txitxo

You have a point there. During the 2000 crisis value stock portfolios certainly didn't do as bad as the rest. The bubble was mostly limited to dotcom stocks. However, even some rock-solid stocks like BRK went down by 50% from the 1999 peak to the 2000 through, about the same percentage as between the 2007 and 2009. But BRK was out of phase with the general market, so somebody buying cheap BRK in 2000 would have outperformed the S&P500 by almost 100% in a couple years. Other stocks like MKL "only" fell by 30%. 2008-2009 was certainly a whole different story, even gurus like Dreman or Miller got absolutely crushed. Quantitative value strategies who had worked very well for decades went down by 70% (as it happened to Pabrai). The 1T$ question is: how is the next leg down going to be? A nice, clean ~30% crash, like the one in 1987? Or another chainsaw massacre?

You have to be careful with making any conclusions about the careers of outstanding investors, because you are just looking at the surviving outliers. The important thing when you are beginning is: what career path offers more a priori chances of success in the investing world? Going to Harvard? Or working for a phone company? My experience in science is that, unless you have very strong reasons to work or study at a particular institution (some project, person or even family reasons) it pays off to go to the place with the highest possible "prestige". It will not do anything special to you, it won't make you smarter or more competent, it is just more convenient from a practical point of view.

Exactly. An update: the meteorite seems to be made of iron (that's why it managed to penetrate so deep into the atmosphere) and apparently it's not related to DA14, which makes this event a really freak coincidence...It seems that the Russians tried to down it...good thing the Cold war is over...

Actually that is not a trivial issue at all. Perhaps prices could stay "on a permanently high plateau", and that's what Bernanke is trying to achieve. But we have never observed them to do so. And there are good reasons (see the Minsky-Kindleberger rationale) to expect them to bounce up and down. So I think the odds are on prices going down sooner or later...

Well, the difference between tail risks and black swans is mostly one of perspective. Yes, DA14 is going to pass below the geosynchronous orbit tonight and asteroids (like cockroaches) are hardly ever alone. Russia is the largest country on Earth, and therefore the most likely to see an event like this, so perhaps you could expect something like this, even it is a very low probability event. But imagine that this thing had been slightly larger, or moving slightly faster, and you had just bought shares on Magnitogorsk Iron and Steel Works, after convincing yourself of the management quality and the company prospects, and then see your investment obliterated by the violent vaporization of a house-size chunk of carbonaceous chondrite. That would certainly quality as a Black Swan.

A meteorite exploding over Chelyabinsk, in Russia. A good reminder of unexpected risks...

Some short positions not only might limit drawdowns, which don’t concern me a lot, since I work only with equity, they also diminish opportunity costs. And that, as far as I am concerned, is key! Listen, I think the art of Buffett and others, you referred to before, is really nothing but a deep and “intimate” knowledge about how some businesses work. If you possess that knowledge, you can judge their future prospects better than the market, and therefore take advantage of the fact that the market might repeatedly price them in a wrong way. For instance, I am truly convinced the market is unable to price correctly “machines that can compound capital at high rates of return for many years into the future”, to pay BV for something like FFH is madness. Now, let’s say that I know more or less 20 of those compounding machines very well. With the only exception of FFH, I believe all of them will see the price of their stocks come down in a market correction. And here is my current allocation of capital: 100% of what I would like to have invested in FFH, 50% of what I would like to have invested in other compounding machines. You see? It is the opportunity to buy more of an outstanding business at even lower prices, that I don’t want to give up! I don’t care about drawdowns! The insurance I buy is against opportunity costs that might be too high! Now, let’s say Mr. Buffett and others know 1000 compounding machines, instead of 20. If I know 1 in 20, that I have the confidence to be already 100% invested, Mr. Buffett would at least know 1000 / 20 = 50, let’s say 30 such companies! More than enough to fill a whole portfolio of long only investments. That’s why I think that the so-called ‘circle of competence’ is very important. The wider your circle of competence, the less your need for insurance buying. Because, if you have a portfolio of investments, the return of which will be almost unaffected by whatever the market does in the future, you will incur no opportunity cost. When the opportunities arrive, you just might switch from your current holdings to those new and better bargains. For instance, right now I am 50% invested in LMCA. Should a market correction come, I am positive the LMCA stock price will decline, offering me an even better opportunity. Vice versa, the FFH stock price might hold its current level or even rise a bit in a market correction. Therefore, I will be able to shift some capital from FFH to LMCA. Actually, if I knew 5 FFH, I would not need any insurance at all. And I would be invested 100% long. :) giofranchi “As time goes on I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.” - John Maynard Keynes I understand your point, Gio, intuitively, if you expect a market drop it makes sense to hedge (via cash or shorts) and wait to buy your companies at lower prices. But unfortunately that doesn't seem to work in practice (although perhaps you are an artist in that area; northern Italy has produced some of the best in the world :)). Not only that; I haven't tested it thoroughly, but I have the impression that it would work even worse with companies as BRK, L, etc. I remember Peter Lynch telling that many of his clients in the Magellan fund did actually lose money because they tried to time the behavior of the fund. I don't have to track any index, and I hate crashes, but all the work I have done on market timing shows that the best strategy is to be 100% invested at all times (if you can find suitable investments, of course) but choosing those markets least likely to have a crash based on the best timing indicators you can muster. My stomach often disagrees with my physicist's brain on that issue. But the numbers offer no hope. It could be that Buffett's art is a profound business instinct, as you say. My particular take is that value investing works by finding market failures. Markets usually are extremely rational and smart machines, but which tend to err in certain corners, in predictable ways. For instance, they tend to undervalue small companies. They also tend to overextrapolate extremes, both at low and high valuations. And one of the most well know market failures is the existence of private quasi-monopolies as Coca-Cola, AMEX or Heinz; that's what moats are all about. Buffett and Munger are extremely adept at spotting and specially, valuing these quasi-monopolies. Doing that involves assessing many intangibles as the company culture, leadership quality, competitive position and extrapolating them into the future. That's like solving geometry problems in 15-D space, even if it is done all intuitively and explained in a folksy manner.

Well, actually I hold very little cash. But I do hold some short positions. Maybe, you are right from a statistical point of view. But the businessman perspective that I always hold very dear (because is what I think I really know and understand) advise me otherwise… Never, not in a single instance, my firm’s engineering works caused any problem from inception (2004). They always adhered to the highest quality standards, and were always delivered on time. Yet I have always bought insurance, which has always been a net loss for my firm, and I will continue to do so nonetheless. I will never do anything (at least not in this world :) ) without buying some insurance. Generally, I don’t like the mutual-fund business model. I think it has some serious flaws. I look for great businesses that I am sure I understand much better than the market. The fact is simply I am convinced great businesses are always lead by outstanding capital allocators. Because I understand and believe in “opportunistic and strategic thinking”, while vice versa I don’t believe in “business-plans” or in “star CEOs”. giofranchi “As time goes on I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.” - John Maynard Keynes I usually buy insurance too, for peace of mind. I love to chop off probability tails. For companies or individuals it makes absolute sense to buy insurance if the maximum expected loss is larger than what they can absorb. But when you are investing, the net effect of cash and shorts is reducing performance, unless you can time the market very well, which, as we have seen, it's very difficult, independently of what intuition tells us. Of course you can hold both for peace of mind too, since they will reduce the depth of drawdowns too. I don't like mutual funds in general, but sometimes it is the only reasonable vehicle you have to invest in a certain market. For instance Bestinfond has returned about 10% after fees over the market during the last 15 years, doing Graham and Dodd text-book value investing. Even if you take into account market dividends that's a pretty nice overperformance. With those numbers, you know that they have to be good at estimating the IV of companies, and right now they think that their portfolio is selling 50% below IV. Other companies we have mentioned here, as Groupe Bruxeless Lambert have much worse numbers and other problems. I'd love to diversify into the Eurozone equivalents of LUK, L, MKL, FFH, BRK...but there doesn't seem to be anything like them here...

Thanks, Gio. Yes, it is obvious, from an empirical point of view, that there are several strategies or styles, all loosely based on value, which work. Cigar butts, which is basically what I do, with a few added twists, can be reproduced mechanically for statistically literate and disciplined retail investors. However buying large quality companies with moats, a la Buffett...that's an art. There are people who have tried to code that, of course, but getting Buffett's numbers with companies of that market size...I don't think you can do that with a formula, too many intangibles there. So those of us who are not artists have to hire one. If I had to forego mechanical investing I would be perfectly comfortable putting 100% of my money on something close to your selection of owner-managers. The main difference is that I would not short nor hold cash (because I am convinced that they hurt long term performance) and I would be more diversified geographically, investing in value-oriented mutual funds if I cannot find owner-managers. Then I would just rebalance the portfolio once in a while using P/B as a guide, nothing fancy, basically trying to avoid extreme situations. With such a portfolio I would sleep very well at night and be absolutely sure of beating the market 10 years from now, come what may.

Bmichaud, actually how long BAC takes to go from $12 to $20 makes a big difference in your return. If it takes 5 years to get there, you make 10.7% per year. If it takes 2 years, then you make 29% per year. That's why stock screens which include mild momentum indicators do better than those which don't. The absolute gain may be smaller if you buy at 52-w highs than at 52-w lows, but it comes about much faster. Regarding timing indicators, I think I've found a very good one, but I don't dare to use it to play at being in/out of the market. It makes lots of sense (it measures optimism in a quantitative way) and the previous two signals were spot-on but how can I be sure it will work now? The study that Plan Maestro has posted (thanks, extremely interesting stuff) shows timing to be a losing strategy in the long term. I've done many simulations, with all the possible timing systems I could find which show the same. You can reduce volatility, but you cannot increase returns significantly. At least I don't know how to do it, perhaps there is some black box somewhere at Medallion's or GS which manages to do it successfully. What you can do is use those timing indicators, which are always probabilistic, to choose which market you are invested in. Europe looks very bad right now from the macro point of view, and because of that stocks are statistically very cheap. So I am fully invested in Europe except for 20% in FFH.

If you change your exposure to stocks/cash depending on the overall level of the market, valuation or other indicators, it is timing. If you cannot find anything to invest which meets your standards, well then it is obviously not. And by the way, the fraction of bargains in the market is actually a mildly useful timing indicator.

The S&P500 earnings are around $105 and it's at 1517...so roughly about 15 times earnings. Neither cheap, nor expensive historically. It won't provide you returns larger than growth in GDP and inflation plus dividends. You also have no boost from interest rates, nor profit margins, which are at historical lows and highs respectively. Cheers! Sanjeev a question for you...do you attempt to do a rough calculation of the free "call/put option" of cash? It seems to me that this cash option has an inverse relationship with the market P/E. To state the obvious, when prices in the market are high (on average), cash's option is more valuable because the market has more downside. Do you think along these lines at all in terms of holding cash, or do you just say to yourself, "well, everything's expensive, and I wouldn't buy some of what I already own at these prices...so let me sell a bit and wait until things get cheaper"? I think most investment managers view cash as an asset class...one that doesn't do well relative to stocks when viewed long-term. But their views become myopic when it comes to the short-term value of cash because of that very trait. So managers, and many investors, want to be fully invested at all times. If you cannot find cheap stocks, then buy alot more of what you already own...but stay fully invested at all times. Unfortunately, when you view cash in those terms, you never realize that very inverse relationship you described above. Cash doesn't have a 1-1 value when markets go down...it becomes exponential the further markets fall. So when you buy something at 1 times book, rather than wait for half of book, you give up significant returns...probably far more than the short-term low rate of return cash provides relative to stocks at higher valuations. Cheers! There is an objective reason for avoiding cash. It is intrinsically very difficult to find an accurate timing system which will increase your performance in the long term. Timing systems which generate many signals are useless. Those which generate few signals seem useful, but with so few instances the statistical confidence is not very high, and it is not always clear whether they will work in the future. As I have been writing for the last months, there are many signs that NA stock markets are likely to fall, and given current valuations, in a dramatic way. And of course, if one doesn't find anything interesting within his/her stock universe, it is absurd to buy. But I find difficult to justify going to cash with half the world's best companies on sale. It is true that there is huge uncertainties surrounding Europe, but as we all know, that's precisely what creates good opportunities...

The main parameter is a rank which combines several value ratios and financial solidness indicators (something which is present, one way or the other, in all value screens like Graham's Enterprising Investor or Piotroski's). Then I apply a moderate momentum selection (which helps to avoid falling knives, and reduces drawdowns) and try to buy the smallest possible companies (but always with enough liquidity). I buy a bit every week and typically hold the stocks for at least a year. Interesting. May I ask how it has worked for you? Quite well, as shown by my investment allocation...

Note to self: do not buy expensive junk. Problem solved. Next! I wouldn't buy cheap junk either...unless, of course, its price is below its net current asset value...

The Shiller ratio can't certainly be used as a timing indicator. It doesn't tell you when you are going to fall, but how hard you may hit the ground. Secular bear markets work by multiple compression, so a CAPE of 20 may be cheap in a bull market and precede a 60% drop in a secular bear. But CAPE is not the only indicator which tells you that US markets are expensive. Mark Spitznagel uses the Q-ratio, which paints a similar picture: http://greenbackd.com/2012/06/04/how-to-value-the-stock-market-using-the-equity-q-ratio/ As he shows, when you have large values of Q (like the current one), the probability of a large drop significantly increases. My timing indicator looks at the amount of expensive junk (companies which are both expensive, and in bad financial shape) in the market. I have been able to backtest starting from 1990, and it has produced 3 signals, 2000, 2007 and now. Of course, with three points only, you have to take it with a pinch of salt. But putting everything together, I think it is much safer, probabilistically speaking, to invest in EU stocks (which besides, is the contrarian thing to do) than to buy US stocks. Even if large caps are fair valued, a big market drop will drag everything down. This is the worst credit crisis since 1929, with markets which reached a CAPE of 45 in 2000. I think it is very unlikely that the secular bottom was reached in 2009, with a CAPE twice as high as the one reached in 1982. We need to see more multiple compression, and the higher interest rates that moore_capital mentions can be the trigger, without any need for external shocks (not that there will be lack of them...)

The main parameter is a rank which combines several value ratios and financial solidness indicators (something which is present, one way or the other, in all value screens like Graham's Enterprising Investor or Piotroski's). Then I apply a moderate momentum selection (which helps to avoid falling knives, and reduces drawdowns) and try to buy the smallest possible companies (but always with enough liquidity). I buy a bit every week and typically hold the stocks for at least a year.

Spain's market is very cheap, statistically speaking. That doesn't mean that it can't get cheaper, of course. But last year my screens didn't return any Spanish stocks, now you get a few, which means that some companies are returning to profitability but are still very cheap, some examples are Duro Felguera, Endesa, Repsol, Prim. I don't know about Santander. Botín is a terrible person, but an amazingly competent banker.

~20% in FFH (but shrinking a bit because of the recent drop in the $) ~40% in Bestinver International (which is 90% invested in European stocks) ~40% in a basket of 30 European stocks selected with mechanical screens (and which have gone up by 7% in January). No cash, no leverage, no hedging (if you exclude FFH). As I have mentioned, my timing indicator warns of a crash in the US soon. In addition, the Shiller P/E in the US is 23. To go back to their 2009 bottom, US stocks would have to drop by 55%. To get to a secular, Shiller P/E~8, floor, they would have to drop by 65%. The Eurostoxx50 is still 40% below its 2007 peak. The European Shiller P/E is around 14. A ~30% drop would already get EU stocks to a 2009-like bottom, and even that wasn't reached in 2011, when the sky was falling on our heads. A 40% drop would put EU stocks at a bear-ending, secular bottom. It seems obvious that, statistically speaking, the downside is much smaller for the eurozone than for the US markets. It seems to me that inflation will start earlier in the US than in the EU (at least while the tee-fest people are in charge). I mostly invest in small caps, but my screens are also throwing out large caps, like Exor, Endesa, Aurubis, Freenet, Portucel, OMV, Ahold, Voestalpine, Total. Experienced stock pickers like the ones in the board should have no trouble finding interesting stocks in the Eurozone.

Thanks to all for the help with Macro 101. I am glad to know that the numbers roughly add up...

Government spending is 47.3% of GDP in Spain, and it is now 5% higher than in 2007, which would add 2.4% to GDP.

Spain's gasoline and diesel consumption is now 20% lower than in 2007. In 2007 there were 180.000 new mortgages per year, now there are only 30.000. In 2007 we were building 760.000 homes/year. Now we are building less than 50.000. Not surprisingly, the unemployment rate has gone from 8% to almost 27%. However, the official GDP figures for Spain, audited by Eurostat (which depends directly from the European Comission) show that the GDP is about the same as it was in 2007. The question is for people who know about macroeconomics: How can this be? Even taking into account that inflation has gone up by 13% during this period, is it possible to undergo such a terrible economic contraction and yet keep the GDP floating in the air like Wile. E. Coyote?

If you *must* invest in NA, and nowhere else, well, then obviously lots of FFH and cash. How about LINTA, BAM, LUK as well. Registered in NA, international exposure and has the management and cash to act if opportunities come their way. LUK (and L and GLRE) are below book value, so they are probably good buys in the long term. BAM is a very solid company, with nice international exposure. But I'd be very surprised if you can't buy any of them much cheaper in the next year or two.

If you *must* invest in NA, and nowhere else, well, then obviously lots of FFH and cash.

I think macro is complicated in some aspects but very simple in others. What we can know is that: - This deleveraging, as any other on Earth except for Great Britain's after the Napoleonic Wars, will be solved by default, by strong inflation or by a combination of the two (Rogoff and Reinhart, see Ray Dalio too). There is no mathematical way developed countries are going to pay what they currently owe in real terms if you add up sovereign debt, pension and health care commitments. - In the developed world, the most powerful political constituency are middle-aged and old people, who apart from real state, are mostly invested in bonds and cash. These people also know that pensions will never keep up with prices, no matter how many laws promise to index them. They are aware that default or inflation will be an economic disaster for them, which means that before any government attempts to default or inflate its debt away, things have to get really ugly, 1930's, blood-on-the-streets ugly. There has to be such a terrible crisis that even people who know that they are going to lose a good chunk of their life savings see inflationary policies as a lesser evil. A very good bet therefore is that before inflation, there HAS to be deflation, nasty deflation. Inflation won't start casually. What we don't know (and can't possibly know): when and how this will happen. I think Japan is a misleading case, because of its incredible economic strength and social cohesion. Any other country but Japan would have collapsed into default or hyperinflation 10 years ago. So things may move faster that we expect. Or not. How does this translate into an investment thesis? If you are very smart (or think that you are) as Ray Dalio, Kyle Bass or Hugh Hendry, you can try to make money off it, by guessing right the timing and sequence of events. If you are not, I don't think the solution is to raise cash and try to time the market, unless you are absolutely constrained to invest in a single country. The best way to protect yourself is to keep away from expensive markets and be fully invested in cheap ones. At the bottom of the Great Depression, the Shiller P/E index fell to 5.6, in the 80's it fell to 6.7. If you invest at a Shiller P/E of 11, you'll see a 40% drop. If you invest at a Shiller P/E of 23, you may see your investments drop by 70%. So if you are in a cheap market and Armageddon arrives, you'll survive, and if it doesn't, you will still do very well, probably outperforming those invested in more expensive markets. It is interesting that Mark Spitznagel's results also predict an eventual >70% drop in the US market from current levels. At market bottoms you get Tobin's Q of ~0.3, now we are above 1. http://www.universa.net/UniversaSpitznagel_research_20110613.pdf So what will cause stocks to collapse? A Japanese implosion, war in Iran with long-term closure of the Hormuz straits, a disordered break-up of the Eurozone, war in the China Sea. Take your pick, there is plenty of trouble brewing in the world.

Thanks. I knew about GBL, but hadn't heard about IDI. I'll have a look, it sounds interesting.