store execution from Tesco.  I was disappointed with this explanation of the Tesco loss, but Buffett would reply that it was only 1/5 of 1%.

Nominal vs. Real Returns

During the 1964-2014 period, the S&P 500 rose from 84 to 2,059, which, with reinvested dividends, generated the overall return of 11,196% shown on page 2. Concurrently, the purchasing power of the dollar declined a staggering 87%. That decrease means that it now takes $1 to buy what could be bought for 13 cents in 1965 as measured by the CPI (Flawed or whats wrong with cpi)

I prefer measuring in gold grams, because gold is a store of value and market-based rather than concocted by Federal bureaucrats.DJIA-1900

There is an important message for investors in that disparate performance between stocks and dollars. Think back to our 2011 annual report, in which we defined investing as the transfer to others of purchasing power now with reasoned expectation of receiving more purchasing power–after taxes have been paid on nominal gains—in the future.”   (I wonder why Mr. Buffett makes no mention of the financial repression of ZIRP and NIRP?  It is the elephant in the room because of the devastating effect it has on savers and on calculating discount rates for investment.)

The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities—Treasuries, for example—whose values have been tied to American currency. That was also true in the preceding half century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century.  Buffett’s comments are backed up by history as shown here:Triumphand triumph_of_the_optimists

Stock prices will always be far more volatile than cash equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments—far riskier investments. Than widely –diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk.  Though this pedagogic assumption makes for easy teaching, it is dead wrong. Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.

It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and purchasing power terms) than leaving funds in cash-equivalents. That is relevant to certain investors-say, investment banks—whose viability can be threatened by declines in asset prices and which might be forced to sell securities during depressed markets. Additionally, any party that might have meaningful near-term needs for funds should keep appropriate sums in Treasuries or insured bank deposits.

For the great majority of investors, however, who can—and should—invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities.

Note the multi-decade horizon. Stocks were unchanged from 1964-1981, please see page 79: A Study of Market History through Graham Babson Buffett and Others.  Read what Buffett has to say about stock markets. Some say it is Time to exit because of high valuations for big-cap stocks in the U.S. market. So even if stocks decline for a decade but your holding period is MULTI-Decade, then hold tight.  Tough to do, but history seems to bear his thesis out: valuing-growth-stocks-revisiting-the-nifty-fifty.  I prefer to act like the pig farmer in A Study of Market History (see link above).

If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risk things. Recall, if you will, the pundits who six years ago bemoaned falling stock prices and advised investing in “safe” Treasury bills or bank certificates of deposit. People who heeded this sermon (to panic) are now earning a pittance on sums they had previously expected would finance a pleasant retirement. (The S&P 500 was then below 700; now it is about 2,100.) If not for their fear of meaningless price volatility, these investors could have assured themselves of a good income for life by simply buying a very low-cost index fund whose dividends would trend upward over the years and whose principal would grow as well (with many ups and downs, to be sure).

spx

Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to “time” market movements, inadequate diversification, the payment of high and unnecessary to managers and advisors and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy. ….Anything can happen anytime in markets. And no advisor, economist, or TV commentator–and definitely not Charlie nor I–can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.

A plug for Jack Bogle’s The Little Book of Common Sense Investing.  Basically, Buffett is saying keep it simple, think and hold L O N G – T E R M, avoid high fees and commissions, and don’t use leverage. 

Next, let’s look at Berkshire–Past, Present and Future in Part II

Beating An Index or What Works on Wall Street

chimp

Chimps Managing  (30-second video) and Sales are down

Why can’t 70% of professional money managers beat chimps?

High fees/costs, index hugging, inconsistency, overconfidence in their ability to be above average, lovers of stories, herding, and the institutional imperative? Don’t forget incentives that differ from achieving performance like asset gathering. See the case study at the end of this post.

what works

We left off with a reader asking why do money managers do better or follow a deep value approach? http://wp.me/p2OaYY-2IZ

One goal of our Deep Value journey is to find a method that suits us. This method should have a large base case rate of beating an index over a long period of time, say fifty years.   The lesson learned so far—I hope—is that CHEAPNESS wins whether that is price to book value, price to sales, price to cash flow.  My recent reading of the most recent 4th Edition of What Works on Wall Street shows that high  EBITDA-to-EV has beaten out Price-to-Sales (3rd Edition) What Works on Wall Street, Third Edition as the best metric as a value factor.  However, combined with quality of earnings metrics, it performs even better or about 18% to 19% per year since 1964 to 2009.  Our goal is to put the odds on our side and CONSISTENTLY play the odds through thick and thin.  Our other edge is to realize how flawed our thinking is and thus we build protection against ourselves by developing a disciplined approach.

What Works: Notes from Joel Greenblatt’s class 2002:

Read: What Works on Wall Street by James P O’Shaughnessy.  He started a fund in 1996-1997 but he underperformed the market by 25% and after three years in business of underperforming he sold his company at the bottom of the cycle.   The guy who wrote the book quit his system!   It seems like it is easy to do, but it is not easy to do.

This book, What Works on Wall Street, has born out its wisdom. The two funds that are patented that follow his strategy have been phenomenal. HFCGX is the patented fund based on his top idea of Cornerstone Growth; over the last 5 years it has had an average return of 13.44% per year vs. the Vanguard 500’s -2.01% per year (6/1/00 through 5/31/05). HFCVX is the patented fund based on his 2nd to best idea of Cornerstone Value; over the last 5 years it has had an average return of 6.47% per year vs. the Vanguard 500’s -2.01% per year (6/1/00 through 5/31/05).

The most interesting point is that the author points out those investors often are too emotionally involved to have the discipline to see the strategy through. Not only did the first reviewer bash the book because he did like the returns strategy JUST one year after the book came out, but Mr. O’Shaughnessy sold the funds to Hennessy Funds at the end of 1999 after it failed to surpass the returns of the bubble that soon after collapsed. Seven years after it was published an investor would be much wealthier had they followed the books top strategy instead of the investors who dog-piled onto the stocks of the market’s bubble.

We are going to try to understand why it works. Why it has to work over time.  That is the only way you can stick it out.  The math never changes: 2 + 2 = 4.   That is the level of your understanding I want you to have by the time we are done.  If I get that right, forget all this other stuff and noise, I will get my money.  No genius required.  Concepts will make you great and your ability to STICK IT OUT.

There is a lot of experience involved in valuation work, but it doesn’t take a genius or high IQ points to know the basic concepts.  The basic concepts are what will make you the money in the long run.   We are all capable of doing the valuation work.

Notes from the 4th Edition of What Works on Wall Street

Why Indexing Works

Indexing works because it sidesteps flawed decision-making and automates the simple strategy of buying the big stocks that make up the S&P 500. The mighty S&P 500 consistently beat 70 percent of traditionally managed funds over the long-term by doing nothing more than making a disciplined bet on large capitalization stocks.

Money Management Performance

Past records of most traditional mangers cannot be predictive of future returns because their behavior is inconsistent.  You can’t make forecasts based on inconsistent behavior.

Common Sense Prevails

We now have the ability to empirically compare different investment strategies and their ongoing performance over time. What you will see in coming chapters is that almost all of them are deeply consistent with what common sense would tell you was true. Strategies that buy stocks that are selling at deep discounts to cash flow, sales, earnings , EBITDA-to-enterprise value (Yeah, but don’t forget MCX), and so on do extraordinary better than those that are willing to buy stocks with the richest valuation.  WE will be sensitive to data mining.

Does Complexity Imply Value  Simple works best–I suggest you read!

Systematic, structured investing is a hybrid of active and passive management that automated the buy and sell decisions. If a stock meets a particular criteria, it’s bought. If not, not. No personal, emotional judgments enter into the process.  Essentially, you are indexing a portfolio to a specific investment strategy and, by doing so, uniting the best of active and passive investing.  The disciplined implementation of active strategies is the key to performance. Traditional managers usually follow a hit-and-miss approach to investing. Their lack of discipline accounts for their inability to beat simple approaches that never vary from the underlying strategy.

The ONE thing that unites the best money managers is consistency.

Successful investing requires, at a minimum, a structured decision-making process that can be easily defined and a stated investment philosophy that is consistently applied.

Goeth said, “In the realm of ideas everything depends on enthusiasm; in the real world, all rests on perseverance.” While we may intellectually understand what we should do, we usually are overwhelmed by our nature, allowing the intensely emotional present to overpower our better judgment.

Human Judgment is limited

Why models beat humans

Models beat the human forecasters because they reliably and consistently apply the same criteria time after time. It is the total reliability of application of the model that accounts for its superior performance.

We are ALL above average.

Base rates are boring

We prefer gut reactions and stories to boring base rates.

Stocks with low PE ratios outperformed the market in 99 percent of all rolling 10-year periods between 1964 and 2009.

The best way to predict the future is to bet with the base rate that is derived from a large sample.

Base rates are boring while experience is vivid and fun.  Never mind that stocks with high P/E ratios beat the market less than 1 percent of the time over all rolling 10-year periods between 1964 and 2009.

Montier in his book, Value Investing writes: “One of the recurring themes of my research is that we just can’t forecast There isn’t a shred of evidence to suggest that we can.

We prefer the complex and artificial to the simple and unadorned.

Nowhere does history indulge in repetition so often or so uniformly as in Wall Street. When you read contemporary accounts of booms or panics, the one thing that strikes you most forcibly is how little either stock speculation or stock speculators today differ from yesterday. The game does not change and neither does human nature.—Edwin Lefevre.

Brain Research

Because of the interrelated nature of the emotional and rational centers of our brain, we will never be able to fully overcome our tendency to make irrational choices.  Simply being aware of this problem does not make it go away. To break from our human tendencies to chase performance and perceive patterns where there are none, we must find an investment strategy that removes subjective, human decision-making from the process and relies instead on smart, empirically proven systematic strategies. We can become wise by realizing how unwise we truly are.

Rules of the Game

It is amazing to reflect how little systematic knowledge Wall Street has to draw upon as regards the historical behavior of securities with defined characteristics. –Ben Graham

Richard Brealey, a respected data analysis, estimated that to make reasonable assumptions about a strategy’s validity (95% confidence level or statistically relevant) you would need 25 years of data.

Short periods are valueless

Consider the “soaring sixties” when the go-go growth managers of that era switched stocks so fast that they were called gunslingers. The go-go investors of the era focused on the most rapidly growing companies without even considering how much they were paying for every dollar of growth. Between Jan 1, 1964, and Dec. 31, 1968, $10,000 invested in a portfolio that annually bought the 50 stocks in the Compustat data base with the best annual growth in sales soared to $33,000 in value , a compound return of 27.34 % a year. That more than doubled the S&P 500’s 10.16% annual return, which saw $10,000 grow to just $16,200. Unfortunately, the strategy went on to lose 15.7% per year for the following five years compared to a gain of two percent for the S&P 500.

Had this same hapless investor had access to long-term returns, he would have seen that buying stocks based just on their annual growth of sales was a horrible way to invest—the strategy returns just 3.88 percent per year between 1964 and 2009.  Of course, the investor received similar results if he repeated the experiment between 1995 and 1999 and then the next five years.

EBITDA to EV was the best on an absolute basis for all the individual value factors we examine from 1964 to 2009 such as price to cash flow, price to earnings, etc.

EV/EBITDA in the lowest decile (the most EBITDA per EV) generated a 16.58% CAGR vs. 11.22% for the All Stocks universe with a standard deviation of returns of 17.71 percent, more than 1 percent below that of All stocks, 18.99 percent.  The worst five-year period for the metric was 2000 during the Internet Mania.  These ups and downs for a strategy are all part of the bargain you must strike with yourself as a strategic investor.  Pages 103 to 124 in What Works (4th Ed.) The EV/EBITDA in the highest decile (the most “expensive) did the worst of all the value metrics studied!

EV works well as a guide to under-and-over valuation when contrasted to EBITDA, SALES, and Free cash flow.

Price to book value ratios are a long-term winner with LONG periods of underperformance.

Accounting Ratios can help identify higher quality earnings:

  • Total accruals to total assets
  • Percentage change in net operating assets (NOA)
  • Total accruals to average asses.
  • Depreciation expense to capital expense.

We are looking for stocks with high earnings quality.

Accounting variables mater. How companies account for accruals, how quickly they depreciate capital expenses and their additions to debt all have a serious impact on the health of their stock price.

Successful investing relies heavily on buying stocks that have good prospects, but for which investors currently have low expectations. Stocks with great earnings gains and high net profit margins are basically high expectations stocks.

History shows that using high profit margins as the SOLE determinant for buying a stock leads to disappointing results.  The only lesson here is that it is best to avoid stocks with the lowest net profit margins.

A Case Study in Why Money Managers Lose Even With a Winning Hand

  • Winning Stock Picker’s Losing Fund

Value Line Research Service Has Beaten Market Handily, But Its Own Fund Suffered By Jeff D. Opdyke and Jane J. Kim Staff Reporters of THE WALL STREET JOURNAL Updated Sept. 16, 2004 12:01 a.m. ET

Value Line Investment Survey is one of the top independent stock-research services, touted for its remarkable record of identifying winners. Warren Buffett and Peter Lynch, among other professional investors, laud its system.

But the company also runs a mutual fund, and in one of Wall Street’s odder paradoxes, it has performed terribly. Investors following the Value Line approach to buying and selling stocks would have racked up cumulative gains of nearly 76% over the five years ended in December, according to the investment-research firm. That period includes the worst bear market in a generation.

Why the Fund Lagged

  • Past managers bought stocks that in some cases were well below the company’s top-rated choices, hurting performance.
  • Style drift: The fund has swung among small-, mid- and large-cap shares.
  • High turnover of fund managers meant little consistent investment discipline.

By contrast, the mutual fund — one of the nation’s oldest, having started in 1950 — lost a cumulative 19% over the same five years. The discrepancy has a lot to do with the fact that the Value Line fund, despite its name, hasn’t rigorously followed the weekly investment advice printed by its parent Value Line Publishing Inc. It also highlights the penalty investors often face when their mutual fund churns its management team and plays around with its investing style. In fact, late last night the person running the fund, Jack Dempsey, said that as of yesterday he had been reassigned and no longer had responsibility for managing the assets. Value Line couldn’t be reached to comment.

Most of all, the discrepancy between the performance of the fund and the stocks it touts shows that investors don’t always get what they think they’re buying in a mutual fund. For even though Value Line’s success is built around stocks ranked No. 1 by the company’s research arm, the fund’s managers have in recent years dipped into stocks rated as low as No. 3.

Ironically, even while Value Line’s own fund struggles to match the Value Line Investment Survey’s success, an independent fund company that licenses the Value Line name is doing much better with Value Line’s investment approach.

The First Trust Value Line 100 closed-end fund, run by Lisle, Ill.,-based First Trust Portfolios, adheres far more rigorously to Value Line’s investment principles, owning only the top-rated stocks.

Each Friday, First Trust managers log on to the Value Line site to download the week’s list of Value Line’s 100 most-timely stocks. During the next week, they sell the stocks that have fallen off the list and buy those that have been added. The result: Since its inception in June 2003, the First Trust Value Line fund’s net-asset value is up 12.4%, slightly better than the 11.6% gain the Standard & Poor’s 500-stock index posted in the same period.

Value Line’s own fund, meanwhile, gained 3.1% in that same time. Because the fund has been such a laggard in recent years, investors have been walking away. Assets in the fund — in the $500 million range as recently as 1999 — are now less than $200 million, though some of that stems from market losses.

Part of the underperformance stems from previous fund managers who didn’t rely entirely on Value Line’s proven model, opting instead to venture into lower-rated stocks, betting that active fund managers could unearth overlooked gems that one day would shine as top-rated stocks. Thus, investors who thought they were buying into Value Line’s winning investment strategy instead were buying into fund managers who thought they could outperform by second-guessing the company’s research — a tactic that didn’t work well.

Because the fund wasn’t performing well, the company changed managers frequently, searching for one who could post winning returns.

Value Line appeared to be moving back toward its roots in March, when it put Mr. Dempsey in charge of the fund. He isn’t the traditional mutual-fund manager; he’s a computer programmer who for a decade helped refine Value Line’s investment models. Value Line, which uses a team-managed approach, has had at least five lead fund managers since 1998, including Mr. Dempsey, according to Morningstar.

In an interview prior to his reassignment, Mr. Dempsey said he had been restructuring the fund to follow the ranking system “in a much more stringent fashion.” Today, about 95% of the stocks in the fund are rated No. 1. Mr. Dempsey said his goal was to liquidate within a week stocks that fell below Value Line’s No. 1 ranking.

The Value Line survey produces independent research on Wall Street stocks. The weekly view of 1,700 stocks, which costs $538 a year online (www.valueline.com) and nearly $600 in print form, is particularly popular with do-it-yourself investors and the abundance of investment clubs in the U.S. Value Line rates stocks in a variety of ways, but is especially known for its so-called timeliness rank. Stocks ranked No. 1 are timely and expected to outperform the market; those ranked No. 5 are expected to lag.

Instead of running an actively managed fund in which a manager cherry-picks the stocks the fund owns, Value Line could operate what amounts to an index fund that simply owns the highest-ranked stocks in the survey. However, active managers believe they can improve the performance of a fund.

“As a fund manager, you want to add value,” Mr. Dempsey said. Still, he acknowledged that “it’s hard to beat our quantitative system.” In the short time that Mr. Dempsey was in charge — a nearly six-month period in which he transformed the portfolio — he accumulated losses of about 2%, compared with losses of 0.2% at the S&P 500. However, he topped the First Trust fund, which is down about 2.5% in the same period. Under Mr. Dempsey, the fund accumulated significant positions in stocks such as Research In Motion Ltd. and added new positions in Yahoo Inc. and Arrow Electronics Inc., among other companies, according to Morningstar.

Value Line, based in New York, doesn’t detail the inner workings of its proprietary stock-picking model. By and large, though, the strategy is built around stocks displaying price and earnings momentum and posting earnings surprises, says John James, chairman of the Oak Group, a Chicago company that runs hedge funds, some of which try to anticipate changes in Value Line’s stock rankings and then invest based on which stocks will rise to No. 1 from No. 2.

However Value Line’s model works, there’s no question the company’s research produces winning choices. Value Line’s list of stocks ranked No. 1 produced cumulative gains of nearly 1,300% from Dec. 31, 1988 through June, 30, 2004, according to Value Line. The S&P 500, by comparison, posted cumulative gains of 311%.

Newbie investor meets a DEEP VALUE INVESTOR

 

Enron Case Study Analysis. Ask Why? Why?

Enron3

Case-Study-So-What-is-It-Worth    Prior Post where students discussed the case.

Turn up the VOLUME: Don’t believe the …..?

Enron-Case-Study-So-What-is-It-Worth  My walk-through. I go straight to the balance sheet then calculate the returns on total capital in the business. These financial statements were easy to discard because of the size of the business and the poor returns. My estimate of $5 to $7 per share worth or 90% less than the current share price, was wrong. The company was worth $0.  This is more a case of institutional imperative and incentive-based bias. Wall Street was feeding at the financial trough to keep raising money for Enron (to keep the bad businesses afloat) so guess what the financial analysts (CFAs and MBAs) suggested? Buy!   I guess the market is not ALWAYS efficient.

Forget accounting scandals, this was a crappy business based on trading so no way to determine normalized earnings.   When I was in Brazil and saw Enron’s newly-built generating plant sitting idle, I asked why.   A project developer said he got paid by doing deals by their size not profitability, therefore, the bigger the white elephant, the better.  When I called mutual funds who owned Enron as it was trading $77 per share to ask the analyst if he/she was aware of Enron’s declining businesses coupled with absurd price, I was told to shut up. As one analyst (Morgan Stanley?) told me, “I only believe what I want to believe and disregard the rest.”

Enron Annual Report 2000  Ha, ha! and Is Enron Overpriced?

The above august panel never answered why anyone would give capital to Enron?  No one mentions the elephant in the room.  Sad.

What does the above case have to do with net/nets and our course. Everything! Look at the numbers, think for thyself, ignore Wall Street, and be aware of incentives.   Buying bad businesses at premium prices is a guarantee of financial death.

This is an aside, but based on the above Enron example, does value investing serve a SOCIAL purpose or benefit? Prof. Greenblatt doesn’t think so–you are just trading pieces of paper, but what do YOU think?

See these two venture capitalists explain the social purpose of their business:

Thinking Differently (Money Ball); Munsingwear Analysis

BREAKING BIASES



I HIGHLY recommend you go see Money Ball or read the book by Michael Lewis.  A metaphor for deep value investing.

Case Study – Munsingwear Analysis Q&A

Who earned their wingtips?  That case was about approaching the problem as a business person.  First you had to notice the two businesses, then break them out. Stop the bleeding, then leave the rest.  Often, the smartest students struggle to resurrect the uncompetitive business. (Buffett at Berkshire Hathaway!)

Next, I will post some questions and supplementary readings for Chapter Two in DEEP VALUE (the book) over the weekend.

Enjoy your Weekend!

DEEP VALUE Videos on Net/Nets and Investing

Closing Arg

How is it possible that an issue with the splendid records of Tonopah Mining should sell at less than the company’s cash assets alone? Three explanations of this strange situation may be given. The company’s rich mines at Tonopah are known to be virtually exhausted. At the same time the strenuous efforts of the Exploration Department to develop new properties have met with but indifferent success. Finally, the drop in the price of silver last year has provided another bearish argument. It is this combination of unfavorable factors which has carried the price down from $7  1/8 in 1917 to its present low of $1  3/8 in 1923.

Granting that the operating outlook is uncertain, one must still marvel at the triumph of pessimism which refused to value the issue at even the amount of its cash and marketable investments; particularly since there is every reason to believe that the company’s holdings in the Tonopah and Goldfield railroad, are themselves intrinsically worth the present selling price. (Ben Graham on Investing)

VIDEOS

Marty Whitman criticizes Graham and Net Nets (3 minutes Must see!)

Marty Whitman: They Just Don’t Get it.  (23 minutes) Marty says many analysts on Wall Street do not understand credit analysis.   We will explore later in this course whether the quality of credit provides a better assessment of the true cost of capital for a firm rather than “beta.”

One investor’s experience investing in Net/Nets (3 minutes)

Net/nets as value traps (5 minutes)

Good advice on behavioral investing (3.5 minutes)

Prof. Greenwald on UGLY and Cheap or Graham’s Search Strategy (8 minutes)

Greenwald on the Balance Sheet (risk of financials) (10 minutes)

Reading Assignments; The Institutional Imperative

ThOdysseusAndSirensWaterhou

All Enrollees in the DEEP VALUE COURSE should have been emailed Security Analysis and The Intelligent Investor.

Please read Chapters 42 – 45 (on the Balance Sheet). Especially focus on Chapter 43, Significance of Current Asset Value in Security Analysis, (pages: 548-613)

Read Chapter 15 in the Intelligent Investor (pages 376-402)

Chapter 22, Graham’s Net-Nets: Outdated or Outstanding in Montier’s Value Investing,  (Pages 229-235)

Chapter 2, Contrarians at the Gate in Deep Value, (pages 19 -34)

Chapters 1 & 2 in Quantitative Value (pages 3 – 59)

A total of about 168 pages.   This is to give you an early start for next week.  If you are short on time, then just read Ch. 2 in DEEP VALUE. 

If you didn’t receive any of those books, then 1) check your spam folder, 2. email me at aldridge56@aol.com with the title BOOKS and what you are missing.  3. if you receive an email with material that you have already received, then ignore/delete.

The Institutional Imperative
Sometimes institutions get caught up in the moment as well.  A company I used to work for held the Fairholme fund in two separate strategies in 2010.  At the end of 2010 I was able to convince the group to completely sell out of the fund in the smaller strategy, but it remained in the larger strategy.  In 2011, the Fairholme fund lost about 32% when the S&P 500 was up 2%.

fairx

At the end of 2011 I (the author of this article, link below) was able to convince the group to add the Fairholme fund back to the smaller strategy, but was unable to convince them to even maintain its weighting in the larger one.  Instead the group decided to cut the allocation in the larger strategy in half, despite my objections.  The argument was that the volatility and amount of underperformance (What about Regression to the Mean?) was too great.  The amount of underperformance was one of the reasons to add it back to the smaller strategy and in my experience returns trump volatility as volatility can actually be your friend.  In 2012, Fairholme was up about 35% which almost beat the S&P 500 by 20%.  In the end it was the clients that were hurt as the investment group followed the herd, on the larger strategy at least, keeping a manager after great performance and selling them after poor performance.  Read more….

The institutional-imperative

Institutional Investors and Analysts tend to herd-like behavior by acting late after trends are established.

Goldman cuts oil outlook, so NOW you tell us! (Perhaps, a tad late on the ADVICE!)

Working at Goldman Sachs

 

How NOT to be a DEEP VALUE INVESTOR

Repetitio est mater studiorum,” says the Latin proverb – repetition is the mother of all learning.

Lessons for this post:

  1. Know what you are doing.
  2. Avoid paying massive premiums over net asset values.

Below is CUBA, a closed-end fund investing in companies that invest in Cuba or will benefit by an increase in business with Cuba. Note the spike upward on the announcement that Obama would allow a prisoner exchange and take Cuba off the US’s terror list opening up the possibility of the end of the US embargo.

large CUBA

Now go: CUBA NAV Summary  (Click on the button, since exception on the right side of the page, to see the history of price vs. Net Asset Value (“NAV”). Note the results last time “investors”/speculators or the confused paid in excess of 50% to the underlying stocks. We can argue about the intrinsic values of the underlying stocks but not the prices–because price is what it is. Mr. Market has spoken.

Here we are todaysmall cuba

Go back and click on CUBA NAV Summary and view the one year summary. Note that the price reached a 70% premium to the NAV AFTER the news event of “improving” US/Cuba relations.   Upon hearing the news:

My first post on CUBA (CEF) SELL!  Can I predict? No, just common-sense.

Where is the efficient market? Perhaps the unavailability of shares to borrow hindered arbitrageurs who could buy the underlying stocks and short the closed-end fund (“CEF”), CUBA.  But to pay such a premium is almost a guaranteed loss unless sold to a greater fool who will pay an even more absurd premium. That is speculating not investing. What is business-like about paying a 70% premium after a news event?

A closed-end fund sells a fixed number of shares to investors. For example, let’s pretend we start a closed-end fund to buy stocks, called the BS Fund. We sell 10 shares at $10 each for $100 in capital, then we buy 1 share of Company X at $50 and 2 shares of Company Y for $25 (ignoring commissions and fees). The net asset value (NAV) is ($50 times 1 share) + ($25 times 2 shares) = $100.   The net asset value per share is also $10.  So the price per share of the CEF ($10) trades at no premium (0) to the NAV per share $100/10 shares.  Now an investor wants to sell 3 of his BS (CEF shares) to an investor who bids for them at $9.00 per share.  Unless, the underlying share prices of Company X and Y change, then the discount is now 10%.  We, as the management, must institute a decision to buy back shares of the BS fund to close the discount or investors increase their demand for the shares.

Carl Icahn got his start as a closed end fund arbitrageur, who would force the managements of the closed-ends funds that traded at large discounts to NAV, to buy-back their shares.

Setting aside the emotional impact of the news announcement, the prisoner exchange and Obama’s reducing of sanctions doesn’t change much.  By the way, if sanctions and embargos don’t work (I agree) as Obama claims then why the sanctions on Russia? If the Russians didn’t surrender during Stalingrad, what are the odds now? Color me cynical.

The US is ALREADY one of the top ten trading partners with Cuba. Of course, the embargo is a farce, kept in place for political purposes. Congress still has to vote to remove the embargo, but even without the embargo Cuba lacks the production of goods and services to trade. Why? Cubans lack the capital to produce because they lack the security of property rights and the rule of law to acquire capital. No Habeas Corpus, no freedom of speech, and no rights. No tyranny generates LONG-TERM economic growth.

What returns will foreign investors require to invest in Cuba?  Say you whip out your spread-sheet and suggest 25% annual returns to build a new hotel in Cuba based on your projection of American tourists hitting the shores of Cuba like locusts.  Two years after the hotel is built, Raul Castro and his military cronies tears up your contract. Investment lost.  Without the rule of law and sanctity of contract, the rest means little. The first lesson is to know what you are doing.

Life in Cuba:

  1. Tengo Hambre A Cuban Says I AM HUNGRY!
  2. Life for Cuban Youth (Cuba with highest suicide rates in the Western Hemisphere.

The investor who buys CUBA would have to understand what the current changes mean for the companies in the fund. Anyone who spends time understanding the current economic conditions there would grasp how little the current announcement means for investment there.  Ask the Canadian investor rotting in a Cuban jail today Canadian investor rots in Cuban jail.

Speculators were willing to pay at 70% premium AFTER the price of the underlying companies had moved higher by 10% to 15% on the news.  A premium on top of a premium–a lesson of what NOT to do.   Questions?

If anyone in this class does that, then this awaits: No Excuse

Emergency and DEEP VALUE Investing (Lesson 1)

planeEmergency Inbound   Please JUST LISTEN (not watch) to the audio. Ignore the skill of the pilot.  What do you notice AS UNUSUAL?   How does this relate (if at all) to Deep Value Investing?

Emergency Inbound Simulation with Audio The two-minute video—please WATCH along with listening carefully to the Captain.

Full Simulation If you don’t grasp the situation (you are in a 50-ton aircraft that flies like a tank with wings once power is lost-the aircraft holds 155 passengers and several tons of fuel, you are over a DENSELY populated area.), watch that seven-minute video.  Thoughts about the Captain?  What was he thinking and doing? Any lessons here for us as investors?

Was he thinking about this? FEARLESS

Was his reaction similar to this? Here’s JOHNNY!

I used to be a pilot of small aircraft so I am biased. Is there any connection between how the pilot acted and investing? The situation and investing?   Was the pilot lucky?   Was the pilot a hero?  Would the pilot consider himself to be a hero?   Why don’t we give parades to mothers who don’t kill their children?

Take a break and go back to the first link.  Before listening again, think about what you would do as the pilot. How many decisions do you have to make and how much time do you have to decide?   What would you be fearful of? Why?   How should we handle fear?  Why are we the enemy?

Don’t hesitate to disagree, contradict or point out other questions.  Do you think that personality has a lot to do with how the person responds–the nature vs. nurture argument?   Buffett said that once you have over a 125 IQ then success is a function of temperament and character. Do you agree? What about this guy: Do You Love the Virgin Mary?.  Can you work around temperament? By the way, have you ever noticed any similar traits among Seth Klarman, Warren Buffett, Ben Graham, Walter Schloss?

One goal of this post is to reinforce the power of emotions in terms of your readings from lesson 1.

Questions on the Readings (Lesson 1, Deep Value)


Contrariwise, if it was so, it might be; and if it were so, it would be; but as it isn’t, it ain’t. That’s logic.
~ Lewis Carroll

When dealing with people, remember you are not dealing with creatures of logic, but creatures of emotion.
~ Dale Carnegie

Mastering others is strength. Mastering yourself is true power.
~ Lao Tzu

Your goal should be to find an investment approach that works for you.  You will need to determine your investment edge.

You should read:

the Preface from Deep Value (Toby Carlisle)

Chapter 20_Margin of Safety Concept

Buffett Klarman and Graham on Mr Market

Behavioral Portfolio Management

Questions from the readings:

  • Do you agree that deep value investing is an investment triumph disguised as business disaster?
  • What do you see as the biggest investment risk(s) in “deep value investing?”
  • When do stocks appear most attractive and when is the risk highest?
  • What is considered the main margin of safety metric?
  • What are investors rewarded for?
  • What concept must you truly grasp to be a successful deep value investor?
  • Why do prices move more than intrinsic value?
  • True or False: A good value investor understands and takes advantage of the behavioral biases of others because he has already eliminated them in him/herself?
  • Deep value investing often means buying distressed assets but can you buy a franchise (see attachment of Wal-Mart or a company able to grow with profits above its cost of capital due to barriers to entry) at deep value prices? Name two investments by Buffett that might fit that criteria? WMT_50 Year SRC Chart
  • How can we think of activist investing?
  • What are your goals for this course?
  • How do Mr. Graham and Mr. Buffett view buying a share of stock?
  •  What do you do if you can’t find an attractive investment?
  • What is Mr. Market’s purpose?
  • How are prices set? in Philadelphia it’s worth fifty Bucks (video)
  • Are prices based on subjective or objective valuation?
  • If you are playing poker and you don’t know who the sucker is—why is that a problem?  Who’s the sucker? Playing the sucker  (video) What EMOTIONAL error did the SUCKER display? When did the sucker CEASE to be a sucker?   What is the main error–man, especially male, beginning investors—exhibit?
  • What is the key to investment success?
  • What TYPE of market participant seeks Mr. Market for investment guidance?  Do you notice any conflicts, ironies or problems?   Or can it be a way to improve your investment results?
  • How do many investors react to huge market volatility?
  • Did Mr. Graham give you a way to access the valuation of a common stock? Explain.
  • Extra credit: Did Graham ever give a FORMULA for determining intrinsic value?  Be careful and read the footnotes to the formula he presents and why he offers it to readers. See Intelligent Investor.
  • What is the biggest mistake investors make when buying securities? How would you prevent that? What does Graham do?
  • What is the danger in growth stock investing?
  • What is a good or bad stock/investment?
  • When during the past fifty years were the greatest American companies (Franchises mostly) bad investments. Why?
  •  What is the best approach to take in investing.
  •  What is risk?
  • Why do so many “smart” people fail at investing or at least do less well than simple stock indexes over time?

You can email me at Aldridge56@aol.com with LESSON 1 in the title with questions and answers or post here in the comments section. If you don’t have time or wish to pass then come back to this lesson later.

  • What are the five investment criteria in the Behavioral Portfolio Management? 
  • What is the cult of emotion?
  • Is it possible for emotion to help you as an investor?

I will be asking for one or two volunteers who wish to research the article BEHAVIORAL PORTFOLIO MANAGEMENT.   You will need to read the articles below and then determine if the author’s five criteria will work.   Over this course, I will probably assign twenty or so special projects. Then we will share your work/efforts.

SSRN_Behavioral Measures of Expected Market Return

SSRN The Importance of Investment Strategy_Howard

SSRN Behavioral Portfolio Management_Thomas

Taking-the-emotion-out-of-investing

Making Money Out of Emotions   How investors fail because of their own brain.  Solution: Pre-program your portfolio.

I will post the review of the lesson/readings by the end of the week. There will be supplementary material posted throughout the week.   You will also be emailed any postings.

Evolutionary Development of Contrarians; Letter to An Analyst

What does it mean to be a true contrarian? (www.truecontrarian.com) Steve explains the fundamentals of his investment philosophy and how to apply it to real-world situations. He details how human herding, group following, and projection of the recent past into the indefinite future enabled our ancestors to survive thousands of years ago, while weeding out those who were contrarians. This has caused contrarian behavior to be quite rare in modern times because it goes against our hard-wired emotions. Steve analyzes why the financial markets often act most irrationally during the first hour of each trading week. He also describes the reasons that financial analysts at major corporations are unable to invest in a contrarian fashion even if they know intellectually why they should be doing so.

Letters to an Analyst    http://researchpuzzle.com/