vinod1

A really good post by Pettis: http://blog.mpettis.com/2014/12/how-might-a-china-slowdown-affect-the-world/ Vinod

So Benjamin Graham is a genius, as well as every other investor who tries to find undervalued securities. To think either Buffett or Graham are not genius's is to do violence to either English language or common sense or both. 1. Graham came up with the process of systematically analyzing companies. 2. He became the only person ever offered professorships from three different Columbia departments —math, English and the classics. 3. Widely credited to be the father of value investing. 4. Wrote two books on international economics despite having no formal study in economics. Keynes himself is said to be impressed by one of the books. 5. He had a show on Broadway at the same time that he is published "Security Analysis". Reading Security Analysis, you can see how accurately he identified, behavioral biases, management behaviour, Wall Street behaviour, investor behaviour and behaviour of corporate boards. It is eerily accurate and decades ahead of its time. So yes, he is a bit more than an investor looking for undervalued securities. Vinod

I guess XOM doesn't fall under this quote ;-) Buffett quote: “Our favorite holding period is forever.” You left out an important caveat that he added to the above quote. "When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever." So this conveys some info on how he views Exxon. Vinod

+1 I too found Michael Pettis book very helpful. It made me rethink a lot of what I thought I knew about macroeconomics. In addition, unlike many economic books, he lays it out the likely causes of something in terms of x, y and z and then gives reasons why one might be more right than the other. So you are free to come to a different conclusion from the author if you think the other reasons are more persuasive. Vinod

Edit: if you want another example, take JNJ. I don't know if we can blame CEO on this one, but this is an example where Buffett business was hit hard by "unknowns". Of course, it recovered - after CEO change and Buffett selling... :) This again makes my point. Even with all the unknowns what happened? At most value is stagnant for a few years and it is up and running again. I did not follow JNJ for a while so just looking at operating earnings, it is growing pretty well after a couple of years of stagnation. I also do not think the CEO is to blame for this and even if he not changed I think JNJ would pretty much be in the same position it is today. Vinod

I don't think KO produced 10% return with bad CEOs. I think pretty much any business can be killed by bad CEO. Of course, if Buffett owns a large chunk of such business, he's likely to can the CEO faster than the business loses 50% of its value. I will agree that there are some businesses that are likely to be resilient to some "unknowns". So your idea to buy businesses resilient to most "unknowns" might be good one. I just don't believe that any businesses are resilient to bad CEO. And in "bad" I don't necessarily mean corrupt or stupid. They might be just not fit the business and the context the business finds itself in. Edit: if you want another example, take JNJ. I don't know if we can blame CEO on this one, but this is an example where Buffett business was hit hard by "unknowns". Of course, it recovered - after CEO change and Buffett selling... :) Well the bad CEO you are referring to must be Paul Austin, who is the CEO from 1966 to 1981. He increased earnings about 10 times during this period from $47 million to $420 million. Even if you include some dilution that is pretty good. Let us look at the bad patch where he did indeed diworsify. This is the period from 1973 till his retirement in 1981. Earnings increased from $215 million to $447 million or about 10% per share. Add in around 1 1/2 to 2% in dividend yield over this period, you are looking at an intrinsic value growth of around 10%. I do not have per share figures and I am sure there is dilution and I am sure it is helped by the high inflation of the 1970s but you get the picture. Here we have a CEO who is hell bent on value destruction and still the result is not so bad. I am not talking about share performance, as it is a different matter as it is impacted by compression of PE multiples across the market. Yes, any business can be killed by a bad CEO, just as any business can go bankrupt. But when we are investing we are looking at probabilities. How many very high quality businesses got killed by a bad CEO? I seem to be in the mood for Buffett quotes so let me answer my own question with another quote: It has an incredible distribution system. Tell me how you'd attack that business? You wouldn't want to anyway, as the market's not big enough. Larson-Juhl has a HUGE moat. I always ask myself how much it would cost to compete effectively with a business. With businesses like these, nothing's going to go wrong. If you bought 20 of them, 19 of them would work out well. All I am saying is if you stick to these kinds of businesses you are much less likely to be exposed to bad kinds of unknowns. Vinod

You can instead take the approach of Buffett. The vast majority of the businesses that Buffett bought, are resilient to all three items you mentioned above. A CEO having an affair or worse do not impact the valuation of most of the businesses in Buffett's portfolio. I do not think Buffett knows the in's and out's of Wells Fargo's or Bank of America's each operation in depth at the division level, and I do not think such knowledge is needed or necessary to invest successfully. Look at his definition of understanding a business and it tells a lot about what he focuses on: "It's a question of being able to identify businesses that you understand and you are very certain about. When I say understand–my definition of understand is that you have to have a pretty good idea of where it's going to be in ten years. I just can't get that conviction with a lot of businesses, whereas I can get them with relatively few. But I only need a few–six or eight, or something like that." or look at his definition of risk "We think first in terms of business risk. Business risk can arise in various ways. It can arise from the capital structure. When somebody sticks a ton of debt into a business, if there's a hiccup in the business, then the lenders foreclose. It can come about by their nature –there are just certain businesses that are very risky. We tend to go into businesses that are inherently low risk and are capitalized in a way that that low risk of the business is transformed into a low risk for the enterprise. The risk beyond that is that even though you identify such businesses, you pay too much for them. That risk is usually a risk of time rather than principal, unless you get into a really extravagant situation. Then the risk becomes the risk of you yourself –whether you can retain your belief in the real fundamentals of the business and not get too concerned about the stock market." I think it is better for us also to focus on such businesses where we are less exposed to risks you mentioned. Sorry for tossing Buffett quotes, you probably know most of these by heart, but they covey the message better. Vinod I actually didn't know these ones. The concept of being able to visualize where a business will be in ten years is very valuable, even if you have no intention of holding it ten years. Would have saved me from botch ups like Yellow pages, sfk, and RIMM. This seems really important in this era of creative destruction. Agree completely. This is probably one of the best filters to avoid "value traps". Vinod

Let me throw one more Buffett quote on Management: We’ve spent many years buying many things without meeting managements at all. If we buy the entire business, we care very much about management and whether they’ll behave in the future as they have in the past. But in marketable securities, we read the annual reports. In marketable securities, however, we’ve still bought into some extremely good businesses run by people we didn’t care for because we thought they couldn’t screw them up. Vinod

Sorry, but this is not true. Please read "Snowball". Buffett has fired multiple CEOs because they underperformed. Including 2 CEOs of KO via backroom deals. So CEOs "having and affair or worse" do impact performance of even KO. And KO is not an exception, this has happened with multiple businesses Buffett invested in. I also think that Buffett is deluding himself if he thinks that he knows where IBM will be in 10 years. But that's perhaps different discussion. :) I did read Snowball. In fact, I spent several months (not including reading over the years his annual letters multiple times, etc) diving into his investments and what he said on many aspects of investing and distilled them into a core set of action items and portfolio constraints in developing my own investment approach. So I do at least know a bit about Buffett. When I say "resilient", it means it does not make or break the investment. So instead of getting a 15% return he would end up with 10% return, if the CEO turns out to be a crook or worse. So it does not mean CEO is totally irrelevant, just that the business can carry a poor manager without killing the investment thesis. When he has a chance of course he would want to have a better manager. Vinod

You can instead take the approach of Buffett. The vast majority of the businesses that Buffett bought, are resilient to all three items you mentioned above. A CEO having an affair or worse do not impact the valuation of most of the businesses in Buffett's portfolio. I do not think Buffett knows the in's and out's of Wells Fargo's or Bank of America's each operation in depth at the division level, and I do not think such knowledge is needed or necessary to invest successfully. Look at his definition of understanding a business and it tells a lot about what he focuses on: "It's a question of being able to identify businesses that you understand and you are very certain about. When I say understand–my definition of understand is that you have to have a pretty good idea of where it's going to be in ten years. I just can't get that conviction with a lot of businesses, whereas I can get them with relatively few. But I only need a few–six or eight, or something like that." or look at his definition of risk "We think first in terms of business risk. Business risk can arise in various ways. It can arise from the capital structure. When somebody sticks a ton of debt into a business, if there's a hiccup in the business, then the lenders foreclose. It can come about by their nature –there are just certain businesses that are very risky. We tend to go into businesses that are inherently low risk and are capitalized in a way that that low risk of the business is transformed into a low risk for the enterprise. The risk beyond that is that even though you identify such businesses, you pay too much for them. That risk is usually a risk of time rather than principal, unless you get into a really extravagant situation. Then the risk becomes the risk of you yourself –whether you can retain your belief in the real fundamentals of the business and not get too concerned about the stock market." I think it is better for us also to focus on such businesses where we are less exposed to risks you mentioned. Sorry for tossing Buffett quotes, you probably know most of these by heart, but they covey the message better. Vinod

I would suggest caution against setting return targets, every very reasonable ones. Buffett, Munger and Klarman, all warned about this very same point. I used to have a return target as well one time, but very quickly realized my mistake before it cost it me too much. Setting a return target is individual equivalent of the Corporate Strategic Plan. It not only does not work but triggers so many other behavioral biases that it would hurt your portfolio. Basically when you target return, you would be focusing on the upside ignoring risk. Of course, you would tell yourself that you would do no such thing. Since investing is not like working in a factory where you can decide to put in an extra 20% more time and make proportionally higher income. You get the returns that are available in the market. If your target returns are not available, you would be tempted to load up on risk to make it up. Vinod Vinod

+1 This has pretty much been my experience. When your boss gives you something to research or investigate, they almost invariably have an idea of what the result should be and you are expected to basically come up with compelling reasons why that is in fact a really great idea. Vinod

Relevant quote from the book: Figure 11-6 also shows the total real return from equities in each country (the green bars). Visually, real returns seem unrelated to GDP growth, and statistically, the correlation is -0.27 for 1900–2000 and -0.03 for 1951–2000. These findings, while based on much longer periods than earlier research, are not new. Siegel (1998) found that from 1970–97, the correlation between stock returns and GDP growth was -0.32 for seventeen developed countries, and -0.03 for eighteen emerging markets. Vinod

There is a good book that has data that provides a very compelling case for inverse correlation between GDP growth and stock market returns. Triumph of the Optimists: 101 Years of Global Investment Returns Vinod So this would mean that over long periods stock returns are always negative right? If countries continue go grow (GDP growth) then returns should be negative over the long haul? If you extrapolate out a bit it would mean that equity investing is a losing game, as the world grows we're trying to swim against the tide. Yet this doesn't seem to be the market experience. Since we have numbers the US has grown as an economy and our market has been biased upwards. So how does this jive with the research? Dont take it too literally. It just means it would be a a bad idea to expect higher equity returns just because it has a higher growth rate. The data if you care to look in the book, shows that countries that have higher growth rate are priced higher. So equity returns tended to disappoint investors who naively investing in high growth countries. Does this remind you of value investing? Part of the explanation is also that to fund additional growth you need to make additional investments via debt and stock market issues which dilute existing shareholders. Vinod I guess I was thinking about this with a longer time window than most. I was thinking if you looked at 100/200/300 years of history what would you see? Someone mentioned short time periods, and in that vein I agree that growth in GDP doesn't correlate to returns. I'd like to see the data from 1906 to 2006 for example, what's the relationship between those two? My guess is that GDP growth and market growth are fairly tightly connected. All of the pessimism and optimism cancel out eventually. The book I mentioned looked at the 101 year data from 1900 to 2000 and came to the conclusion I mentioned. The authors periodically publish an updated version of the data for a report they do for institutional investors so if you are interested you might find the data you are looking for there - but the conclusion does not change. Their conclusions were something along the lines that as long as there is positive GDP growth, the GDP growth rate itself has weakly negative correlation to stock market returns. Vinod

There is a good book that has data that provides a very compelling case for inverse correlation between GDP growth and stock market returns. Triumph of the Optimists: 101 Years of Global Investment Returns Vinod So this would mean that over long periods stock returns are always negative right? If countries continue go grow (GDP growth) then returns should be negative over the long haul? If you extrapolate out a bit it would mean that equity investing is a losing game, as the world grows we're trying to swim against the tide. Yet this doesn't seem to be the market experience. Since we have numbers the US has grown as an economy and our market has been biased upwards. So how does this jive with the research? Dont take it too literally. It just means it would be a a bad idea to expect higher equity returns just because it has a higher growth rate. The data if you care to look in the book, shows that countries that have higher growth rate are priced higher. So equity returns tended to disappoint investors who naively investing in high growth countries. Does this remind you of value investing? Part of the explanation is also that to fund additional growth you need to make additional investments via debt and stock market issues which dilute existing shareholders. Vinod

There is a good book that has data that provides a very compelling case for inverse correlation between GDP growth rate and stock market returns. Triumph of the Optimists: 101 Years of Global Investment Returns Vinod

From the Fairholme AR: Few have the inclination to dig very deep, let alone the willingness to devote a full time analyst – supported by three additional researchers and a small army of third-party consultants with expertise in topics such as advertising and marketing, defined benefit plans, distribution and logistics, real estate valuation and redevelopment, and reinsurance – to cover a single company day in and day out. Now we know why he drank Sears kool aid. Munger's warning on incentives comes to mind. What else does Berkowitz expect to hear from the full time analyst and consultants other than something like "Bruce, Sears has the greatest margin of safety in the history of investments ever". Hiring a full time associate to research one particular stock and nothing else where it is already one of your largest positions? I just cannot comprehend this. Every damn behavioral bias got to be working against you. Vinod

I think the best way to evaluate a fund manager is over one of more full market cycles. If you look at closer to bull market peak or a bear market bottom, you get quite different results. Or a second best way would be to look at multiple independent multi-year periods. Otherwise performance is too sensitive to starting and end point levels. Vinod

Cardboard, When a key input cost to the economy declines, I would think the benefits would far outweigh the loss to the oil producers. In the short run (6 months or so), I can see your point but not over the long run, when the benefits of lower prices start translating into more jobs. Stephen Roach (when he was at Morgan Stanley) used to pound the table in the early 2000's that oil going above $50 would cause a recession as it always did. I keep thinking of this essay, anytime, I see arguments to the contrary. http://bastiat.org/en/petition.html Vinod

Good points but give Gio a break. He is a thoughtful, accomplished businessman and investor. So he does understand that such short term performance is meaningless, just look at the title "I know this doesn’t mean anything, and is absolutely not repeatable, but…". It is not like these thoughts do not cross our minds once in a while. Gio just thought it out loud. Vinod

original mungerville, I did a little analysis on hedging, it seems to me that buying puts is very expensive and the payoff does not seem all that attractive. I would love to hear your opinion on a short half page analysis that I am attaching below. Basically, you need to put nearly 16% of your portfolio into put options to be able to hedge your portfolio completely against a 40% loss. That means we can invest only 84% into stocks. I might be missing something and any feedback would be most welcome. Thank you! Vinod Vinod, I am sure your analysis is reasonable. Just to be clear, I am advocating the following: 1. My neutral position is no longer 100% cash, its something like 90% cash (or less) and 10% (or more) precious metals. This is because of the global monetary debasement and its irrespective of whether we get deflation or inflation coming. Its just about the debasement. 2. I advocate being at least partially hedged after a 5 to 6 year run. The alternative is reduce value picks and move to cash. But if you are a really good value investor, then some hedging allows you to benefit from your Alpha without incurring market risk. 3. I advocate asymmetrical hedges. They are more expensive, but they can't kill you like symmetric ones which go the wrong way. After all, with money printing, the stock market's potential return is very very high - so you can get killed on a symmetric hedge. Asymmetrically hedging your entire portfolio is extremely expensive - I agree. And it would not permit you to invest the entire portfolio unless you use some margin for the hedge. 4. After over ten years at this, I have come to the conclusion that diversifying your hedge is intelligent. So buy some puts, but also be fearful when others are greedy (and the reverse) by moving to cash (and vice-versa), and also consider using long govt bonds as a third and less expensive option. (But in this environment with bond yields already so low I am less inclined). The point is don't put all your hedging eggs in one basket, and don't necessarily hedge 100% of your portfolio. So, for example, after a 6 year bull market, maybe instead of hedging 100% of your portfolio, something like the following: Neglecting my point #1 above for simplicity: A) 25% cash, 75% value picks (ie discard your worst 25% of ideas to get from 100% down to 75%), hedge with puts say 35% of your entire portfolio. So net you would be long equities 40% and effectively be 60% cash. B) IF we were in a more normal environment for govt bonds, you could instead invest the 25% cash in long govt bonds which earns a better yield and is roughly the equivalent of say an extra 15 % hedge on your equities (at least according to Ray Dalio of Bridgewater - and I am talking in very rough terms), so effectively you would then be 25% unhedged equities (instead of 40%) and effectively 75% cash. In reality, you would have 25% long bonds, 75% equities and 35% of notional covered by puts you bought on margin. C) You might want to split A) and B) if you do not feel comfortable relying on the inverse correlation between the long-bond and equities. I would either do A) or C). The idea is to diversify the hedge. D) Also, if a major holding is a large cap, you could consider buying the LEAPs instead of the common. Its more costly, but they act as a floor on what you can lose. So if you are really really scared of the environment and 25% to 40% long equities is still too long, you might consider a bit of this (should you have this type of security in your portfolio). Diversify the hedge into 3 or 4 strategies (all of them asymmetric) so you can't get killed by things working against you for some time and also the cost won't kill you because you limit your maximum notional your puts reference to 35% of your entire portfolio's notional Now, having said all the above - given the monetary debasement going on, cash is probably going to ultimately be trash. So how does one stay conservative (ie how does one not be forced to hold equities as central banks debase and force everyone into equities?) as equity valuations go sky-high - at a time that cash is likely to be debased? I think its really important for everyone to hold at least 10% of their portfolio in physical precious metals. I am not going to get into how that should fit into a hedged value portfolio in this thread, but basically with A through D above, and combining that with #1, each person can figure it out for themselves. original mungerville, Thank you for the detailed and very insightful reply. It looks like you have put a great deal of thought into this issue. My portfolio since late 2011 has been mostly in LEAPS. It is partly due to the concerns you mentioned, partly due to valuations and partly because the opportunity set (BAC, AIG, et al.) of deep value + Tail risk lent itself to LEAPS. I also have about 2% in precious metal equities (GDX) because they are attractive on their own due to valuations (mean reversion) while also serving as a hedge. Vinod

Most of US investments overseas are ownership interests (equity, direct ownership of businesses, etc). Rest of the world owns mostly US debt. US earns very high returns on its investments and pays very little on its debt. Looking at the net returns, it is still mostly favorable to US. Vinod

You can look up all my holdings in the Investment Idea section. NRW.AX and the japanese stocks are mainly asset plays (thats the reason that these stocks are all smaller holdings), the rest have something in place that protects the cashflows for the next years. PKX is the lowest cost steel producer (though i am not sure if the currency wars deteriorate that one). When Buffett is doing concentrated investing he is finding deep values with a very large margin of safety: 1. Western Insurance - it earned $22 and $29 the previous two years and he is buying at something like $3 to $13 per share. 2. National American Fire Insurance - Good capital allocator at the helm, with book value of $135 and earning $29 and he is buying in the stock in the $30s. That is margin of safety. Or he is buying Coke and Amex with near impregnable moats. In either case margin of safety is pretty high. That is when he concentrates his portfolio. This kind of concentrated portfolio does not work if applied to marginal businesses. Being recession resistant is not really the key, as there are many ways to lose, it is not just to economic cycle. Again, just a note of friendly caution to a fellow board member. Vinod

Most of the concentrated investors had portfolios consisting of nearly iron clad moats or hard asset values. FFH should be fine, but I have no idea of the moatiness of the rest of your portfolio. Do you think the rest have solid moats? Vinod

ni-co & CorpRaider, Thanks! Futures would be a lot more risky unless valuations reach truly absurd levels. At the current level, there are enough economic scenarios in which shorting could cause quite a bit of pain. So I am primarily exploring puts - it is not hedging as much as buying insurance. Mungerville pointed the use of puts, but I am just not seeing them to be of much help unless one gets the timing right. Vinod