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The Era of Uncertainty - Francois Trahan & Katherine Krantz


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[amazonsearch]The Era of Uncertainty[/amazonsearch]

 

I know that many of you don’t believe macro is really useful, but, please, read the following passage from “The Era of Uncertainty”, written by Mr. Trahan and Mrs. Krantz:

 

 

David Einhorn of Greenlight Capital – arguably most famous for shorting Lehman Brothers in 2007 – told his personal tale of learning this lesson at the Value Investing Congress in October 2009. He referred to a speech he delivered in May 2005 at the Ira Sohn Investment Research Conference when he recommended MDC Holdings, a homebuilder, at $67 per share. The stock reached $89 within two months, but anyone who held on to the position rode it down with the rest of the sector in 2007. H said,

 

“Some of my MDC analysis was correct: it was less risky than its peers and would hold up better in a down cycle because it had less leverage and held less land. But this just meant that almost half a decade later, anyone who listened to me would have lost about 40 percent of his investment, instead of the 70 percent that the homebuilding sector lost.”

 

The reason he gave for revisiting this story was that it was not bad luck, but bad analysis. He contrasted what he said that day with what he heard from legendary hedge fund manager Stan Druckenmiller a bit later in the conference. Stan’s chosen topic was the grim story of the problems we faced from an expanding housing bubble inflated by a growing debt bubble. David wondered, even if Stan were correct, how would one translate such big picture macro view into a successful investment strategy? He soon had the answer to his own question:

 

“I ignored Stan, rationalizing that even if ha were right, there was no way to know when he would be right. This was an expensive error. The lesson that I learned is that it isn’t reasonable to be agnostic about the big picture. For years I had believed that I didn’t need to take a view on the market or the economy because I considered myself to be a “bottom up” investor. Having my eyes open to the big picture doesn’t mean abandoning stock picking, but it does mean managing the long-short exposure ratio more actively, worrying about what may be brewing in certain industries, and when appropriate, buying some just-in-case insurance for foreseeable macro risks even if they are hard to time.”

 

David then proceeded to discuss the macro risks he believed were facing the markets at that point in late 2009. We couldn’t have said it better ourselves.

 

 

I remember in 2010, at the Value Investing Congress held in Trani (Italy), Mr. Parames of Bestinver Asset Management, after exposing how crazy things were in Spain, made the following joke: “Well, I guess at least we are good soccer players!” (Spain had just won The World Championship). And I remember that I asked him: “If you saw it coming, why didn’t you short Spain?”. He answered: “Because of the timing. I couldn’t predict the timing.”

Now, I have read that many of you are long BAC and AIG, and… are you sure of the timing? Can you really predict when your investment in BAC or in AIG will pay off? “buying some just-in-case insurance for foreseeable macro risks even if they are hard to time.” Things hard to time are the bread and butter of value investors, of the cool, the patient, of people who are able to sit still in a room doing nothing (paraphrasing Mr. Pascal). Does it really matter if those things are on a micro or on a macro level?

Imho, this is exactly what Mr. Watsa is so unbelievably able to do:

2007: he did not ignored Mr. Druckenmiller advice and bought some just-in-case protection,

2009: with the S&P500 at almost half of its former high, and with Wells Fargo at $8 (I still can ear Mr. Buffett saying back then: “If I had to put all my wealth in just one stock, right now it would be WFC!”), he became greedy,

2011: with the S&P500 up almost 100% from its 2009 low, he managed FFH long-short exposure ratio accordingly.

 

So, strange as it might seem, I probably recommend “The Era of Uncertainty” more to “bottom up” investors, than to “top down” analysts: I think they could find something very useful!

 

giofranchi

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All I wanted to know about macro and investing I learned it from a guy that:

 

* understood macro more than all the tourists out there.

* was one of the first - with Frank Knight-  in highlighting the key role of uncertainty.

* was a great author, and wrote Chapter 12 one of the great introductions to financial markets

* to top it all, is one of the best investors ever and a pioneer of value investing.

* and he did all that in a period much more difficult than the one we are facing.

 

* It is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behavior that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy.

 

* We have not proved able to take much advantage of a general systematic movement out of and into ordinary shares as a whole at different phases of the trade cycle.

 

* 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… One’s knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence.

 

* Many of the greatest economic evils of our time are the fruits of risk, uncertainty, and ignorance. It is because particular individuals, fortunate in situation or in abilities, are able to take advantage of uncertainty and ignorance, and also because for the same reason big business is often a lottery, that great inequalities of wealth come about; and these same factors are also the cause of the Unemployment of Labour, or the disappointment of reasonable business expectations, and of the impairment of efficiency and production.

 

 

It is OK to worry and is OK to filter difficult to understand stocks. But if after finding some true bargains, that can survive all those worries, and are understandable ... that hypothetical investor doesn't buy? The only thing to conclude is that that investor doesn't have the temperament for the game and he would be better off buying an index fund and forgetting about it.

 

http://www.cornerofberkshireandfairfax.ca/forum/general-discussion/wsj-keynes-one-mean-money-manager/

http://online.wsj.com/article/SB10001424052702304177104577313810084976558.html

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PLANMAESTRO,

 

I have read an insightful book about how Mr. Keynes invested: “Keynes and the Market” by Justyn Walsh. And I recommend that book too.

 

Maybe I am wrong, and my investments in FFH and GLRE will turn out to be poor investments. Then, my firm will suffer much, because they are our largest investments by far… Anyway, they are made on the assumption that both Mr. Watsa and Mr. Einhorn have the right temperament to be very good investors. Even though they do not disregard the big picture. If this assumption is correct, I do believe that FFH and GLRE will turn out to be worthwhile investments.

 

giofranchi

 

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PLANMAESTRO,

 

I have read an insightful book about how Mr. Keynes invested: “Keynes and the Market” by Justyn Walsh. And I recommend that book too.

 

Maybe I am wrong, and my investments in FFH and GLRE will turn out to be poor investments. Then, my firm will suffer much, because they are our largest investments by far… Anyway, they are made on the assumption that both Mr. Watsa and Mr. Einhorn have the right temperament to be very good investors. Even though they do not disregard the big picture. If this assumption is correct, I do believe that FFH and GLRE will turn out to be worthwhile investments.

 

giofranchi

 

So you prefer to buy a below average reinsurer at book value instead of an above average insurer at half book value because of the macro foresight thing? That does not sound like a good reason, especially w/ Einhorn where you are making a big assumption that he knows what he is doing on that macro front. To me it looks more like public relations stunt with those small positions.

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One’s knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence.

 

I invested in GLRE, because I think I know and understand what they are doing. Instead, I have no particular insight in AIG… It is very tempting to follow Mr. Berkowitz and many of you, who are great investors, in AIG at half book value! It is just that “I personally DON’T feel myself entitled to put full confidence” in AIG.

 

Anyway, why do you judge GLRE a below average company? Please, look at pag.7 of the file attached: they achieved a 11,7% CAGR in book value per share from 2004 to 2012. And it was not an easy time! Furthermore, look at pag.9: they achieved that CAGR while being significantly under leveraged, if compared to other insurers/reinsurers. Then, please look at page 11, 21 and 38: GLRE’s combined ratio has stayed well below 100% in 2007, 2008 and 2009, and was slightly above 100% in 2010 and 2011; investment return was an annualised 9,6% since formation of GLRE, but it was not an easy time! In the GuruFolio attached you can find that Mr. Einhorn had achieved returns of 29% from May of 1996 through August 2006. On page 38 you can see that, if the combined ratio stays around 100%, and Mr. Einhorn compounds capital at 10%, and GLRE stays very under leveraged, a 13% CAGR in book value per share will be achieved in the future. What if Mr. Einhorn will compound capital closer to the 29% he achieved in the 1996-2006 period? What if the GLRE will get a little bit more leveraged? It has still very ample room to grow its float an to write more premiums! What if an hard market finally arrives and their combined ratio falls below 100% (like in 2007, 2008 and 2009)? After all, even Markel, which is a very good underwriter, had a combined ratio higher than 100% in 2011. I think we are talking about CAGR in book value per share ranging from 20% to 30%: not exactly my idea of a below average company! What if the market recognizes the potential for growth and price GLRE at 1,3 or 1,4 x book, instead of book value?

I know you will now demolish my thesis… you are welcome!! That’s what I look for!

 

giofranchi

Greenlight_Re_2012_Investor_Meeting.pdf

GuruFolio_DavidEinhorn_2012-06-30.pdf

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All I wanted to know about macro and investing I learned it from a guy that:

 

* understood macro more than all the tourists out there.

* was one of the first - with Frank Knight-  in highlighting the key role of uncertainty.

* was a great author, and wrote Chapter 12 one of the great introductions to financial markets

* to top it all, is one of the best investors ever and a pioneer of value investing.

* and he did all that in a period much more difficult than the one we are facing.

 

* It is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behavior that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy.

 

* We have not proved able to take much advantage of a general systematic movement out of and into ordinary shares as a whole at different phases of the trade cycle.

 

* 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… One’s knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence.

 

* Many of the greatest economic evils of our time are the fruits of risk, uncertainty, and ignorance. It is because particular individuals, fortunate in situation or in abilities, are able to take advantage of uncertainty and ignorance, and also because for the same reason big business is often a lottery, that great inequalities of wealth come about; and these same factors are also the cause of the Unemployment of Labour, or the disappointment of reasonable business expectations, and of the impairment of efficiency and production.

 

 

It is OK to worry and is OK to filter difficult to understand stocks. But if after finding some true bargains, that can survive all those worries, and are understandable ... that hypothetical investor doesn't buy? The only thing to conclude is that that investor doesn't have the temperament for the game and he would be better off buying an index fund and forgetting about it.

 

http://www.cornerofberkshireandfairfax.ca/forum/general-discussion/wsj-keynes-one-mean-money-manager/

http://online.wsj.com/article/SB10001424052702304177104577313810084976558.html

 

Plan, excellent post ! thanks for sharing

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I think the difference betwenn AIG/BAC and GLRE is the market's percepetion of them versus the underlying economics.  All AIG and BAC have to do to be winners is achieve average performance and have a typical market to approach book value.  GLRE has to have above average performance and receptive market to price it above book value. 

 

It also depends upon what your objective is in holding these stocks.  If it is a more defensive position then GLRE and FFH may make more sense but if it is to increase capital gains betting on BAC and AIG has better odds (returns) as long as BV is a conservaitve estimate of value.  On note on GLRE, Mr. Einhorn gets paid pretty well to run GLRE so a good portion of the gains go to him vresus the investors.

 

Packer

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Thank you very much Paker!

Actually, the most important thing for me is to sleep well at night… then comes capital appreciation.

 

I believe that in an insurance business the quality of management is paramount. And, before investing in an insurance company, I require to know what they are doing and why. I think I know and I think I understand what Mr. Watsa and Mr. Einhorn are doing.

PlanMaestro wrote: “you are making a big assumption that he knows what he (Einhorn) is doing on that macro front. To me it looks more like public relations stunt with those small positions.”

Actually, since the formation of GLRE, average gross exposure was 90% long and 53% short. It doesn’t really look like the shorts were/are such small positions after all! And, as he said, macro reasoning help him choose the right long-short exposure ratio. His exposure to gold derives from a macro reasoning, and it surely is not a small position (at the end of Q2 2012, gold was GLRE third largest position, after Apple and General Motors)!

 

Vice versa, I will not pretend to know what AIG’s management is doing.

But I agree with all of you: for anyone who understands well what AIG’s management is doing, and reckons that they are doing a great job, AIG today is a wonderful opportunity!

 

One more thing on GLRE: the 11,7% CAGR in book value they achieved from 2004 to 2012 is, of course, after paying Mr. Einhorn. Results from investments are after management fees.

 

And one last thing about macro reasoning: talking about EMT, Mr. Buffett once wrote (quoting by hart, because I do not have his letter with me right now): “we are in great debt to those academics who taught so many investors that, in what is essentially an intellectual game, reasoning is useless”. I know it is odd to quote Mr. Buffett AND defend macro reasoning… Mr. Buffett has always despised macro reasoning… Anyway, I believe that what Mr. Buffett said about EMT also readily applies to macro reasoning!

 

giofranchi

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Macro has many facets. It probably was one of Buffett's major conviction points for buying BNSF to give an example. But you'll never hear him make specific predictions on "the when or the how" as far as I know.

 

 

---

 

Giofranchi: A bit off-topic, but I think you will appreciate this post by board member Harry Long:

 

The 10 Commandments of Insurance Investing 

 

I. Thou shalt protect thy ass, capital being an extension of it. Keep this above all other Commandments.

 

II. Thou shalt not sacrifice Quality for Price.

 

III. Thou shalt Live by the Dice and Die by the Dice. Make sure thy Dice be Loadeth in thy favor if thou wish for thy days to be long with capital on this Earth.

 

IV. Thou shalt not believe in the craven image that paying a discount to book value will save thou from loss of capital.

 

V. Thou shalt pay special attention to the combined ratio during a period of weak pricing in the industry. Such periods reveal the True Character of the Underwriters and in the strength of the Loadeth Dice.

 

VI. Thou shalt respect thy Reserving Tables.

 

VII. Thou shalt buy the insurer for its underwriting prowess if thou art an investor. If thou taketh the insurer over, firing its incompetent portfolio managers is but a small feat, but bad underwriting may take a decade to dig thy self out of if the tail of the insurance be long.

 

VIII. Thou shalt pay special attention to the Premium to Surplus ratio. If it be high, and the underwriting be solid, thou art probably safe, but if it be high and the combined ratio be over 100, Woe unto you! Short are thy days with thy capital on this Earth!

 

IX. Thou shalt attempt to find insurers which can underwrite with a combined ratio below 90. Such a situation is Heaven on Earth for they who live by Loading the Dice.

 

X. Thou shalt not believe the foolish soothsayers who say that it is impossible to find a fine underwriter that is selling cheaply. Have faith in thy research and the eternal patience to keep honor with the nobility and sanctity of thy quest.

 

I have no opinion or knowledge on the matter to add but am enjoying the discussion. Thank you.

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Thank you tombgrt,

always can count on you for great insights! And who could disagree with the 10 commandments of insurance investing?!

 

I really would like to know what Harry Long thinks about FFH and GLRE. I always look for people who could warn me about dangers to which I might be oblivious.

 

giofranchi

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Relax Gio, I am not saying it is a bad investment. A below average reinsurance company with an above average investor (paid very well though) at 1x BV is most probably a good investment.

 

But you were criticizing an investment in, among others, AIG that has distribution and size strengths, it is very diversified, has turned around its underwriting, has been fantastic with its capital allocation, and it is priced at half book. And then, suggested a below average reinsurer priced at book. Below average CORs in an industry that is notorious for attracting dumb money and where mistakes can get you "asbestosed" like Lloyd's or "9/11d" like GenRE ... well, it is an important factor to consider.  And the justification of buying GLRE based on the macro foresight of your initial post looks very thin and pales in comparison with those risks.

 

Also by throwing GLRE into the ring you have abdicated the "black box" argument (BTW, I think is being very exaggerated for a very regulated industry with tons of info in those statutory reports). Therefore, if you think AIG is impossible or very hard to understand it is difficult to argue that GLRE is a LOT easier. Hey, I personally admit to not have even tried to understand GLRE because I prefer to ignore it considering its CORs and Einhorn (yes, not all people are his fans). Ignoring is OK.

 

Maybe I am wrong, maybe this is just a case where you have not tried to understand AIG but have really analyzed GLRE in depth.

But I admit this kind of arguments irritate me because there are a lot of value pretenders that are more like cheerleaders than real investors. Hiding behind the brand throwing feces w/o thinking critically that in my view is a key part of being a good investor.

 

Let me emphasize, I am not saying this is your specific case. As I said, I do not know GLRE in depth and you may have done a lot of work on it. But the macro thing argument has been in fashion lately.

 

http://variantperceptions.wordpress.com/2011/09/15/thinking-about-investing-in-us-banks-a-short-answer-to-david-merkel/

 

http://en.wikipedia.org/wiki/Lloyd's_of_London#1988.E2.80.9396

 

There are two requirements for success in Wall Street. One - you have to think correctly; and secondly you have to think independently. — Benjamin Graham

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Thank you PlanMaestro!

I don’t understand why you say that GLRE’s CORs are below average. If you look at pag.10 of the GLRE’s presentation, and you sum the CORs of the last 4 years, you obtain: 399,6 for GLRE, 404,2 for THR, 405,6 for RE, 396,3 for PRE, and 397,6 for PTP. It looks that GLRE is not above average, but neither below! And, while THR earns net premiums which are 40% of surplus, precisely in line with GLRE, RE earns premiums which are 70% of surplus, PRE earns premium which are 75% of surplus, and PTP earns premiums which are 95% of surplus. So, the equities of RE, PRE, and PTP are much more negatively affected by a COR > 100%, than GLRE’s equity is. It seems to me that GLRE is an average underwriter, which runs a lower premiums risk than the competition. All in all: average CORs + below average premiums risk = above average reinsurance operations (I mean safer than average). Not below average!

 

I do not claim to know every participant in the reinsurance market! And it is possible that the comparisons chosen by the GLRE management are the four worst performers in the whole industry! If that is so, I was fooled by Mr. Einhorn, Mr. Hedges & Co. … and I will sell my shares tomorrow morning!

 

giofranchi

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But you were criticizing an investment in, among others, AIG that has distribution and size strengths, it is very diversified, has turned around its underwriting, has been fantastic with its capital allocation, and it is priced at half book.

 

Far from me criticizing an investment that I haven’t either studied! I did not express myself correctly!

 

In my original post I referred to BAC and AIG, just because they are two of the most talked ideas on this board. What I was trying to say is that the timing of even the best long micro ideas, in this case BAC and AIG, is hard to predict. You all have studied BAC and AIG very well, and you know that the value is there, and that sooner or later it will be recognized. But I guess it is very hard to say exactly when. Isn’t it?

 

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!

 

But: can you have an idea of secular bull or secular bear markets? And where are we now? Yes! 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.

 

giofranchi

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Letter to Khan May 5, 1938. I will not dare to highlight anything from such a perfect piece.

 

The question about policy is very interesting. I daresay there is more temperament than logic in the solution.  I can only say that I was the principal inventor of credit cycle investment and have seen it tried by five different parties acting in detail on distinctly different lines over a period of nearly twenty years, which has been full of ups and downs; and I have not seen a single case of a success having been made of it.  In addition to this experience, the most logical followers of the policy whom I know are some of the American investment trusts, and their results are not encouraging.  As regards individuals, I know one or two who make a modest livelihood by jobbing on general short-term principles without perhaps too much regard to the longer swings, but the credit cyclers have not by now enough capital left to be much of a recent guide.

 

Credit cycling means in practice selling market leaders on a falling market and buying them on a rising one and, after allowing for expenses and loss of interest, it needs phenomenal skill to make much out of it. My alternative policy undoubtedly assumes the ability to pick specialities which have, on the average, prospects of rising enormously more than an index of market leaders.  The discovery which I consider that I have made in the course of experience is that it is altogether unexpectedly easy to do this, and that the proportion of stunners amongst one's ultra favourites is quite small.  Moreover, this practice does, in my opinion, in fact enable one to take at least as good an advantage of fluctuations as credit cycling, though in a rather different way.  It is largely the fluctuations which throw up the bargains and the uncertainty due to fluctuations which prevents other people from taking advantage of them.

 

The refusal of the American investment trusts to pick up bargains as long as they believe that it is still broadly speaking a bear market is typical of credit cycling mentality.  For it is an essential of a logical carrying out of this not to allow exceptions or be carried away by having fancies about specialities.

 

The whole thing is really summed up in something that I said in the original version of my memorandum.  It is a much safer and easier way in the long run by which to make investment profits to buy £1 at 15s. than to sell £1 at 15s. in the hope of repurchasing them at 12s.

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Thank you PlanMaestro!

I don’t understand why you say that GLRE’s CORs are below average. If you look at pag.10 of the GLRE’s presentation, and you sum the CORs of the last 4 years, you obtain: 399,6 for GLRE, 404,2 for THR, 405,6 for RE, 396,3 for PRE, and 397,6 for PTP. It looks that GLRE is not above average, but neither below! And, while THR earns net premiums which are 40% of surplus, precisely in line with GLRE, RE earns premiums which are 70% of surplus, PRE earns premium which are 75% of surplus, and PTP earns premiums which are 95% of surplus. So, the equities of RE, PRE, and PTP are much more negatively affected by a COR > 100%, than GLRE’s equity is. It seems to me that GLRE is an average underwriter, which runs a lower premiums risk than the competition. All in all: average CORs + below average premiums risk = above average reinsurance operations (I mean safer than average). Not below average!

 

I do not claim to know every participant in the reinsurance market! And it is possible that the comparisons chosen by the GLRE management are the four worst performers in the whole industry! If that is so, I was fooled by Mr. Einhorn, Mr. Hedges & Co. … and I will sell my shares tomorrow morning!

 

giofranchi

 

See, I don't know anything about Greenlight RE :)

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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!

 

But: can you have an idea of secular bull or secular bear markets? And where are we now? Yes!

 

 

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.

 

giofranchi

 

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

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The refusal of the American investment trusts to pick up bargains as long as they believe that it is still broadly speaking a bear market is typical of credit cycling mentality.

 

I couldn’t agree more! But the assumption implicitly made is the presence of bargains… Now, the July 31, 2012 GMO Asset Class Return Forecasts foresee a 0,2% annualised return for US large caps, and a negative –0,3% annualised return for US small caps (negative!). Even high-quality companies are forecasted to return an anaemic 4,5% annualised, while the long-term historical US Equity Return is 6,5%. If you think of the long-term historical US Equity Return as “Fair Value”, even high-quality companies as a group are trading above fair value. Instead, everybody on this board likes to see things trading at least 30% below fair value! Right? It doesn’t seem to me an environment ripe of many healthy bargains! Paraphrasing Mr. Cummings and Mr. Steinberg, “opportunities meeting our investment criteria are few and far between” (2011 Letter to Shareholders). I am not saying don’t buy a true bargain, if you can get one! Far from me! I am just saying buy a true bargain AND buy some protection: buy AIG (if you know it well), and short a bunch of US small cap. I am just saying that in this environment I prefer a long/short strategy to a long only strategy.

 

What does "think about the big picture" mean?

 

Well Vinod, in the rest of you post you have answered to that question better than I could have!! ;)

 

A bull market and bear market as Hussman points out is only realized afterwards never at that particular point in time.

 

I like John Hussman and I respect his work very much! But I wasn’t thinking of a cyclical bull or a cyclical bear. Instead, I was thinking of structural, secular markets. I guess everybody on this board has read “The Snowball”. Well, you might remember that it begins with the Sun Valley speech Mr. Buffett made in July 1999: Dow Jones Industrial Average December 31, 1964 = 874,12, December 31, 1981 = 875,00. He implied that, just the way it had happened during the 1964-1981 stretch, for the next 15-20 years stocks returns would most probably be sub par. And that was from Mr. Buffett, who has always despised macro! Of course, the 1964-1981 stretch was not the first secular bear market in history: the 1931-1949 stretch comes obviously to mind, or also the 1900-1919 stretch. But, if you read, for instance, the wonderful biography of Andrew Mellon by David Cannadine, you realize that the 19th century was characterized by as many difficult, long and deep secular bear markets as the 20th century was. Not a single one of them ever ended with valuations as high as they were in March 2009, and not a single one of them ever ended in so short a time as the 2000-2009 stretch. If history is any guide, all I know about the history of the financial markets tells me that we still need one more shoe to drop. Then I will be glad to employ a long only strategy. For the time being, I stick with a long/short strategy and, if I am wrong, better be late to the party than be sorry!

As an aside, it should be noted that Mr. Buffett closed his Partnership in 1969 and went working on his “new venture”, Berkshire Hathaway. In the early 70s Mr. Buffett acquired See’s Candies through Berkshire, and See’s Candies began distributing all its earnings to be allocated by Mr. Buffett: that is another wonderful way to invest in a secular bear market! Control value investing in a secular bear market is great! If you control a very good business, that each month generates a lot of free cash and pays you all its earnings, of course you could afford the luxury to invest them with a long only strategy and just wait (that’s part of the reason why I like BH).

 

giofranchi

GMO_7-Year_Asset_Class_Return_Forecasts_July_31_2012.pdf

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What does "think about the big picture" mean?

 

Well, I guess it means, for instance, to make the effort to read and study what Mr. Dalio has to say about deleveraging periods. Thinking that maybe you could find something useful in his work. And not casting it aside, just because it is macro… and, if it is macro, then it surely cannot help us!

 

Ray Dalio is a genius. He writes and talks about investing in his own unique way. I really think it will pay off big time to listen to what he has to say.

 

giofranchi

Delevergaing_Studies_BridgewaterDraftConfidential.pdf

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I think alot of the macro stuff is predicting the unpredicatble.  There have been very smart folks over the past 100 years trying to do this to no avail.  If you look at some of the best performing macro guys (Soros) they made money by betting big on trades that started going there way.  Dalia, Paulson and others who try to play the macro game in my mind will be disappointed.  I think the focus should be on the knowable: companies, industries and securities and let other spend time speculating on the macro.  Where some of these factors can help is to gauge where we are.  Marks (who is a great value investor) thinks we are in a middle ground.  His indicators (on page 131 of his book) include debt, equity, fund and sentiment.  The debt indicators are bullish in that there is very little speculative lending and the return for HY bonds is good for the risks taken.  The equity indicators and neutral, the valuations are high based upon past metrics but modest based upon current metrics (it depends upon you view on profit margins).  I think a better way to think about equity is by sector and you can find undervalued sectors (banks, life insurance, computer devices, radio and TV) and some overvalued sectors but the average is just an average of overvalued and undervalued sectors.  Fund indicators are bullish in that new funds are not being raised and those that are don't have folks running over themselves to get in. Sentiment is inline with economic performance which is weak. 

 

Packer   

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Packer,

I have read Mr. Mark’s book, and I hold him in the greatest regard, to the point that I invested with him: OAK is my firm’s fourth largest holding. And I agree with you: my idea of paying attention to the big picture is not at all trying to forecast what is unknowable. Instead, just like you said, it is to gauge where we are. And, imho, during a secular bear and a deleveraging you don’t want to see Mr. Grantham forecasting a +0,2% annualised return for the next 7 years in US large caps, and a negative –0,3% annualised return for the next 7 years in US small caps, and just think: “well, that doesn’t apply to me, because I am a bargain hunter! The stocks I pick cannot be affected by the general behavior of the markets!”. Maybe in a secular bull, maybe in a leveraging period… but I wouldn’t do that now. The trailing P/E of the Russell 2000 is almost 30… Probably, I will be proven wrong, but I really don’t like to be greedy at this point!

 

giofranchi

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Some of Mr. Grantham's observations are interesting as far as see he has failed to make any money on them other than gathering assets and charging a fee.  He has some great thinkers who work for him but as far as I can see from his fund performance it has been average.  His largest allocation has been to timber which has been a dud in my opinion and has totally missed the micro story of declining book/magazine demand.  Mr. Marks on the other hand has done outstanding.

 

The other question I ask is the data or observation unique.  The data GMO presents is not.  If this was the way to obtain excess returns you would see it in their returns.  The data they provide is an average (similar to the Mark's observation that a man drowned crossing a stream that on average was half his height).  Marty Whitman has the same observations about bear markets being industry specific and overall market bear markets are a sum of those markets.  I think what you are seeing on this board is the indentification of industry bear markets and based upon Mark's framework of the company/security parameters being much more predictable than aggregate data.

 

Packer

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Packer,

this is just an example, but, as you can see on page 9 of the letter attached, the evidence shows that Mr. Grantham forecasts are very accurate.

Good results in the mutual fund industry, which I don’t like, are as much dependant on a good management as on a good clients base. If your reasoning is right, but your clients think otherwise, and you don’t have locked in capital, like Mr. Marks fortunately has (one of the reasons I decided to invest with him, even if I don’t like the mutual fund industry), your results will surely suffer. Ask Mr. Berkowitz, who last year was forced to liquidate very good investments at ridiculously low prices, to meet all the redemptions! It doesn’t matter that those investments will prove to be spectacular successes in the years to come, and that Mr. Berkowitz’s reasoning was outstanding, because he was forced to sell at the worst time possible! It is well known that Mr. Grantham suffered many times from this same weakness during his long career (once redemptions were almost 50% of AUM). Many times Mr. Grantham has posted the accuracy of his forecasts, and his track record is pretty darn good!

 

I am not sure I have understood correctly the second part of your post… please, be patient with my poor English! Anyway, you end up saying: the company/security parameters being much more predicable than aggregate data. Well, I know this is self-evident, and that’s why I most probably have misunderstood you, but, if each component of the S&P500 taken singularly is somewhat predictable, then the same degree of predictability belongs to the S&P500 as a whole as well.

 

giofranchi

JGLetter_3Q09.pdf

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The forecast may be accurate but what are we to do with this?  I am not constrained to investing in asset class indexes and as far as I can see asset class switching has not been a very good way to outperform.  There is much more outperformance in stock selection. I was invested in A GMO fund for over 7 years and was disappointed by the poor relative and absolute performance.  What he provides are some nice aggregate statistics but I would use bottoms up valuation as better indicator of investment opportunities.  I also think funds provide the acid test of philosophy and although Berkowitz stumbled in 2011,  I think he will more than make up for it goig forward.

 

Packer

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The forecast may be accurate but what are we to do with this? 

 

Well, in today's environment I would follow Mr. Templeton’s advice: “Go long the best stock you can find, and go short the worst stock you can find”. That’s also what Mr. Watsa said at the 2011 AGM. Bottom up analysis is useful also to spot overvaluation. And possibly profit from it! In a secular bull (1982-1999) a long/short strategy won’t lead you to outperformance (probably, it will lead to underperformance!). Vice versa, in a secular bear and when aggregate statistics point to high valuations, a long/short strategy strikes me as very sensible. And the chances to outperform your benchmark are reasonably good. So, when to employ a long only value based strategy, and when to employ a long/short value based strategy? How much capital to deploy in long ideas and how much in short ideas? Imho, that’s where a little bit of macro reasoning might prove to be helpful…

 

giofranchi

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"John Templeton made a good deal of money for his own accounts in 2000 by a twin-track strategy of shorting shares in Internet stocks and making a leveraged bet on long-dated U.S. government bonds, which he expected to rise sharply in price as interest rates continued to fall.

 

TEMPLETON'S Way with Money

 

giofranchi

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