vinod1

Cigarbutt, Snce 2009, I changed my mind on two points relevant to S&P 500 valuation: 1. Mean reversion of profit margins. I must have spent several hundreds of hours thinking and researching this issue over the last 17 years. I would not go into detail, but I no longer expect mean reversion of profit margins on a sustained basis to the levels of the period before 1980s. Not saying profit margins dont fluctuate or go down. Just the mean has shifted to a much higher level than the past. It might shift lower again sometime in future but not anytime soon. 2. Expected returns on stock market. I previously expected real returns of 6 to 7% as fair value for the stock market. With inflation of 2-3%, nominal returns of around 9%. In line with what stocks had historically provided. I now think fair value for stock market would be lower returns that this for a several reasons: a) Even though 9% were the realized returns historically, it is very expensive in the past to get those returns. And few could actually get this return from a diversified portfolio. Think how expensive it would have been in 1900 or 1920 for a person to build a diversified portfolio of stocks to get this return. Think of the difficulty of getting relevant information about companies financials. Think of broker costs, transaction costs, etc. Fraud costs involved with physical shares. Risk of losing those physical shares, etc. A lot of the 9% expected or realized return on stock market would have been consumed by this. So if a person wants to hold 50 stocks, I would think that these costs could easily eat up 2% or more of the return. Now you can get a very diversified portfolio for less than 0.1% cost. So the expected return that the investor could actually realize has gone up by nearly 2% just from these lower costs. b) Economic risks have gone down as well. Look at the frequency and magnitude of the recessions in the past compared to now (ya even with the 2008 Great Recession). This should naturally reduce the stock risk premium as well. c) Inflation risk has gone down as well. When you take all these factors (a, b & c) into account and consider that cash/bond returns are also going to be low (low real rate + low inflation + low inflation risk premium), then a higher multiple can be justified for S&P 500. So not only are normalized earnings much higher in 2017 than I expected in 2009 (due to point #1) but the multiple that can be justified is also much higher than I expected in 2009 (due to point #2). So I was actually wrong in my assessment of S&P 500 value in 2009. I made the mistake of reducing my allocation due to this a couple of years later. But was saved from this mistake due to opportunity in financials in 2011/12 period. I actually reduced allocation in 2006/7/8 due to worries about profit margins and mean reversion. When markets fell in 2008/9 I felt vindicated. I was wrong of course. But got bailed out by the financial crisis in 2008/9. The reason I changed my mind about profit margins/mean reversion is that when reducing allocation in 2006/7/8, I made a note to myself that if profit margins again go up in 5 years, then I should take a hard look at this issue again. Vinod

“If you don't feel comfortable owning something for 10 years, then don't own it for 10 minutes.” “Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management, and d) a sensible price tag.” Both Buffett quotes. I don’t think Biglari is an investment you should feel comfortable owning long-term, nor Sardar a trustworthy partner! I think people are interpreting Buffett way too literally. His Korean stock purchases clearly do not meet the criteria above as well. But Buffett still did that trade and made it a point to highlight that. treasurehunt has a rationale for why the business could be mispriced due to structural factors, understands management factor and seems to think there is enough margin of safety to make a profitable trade. That to me is the essence of value investing. Whether it works or not is a separate issue. Vinod I quoted Buffett because I agree with the quote, completely! If you put your money in the hands of somebody that’s not trustworthy you’re on a ride you shouldn’t be. That to me is the essence of a bad investment, whether it works or not. All I am saying is, by being less dogmatic and our returns would be much better. If you draw a line in the sand and say if there is a question of management integrity, you would not invest. I can understand that. We all have to draw the line somewhere. When Buffett invested in Korean stocks, he had no idea about the management. The margin of safety is so high, he can ignore it and still expect good results. There are many approaches that work in investing. No need for a value investing Jihad on the one right approach. It is not like what Buffett says is the scripture. There is always more nuance. What you quote makes perfect sense. I agree too. But you also need to understand the context and where it is applicable. Here a person is not investing in a business with the intent to hold long term. Walter Schloss did alright with a different approach. I would buy BH too if the discount to IV is large enough. It is not there for me. Vinod

“If you don't feel comfortable owning something for 10 years, then don't own it for 10 minutes.” “Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management, and d) a sensible price tag.” Both Buffett quotes. I don’t think Biglari is an investment you should feel comfortable owning long-term, nor Sardar a trustworthy partner! I think people are interpreting Buffett way too literally. His Korean stock purchases clearly do not meet the criteria above as well. But Buffett still did that trade and made it a point to highlight that. treasurehunt has a rationale for why the business could be mispriced due to structural factors, understands management factor and seems to think there is enough margin of safety to make a profitable trade. That to me is the essence of value investing. Whether it works or not is a separate issue. Vinod

I think since time immemorial, the previous generation probably always thought the next generation is going to hell in a hand basket. I think the new generation is going to be better than the past. Vinod

If anything, I see a bubble in people calling out "bubbles". Otherwise, it is same old, same old. Nothing much has changed. We first need to have a working definition of a bubble. Rob Arnott's definition would be a good starting point, We define a bubble as a circumstance in which asset prices 1) offer little chance of any positive risk premium relative to bonds or cash, using any reasonable projection of expected cash flows, and 2) are sustained because investors believe they can sell the asset to someone else for a higher price tomorrow, with little regard for the underlying fundamentals. By this definition, I would put only the dot com stocks in the late 1990's and the housing market in 2005 as a bubble. Others cases do not meet the criteria. I do not think we are having more bubbles nowadays than we had in the past. It is just that people scare themselves silly, looking for bubbles everywhere. High prices? Yes. Bubbles? No. Vinod

I think having blanket rules in investing is going to only needlessly hurt one's returns. Things like 1. Dont invest in financials (banks) 2. Dont invest in Tech 3. Dont use leverage, etc. As investors we accept that majority of the time markets are efficient but can occasionally be inefficient for us to make a profitable investment. It is generally true that leverage is risky. But if a rare opportunity comes up, say like the banks (BAC, JPM, etc) over the last few years, I would posit that it is less risky to use leverage (use lots of cash + LEAPS, warrants on deeply undervalued businesses) than most conventional portfolios of value investors. Vinod

Buffett made the following comments in the Annual Meeting last year I think: I don’t think it’s sufficiently appreciated—I believe that, probably, the five largest American companies by market cap—on a given day, they have a market value of over $2.5 trillion. That $2.5 trillion is a big number. That’s probably getting up close to 10% of the whole market cap of the United States. If you take those five companies, essentially, you could run them with no equity capital at all, none. That is a very different world than when Andrew Carnegie was building a steel mill and then using their earnings to build another steel mill and getting very rich in the process, or Rockefeller was building refineries and buying tank cars. Generally speaking, for a very long time in capitalism, growing and earning large amounts of money required considerable reinvestment of capital and large amounts of equity capital, the railroads being a good example. That world has really changed and I don’t think people quite appreciate the difference. Our world was built and when we first looked at it, our US, our capitalist system, basically, was built on tangible assets and reinvestment and all that sort of thing. And a lot of innovation and invention to go with it, but this is so much better if you happen to be good at it. To essentially be able to build hundreds of billions of market value without really needing any capital, that is a different world than what existed in the past, and I think it’s a world that’s likely to continue. I don’t think the trend in that direction is over by a long shot. Besides infatuation with Macro, I think many value investors have paid no attention to the the change that Buffett was talking above. These two along with the growth of Indexing/ETF's, I think are the main sources of underperformance for value investors. Vinod

+1 Very good points. - Investing is a continuously evolving process. The same thing that worked in 40s would not work in 60s and so on. We see that with Net-Nets, high dividend yield, low PE strategies, etc. What was difficult in one era either because of informational advantage or available knowledge, becomes easier to execute in the next era which makes the past strategies lose their effectiveness. - Graham in fact is also evolving he keeps tinkering with his recommendations in each edition of his book. He probably would have been very successful in this era as well. Vinod

Quote from the FPA Funds Report: The macro picture is only an afterthought. The larger environment might help explain why we buy more or less of something but it certainly does not drive the Fund’s overall exposure. Understanding where the world is and the prices markets are offering us for the assets we’d like to own helps to explain the Fund’s positioning. We lack any ability to prognosticate, but here’s what we know… Global stock markets have not been inexpensive enough for a number of years to offer the potential for high single-digit rates of return and are now trading at new highs. We continue to believe there isn’t enough of a margin of safety to warrant a fully-invested portfolio. In one paragraph he says we are not macro investors and in the very next paragraph he makes a macro call on valuations to limit exposure to stocks. This is the issue. Once you begin to develop a view about macro valuations, it is very difficult to avoid taking the next step, which is acting out on them. Even though you know better. The only way out I see is to stop thinking about macro. I know it is difficult. They way I came to handle this is to spend a couple of days of the year, usually in late January to read up everything you want to take a look at from a macro perspective write out a few thoughts (what you think about it and how it might play out) and never look back again until next year. After you have done this for a few years, reading up on what you have written would be a good source material for comedy. And it would also help in not taking macro seriously. Vinod

You are measuring against the wrong benchmarks. A couple of years back I am trying to answer the question of why they are outperforming so much in the bond markets. Equity I can understand and we can see the major investments and how they played out. In bond markets the alpha has to come from (a) security selection or (b) making correct macro calls on interest rates. No doubt there is some of both. But it still does not explain such a large out performance. What I realized is that they are including non-stock investments such as convertibles and possibly warrant deals into the fixed income segment. Nothing wrong in that. But they have a different risk profile and you cannot then measure up against pure bond benchmarks. Vinod

Need to break down the 7% returns. Fairfax has averaged 23% / 50% / 27% for Cash/Bond/Stock Allocation between 1986 to 2014 (when I last calculated them). Assuming a 25% 50% 25% cash bond stock allocation. If you assume 2% returns for the cash portion, 5% returns for bond portion, to get to 7% investment returns on total portfolio, the stock portfolio has to return 16%. Even assuming 6% for bond portfolio would require the stocks to deliver 14% annually. Vinod

Gokou3 - You need to take into account Corporate expenses, runoff, interest expenses and preferred dividends. Vinod

Race - I could not wrap my head around your example. I cannot see any rationale when investing in say the total stock market index or the S&&P 500 index would cause some stocks to get overvalued. Passive investors are buying market weights of the stocks. Stock A might have 10% weight, Stock B might have 5% weight and Stock Z might have 0.1% weight based on their market cap. Every additional dollar value of passive investors is invested in the same exact proportion. So I cannot see any reason for why this would benefit some stocks but not others. One way some stocks could get overvalued is if a sector or a narrow index fund like say Social Media Index Fund (just making it up) attract a large investor base which would increase demand for all the stocks in such indexes to increase which would drive up their prices. Regarding the letter. Blaming indexing and central bankers seem to be the common theme of all the value fund managers who are under-performing the index funds. If you read about either of these in their letter it is pretty good bet they are underperforming the index. Vinod

I made the same argument as you about DCF in the past. "DCF to is sort of like Hubble telescope - you turn it fraction of inch and you're in different galaxy" But I have changed my mind. Any valuation work you do is based on DCF with the exception of relative valuation or valuation of options. Let me explain. DCF does not mean you have to do spreadsheets. When you say a company is worth 10x earnings, you are doing a DCF valuation. The fact that you did not use a growth rate or discount rate or explicitly model cash flows, does not mean you are not making assumptions about these. You have just assumed away all these variables. You do not even know what you have assumed away. When you do DCF you are forced to think through these and it gives you a chance to make sure they are reasonable and consistent. If you are honest with yourself, this can make the valuation more robust. The fact that Buffett does not put this on paper should not mislead us into thinking we can do the same. He probably can model that in his head. Not so for most of us who have much less practice with DCF. I think it would be helpful for most of us to do a few hundreds of DCF valuations before resorting to shortcut of multiples. It would give one an idea of how cash flows, reinvestment rates, return on reinvested capital, dividends, buybacks, debt, etc impact business value. This is very hard to get an intuitive understanding of these without putting them on paper and looking at the results. These does not have to be complex. Actually these are much better if done by hand on paper at least for the first few. Vinod Hi Vinod, I agree with you probably more than you realize. I distinguish between the theory of DCF (which I agree with 100%) and the practice of DCF (which I think has serious shortcomings). Part of the reason I went through this exercise is to find a middle point between an all-stops-out DCF and the sort of ratios many of us use. The former incorporates all the variables but usually suffers from incorrect inputs. The latter is oversimplistic but, through its ease of calculation, enables the experienced investor to establish appropriateness in different situations. Buffett often says he can decide whether he wants to buy a company in 5 minutes, which means he's using pattern recognition as you say. I use probably 10-20 different ratios to value a stock. The most important are MC/ Cash, Price/ Tang book, Debt/ Equity (more risk means less value) EV/ Rev, EV/ EBITDA, EV/ FCF, Operating PE, PE, ROA, ROE, ROIC, revenue growth, tang book growth. But the most difficult thing is always figuring out how much value I should attribute to different levels of growth. I have used the PEG in the past because it produces numbers that pass my "whiff test" based on experience, at least for growth rates in the 10%-30% range. But I dislike the PEG because it's clearly a tool pulled out of thin air. It seems like the formula: P/ E > 2/(G+R)*ln(g0/r0)-1 provides a better estimate of the appropriate PE, so I plan to start using it rather than the PEG. Hi Graham, To me, once you have a fix on the moatiness of the company, usually the next most difficult issue is estimating the growth. The way I approach is to estimate the the earnings 7 years down the line and put a multiple of those earnings at that time and then discount it back. The multiple would depend on what I conservatively estimate to be how the market would be valuing the company. A 14x multiple if the company is an average business that can grow somewhat in line with the economy, pass on inflation, a decent level of free cash flow conversion and low disruption potential. Adjusting the multiple up or down. But I bother with looking out 7 years only for those companies that have strong moats. Vinod

A good critique of PEG which I agree with http://people.stern.nyu.edu/adamodar/pdfiles/peg.pdf Vinod

I made the same argument as you about DCF in the past. "DCF to is sort of like Hubble telescope - you turn it fraction of inch and you're in different galaxy" But I have changed my mind. Any valuation work you do is based on DCF with the exception of relative valuation or valuation of options. Let me explain. DCF does not mean you have to do spreadsheets. When you say a company is worth 10x earnings, you are doing a DCF valuation. The fact that you did not use a growth rate or discount rate or explicitly model cash flows, does not mean you are not making assumptions about these. You have just assumed away all these variables. You do not even know what you have assumed away. When you do DCF you are forced to think through these and it gives you a chance to make sure they are reasonable and consistent. If you are honest with yourself, this can make the valuation more robust. The fact that Buffett does not put this on paper should not mislead us into thinking we can do the same. He probably can model that in his head. Not so for most of us who have much less practice with DCF. I think it would be helpful for most of us to do a few hundreds of DCF valuations before resorting to shortcut of multiples. It would give one an idea of how cash flows, reinvestment rates, return on reinvested capital, dividends, buybacks, debt, etc impact business value. This is very hard to get an intuitive understanding of these without putting them on paper and looking at the results. These does not have to be complex. Actually these are much better if done by hand on paper at least for the first few. Vinod

“Our results in 2017 were the best in our thirty-two year history, in spite of some of the largest catastrophe losses in history as a result of Hurricanes Harvey, Irma and Maria and the California wildfires,” said Prem Watsa, Chairman and Chief Executive Officer. “We achieved record earnings of over $1.7 billion, resulting in a 22.4% increase in our book value per share to $449.55." I cannot imagine Buffett or Mark Leonard would ever say such a thing with the results achieved. Vinod

Consumer Packaged Goods Industry. Not for cyclical reasons but more for structural changes. Many of the changes brought about by Internet are chipping away at almost all of the advantages these companies used to enjoy. In addition these guys have increased margins considerably over the last 20 years compared to their previous 50 years. It seems likely that margins would be significantly compressed for many of these companies over the next couple of decades. Vinod

Thank you! Gamecock-YT, mhdousa, rb - Very impressive how quickly you guys figured it out. GE and Allergan (industry wide pressure likely means generics segment) fit the description. Vinod

Longleaf referred to two investments they made in Q4, 2017 which they did not name: We purchased two undisclosed positions in the quarter. One, like Mattel, was a time horizon arbitrage opportunity where past mismanagement and a dividend cut obscured the longer term value and prospects for industry-leading businesses. The other was an example of how complexity often leads Southeastern to investments. A more traditionally associated segment of the company was under pressure industry-wide, taking the stock to a multiple similar to peers within that segment. In the case of this company, however, its most valuable segment consists of leading, protected brands that are growing in strength and demand. I am not able to figure these out and hoping some enterprising board members might be able to fish them out. Thanks Vinod

You guys had me hook, line and sinker. I was at a science event for my son when I read this thread. Not wanting to read the letter just standing, I searched and chose a comfy spot to read, and when the link too me to YouTube, I turned on cellular which I turned off for YouTube and vola, the song comes. Determined I try it a couple of more times. Vinod

The link goes to YouTube song. Can you please repost the link. Or am I missing on the joke. Thanks Vinod

I am attaching a chart of 10 year treasury rate from 1790 onwards. Data from 1871 onwards is more reliable but this is the data we have. 1790 to 1870 rates are 5% to 7% 1870 to 1960 rates hovered around 3% 1960 to 2000 rates shot up from 5% to 15% and then back to 5% 2000 to 2017 rates kept dropping from 5% to 2% When people talk about "Normal" they are primarily referring to the 1960 to 2000 period. When people talk about "New Normal" they are primarily referring to the post 2000 period. But what is normal, is really a matter of how far back you are looking. If we consider rates from 1870 ("Old Normal"), then current rates are nothing unusual. If we consider rates from 1790 ("Really Old Normal"), then current rates are indeed low but not exceptionally so. Vinod

I have been very closely following Buffett's comments on interest rate impact on stock valuations. Buffett has said that stocks would look cheap in three years time if interest rates were 1% higher, but not if they were 3% points higher. I think he made these comments when the 10 year is in the 2.2% to 2.3% range. I think only if bonds start hitting the 4% range it would start impacting stock valuations. Vinod

A week ago, I was helping a relative to come home after surgery. He was given general anesthesia for the procedure. As I was picking him up, all he can talk about is crypto-currencies. It seems he was talking to the nurses about it as well while is is half awake. The entire 30 minute drive home is talk about Ripple and that it has a very good potential and that I should look into it. My relative has shown the least bit of interest in investing over the last several years. I would implore him to get started with investments and he has never shown any interest. Now his wife tells me that instead of playing with his less than year old baby, he would be looking at all these charts about Ripple on his computer. As I took a quick look, crypto-currencies to me is close to a certainty as one can get in investing, that it is a bubble. Crypto-currencies are of course wonderful inventions and are of great use - for drug dealers and terrorists. All it takes is one terrorist attack financed using crypto-currencies for governments to crack down hard on these. Vinod