Thoughts On Diversification & Ideal Portfolio Management: A Reply

I’ve been having a constructive conversation on the topic of diversification fellow value investor Nate Tobik of OddballStocks.com.

Now, this conversation all started because of an e-mail I sent entitled “why isn’t AAPL cheap?”, the point of which was to discuss the reasons why a company that looks like it is cheap statistically (AAPL has a low P/E, outstanding balance sheet, huge FCF generation, etc.) still might not be. The diversification discussion arose organically and orthogonally. I mention this only because reading Nate’s comments is kind of like jumping into the middle of a conversation– that’s not his fault.

Below, I reproduce several of his e-mails (with his permission) and add my own commentary as well:

The other thing is most companies I end up investing in are small caps and they do one thing. So I can look at a OPST or MPAD and read the annual report in 20m. Keeping up with them probably requires 45m a year and I can explain them quickly. So having a stable of companies like this isn’t really a big deal at all. Contrast that with how much time it would take to look at BAC or AIG, it’s crazy. I can probably look at 15 small caps in the same amount of time as I’d spend looking at AIG.

My comment: In this first quote, Nate is explaining why he feels comfortable having a diversified portfolio. While I am worrying about scaling the number of positions in my portfolio down, Nate admits he is looking forward to celebrating his 50th pick one day.

I think Nate raises a valid point here. A company like BAC or AIG is so incredibly complicated, it’s hard to imagine how you’d have time to analyze anything else you might want to add to your portfolio after researching and fully understanding the risks of one of them. On the other hand, a lot of these net-nets we look at are simple businesses and while they have risks, the risks are easy to understand and keep track of for the most part. This is a fair response to the challenge I raised in my first post in which I suggested that diversification may add risk to a portfolio by creating confusion and dividing the attention of the portfolio manager.

Yeah, I’m not married to the idea of a single best idea, I mean what is that? Well America Movil has grown the most for me so is that my best idea? What about Mastercard a 10-bagger since 2006. Here’s the problem, when I purchased both of those I had no idea they’d do as well as they would, I just figured they were worth more than I paid.

[…]

In my view as long as every position I buy meets my return characteristics buying one more position doesn’t diworsify me because that next stock added has the same potential return as all the others. So holding 200 stocks that I think are all worth 50-100% more, or are compounding at 10-15% a year is fine, I would be happy with that. The reality is that many probably don’t exist.

My comment: This is probably true. But at the same time, there is nothing being added by diversification. The free lunch remains elusive. If you have 20 positions that all have a 15% per annum return potential with similar risk, you really just have 1 position with a 15% per annum return potential.

So if I looked and had to tell you what had the best prospects I really don’t know, and that’s not because I question my judgement, it’s because in my experience it’s impossible to tell. I could tell you what is growing on my basis the quickest, or what is the cheapest, but absolute best idea, I don’t know. I don’t think that’s in my investor DNA.

I’ll say though when I see something crazy cheap I will try to keep buying up to a limit, I’ll usually max out at 5% or so.

My comment: Nate is responding to my argument in the previous post that, instead of diversifying, you should put everything into your “best idea”, whatever that may be at the time (best defined as highest return potential for lowest risk out of all alternatives being considered). And he’s definitely correct that you can’t know ahead of time which investment out of a “crop” will realize the highest “yield” ahead of time. I agree there.

But my point was slightly different– that if you’ve got three different plants, say, and one of them looks the healthiest of the other two, water that one, a lot. Don’t water all three, a little, and see what happens.

I think this is where Nate’s comments on the subject are weakest. I think he’s essentially making my point (one of my points, anyway), for me. In contrast, where I think his comments are strongest are just below.

So here’s my thinking on ‘best idea’ and diversification. There is merit to it with a big “BUT.” So for you, say you take over the business, you have the ability to affect change, to run it as you like. You can only own the one business and nothing else and that’s fine, plenty of business owners do that. In a classic sense you have no diversification but it doesn’t matter because you have control.

I don’t control anything I own, and there is a limited amount someone can know about a business from the outside. So if your business sent me the financial statements I could learn a lot, but I would never know as much as you because you’re inside. Even if you don’t have statements you know more, you see salesmen walking around, you know if they’re selling a lot or not by their attitude. You know if the carpet has been replaced recently or if the furniture is getting old. All those little intangibles add up. I could go visit every company I invest in and try to learn this, some people do. That is the point of the sleuth investor, he gets to know the customers, sleuths the company, gets to know the employees. he basically gets to know everything you can know without being an insider, then he loads up. So the idea has merit.

I don’t do any of that, I’m reading statements from my basement and even when I get involved in a company all I get back is a nice letter saying thanks they’ll look into it. So I need to diversify my ignorance, I have a 5% rule because I initially don’t want to go crazy on a new position. I let positions run, at one point Mastercard and America Movil were 50% of my portfolio. I know the companies, I didn’t care, I’ve sold them down so they’re about 25% now, but still. I like to scale into something as I get to know it better. A company I’ve owned for five years I know a lot better than a company I just researched no matter how much reading I did on it.

My comment: This makes sense. Essentially what Nate is saying is that you’re taking an undue risk putting 100% into a non-control situation. There are probably few and rare opportunities where the situation is so clear cut and the risks of total concentration so minimal that you can get away with full concentration (zero diversification, or “non-portfolioization” as I put it before).

This has me “stumped.” I don’t have a great response for this (not that I need to… this is an argument about being right, it’s a discussion about merits and lack thereof). Intuitively it makes sense because my belief all along has been that the more information you have and the more conviction you have about an idea, the more you should be concentrated in it, with the extreme being 100%. But Nate is pointing out that the only place where you can be “certain” or have full knowledge of the business itself, have full conviction about what the world looks like from the business’s perspective, is if you have control of the business. So, outside of that condition, you should not concentrate 100% in normal circumstances.

As Nate mentioned later in an e-mail, he is a “serial investor”, meaning, he is looking at ideas one at a time and evaluating if that investment meets his hurdle. He is not usually comparing multiple investment ideas at once and then picking the “best idea” of the bunch.

This reminds me of a section from early in The Snowball where Schroeder says that Buffett was typically fully invested but, for the first time in his life in the mid-1960s, he was finding the bargain pool to be dried up and felt forced to sit in cash as opposed to deploying his capital.

I think in that situation, you’re forgiven for “diversifying” into cash. But short of that, this “I am holding some cash ‘just in case'”, where the “just in case” is interpreted as “just in case I come across a great bargain or the market crashes” doesn’t hold water. What if that crash never comes, or the bargains you see right now are as good as they’ll get?

Why be “diversified” in cash at that point?

Should You Hedge Currency Risk When Investing Internationally?

I read a white paper by Tweedy, Browne entitled “How Hedging Can Substantially Reduce Foreign Stock Currency Risk” the other day. I actually find the title of the paper misleading because the way it’s written it sounds like they’re recommending you hedge your foreign currency exposure when investing overseas.

Instead, the finding of the paper seemed to be that for long-term investors, currency fluctuations are generally a wash over time and hedged and unhedged portfolios perform similarly.

Here’s a quick, bullet-point list of info from the paper:

  • currency fluctuations are generally more extreme than stock market fluctuations (greater volatility)
  • depending on whether or not home currency interest rates are higher or lower than foreign country interest rates, one can contractually lock-in either a cost or a gain from currency hedging operations
  • the investor who enters into a hedging contract to sell forward the foreign currency of a country whose interest rates are lower than his home country’s interest rates will receive a locked-in contractual gain
  • over long measurement periods, the returns of hedged portfolios have been similar to the returns of portfolios that have not been hedged
  • “Over the 1975 through June 1988 study period, the compounded annual returns on hedged and unhedged foreign equities were 16.4% and 16.5%, respectively” according to one study
  • According to TB’s own experience: “over the 15.75-year period from Jan 1, 1994 through September 30, 2009, the MSCI World Index (Hedged to US$) had an annualized return of 5.7%; this return was nearly the same as the return over the same period for the unhedged MSCI World Index, which had an annualized return of 5.8%”
  • studies have generally indicated that the compounded annual returns on hedged foreign stock portfolios have been similar to the returns on unhedged foreign stock portfolios
  • currency hedging is similar to selling short
  • the cost to an investor of hedging foreign currencies through forward and futures contracts is approximately equal to the difference between interest rates in the home country and the particular foreign country over the contract period

Investor Adam Sues, who blogs over at ValueUncovered.com, wrote in to share Currency Hedging Programs: The Long-Term Perspective (PDF). I appreciate the link and have reproduced my outline notes of key take-aways below:

  • Remember, the floating exchange rate system is relatively new as it began in 1973
  • While median hedging impact numbers were close to zero in the Brandes Institute’s study, the range of outcomes was wide, with almost half outside the range of +/- 3% annualized; be prepared for extended periods of possible hedging losses
  • Japanese and US-based investors have experienced more volatile hedging results than Canadian-based investors; UK investors have had more favorable outcomes from hedging programs than US investors
  • As the timeframe lengthened, the impact of hedging overlays relative to long-term equity returns tended to diminish
  • A US-based currency hedging program for a non-US equity portfolio would have suffered an average annualized 1.8% loss over the entire 34-year period since the start of floating exchange rates (passive hedging programs are costly for US investors in the long-term
  • The dollar, when measured against other major currencies, has more often been at the extremes of valuation than in the middle
  • Currencies exhibited significant volatility in the short term but generally have been mean-reverting in the long term
  • Currency moves and the related hedging impact tended not to wash-out completely over time, and even for 5- or 10-year periods, the range of results remained wide
  • Currency overlay managers have shown evidence of value-add, but this effect has been small relative to the size of overall currency impact
  • Bottom-line: it’s appropriate for investors to choose either a hedged or unhedged benchmark, and then stick to it for the long-term

Review – More Money Than God

More Money Than God: Hedge Funds And The Making Of A New Elite

by Sebastian Mallaby, published 2010

A veritable pantheon of masters of the universe

Mallaby’s book is not just an attempt at explaining and defending the beginning, rise and modern state of the hedge fund industry (the US-focused part of it, anyway), but is also a compendium of all of the hedge fund world’s “Greatest Hits.” If you’re looking for information on what hedge funds are, where they come from, what they attempt to do, why they’re called what they are and how they should be regulated (SURPRISE! Mallaby initially revels in the success “unregulated” funds have had and feints as if he’s going to suggest they not be regulated but, it being a CFR book and he being a captured sycophant, he does an about-face right at the last second and ends up suggesting, well, umm, maybe SOME of the hedge funds SHOULD be regulated, after all) this is a decent place to start.

And if you want to gag and gog and salivate and hard-to-fathom paydays and multiple standard deviations away from norm profits, there are many here.

But that wasn’t my real interest in reading the book. I read it because I wanted to get some summary profiles of some of the most well known hedgies of our time — the Soroses and Tudor Joneses and such — and understand what their basic strategies were, where their capital came from, how it grew and ultimately, how they ended up. Not, “What’s a hedge fund?” but “What is this hedge fund?” As a result, the rest of this review will be a collection of profile notes on all the BSDs covered by the book.

Alfred Winslow Jones – “Big Daddy”

  • started out as a political leftist in Europe, may have been involved in U.S. intelligence operations
  • 1949, launches first hedge fund with $60,000 from four friends and $40,000 from his own savings
  • By 1968, cumulative returns were 5,000%, rivaling Warren Buffett
  • Jones, like predecessors, was levered and his strategy was obsessed with balancing volatilities, alpha (stock-picking returns) and beta (passive market exposure)
  • Jones pioneered the 20% performance fee, an idea he derived from Phoenician merchants who kept one fifth of the profits of successful voyages; no mgmt fee
  • Jones attempted market timing as a strategy, losing money in 1953, 1956 and 1957 on bad market calls; similarly, he never turned a profit following charts even though his fund’s strategy was premised on chartism
  • Jones true break through was harvesting ideas through a network of stock brokers and other researchers, paying for successful ideas and thereby incentivizing those who had an edge to bring him their best investments
  • Jones had information asymetry in an era when the investment course at Harvard was called “Darkness at Noon” (lights were off and everyone slept through the class) and investors waited for filings to arrive in the mail rather than walk down the street to the exchange and get them when they were fresh

Michael Steinhardt – “The Block Trader”

  • Background: between end of 1968 and September 30, 1970, the 28 largest hedge funds lost 2/3 of their capital; January 1970, approx. 150 hedge funds, down from 200-500 one year earlier; crash of 1973-74 wiped out most of the remainders
  • Steinhardt, a former broker, launches his fund in 1967, gained 12% and 28% net of fees in 1973, 74
  • One of Steinhardt’s traders, Cilluffo, who possessed a superstitious eating habit (refused to change what he ate for lunch when the firm was making money), came up with the idea of tracking monetary data, giving them an informational edge in an era where most of those in the trade had grown up with inflation never being higher than 2% which meant they ignored monetary statistics
  • One of Steinhardt’s other edges was providing liquidity to distressed institutional sellers; until the 1960s, stock market was dominated by individual investors but the 1960s saw the rise of institutional money managers; Steinhardt could make a quick decision on a large trade to assist an institution in a pinch, and then turn around and resell their position at a premium
  • Steinhardt’s block trading benefited from “network effects” as the more liquidity he provided, the more he came to be trusted as a reliable liquidity provider, creating a barrier to entry for his strategy
  • Steinhardt also received material non-public information: “I was being told things that other accounts were not being told.”
  • In December 1993, Steinhardt made $100M in one day, “I can’t believe I’m making this much money and I’m sitting on the beach” to which his lieutenants replied “Michael, this is how things are meant to be” (delusional)
  • As the Fed lowered rates in the early 90s, Steinhardt became a “shadowbank”, borrowing short and lending long like a bank
  • Steinhardt’s fund charged 1% mgmt fee and 20% performance fee
  • Anecdote: in the bloodbath of Japan and Canada currency markets in the early 90s, the Canadian CB’s traders called Steinhardt to check on his trading (why do private traders have communications with public institutions like CBs?)

Paul Samuelson & Commodities Corporation – “Fiendish Hypocrite Jackass” (my label)

  • Paul Samuelson is one of history’s great hypocrites, in 1974 he wrote, “Most portfolio decision makers should go out of business– take up plumbing, teach Greek, or help produce the annual GNP by serving corporate executives. Even if this advice to drop dead is good advice, it obviously is not counsel that will be eagerly followed.”
  • Meanwhile, in 1970 he had become the founding backer of Commodities Corporation and also investing in Warren Buffett; he funded his investment in part with money from his Nobel Prize awarded in the same year
  • Samuelson paid $125,000 for his stake; total start-up capital was $2.5M
  • Management of fund resembled AW Jones– each trader was treated as an independent profit center and was allocated capital based on previous performance
  • Part of their strategy was built on investor psychology: “People form opinions at their own pace and in their own way”; complete rejection of EMH, of which Samuelson was publicly an adherent
  • Capital eventually swelled to $30M through a strategy of primarily trend-surfing on different commodity prices; in 1980 profits were $42M so that even net of $13M in trader bonuses the firm outearned 58 of the Fortune 500
  • Trader Bruce Kovner on informational asymetries from chart reading: “If a market is behaving normally, ticking up and down within a narrow band, a sudden breakout in the absence of any discernible reason is an opportunity to jump: it means that some insider somewhere knows information that the market has yet to understand, and if you follow that insider you will get in there before the information becomes public”

George Soros – “The Alchemist”

  • Soros had an investment theory called “reflexivity”: that a trend could feedback into itself and magnify until it became unavoidable, usually ending in a crash of some sort
  • Soros launched his fund in 1973, his motto was “Invest first, investigate later”
  • Soros quotes: “I stood back and looked at myself with awe: I saw a perfectly honed machine”; “I fancied myself as some kind of god or an economic reformer like Keynes”
  • Soros was superstitious, he often suffered from back pains and would “defer to these physical signs and sell out his positions”
  • Soros believed in generalism: know a little about a lot of things so you could spot places where big waves were coming
  • Soros had a “a web of political contacts in Washington, Tokyo and Europe”
  • Soros hired the technical trader Stan Druckenmiller, who sometimes read charts and “sensed a panic rising in his gut”
  • As Soros’s fund increased in size he found it harder and harder to jump in and out of positions without moving the markets against himself
  • Soros rejected EMH, which had not coincidentally developed in the 1950s and 1960s in “the most stable enclaves within the most stable country in the most stable era in memory”
  • Soros was deeply connected to CB policy makers– he had a one on one with Bundesbank president Schlesinger in 1992 following a speech he gave in Basel which informed Quantum fund’s Deutschemark trade
  • “Soros was known as the only private citizen to have his own foreign policy”; Soros once off-handedly offered Druckenmiller a conversation with Kissinger who, he claimed, “does know things”
  • Soros hired Arminio Fraga, former deputy governor of Brazil’s central bank, to run one of his funds; Fraga milked connections to other CB officials around the world to find trade ideas, including the number two official at the IMF, Stanley Fischer, and a high-ranking official at the central bank of Hong Kong
  • Soros was a regular attendee at meetings of the World Bank and IMF
  • Soros met Indonesian finance minister Mar’ie Muhammed at the New York Plaza hotel during the Indonesian financial crisis
  • Soros traveled to South Korea in 1998 as the guest of president-elect Kim Dae-jung
  • In June 1997, Soros received a “secret request” for emergency funding from the Russian government, which resulted in him lending the Russian government several hundred million dollars
  • Soros also had the ear of David Lipton, the top international man at the US Treasury, and Larry Summers, number 2 at the Treasury, and Robert Rubin, the Treasury secretary, as well as Mitch McConnell, a Republican Senator

Julian Robertson – “Top Cat”

  • Managed a portfolio of money managers, “Tigers”
  • Used fundamental and value analysis
  • Once made a mental note to never buy the stock of an executive’s company after watching him nudge a ball into a better position on the golf green
  • Robertson was obsessed with relative performance to Soros’s Quantum Fund
  • Called charts “hocus-pocus, mumbo-jumbo bullshit”
  • Robertson didn’t like hedging, “Why, that just means that if I’m right I’m going to make less money”
  • High turnover amongst analysts, many fired within a year of hiring
  • Tiger started with $8.5M in 1980
  • A 1998 “powwow” for Tiger advisers saw Margaret Thatcher and US Senator Bob Dole in attendance
  • Tiger assets peaked in August 1998 at $21B and dropped to $9.5B a year later, $5B of which was due to redemptions (Robertson refused to invest in the tech bubble)

Paul Tudor Jones – “Rock-And-Roll Cowboy”

  • Jones started out as a commodity trader on the floor of the New York Cotton Exchange; started Tudor Investment Corporation in 1983, in part with an investment of $35,000 from Commodities Corporation
  • “He approached trading as a game of psychology and high-speed bluff”
  • Superstition: “These tennis shoes, the future of this country hangs on them. They’ve been good for a point rally in bonds and about a thirty-dollar rally in stocks every time I put them on.”
  • Jones was a notorious chart reader and built up his theory of the 1987 crash by lining up recent market charts with the 1929 chart until the lines approximately fit
  • Jones was interested in Kondratiev wave theory and Elliott wave theory
  • “When you take an initial position, you have no idea if you are right”but rather you “write a script for the market” and then if the market plays out according to your script you know you’re on the right track
  • Jones made $80-100M for Tudor Investment Corp on Black Monday; “The Big Three” (Soros, Steinhardt and Robinson) all lost heavily in the crash
  • Jones, like Steinhardt, focused on “institutional distortions” where the person on the other side of the trade was a forced seller due to institutional constraints
  • Jones once became the catalyst for his own “script” with an oil trade where he pushed other traders around until they panicked and played out just as he had predicted
  • PTJ never claimed to understand the fundamental value of anything he traded
  • PTJ hired Sushil Wadhwani in 1995, a professor of economics and statistics at the LSE and a monetary policy committee member at the Bank of England
  • PTJ’s emerging market funds lost 2/3rd of their value in the aftermath of the Lehman collapse

Stanley Druckenmiller – “The Linebacker” (my title)

  • Druckenmiller joined Soros in 1988; while Soros enjoyed philosophy, Druckenmiller enjoyed the Steelers
  • He began as an equity analyst at Pittsburgh National Bank but due to his rapid rise through the ranks he was “prevented from mastering the tools most stock experts take for granted” (in other words, he managed to get promoted despite himself, oddly)
  • Survived crash of 1987 and made money in the days afterward
  • Under Druckenmiller, Quantum AUM leaped from $1.8B to $5B to $8.3B by the end of 1993
  • Druckenmiller stayed in touch with company executives
  • Druckenmiller relied on Robert Johnson, a currency expert at Bankers Trust, whose wife was an official at the New York Fed, for currency trade ideas; Johnson himself had once worked on the Senate banking committee and he was connected to the staff director of House Financial Services Committee member Henry Gonzalez
  • Druckenmiller was also friends with David Smick, a financial consultant with a relationship with Eddie George, the number 2 at the Bank of England during Soros and Druckenmiller’s famous shorting of the pound
  • Druckenmiller first avoided the Dot Com Bubble, then jumped aboard at the last minute, investing in “all this radioactive shit that I don’t know how to spell”; he kept jumping in and out until the bubble popped and he was left with egg on his face, ironic because part of his motivation in joining in was to avoid losing face; Druckenmiller had been under a lot of stress and Mallaby speculates that “Druckenmiller had only been able to free himself by blowing up the fund”

David Swensen & Tom Steyer – “The Yale Men”

  • Swensen is celebrated for generating $7.8B of the $14B Yale endowment fund
  • Steyer and his Farallon fund were products of Robert Rubin’s arbitrage group at Goldman Sachs; coincidence that Rubin proteges rose to prominence during the time Rubin was in the Clinton administration playing the role of Treasury secretary?
  • Between 1990 and 1997 there was not a single month in which Steyer’s fund lost money (miraculous)
  • Farallon somehow got access to a government contact in Indonesia who advised Bank Central Asia would be reprivatized soon and Farallon might be able to bid for it
  • Some rumors claimed Farallon was a front for the US government, or a Trojan horse for Liem Sioe Liong (a disgraced Indonesian business man); it is curious that Yale is connected to the CIA, Farrallon is connected to Yale

Jim Simons & Renaissance Capital – “The Codebreakers”

  • Between the end of 1989 and 2006, the flagship Medallion fund returned 39% per annum on average (the fund was named in honor of the medals Simons and James Ax had won for their work in geometry and number theory– named in honor of an honor, in other words)
  • Jim Simons had worked at the Pentagon’s secretive Institute for Defense Analyses (another possible US intelligence operative turned hedgie?)
  • Simons strategy was a computer-managed trend following system which had to be continually reconfigured due to “Commodities Corporation wannabes” crowding the trades by trending the trends
  • Simons looked to hire people who “would approach the markets as a mathematical puzzle, unconnected to the flesh and blood and bricks and mortar of a real economy” (this is distinctly different than the Graham/Buffett approach, and one wonders how this activity is actually economically valuable in a free market)
  • “The signals that we have been trading without interruption for fifteen years make no sense. Otherwise someone else would have found them.”
  • Renaissance treated employee NDAs like a wing of the CIA– anyone who joined could never work elsewhere in the financial industry afterward, and for this reason they specifically avoided hiring from Wall St in the first place; they were required to invest a fifth of their pay in the Medallion Fund and was locked up as bail payment for four years after they departed (money hostage)

David Shaw & D.E. Shaw

  • Began trading in 1988, the same year as the Medallion fund
  • Shaw was originally hired by MoStan in 1986 into their Analytical Proprietary Trading unit which aimed at beating Steinhardt at his block-trading game using predictive computer technology
  • In 1994, Shaw’s 135-member firm accounted for 5% of the daily turnover on the NYSE
  • Jeff Bezos, of Amazon, was originally a DE Shaw employee
  • The strategy was heavily reliant on pair-trade “arbitrage”, looking for securities in similar industries which were temporarily misaligned in price/multiple
  • Circle of competence: in 1995 the firm launched the ISP Juno Online, as well as FarSight, an online bank and brokerage venture

Ken Griffin & Citadel

  • Created in 1990, grew to $15B AUM and 1400 employees by 2008
  • Griffin’s goal was to develop an investment bank model that could compete with traditional, regulated ibanks, but which was actually a hedge fund
  • Flagship funds were down 55% at the end of 2008, losing $9B (the equivalent of two LTCMs)

John Paulson

  • Paulson graduated from HBS in 1980 and went to work for Bear Stearns; he launched his hedge fund in 1994 with initial capital of $2M which grew to $600M by 2003; by 2005 he was managing $4B
  • Paulson’s main strategy was capital-structure arbitrage
  • He looked for “capitalism’s weak spot”, the thing that would blow up the loudest and fastest if the economy slowed even a little; cyclical industries, too much debt, debt sliced into senior and junior tranches, risk concentrated
  • Paulson spent $2M on research related to the US mortgage industry, assembling a proprietary database of mortgage figures and statistics
  • Many of Paulson’s investors doubted him and threatened to pull capital in 2006
  • Paulson enlarged his bets against the mortgage market through derivative swaps on the ABX (a new mortgage index) and eventually acquired over $7.2B worth of swaps; a 1% decline in the ABX earned Paulson a $250M profit, in a single morning he once netted $1.25B
  • By 2007, he was up 700% net of fees, $15B in profits and made himself $3-4B

Conclusion

I’m actually even more bored with this book having finished typing out my notes than I was when I finished the book the first time I read it. The book actually has some great quotes in it, from the insane delusions of grandeur of government officials and central bank functionaries, to wild facts and figures about the statistical trends of the hedge fund and financial industries over the last 60 years. I am too exhausted to go back and type some of it out right here even though I kind of wish I had some of the info here even without an idea of what I’d use it for anytime soon.

My biggest takeaway from MMTG is that most of these masters of the universe have such huge paydays because they use leverage, not necessarily because they’re really good at what they do. Many of their strategies actually involve teasing out extremely small anomalies between asset prices which aren’t meaningful without leverage. And they’re almost uniformly without a meaningful and logically consistent understanding of what risk is– though many are skeptics of EMH, they seem to all see risk as volatility because volatility implies margin calls for levered traders.

There were so many displays of childish superstition. Many of these guys are chart readers. The government intelligence backgrounds of many was creepy. And it was amazing how many relied on informational asymmetries which are 100% illegal for the average investor. These people really travel in an elite, secretive world where everyone is scratching each other’s backs. How many one on one conversations have you had with central bank presidents? How many trips to foreign countries have you been on where you were the invited guest of the head dignitary of the country? Are you starting to put the picture together like I am?

Overall, it seems so arbitrary. The best word that comes to mind to describe these titans and their success is– “marginalism”. We have lived in an inflationary economy for the last 60+ years and these players all seem to excel in such an environment. But inflationism promotes marginalism; the widespread malinvestment of perpetual inflation confuses people looking to engage in real, productive economic activity, and paper shuffling necessarily becomes a high value business.

The author himself is incredibly ignorant of economic fundamentals and the role monetary intervention plays in the economy. All of the various crises these hedgies profited from seem to come out of nowhere according to his narrative. The incredible growth in volumes of money managed by the hedge fund industry over time goes without notice, as if it was just a simple, unexceptional fact of life. Shouldn’t that be interesting? WHY ARE THERE HUNDREDS OF FIRMS MANAGING TENS OF BILLIONS OF DOLLARS EACH? Where did all this money come from?!

That makes the book pretty worthless as it’s key.

One thing that does strike me is that many of the most successful, most levered trades of Soros, Druckenmiller and others were related to currencies. These guys are all Keynesians but they probably don’t fully believe their own economic theories. However, they do understand them well enough to make huge plays against the dope money managers who DO put all their credence into what they learned at university. I should think an Austrian econ-informed large cap macro fund would have quite a time of it playing against not only the dopes, but the Soroses of the world– they’ll get their final comeuppance as this system of artificial fiat exchange finally unwinds over the next decade.

And, little surprise, the guy with the nearly perfect trading record for almost a decade (Farrallon) was involved in arbitrage trades.

Trend following is for slaves. It may have proven to be a profitable strategy (with gobs of leverage) for the contemporary crop of hedgies but I feel fairly confident in saying most of these guys will get hauled out behind the woodshed in due time if they keep it up, to the extent their strategies truly are reliant on mystic chart reading and nothing more.

Bon voyage!

Notes – A Compilation Of Ideas On Investing

How To Think About Retained Earnings

  • Grab 15 years of data from EDGAR and compare receivables, inventory, PP&E, accounts payable and accrued expenses to sales, EBITDA, etc.; E.g., if receivables rise faster than sales, this is where “reinvestment” is going
  • For a quick comparison, look at:
    • Net income
    • FCF
    • Buybacks + dividends
  • Compare debt (total liabilities) between the start of the period and the end and subtract the difference to get growth in debt
  • Then, sum all dividends and buybacks over the period, and all net income over the period
  • Then, subtract the change in debt from dividends/buybacks; what is left is dividends/buybacks generated by the business, rather than growth in debt
  • Then, compare this to net income to see the ratio of earnings paid out to shareholders
  • You can compare the growth in net income to retained earnings to get your average return on retained earnings
  • Look at the change in net income and sales over 10 years and then the ratio of cumulative buybacks and dividends to cumulative reported earnings
  • You’re looking for the central tendency of return on retained earnings, whether it is approx:
    • 5%, bad business
    • 15%, good business
    • 30%, great business
  • Companies with single products easily generate high returns on retained earnings, but struggle to expand indefinitely

One Ratio to Rule Them All: EV/EBITDA

  • EV/EBITDA is the best ratio for understanding a business versus a corporate structure
  • Net income is not useful; FCF is complicated, telling you everything about a mature business but nothing about a growing one
  • General rule of thumb: a run of the mill business should trade around 8x EBITDA; a great business never should
  • Low P/E and low P/B can be misleading as it often results in companies with high leverage
  • P/E ratio punishes companies that don’t use leverage; they’re often worth more to a strategic buyer who could lever them up
  • The “DA” part of a financial statement is most likely to disguise interesting, odd situations; if you’re using P/E screens you miss out on companies with interesting notes on amortization
  • Control buyers read notes; why use screens that force you to ignore them?
  • FCF is safer than GAAP earnings or EBITDA because it’s more conservative and favors mature businesses
  • EBITDA misses the real expense in the “DA”, but FCF treats the portion of cap-ex that is an investment as expense, so they’re both flawed; investment is not expense
  • No single ratio works for all businesses in all industries; but to get started, EV/EBITDA is the best for screening
  • Example: cruise companies have huge “DA”, but no “T” as they pay no taxes
  • “Only you can calculate the one ratio that matters: price-to-value; there is no substitute for reading the 10-K”
  • Empirical evidence on ratios:

Blind Stock Valuation #2: Wal-Mart (WMT) – 1981

  • There is something wrong with believing a stock is never worth more than 15 times earnings
  • “Growth is best viewed as a qualitative rather than a quantitative factor.”
  • Buffett’s margin of safety in Coca-Cola was customer habit– repeatability
  • Buffett looks for:
    • Repeatable formula for success
    • Focus
    • Buybacks
  • “The first thing to do when you’re given a growth rate is not geometry. It’s biology. How is this happening? How can a company grow 43% a year over 10 years?”
  • Stable growth over a long period of time tells you a business has a reliable formula; look for businesses that behave like bacteria
  • Recognizing the value of changes after they happen is important, not predicting them ahead of time
  • You can’t post the kind of returns Wal-Mart did through the 1970s without a competitive advantage
  • Buffett gleans most of his info from SEC reports, things like 10-year records of gross margins, key industry performance metric comparisons, etc.

GTSI: Why Net-Net Investing Is So Hard

  • The challenge of net-nets is you often have no catalyst in sight and no wonderful future to visualize as you hold a bad business indefinitely
  • Graham’s MoS is integral– you can be off in your calculation of value by quite a bit but Mr. Market will often be off by even more
  • Focusing too much on time could be a problem in net-net investing
  • Two pieces of advice for net-net investing:
    • Put 100% of focus on buying and 0% on selling
    • Put 100% of focus on downside and 0% on upside
  • Money is made in net-nets not by the valuing but by the buying and holding
  • “You want to be there for the buyout.”
  • The hardest part of net-net investing: waiting
  • Graham and Schloss were successful likely because they built a basket, so they were always getting to buy something new that was cheap instead of worrying about selling
  • Focus on a process that keeps you finding new net-nets and minimizes your temptation to sell what you own

Can You Screen For Shareholder Composition? 30 Strange Stocks

  • Shareholder composition can help explain why a stock is cheap
  • A company’s shareholder base changes as the business itself changes; for example, a bankruptcy turns creditors into shareholders
  • Shareholders often become “lost” over the years, forgetting they own a company and therefore forgetting to trade it
  • Some companies go public as a PR ploy, so investors may be sleepy and inactive
  • Buffett understood this and understood that a stock could be a bargain even at 300% of its last trade price– National American Fire Insurance (NAFI) example
  • Buying a spin-off makes sense because many of the shareholders are stuck with a stock they never wanted
  • An interesting screen: oldest public companies with the lowest floats (in terms of shares outstanding); a lack of stock splits combined with high insider ownership is a recipe for disinterest in pleasing Wall St

How My Investing Philosophy Has Changed Over Time

  • Info about Geoff Gannon
    • high school dropout
    • bought first stock at 14
    • read [amazon text=Security Analysis (1940 Edition)&asin=007141228X] and [amazon text=The Intelligent Investor (1949 Edition)&asin=0060555661] at 14
    • over time, became more Buffett and less Graham
    • made most money buying and holding companies with strong competitive positions trading temporarily at 6, 10 or 12 times earnings
  • I like a reliable business with almost no history of losses and a market leading position in its niche
  • Geoff’s favorite book is Hidden Champions of the Twenty-First Century, which is part of a set of 3 he recommends to all investors:
    • You Can Be a Stock Market Genius (by Joel Greenblatt)
    • The Intelligent Investor (1949 Edition)
    • Hidden Champions of the Twenty-First Century
  • Everything you need to know to make money snowball in the stock market:
    • The Berkshire/Teledyne stories
    • Ben Graham’s Mr. Market metaphor
    • Ben Graham’s margin of safety principle
    • “Hidden Champions of the 21st Century”
  • Once you know this, if you just try to buy one stock a year, the best you can find, and then forget you own it for the next 3 years, you’ll do fine; over-activity is a major problem for most investors
  • Bubble thinking requires higher math, emotional intelligence, etc.; that’s why a young child with basic arithmetic would make a great value investor because they’d only understand a stock as a piece of a business and only be able to do the math from the SEC filings
  • There are always so many things that everyone is trying to figure out; in reality, there are so few things that matter to any one specific company
  • One key to successful investing: minimizing buy and sell decisions; it’s hard to screw up by holding something too long
  • Look for the most obvious opportunities: it’s hard to pass on a profitable business selling for less than its cash
  • Extreme concentration works, you can make a lot of money:
    • waiting for the buyout
    • having more than 25% of your portfolio in a stock when the buyout comes
  • I own 4-5 Buffett-type stocks (competitive position) bought at Graham-type P/E ratios
  • “There is a higher extinction rate in public companies than we are willing to admit.”
  • Most of my experience came through learning from actual investing; I wish I had been a little better at learning from other people’s mistakes

Notes – There’s Always Something To Do

There’s Always Something To Do: The Peter Cundill Investment Approach

by Christopher Risso-Gill, Peter Cundill, published 2011

The Peter Cundill approach to value investing

The following note outline was rescued from my personal document archive. The outline consists of a summary of Christopher Risso-Gills’ recent biographical investment profile of Canadian value investor Peter Cundill, There’s Always Something To Do. The notes are in summary form of the most critical aspects to Cundill’s value investment perspective and analytical process.

There’s Always Something to Do: The Peter Cundill Investment Approach

  • “I think that intelligent forecasting should not seek to predict what will in fact happen in the future. Its purpose ought to be to illuminate the road, to point out obstacles and potential pitfalls and so assist management to tailor events and to bend them in a desired direction.”
  • He made a habit of visiting whichever country had the worst performing stock market in the past 11 months.
  • “In a macro sense, it may be more useful to spend time analyzing industries instead of national or international economies.”
  • “It must be essential to develop and specify a precise investment policy that investors can understand and rely on the portfolio manager to implement.”
  • A few investment principles:
    • never use inside information, “All you get from inside information is a whiff of bad breath.”
    • economic facts and company values always win out in the end
    • don’t try to be too clever about the purchase price
    • isolate what the real assets are
    • never forget to examine the franchise to do business
  • Insider buying is not always well-informed– Peter once scooped up shares of J. Walter Thompson (JWT) at a perceived discount and faced a hostile and confused president who was selling stock from the companies pension fund and couldn’t figure out why Cundill was buying (pg. 29), which demonstrates that there are informational disadvantages and ambiguities that keen analysts can take advantage of, even over company insiders; insider buy/sell ratios and actions should be considered thoughtfully and fully “discounted”, not taken as authoritative proof of anything by themselves
  • “Very few people really do their homework properly, so now I always check for myself.”
  • Look for hidden gems on the balance sheet
  • Investing globally:
    • if you find one foreign stock that is trading at a significant discount, snoop around because there may be other bargains in the foreign industry or market
    • There was nothing “ad hoc” about the way Peter addressed the process of international value investment. In every instance it had to be firmly based on a clear understanding of local accounting practices and how those might differ from accepted standards in North America. The fact that it was different, less transparent, or deliberately opaque was never a reason for ignoring or excluding a market or security. Peter’s attitude was “vive la difference”; if a balance sheet was hard to penetrate it was not just a challenge but an opportunity because the difficulties actually represented a “barrier to entry” even for the experienced professional investor and undoubtedly excluded all but the most sophisticated private investors.
    • The other aspect, which Peter considered to be a vital component of a successful international strategy, was building carefully constructed networks of locally based professionals who had a thorough understanding of value investment principles and would instinctively recognize a security that would potentially fit the Cundill Value Fund’s investment criteria.
  • “THE MOST IMPORTANT ATTRIBUTE FOR SUCCESS IN VALUE INVESTING IS PATIENCE, PATIENCE AND MORE PATIENCE. THE MAJORITY OF VALUE INVESTORS DO NOT POSSESS THIS CHARACTERISTIC.”
  • “It is also dangerous to rely on a single strategy in a doctrinaire fashion. Strategies and disciplines ought always to be tempered by intelligence and intuition.”
  • Personal margin note: Peter did not succeed in isolation but cultivated and utilized networks of knowledgeable and influential people (investors, political activists and politicians, business people); he also had several mentors
  • Peter was impressed by a group of corporate socialites he had dinner with, “They maintain that having a hangover is a waste of a day.”; personal margin note: respect the value of time, the ultimate scarce resource, always
  • Peter organized a prestigious investment conference, the Cundill Conference, where he both talked and exchanged ideas on investing with other friends and gurus, as well as heard from invited guest expert speakers who spoke on a range of topics totally unrelated to investing, to promote cross-disciplinary rigor and creative spark
  • “The boards of charitable foundations are convenient meeting places for influential people. Their ostensible purpose is intimately bound up with the social and commercial ones.”
  • Peter relocated to London from Toronto to better pursue his global value investment approach, seeing London as the center of capital and the business crossroads of the world at the time; personal margin note: where is today’s London, or tomorrow’s?
  • On flying across the Atlantic routinely on the Concorde:
    • “It is a remarkable sounding board, especially in my world of matters financial.”
    • “One becomes even more keenly aware that there is never just one factor determining events, there are many of them interwoven and acting simultaneously.”
    • “I always need to discipline myself to be aware of the world generally, rather than trying to be specific. I only need to be specific about the numbers.”
  • Selling stocks which near or surpass their intrinsic value often acts as an “inbuilt safety valve” for the value investor in markets which are in a bubble or overpriced generally
  • Peter channels Horace’s Ars Poetica via Graham in a journal entry prior to the 1987 Crash: “Many shall be restored that now are fallen, and many shall fall that are now held in honor.”
  • “Sooner or later the market will do what it has to do to prove the majority wrong.”
  • Cundill, via Oscar Wilde, on an approach to stocks: “Saints always have a past and sinners always have a future.”
  • “Being out on a limb, alone and appearing to be wrong is just part of the territory of value investment.”
  • Cundill on overvalued markets: “it can tempt one to compromise standards on the buy side and it may lure one into selling things far too early.”
  • Cundill’s value approach gently evolves: “Discounts to asst value are not enough, in the long run you need earnings to be able to sustain and nurture these corporate values. We now, as a matter of course, ask ourselves hard questions as to where we expect each business to be in the future and, as well, make a judgment on the quality of management.”
  • Cundill defines shorting based off of his ‘antithesis of value’: “identifying a market where values are so stretched and extreme that they are clearly unsustainable. They have passed far beyond the realms of any measure of statistical common sense.”
  • “The great records are the product of individuals, perhaps working together, but always within a clearly defined framework.”
  • “In reality outstanding records are made by dictators, hopefully benevolent, but nonetheless dictators.”
  • On avoiding the temptation to sell an eventual winner: “What we ought to do is go off to Bali or some such place and sit in the sun to avoid the temptation to sell too early.”
  • Cundill on his shock related to 1968 sentiment toward the shoddy accounting of the conglomeration movement: “Nobody cared; accounting is a bear market phenomenon!”
  • “Every company ought to have an escape valve: inventory that can readily be reduced, a division that can be sold, a marketable investment portfolio, an ability to shed staff quickly.”
  • “We always look for the margin of safety in the balance sheet and then worry about the business.”
  • “If there’s no natural skeptic on an investment maybe it would be wise to appoint one of the team to play Devil’s Advocate.”
  • More on investing overseas in developing markets: What was required was an asset-based margin of safety significantly greater than would be considered adequate in the more developed markets. It was also fairly obvious that in these less developed markets tangible fixed assets were superior to cash, which had a nasty habit of evaporating.
  • Cundill on retirement: “Retirement is a death warrant.”
  • Poetic Cundill: “No fortunes are made in prosperity, Ours is a marathon without end: Enjoy the passing moments.”
  • Cundill’s wit and wisdom on what makes for a great investor:
    • “Curiosity is the engine of civilization”, he advises to have serious conversations with people that result in an exchange of thoughts and to keep one’s reading broad.
    • “Patience, patience and more patience.”
    • “Always read the notes to a set of accounts very carefully… seeing the patterns will develop your investment insights, your instincts — your sense of smell. Eventually it will give you the agility to stay ahead of the game, making quick, reasoned decisions, especially in crisis.”
    • “Holding on to a heavily discounted stock that the market dislikes for a period of five or ten years is not risk free. As each year passes the required end reward to justify the investment becomes higher, irrespective of the original margin of safety.”
    • “An ability to see the funny side of oneself as it is seen by others is a strong antidote to hubris.”
    • Routines: “They are the roadmap that guides the pursuit of excellence for its own sake.”
    • Via Peter Robertson, “always change a winning game.”
    • “An investment framework ought to include a liberal dose of skepticism both in terms of markets and of company accounts.”
    • Personal responsibility: “If you lose money it isn’t the market’s fault… it is in fact the direct result of your own decisions. This reality sets you free to learn from your mistakes.”
    • Suggested reading list:
      • Extraordinary Popular Delusions and the Madness of Crowds
      • The Crowd: A Study of the Popular Mind
      • Buffett: The Making of an American Capitalist
      • The Money Masters
      • The Templeton Touch
      • The Alchemy of Finance
    • Cundill’s Corrolary to Murphy’s Law: “When things get so bad that you’re really scared, that’s the time to buy.”
    • Global investing: “Given the dearth of bargains today, it pays to search for them everywhere.”
    • On independence, via Ross Southam, “You have to be willing to wear bellbottoms when everyone else is wearing stovepipes.”
    • “If it is cheap enough, we don’t care what it is.”
    • “I would say that the problem with big businesses that have moats around them is they tend to over-expand.”
    • “IPOs for the most part are dreams engendered by the hope that pro forma estimates will be met. We deal to a certain extent in nightmares that everyone knows about.”
  • Three parts to Cundill’s investment strategy:
    • NAV
    • sum of the parts analysis
    • future NAV estimation
  • “Sometimes nothing is more misleading than personal experience.”
  • Investments held by Peter Cundill, managed by others, a potential place to search for ideas or gain more insight, pgs. 223 and 224

Notes – The Aggressive Conservative Investor

The Aggressive Conservative Investor

by Marty Whitman, published 1979, 2005

A seeming contradiction in terms

The following note outline was rescued from my personal document archive. The outline consists of a summary of Marty Whitman’s classic value investing tome, The Aggressive Conservative Investor.

Chapter 1, An Overview

  1. Two main types of investors
    1. passive, outsider investors
      1. no control over the management of their investments
      2. no knowledge of the investment other than what is publicly disclosed
    2. activist, insider investors
      1. have control over the management of the investments
      2. privvy to non-public information and disclosures
  2. Two major types of businesses which require two different kinds of analysis
    1. strict, going-concern
      1. large, stable institutions which tend to sell the same product and finance the selling of it in similar ways over time
    2. asset-conversion firms
      1. merger/acquisitions
      2. the purchase and sale of assets in bulk
      3. major financial restructurings or recapitalizations
      4. sales of control or contests for control
      5. creation of tax shelter entities
  3. Key emphasis is placed upon financial position
    1. ability to create liquidity (from cash or from liquid assets)
    2. ability to borrow
    3. ability to generate surplus cash from operations
    4. ability to market new equity securities
  4. In contrast, conventional fundamental analysis focuses on primacy of earnings
    1. reported earnings are a fundamental determinant of stock price
    2. this primacy of earnings theory is emphasized only in special circumstances where the company is a strict going concern or when its securities are being studied via day to day share price fluctuations
    3. most securities holders are not stock traders
    4. most businesses are not strict going concerns
    5. financial position reveals itself to be a better long-run determinant of valuation because it more fully represents the character of the underlying business
  5. Concerned with fundamental rather than technical analysis
  6. What is a security?
    1. investment vehicle which allows the holder to benefit from an inactive creditor or owner role
    2. examples: common stocks, preferred stocks, bonds, leasehold interests, limited partnership participations, savings-bank deposits and commercial paper
    3. example of a non-security: fast food franchise agreement which requires the owner to participate as manager as part of the agreement
  7. Understanding the underlying business becomes increasingly important as larger amounts of funds or increasing proportions of the individual’s resources are invested in a security
  8. Additionally, understanding the business is increasingly important with diminishing seniority within the security hierarchy, which exposes the investor to increasing risk
  9. The book takes a broad perspective on the strategies and perspectives of numerous types of investors because understanding the motives of others can highlight specific opportunities and risks for the individual investor himself
  10. Emphasis is on “business internals” rather than market and economic externals
    1. most individuals have little ability to predict the latter
    2. keen awareness of the former can remove a lot of the risk from the equation and protect the investor from mistakes made about the latter
  11. Disagree with modern capital theorists
    1. most markets and common-stock prices are in disequilibrium
    2. careful and thorough perusal of publicly available documents can guard the individual from unsystematic risk
  12. Underlying conviction that the value of a business has no necessary relationship to the price of its stock
  13. The primary determinant of future earnings and common-stock prices is financial position; quality and quantity of a business’s resources
  14. “Magic formula” for investment success is not arithmetic but grows out of:
    1. experience
    2. insight
    3. maturity of judgment
  15. Three general topics covered by the book:
    1. educate outside investors about the way insiders and deal promoters tend to think
    2. help the outsider to gain familiarity with the uses and limitations of required disclosures of the SEC
    3. attempt to impart understanding about the roles of the various players in the financial community and how they each participate in the investment process
  16. Focus on four types of investments to be made in commercial paper, corporate bonds, certain leases, preferred stock, limited partnership interests and common stocks:
    1. trading investments
    2. investments in the securities of emerging companies or industries
    3. workout and special-situation investments
    4. cash-return investments

Chapter 2, The Financial-Integrity Approach to Equity Investment

  1. Successful investors-activists prioritize their concerns as the potential issuer of a loan would:
    1. First, how much can I lose?
    2. Second, how much can I make?
  2. Strong financial positions generally translate to:
    1. less risk
    2. greater ability to expand business
    3. more attractive candidate for asset-conversion activities
  3. Attractive equity investments for outsiders should have the following characteristics:
    1. strong financial position, measured not so much by presence of assets as by the absence of significant encumbrances
    2. run by reasonably honest management and control groups that are aware of the interests of creditors and other security holders
    3. availability of a reasonable amount of relevant information, necessarily falling short of “full disclosure”
    4. price out to be below the investors reasonable estimate of net asset value
  4. Primary motivation for buying is that values are “good enough”, no search for bottoms in the short-run
  5. Shortcomings of the Financial-Integrity Approach
    1. requires an enormous amount of work; sifting through documents
    2. know-who is helpful and at times essential; special information discernible only from non-public relationships
    3. the most attractive securities uncovered by FIA tend to be in inactive markets, especially post-arbitrage
    4. risk aversion results in a severely limited selection of attractive securities which might be fully enjoyed by the less risk-averse
    5. securities issued by those believed to be “predators” should be avoided
    6. FIA approach is mostly useless in areas where sufficient public disclosure can not be obtained
    7. insiders sometimes pose a risk to outsiders and because of their ability to force-out outsiders and independently appraise values, some attractive opportunities will be avoided by the FIA adherent
  6. FIA view of risk
    1. quality of the issuer
    2. price of the security
    3. financial position of the holder

Chapter 3, The Significance of Market Performance

  1. Stock market value should be weighted differently for different individuals
    1. traders; 100% because they are trading for capital appreciation
    2. investors seeking secure income; 0%, because they may want to acquire a larger position over time at lower prices
    3. vast majority of people; somewhere considerably more than 0 and considerably less than 100
  2. Investors who do not weight stock prices as 100% important:
    1. investors who would benefit from low market valuations for estate tax or personal-property tax purposes
    2. investors primarily interested in maximizing cash return and/or are continually creating cash for new investment from non-investment sources
    3. investors seeking to accumulate large positions for control or to influence control shareholders
  3. One can not beat the market by trying to beat the market; instead, long-term performance comes from buying clear values and holding them in the absence of clear evidence that a mistake has been made
    1. evidence for this mistake comes in the results of the business, not the market’s valuation of the business
  4. Market performance is more important to a portfolio of fixed size or facing continued withdrawals of cash; less important to a portfolio which is a continual recipient of new cash and is thus a dollar-averager
    1. for the dollar-averager, good market perf results in less attractive terms for continued investment, bad market perf leads to more attractive terms for continued investment
    2. dollar averaging diminishes the need to beat inflation because changes in the value of money, in the long-run, will be offset by changes in the return on securities
    3. example; a well-run fire and casualty insurance company, which receives continuous cash injections from underwriting department
  5. An outside investor holding a completely marketable security should give a weighting of close to zero to market perfomance when:
    1. he knows has reason to believe that the security’s real worth is not close to the market price
    2. he knows he will not need to liquidate in the near future
    3. he knows he will not need to use the security as collateral for borrowings
  6. Important to remember that stock market prices are not business or corporate values but a realization price that will likely not hold in the event of a merger or acquisition; market price is a value of only part of the total outstanding, not all outstanding stock
  7. Comparative measures of portfolio performance are imprecise; a company can beat its industry benchmark but still have performed poorly in an absolute sense, or vice versa
  8. Professional money managers and beating the market
    1. some economists believe that the goal of professional money mgrs is to beat the market and they have failed if they don’t
    2. many professional mgrs have other concerns than simply beating the market:
      1. maintenance of cash income
      2. maintenance of cash principal
    3. for example, is it important that a strongly capitalized insurance company outperform the market when its net investment income is increasing at 10% annualized?
  9. Investors seeking “bailouts” from their investments might weight market performance low
    1. control of a company can allow for control over cash bailouts through dividend policy, mgmt of salaries and fees
    2. control of a company can allow for non-monetary bailouts via three P’s
      1. power
      2. prestige
      3. perquisites
  10. Three types of security holders who rate market performance highly, seeking “bailout” in the market:
    1. common stock holder with minority interest in which dividend income is insignificant or not part of the objectives
    2. control stockholder and company seeking to sell securities or issue them in merger and acquisition transactions
    3. holder without a strong financial position; someone who intends to borrow or has borrowed heavily to finance his portfolio

Chapter 4, Modern Capital Theory

  1. Description of MCT and efficient portfolios
    1. an individual knows how he reacts to risk and must choose from stocks, bonds and cash
    2. he evaluates each instrument accurately in terms of risk, expected return and relative valuation/price movement
    3. assuming all assumptions are accurate, the individual creates a portfolio that provides the largest expected return for a given level of risk
    4. this best describes the environment faced by the stock trader
    5. this theory fails to account for thin markets, price formation mechanisms, non-symmetric information and general equilibrium considerations
    6. this theory is not suitable for outside investors primarily interested in income, dollar averaging or special-situation investors who ignore timing considerations, as well as all activist investors
    7. MCT also assumes the avg outside investor and his adviser are capable and able to interpret information correctly; empirical evidence points to the opposite
  2. The computer and mathematical analysis
    1. the fatal flaw of mathematical analysis is the non-quantifiable variables or ugly facts that get left out of the models assumptions
  3. On systems for playing the market
    1. Chartist-approach
      1. Not necessarily irrational or illogical
      2. Movements of the market do represent aggregate behavior, however, to date no truly successful chartist model has been created
    2. Random-walk theorists
      1. at any instant, price changes follow no predictable pattern
      2. using only trading information, there is no predictability to prices
    3. filtering rules or formula-timing
      1. best that can be said is their mechanical application can save investors from getting suckered into go-go markets or being rushed out the exits by mass panic
  4. On arbitrage
    1. topic for a professional, requires plenty of calculation and minimization of trading costs (should be a member of an NYSE firm)
    2. Thorpe and Kassouf’s book is recommended
  5. Portfolio balancing
    1. “Beta” is the estimated market sensitivity of a stock, measured in terms of an expected incremental percentage return associated with a one percent change in return of the S&P500
    2. For the avg investor, problems occur far more often with security analysis than portfolio selection
    3. Most important for someone running many millions of dollars; for everyone else, this is over-rated; all the best portfolio-balancing in the world won’t save you from poor analysis
  6. Fundamental security analysis and corporate finance
    1. Good fundamental analysis involves perception, training, understanding and a high degree of abstraction in implicit or explicit model building– picking the right variables and causal relations
    2. There are far fewer skilled practitioners than there are opportunities to practice security analysis
    3. The idea that fundamental analysis is not necessary because markets are efficient is flawed because most analysts are incompetent, which prices ultimately reflect
  7. Calculation or evaluation
    1. The problem facing any serious analyst is what the figures mean, not what they happen to be
    2. For example, imagine a company carrying real estate on its books at $1.5M; the significance changes when we learn that they represent 100,000 acres of California coastal land carried at the 1880 purchase price
    3. Valuations change depending upon the context of valuation; estate planning, income taxes, obtaining a loan, etc. all produce different valuations of the same entity

Chapter 5, Risk and Uncertainty

  1. The outsider faces greater risks than the insider
    1. he cannot acquire complete knowledge of a company, no matter how many documents he studies
    2. he (and the insider) face the possibility that the analysis is wrong
    3. he may fail to properly appraise the quality and honesty of the management
    4. he may simply fall prey to the unpredictability of the future
    5. the market may fail to realize intrinsic value for extended periods of time, even if the analysis of those values is correct
  2. Assessing the investment odds: risk and reward
    1. conventional wisdom states that the key to investment risk is the quality of the issuer
    2. high quality issuers tend to be well-known, and this knowledge is reflected in asset prices
    3. therefore, the cliche, “You have to take chances if you want to make money”
    4. but financial position of the security holder and the price of the issue are also important factors in judging risk and reward
  3. Quality of the issuer
    1. A company can become high quality just because important people within the investment community say it is; they’re often proven wrong
    2. never buy when a high quality company is being touted because it is probably overpriced then
    3. if your investment matters to you, obtain at least a rudimentary knowledge of the company before investing
  4. Price of the issue
    1. Good investors focus on how much they can lose; “risk averse”
    2. higher price translates to higher risk, lower price, lower risk
    3. there can be considerably lower risk investing in a lower quality company at a lower price than at a higher quality company at a higher price
    4. an investor with more time and expertise to spend on his analysis should weigh price considerations more heavily; an investor with less time and less expertise should weigh quality considerations more heavily
  5. Financial position of the holder
    1. an investor who buys the best quality stock at a fraction of its overall value is taking a significant risk if he can’t afford the purchase
    2. investors on margin can turn high quality investments (such as USTs) into speculative gambles
    3. investors often take losses when they do not have enough funds to live on and are forced to liquidate at an inopportune time
    4. without the resources to ignore them, an investor has no guard against stock-price fluctuations
  6. Portfolio diversification versus securities concentration
    1. diversification is a way to reduce risk in situations where the investor lacks knowledge
    2. in situations where the investor enjoys enough knowledge, confidence and financial position to weather temporary setbacks, the risk-reward ratio may be tipped in favor of concentration
  7. Considering the consequences
    1. The astute investor examines consequences as well as odds
    2. The odds can be strongly in favor of appreciation/success, but the consequences of failure so severe (insolvency) that the risk-reward ratio is still not in favor of making an investment
  8. Risk and investment objectives
    1. The cash-return investor will base his investment decision on different factors in evaluating risk than the special-situation investor, even when using the same facts
    2. Risk-reward ratio will provide the investor with a guide to use in defining his investment objectives
    3. Cash-return investors with no opportunity to investigate carefully should focus primarily on quality of the issuer
      1. reference bond rating services
      2. reference the investors own independent conclusions
      3. any doubts, don’t invest; sell if owned
      4. should limit investments to debt securities in most instances
        1. debt securities have a legally enforceable right to be paid principal and interest
        2. higher up in the capital structure in the event of an insolvency
    4. workout- or special-situation investor should focus on price of the issue
      1. he finds safety in a low price
      2. place important emphasis on the four elements of the FIA

Chapter 6, Following the Paper Trail

  1. Principle documents of the paper trail:
    1. Form 10-K; official annual business and financial report
    2. Form 10-Q; quarterly financial report, includes disclosures of certain material and extraordinary events that occurred during the three-month period
    3. Form 8-K; filed within 15 days of a reportable event, unscheduled material events or corporate changes
    4. Annual reports; most important way most public companies communicate with shareholders
    5. Quarterly reports
    6. Annual-meeting proxy statements; used to solicit votes of shareholders
    7. Merger proxy statements; issued to shareholders to vote on an asset conversion-matter such as merger, consolidation, sale of assets or liquidation (S-14)
    8. Prospectuses; registration statements issued when securities are being offered publicly (S1 & S7)
    9. Cash tender offer circulars; sent when a publicly announced offer is made to buy shares for cash
    10. Encumbrances are almost always spelled out in these documents and their footnotes
  2. The documents and how to read them
    1. Simply reading these documents will give you a good idea of whats contained within and what their use is
    2. If you can obtain copies of the preparation documents used to create the SEC officially regulated forms, you can get an idea of what the preparer has to consider in making disclosures
    3. Other important documents
      1. Forms 3 and 4; disclosure by insiders concerning their shareholdings and changes in holdings
      2. Form 144; filed by holders desiring to sell restricted stock under Rule 144
      3. Form 13F; filed by all managers with accounts of marketable equity securities greater than $100,000,000
      4. Schedules 13D; filed within ten days by persons who have acquired 5 percent or more of an outstanding security issue (or, who acquire an additional 2 percent within a 12 month period after already acquiring 5 percent)
      5. Schedules 14D; similar to 13D, filed prior to making a cash tender offer for more than 5% of shares outstanding
    4. What the paper trail doesn’t do
      1. does not provide company forecasts, company budgets and valuation appraisals of assets
      2. no real disclosure as to specifics of running the business, such as appropriate levels of capital expenditure, marketing, research and development, etc.
      3. might miss small acquisitions that do not require a shareholder vote

Chapter 7, Financial Accounting

  1. Types of accounting
    1. cost (or control or managerial)
      1. purpose is to tell a management what its costs are
      2. internal, essential to the operation of the business
    2. income-tax
      1. not supposed to measure economic reality, unlike cost-accounting
      2. designed to create an economic reality (tax bill) based on rigid set of principles (Internal Revenue Code)
      3. emphasis is on minimizing tax exposure
    3. financial
      1. sandwiched between cost accounting and income-tax accounting
      2. “primary purpose is to provide quantitative financial information about a business enterprise useful to owners and creditors”
      3. seeks to “fairly” represent the results of operations and the financial position of the company
  2. How to understand financial accounting, five major misconceptions:
    1. no need to distinguish between financial accounting versus income-tax and cost accounting
    2. financial accounting has much the same role in corporate analysis and in stock market analysis
      1. primary emphasis in corp analysis is on what numbers mean, not what they are
      2. in corp analysis, no rule that one accounting number is more important than any other; in stock market analysis, primary emphasis tends to be put on net income/earnings per share
      3. in corp analysis, profit is thought to come from the business factors themselves; stock market analysis, profit comes from what one thinks someone else will pay for the security later
      4. because stock market analysis doesn’t rely on deep understanding of the underlying business, value is sought elsewhere– in precise attainment of estimated numbers
    3. accounting can be made distortion-free an/or realistic and/or uniform
      1. financial accounting is based on Generally Accepted Accounting Principles
        1. an attempt is made to match revenues with costs on an accrual basis to the exclusion of matching cash inflow with cash outflow
        2. an attempt is made to view businesses on a going-concern basis
        3. financial-accounting is primarily based on exchange prices
        4. financial-accounting is primarily based on historical costs
        5. financial statements are designed to be general-purpose, “serve the common needs of a variety of groups”
      2. as a result, financial-accounting can not be distortion-free, realistic or uniform
      3. financial-accounting is more useful at measuring the economics results and values rather than the solvency of a business
        1. more useful for judging a strict going-concern
        2. less useful for a natural resource company, real estate or life insurance companies or companies engaged in mergers, acquisitions and imaginative financing and refinancing
        3. as an example, most high quality real estate that is well-maintained doesn’t depreciate over time, but it has to for tax and accounting purposes
    4. about the meanings of GAAP
      1. inter-industry distortions arise based upon calling similar circumstances “permanent differences” or “timing differences”
    5. about the shortcomings of the corporate audit function and the ethical standards of independent auditors in the US

Chapter 8, Generally Accepted Accounting Principles

  1. Myths and realities about the meaning of GAAP
    1. Myth #1; GAAP tends to, or ought to, be rigidly codified with a series of well-articulated do’s and don’ts
    2. Myth #2; GAAP is all-encompassing and is, or should be, designed to measure all sorts of corporate events and phenomena
    3. Myth #3; GAAP should tell the Truth, that somehow it can be made more realistic for average investors while still becoming more informative and more useful for all of its users
  2. Eleven underlying assumptions of GAAP which provide insights into its uses and limitations:
    1. ownership of, that is, title to, tangible assets is the basis of value and the means of creating income
      1. ignores the value of intangible assets, such as lack of debt or ability to create new debt, advantageous debt terms, price at which new equity can be raised, etc.
      2. some other intangibles:
        1. long-term, favorable (or unfavorable) contracts with key employees, customers and vendors
        2. trade names and patents
        3. distribution channels, such as dealer organizations
        4. manufacturing know-how
        5. licenses to do business
        6. tax-loss carry-backs (worth cash) and tax-loss carry-forwards
      3. GAAP becomes increasingly less descriptive when intangibles play a larger role in creating value and income
        1. GAAP provides good benchmarks to value the output of a steel mill, for example
        2. GAAP does not provide good bench marks for valuing the worth of a medical degree
    2. corporate asset items have independent values unmodified by their inclusion as but one small part of a going concern
      1. as a practical matter, few assets of a going concern have value that is independent of the going concern
      2. independent values exist only in asset-conversion
      3. passivity and liquidity are highly interrelated; more liquidity means less responsibility in administering the asset
    3. changes in accounting rules should not be disruptive of important existing practices unless there is conflict among establishment members
      1. GAAP is an establishment tool and its basic purpose is to aid, not to fight or alter, an existing economic system
      2. changes should be expected to be evolutionary, not revolutionary or radical
    4. a puritan work ethic is desirable; hence achievement through going-concern operations are far more desirable than achievements through asset conversions– mergers and acquisitions, reorganizations or refinancings
      1. profit should be created from going-concern operations, not capital appreciation through asset arbitrage
    5. the medium is the message
      1. immediate stock market impact is what financial statements are directed to
    6. precise definitions are a desirable goal
      1. as much as possible, items should be defined as expense or income, liability or proprietorship
      2. except for insurance-company accounting, no recognition that many items (deferred income taxes, unexpired subscriptions, low-interest rate mortgage loans, etc.) have elements of both expense and income, or liability and proprietorship
    7. GAAP is designed primarily to protect the cash buyer of securities
      1. great bulk of cash buyers of corporate securities are lending institutions– banks, insurance companies, pension trusts and finance companies
      2. GAAP tends to explain “how bad things are if you give up your cash for this security”
      3. GAAP is less suited to explain how a holder of equity securities will fare when asked to give them up for cash or other securities, such as in an acquisition or merger
    8. security holders tend to be monolithic: all have the same interests
      1. GAAP assumes all stockholders are interested in the price of the stock they own
    9. per-share market prices are per se important and are the single most significant indicator of the value of entire businesses
    10. in classifying assets or liabilities, physical substance and legal substance are deemed to be more important than economic substance
      1. often non-current, fixed assets are highly liquid due to their being subject to asset-conversation activities
      2. similarly, many current assets are locked up as part of the operation of the going-concern and are not liquid or marketable
    11. there is a basic identity of interests between a company and its various stockholder groups
      1. much more realistic to consider the relationships between company and stockholders and stockholders vs. stockholders as combinations of communities of interest and conflicts of interest
  3. Myths about the shortcomings of the corporate audit function and the ethical standards of the US independent auditing profession
    1. most speculative bubbles have been in industries or issues where GAAP is either nonexistent or of little significance in appraising a business or stock

Chapter 9, Tax Shelter (TS), Other People’s Money (OPM), Accounting Fudge Factor (AFF) and Something Off the Top (SOTT)

  1. Tax shelters
    1. people try to avoid maximum rates
    2. people try to avoid being unable to control the timing of a tax liability
    3. people try to avoid transactions that produce a taxable event but not the cash to pay for it
  2. Other People’s Money
    1. OPM is different in different situations
      1. banks, it is depositors’ money
      2. AmEx, it is paid but not cashed traveler’s checks
      3. insurance company, it is premiums paid
    2. OPM can be used to enrich an opportunistic promoter at little to no cash cost to himself
    3. OPM is dangerous for common-stock investors
      1. hard to predict the short- to intermediate-term price activity
      2. danger of loss where there is a lack of positive cash-carry (cash income on investment exceeds cash interest costs of loan)
  3. Something Off The Top
    1. insiders view outsiders SOTT as having a free ride; enjoying the profits of a company without doing the work
    2. insiders themselves enjoy SOTT through special information access, nice offices, special opportunities through business relationships and contacts, opportunities to buy cheap stock and PPM (power, prestige, money)
    3. control can often be a negative in the event of a company being “sick”; in this case, being an outsider is SOTT
    4. a general rule for public investors is to avoid companies whose mgmts have general disdain for outsiders and try to claim SOTT at their expense
  4. Some preliminaries on the Accounting Fudge Factor (AFF)
    1. there is no “right” way to account for things
    2. are you a senior lender, a common stockholder or the president of the company, etc?
    3. are you interested in cash returns, the build-up of intrinsic value, the price of the stock or some combination of the three?

Chapter 10, Securities Analysis and Securities Markets

  1. Companies and securities can only be analyzed in context; what is good or bad in one context becomes bad or good in another
  2. Variables that can not be quantified as good or bad:
    1. profit margins
    2. size
    3. liberal accounting policies
    4. low net asset value
    5. Wall Street sponsorship
    6. the trading assumption versus the investment assumption
    7. convertible securities
    8. limitations of comparative analysis
  3. Reasons for acquiring and holding securities
    1. aggressive mgmts might fully utilize liquidity, thus creating a weak financial position
    2. high book value relative to market price when price-earnings ratios are high results in low return on investment
    3. companies with high profit margins, high stock prices and low book values attract competition
    4. companies that survive and prosper in highly cyclical, unprotected industries tend to be run by able mgmts
  4. Profit margins
    1. low profit margins can be a strong reason for purchasing a security if it is believed the margins will improve; small improvements in low margin situations can result in big, leveraged returns
    2. companies with consistently high profit margins tend to be popular and thus over-priced
    3. it often happens that companies with consistently high profit margins suddenly lose them overnight
  5. Size
    1. small companies should be chosen because of the appreciation potential inherent in their prospects for growing into giant businesses
    2. many small and medium sized companies are well financed and effective competitors, meaning they are high quality issuers even if not recognized as such
    3. large firms are best selected by investors with no ability or time to get to know their investments better
    4. in general, the smaller the business, the riskier, however, there are times when high prices can make large businesses riskier on a relative basis
  6. Liberal accounting policies
    1. a firm can use liberal accounting policies to gain market sponsorship through excitement about its strong earnings profile; this market sponsorship can be used to attract financing at extremely generous rates, improving the firm’s financial position
    2. if a stock goes up far enough and its management is astute, it can use the “Chinese dollar”, or puffed value, to buy economic value elsewhere at a discount
    3. The standard of investment behavior for passivists as well as activists should be, “Worry about the investments you made, that you shouldn’t have,” not, “Worry about the investments you should’ve made, but didn’t”
  7. Advantages of a low net asset value
    1. a company with a lower NAV might have a higher ROI
    2. all assets come with encumbrances; sometimes having a lower NAV relative to a competitor with higher NAV can result in greater ROI because the higher NAV requires more maintenance and other costs to keep it current, even when not actively productive
  8. Wall Street sponsorship
    1. “sponsored security” is an issue that is recommended and/or purchased by people in the financial community who are able to lure or influence others to acquire that security
    2. important for those interested in immediate performance or timing or in owning a highly marketable, actively traded security
    3. buying poorly sponsored or unsponsored equity securities has its advantages for long term investors because this is typically where bargains are found
  9. The trading assumptions versus the investment assumptions
    1. Much advice about how to invest is given from the perspective that the market knows more than the individual investor, and thus should be heeded accordingly
  10. Convertible securities
    1. issuers of convertibles are frequently second-rank companies who include convertibility to “sweeten the deal”
  11. Limitations on comparative analysis
    1. the goal is not completeness, but “good enough”; time and knowledge are at a premium
    2. “good enough” is the standard for measuring market and business performance; no one can be best all the time or own all the resources in the world

Chapter 11, Finance and Business

  1. Heavy Debt Load
    1. high debt can be viewed as a reason to purchase a stock, especially in a bull market, because many equate it to aggressive mgmt
    2. another reason high debt can be an asset is if the debt was acquired at attractive terms and competitor firms are not able to replicate such financing
  2. Large cash positions
    1. can be a sign of unattractiveness when:
      1. entrenched, non-raidable mgmts refuse to make productive use of funds
      2. where mgmt refuses to use funds to undertake necessary expenditures
    2. watch out for companies that appear strong financially but operationally are weak because they have not invested properly in their businesses
  3. Diversification versus concentration
    1. some enterprises excel with a singular focus
    2. others benefit from diversification
    3. the jury is out
  4. Management incentives
    1. management expenses and salaries are paid before all other securities
    2. management looting is generally not a problem in larger firms, but it is widespread enough that no security holder should assume there is a community of interest between mgmt and security holders
  5. Advantages of highly cyclical companies in competitive industries
    1. the adversity and challenge of these industries tend to attract highly talented mgmt
    2. they also tend to be well financed and relatively liquid because they can’t afford not to be
  6. Going public and going private
    1. What a business is worth as a private enterprise is different from what it is worth as a public enterprise
    2. A private company can go public by selling its own equities, or it can sell out for cash to a company that is already public
    3. Many times a public company is worth far more private than public so it will go private by purchasing up shares for cash
      1. a company repurchasing stock is, in effect, going private when it does so
  7. Who runs most companies?
    1. Myth is that they’re run by their directors; day-to-day reality is they are run by their mgmt
  8. Consolidated versus consolidating financial statements
    1. Sometimes, due to cross-ownership of securities held within a senior organization, the common equity of a child company can take a “de facto” status as a senior security within the parent organization
  9. Negative values in owning assets
    1. “everything’s got a price”
    2. “I wouldn’t own that asset if you gave it to me”
    3. Because ownership of most assets entails obligations and expense, the second statement is typically truer than the first

Chapter 12, Net Asset Values

  1. The usefulness of book value in security analysis
    1. book value is an accounting number and it is limited in usefulness as any accounting number is
    2. by itself it means little; gains significance relative to other figures and information
    3. quantitative measure of assets; tells us “how much”
  2. Book value as one measure of resources
    1. the amount of resources a company has to create future earnings is a good indicator of future earnings power; book value measures available resources
    2. corporate buyers tend to focus on book value as an indicator of how they can redeploy newly acquired resources
    3. important in calculating ROI and ROE
  3. Book value as one measure of potential liquidity
    1. opportunities to create tax carry-backs can occur when a common stock is selling at a steep discount from brick-and-mortar book value and the business has been paying high tax rates
    2. useful when a profitable business is available for acquisition at a price well below net asset value as shown on the tax records
    3. IRS can end up providing a substantial amount of the cash needed to finance the acquisition
  4. Book value analysis as a competitive edge
    1. most stock traders focus on short-term earnings, which is reflected in market prices
    2. focusing on large high-quality asset values as an indicator of good future earnings could give an investor an edge as these will not be reflected in high market prices
    3. changes in earnings and P/E ratios can be sudden and violent; changes in book value, however, tend to be gradual
  5. Limitations of book value in security analyses
    1. does not, in and of itself, measure the quality of a company’s assets
      1. high-quality means approaching being down free and clear of encumbrances
      2. high-quality means the business has a mix of assets and liabilities that appear likely to produce high levels of operating earnings and cash flows
      3. high-quality means assets tend to be salable at a price that can be estimated accurately

Chapter 13, Earnings

  1. Wealth or earnings?
    1. Generation of reported income is one way to create wealth
      1. another is creating unrealized appreciation
      2. another is realizing the appreciation that has been created
    2. Reported income generation is the least tax sheltered way to grow wealth; creates incentive for asset-conversion
    3. Private company mgmt tends to minimize reported income to minimize tax burden; public company mgmt tends to maximize to enjoy higher stock price
      1. allows investor to realize gains through selling and borrowing
      2. allows the company to issue stock for cash or to acquire other companies
  2. The long-term earnings record
    1. In fundamental analysis, special attention should be given to the importance of a favorable long-term earnings record
    2. The major component of NAV for most publicly owned businesses is retained earnings
    3. Earnings record is extremely important for a strict going-concern analysis
    4. Judging the quality of an issuer is another situation where a strong long-term earnings record is important to the analysis
  3. “Parsing” the income account
    1. The static-equilibrium approach
      1. looks at current earnings and the earnings record as principal factors in market price determination
      2. market prices within an industry tend toward equilibrium– a stock out of equilibrium could be a reason for buying or selling
      3. important in i-banking world, where new issues are commonly priced at lower than typical multiples as a marketing tool
    2. The dynamic-equilibrium model
      1. uses past and current record of current earnings as a base for estimating future earnings
      2. projected increase is then used for predicting a future stock price
    3. Various definitions of earnings
      1. what accountants using GAAP report them as
      2. what accountants using GAAP report them as, as measured by overall performance, including extraordinary items and discontinued operations
      3. the increase in value of a business (incl stockholder distributions) from one period to the next; ie, changes in NAV
      4. the increase in the ability to make stockholder distributions over and above actual stockholder distributions without reducing actual invested capital
      5. the increase in the ability to make payments to all security holders, not just equity holders, during a period
      6. the increase in ability to improve future sales, accounting profits and/or cash flow during a period
    4. use caution when an expanding business’ earnings are not “real” because they can not finance their own growth without being acquired, ex, Parliament brand cigarettes from small private company Benson and Hedges
    5. may make sense to stress “earning power” (wealth creation) versus “earnings” (reported accounting earnings)

Chapter 14, Roles of Cash Dividends in Securities Analysis and Portfolio Management

  1. The three conventional theories
    1. John Burr Williams
      1. common stock is worth the sum of all the dividends expected to be paid out on it in the future, each discounted to its present worth
      2. criticism: only apply in a tax-free world where the reason for owning stocks is to receive dividends and the reason for all corp activities was to pay dividends
      3. instead, more realistic to say that common stock held by non-control stockholders is worth the sum of all the net after-tax cash expected to be realizable in the future from ownership of the common stock, with such net cash coming in the form of cash disbursements from within the company (dividends, liquidations) or from without (stock purchasers, lenders accepting stock on margin)
    2. Modigliani and Miller
      1. as long as mgmt is thought to be working in the best interests of the shareholder, retained earnings should be regarded as equivalent to a fully subscribed, preemptive issue of common stock, and therefore that dividend pay-out is not material in the valuations of a common stock
      2. criticism: no evidence that mgmts share a “community of interest” with stockholders
      3. mgmt, if they are responsive to stockholders, tend to focus on the interests of holders that will bring the best benefits to mgmt
    3. Graham and Dodd
      1. in the vast majority of companies, higher common-stock prices will prevail when earnings are paid out in dividends rather than retained in a business
      2. criticism: emphasis should be on which stock — low dividend payer or high dividend payer — is more attractive to which type of investor
  2. Cash dividends as a factor in market performance
    1. ceteris paribus, a low dividend payer is better for an investor seeking market appreciation rather than cash-carry
    2. lower dividend companies tend to sell at lower prices, thus they tend to be more attractive buys
    3. a company whose common stock is available at a lower price will have more room to increase its dividend; dividend increase record is important for some in valuing stocks
    4. lower dividends translates to higher retained earnings and thus improved financial position over time
    5. countervailing argument: high-dividend payers tend to be better buys because a high payout ratio means mgmt is more attuned to the desires of most outside stockholders
    6. stockholders can be hurt by companies paying out high dividends long after it is wise for them to do so
    7. Graham and Dodd view is valid in the short-run but seems to make less sense in the long-run
  3. The placebo effect of cash dividends
    1. dividends increase in importance for securities holders insofar as they lack confidence in their outlook or mgmt or in the reliability of disclosures
    2. dividends are a hedge against being wrong
  4. Cash dividends and portfolio management
    1. Dividends increase in importance with the shareholder’s need for immediate cash income from his portfolio
    2. dividends become a negative factor when the shareholder wants a tax shelter or has no need for income and has confidence mgmt will successfully reinvest retained earnings
    3. securities with a high cash return can be attractive due to positive cash-carry
  5. Cash dividends and legal lists
    1. cash dividend income is a legal or quasi-legal necessity for many securities holders
  6. Cash dividends and bailouts
    1. the ability to convert assets to cash is a key consideration for many buyers for control purposes; always key for outside investors
    2. assuming an investor has no control over a company whose common stock he has invested in, eventually he will want the opportunity to convert into cash
  7. The goals of security holders
    1. most owners of senior securities are interested solely in cash income
    2. in contrast, some equity holders can be interested in cash return (dividends or cash sale of shares) but many are interested in earnings return

Chapter 15, Shareholder Distributions, Primarily from the Company Point of View

  1. Cash dividends or retained earnings
    1. “proper” dividend payout policy should be made from the point of view of the corporation, not the stockholder
    2. dividend payouts are a residual use of corporate cash and company requirements for cash in other areas have primacy
    3. dividend policy should be dictated by company needs for funds for expansion as well as for margin of safety
    4. companies should retain earnings whenever they have profitable ways to deploy it– this is not determined by the price of their stock as proclaimed by the stock market
    5. high dividends can be used by mgmt to create a higher stock price and thus protect the mgmt from raids
  2. Distributions of assets other than cash
    1. can create a taxable event with no cash to pay it
  3. Liquidation
    1. any payment by a corporation to its shareholders is a form of liquidation
    2. in truth, there is no such thing as liquidation in any meaningful sense, but rather asset-conversion
  4. Stock repurchases
    1. receipts of cash are taxed on a capital-gains rate only
    2. benefits:
      1. corporation benefits because cash requirements on future dividends are reduced
      2. EPS, BVS and corp reality value per share may be enhanced
      3. can promote strong stock market price, thus increasing the companies future financial position and financing opportunities
    3. disadvantages:
      1. if buy-ins are of massive size, investors may be forced out of the company at a price much lower than corp reality, even if at a substantial premium to market prices
      2. possible conflicts with insiders who might want to purchase shares, appearance of payoffs to insiders who want to sell

Chapter 16, Losses and Loss Companies

  1. Quality considerations and tax-loss companies
    1. an organization suffering economic losses can be attractive from the POV of asset-conversion acquisitions if:
      1. the resources employed by the company can be put to another use so losses are stemmed
      2. the business lacks overwhelming amounts of indebtedness
      3. it has available to it tax benefits growing out of the former losses
  2. On accounting and income
    1. tax benefits, for accounting purposes, are treated as extraordinary items
    2. however, these benefits have very real cash consequences and can generate substantial future earnings when reinvested, regardless of how they are accounted for
  3. Be wary of acquiring equity securities of the encumbered firm
    1. the danger in investing in loss corporations is that they have become so encumbered that there is no practical way to invest safely and profitably
    2. “big-bath” write-downs should be viewed as nonrecurring from the standpoint of judging the stewardship of the mgmt
  4. Commercial banks’ portfolio losses
    1. principal earnings assets of banks are investments in loans to customers and investments in securities, notably UST and munis
    2. when interest rates rise, the banks’ loan book falls in value, so they purposefully take losses to reinvest in higher yielding securities
  5. The “turned the corner” theory
    1. many times people will invest in small, losing companies with no record of profitability with the belief that when they “turn the corner” the market will substantially appreciate their new growth records
    2. risky
      1. hard to predict the future of uncertain businesses
      2. new issues normally not priced on bargain bases relative to corporate reality
    3. these securities rarely prove attractive from the FIA

Chapter 17, A Short Primer on Asset-Conversion Investing: Prearbitrage and Postarbitrage

  1. prices paid for common stocks for investment purposes are different from prices paid for control of businesses
  2. Four types of “do-able” asset-conversion activities that might be spotted with the FIA
    1. more aggressive employment of existing assets
    2. merger and acquisition activities
    3. corporate contests for control
      1. incorporated and domiciled in states where there are no strong anti-takeover statutes
      2. share ownership is widespread or blocks are locked up in private transactions
      3. possible low will of mgmt to resist a takeover
      4. absence of impediments to takeover, such as being in a regulated industry
      5. no antitrust problems
      6. there do not appear to be important people or institutions, such as customers, employees or suppliers, who could harm the takeover target by terminating relationships
    4. going private
  3. Postarbitrage
    1. occur after an asset-conversion event when securities owned by public shareholders remain outstanding
    2. sometimes when an offer to acquire securities is announced and less than all the shares tendered are accepted, arbitragers tend to dispose of masses of stock they have accumulated shortly afterward, depressing market prices
    3. important to avoid mgmts that have a predatory predilection
    4. post-arbitrage securities tend to be relatively unmarketable or not marketable at all
    5. one important rule of thumb: acquire shares at prices two thirds or less than control shareholders paid in the recent past to obtain control

 

Notes – A Compilation Of Ideas On Investing

Is Negative Book Value Bad?

  • Negative equity itself is meaningless (could be good or bad)
  • Compare net financial obligations to EBITDA
  • Think of borrowed money as the price of time; ask yourself if you’d rather they borrow money or spend time
  • Stocks in Geoff’s portfolio tend to:
    • have positive FCF
    • have unusually high ratios of FCF to reported earnings
    • buy back shares
    • pay dividends
    • have excess cash after the above
  • “I have found I do not make good decisions when I have to juggle 10 or more opportunities in my head at once”
  • “I don’t believe in taking a risk where I think if everything goes perfectly the upside is still going to be in the single digits”
  • How much debt is too much debt is a separate issue from whether the debt is being used productively
  • When soaring over the market trying to find bargains, these are useful as screening tools:
    • tangible book value
    • EV/EBITDA
  • If an entire country’s market has a low P/TBV or EV/EBITDA, this is important to know; you can buy indexes on this info alone
  • However, ultimately the following matter more:
    • liquidation value
    • market value
    • replacement value
    • Owner Earnings
  • Move beyond being a record keeper — an accountant — and become an appraiser
  • The assets that matter most on the balance sheet:
    • cash
    • investments
    • land
    • intellectual property
    • tax savings
    • legal claims
  • Cash flow protection is much better than asset protection
  • Businesses with special assets that are not separable from the operating business are most likely to not be reflected on the balance sheet and present hidden value
  • Being in a strong, safe liquidating position does not necessarily mean you are in a strong, safe operating position
  • Working capital needs and capital spending needs are part of the DNA of a business; “you can’t turn a railroad into an ad agency”
  • Negative equity itself is not a risk; poor interest coverage is
  • Non-aggressive long-run return assumptions:
    • stocks – 8%
    • bonds – 4%
  • When looking at companies with negative equity and stock buybacks, ask yourself the following:
    • Earnings yield of stock buybacks > interest rate on borrowed money?
    • Need to adjust financial obligations (such as unfunded pension liability) to determine true extent of liabilities?
    • Are net financial obligations (debt and pensions minus cash) a low enough multiple of their EBITDA?
    • How many years of FCF would it take to pay off all financial liabilities?
    • Is the price of the entire company in terms of EV/EBITDA low enough to justify investment?
    • How reliable is EBITDA, FCF, etc?
  • Common concerns in these situations:
    • Moat not wide enough
    • High risk of technological obsolescence
    • No pricing power/cost cutting potential to support margins
  • The right company can have negative equity and be investable if it is a wide moat business with almost no need for tangible investment:
    • Negative working capital
    • Minimal PP&E
    • A wide moat

Is It Ever Okay For A Company To Have No Free Cash Flow?

  • Four cash flow measures:
    • Owner’s Earnings (most important)
    • EBITDA
    • CFO
    • FCF
  • You can get a hint where a company is tripping up in delivering cash to shareholders (FCF) when:
    • EBITDA is positive
    • CFO is positive
    • Net income is positive
  • EBITDA measures the capitalization independent cash flow of the business; it doesn’t take into account spending today for benefits that won’t be realized until tomorrow; also misses working capital changes
  • Look for companies that are growing quickly in an industry that is not
  • Avoid companies that are fast growing in a fast growing industry; it will face more competition every year
  • To judge the future ROI of FCF reinvestment with a company that has no FCF, look at:
    • Will they be competitive?
    • Will competitors over expand?
    • Do they have a moat?
  • When a company spends so much on growth for so long, you really are betting on what the ROI will be way out in the future
  • “There isn’t necessarily a prize for being the last one to succumb to the inevitable. It’s usually more of a moral victory than an economic one”
  • Don’t short a great brand; if you want to short something, short a company:
    • with a product with inherently poor economics
    • a bad balance sheet
    • with deteriorating competitiveness
    • preferably in an industry with a high morality rate
  • When a company reinvests everything, you need to worry about what they’ll earn on their capital many years out

Value Investor Improvement Tip #1: Settle For Cheap Enough

  • A lot of people look for:
    • lowest P/Es
    • lowest P/Bs
    • highest div yields
    • new lows
  • This creates lists of companies that are quantitative outliers, instead of companies you know something about
  • You should feel comfortable throwing out 7/10 names found on a screen
  • Better to cast a wider net and then focus on companies you can learn a lot about by reading 10-Ks
  • Try a screen that combines (Ben Graham-style):
    • above average div yield
    • below average P/E
    • below average P/B
    • fewest unprofitable years in their past
  • Start with the company that sounds simplest, then move out slowly and carefully to those you understand less well; stop when you find something cheap that you know you can hold as long as it takes
  • Another screen:
    • EV/EBITDA < 8
    • ROI > 10%
    • 10 straight years of operating profits
  • You need a good reason for picking stocks that don’t meet this criteria
  • It’s hard to figure out companies with a lot of losses in their past; so don’t try
  • Familiarize yourself with a few stocks; what insiders have is familiarity
  • You want to find companies where you can think more like an insider
  • For long-term investing health, it’s better to find a slightly less cheap — but still cheap enough — stock you can get familiar with than a super cheap one that is a mystery
  • Anything less than NCAV is cheap enough
  • “Some of value investing is in the buying; most of value investing is in the holding; almost none of value investing is in the selling”

Notes – How To Pick Net-Nets: Two Philosophies From Geoff Gannon And Gurpreet Narang

Buying Net-Nets: What Is The Right Margin Of Safety? by Gurpreet Narang

  • Margin of safety demanded depends on the quality of assets and quality of earnings
  • The subtext of Graham’s 2/3 Rule is that asset values on the balance sheet are inexact
  • In liquidation, liabilities are real but asset values are questionable
  • Liquid assets are easily squandered by bad management or bad operating businesses
  • In addition to discounting assets, look for other positive factors to enhance margin of safety:
    • excess cash relative to assets
    • high return on invested capital
    • ten straight years of operating income
    • ample free cash flows
  • The more liquid the assets, the better the margin of safety
  • One way to improve upon NCAV is P/NQAV, or Price-to-Net Quick Asset value (cash, securities and receivables)
  • Discount demanded moves in inverse proportion to:
    • quality of assets
    • quality of management
    • quality of return on assets
  • Earnings should be backed up by cash flows, preferably with free cash flows
  • Net-nets should be chosen for inherent cheapness, not a hope for liquidation
  • Walter Schloss: “A stock well-bought is half-sold.”
  • Michael Burry: buy at prices “so low that a potential acquirer proposing them would be laughed out of the boardroom”

How To Pick Net-Nets by Geoff Gannon

  • Best Net-Nets:
    • Are around $25M market cap or less
    • High insider ownership
    • High F-score
  • Biggest risks for Net-Nets:
    • Fraud
    • Bankruptcy
    • Share dilution
  • Look for Net-Nets:
    • In the US
    • With positive retained earnings
    • Z-score >3
    • Highest F-scores amongst current crop of NCAVs
    • Highest insider ownership %
  • Similarly, avoid:
    • Foreign
    • Negative retained earnings
    • Z-score ❤
    • Lower/lowest F-score
    • Lower/lowest insider ownership
  • Magic Formula for NCAVs:
    • Rank by F-score
    • Rank by insider ownership
  • Add up the two ranks and choose the highest combined scores
  • You don’t need upside potential, you need downside protection
  • Hold them for longer than a year
  • Take the 10-Q and read it like a credit analyst, asking yourself, “Would you be willing to lend money to this company?”
  • More by Geoff Gannon at How To Pick Solid Net-Nets

Gary North Pulverizes IRA-based Retirement Investing

Austrian school economic commentator Gary North has written an outstanding take-down of some of the political and financial risks inherent in government-approved IRA retirement savings vehicles. It’s creatively written from the point of view of a CPA counseling his client on why he should use an IRA for tax-reduction retirement planning. But, it’s written sarcastically and shows the naivety of this advice, so it could be a little confusing to read as you have to realize the opposite of what the fictional CPA is saying is what Gary North believes.

I list the major points against investing via an IRA for tax-reduction purposes made by Gary North below:

  1. Free money from Congress
    1. Congress is not looking for ways to save US citizens from their tax burden; historically, they have worked to expand it
    2. There is no incentive for Congress to not change the rules and force you to pay taxes to withdraw your money from your IRA, eventually
    3. The record of Congress is one of repeated duplicitousness, lies and rules-changes, none of which have ever benefitted the average investor
  2. Emotionally locked in
    1. Most people are emotionally locked in to non-Roth IRA plans because they fear paying taxes now and would prefer to push that inevitability into the future
    2. It is unlikely their tax terms will improve with time; Congress raises taxes and fees over time
    3. People have emotionally committed themselves to higher future tax burdens to avoid confronting the reality of their tax burden right now
  3. Price inflation
    1. Investors must contend with constant price inflation caused by the Federal Reserve
    2. Even at 2% inflation per annum, prices double every 35 years
    3. If you begin investing at 30, prices will have doubled by the time you retire at 65; your IRA will have lost half its value
    4. Traditional IRA investment choices, such as major stock market index funds, have yielded negative net returns for the last 12 years
    5. It’s unlikely the average investor can shield himself from inflation within the investment choices available in an IRA
  4. Privacy
    1. Information on IRA holdings must be sent to the IRS every year
    2. Congress and the IRS know exactly what you hold in your IRA
    3. You have no privacy and no secrecy of your investments via an IRA
    4. Congress and the government do not set a good precedent in this regard, as they insist on transparency from investors but lie, cheat and distort the truth on their own behalf
  5. A freeze on IRA accounts
    1. The odds of another crisis, financial or otherwise, are relatively high
    2. The government could use this as a pretext for issuing an executive order to lay claim to IRA assets, or otherwise freeze individuals’ ability to manage them
  6. Gold in an IRA
    1. It is difficult and costly to buy gold in an IRA
    2. Placing gold in an IRA negates part of the benefit of owning gold (privacy)
    3. Typical IRA offerings are managed by graduates and defenders of the current financial and political system, who have proven themselves incompetent on numerous occasions (2007-2009 being the most recent) and who are ignorant of economics and have a vested interest in propping up the current system

I don’t get how anyone could doubt the Austrian school.

Notes – Distilled BuffettFAQ.com Investment Wisdom Of Warren Buffett

All quotes were originally collected and compiled at the outstanding BuffettFAQ.com

On Learning Businesses

Now I did a lot of work in the earlier years just getting familiar with businesses and the way I would do that is use what Phil Fisher would call, the “Scuttlebutt Approach.” I would go out and talk to customers, suppliers, and maybe ex-employees in some cases. Everybody. Everytime I was interested in an industry, say it was coal, I would go around and see every coal company. I would ask every CEO, “If you could only buy stock in one coal company that was not your own, which one would it be and why? You piece those things together, you learn about the business after awhile.

Funny, you get very similar answers as long as you ask about competitors. If you had a silver bullet and you could put it through the head of one competitor, which competitor and why? You will find who the best guy is in the industry.

On The Research Process

It’s important to read a lot, learn about the industries, get background information, etc. on the companies in those piles. Read a lot of 10Ks and Qs, etc. Read about the competitors. I don’t want to know the price of the stock prior to my analysis. I want to do the work and estimate a value for the stock and then compare that to the current offering price. If I know the price in advance it may influence my analysis.

Pick out five to ten companies in which you understand their products, get annual reports, get every news piece on it. Ask what do I not know that I need to know. Talk to competitors and employees. Essentially be a reporter, ask questions like: If you had a silver bullet and could put it into a competitor who would it be and why. In the end you want to write the story, XYZ is worth this much because…

Narrowing the Investment Universe

They ought to think about what he or she understands. Let’s just say they were going to put their whole family’s net worth in a single business. Would that be a business they would consider? Or would they say, “Gee, I don’t know enough about that business to go into it?” If so, they should go on to something else. It’s buying a piece of a business. If they were going to buy into a local service station or convenience store, what would they think about? They would think about the competition, the competitive position both of the industry and the specific location, the person they have running it and all that. There are all kinds of businesses that Charlie and I don’t understand, but that doesn’t cause us to stay up at night. It just means we go on to the next one, and that’s what the individual investor should do.

Q: So if they’re walking through the mall and they see a store they like, or if they happen to like Nike shoes for example, these would be great places to start? Instead of doing a computer screen and narrowing it down?

A computer screen doesn’t tell you anything. It might tell you about P/Es or something like that, but in the end you have to understand the business. If there are certain businesses in that mall they think they understand and they’re public companies, and they can learn more and more about them…. We used to talk to competitors. To understand Coca-Cola, I have to understand Pepsi, RC, Dr. Pepper.

The place to look when you’re young is the inefficient markets.

Investment Process

  • Read lots of K’s and Q’s – there are no good substitutes for these – Read every page
  • Ask business managers the following question: “If you could buy the stock of one of your competitors, which one would you buy? If you could short, which one would you short?”
  • Always read source (primary) data rather than secondary data
  • If you are interested in one company, get reports for competitors. “You must act like you are actually going into that business, and if you were, you’d want to know what your competitors were doing.”

Four Investment Filters

Filter #1 – Can we understand the business? What will it look like in 10-20 years? Take Intel vs. chewing gum or toilet paper. We invest within our circle of competence. Jacob’s Pharmacy created Coke in 1886. Coke has increased per capita consumption every year it has been in existence. It’s because there is no taste memory with soda. You don’t get sick of it. It’s just as good the 5th time of the day as it was the 1st time of the day.

Filter #2 – Does the business have a durable competitive advantage? This is why I won’t buy into a hula-hoop, pet rock, or a Rubik’s cube company. I will buy soft drinks and chewing gum. This is why I bought Gillette and Coke.

Filter #3 – Does it have management I can trust?

Filter #4 – Does the price make sense?

Finding Bargains

The world isn’t going to tell you about great deals. You have to find them yourself. And that takes a fair amount of time. So if you are not going to do that, if you are just going to be a passive investor, then I just advise an index fund more consistently over a long period of time. The one thing I will tell you is the worst investment you can have is cash. Everybody is talking about cash being king and all that sort of thing. Most of you don’t look like you are overburdened with cash anyway. Cash is going to become worth less over time. But good businesses are going to become worth more over time. And you don’t want to pay too much for them so you have to have some discipline about what you pay. But the thing to do is find a good business and stick with it.

Don’t pass up something that’s attractive today because you think you will find something way more attractive tomorrow.

Defining Risk

We think first in terms of business risk. The key to Graham’s approach to investing is not thinking of stocks as stocks or part of the stock market. Stocks are part of a business. People in this room own a piece of a business. If the business does well, they’re going to do all right as long as long as they don’t pay way too much to join in to that business. So we’re thinking about business risk. Business risk can arise in various ways. It can arise from the capital structure. When somebody sticks a ton of debt into a business, if there’s a hiccup in the business, then the lenders foreclose. It can come about by their nature–there are just certain businesses that are very risky. Back when there were more commercial aircraft manufacturers, Charlie and I would think of making a commercial  airplane as a sort of bet-your-company risk because you would shell out hundreds and hundreds of millions of dollars before you really had customers, and then if you had a problem with the plane, the company could go. There are certain businesses that inherently, because of long lead time, because of heavy capital investment, basically have a lot of risk. Commodity businesses have a lot of risk unless you’re a low-cost producer, because the low-cost producer can put you out of business. Our textile business was not the low-cost producer. We had fine management, everybody worked hard, we had cooperative unions, all kinds of things. But we weren’t the low-cost producers so it was a risky business. The guy who could sell it cheaper than we could made it risky for us. We tend to go into businesses that are inherently low risk and are capitalized in a way that that low risk of the business is transformed into a low risk for the enterprise. The risk beyond that is that even though you identify such businesses, you pay too much for them. That risk is usually a risk of time rather than principal, unless you get into a really extravagant situation. Then the risk becomes the risk of you yourself–whether you can retain your belief in the real fundamentals of the business and not get too concerned about the stock market. The stock market is there to serve you and not to instruct you. That’s a key to owning a good business and getting rid of the risk that would otherwise exist in the market.

Valuation Metrics

The appropriate multiple for a business compared to the S&P 500 depends on its return on equity and return on incremental invested capital. I wouldn’t look at a single valuation metric like relative P/E ratio. I don’t think price-to-earnings, price-to-book or price-to-sales ratios tell you very much. People want a formula, but it’s not that easy. To value something, you simply have to take its free cash flows from now until kingdom come and then discount them back to the present using an appropriate discount rate. All cash is equal. You just need to evaluate a business’s economic characteristics.

[Highly qualitative, descriptive and verbal, has little to do with the numbers in justifying an investment]

The Ideal Business

WB: The ideal business is one that generates very high returns on capital and can invest that capital back into the business at equally high rates. Imagine a $100 million business that earns 20% in one year, reinvests the $20 million profit and in the next year earns 20% of $120 million and so forth. But there are very very few businesses like this. Coke has high returns on capital, but incremental capital doesn’t earn anything like its current returns. We love businesses that can earn high rates on even more capital than it earns. Most of our businesses generate lots of money, but can’t generate high returns on incremental capital — for example, See’s and Buffalo News. We look for them [areas to wisely reinvest capital], but they don’t exist.

So, what we do is take money and move it around into other businesses. The newspaper business earned great returns but not on incremental capital. But the people in the industry only knew how to reinvest it [so they squandered a lot of capital]. But our structure allows us to take excess capital and invest it elsewhere, wherever it makes the most sense. It’s an enormous advantage.

See’s has produced $1 billion pre-tax for us over time. If we’d deployed that in the candy business, the returns would have been terrible, but instead we took the money out of the business and redeployed it elsewhere. Look at the results!

CM: There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there’s never any cash. It reminds me of the guy who looks at all of his equipment and says, “There’s all of my profit.” We hate that kind of business.

Making Mistakes In Investments

We bought it because it was an attractive security. But it was not in an attractive industry. I did the same thing in Salomon. I bought an attractive security in a business I wouldn’t have bought the equity in. So you could say that is one form of mistake. Buying something because you like the terms, but you don’t like the business that well.

The Market and Its Price

The NYSE is one big supermarket of companies. And you are going to be buying stocks, what you want to have happen? You want to have those stocks go down, way down; you will make better buys then. Later on twenty or thirty years from now when you are in a period when you are dis-saving, or when your heirs dis-save for you, then you may care about higher prices. There is Chapter 8 in Graham’s Intelligent Investor about the attitude toward stock market fluctuations, that and Chapter 20 on the Margin of Safety are the two most important essays ever written on investing as far as I am concerned. Because when I read Chapter 8 when I was 19, I figured out what I just said but it is obvious, but I didn’t figure it out myself. It was explained to me. I probably would have gone another 100 years and still thought it was good when my stocks were going up. We want things to go down, but I have no idea what the stock market is going to do. I never do and I never will. It is not something I think about at all.

Forecasting

People have always had this craving to have someone tell them the future. Long ago, kings would hire people to read sheep guts. There’s always been a market for people who pretend to know the future. Listening to today’s forecasters is just as crazy as when the king hired the guy to look at the sheep guts. It happens over and over and over.

What’s going to happen tomorrow, huh? Let me give you an illustration. I bought my first stock in 1942. I was 11. I had been dillydallying up until then. I got serious. What do you think the best year for the market has been since 1942? Best calendar year from 1942 to the present time. Well, there’s no reason for you to know the answer. The answer is 1954. In 1954, the Dow … dividends was up 50%. Now if you look at 1954, we were in a recession a good bit of that time. The recession started in July of ’53. Unemployment peaked in September of ’54. So until November of ’54 you hadn’t seen an uptick in the employment figure. And the unemployment figure more than doubled during that period. It was the best year there was for the market. So it’s a terrible mistake to look at what’s going on in the economy today and then decide whether to buy or sell stocks based on it. You should decide whether to buy or sell stocks based on how much you’re getting for your money, long-term value you’re getting for your money at any given time. And next week doesn’t make any difference because next week, next week is going to be a week further away. And the important thing is to have the right long-term outlook, evaluate the businesses you are buying. And then a terrible market or a terrible economy is your friend. I don’t care, in making a purchase of the Burlington Northern, I don’t care whether next week, or next month or even next year there is a big revival in car loadings or any of that sort of thing. A period like this gives me a chance to do things. It’s silly to wait. I wrote an article. If you wait until you see the robin, spring will be over.

Managers Should Be Investors

Charlie makes a good point. Managers should learn about investing. I have friends who are CEOs and they outsource their investing to a financial advisor because they don’t feel comfortable analyzing Coke and Gillette and picking one stock vs. the other. Yet when an investment banker shows up with fancy slides and a slick presentation, an hour later the CEO is willing to do a $3 billion acquisition. It’s extraordinary the willingness of corporate CEOs to make decisions about buying companies for billions of dollars when they aren’t willing to make an investment for $10,000 in their personal account. It’s basically the same thing.

The Value of Accounting

I had a great experience at Nebraska. Probably the best teacher I had was Ray Dein in accounting. I think everybody in business school should really know accounting; it is the language of business. If you are not comfortable with the lan- guage, you can’ t be comfortable in the country. You just have to get it into your spinal cord. It is so valuable in business.

Staying Rational

One thing that could help would be to write down the reason you are buying a stock before your purchase. Write down “I am buying Microsoft @ $300B because…” Force yourself to write this down. It clarifies your mind and discipline. This exercise makes you more rational.