Chou 2016 semi annual report

[Packer16]

Where does the money go at 0% rates?  Most of the stock declines in the past occurred when the earnings yield approached or was less than bond rates.  We still have a long way to go if rates stay where they are.  If it takes higher rates to cause declines then IMO we will be waiting a long time.  The other way is for earnings to decline.  How much will earnings have to decline? Now the 20 yr. treasury is at 2% & Damodaran's ERP is 5 - 6% so you have an equity expected return of 7 to 8%.  So to equate these two yields, earnings would have to decline by over 70%.  Do we think this is going to happen going forward?

 

Packer

[Parsad]

Where does the money go at 0% rates?  Most of the stock declines in the past occurred when the earnings yield approached or was less than bond rates.  We still have a long way to go if rates stay where they are.  If it takes higher rates to cause declines then IMO we will be waiting a long time.  The other way is for earnings to decline.  How much will earnings have to decline? Now the 20 yr. treasury is at 2% & Damodaran's ERP is 5 - 6% so you have an equity expected return of 7 to 8%.  So to equate these two yields, earnings would have to decline by over 70%.  Do we think this is going to happen going forward?

 

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No.  Outside of inflated tech stocks, equities are still appealing compared to the alternatives, so betting against stocks at the moment may not be the best idea. 

 

Question is, and there is ample ammunition for this line of thought, is there an exogenic event that would cause yields to go back to much more sensible levels?  The world is an economic powder keg at the moment...is someone or something going to light a match?

 

If yes, then staying out of most asset classes is a good idea.  If not, then stocks will continue to prove more appealing.

 

That being said, I do know of one asset class that provides equity-like yields with zero correlation to other asset classes.  In fact, an exogenic event would have little or no effect on this asset...insurance-linked securities!

 

Why every pension fund, endowment, family office and large hedge fund isn't allocating a portion of their capital into it, I don't know?!  But it exists!

 

www.sequantre.com

 

Cheers!

[petec]

Where does the money go at 0% rates?  Most of the stock declines in the past occurred when the earnings yield approached or was less than bond rates.  We still have a long way to go if rates stay where they are.  If it takes higher rates to cause declines then IMO we will be waiting a long time.  The other way is for earnings to decline.  How much will earnings have to decline? Now the 20 yr. treasury is at 2% & Damodaran's ERP is 5 - 6% so you have an equity expected return of 7 to 8%.  So to equate these two yields, earnings would have to decline by over 70%.  Do we think this is going to happen going forward?

 

Packer

 

I do wonder whether these relationships break down at interest rate extremes.  If not, then 50x earnings with rates at 2% is the equivalent of 33x earnings with rates at 3%, which seems a little crazy to me!  And we all know that stocks wouldn't stay where they are if earnings dropped, say, a mere 30%.

[AtlCDore]

I think investor expectations are so f**king wacky that investors themselves don't know what they are talking about.  Buffett hasn't beaten the indices over the last 7 years...is he suddenly retarded?  Not good enough?  A has been?  Apparently Chou, Pabrai and Watsa don't know what they are doing anymore!

 

I've made money for my partners since May of 2006...beating the indices over those years by about 3.5% annualized...that's the top 1% of money managers during that span.  Even this year, we are up 9% for the first half, while the market is up 3%, but I've got a partner who is pulling some money because I don't report often enough or consistently enough. 

 

I suppose they would prefer if I expounded on the markets, macroeconomics, stock picks and all of the other value investing bullshit you could put into a letter, instead of making money for them and working my ass off!  Incidentally, that 9% is on a portfolio holding about 45% PDH which hasn't moved...so I've returned about 18% at June 30th on half of the portfolio I could allocate into ideas.  Again, it must be time to part ways with me, since I have no f**king clue what I'm doing.  Maybe Francis should be put out to pasture with me...Pabrai too...he's really sucking ass right now. 

 

Anyone else you guys can think of that are poor performers?  Cheers!

 

Always better to weed out the partners who don't appreciate your process.

 

I have a couple theories as far as why a lot of managers start underperforming once they become popular.  Say you manage $20 million and grow it to $100 million over ten years without raising new AUM.  Once you have that track record and your first partners can trust your judgement and deal with the volatility a little better, it's easier to stick with the same process and keep doing what you do best.  Maybe even take on some investments that other managers would shy away from.

 

But now imagine someone throws another $200 million at you, so you have to manage $300 million.  The $200 million investor(s) don't like the idea of losing money.  But your original partners are a little better about that because you've already made a ton and proven yourself.  Since the fees on $300 million are much higher, you kind of change your process to bend over to the new investor(s) because you don't want to risk losing them.  I think this kills a fund or long-term track record.

 

One guy who comes to mind is that Arlington Value fellow.  He's raised so much over the past few years that I don't know how one can expect him to keep the same investment process.  It's simply very difficult to subject new money to lots of volatility no matter how great your previous track record is.  It becomes much harder when your capital base grows five fold.

 

The best long-term track records often come from those who basically shut down to outside capital after a certain period of time.  They stop caring about bringing in tons of new management and incentive fees and cashing in on their track record.  It becomes more about making money for their original partners and the pure enjoyment of the investing process.  Like Buffett.

 

Which ties a bit into my second theory.  It becomes much more fun to focus on things other than investing once you've made a killing if you don't love investing.  Look at Berkowitz.  He's too busy running some art exhibit or something.  And the game gets harder over time so you need to always have a passion for the game or you'll end up "being thrown out to pasture."  I'm sort of amazed by how many young people I meet that have a great sense for deep, insightful value investing.  The competition is so much harder today.

 

Anyway that's my theory.  It's very tempting to raise a lot of AUM but I think the slow process of being very mindful of your LP's and when you raise capital is a very big part of a solid long-term track record.  And mental health for the manager.

 

Congrats on good results by the way.

 

I think Picasso is wiser than his years.  He brings up a good point that most investors don't want to face.  I'd bet that for most funds their best returns took place during the earlier years and their performance tailed off after they raised the majority of their money. 

 

The other thing I would add is as funds get larger the mindset of the manager can and probably in most cases changes.  They start making a lot of money and begin to enjoy the fruits of all that money.  Their focus shifts to making sure the money stays in the fund meaning the management fee starts to become more important than the incentive fee.  They tell themselves as long as we don't "screw the pooch", the money will stay in the fund and I can live a pretty good life off of the monthly management fee.  Country Clubs, cars and houses soon follow and their focus is not on generating the best returns but keeping their lifestyle going. 

[Packer16]

Where does the money go at 0% rates?  Most of the stock declines in the past occurred when the earnings yield approached or was less than bond rates.  We still have a long way to go if rates stay where they are.  If it takes higher rates to cause declines then IMO we will be waiting a long time.  The other way is for earnings to decline.  How much will earnings have to decline? Now the 20 yr. treasury is at 2% & Damodaran's ERP is 5 - 6% so you have an equity expected return of 7 to 8%.  So to equate these two yields, earnings would have to decline by over 70%.  Do we think this is going to happen going forward?

 

Packer

 

I do wonder whether these relationships break down at interest rate extremes.  If not, then 50x earnings with rates at 2% is the equivalent of 33x earnings with rates at 3%, which seems a little crazy to me!  And we all know that stocks wouldn't stay where they are if earnings dropped, say, a mere 30%.

 

If you apply a 30% decline to current earnings you get an expected return on stocks of 5%, or an ERP of 3.6% pretty close to the average ERP of 4% over time.  So the 30% is already factored into prices with no interest rate decline.  IMO to reach an overvalued breaking point (ERP = 2% ala 2000) you we need both a 30% permanent decline in earnings and a 1.6% permanent increase in interest rates.

[KCLarkin]

I do wonder whether these relationships break down at interest rate extremes.  If not, then 50x earnings with rates at 2% is the equivalent of 33x earnings with rates at 3%, which seems a little crazy to me!  And we all know that stocks wouldn't stay where they are if earnings dropped, say, a mere 30%.

 

If you plot this relationship, you will see that risk goes up dramatically as PE increases. If you pay 50x (2% yield) and interest rates increase 1% (to 3% yield), then your stocks drop 34%. At a more "normal" 20x, the drop is only 16% for a 1% rise in rates. Theoretically, the risk premium should increase at lower interest rates to compensate for the higher risk. This risk premium puts a limit on the rational multiple you will pay.

[Spekulatius]

I do wonder whether these relationships break down at interest rate extremes.  If not, then 50x earnings with rates at 2% is the equivalent of 33x earnings with rates at 3%, which seems a little crazy to me!  And we all know that stocks wouldn't stay where they are if earnings dropped, say, a mere 30%.

 

If you plot this relationship, you will see that risk goes up dramatically as PE increases. If you pay 50x (2% yield) and interest rates increase 1% (to 3% yield), then your stocks drop 34%. At a more "normal" 20x, the drop is only 16% for a 1% rise in rates. Theoretically, the risk premium should increase at lower interest rates to compensate for the higher risk. This risk premium puts a limit on the rational multiple you will pay.

 

Very true.

 

These relationships fall apart on the fringes. As we approach the ZIRP singularity, strange things are going to happen.