txitxo

txitxo, you are surely very good at what you are doing! Congratulations! You talk exactly like the nuclear engineer friend of mine is used to talking. And he is very successful too. So, I do not doubt that your method has great merit and that it deserves to be studied. Actually, I wasn’t hedged in 2007. I was worried and I moved to blue chip stocks: BRK.B, KO, JNJ, PG and XOM. In 2008 they behaved better than the market, but they were down nonetheless… After they recovered, at the end of 2010, I sold them fortunately with a profit, and moved to owner-operated companies, which are the businesses I really like. Don’t get me wrong, KO, JNJ, PG; XOM, etc. are awesome businesses, but… what do I really know about them? Who am I really partnering with? When my firm starts a new business idea, I want to know everything there is to know about it, and I want to be sure the right people are in charge. So, I reasoned, why invest differently? As you might have guess by now, Mr. Singleton of the former Teledyne Inc. is my “role model”! By the way, have you read “The Magic Formula” by William Poundstone? It is interesting to note that Claude Shannon, a great scientist, at the end of his life could have boasted a wonderful track record in the stock market (not far from Buffett’s track record!). He ran a very concentrated portfolio, of which the greatest majority of funds (by far!) was invested in Teledyne Inc.! So, a scientist like you, invested in an owner-operated company, the way a business person like me would do, and was very successful! That gives me hope… My company engages in structural engineering for civil and infrastructural developments, and manages a for profit Master School at the Politecnico of Milan University. They are both low margins businesses, but what gets to the bottom line is all free cash (maintenance capital expenditures are almost nil, and also growth is very cheap). So, I extract cash from not too good businesses and try to redeploy it buying very good businesses at attractive valuations. In a sense, I am copying what Mr. Buffett did with Dempster Mill Manufacturing and many times again during his career! Unfortunately, I am not that successful… I judge our results based on the increase of my firm’s equity at the end of each year. So, my investments return is not the only part of the equation: the earnings from our operations matter a lot too. Until now we have done pretty well, but we are still young and unproven: we got incorporated in 2004 with little capital, started operations in 2005, and I began investing our original capital plus the first retained earnings in 2006. Right now the business environment in Italy is dire… Results from our operations will surely suffer! Fortunately, I work with permanent capital and I don’t have to worry about redemptions. I ask for Mr. Watsa (FFH), Mr. Einhorn (GLRE), Mr. Loeb (TPOU), Mr. Steinberg (LUK), Mr. Marks (OAK), Mr. Flatt (BAM), Mr. Tisch (L), and Mr. Biglari (BH) to help me!! ;D I could not agree with you more! ‘Thinking Fast and Slow’ is a terrific reading!!! giofranchi Giofranchi, I am a scientist but no Claude Shannon...he was truly a genius, and he had an excellent and privileged understanding of technology, that's a real competitive advantage. 2008 was pretty bad, things were dropping like crazy...what looked like solid companies were going bankrupt...luckily we had some cash and added significantly to the portfolio at the end of 2008. Then stocks fell even further in 2009...I really wished I had a hedge at that time, long term performance be damned. But suddenly, everything went up like a rocket after March 2009. And as Conan said, (well it was actually Nietzsche, but it sounds cooler when said by Conan) "what does not kill you makes you stronger". If you survive through a crash like that, still as a novice in investing, nothing else will scare you out of the markets in the future. By the way, García-Paramés from Bestinfond started in a position very similar to yours, he was investing Acciona's money, also an infrastructure company, when it was still called Entrecanales. In any case, as I've told my family, our "safety", long-term portfolio in case I could not keep investing with the current system, is to put everything into L, LUK, FFH, MKL, BAM, SHLD, BRK + Bestinfond...so we think quite alike. I'm sure you'll do very well with your portfolio...you have chosen very good companions to help you with it.

I was going to answer this in detail, but I found that somebody else had already done it: http://can-turtles-fly.blogspot.com.es/2011/12/warren-buffetts-evolution-and-his-three.html

txitxo, maybe I misunderstood you, but on a 10 years basis the table shows a much better performance with equity hedges than without equity hedges... Well, from the table, the total return for the *first* 10 years, as I said in my message, that is, between December 31 1995 and December 31 2005 was 1.172**15/1.142**5= 5.57 times the initial investment for the hedged strategy, whereas for the unhedged one it was 1.148**15/1.069**5=5.68 times. Even for Watsa, and going through the 2000 crash, hedging may take a while to pay off. Well, of course I tried to do that... and it never really worked! But I guess it never worked JUST FOR ME. It usually does not work for most people. Have a look at the mechanical investing forums. Typical causes are too frequent trading, choosing screens which are backtesting flukes or not diversifying enough. But the worst one is handpicking stocks from the screen. Screens work statistically. Some of the companies look like utter crap which no self-respecting value investors would touch with a 10-feet pole. Imagine explaining why you bought that to your clients, specially if the company later goes belly up. However, often enough it turns out that utter crap is just crap, and instead of selling for P/B=0.25, it goes to P/B=0.5 and you make 100% on it. The really cheap stocks are the ones that not even value investors will buy. Well, your comments illustrate where my edge is. I am not interested in winning the value investor purity award. But I think I understand how value investing works, from a mathematical point of view. And although this may sound like sacrilege to many people in this board, my impression is that most of the stuff about intrinsic value, Mr. Market, margin of safety, etc. is just nice folklore. You ask 2 competent investors to estimate the value of company and you'll get 4 different opinions. It is not just a question of appraisal error. Valuations can differ by a huge amount. Sometimes very competent people short a company while others are buying it. Do you know any value investor which hits 100% of its pitches, no matter how large the margin of safety he uses? And has anybody figured out which economical or mathematical law ensures that prices converge towards a quantity that nobody agrees about? No, of course. But the facts are clear: value investing works. Why? I think that what Graham and others found is that there are a few little corners in the stock parameter space where markets tend to temporarily misprice companies. Probably due to a combination of herding and some faulty wiring in our system 1 (I loved Kahneman's book). If you buy stocks in that area the statistical mispricing will correct itself eventually (because markets are efficient in the long run, that's Graham "weighting machine") and you'll beat the indexes. So you can read the balance sheet, talk to the CEO, visit the premises, and taste their products. But in the end, even if you don't know about it, the crucial part which will determine your results is where in the stock parameter space you are sampling from. And there *are* people out there using value screens. I remember reading that Jim Grant and Renaissance Technologies were buying Net-nets. There are many fundamental funds which are quantitative-based. But like I said before, the more money you manage, the most difficult it is to outperform using this approach because large caps are much more efficiently priced. Well, congratulations on reading Buffet letters twice! That makes you a true value investor. I obviously am not implying that Buffett, Schloss and Graham were running screens on their iPads and buying 50-stock portfolios (although that is not so far away from what Schloss did in practice, if we substitute Value Line issues for the iPad). What links those three investors is the "good price, fair company" approach. You can approximate that with a system like the one I described. Later, Buffett changed to "good company, fair price". That's a totally different game. You must be really curious, to request quotes of unverified performance in an anonymous forum. Anyway: about 10% above the August 1st 2007 level, most of the money and most of the time in European Small caps. Some friends recommended me in 2011 that I set a public record of my performance, so in a few years we may be able to truly settle this discussion. And what about you, Giofranchi? How well have you done with your hedges? They certainly would have been a nice thing to have in August 2007.

Well txitxo, I won’t speak about the Dark Energy endeavour… but I hope that studying and acquiring businesses will prove to be, at least, a little bit profitable!! :) Take a look at the attachment: it is from the FFH's 2011AGM, and it shows the Hamblin Watsa Investment Performance in common stocks, with and without equity hedging. On a 5, 10, 15 years basis, the performance with equity hedging is significantly superior to the one without equity hedging. Even on a 15 years basis, the strategy with equity hedging returned 2,4% per year more than the strategy without hedging, which is big! On a 5 years basis, the strategy without hedging got literally killed! You may object that FFH can’t invest only in small caps. And you would be right: they are compelled to invest in medium and large cap stocks. So, is it possible that, if you invest in small caps and hedge, your performance will suffer, while, if you invest in medium and large caps and hedge, your performance will be much better? Is that what your model suggests? If so, why are you investing in FFH without hedging? I wouldn’t define FFH a small cap! That's exactly why I am hedging!! giofranchi You, of all people, will understand very well why I invest in FFH. This is not a normal stock investment. Imagine that the eurozone breaks up and the new peseta or lira depreciate by 50%. Your foreign stock holdings would appreciate by 100%. Those are taxable capital gains. And imagine the new government sets the new tax rate, for "speculators", at 50%. If you sell a stock, you would lose 25% of your capital even if its price in dollars (or euros) didn't change. After a few years I am sure that the capital gains tax rate will go down, but in the aftermath of an euro exit anything can happen. So if you have to put a fraction of your money in a stock which you will not be able to sell in 10 years, even if the euro breaks up and the world markets sink like the Titanic, which one would you choose? LUK or FFH? I hope that the eurozone survives and, in the future, I'll be able to redeploy the money in FFH to more productive investments. But these are exceptional times and one should chop off as many nasty tails as possible. Thanks for the FFH attachment. This sort of qualitatively agrees with my simulations. When you don't have much money to invest, you can always live in "P/E~7 land" and buy a basket of stocks which have valuations similar to those of a market bottom. That gives you considerably downward protection (although sometimes they can go to P/E~4). So in principle you don't have to worry much about what the general market is doing. You stay fully invested, buy some omeprazole at market crashes, and see your money grow. Only rarely you cannot find ANY company to invest in, and have to go to cash. That's pretty much what Walter Schloss did. But if you manage billions, like Watsa, the market for the large caps is much more efficient, and such valuations only exist at panics. Investors at that altitude have to buy what they can, and go to cash when they don't find anything or hedge when the valuations are so-so. Managing when to buy, when to go to cash, and when to hedge is a high form of art. In any case, if you look at the returns in the FFH table, you see that the first 10 years, the returns for the unhedged stocks was slightly higher than for the hedged ones. And that's for Watsa, who is the world champion of hedging. I bet almost any other investor would see a serious underperformance unless they used margin to pump up their alpha, exposing themselves to a major blow up. My impression is that almost anybody managing up to few million could theoretically reproduce or at least get close to what Walter Schloss or the early Buffett did (the main limiting factors are character and discipline). Just choose 4 or 5 screens, e.g. Graham's enterprising investor formula, Graham net-nets, Graham Defensive Investor and Piotroski. Or design your own value screens using realistic backtesting. Avoid too thinly traded issues (or slippage will kill you) and aim for a portfolio of at least 55 stocks. Move among the major world markets to make sure you always have enough stocks to buy (this is crucial). Do not try to rebalance monthly or commissions will eat you up. Just sell and buy 1 stock every week, that'll ensure you keep them a bit longer than 1 year to avoid short terms capital gain taxes. If you do that consistently, I don't know whether you'll get 20% a year, but I guarantee that you'll put most mutual fund managers to shame. But doing what Watsa, Berkowitz or the late Buffett do? No way of putting that into a mathematical formula. That's like painting the Sixtine Chapel or composing Mahler's Resurrection Symphony.

Thanks! Very useful information.

Let's just say that because of my professional experience, I could write a little book about the perils of overfitting and data mining. That's why I combine value investing with statistics. If you don't have a guiding framework you will find all kind of fake correlations in the data. That's probably what caused the quant implosion in 2008-2009. I've done many backtests, as realistic as possible, with different investing strategies, and I find myself time and again just reproducing Warren Buffet and Ben Graham insights in mathematical form. For instance, if you invest in small caps, almost any strategy similar to Ben Graham screens (cheap + financially sound companies) works beautifully. And that's basically how Graham, the early Buffett and Walter Schloss invested. You just go to the region of the stock space where it is easier to find unwarranted pessimism, sit there for a while and make out like a bandit. However, the simulations also show that once you have a large pot of money to invest, it is very difficult to outperform just based on ratios. Every company is scrutinized to death by the market, and investing becomes an art, with very few high level practitioners. That's where you have to start worrying about moats, quality, etc. It is amazing to see how Buffett chose at every moment the optimal investing strategy for the amount of money he was managing. The simulations show that when you can invest in small caps, hedging and going to cash significantly damage the long term performance. You reduce the volatility, but also the returns. Warren Buffett of course knew that in his 20's, without having to do any simulations, and he was always fully invested at the beginning of his partnership period, even when he was managing OPM. I also try to be fully invested at all times, but in the markets which offer me the best odds. Europe is much better than the US or Canada at this time. In any case, I understand you, Giofranchi. If your passion lies in analyzing business, go for it. After all, I spend most of my time trying to figure out what the heck Dark Energy is, a fascinating but not very profitable endeavor. And by the way, I too gave a hard look to LUK the other day. Extremely tempting, but I bought FFH instead. My models say that it is very likely that there will be better times to buy LUK during the next year.

The indicator was much higher in 2007 than in 1999, which was actually a relatively good time to be in the market for value stocks. The bubble did not affect all sectors. Now the US is getting pretty ugly, almost at the same level as early 2007. Canada is actually the most dangerous market I see, specially companies involved in energy and natural resources. There is a huge amount of optimism there. In Europe it's OK, still within the safe zone. In Japan is ridiculously low.

Thanks for the good wishes, Plan. But the debt/GDP ratio is more 90% than 70% once you take into account all the hidden liabilities. Providers have not been paid in many months, there are many off the balance sheet public companies which are bankrupt. Today's front pages are filled with news that many regional governments have stopped payments to hospitals. Add ~7% deficit more this year and probably 5% the next, and we are already over 100% at the end of 2013. That, we could manage. In fact we are already negotiating a full bailout with the Troika. But having to pay a bank debt of >30% of the GDP is like getting a big boulder dropped on your head when you are barely managing to stay afloat. No easy way out of this. Either Germany truly accepts direct recapitalization of banks (which will be sorely needed for Italy and France further down the road), with the ECB printing a couple trillions, or the euro is toast.

Thanks for the tip. I didn't know about Flinvest, pretty impressive record. But I never invest with managers which charge 2 and 20, no matter how good they are: http://castlehall.typepad.com/risk_without_reward/2010/10/buffett-versus-2-and-20.html.

You have to balance the balance sheet with the profit effect. Anyway, real estate is not the main problem in Spain as we in Latin America very well know. Krugman recognizes mistake: http://krugman.blogs.nytimes.com/2010/04/14/the-secret-of-the-banks-success/ My impression is that the big Banks, that is, Santander and BBVA, should be OK. They saw what was coming, they were much more conservative giving out mortgages (young couples used to complain) and, as it has been discussed in the STD thread, they have large and profitable operations outside Spain. But that is not the case for the rest of the financial system, which barely has any international presence and is full of toxic assets. Bancaja (one of the banks which merged into Bankia) had a ballet dancer on the Board. She of course couldn't read a balance sheet and just signed whatever they put in front of her. The Board of CAM falsified the accounts to get bonuses. The public banks were run by politicians, often for their personal profit. There are at least 1.5M of new, empty housing units in Spain which either belong to financial institutions or are financed by them and which will have to be sold at 1/3 of the price they had when built. We have a functioning state and tax system, and with a reasonable amount of cuts and reforms we could repay our public debt. It would be hard, but we have killed worse bulls. However, it is arithmetically impossible to bail out our banks. The total hole is probably 30-40% of our GDP. That debt has default written all over it, and it will be eventually paid by the ECB printer or not paid at all.

I really don't have many details, I know about them from the press. As far as I understand, they have just set up clones of their main three funds (with differ in the fraction of Iberian stocks). This is the Bloomberg quote for one of them: http://www.bloomberg.com/quote/UISBESX:LX

Spain's property market is still expensive, generally speaking. Of course you can find good deals if you know how to look for them. Some people are using a "shotgun" approach, they look for 20-30 properties similar to what they'd like to buy and make extremely low offers to all the owners. In some cases they receive replies which illustrate how powerful the Spanish language is for cursing, but almost always one or two of the owners are so desperate that they will sell at prices well below official valuations. I think rental yields are useful to give you a sense of where prices should go. In the last "big crisis" in Spain the price/ gross rental ratio was P/E ~30 in 1974 and it reached P/E~11 in 1984 (just before we entered the European Union). We also started with a P/E~30 in 2006. Rents have gone down by 25% since then, and although it is difficult to gather good information, it seems that real market prices for housing are down by at least ~45%. So we are still at P/E ~25, and to get to P/E~11 we need an additional 50% drop from today's prices. And that's assuming that we don't go below P/E 10, this crisis is already much worse than the one in the 70's. Now, when you feed these prices into the bank balances (where housing is only down by 25%) you'll realize why Egan-Jones says that 100.000M€ is not enough to bail out Spanish cajas, and that you probably need 4 times that amount...

What if anything are people on this board buying in Europe? Buy Bestinfond. These guys have been systematically outperforming the indexes since 1993. If you don't want to send your money to Spain they also have a fund in Luxembourg for non-residents in Spain: http://www.bloomberg.com/quote/UISBINX:LX . Apart from a large position on Bestinfond, we are buying a basket of French and German small caps with solid financials and ridiculously low valuation ratios, a variation on Ben Graham's cigar butt approach. Once in a while one of them implodes, but on average they do very nicely.

Thanks for the Gave paper, Giofranchi. It is an interesting viewpoint, but certainly not a contrary one. People expect very bad news from Europe, and therefore European stocks are very cheap, way cheaper than American stocks. Can they go down 40% from this point? Certainly. But if they do, they will get to secular bear market valuations. On other other hand, US stocks need to go down by 40% just to be where European stocks are now. You'll need another 40% drop to make an undisputed bottom. That's why I only trust FFH in NA, I consider it as an inflation protected bond in a safe currency. Benjamin Roth's book is fascinating. But his investing advice is based on hindsight. You never know for sure what is going to happen, so you have to choose the strategy which maximizes your returns a priori. Being hedged for long periods of time is no such strategy, unless you use lots of margin. And that's what almost killed Ben Graham's partnership in 29-31. After that near-death experience he "invented" value investing, which, almost by definition, should be the best way of sailing through a Great Depression. From a cold, mathematical point of view, what we do is just place bets with the odds in our favour. Nobody knows for sure whether a company is going to go up or down. We just use the knowledge, based on experience, that if you buy companies which a) are much cheaper than comparable ones (e.g. intrinsic value much lower than market price) b) have stable long term behaviour (a.k.a. moat), and c) you average over a large enough number of stocks (diversification) d) and over a large enough stretch of time (long term) you'll beat the index. In fact if a) is cheap enough (cigar-butts) you don't need b). It worked during Ben Graham's time and keeps working now because of how human beings are wired.

It is a numeric indicator, but I'd rather not give the exact details. My research shows that once the fraction of expensive crap reaches 3% of your stock universe, the returns for a value investing strategy are ~-1% on average, with a large scatter. It is basically a coin toss. It is not worth being invested in that situation. The indicator is getting close to 6% now, that only happened before in 1999 and 2007. In Europe the indicator is still below 3%. I got my inspiration from James Montier's "Joining the Dark side: Pirates, Spies and short sellers", so people with access to a reasonably good stock screener could reproduce his screen.

Speaking about valuations, 1982 was 2011 in Europe (have a look http://mrmarket.eu/). The Shiller P/E hit 11, the same level it had in 1982 (of course it went well below 10 in 1975). I have looked really hard at how to use value-informed statistics for investing (as a scientist, that's my circle of competence). Valuations are very limited tools. They obviously identify extremes, if the Shiller P/E hits 30, run for the exits, and if it gets close to 5 you should pawn all your possessions to buy stocks. However, anything in the middle is useless as a short term predictor. You can have a 40% drop from P/E=11, although you will do well in the long term if you buy at that level. The best tool I've found for timing (where "timing" is ~1 year) is what I call the "expensive crap" indicator. You look for companies which have really bad financial indicators, lots of debt, fuzzy accounting, etc. but which are relative expensive in a statistical sense. That of course will not tell you much about any single company, but when you look at the aggregate, at their fraction in the market, it is a very accurate signal of overall "optimism". And we all know what happens when too many people are paying too much for objectively crappy companies just based on their "stories". That indicator is now flashing crimson red for the US market, may be due to QE3 expectations. Every time that happened since 1990 the returns were extremely poor during the next year. That's why I also have a large chunk of my portfolio in FFH and keep adding to it. The Euro-core countries, on the other hand, look like a safe place to invest right now. Lots of pessimism already baked into the prices.

Thanks. I'll have a look at them.

That's what we did in 2004. It was so obvious that there was a huge bubble in Spain that we sold our apartment after doubling the money we paid for it, rented a nice villa (paying a 1% rental yield), read a bunch on books on value investing and started managing the money from the sale. We've done pretty well since then, despite this being the worst environment for investing since the Great Depression. House prices have gone down by almost 50% in our area in real terms, but they still have a long way to go (rental yields are still ~3%, I am pretty sure they will eventually get close to 10%, as it happened in the 80's ) so we keep renting and enjoying life. As a value investor I am reluctant to short anything. But since 2007, the stock prices of Spanish banks and real state companies heavily involved in the housing bubble have gone down by a huge amount. The pattern in Canada (and for instance in Brazil) is starting to look the same. So I am trying identify the Canadian equivalents of Metrovacesa and Banco de Sabadell to keep an eye on them.

For the Canadians in the forum: which do you think is the best practical way of shorting housing in Canada? It may take some time to burst, but you have all the symptoms of a housing bubble forming, same as in Spain 6-7 years ago. The Canadian banking system looks very solid (as Spanish banks did 6 years ago). Which Canadian banks are more exposed to housing? Which are the weakest construction or construction-related companies (suppliers, etc.)?

My bet is that the US and UK markets will have negative returns during next year. There is still too much optimism. I am also betting that the eurozone markets will produce good returns, not only the eurocore, but specially Greece, Spain and Portugal. As Templeton said, one should buy at the point of maximum pessimism. And we are pretty close to that point. If things get sorted out in Europe, it will necessarily involve lots of money printing by the ECB, something positive for stocks. If, on the other hand, the euro breaks up, and you can't take your cash out of your country, which is the only safe thing to buy? Stocks. Look at Argentina in the 90's or to the Weimar republic. Gold can get confiscated, cash evaporates, bonds default. Only people owning stocks kept their wealth long term. So nobody knows when the bottom will be (probably a few days after a country leaves the euro zone, or the day before the ECB switches on the printer), but that bottom has to be close, the markets are ridiculously cheap. Buttonwood's column explains it very well : http://www.economist.com/node/21556299. About my returns, I am down by 7.9% since January 2nd 2011. Not stellar compared with other people here. But not too bad taking into account that I've been almost 100% invested in European stocks (French and German), and the Eurostoxx50 is down by 27.15% since that date.

That is an interesting point of view. The thing is that many Spanish firms are arguing that the problems in Spain are overblown because of their large Latin American presence. But if they are stopped from repatriating funds, like the Argentinian banks recently, the argument can show some cracks. These are some of the Spanish firms with Argentinian presence Gas Natural Fenosa, Endesa, Santander, BBVA, Mapfre, Telefónica, ACS, OHL, NH, Sol Melia, Inditex. None of those companies is so exposed to Argentina as Repsol, which derived 26% of their profits from YPF. For instance Argentina represents only 3% of the Santander Group earnings, or 5% of the BBVA. Brazil and Mexico are much larger markets for Spanish companies.

Forget about Argentina. The government there is totally focused on the short term, trying to find resources to keep the public spending machine going in an attempt to win 2/3 majority in the congressional elections and amend the Constitution to get Cristina Fernández an additional term. They are following the Hugo Chávez manual to the letter. Remember that Warren Buffett still keeps a Cuban stock certificate as a reminder that, no matter how good the fundamentals, country risk can and will kill you. Argentina had one of the highest GDP/person in the world in the first half of the XXth century, in fact it is still one of the best educated countries in the world. And look at them now. Compare their trajectory in the last 40 years with Brazil or Chile. There are countries which choose to self-destruct, and there is nothing you can do apart from getting the hell out of them. The contrarian thing to do is give a good look at the Spanish stocks, some of which are very cheap. Repsol boss, Brufau, looks extremely relieved to be out of Argentina. They are suing the Argentinian government, trying to recover as much cash as possible to focus on their extremely interesting partnership with Petrobras to exploit the pré-sal findings in the Brazilian atlantic coast. There are plenty of other Portuguese and Spanish companies which obtain most of their earnings outside the Iberian Peninsula (and outside places like Argentina) and which are suffering unfair group punishment. For instance have a look at the top 5 holdings of Bestinver Bolsa: Semapa, Sonae, Corporación Financiera Alba, Ferrovial, Portucel, etc. Those guys are hard-core value investors, who have been beating the indexes by 7-8% for decades.