vinod1

I think there are basic differences in what value investing means to academics and to practitioners. To academics it means low P/B and/or low P/E. Any stock that fits the lower 30% of P/B is categorized as value and upper 30% is categorized as growth. The middle 40% is core. Academics hold that the higher returns from these low P/B stocks is due to the fact that they are more risky companies and they are much more likely to go bankrupt and to lead to bad outcomes during periods of economic turbulence. Thus they see the higher returns as just compensation for the greater risk. Behavioral academics point out that the low P/B stocks have lower volatility and lower beta and suggest that at least some of the higher returns is behavioural based and thus irrational. I tend to agree with this view. Value Investing as practiced by Buffett and Graham is also quite different 1. Bufffett emphasizes concentration, very deep indepth knowledge of the company/management and ability to see how the company would be like several years into the future. Almost all the companies that Buffett invests increase IV at a pretty good clip and that provides the margin of safety even as the companies price rises. 2. Graham emphasizes trying to find a basket of securities that are very likely to be undervalued due to behavioral reasons, economic cycle or mean reversion. While individual securities could go bankrupt it is very unlikely that the basket itself would all go broke. This necessarily leads to some turnover. Once securities in the portfolio go up in price the margin of safety is lost. So I do not think we can look at just the portfolio from the past to evaluate their “value investing” credentials. I think their strategy has to be taken into account. Graham himself may fail this test if ignore their approach. Vinod

First, let me say that I find your posts very informative and a joy to read. Thank you! So, refusing to even think about the big picture, because anyway macro events are impossible to time correctly, is not an argument that I agree with. Nothing can be timed with great precision! What does "think about the big picture" mean? A company's value is highly dependent on the economic environment and in that sense I think every value investor incorporates their own macro economic variables into the valuation. Say a value investor in looking at a car company during a housing boom, massive credit expansion, elevated level of automobile sales, etc. The value investor would normalize this to a more reasonable overall economy wide sales of automobiles and make a corresponding adjustment to the sales of the company. So too many of the factors you mention would go into the IV estimation. At least this is how I think the macro should be incorporated. But: can you have an idea of secular bull or secular bear markets? And where are we now? Yes! A bull market and bear market as Hussman points out is only realized afterwards never at that particular point in time. Can you know if markets in general are richly priced or are cheap? Yes! Can you know if there is too much debt in the system? If we are leveraging or deleveraging? Yes! Can you recognize a bubble? And avoid its burst? Yes! Can you study history and see if similar patterns were repeated in secular bull and bear markets of the past? In richly priced and cheap markets of the past? In leveraging and deleveraging periods of the past? In past bubbles? I think you can! And I think it can be useful, even if you cannot time events. No disagreement here. The way I would incorporate this would be in requiring a larger margin of safety in price and/or the type of business risks that an enterprise has or modestly changing the cash allocation. Vinod

I think the key here is to be very very selective i.e. limit it to someone in which one can have very high degree of confidence which can only be achieved with a terrific long term track record combined with a very good understanding of how that track record was achieved. The only ones who meet this criteria for me are Buffett, Klarman, Watsa, Berkowitz and Hawkins. Vinod

A fantastic book that shows why many of the popular business books "Good to Great", "Built to Last" and "In Search of Excellence" are garbage. More importantly shows investors risks in how they can become biased in assessing companies and management. Key point that I skimmed off the web for my own reference on this book: The Halo Effect of the book's title refers to the cognitive bias in which the perception of one quality is contaminated by a more readily available quality (for example good-looking people being rated as more intelligent). It is the tendency to make specific inferences on the basis of general impression. In the context of business, observers think they are making judgements of a company's customer-focus, quality of leadership or other virtues, but their judgement is contaminated by indicators of company performance such as share price or profitability. Correlations of, for example, customer-focus with business success then become meaningless, because success was the basis for the measure of customer focus. How does the halo effect manifest itself in the business world? Imagine a company that is doing well, with rising sales, high profits, and a sharply increasing stock price. The tendency is to infer that the company has a sound strategy, a visionary leader, motivated employees, an excellent customer orientation, a vibrant culture, and so on. But when that same company suffers a decline—if sales fall and profits shrink—many people are quick to conclude that the company’s strategy went wrong, its people became complacent, it neglected its customers, its culture became stodgy, and more. In fact, these things may not have changed much, if at all. Rather, company performance, good or bad, creates an overall impression—a halo—that shapes how we perceive its strategy, leaders, employees, culture, and other elements. The fact is that many everyday concepts in business—including leadership, corporate culture, core competencies, and customer orientation—are ambiguous and difficult to define. We often infer perceptions of them from something else, which appears to be more concrete and tangible: namely, financial performance. As a result, many of the things that we commonly believe are contributions to company performance are in fact attributions. In other words, outcomes can be mistaken for inputs. Vinod

HP

This book ranks as one of the best investing books - and would be in my list of the top 10 investing books of all time. For such really key books, I try to summarize or take the key points and make short notes that I can review periodically. For those interested, here is a link to my notes for this book http://vinodp.com/documents/general/MostImportantThing.pdf Vinod

Profit Margins are mean reverting but the mean itself changes due to structural changes in the economy and capital markets. As mentioned factors such as 1. The weights of different industries in the economy has changed dramatically over the last century and normalized profit margins have to be adjusted for these changes and these are probably very long term phenomenon. 2. Worker incomes are depressed due to rise of Indian and Chinese workers into the global markets and this is also a very long term phenomenon. Both these factors suggest the mean for profit margins should be higher than the past. What we cannot know is how much higher. My guess is profit margins would drop from the current high but to a much higher mean than before. That said, I am shocked that profit margins have returned to such levels so soon after the 2008-2009 crisis. Vinod

I cannot recommend enough "The Halo Effect" before you undertake this effort. It helps you to avoid many errors that you might otherwise make. Vinod

DC area housing market has the same characteristics. Vinod

Agree it is not exactly an apples to apples comparison :) What I am questioning is how big of a lock the OS/Development platform poses. To me, even though OS might not exactly be a fungible product, the presence of an Android and its rapid rise suggests that the OS/Dev Platform might not allow Apple to extract the rents that Microsoft did with Windows. I do not know if Google/Apple go the route of Fedex/UPS earning high returns or the route of Car manufacturing reducing returns for all parties. I see people mostly downloading apps as needed and discarding them as better ones come up. There is very little lock in with apps. So any well funded competitor (Microsoft) can have a viable OS/Dev Platform in the future. Vinod

And what would Apple's economies of scale be in that scenario? How dominant will their platform be? Would Apple be a monopoly? Would people just stop supporting other platforms once Apple is that dominant? In that scenario, would the defending be tough or the attacking? :) Apple is the RCA of our age. I am sure you could have made that argument about RCA in the early 1920s and 1930s as well. Vinod

That's the hardest to say. I mean, there will definitely be tremendous amount of competitors targeting this space, but to succeed in capturing share from Apple it'll require a combination of superior vision and execution. If Apple has assembled the right culture and team, it would potentially be possible for them to defend against new entrants. I mean, maybe Jobs has figured out the secret Coca-Cola recipe for tech/product R&D success and maybe it tastes like an Apple? What Apple has is not much of a moat. It is mainly operational excellence and superior management both of which can either be copied or hired away. I would not be surprised to see many of the Apple's senior management venturing out on their own and be hired away by competitors. Vinod

At some point, you need to assimilate all the facts out there and see if it agrees with your hypothesis. To me this thread is about biases in thinking. It is about assuming that we know things that we actually don't and jumping to conclusions. I think Parsad and Uccmal represent what Howard Marks calls “I don’t know” school of investing. You seem to be pretty confident that you have handicapped the downside scenario for Apple. So I do not think it is fair to say they are assuming things that they dont know, when in fact, they are saying the opposite. I am not very confident about Apple's future's earnings for all the reasons they mentioned above. If apple just maintains current profit margins and increases revenues in line with GDP growth then it would be earning about $0.5 trillion over the next 10 years at very very high rates of return on invested capital. Such a big honey pot would be very tough to defend. Here is my comments on fool board regarding Apple's moat: Coming to the question of moats, purely based on my own circle of friends, I am not seeing much of a moat. 1. Network effect - The number of apps for a platform would likely not be a big factor for users. It is not like Ebay where the number of sellers increases the value to buyers and vice versa. The most common apps and those which the users care about are quite limited in number. Once a core set of say 5000 apps are developed, it really does not make much difference to how many additional apps are available. These core set of apps would be available on other platforms as well. Users are going to iPhone mostly because it is such a well made device and it is so easy to use. Once the others catch up in learning curve this difference would become minor enough to not be a significant factor in purchase decision. I see the iPhone more as a fashion choice and fashions do (or rather must) change over time. 2. Switching costs - Most of the tasks that are performed on apps are very easy, non critical and does not require much training to become proficient. There is very limited data in any of these apps. Even the data that exits would become portable between platforms in future. The cost of apps also is minor compared to device or yearly phone costs. So I do not see much of a switching moat here. I had several friends (one used to be a diehard iPhone guy) who switched to Android just because they got bored with iPhone. iTunes did not really get them to stick with Apple so at least right now it is not much of a moat. Much of the above would be true for iPad as well. Vinod

I see industry reports as a way to get up to speed in a new industry or just to update myself on an industry that is already within my circle of competence as I sometimes pick up a data point or an industry nuance. If I know the industry, it would be a quick review so not that much time is involved. Learning about a new industry just broadens my understanding of how different businesses work. I cannot get such a quick overview by reading a couple of annual reports of a few companies in that industry. Agree completely that you do not need to be an expert on all the low level details of an industry. Vinod

Wow! Great find. Thanks for sharing. Vinod

Welcome to my mind! Vinod

I would think a dis-orderly breakup of Eurozone would reduce GDP of Europe as a whole by anything from 5%-20%. I see several transmission mechanisms 1. Direct export of goods to Europe would be severely impacted for American companies with european exposure. 2. European operations of American companies would likewise be severely impacted reducing their subsidiary profits which would trigger some job losses in US as companies try to stabilize profits. 3. A break up of the most viable alternative to USD would cause Dollar to appreciate probably quite significantly as the obvious safe haven further reducing US exports and US company profits. 4. Large US banks with CDS, Swaps and Futures exposure would have quite a mess on their hands. Trade finance would freeze up. This in turn would impact emerging markets in which European banks are big players. US insurance companies with european bonds, etc in their investment portfolios would be severely stressed as well. Main point here being there are too many unknown unknowns and too many ways in which this could impact banking and availability of credit. All in all, I do not think a Euro break up would only have a temporary effect on Asset values. This is something that would fundamentally alter the earnings power of many of the large US companies. I have significant investments in equities but the above is why I am not all in even though I know many companies are at very attractive valuations. Vinod

Vinod, have you seen any report on this? Nothing that directly addresses the question of causes behind low NIM. But a good paper that goes into the issues is by IMF www.imf.org/external/pubs/ft/wp/2000/wp0007.pdf Vinod

I think there are several differences 1. Net Interest Margin is less than 2% all through the 1980's, way before the ZIRP. Lots of reasons, and not related to deflation. 2. Low ROA of Japanese banks is due to several reasons. Among them, due to cross holdings Japanese banks are holding more than 150% of the common equity in stocks of other companies. All these equity investments are less than 5% each so they are exposed to stock market declines but these are not marked to market and they had to write them down over a period of several years. Their loan losses and NPL are also much much higher. A consequence of their total RE value being priced at 5x their GDP and banks using this overvalued RE as collateral. You can look at corporate governance, shareholding patterns, Govt response. Low ROA is not primarily due to low NIM. And none of this is even remotely close to what we have in US. Vinod

Very well put. Hair cut. For 6 years I ended up driving 120 miles round trip to get a haircut from a person who knows how to cut my hair just the way I like. Vinod

6 months rule of thumb is more applicable to people who are at the accumulation stage of their life and 3 year rule of thumb is for those who are closer to retirement. 6 months expenses is for getting through to the next job if you lose the current one. 3 year expenses is to ensure that in retirement you are not liquidating your investments when they are down. I personally prefer to squirrel away a few years expenses in inflation protected securities (I-Bonds accumulated at a time when they are offering 3.6%, 3% and 2% real returns - around 6-7% nominal currently - and limits are $60k per annum per family member). I learned to live with these returns and not be too greedy for part of my portfolio. Vinod

How do you calculate the net rental yield? Is this the yield after paying the mortgage? Thanks Vinod I'm figuring if he had no mortgage -- he has my rent checks and he has to pay for property tax and other things. The remainder of cash he has left at the end of the year after expenses, I'm guessing is about 3%. That's 3% of what I think the property is worth, but my valuation estimate is about 77% of the tax assessed value appraisal. If the tax assessor is more accurate then it's only a 2.8% yield. I am scratching my head on how this could be an attractive investment or is there is a non economic reason for this investment? Vinod Owner bought the house in 2007 for 2.2m, sunk "about a million" into upgrades/renovations, and is holding onto it until he can get his money back out. He moved into a lower cost home after having some health deterioration and needing a care giver. You should see some of the homes for rent in Montecito, it's hysterical. www.realtor.com Thanks. I misunderstood. I thought you bought the house and renting it someone else, I did not realize it is the other way around. Vinod

How do you calculate the net rental yield? Is this the yield after paying the mortgage? Thanks Vinod I'm figuring if he had no mortgage -- he has my rent checks and he has to pay for property tax and other things. The remainder of cash he has left at the end of the year after expenses, I'm guessing is about 3%. That's 3% of what I think the property is worth, but my valuation estimate is about 77% of the tax assessed value appraisal. If the tax assessor is more accurate then it's only a 2.8% yield. I am scratching my head on how this could be an attractive investment or is there is a non economic reason for this investment? Vinod

I understand why my cap rate is lower. What I am trying to think through if a cap rate of 4% could still be attractive when one can borrow at under 4% pre-tax and around 3% after tax deduction of interest. I am sure this would not be enough of a margin of safety for investment, but for making a rent vs buy decision it seems buying would be slightly cheaper. Vinod

How do you calculate the net rental yield? Is this the yield after paying the mortgage? Thanks Vinod