vinod1

Prof Damodaranon writes clearly and is always a good read. However, he totally ignores the profit margins. His whole model, while very good theoretically, is based entirely on current year earnings (or TTM). If you assume that, his conclusion is pretty reasonable but you do not have to do any of his calculations either if that is your assumption. Vinod

I absolutely agree that the key to future market returns would hinge on profit margins. I think there are several reasons for why profit margins might be higher than in the past: 1. Structural change in the composition of the businesses remaining in the US. Many have outsourced or moved to higher margin products in US, leaving the lower margin ones to emerging market countries. Examples of this is the change in composition of sectors in the total market - technology sector, health care both of which have very high margins have become a much larger part of the economy. Unless something changes, I do not see these margins or these sectors losing margins or their share in the economy. 2. Relative strength of labor has been weakened by entry of large emerging market (China/India) workers, so returns to labor would be lower for a while (say 20-30 years) while they are brought into the economy. 3. Debt costs have gone down pretty significantly compared to the past. 4. Tax rates have gone down as companies were taking advantage of off-shore tax havens especially via transfer pricing. I think factors #1 and #2 are the critical ones and likely lead to a much higher sustainable profit margins going forward compared to the past. The current profit margins of around 10% are very likely not sustainable but I think they are more likely to mean revert say around 8% than around 6% as they had in the past. Vinod

This is one of the better letters from Hussman. The key issue is the level of profit margins going forward compared to the past. Hussman is betting that profit margins revert around the 6% level. I have absolutely no doubt that profit margins are mean reverting but think the mean they would be reverting would be higher than in the past. This is sort of like the old rule of dividend yield for stocks should be higher than the bond yields since stocks are risky. This used to be a good indicator for when stocks are getting overvalued. Anyone following it would have been out of stocks for about 55 years from the mid 1950s till about march 2009. The point being, big macro calls could turn out to be wrong for very long periods of time, far longer than the investment horizon of most people. I agree stocks are pretty highly valued, just not as much as Hussman thinks or as certain as he seems to be that they would come crashing down. Vinod

+1 dcollon, Thanks for uploading this fantastic transcript. This is definitely one that needs to be re-read every year. Vinod

I agree with Giofranchi having lived through an almost exact scenario in the 2008-2009 crisis. I went into the 2008-2009 crisis with about 70% cash and I had been able to take advantage of the market behaviour in that period nearly perfectly buy a lot in Oct/Nov 2008, trim a bit in Dec, load up in Feb/March 2009. The one thing I have not been able to do however is sell BRK at the lows in 2009 to buy other more attractive stocks. I was able to do it with cash I had, but for the life of me I cannot pull the trigger to sell BRK when you know with a near certanity it is less than 50% of IV and buy other stocks that are at 20-25% of IV. This is my one regret from that period but even going forward I doubt if I would be able to pull this off. Vinod

If you estimate the cap rate you are getting if you rent it out (assuming say 11 month occupancy, netting out other expenses, etc) and see how attractive the house might be as an investment. If it does not appear to be too undervalued you might want to avoid the whole "landlord" experience. Vinod

A member on the Fool message board who has done some research on MF. Some very interesting results. http://boards.fool.com/brk-shareholders-mtg-30027775.aspx?sort=whole#30027775 Note, reputable studies (including my own) generally show market beating performance, but the advantage is a fraction of what is claimed. A typical test of mine: buy the 6 highest-ranked stocks each 3 months and hold for a year, a portfolio of 24 stocks--about what he recommends. Total return 1989-2011 14.7% versus 9.3% for the S&P, advantage 5.4% without trading costs. This particular test limits itself to the largest 1000-1500 US stocks meeting [best guess of] his industry filters, so the big outperformance if any must lie in very small stocks. Other tests including the very small stocks also found only small advantages. What can I say? A large number of people have tested this. Only one, Mr Greenblatt, got really high returns from it. The exact reason isn't very important--it's not a foolproof money spinner. Having spent over a decade examining tens of thousands of quantitative investing methods, I have never seen a single plausible scheme that showed 30% returns with annual holds while long equities all the time even in backtest, let alone in real life. Maybe a few systems with tortuously complex over-fix filter criteria, but I can't even remember one of those. I don't imagine even Jim Simons could manage it, and he's the Gretzky of quants.

I used to keep an eye on him a few years back ( in 2001-2003 time frame) and from what I learned he is extremely obsessed with beating the S&P 500 more than anything. He would keep track hour by hour his relative performance. He would much rather prefer a 50% loss if S&P 500 loses more than 50% than a large gain that under performs the index. He is more of a contrarian investor rather than a margin of safety kind of investor. I realized pretty quickly he is not someone worth keeping track of and kind of lost track of him after that. Vinod

LOL

giofranchi, That is almost entirely due to the CDS gains. I do not see that happen in a market crash going forward. I am referring to the fact that if Fairfax did not have CDS gains I think it would have declined along with BRK, LUK, etc. I have benefited a lot from Fairfax during that period but I do not expect a repeat performance. Also I think Market would probably give us some time to load up on Fairfax if any deflation hedges look like they would be a home run. Hence, my preference for cash as a hedge instead of Fairfax. I could be wrong but that is the only way I can sleep well with my portfolio. Vinod

Dont Corporate profit margins and Corporate profits as a percent of GDP go hand in hand? Sales in the economy overall do not change dramatically and tax rates have been stable so I would think that they tend to track pretty closely. Vinod

Hi Uccmal, I sold FFH at around $420 primarily due to a major portfolio overhaul in 2011. Given all the economic issues in Europe and its potential impact on US, along with US own set of issues and the opportunity set that is available (BAC/AIG/C/GS), I wanted to have a barbell type portfolio. A large allocation of cash (60-75%) coupled with high leverage via warrants and LEAPS on deeply undervalued businesses. I know FFH is hedged but if 2008-2009 crisis taught me anything it is that only cash is truly liquid. So I sold out of FFH. If BAC or AIG works out while FFH is still available around book I would revert back to FFH. I do not see underwriting profits or growth in float making much of difference to growth in book value. Growth will again likely come from portfolio performance but with the hedges in place the macro has to cooperate. Vinod

But isn't there more to earn by keeping their capital strength and strong ratings at all times and then be able to increase the float when opportunities are good? I agree with the need for keeping capital strength and strong ratings and hedging does provide that benefit. However, I do not think the ability to write more business in hard markets adds all that much to Fairfax IV. I have long given up on expecting any underwriting profits from Fairfax. :) Value is predominantly going to be created by the investing abilities of HWIC. My main point is that most of the value created in the last decade has been due to a macro bet that succeeded. Fairfax now is much better positioned going forward but even with that it would need its macro bets to come through to get to the 15% annual BV growth. In a scenario where their macro bet does not play out successfully I think 15% BV growth is too optimistic unless Watsa pulls out another rabbit out of his hat. Vinod

I wonder how we would view Fairfax if 2008-2009 crisis did not turn out as it did. It is not like the 2008 crisis is a near certanity, so if the crisis had been more contained with housing only declining a little bit and stock market (S&P 500) declining to say only 1100 and with CDS not paying all that much, I would think Fairfax would have a book value of around $200 only at this time. So that would be a 12 year near flatlining of book value, but for the 2008-2009 crisis. I am not trying to take away Prem's achievements, I think they made a very astute macro economic bet (let us say where the odds are 80/20 or some such high number) but they had been a little lucky that it played out in their favor. Now, they are making another bet, which I agree with, but this time it could end up hurting Fairfax in terms of lost opportunity cost. Vinod

Congratulations! Thank you Parsad, for all the effort you put into making this such a great value investing board.

LOL ShahKhezri, How are they special? Any insight you can share? Thanks Vinod

Here are two books 1. Bull! A History of the Boom, 1982-1999 by Maggie Mahar - Also recommended by Buffett 2. Origins of the Crash: The Great Bubble and Its Undoing by Roger Lowenstein Vinod

Looking at this particular point in time, I like FAIRX allocation with about 50% in AIG/BAC. I would expect FAAFX to have better returns over the long term, for reasons already mentioned by others. I split the investment equally between them. Vinod

Ok Eric, this might make you happy. http://www.businessinsider.com/goldman-the-economic-crisis-ends-in-2013-2012-12 Vinod

Feeding the Dragon - GMO paper on Chinese credit bubble. https://www.gmo.com/America/CMSAttachmentDownload.aspx?target=JUBRxi51IIA6KcUdqlSIwIXyKFLDu0ahgi%2fVwwPhMBjQBiRm%2bRLnDmOmauuxY3ieIGb5rFygoEWoFXDEs8Gu%2bAyctYJBUNhPmb9KxTYFrE8%3d From a valuation perspective, Chinese equities do not, at first glance, look to be a likely candidate for trouble. The PE ratios are either 12 or 15 times on MSCI China, depending on whether you include financials or not, and the market has underperformed MSCI Emerging by about 10% over the last three years (ending December 31, 2012). Neither of these characteristics screams “bubble.” And yet, China has been a source of worry for us over the past three years and continues to be one, affecting not merely our behavior with regards to stocks domiciled in China but the entire emerging world, as well as some specific developed market stocks, which we believe are particularly vulnerable should things in China go down the road we fear it might. Vinod

giofranchi 1. To your point about comparing to Weimar Republic in Germany or Japan during the last 20 years. I do not think US position now can be compared to Weimar Republic in Germany of 1920's. The magnitude of the monetary increase is several orders of magnitude higher in Germany. When we are talking about inflation in US we are talking about 3%, 4% or 5% or even high single digits. Compared to US GDP, all the US monetary increase is still a smallish number compared to the increases required for hyperinflation. The situation US is in could be compared to either 1929 GD in US or Japan in the last 20 years. As Richard Koo points out these are both cases of a "Balance Sheet Recession". Here a lot of private sector balance sheets needs to be repaired. The defining characteristic of this case is that private sector moves away from their usual profit maximization to debt minimization. Japan's stock market is down 75% from its peak, whiles its real estate is down 70% from its peak. The fact that they have been able to avoid a great depression type economic contraction, I think they did pretty good. Given that US has been much more aggressive I think US would do much better compared to Japan. Either way there is a price to be paid and it might end up as either sub par economic growth for a while, higher inflation, more economic uncertanity, etc. 2. To you point about "once you go into debt you are screwed". I agree and think most of the policy makers realize this as well but they cannot come out and say that. It is now a matter of coming out of this with the as little collateral damage as possible. 3. To your point about investment implications. I have no idea of how this all plays out, only thing I know is that risk is much much higher than normal. The prices of overall market in general does not seem to reflect this risk. So I have repositioned my portfolio for the last two years with this in mind. This means several things: - Portfolio with much higher cash allocation. - Strict selling criteria. Selling any business which exceeds 80% of IV unless there is a clear and imminent catalyst. - Portfolio concentrated on extreme value leveraged via LEAPS or Warrants. So I can have like a 80% nominal portfolio exposure while having very roughly around 70% cash. Vinod

giofranchi, Some info on the liquidationist school: http://www.mannmuseum.com/american-policies-during-the-great-depression/2/ Contemplating the wreck of his country's economy and his own political career, Herbert Hoover wrote bitterly in retrospect about those in his administration who had advised inaction during the downslide: The 'leave-it-alone liquidationists' headed by Secretary of the Treasury Mellon felt that government must keep its hands off and let the slump liquidate itself. Mr. Mellon had only one formula: 'Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate'. He held that even panic was not altogether a bad thing. He said: 'It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people' But Hoover had been one of the most enthusiastic proponents of "liquidationism" during the Great Depression. And the unwillingness to use policy to prop up the economy during the slide into the Depression was backed by a large chorus, and approved by the most eminent economists. For example, from Harvard Joseph Schumpeter argued that there was a "presumption against remedial measures which work through money and credit. Policies of this class are particularly apt to produce additional trouble for the future." From Schumpeter's perspective, "depressions are not simply evils, which we might attempt to suppress, but forms of something which has to be done, namely, adjustment to change." This socially productive function of depressions creates "the chief difficulty" faced by economic policy makers. For "most of what would be effective in remedying a depression would be equally effective in preventing this adjustment." From London, Friedrich Hayek found it: ...still more difficult to see what lasting good effects can come from credit expansion. The thing which is most needed to secure healthy conditions is the most speedy and complete adaptation possible of the structure of production. If the proportion as determined by the voluntary decisions of individuals is distorted by the creation of artificial demand resources [are] again led into a wrong direction and a definite and lasting adjustment is again postponed. The only way permanently to 'mobilize' all available resources is, therefore to leave it to time to effect a permanent cure by the slow process of adapting the structure of production... Hayek and company believed that enterprises are gambles which sometimes fail: a future comes to pass in which certain investments should not have been made. The best that can be done in such circumstances is to shut down those production processes that turned out to have been based on assumptions about future demands that did not come to pass. The liquidation of such investments and businesses releases factors of production from unprofitable uses; they can then be redeployed in other sectors of the technologically dynamic economy. Without the initial liquidation the redeployment cannot take place. And, said Hayek, depressions are this process of liquidation and preparation for the redeployment of resources. As Schumpeter put it, policy does not allow a choice between depression and no depression, but between depression now and a worse depression later: "inflation pushed far enough [would] undoubtedly turn depression into the sham prosperity so familiar from European postwar experience, [and]... would, in the end, lead to a collapse worse than the one it was called in to remedy." For "recovery is sound only if it does come of itself. For any revival which is merely due to artificial stimulus leaves part of the work of depressions undone and adds, to an undigested remnant of maladjustment, new maladjustment of its own which has to be liquidated in turn, thus threatening business with another [worse] crisis ahead" This doctrine--that in the long run the Great Depression would turn out to have been "good medicine" for the economy, and that proponents of stimulative policies were shortsighted enemies of the public welfare--drew anguished cries of dissent from those less hindered by their theoretical blinders. British economist Ralph Hawtrey scorned those who, like Robbins and Hayek, wrote at the nadir of the Great Depression that the greatest danger the economy faced was inflation. It was, Hawtrey said, the equivalent of "Crying, 'Fire! Fire!' in Noah's flood." Vinod

That’s simple. To cure the debt problem with more debt… I don’t understand how it should work: so, either I am dumb, or it is too complicated. Probably, the former. :( giofranchi No, no, no. I think you choose not to understand since it does not conform to your view of the world. :) I do that all the time. On this particular issue, I have changed my own opinion on this a couple of years back. I would lay out my understanding briefly and you can point out where you disagree. I am talking just about US here. Consumers took out more debt than they can service over the past several years for a variety of reasons (housing bubble, easy loans, falling interest rates, central bank encouragement, stagnating wages, etc.). The financial crisis of 2008-2009 with falling asset prices, unemployment, etc made debt servicing more difficult for consumers who have logically pulled back from spending and started saving, thus beginning the process of reducing debt levels. The reduced spending by consumers creates headwinds for the economy resulting in sub par growth and also reduces government revenues. The government at this time can choose not to do much and just let nature take its course and let those who have recklessly borrowed more money suffer. The result would be that economy would take a much sharper downturn, housing and other assets deflate, bad banks get wiped out, lenders take haircuts on the money lent. Once this process works through, economy regains strength. The problem with this approach is that it would cause tremendous suffering. We are probably talking about GDP declines of peak to trough of something like 10-15%, unemployment shooting to 20%, etc. Jim Grant, Hussman, Rodriguez and many others think this should be the process that should be followed. There is a moral component to this line of reasoning. This approach has been argued as the quicker way to resolve the crisis, but we cannot be sure about that. We have tried this in 1929 with disastrous results. The other approach has been for Government to step in and try to take debt for a while as the consumer slowly deleverages. The Government does take on debt so Government spending would try to offset some of the reduction in spending by consumers. Monetary policy is kept as loose as possible via various mechanisms to allow borrowers to deleverage via lower interest rates or via higher inflation. We do know this is not sustainable for ever and this is not without risks. But this would be the best of the bad options. Vinod

No one is saying there is a magical solution. That is a strawman argument. Monetary policy is not the right tool to fight a liquidity trap, but Fed is doing what it can with the tools it has. From "End the Depression Now" Can Debt Cure a Problem Created by Debt? One of the common arguments against fiscal policy in the current situation—one that sounds sensible—runs like this: “You yourself say that this crisis is the result of too much debt. Now you’re saying that the answer involves running up even more debt. That can’t possibly make sense.” Actually, it does. But to explain why will take both some careful thinking and a look at the historical record. It’s true that people like me believe that the depression we’re in was in large part caused by the buildup of household debt, which set the stage for a Minksy moment in which highly indebted households were forced to slash their spending. How, then, can even more debt be part of the appropriate policy response? The key point is that this argument against deficit spending assumes, implicitly, that debt is debt—that it doesn’t matter who owes the money. Yet that can’t be right; if it were, we wouldn’t have a problem in the first place. After all, to a first approximation debt is money we owe to ourselves; yes, the United States has debt to China and other countries, but as we saw in chapter 3, our net debt to foreigners is relatively small and not at the heart of the problem. Ignoring the foreign component, or looking at the world as a whole, we see that the overall level of debt makes no difference to aggregate net worth—one person’s liability is another person’s asset. It follows that the level of debt matters only if the distribution of net worth matters, if highly indebted players face different constraints from players with low debt. And this means that all debt isn’t created equal, which is why borrowing by some actors now can help cure problems created by excess borrowing by other actors in the past. Think of it this way: when debt is rising, it’s not the economy as a whole borrowing more money. It is, rather, a case of less patient people —people who for whatever reason want to spend sooner rather than later—borrowing from more patient people. The main limit on this kind of borrowing is the concern of those patient lenders about whether they will be repaid, which sets some kind of ceiling on each individual’s ability to borrow. What happened in 2008 was a sudden downward revision of those ceilings. This downward revision has forced the debtors to pay down their debt, rapidly, which means spending much less. And the problem is that the creditors don’t face any equivalent incentive to spend more. Low interest rates help, but because of the severity of the “deleveraging shock,” even a zero interest rate isn’t low enough to get them to fill the hole left by the collapse in debtors’ demand. The result isn’t just a depressed economy: low incomes and low inflation (or even deflation) make it that much harder for the debtors to pay down their debt. What can be done? One answer is to find some way to reduce the real value of the debt. Debt relief could do this; so could inflation, if you can get it, which would do two things: it would make it possible to have a negative real interest rate, and it would in itself erode the outstanding debt. Yes, that would in a way be rewarding debtors for their past excesses, but economics is not a morality play. I’ll have more to say about inflation in the next chapter. Just to go back for a moment to my point that debt is not all the same: yes, debt relief would reduce the assets of the creditors at the same time, and by the same amount, as it reduced the liabilities of the debtors. But the debtors are being forced to cut spending, while the creditors aren’t, so this is a net positive for economy wide spending. But what if neither inflation nor sufficient debt relief can, or at any rate will, be delivered? Well, suppose a third party can come in: the government. Suppose that it can borrow for a while, using the borrowed money to buy useful things like rail tunnels under the Hudson, or pay schoolteacher salaries. The true social cost of these things will be very low, because the government will be employing resources that would otherwise be unemployed. And it also makes it easier for the debtors to pay down their debt; if the government maintains its spending long enough, it can bring debtors to the point where they’re no longer being forced into emergency debt reduction and where further deficit spending is no longer required to achieve full employment. Yes, private debt will in part have been replaced by public debt, but the point is that debt will have been shifted away from the players whose debt is doing the economic damage, so that the economy’s problems will have been reduced even if the overall level of debt hasn’t fallen. The bottom line, then, is that the plausible-sounding argument that debt can’t cure debt is just wrong. On the contrary, it can—and the alternative is a prolonged period of economic weakness that actually makes the debt problem harder to resolve. I have been pissed off with Krugman's columns in NYT for various reasons (too partisan) but his book is a gem. Vinod

If you are going to index then at the very least you need to keep up to date on GMO's asset class forecasts. If you are going to be putting small amounts of money over very long periods of time, then this might not be needed, but if you are going to put say significant amounts then you need to pay attention to valuation. Other choice is go with DFA Funds and focus on value indexes. They have pretty good funds although for the wrong reasons (Fama French nonsense...). Vinod