vinod1

That’s the very same question I had already asked! And let me tell you what I think: if I were to decide the level of cash I hold only on the basis of “very cheap” opportunities, I would always be 100% invested. In fact, right now I would be 100% invested. Following the pendulum is nothing but to heed Buffett’s warning: And of course also the opposite is true. And imo the level of cash plays a big role! Gio If say your favorite stocks, FFH, LMCA and BH close today at $380, $25 and $250 and S&P 500 at 2500, would that change your allocation? I have come to peace with the fact that there are a few things I would not know in this world: The meaning of life; If there is God; Your investment in BH. But I would love to understand how the above would change your allocation. Vinod

That's for each investor to determine. Some have very high hurdles, some are looking for 10%.. But whatever your target is, you have to ask if holding lots of cash helps you get closer to that target over long periods of time or if it holds you back. Thanks Liberty!

The question is what is "very cheap"? A couple of years ago, the weighted average of my portfolio (just a rough estimate) price/IV would have been below 50%. Right now it is likely above 70%. This is even if you ignore the much higher quality of the investments available a couple of years ago. In addition, the number of ideas that meet the criteria are below the level that would provide adequate diversification for putting 100% of the portfolio. Would you be willing to say put near 100% of the portfolio when you have say only 3-4 ideas that are say around 75% of IV? Would love to hear your perspective on this. Vinod

Yes, that's pretty much my conclusion. It also does some other tests besides market timing (e.g., hypothetical and real investor testing to determine ideal amounts of cash for non-market portfolios). Thank you!

I haven't seen any. Can you show me a study that uses market cap to GNP to determine when to stay in the market and get out that outperforms? e.g., CAPE is predictive of future returns, but it does not appear to be usable, a priori to outperform the market. So my point is, if no one can show that whatever metric they are using to justify holding cash actually outperforms, then it is not a valid basis for holding cash. I'm happy to be proven wrong here, but I haven't seen any evidence to the contrary. Moreover, if it can be done based on something basic (e.g., GNP ratio, CAPE, P/E, etc.), then everyone should be doing it to outperform the market, right? That is just the sort of thing that would be arbitraged out of the market, because it is too easy to do. Basically, all these arguments come down to "timing the market" which is incredibly hard to do. I used Shiller's data from 1871-current, to avoid issues related to specific time period. For example, there are studies that I reproduced that worked in their sample period (e.g., 1970-2001), but not out of sample. I'm basing my statements on historical studies, not my personal history. I think if you read the essay you'll see what I'm saying. However, to answer your question directly, I've been investing since 2010, and I would fully agree that if my statements were based on that period, it should not be trusted, but that's not where I base my conclusions from. Is it safe to summarize your study as saying market timing does not work with the exception you mentioned as active investors with extreme volatility? I apologize for asking this question before reading your report in detail. I took a quick look and it is very impressive. Vinod

Then, please, answer the question I asked anders just a few posts ago... Gio The answer is obvious and he already gave it to you. The point is that your initial post and how it's written suggests that you positioned yourself for a crash by having a high cash allocation and limiting your spectrum of investments as opposed to allocating cash "naturally". I would argue that I have no idea whether we are in 1996 or 1999. For all I know the market could start a 30% slide tomorrow because [reasons that will be apparent only after the fact] or keep going for years. As long as there are compelling opportunities you should seize them and avoid forming a strong opinion about the market (à la Hussman) which can put a big part of your capital on the sidelines for a long time. I think there is a difference between having a strong view on market direction (like Hussman) and knowing where we are in the cycle (pendulum in Mark's words) and trying to adjust our portfolio accordingly. When valuations are unambiguously high, you might want to be a little bit more careful - avoiding marginal investments, selling closer to 90% of IV, invest in opportunities that benefit from a negative shocks, etc. If someone is a truly great investor, I am sure they would still find investments selling at 50% of IV even when the market is richly priced. If I can find opportunities like that, I would be buying all day long regardless of market valuations. But IMO, those kinds of opportunities are a mirage for most investors, they are most likely overlooking some risks, if they think they found deeply undervalued securities when market is very richly priced. For most, slightly better than average investor (hopefully), it is much easier to find opportunities when there is some dislocation or market is cheap overall. I would differentiate the above from holding off on making investments when the market is richly priced hoping for a crash. Vinod

Hussman not only prints graphs about stock market predictions and subsequent actual returns, he also give a numerical correlation. Does the blog point that out? If it doesn’t, I am already suspicious… ;) Gio Yes! He digs deep into the data, to point out the flaws. As I pointed out nearly everything written by Hussman is based on two things (1) profit margins mean revert to 6% (2) stocks normal returns are 10%. He thinks these are pretty much as certain as Planck's constant. He is 100% certain that these would hold true in future. If these do not hold in future, neither does any of his estimates. Vinod

On profit margins, this is worth reading: http://www.philosophicaleconomics.com/2014/05/profit-margins-dont-matter/ Businesses optimize for ROE, not for profit margins. I did read that and it was an eye opener for me. The blog is an absolute gem. Vinod

+1 Gio, What you state makes a lot of sense and I agree with you. That said, as original mungerville mentioned above, reading the blog might, just might make you a bit less certain about Hussman's research. There is an article where he exposes the limitations of Hussman's graphs - especially how the visual illustration makes them look more reliable then they really are. Hussman makes two assumptions basically in his conclusions (1) profit margins reliably mean revert around 6% (2) normal stock market returns should be 10%. Both these might change as economic conditions change. Vinod

Hi Vinod, please take a look at the slide in attachment. Of course, if you think SIRI is wildly overvalued, that won’t be of great help to you… Anyway, buybacks at SIRI just keep going on (share repurchases year-to-date at the end of 2014Q3 totalled nearly $2.1 billion), and Malone is not someone who likes buybacks if he thinks the price of the shares is overvalued! ;) Gio Hi Gio, Thank you! I agree, just do not have enough confidence in the extent of the undervaluation to increase the position size. I think as with Leucadia's previous owners, it would not be possible to predict the value created by looking at just the existing individual parts. Vinod

That’s why I hold lots of cash! ;) Anyway, I don’t know of anyone better than Malone at taking advantage of any market crash that might await us. I will be much more willing to double down in the Liberty family of businesses than in any other company, because I know Malone is working on some incredible bargain. And don’t forget LMCA today is almost debt free! In 2008 it was not so, and that could be a great advantage this time around. As far as Biglari is concerned, the fast food industry generally behaves much better than the general market in a downturn. Furthermore, he hold lots of cash, which could be deployed opportunistically. And he surely knows how to do that! Last but not least, both LMCA and BH are among the cheapest stocks I know today (at least in the North American stock market). Gio I have an investment in LMCA as well. This is a small investment for me at this time as I am quite not comfortable with the valuation primarily because this is not an industry that I spent time on. It is more of a smart owner operator/capital allocator in an industry with good economics that is undergoing change. Could you please share your thoughts on how you are valuing LMCA? Vinod

I read "Keynes Hayek : The Clash that Defined Modern Economics" and it has a pretty good summary of the key differences between the two approaches and their origins. I did not actively look to read about Austrian economics but I found this side by side comparision much more easy to understand. Vinod

Taking on a lease is the same as taking on debt. Instead of buying machinery that has a life of 10 years you take on amortizing debt for a term of 10 years and they are essentially the same. You would have incurred a contractual liability. Vinod

vinod1, but he uses the Book Value of Debt, NOT Adjusted Debt, in the denominator of the ROIC calculation. Adjusted Debt is used in other locations, like in the EV calculation. West, Yes, he does mention book value of debt but I think that is because he introduces this equation on page 44 of a 992 page book. He talks about leases in detail much later in the book. He keeps hamming away throughout the book that operating leases are functionally equivalent to debt and should be treated as such. In the examples, he keeps adding PV of leases to debt. In the section on "What is Debt?" on page 214, he makes this very clear that debt should include capitalized operating leases. To him there is no difference between the two. Vinod

To paraphrase Buffett, what you really want to measure is return on tangible invested capital. We can calculate invested capital either two ways (1) Net working capital + Long term tangible assets or (2) Debt + Equity. The second method is simpler. Vinod

I was re-reading Damodaran's "Investment Valuation" book the last few weeks and he emphasizes that we make the following adjustments, so when he says debt he means adjusted debt. Adjusted Debt = Interest-bearing Debt + Present Value of Lease Commitments Adjusted Operating Income = Operating Income + Operating lease expense in current year – Depreciation on leased asset This adjustment would correct both numerator and denominator in calculating ROIC. Vinod

Yes, it's good and much easier than his other book, but I would say it still really isn't as straightforward for a beginner. I'd still go with something like the Boglehead's Book. That probably explains why none of my friends are really indexing. Vinod

The Four Pillars of Investing by Bernstein. This is the book I recommend to most friends and by far the best book on indexing I read. The author wrote this book because his earlier book the intelligent asset allocator is hard to read for beginners. Vinod

These are internal demons most of us investors face since it directly contradicts his main message of ignoring Mr. Market. Keynes, Buffett and Graham himself heavily emphasize the dictum: It is preferable to buy dollar bills at seventy cents, rather than selling them at seventy cents in the hope of subsequently repurchasing the notes at fifty cents. Vinod As much as Graham believed in the Mr Market parable, there was a part of him that always feared losses, even paper losses if they lasted too long, as a result of his experience during the Great Depression. Good point. When it comes to shaping people's outlook regarding stock market's future returns, personal experience almost always trumps centuries of historical data. - James O'Shaughnessy Vinod

These are internal demons most of us investors face since it directly contradicts his main message of ignoring Mr. Market. Keynes, Buffett and Graham himself heavily emphasize the dictum: It is preferable to buy dollar bills at seventy cents, rather than selling them at seventy cents in the hope of subsequently repurchasing the notes at fifty cents. Vinod

I also stopped reading halfway through. Maybe the good part is the second half? It wasn't bad, I just didn't feel he was saying much other than "JPM is a good business, it'll continue to be a good business, because we'll keep going with our long term strategy, but we'll also adapt, because we're good, etc, etc". Yes. Read the second half. Slowly. One of the few people who have a direct pulse on the economy due to the nature of the company. Here you have a guy who is giving his opinion, unvarnished, without hedging every sentence. Vinod

Vinod, I asked Mr. Watsa my question exactly because of that concern I share with you. As they keep buying more operating businesses, and building earning power, they might be able to transition to a balance sheet more similar to BRK’s today (where bonds amount to barely 8% of total assets). That way regulatory constrains will become less and less significant. And they have time: interest rates might not come down much more from present levels, but it is not likely they are going up soon either. Also Mr. Watsa’s answer tells me they will find good value propositions wherever they might be (more equities and/or high yield bonds): it might be done and I don’t have any reason to believe he was not in earnest while replying to my question. :) Gio Thank you!

Take 1990 to 2002 period. I am guessing, that the worst of the tech stock funds would have had pretty high rolling outperformance but would have had very large permanent loss of capital in the end. I understand you are trying to come up with a mathematical way but I do not think this is the solution. Vinod Ah, good point, I think if we add a requirement that this is only done for long term outperformance company/investors, then it would remove the permanent loss issue. (I would generally only want to do this for something I was interested in investing in, which would only include something that is outperforming). The main difficulty is style differences impact your returns depending where you are in the cycle. Given a sufficiently long time period covering multiple cycles this effect would be reduced but still not be accurate. Why not measure at similar points in a cycle? That would take away the biggest error term in measuring performance. Vinod

Thanks for detailed and thoughtful responses. Your patience is amazing! Fairfax is one of my first investments and following Prem has taught me a lot. So regardless of our difference in expectations regarding Fairfax, I would be rooting for both Fairfax and your investment. You mention frequently and it is something I have not been able to make the same leap of faith as you do, is the return expectation of 7% vs the 9% historical rate. How can you just lop of 2% off historical record and say that is conservative and provides us with a margin of safety? Take the example of a 10 year bond, as the yield went down from 5% to 2% over 5 years, the returns on that bond would be 8% annual (roughly). We cannot just say, I would chop off 4% or half of the return and conservatively expect just 4% over the next 5 years. It is not going to happen. We would just get 2% returns. The math for Fairfax bond portfolio is very similar to the example above. I think Fairfax is one of the best if not the very best bond investors, but without a major dislocation in bond markets, I just cannot make the leap where Fairfax would be able to make 7% on their overall portfolio given where the bond yields are. Bond market is probably more important to Fairfax than the stock market given how they are forced to invest their portfolio due to insurance requirements. This is just not Fairfax specific, it is endemic for the P&C industry. Vinod

Al, Which strike JPM LEAPS have you bought? Thanks Vinod 57.50 & 60.00 I am sort of operating with an interim target of 72 by the end of 2015 - low ball Thank you! I started looking at JPM LEAPS and thinking of $55 strikes. You seem to prefer ones that are slightly out of money. Vinod