vinod1

No one would be more happy to have the stock market fall 50% than me. My daily prayer goes something like this: "Lord, I do not ask for a bull market. I do not even ask for a bear market. All I ask is for some volatility, is that so freakin too much to ask?" I do not think anyone knows or can know where profit margins are going. It is just too complex. In cases like this, I would always ask myself what would cause me to change my mind? I had written to myself in my investment diary way back in 2004/2005 or so, that if profit margins are going to remain high in another 5 years I should reconsider my assumption of historical profit margins. I used to be fairly confident that profit margins would go down rather quickly below 6% but I was wrong so I am now more agnostic about this. Maybe I am the perfect contrary indicator when a true hard core believer in mean reversion and 6% profit margins, throws in the towel on the 6% margins. Vinod

I went from 65% cash to over 80% cash last week. Wanted to cash in my gains given the overall market level. My nominal portfolio exposure is about 60% due to leveraged exposure via LEAPS. I remain very defensively positioned. Wide eyed optimist I am not :) I am more looking at profit margins as a percent of sales (though they are pretty tightly related to profits/GDP as well). My main point is that 6% profit margins are not like the Planck constant or the value of PI, I would expect it to change over time due to structural changes in the economy. To me it seems more likely that it might be higher in the future for various reasons - primary ones being weaker labor power due to emergence of Chinese and Indian work forces into global economy and associated offshoring of low margin production to these countries. I do not want to bet on it but I would not be surprised either if margins are at a slightly higher level in future compared to past. I just disagree with the absolute confidence that Hussman seems to have that they have to revert to 6%. Shiller does not show the anywhere near the same level of confidence in this. In 20 years, we might again go back to 6% margins, that again would not surprise me. The Montier equation showing how deficits are related to high profit margins is technically correct but is very limited use as it most certainly does not show causation. It is an accounting identify, which is true by definition. Sort of like the monetary equation MV = PQ which says as velocity increases prices increases holding others constant. It is true but it tells us zilch. Montier derivation seems to be about the same. Where I am going with all this is that, we need to be much less confident in basing our valuations on the 6% margin number. I can imagine Hussman if he is writing in the 1950s. "We remain 100% hedged because the dividend yield on the stock market is less than the dividend yield on the bonds. The only few times this has been true in the last 75 years, it resulted in losses of 40% to 85%. Suffice to say, we do not speculate and intend to fully protect our shareholders from such unacceptable losses.". He would have waited for 55 years or so until he got the opportunity in 2009. Vinod

At the end of the day, it is really boils down to what profit margins you believe are normal. Shiller PE is implicitly incorporating some of the higher profit margins of the past decade (mitigated somewhat by the presence of two deep recessions, which might be more than can be expected over a 10 year period). Hussman seems to be 100% certain that profit margins would absolutely without any doubt revert to and probably below the 6% historical margins. I think it is more likely that profit margins are going to be somewhat higher in the future than in the past to say 7 or 8% for maybe another decade or so if not more. If we assume normalized S&P 500 per share sales are about $1000 (compared to $910 at the recession bottom in 2009 and $1075 TTM) and apply 7.5% margins it gives about $75 per share earnings. Put in a 16 multiple, the fair value is about 1200. If we assume interest rates are likely to remain low for a long time and deficits would continue for a long time, then I can see an 18 or even 20 multiple which puts the current value as rich but not outrageously expensive. I do not think it would make sense to both believe that deficits would continue for a long time and also argue that profit margins would revert to historical levels in the near future when as Hussman and GMO articles specify that the deficits are really behind the surge in profit margins. Vinod

My library account includes access to M* research. All you have to do is put your library card # when you login to M* website from your home pc and you get all the access. Vinod

Investment Survey. Vinod

I periodically go through value line. I get a 3 month subscription about once a year. I note down companies that seem to have good operating results over long periods and cyclicals that probably would be available purchase at deep discounts during the inevitable downturns. One thing I found helpful is to actually write out a short investment thesis for every businesses you are interested in, even though it might not be worth buying at this time. Set a price target 3 years out (one each for pessimistic case, baseline case, and optimistic case) and lay out your expectations for the 2-3 core drivers. I think three years out is a reasonable time for the market to recognize a company's value and this would give you good feedback on your investment process. Also an Investment diary that captures your thought process behind each trade - not just a particular businesses but the days that you actually bought and what you are thinking in real time as you make the trade. Vinod

Good interview with Shiller. Recommends financials using sector index fund as they are the cheapest sector trading at a CAPE of 14 which below average. Others sectors that are attractive Health Care, Energy, and Industrials. http://blip.tv/wealthtrack-AppleTV/robert-shiller-6560861 Vinod

Here is how I think about this. I would classify every investment opportunity into one of three categories 1. Businesses which increase IV at about 8% or more annually. Need not be smooth but they should be able to meet this hurdle over the long term as a normal course of business. Think BRK, JNJ, WMT, FFH, MKL, etc. 2. Businesses which about maintain their IV steady or increase at a sub par rate. Unlikely to go out of businesses but managers would need to do something out of normal course of business to increase IV. Think Dell, SD, FTP, LUK (in the past), etc. 3. Businesses which have a tough time maintaining their IV. Perpetually money losing companies, most net nets, etc fall under this. This classification basically simplifies a lot of things like position sizing, buy/sell criteria including what to do in case of large price changes, holding period, etc. Averaging in/out works well with investments of the #1 category but it is not a good idea for #3. Averaging in/out would probably be fine with #2 but within strict position limits. Vinod

Did not get around to reading about Carnegie. Thanks for the recommendation, I would add it to my reading list. Vinod

I would recommend House of Morgan by Ron Chernow. Along with Titan by the same author and The First Tycoon, these would make a very nice trinity that provides insight from three different perspectives on the same time period. Check out the videos on You Tube, there are hour to two hour segments on many of them as well. Vinod

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.