The Ideas Report For Serious Investors

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Once upon a time media personalities enjoyed ratings shares that are unheard of today: people like Ed Sullivan, Perry Como, and Johnny Carson in his prime could count on something like 1/3 of the country tuning in to see them every time they did a show. As media fragmented, many predicted that the age of the mega-celebrity would end, to be replaced by a long tail of niche celebrities.

It hasn't quite worked out that way. There are plenty of niche celebrities, but the mega-celebrity has not gone away. In his unassuming way, Ryan Seacrest is one of them. Through his various television, radio, and digital projects, he gets more regular face time with more Americans than any other person, with one possible exception.

And no one does a better job monetizing celebrity than Seacrest. Unlike many of his mass media peers, he recognizes that he is, at the end of the day, in the advertising business. His job is to generate advertising return on investment for marketers by aggregating audiences and associating his personal brand with the brands of others.

The author of this post is Nadav Manham, president of Elera Advisors LLC, an investment advisory company focused on value-oriented manager selection. Mr. Manham is a Manual of Ideas contributor and editor of The Investor's Consigliere.    

Posted by manualofideas at 01:19 PM | Permalink | Comments (0)

In a warning that was largely ignored at the time but proven correct in subsequent years, Warren Buffett referred to derivatives as “financial weapons of mass destruction” in his 2002 letter to Berkshire Hathaway shareholders.  Critics of Berkshire’s recent involvement in derivatives often like to point out the superficial inconsistency between Mr. Buffett’s earlier warnings and his willingness to enter into derivatives contracts in recent years.  Today’s Wall Street Journal article regarding Berkshire Hathaway’s lobbying efforts related to the financial regulatory reform bill are already raising charges of hypocrisy. Let’s take a brief look at the facts and how the legislation may impact Berkshire Hathaway.

Background

While Warren Buffett has emphasized the dangers of derivatives on many occasions, he entered into a number of derivatives contracts in recent years to take advantage of what he believed were mispriced terms at the inception of each contract.  The derivatives generally fall into two categories:  Equity puts and credit default swaps on individual companies.  The equity puts are long term contracts that require minimal collateral and are not exercisable until contract expiration.  In a previous article, we provided more details regarding the nature of these contracts in an attempt to clear up persistent misunderstandings regarding the issue.  Mr. Buffett’s latest letter to shareholders provides updated information based on developments in 2009

In addition to the derivatives portfolio managed personally by Mr. Buffett, certain Berkshire subsidiaries such as MidAmerican enter into derivatives contracts for hedging purposes.

Derivatives “Float” and Collateral Requirements

At the end of 2009, Berkshire Hathaway held approximately $6.3 billion of “derivatives float” which represents funds received from counterparties that Berkshire can use for investment purposes.  Berkshire’s counterparties are required to make payments at the inception of contracts. According to Note 12 in Berkshire’s 2009 annual report, very minimal collateral requirements exist and even additional credit downgrades would only require a relatively modest increase in collateral:

With limited exceptions, our equity index put option and credit default contracts contain no collateral posting requirements with respect to changes in either the fair value or intrinsic value of the contracts and/or a downgrade of Berkshire’s credit ratings. Under certain conditions, a few contracts require that we post collateral. As of December 31, 2009, our collateral posting requirement under such contracts was $35 million compared to about $550 million at December 31, 2008. As of December 31, 2009, had Berkshire’s credit ratings (currently AA+ from Standard & Poor’s and Aa2 from Moody’s) been downgraded below either A- by Standard & Poor’s or A3 by Moody’s an additional $1.1 billion would have been required to be posted as collateral.

One additional point that is often missed is that Berkshire continues to own the securities posted as collateral and benefits from any returns earned by the collateral.

It is obvious that Berkshire was able to secure very favorable terms from counterparties regarding collateral requirements precisely because the financial strength of Berkshire has never been seriously questioned.

Berkshire Objects to Retroactive Changes to Collateral Requirements

According to the Wall Street Journal article, Berkshire Hathaway is only objecting to efforts in Congress to retroactively apply new collateral requirements to existing contracts:

The provision, sought by Berkshire and pushed by Nebraska Sen. Ben Nelson in the Senate Agriculture Committee, would largely exempt existing derivatives contracts from the proposed rules. Previously, the legislation could have allowed regulators to require that companies such as Nebraska-based Berkshire put aside large sums to cover potential losses. The change thus would aid Berkshire, which has a $63 billion derivatives portfolio, according to Barclays Capital.

Mr. Buffett’s push is especially notable because he has warned of the potential dangers of derivatives, famously branding them “financial weapons of mass destruction.”

The White House has been trying to kill the Berkshire provision on the grounds that it would weaken the government’s ability to regulate the enormous market for derivatives. Berkshire Hathaway argued that it shouldn’t be made to redo existing contracts and that it is already healthy enough to cover its obligations. The battle over the provision shows how lobbying by businesses and lawmakers to insert just a few words into a complex bill can have a major impact on the country’s biggest companies.

The proposed changes to collateral requirements would have widespread impacts and are not targeted specifically to Berkshire.  The current reports regarding Berkshire’s lobbying indicate that the company is seeking a broad based “fix” to prevent the government from forcing retroactive changes to existing contracts rather than a special exemption only for Berkshire.

Bottom Line Impact

While it is impossible to know exactly what the bottom line impact of the proposed legislation would be for Berkshire Hathaway, it is important to note that any additional collateral that Berkshire is forced to post would continue to be owned by Berkshire and would earn income for the company while it is held.  The ultimate gain or loss from the derivatives position would be unchanged with the main difference being that additional collateral would have to be posted for the duration of the contracts, most of which will remain outstanding for many years.

The more significant impact going forward may be to discourage Berkshire from entering into new derivatives contracts if collateral requirements for new contracts become even more onerous.  A reduction in this type of activity may be inevitable in any case because many Berkshire shareholders may only trust Warren Buffett to personally manage these types of risks.  Whether shareholders would be comfortable with a proprietary derivatives strategy run by Mr. Buffett’s successor is far from clear.

From a valuation perspective, it seems most conservative to consider the $6.2 billion proprietary derivatives float to be in “run off” rather than a permanent source of value.  The derivatives positions will likely produce significant profits for Berkshire over the next several years but renewal of such opportunities seems too uncertain to rely on the proprietary derivatives strategy as a source of ongoing value.  In contrast, Berkshire’s much larger $62 billion of insurance float remains a long standing and enduring source of intrinsic value for the company.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. 

Disclosure:  The author owns shares of Berkshire Hathaway and is the author of The Rational Walk’s Berkshire Hathaway 2010 Briefing Book which provides more information regarding the company including a brief section regarding the derivatives portfolio.

Posted by manualofideas at 01:16 PM | Permalink | Comments (0)

By Greenbackd

Jeremy Grantham’s 2010 first quarter investor letter (.pdf) appends the first part of a speech he gave at the Annual Benjamin Graham and David Dodd Breakfast at Columbia University in October last year. The speech was titled Friends and Romans, I come to tease Graham and Dodd, not to praise them. In it Grantham discussed the “potential disadvantages of Graham and Dodd-type investing.” It seems to have struck a chord, as I’ve received it from several quarters. As one of the folks who forwarded it to me noted, we learn more from those who disagree with us.

Hat tip Toby, Raj and everyone else.

Posted by manualofideas at 01:13 PM | Permalink | Comments (0)

By Greenbackd

Oh dear (Daily Reckoning via Guru Focus):

04/21/10 Gaithersburg, Maryland – Ken Heebner’s CGM Focus Fund was the best US stock fund of the past decade. It rose 18% a year, beating its nearest rival by more than three percentage points. Yet according to research by Morningstar, the typical investor in the fund lost 11% annually! How can that happen?

It happened because investors tended to take money out after a bad stretch and put it back in after a strong run. They sold low and bought high. Stories like this blow me away. Incredibly, these investors owned the best fund you could own over the last 10 years – and still managed to lose money.

…

Psychologically, it’s hard to do the right thing in investing, which often requires you to buy what has not done well of late so that you will do well in the future. We’re hard-wired to do the opposite.
I recently read James Montier’s Value Investing: Tools and Techniques for Intelligent Investment. It’s a meaty book that compiles a lot of research. Much of it shows how we are our own worst enemy.

One of my favorite chapters is called “Confused Contrarians and Dark Days for Deep Value.” Put simply, the main idea is that you can’t expect to outperform as an investor allthe time. In fact, the best investors often underperform over short periods of time. Montier cites research by the Brandes Institute that shows how, in any three-year period, the best investors find themselves among the worst performers about 40% of the time!

See the rest of the article here.

Posted by manualofideas at 07:02 PM | Permalink | Comments (0)

In a more perfect world, no high school student would be permitted to graduate without understanding the basics of personal finance.  Required material would include elementary topics such as balancing a checkbook, creating and monitoring a budget, and above all else, the power (and peril) of compound interest.  Part of achieving basic financial literacy should also include a working understanding of accounting and financial statements.

Since the primary goal of such a program would be to provide Americans with basic knowledge, a comprehensive accounting text book may be overkill.  Instead, a basic introductory guide to reading financial statements is needed.  Such a guide would cover the three main financial reports:  Balance Sheet, Income Statement, and Cash Flow Statement.  Mariusz Skonieczny, President of Classic Value Investors has written a concise primer on financial statements that allows the reader to gain a basic understanding of these key financial reports.  The e-book is being offered free of charge to readers who subscribe to the Classic Value Investors Blog.

Mr. Skonieczny is also the author of Why Are We So Clueless about the Stock Market? which we reviewed in December.  The author has a talent for simplifying potentially confusing topics for readers who are new to investing and are looking for basic information that will help to build the foundation for further study of accounting topics.

In some ways, Mr. Skonieczny’s e-book may remind the reader of Benjamin Graham’s classic book The Interpretation of Financial Statements which was discussed in one of the earliest book reviews presented on The Rational Walk. In a concise 120 page book, Ben Graham provided the reader with all of the basics required to navigate a financial statement and the book is still very relevant today, more than 70 years after its initial publication.

Neither of these brief surveys of financial statements are sufficient for an individual who is interested in allocating his own capital, but they are solid starts and highly recommended for new investors.

To receive a copy of The Basics of Understanding Financial Statements, visit the Classic Value Investors blog and enter your name and email to subscribe to the blog.  You will then receive an email with a download link.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

Posted by manualofideas at 07:01 PM | Permalink | Comments (0)

By Greenbackd

Yesterday I discussed Michael Mauboussin’s December 2007 Mauboussin on Strategy, “Death, Taxes, and Reversion to the Mean; ROIC Patterns: Luck, Persistence, and What to Do About It,” (.pdf) about Mauboussin’s research on the tendency of return on invested capital (ROIC) to revert to the mean.

Mauboussin’s report has three broad conclusions, with significant implications for modelling:

Reversion to the mean is a powerful force. As has been well documented by numerous studies, ROIC reverts to the cost of capital over time. This finding is consistent with microeconomic theory, and is evident in all time periods researchers have studied. However, investors and executives should be careful not to over interpret this result because reversion to the mean is evident in any system with a great deal of randomness. We can explain much of the mean reversion series by recognizing the data are noisy.

Persistence does exist. Academic research shows that some companies do generate persistently good, or bad, economic returns. The challenge is finding explanations for that persistence, if they exist.

Explaining persistence. It’s not clear that we can explain much persistence beyond chance. But we investigated logical explanatory candidates, including growth, industry representation, and business models. Business model difference appears to be a promising explanatory factor.

How to identify ROIC persistence ex ante

The goal of the investor is to identify businesses with future, sustainable, high ROIC. Mauboussin explores three variables that might be predictive of such persistent high ROIC: corporate growth, the industry in which a company competes, and the company’s business model.

Corporate growth

The bad news about growth, especially for modelers, is it is extremely difficult to forecast. While there is some evidence for sales persistence, the evidence for earnings growth persistence is scant. As some researchers recently summarized, “All in all, the evidence suggests that the odds of an investor successfully uncovering the next stellar growth stock are about the same as correctly calling coin tosses.” 16

Industry

Mauboussin finds that industries that are overrepresented in the highest return quintile throughout the measured period are also overrepresented in the lowest quintile. Those industries include pharmaceuticals/biotechnology and software. He concludes that positive, sustainable ROICs emerge from a good strategic position within a generally favorable industry.

Business model

This is perhaps the most useful and interesting variable considered by Mauboussin. He relates Michael Porter’s two sources of competitive advantage – differentiation and low-cost production - to ROIC by breaking ROIC into its two prime components, net operating profit after tax (NOPAT) margin and invested capital turnover (NOPAT margin equals NOPAT/sales, and invested capital turnover equals sales/invested capital. ROIC is the product of NOPAT margin and invested capital turnover.):

Generally speaking, differentiated companies with a consumer advantage generate attractive returns mostly via high margins and modest invested capital turnover. Consider the successful jewelry store that generates large profits per unit sold (high margins) but doesn’t sell in large volume (low turnover). In contrast, a low-cost company with a production advantage will generate relatively low margins and relatively high invested capital turnover. Think of a classic discount retailer, which doesn’t make much money per unit sold (low margins) but enjoys great inventory velocity (high turnover). Exhibit 8 consolidates these ideas in a simple matrix.

Mauboussin examined the 42 companies that stayed in the first quintile throughout the measured period to see whether they leaned more toward a consumer or production advantage:

Not surprisingly, this group outperformed the broader sample on both NOPAT margin and invested capital turnover, but the impact of margin differential (2.4 times the median) was greater on ROIC than the capital turnover differential (1.9 times). While equivocal, these results suggest the best companies may have a tilt toward consumer advantage.

An analysis of the poor performers reveals that they posted NOPAT margins and invested capital turnover “symmetrical” with the high-performing companies i.e. below the full sample’s median.

Mauboussin concludes:

Our search for factors that may help us anticipate persistently superior performance leaves us little to work with. We do know persistence exists, and that companies that sustain high returns over time start with high returns. Operating in a good industry with above-average growth prospects and some consumer advantage also appears correlated with persistence. Strategy experts Anita McGahan and Michael Porter sum it up: 22

It is impossible to infer the cause of persistence in performance from the fact that persistence occurs. Persistence may be due to fixed resources, consistent industry structure, financial anomalies, price controls, or many other factors that endure . . . In sum, reliable inferences about the cause of persistence cannot be generated from an analysis that only documents whether or not persistence occurred.

More to come.

Posted by manualofideas at 12:28 PM | Permalink | Comments (0)

By Greenbackd

In Michael Mauboussin’s December 2007 Mauboussin on Strategy, “Death, Taxes, and Reversion to the Mean; ROIC Patterns: Luck, Persistence, and What to Do About It,” (.pdf) Mauboussin provides a tour de force of data on the tendency of return on invested capital (ROIC) to revert to the mean. Much of my investing to date has been based on the naive assumption that the tendency is so powerful that companies with a high ROIC should be avoided because the high ROIC is not sustainable, but rather indicates a cyclical top in margins and earnings. This view is broadly supported by other research on mean reversion in earnings that I have discussed in the past, which has suggested, somewhat counter-intuitively, that in aggregate the earnings of low price-to-book value stocks grow faster than the earnings of high price-to-book value stocks. I usually cite this table from the Tweedy Browne What works in investing document:

In the four years after the date of selection, the earnings of the companies in the lowest price-to-book value quintile (average price-to-book value of 0.36) increase 24.4%, more than the companies in the highest price-to-book value quintile (average price-to-book value of 3.42), whose earnings increased only 8.2%. DeBondt and Thaler attribute the earnings outperformance of the companies in the lowest quintile to mean reversion, which Tweedy Browne described as the observation that “significant declines in earnings are followed by significant earnings increases, and that significant earnings increases are followed by slower rates of increase or declines.”

Mauboussin’s research seems to suggest that, while there exists a strong tendency towards mean reversion, some companies do “post persistently high or low returns beyond what chance dictates.” He has two caveats for those seeking the stocks with persistent high returns:

1. The “ROIC data incorporate much more randomness than most analysts realize.”

That said, Mauboussin presents some striking data about “persistence” in high ROIC companies that suggests investing in high ROIC companies is not necessarily a short ride to the poor house, and might actually work as an investment strategy. (That was very difficult to write. It goes against every fiber of my being.) Here’s Mauboussin’s research:

Mauboussin’s report has three broad conclusions, with significant implications for modelling:

Reversion to the mean is a powerful force. As has been well documented by numerous studies, ROIC reverts to the cost of capital over time. This finding is consistent with microeconomic theory, and is evident in all time periods researchers have studied. However, investors and executives should be careful not to over interpret this result because reversion to the mean is evident in any system with a great deal of randomness. We can explain much of the mean reversion series by recognizing the data are noisy.

Persistence does exist. Academic research shows that some companies do generate persistently good, or bad, economic returns. The challenge is finding explanations for that persistence, if they exist.

Explaining persistence. It’s not clear that we can explain much persistence beyond chance. But we investigated logical explanatory candidates, including growth, industry

ROIC mean reversion

Here Mauboussin charts the reversion-to-the-mean phenomenon using data from “1000 non-financial companies from 1997 to 2006.” The chart shows a clear trend towards nil economic profit, as you would expect:

We start by ranking companies into quintiles based on their 1997 ROIC. We then follow the median ROIC for the five cohorts through 2006. While all of the returns do not settle at the cost of capital (roughly eight percent) in 2006, they clearly migrate toward that level.

And another chart showing the change:

Mauboussin has this elegant interpretation of the results:

Any system that combines skill and luck will exhibit mean reversion over time. 7 Francis Galton demonstrated this point in his 1889 book, Natural Inheritance, using the heights of adults. 8 Galton showed, for example, that children of tall parents have a tendency to be tall, but are often not as tall as their parents. Likewise, children of short parents tend to be short, but not as short as their parents. Heredity plays a role, but over time adult heights revert to the mean.

The basic idea is outstanding performance combines strong skill and good luck. Abysmal performance, in contrast, reflects weak skill and bad luck. Even if skill persists in subsequent periods, luck evens out across the participants, pushing results closer to average. So it’s not that the standard deviation of the whole sample is shrinking; rather, luck’s role diminishes over time.

Separating the relative contributions of skill and luck is no easy task. Naturally, sample size is crucial because skill only surfaces with a large number of observations. For example, statistician Jim Albert estimates that a baseball player’s batting average over a full season is a fifty-fifty combination between skill and luck. Batting averages for 100 at-bats, in contrast, are 80 percent luck. 9

Persistence in ROIC Data

“Persistence” is the likelihood a company will sustain its ROIC. If the stocks are ranked on the basis of ROIC and then placed into quintiles, persistence is likliehood that a stock will remain in the same quintile throughout the measured time frame. Mauboussin then measures persistence by analysing “quintile migration:”

This exhibit shows where companies starting in one quintile (the vertical axis) ended up after nine years (the horizontal axis). Most of the percentages in the exhibit are unremarkable, but two stand out. First, a full 41 percent of the companies that started in the top quintile were there nine years later, while 39 percent of the companies in the cellar-dweller quintile ended up there. Independent studies of this persistence reveal a similar pattern. So it appears there is persistence with some subset of the best and worst companies. Academic research confirms that some companies do show persistent results. Studies also show that companies rarely go from very high to very low performance or vice versa. 13

These are striking findings. In Mauboussin’s data, there was a 64% chance that a company in the highest quintile at the start of the period was still in the first or second quintile at the end of the 10 year period. Further, it seems that there is a three-in-four chance that the high quintile stocks don’t fall into the lowest or second lowest quintiles after 10 years. It’s not all good news however.

Before going too far with this result, we need to consider two issues. First, this persistence analysis solely looks at where companies start and finish, without asking what happens in between. As it turns out, there is a lot of action in the intervening years. For example, less than half of the 41 percent of the companies that start and end in the first quintile stay in the quintile the whole time. This means that less than four percent of the total-company sample remains in the highest quintile of ROIC for the full nine years.

The second issue is serial correlation, the probability a company stays in the same ROIC quintile from year to year. As Exhibit 5 suggests, the highest serial correlations (over 80 percent) are in Q1 and Q5. The middle quintile, Q3, has the lowest correlation of roughly 60 percent, while Q2 and Q4 are similar at about 70 percent.

This result may seem counterintuitive at first, as it suggests results for really good and really bad companies (Q1 and Q5) are more likely to persist than for average companies (Q2, Q3, and Q4). But this outcome is a product of the methodology: since each year’s sample is broken into quintiles, and the sample is roughly normally distributed, the ROIC ranges are much narrower for the middle three quintiles than for the extreme quintiles. So, for instance, a small change in ROIC level can move a Q3 company into a neighboring quintile, whereas a larger absolute change is necessary to shift a Q1 and Q5 company. Having some sense of serial correlations by quintile, however, provides useful perspective for investors building company models.

So, in summary, better performed companies remain in the higher ROIC quintiles over time, although the better-performed quintiles will still suffer substantial ROIC attrition over time.

More to come.

Hat tip Fallible Investor.

Posted by manualofideas at 11:32 AM | Permalink | Comments (0)

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Warren Buffett started his investment partnership in 1956 with $105,100 of capital made up of his own funds and investments from family and close friends.  According to the BLS inflation calculator, initial capital was $840,920 measured in 2010 dollars which would be a very small sum to start a modern day hedge fund.  What is even more remarkable was the fee structure of the Buffett Partnerships.  Mr. Buffett, as the general partner, took 25 percent of all profits in excess of 6 percent.  There was no “2 and 20″ structure in which the general partner received any guaranteed payment.  With nearly all of his net worth invested in the fund and a young family to support, it obviously took a very self confident 25 year old to start this venture.

Mr. Buffett’s early letters to partners have become investment classics and required reading for value investors.   By reading the letters in chronological sequence, one can see how Mr. Buffett’s investment philosophy evolved over the years.  It is particularly interesting to note that many of the same themes that continue to appear in recent Berkshire Hathaway annual letters were regularly appearing in partnership letters during the 1960s.

On an annual compounded basis, the Buffett Partnership returned 23.8 percent/year to limited partners over its history compared to 7.4 percent/year for the Dow Jones Industrial Average.  The limited partners only had one year (1958) in which their results failed to match the Dow Industrials.  (See The Superinvestors of Graham-and-Doddsville for more details)

In his letter to partners in 1969 announcing his “retirement”, Mr. Buffett had the following to say:

“As long as I am “on stage”, publishing a regular record and assuming responsibility for management of what amounts to virtually 100% of the net worth of many partners, I will never be able to put sustained effort into any non-BPL [partnership] activity.  If I am going to participate publicly, I can’t help being competitive.  I know I don’t want to be totally occupied with out-pacing an investment rabbit all my life.  The only way to slow down is to stop.”

Partners who elected to take part of their final partnership distribution in Berkshire Hathaway stock probably did not notice much of a “slow down” in subsequent years.

I was recently contacted by Frank Gifford, a Berkshire Hathaway shareholder who has studied the partnership letters and agreed to share his notes with readers of The Rational Walk.  Mr. Gifford provides a great 20 page introduction to the letters which is very useful for someone looking for a concise summary.

Click on this link to download the partnership letter notes

Disclosure:  The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 12:46 PM | Permalink | Comments (0)

In an interview with The Financial Times, Jeremy Grantham discusses a study on various financial bubbles that his firm has recently completed.  Mr. Grantham found 34 examples of bubbles that fit his definition as a “forty year event” statistically.  Of these 34 bubbles, 32 have moved back to trends prior to the bubble forming.  The two bubbles currently outstanding are the U.K. and Australian housing bubbles which Mr. Grantham believes are driven by low rates on floating rate mortgages.

Mr. Grantham is critical of the Federal Reserve under Alan Greenspan and Ben Bernanke’s leadership and attributes recent bubbles in the United States to errors in monetary policy:

It is not usual that you get three bubbles in a ten or twelve or thirteen year period.  Normally one bubble will chew up twenty years because it leaves such a painful experience people don’t queue up to put their hands on the same stove and burn themselves again.  But under Greenspan’s incredible leadership, he managed to give us the tech bubble and then by keeping interest rates at negative levels for three years drove up the housing bubble and then finally the risk bubble — everything risky — was inflated by ‘07 and Bernanke has happily picked up the mantle and seems totally unconcerned about creating yet another bubble.

Where might the next bubbles form?  Mr. Grantham is concerned about equities in emerging markets and commodity prices.

To view the interview, please click on the image below.

Posted by manualofideas at 08:49 AM | Permalink | Comments (0)

National Underwriter P&C magazine recently reported that the soft insurance market is showing no signs of reversing as abundant capacity combined with diminished demand keep downward pressure on rates.  This is the seventh consecutive year of soft overall market conditions. At the same time, forecasters are calling for a more active than normal Atlantic hurricane season with fifteen named storms, eight hurricanes, and four “major” hurricanes.

Soft market conditions exist in a many different product lines:

As has been the case throughout much of the soft market phase, the report said, general liability was the most competitive line during the quarter, with the average premium falling 4.4 percent. The average property premium, which had been essentially flat over the past several quarters, fell 2.9 percent. The average workers’ compensation premium was down 2.0 percent, and average directors and officers liability (D&O) premium was off 1.1 percent. D&O average premium had been flat to slightly higher throughout 2009 due to rate increases in the financial institution sector, but those increases now have abated, according to the report.

Although rates are under pressure, insurers reported good results in 2009 and underwriters have not been pushing for higher premiums.  Another way of interpreting this news is that insurers appear to be willing to compromise on pricing in exchange for volume or market share.

If lack of underwriting discipline is combined with higher than normal catastrophe claims in 2010, the overall industry could be looking at poor results for the year.  Insurers that maintain underwriting discipline even at the cost of giving up market share should mitigate the damage and preserve capital for the harder pricing markets that inevitably return in periods following poor financial results for the overall industry.

Disclosure:  The author owns shares of Berkshire Hathaway, a major provider of many lines of insurance through several subsidiaries, and also owns shares of other insurance companies.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

Posted by manualofideas at 08:46 AM | Permalink | Comments (0)

Burton Malkiel, professor of economics at Princeton University, is the author of A Random Walk Down Wall Street and is currently preparing the tenth edition of the book.  In a recent Financial Times interview, Mr. Malkiel insists that the data continue to indicate that markets are efficient despite the turmoil of recent years.  He has found that the majority of active investors continue to underperform passive index funds over long periods of time.  In addition, his research indicates that the passive approach provides better results even in emerging markets such as China.

One objection to the formulation of Mr. Malkiel’s argument is that it is not necessary to claim that markets are “efficient” in order to agree with the recommendation that the majority of investors would be better served in passive index funds.  Since the majority of individual and professional investors can hardly be characterized as value investors, it is unsurprising that the results of most active portfolios would underperform the overall market over long periods of time.  However, it does not follow that markets are therefore “efficient”.  Instead, it appears that the majority of investors lack the discipline and methodology needed to produce superior results.

Warren Buffett’s famous article, The Superinvestors of Graham-and-Doddsville, was published over 25 years ago but remains a powerful reminder of how value investors can outperform the market using a common set of principles even though the application of these principles leads different investors to entirely different portfolios.  In recent years, value investing has been able to produce good returns during a time when the overall market has been essentially flat after years of roller coaster movements.

Mr. Malkiel’s recommendation is correct:  The majority of investors are best served in passive index funds.  But this is because of the inherent failings of poor analysis, human emotion and temperament rather than because the markets are “efficient”.

Mr. Malkiel makes his case for market efficiency in the Financial Times video below.  Click on the image to start the video.

Posted by manualofideas at 08:44 AM | Permalink | Comments (1)

By Greenbackd

Posted by manualofideas at 07:51 AM | Permalink | Comments (0)

Joel Greenblatt outlined his “magic formula” for stock market investing in The Little Book That Beats the Market. The formula ranks stocks based on two simple and easily calculated figures:  earnings yield and return on capital.  Rather than merely looking for the cheapest companies, the goal is to also find good businesses that achieve high returns on capital.  In the interview shown below, Mr. Greenblatt discusses a new fund that he is introducing which will apply the magic formula to global markets.

Forbes has also published a new interview with Joel Greenblatt with some good background information on the magic formula.

Mr. Greenblatt is also the author of You Can Be a Stock Market Genius which we reviewed last year.  Both books are well worth reading.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

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By Greenbackd

Posted by manualofideas at 05:37 PM | Permalink | Comments (0)

Posted by manualofideas at 05:35 PM | Permalink | Comments (0)

Berkshire Hathaway has been attracting more analyst coverage in recent weeks due to the company’s inclusion in the Standard & Poor’s 500 and expanded institutional interest related to factors such as the Burlington Northern Santa Fe acquisition.  Earlier this week, Barclays Capital initiated coverage on Berkshire with a price target of $88 on the Class B shares.  The report makes predictions regarding all aspects of Berkshire’s businesses including forecasts for GEICO’s combined ratio in 2010 and 2011.  The projections specific to GEICO seem excessively negative.

Barclays states the following regarding GEICO’s combined ratio:

GEICO’s combined ratio rose over the past several years reflecting an increasingly competitive auto insurance market.  We expect this result to deteriorate further from 95% in 2009 to 98% in 2010 and 100% in 2011 as loss cost inflation rises. (Page 17)

GEICO has demonstrated a consistent ability to deliver combined ratios well under 100 over the past decade.  We presented the ten year history of GEICO through 2008 in a post in June 2009 and included much more detail regarding performance in our Berkshire Hathaway Briefing Book which includes 2009 data.  While it is true that GEICO’s combined ratio has been rising in recent years, there is no reason to believe that underwriting profitability will disappear by 2011.

One clue regarding early 2010 performance can be found in Progressive’s first quarter results which were released today.  Progressive reported a combined ratio of 90.9 for the first quarter demonstrating continued underwriting profitability.  Over the past decade, there has been a strong correlation between combined ratios at Progressive and GEICO which we also discuss in the Berkshire Hathaway Briefing Book.  While Progressive generated a more favorable combined ratio in 2009 at 91.6 compared to GEICO’s 95.2, there is little reason to believe that GEICO’s combined ratio will rise to 98 in 2010 if Progressive’s Q1 performance is any indication.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.  

Disclosure:  The author owns shares of Berkshire Hathaway. No position in Progressive.

Posted by manualofideas at 05:33 PM | Permalink | Comments (0)

U.S. News & World Report recently profiled ten mutual funds it considers worthy of investor consideration. While we may not agree with all the selections, we were pleased to see Tilson Dividend Fund (TILDX) on the list. The fund is managed by value investor Zeke Ashton who has remained somewhat of a secret in the mutual fund world, despite performance in the top 1% of his peer group.

Read the U.S. News & World Report article.

We interviewed Zeke Ashton late last year - read more here.

Posted by manualofideas at 09:49 PM | Permalink | Comments (0)

From dshort.com:

The ten-year inflation-adjusted ratio of price to earnings has been a favorite long-term indicator of market valuation that I regularly update on this website.

Another ratio, less familiar and more tedious to calculate, was developed by economist and Nobel laureate James Tobin. Tobin's Q Ratio is based on the assumption that the combined market value of all the companies on the stock market should be about equal to their replacement costs. John Mihaljevic, who served as Professor Tobin's research assistant from 1996-98, assisted Tobin in developing a new Q estimation methodology and in periodically updating data related to the Q ratio. John continues to maintain the Q Ratio in an online subscription service at The Manual of Ideas. In addition to monitoring the Q Ratio for the aggregate US market, the service also tracks Q for the 1,000 largest US-listed public companies ranked by market value.

Read the full article.

Posted by manualofideas at 09:38 PM | Permalink | Comments (0)

Mohnish Pabrai provides some great insights on investing in an interview with Steve Forbes this week. Mr. Pabrai comments on a number of topics including the influence Warren Buffett has had on his investment style and the fee structure of his hedge fund.  One quote has particular resonance for someone who has been involved in technology but has chosen to generally avoid tech investments:

I spent a lot of time in the tech industry. And I like to say that I don’t invest in tech because I spent time in it. And I saw firsthand that the durability of technology moats is many times an oxymoron.

Mr. Pabrai also comments on index funds, the benefits of viewing investing as a “gentleman of leisure activity”, the virtues of an afternoon nap, and the main source of misery for investment managers:

Forbes: So what’s that saying of Pascal that you like about just sitting in a room?

Pabrai: Yeah. “All man’s miseries stem from his inability to sit in a room alone and do nothing.” And all I’d like to do to adapt Pascal is, “All investment managers’ miseries stem from the inability to sit alone in a room and do nothing.”

One suspects that “doing nothing” actually refers to moving funds around by frequent trading.  A prepared mind is required to take action quickly and in size when opportunities arise.  For most investors this requires a tremendous amount of reading and hard work.  To view the entire interview, please click on the image below:

For a list of Mr. Pabrai’s investment holdings as reported in his latest 13-F filing showing positions on December 31, 2009, please click on this link.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.  

Posted by manualofideas at 06:00 PM | Permalink | Comments (0)

Most companies on a calendar fiscal year have released proxy statements over the past month.  In addition to annual reports, intelligent investors must pay close attention to proxy statements to determine the company’s philosophy on executive compensation.  Nearly every compensation committee includes what seems like boilerplate statements regarding aligning the incentives of management and shareholders.  However, as we have seen on many occasions, such as the example provided by Kraft’s absurd compensation policies, shareholders must be vigilant when it comes to matching rhetoric with reality.

Stephen F. O’Byrne and S. David Young have published a very interesting article entitled What Investors Need to Know about Executive Pay in the Spring 2010 issue of The Journal of Investing.  An abstract is available by clicking on the article link and the full article is available for purchase.  Mr. O’Byrne is the president of Shareholder Value Advisors and Mr. Young is a professor of accounting and control at INSTEAD.

Value Wealth Leverage and Revenue Wealth Leverage

The alignment of management with shareholder interests should be the ultimate goal of compensation committees.  The authors have developed two measures that help shareholders think about how management compensation reacts to changes in shareholder wealth as well as changes in revenues.

Value wealth leverage is defined as the ratio of executive wealth return to shareholder wealth return for a given measurement period.  In the case of an executive who also owns all of a company’s stock, the ratio is equal to 1.0 since changes in shareholder wealth create exactly proportional changes to the executive’s wealth.  On the other hand, a ratio of 0 indicates no relationship between executive wealth and shareholder wealth.

The authors have also defined a measure called revenue wealth leverage which calculates the ratio of executive wealth return to the percentage change in sales for the  measurement period.

Incentives for Value Destroying Growth

Simply having a high revenue wealth leverage is not, by itself, an indication that a manager will pursue value destroying growth because the components of pay that react to changes in shareholder wealth may partly or entirely offset the components of pay that benefit from the revenue growth.  The authors test whether there are incentives for management to pursue value destroying growth by assuming a situation where an acquisition would result in a 25 percent increase in revenue and a 15 percent reduction in shareholder wealth.

The question is whether the executive’s action will result in sufficient incremental executive wealth as a result of the revenue gain to offset the loss of executive wealth due to the erosion in shareholder value.  The authors use the example of Rex Tillerson of Exxon-Mobil to show that he would have a financial incentive to pursue an acquisition that increases revenue by 25 percent but reduces shareholder value by 15 percent.  This observation is particularly interesting in light of Exxon’s planned acquisition of XTO Energy. (Note:  This is simply an “interesting observation” on my part rather than a statement regarding whether Exxon’s acquisition of XTO makes sense.)

For more information regarding this research, visit The Journal of Investing website to read the abstract or to purchase the full paper.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. 

Disclosure:  The author of this article received a review copy of The Journal of Investing paper from Mr. O’Byrne.

Posted by manualofideas at 08:40 AM | Permalink | Comments (0)

We'll be updating the following list throughout this year's public company annual meeting season:

• Berkshire Hathaway (BRK.A, BRK.B), by Warren Buffett
• Biglari Holdings (BH), by Sardar Biglari
• Coca-Cola (KO), by Muhtar Kent
• Fairfax Financial (FRFHF), by Prem Watsa
• Goldman Sachs (GS), by Lloyd Blankfein
  
• JP Morgan (JPM), by Jamie Dimon
• Leucadia (LUK), by Ian Cumming
• Sears Holdings (SHLD), by Eddie Lampert
  
• Winthrop Realty Trust (FUR), by Michael Ashner

Posted by manualofideas at 09:44 AM | Permalink | Comments (1)

Robert Rubin received a total of more than $126 million in cash and stock compensation over a ten year period at Citigroup for serving as a board member and as a “strategic advisor” to senior management.  However, the role never had any clearly defined operational responsibilities as Mr. Rubin was quick to point out at a hearing of the Financial Crisis Inquiry Commission yesterday:

Let me know turn to Citigroup more specifically.  My role at Citi, defined at the outset, was to engage with clients across the bank’s businesses here and abroad; to meet with foreign public officials for a bank present in 102 countries; and to serve as a resource to the bank’s senior executives on strategic and managerial issues.

Having spent my career in positions with significant operational responsibility — at Treasury and Goldman Sachs — I no longer wanted such a role at this stage of my life, and my agreement with Citi provided that I would have no management of personnel or operations.

This brings to mind the old saying:  “Nice work if you can get it”.

While there is no doubt that Mr. Rubin brought a great deal to the table in terms of his contacts with foreign officials and experience in the industry, this situation always appeared to be an example of the revolving door between Washington and Wall Street that Simon Johnson criticized in his recent book, 13 Bankers, which we reviewed last month.

Was Mr. Rubin really hired for his expertise in the industry and the advice he could provide to senior management or to use his knowledge of government to pave the way for Citi to grow in size and influence to the point where it clearly became “too big to fail” in the recent crisis?  This is a legitimate question to ask in light of Mr. Rubin’s statement that he had no operational responsibilities and was unaware of serious problems until it was too late.

To be fair to Mr. Rubin, it is clear that Citi’s management (which undeniably did have “operational responsibilities”) entirely failed to manage risk properly.  While former CEO Charles Prince should get credit for expressing remorse at the hearings yesterday, he bears a great deal of responsibility for delegating key risk management tasks to a chief risk officer.

As Warren Buffett has stated on several occasions, risk management must be a core responsibility of a CEO and should never be delegated.  Mr. Prince obviously failed to follow this advice and instead famously stated that “as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

We have now seen what happens when the music stops and an institution is left only with incompetent management and senior advisors who disclaim any operational oversight responsibilities.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. 

Posted by manualofideas at 06:36 PM | Permalink | Comments (0)

By Greenbackd

The wonderful DShort.com blog has a post, Is the stock market cheap?, examining the S&P500 using Benjamin Graham’s P/E10 ratio. Doug Short describes the raison d’être of the Graham P/E10 ratio thus:

Legendary economist and value investor Benjamin Graham noticed the same bizarre P/E behavior during the Roaring Twenties and subsequent market crash. Graham collaborated with David Dodd to devise a more accurate way to calculate the market’s value, which they discussed in their 1934 classic book, Security Analysis. They attributed the illogical P/E ratios to temporary and sometimes extreme fluctuations in the business cycle. Their solution was to divide the price by the 10-year average of earnings, which we’ll call the P/E10. In recent years, Yale professor Robert Shiller, the author of Irrational Exuberance, has reintroduced the P/E10 to a wider audience of investors. …  The historic P/E10 average is 16.3.

Here’s the chart from DShort.com to April 1st:

So what is the P/E10 ratio now saying about the market? In short, the market is expensive. The ratio has entered the most expensive quintile, which means it is more expensive than it has been 80% of the time. What are the implications for this? In his most recent Popular Delusions (via Zero Hedge), Dylan Grice has provided the following chart setting out the expected returns using each valuation quintile as an entry point:

Grice says:

If history is any guide, those investing today can expect a whopping 1.7% annualised return over the next ten years.

Doug Short has a more frightening conclusion:

A more cautionary observation is that every time the P/E10 has fallen from the first to the fourth quintile, it has ultimately declined to the fifth quintile and bottomed in single digits. Based on the latest 10-year earnings average, to reach a P/E10 in the high single digits would require an S&P 500 price decline below 540. Of course, a happier alternative would be for corporate earnings to make a strong and prolonged surge. When might we see the P/E10 bottom? These secular declines have ranged in length from over 19 years to as few as three. The current decline is now in its tenth year.

Or was March 2009 the beginning of a secular bull market? Perhaps, but the history of market valuations doesn’t encourage optimism.

Posted by manualofideas at 06:29 PM | Permalink | Comments (0)

Ezra Klein writes in The Washington Post:

In testimony before the Financial Crisis Inquiry Commission yesterday, Alan Greenspan pretty much adopted the Shaggy defense: Interest rates? It wasn't me. Deceptive lending practices? It wasn't me. Unchecked excesses on Wall Street? It wasn't me. They even got us to deregulate! It wasn't me.

Better culprits, according to Greenspan, included the fall of the Berlin Wall, Congress, developing economies, and systemic complexity. Left unanswered is what would've happened had Greenspan walked out and said that there's a global savings glut powering a housing boom that's being repackaged by a finance sector that has become too complicated to regulate and people should proceed with extreme caution and Federal Reserve regulators should adopt a more jaundiced eye.

Full testimony here (pdf). James Kwak has further commentary.

For the Shaggy fans out there, here are the lyrics Greenspan is reportedly considering singing in a duet with the Jamaican-American reggae singer:

But she caught me on the counter (It wasn't me)
Saw me bangin' on the sofa (It wasn't me)
I even had her in the shower (It wasn't me)
She even caught me on camera (It wasn't me)

She saw the marks on my shoulder (It wasn't me)
Heard the words that I told her (It wasn't me)
Heard the scream get louder (It wasn't me)
She stayed until it was over

Posted by manualofideas at 04:40 PM | Permalink | Comments (0)

The Rational Walk is pleased to have this opportunity to present an exclusive interview with Prem C. Jain, the author of the recently released book Buffett Beyond Value which we reviewed last week.  Prem Jain is the McDonough Professor of Accounting and Finance at Georgetown University.  He has previously taught at the Wharton School of the University of Pennsylvania and the Freeman School of Business at Tulane University.  His research has been published in many prestigious finance and accounting journals including the Journal of Finance and the Journal of Accounting Research.

Professor Jain generously took the time to provide extensive answers to several questions regarding Warren Buffett, the evolution of behavioral finance in academia, defining an investing circle of competence, approaches for investors who wish to expand their competence over time, and much more.

Please click on this link to read the interview in a formatted pdf file.

Q:  There are many books covering Warren Buffett’s career, particularly over the past few years. What made you decide to write a book about Warren Buffett and how is your book differentiated from Buffett biographies such as Snowball?

Most authors of books on Warren Buffett spend a significant part of their books on narratives about Warren Buffett as a person. They do not analyze his investing philosophy in enough detail to develop a good sense of Buffett-style investing. I have tried to fill that gap. Having taught Buffett’s principles for over twenty years and having personally benefitted from his principles, I have written a book that is primarily about Buffett’s investing principles. My book is even more valuable to those who already have some background on Buffett from reading biographical books such as Snowball.

Q:  Much of your book focuses on how investors can learn from Warren Buffett’s techniques and generate market beating returns. Yet, the usual caveat is that investors must not stray from their circle of competence. Many investors have trouble precisely identifying the boundaries of this circle. How would you suggest that investors go about defining their circle of competence?

An investor should start with analyzing one industry that the investor knows the most about. The investor is in his circle of competence if he is not often surprised by the developments in that industry. Else, he needs to study it more. As a professor, I have benefited from investing in education stocks as I understood the business models of several of those companies. Furthermore, to precisely identify the boundaries of one’s circle of competence, one must also test one’s knowledge in several additional stocks in the same industry.

It is often the case that an investor would invest in one company in an industry (say, Wal-Mart) and would not know much about other companies in the same industry (say, Costco and others). To understand Wal-Mart well, they should study and monitor other similar companies as well. This is how I came across Wal-Mart de Mexico (a Wal-Mart subsidiary in Mexico that trades independently). Only after developing a good understanding of one industry, the investor should start investigating in other industries.

Q:  You identify Warren Buffett as a “renaissance investor” because he was one of the first to blend the “growth” and “value” styles into a model that has produced consistently superior results over many decades. Part of Mr. Buffett’s shift toward “growth + value” was due to the influence of Charlie Munger and others such as Philip Fisher, but part of this was due to size. As Berkshire grew, the small “cigar butt” opportunities were not able to “move the needle” for Berkshire. Portfolio size is not an issue for most small investors. In early 2009, there were many small stocks selling under “net-net current assets” as defined by Graham. Does it make sense for small investors to pursue the “cigar butt” style advocated by Graham or does it make more sense to emulate Buffett’s “growth + value” approach?

Buffett’s investing philosophy has evolved over time. An investor can similarly become a better investor over time. In 1963, Warren Buffett invested in American Express because American Express’s stock price had declined in the wake of the infamous Salad Oil Scandal in which American Express lost money. However, the American Express charge card business was not affected. After a year or two, Buffett sold those shares as the price recovered. In this investing approach which is usually classified as “cigar butt” investing, the focus is on finding stocks when declining stock prices can be attributed more to market psychology than to fundamentals.

The “cigar butt” investing is based on examining numbers such as P/E ratios or other quantitative metrics. However, even as far back as 1967, Buffett wrote in his letter to his partners that really big money tends to be made by investors who are right on qualitative (as opposed to quantitative) decisions. Clearly, Buffett’s investing style was evolving.

An evaluation of Buffett’s writings and decisions over decades suggests that he has maintained the principle of not paying excessively as a value investor (or as a “cigar butt” investor), he is now willing to pay a fair price as a growth investor. If we were to think of him as a pure value investor, it would be difficult to explain him paying about market P/E for several of his stock acquisitions such as BYD and Burlington Northern Santa Fe or even Wal-Mart. He has clearly evolved into a value + growth investor over time and has specifically mentioned that value and growth are two sides of the same coin. An investor should not ignore “cigar butts” but in this day and age when information is ubiquitous, cigar butts are not easily found. However, an investor incorporating the principles of both value investing and growth investing together is more likely to earn large returns.

Q:  Professional familiarity in a field does not necessarily extend to investment competence. For example, many doctors have a reputation as terrible investors because they mistakenly believe that knowledge of technical details of drugs or medical devices makes them qualified to pick investments. The same can be true for many in technology and software fields. But at the same time, it seems natural to invest in areas that professionals know the best. How can a doctor, for example, develop an investment circle of competence that would allow for intelligent investment in companies related to his profession?

This is a good example of an investor not making good returns even when he may have a good understanding of a particular product. The reason is that investment circle of competence requires not only the knowledge of the products but also the ability to understand the financial statements and to project future earnings. Many investors can not translate success of a product into financial success of the company.

I recommend the following to doctors and others who are interested in investing. Investor should think whether the company and not just a product will be successful for a long time. They should forecast sales and earnings in dollar terms and not only evaluate a product’s technical ability. If they are financial-statements-challenged, they should join hands with others who know some accounting and finance. This may prove to be a fruitful partnership.

Q:  Over the past decade, behavioral finance has attracted much more attention than in the past, perhaps due to several events over the past 25 years that could not be easily explained by the Efficient Market Hypothesis. I recall as an undergraduate student majoring in Finance in the early 1990s that there were few mentions of Warren Buffett or other investors who have routinely achieved market beating returns. Most references to Mr. Buffett tended to dismiss his record as an aberration unlikely to be replicated. Do you see this attitude changing in Finance departments today?

Warren Buffett has had tremendous influence on the academia. In 2003, I invited him to Georgetown University to conduct a question-answer session and the response from the students and the faculty was overwhelming. The finance discipline now acknowledges that professors during the 1970s to 1990s overemphasized the market efficiency paradigm. Fortunately, we have people like Buffett who constantly reminded the academia that the professors had much to learn. And professors have learned. For example, in one of the courses at Georgetown, the first class of the course centers on what we may learn from Warren Buffett. Thanks to Buffett that we do not claim that markets are efficient all the time. It is not easy but if investors work hard, they can beat the indexes and possibly earn very high returns.

Q:  How can investors prepare themselves to mentally deal with temporary declines in the market value of their investments? Even if an investor finds undervalued companies, it is obviously possible for market prices to suffer material declines. We have seen this in Berkshire Hathaway, for example, over the past two years. Is the ability to deal with temporary declines a matter of inherent temperament or personality that cannot be changed, or can investors find ways to improve their investment temperament over time?

Knowledge is the best antidote to making bad decisions. For example, if you know about jewelry and diamonds, all that glitters is not gold for you. Your knowledge will allow you to pick diamonds in the rough and hold on to them. In investing, if you know a lot about certain companies and their managers, you will not become nervous and sell the stock at the wrong time or when the market declines. No wonder, Buffett suggests that you should invest only in companies you understand. Both in 2000 and 2009 when Berkshire stock prices went down by about 50%, I added to my Berkshire holdings.

Q:  Most individual investors attempt to pick stocks on a part time basis. How much time per week do you think is required for part time investors to dedicate to this pursuit? It seems like spending a couple of hours each weekend reading Barron’s or The Wall Street Journal simply wouldn’t be sufficient, yet most people do not have 15 to 20 or more hours per week to delve in more deeply. How should investors think about the time investment required to actively pursue undervalued opportunities?

This is related to an earlier question. If a person has a full time day job, he should study only one industry at a time. Only after he understands one industry, he should move to studying other industries. If he does that, he would not need more than a few hours a week. After several years, he should end up with 20 stocks to invest about 5% in each. In the meantime, he can invest partly in an index fund and party in individual stocks. An average investor need not hold more than 20 stocks in a portfolio. Buffett does not invest in a large number of stocks and most of his holdings are for the long term. In Berkshire, five of the top stocks have often constituted 50% of its total stock holdings. Finally, if a person is very busy and does not have any time to find good stocks, he should simply invest in an index fund such as the Vanguard S&P 500 index fund.

Q:  If an investor decides that he has no particular circle of competence or lacks the time to dedicate to the pursuit, does it make more sense to invest in index funds or in mutual funds such as Fairholme that are run by proven value oriented managers? In your book, you recommend against investing in hedge funds due to the asymmetry that is common in the “2 and 20” compensation models. Does the same caveat apply to value oriented mutual funds? Although they are more cost efficient, certainly index funds remain far cheaper.

For a person who has no particular circle of competence but has decided to invest in the stock market, I recommend investing an index fund and not in mutual funds. An investor is less likely to sell an investment in an index fund when the market goes down than if he were to invest in a mutual fund. I am afraid that the investor would blame the manager for not performing well in a down market and sell all his holdings at the wrong time. It may not be the manager’s fault at all but the investor may not be able to see through the effect of the market on an otherwise well run mutual fund. Even the best of managers do not outperform the market in all the years. The only time a busy investor should invest in a mutual fund is when the investor is extremely comfortable with the manager’s style of investing and has examined it in great detail. It is not enough to simply examine a manager’s past performance and invest with the manager.

Q:  One of the most difficult decisions involves when one must sell an investment at a loss. You cover this topic in the book and suggest that investors should be willing to sell at a loss if subsequent events lead the original investment thesis to be invalid. This is perhaps the most difficult aspect of investing for most people because selling at a loss involves admitting a mistake and making it “permanent”. Is this just a matter of inherent “stubbornness” or can investors take any steps to mentally allow them to sell at a loss with more philosophical detachment?

I think we are hard-wired not to admit mistakes. Selling at a loss is indeed difficult. Or, we are optimistic and hope for an improvement in the stock price. I recommend two specific steps. First, one should write detailed notes whenever a purchase decision is made. Periodically, as the company makes earnings announcements or other important announcements, the notes should be updated. I have benefited from this practice a lot. When individuals are forced to write their thoughts on the paper, they can more easily see the right thing to do. For example, if one has a good knowledge of the company’s products, managers and financial statements, a decline in the stock market may be a good time to invest more in the stock market. Second, they should compute a stock’s intrinsic value periodically. I discuss the concept of intrinsic value in detail in my book.  When the intrinsic value is below the current stock price, they may find it easier to sell.

Q:  Berkshire Hathaway is often misunderstood by the media and characterized as Warren Buffett’s “hedge fund”. This leads many investors to worry about succession at Berkshire. Do you have any views regarding who Mr. Buffett’s successor will be and how confident are you that the success will (a) be able to retain Berkshire’s unique culture and (b) continue Mr. Buffett’s capital allocation track record? It seems like the next CEO will have impossible shoes to fill. Could this result in a “shooting for the moon” attitude that could introduce greater risk at Berkshire?

If the Berkshire board decides to have only one person at the top, I think Ajit Jain is the right person. After all, Buffett talks to him every day, insurance is the most important part of Berkshire, and he has been at Berkshire for about 25 years. (This has nothing to do with the fact that I have the same last name. I don’t know him at all.) The two other names often mentioned are those of Tony Nicely of GEICO and David Sokol of MidAmerican and NetJets. It will however not matter much if any one of the three is the CEO. After all, the Berkshire CEO does not interfere with the subsidiary CEOs.

Yes, the culture! What is the culture at Berkshire, I have often asked myself. Once we reflect on some of the unique features of the Berkshire culture, we are less likely to be concerned about the future of Berkshire even if the next CEO is not as good as Warren Buffett. There are at least two important features of the Berkshire culture. First, the subsidiary CEOs (and employees) are compensated according to what is most meaningful. Buffett has often talked about compensation based on return on assets or other appropriate metrics. This creates a sense of fair play resulting in high productivity. Second, subsidiary CEOs are given independence to make all decisions at the subsidiary level. Hence, Berkshire will continue to do well after Buffett because of its decentralized management structure. The capital allocation process may not be as good as it is today under Buffett but there are many people who have been close to Buffett and my guess is that the new CEO will continue to do a good job for a long time to come.

Professor Jain, this has been very insightful.  Thank you very much.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

Posted by manualofideas at 06:47 PM | Permalink | Comments (0)

By Greenbackd

Alfred Winslow Jones is generally regarded as the progenitor of the modern “hedge fund.” Jones’s strategy, to construct a portfolio 130% long and 30% short (known as “130/30″), seems pretty prosaic by today’s standards, but it was state-of-the-art when he established the partnership A. W. Jones & Co. in 1949. In the April 1966 Fortune article, The Jones Nobody Keeps Up With (.pdf), by Carol Loomis (the same Carol Loomis who edits Buffett’s Berkshire Hathaway shareholder letters), Loomis described Jones’s strategy thus:

[The] fund’s capital is both leveraged and “hedged.” The leverage arises from the fact that the fund margins itself to the hilt; the hedge is provided by short position – there are always some in the fund’s portfolio.

How did Jones’s “hedge” work?

In effect, the hedge concept puts Jones in a position to make money on both rising and falling stocks, and also partially shelters him if he misjudges the general trend of the market. He assumes that a prudent investor wants to protect part of his capital from such misjudgements. Most investors would build there defenses around cash reserves or bonds, but Jones protects himself by selling short.

And his strategy seemed to perform. Loomis reports that he was up 670 percent for the ten-year period to May 1965. Here’s Jones’s performance chart from the article (performance of a $100,000 investment net of fees):

Particularly interesting was Loomis’s assessment of Jones’s ability to predict the direction of the market:

Jones’s record in forecasting the direction of the market seems to have been only fair. In the early part of 1962 he had his investors in a high risk position of 140 [indicating Jones was unhedged 140% long]. As the market declined, he gradually increased his short position, but not as quickly as he should have. his losses that spring were heavy, and his investors ended up with a small loss for the fiscal year (this is the only losing year in Jones’s history). After the break, furthermore, he turned bearish and so did not at first benefit from the market’s recovery. Last year, as it happens, Jones remain quite bullish through the May-June decline, and then got bearish just about the time the big rally began. As prices rose in August, Jones actually moved to a minus 18 risk – i.e., his short positions exceeded his longs, with the unhedged short position amounting to 18 percent of partnership capital.

A perfect contrary indicator. Regardless, he seems to have generally been right when purchasing individual stocks:

Despite these miscalculations about the direction of the market, Jones’s selections of individual stocks have generally been brilliant.

Loomis credits someone else with the idea for the limited partnership structure and fee calculation adopted by Jones:

The idea is common to all the hedge funds, and the idea was not original with Jones. Benjamin Graham, for one, had once run a limited partnership along the same lines.

It’s hard to find a place in investment where Ben Graham hasn’t gone first.

Posted by manualofideas at 10:30 AM | Permalink | Comments (0)

Former Federal Reserve Chairman Alan Greenspan testified today in Washington before the Financial Crisis Inquiry Commission.  We suggested earlier this week that Mr. Greenspan and others who failed to foresee the crisis should simply accept responsibility and play a role in helping society learn from past mistakes in an effort to prevent similar problems from taking place in the future.  While Mr. Greenspan now admits that he was only correct “70 percent of the time”, he continues to minimize the role of monetary policy in the crisis.

In the video clip shown below, Vanguard Founder John Bogle comments on Mr. Greenspan’s “disingenuous” testimony.  Mr. Bogle looks with suspicion when policy makers say “mistakes were made”.  Instead he thinks they should say “I made mistakes”.  In general, it seems like very few people in leadership positions today are ever willing to make such a direct statement.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

Posted by manualofideas at 12:04 AM | Permalink | Comments (0)

Jim Grant of Grant's Interest Rate Observer calls it like it is in a Bloomberg interview following former Fed chairman Alan Greenspan's testimony before Congress today.

Why anyone still pays any attention to what Greenspan has to say is hard to understand. It is hard to think of one individual more responsible for the financial blowup of 2008 than Alan Greenspan. His policies laid the foundation for the house of cards that was built during his time as Fed chairman. For him to claim that nothing could have been done by the Fed to prevent the crisis is laughable.

Here is Jim Grant on Alan Greenspan, The Worst Central Banker in History:

Posted by manualofideas at 03:34 PM | Permalink | Comments (0)

(click to view interactive chart)

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Click here to listen to an interview with Eric Sprott, dated March 27, 2010, or visit the source page.

"Eric Sprott has over 35 years of experience in the investment industry and manages roughly $5 billion.  Eric has been stunningly accurate in his writings for quite some time and is one of the highly respected industry professionals who foresaw the current crisis and chronicled the dangers of excessive leverage as well as the bubbles the Fed was creating while correctly forecasting the tragic collapse we are all enduring.  In this interview Eric discusses the stock market, bond market, inflation, deflation, gold, silver, gold stocks, consolidation in the gold sector, the economy, the US Dollar, paper currencies globally, tax revenues going down, layoffs in US government jobs in states, oil and much more."

Posted by manualofideas at 10:05 PM | Permalink | Comments (0)

H. Kevin Byun, managing partner of Denali Investors, provides some enlightening commentary in his just-released Q1 letter to investors. Byun argues that the equity market is behaving as irrationally on the upside today as it did on the downside in late 2008 and early 2009. He attributes some of the recently exuberant action to so-called "Mr. Magoo pretenders" who suffered big losses in 2008 and may still be chasing their high watermarks. In a quest to recoup losses and get paid, Messieurs Magoo appear content to gamble with their investors' capital, risking disaster yet again. Byun also discusses his concerns surrounding the recent rise of protectionism.

Download Byun's Q1 letter or keep reading his market commentary here:

The first quarter of 2010 has been marked by a continued upward creep in the markets, in stark contrast to recent fear and dislocation. From the lows reached far back in March, when the S&P broke to 667, we have seen a rally of over 75%.

2010, as it turns out, is a make-or-break year for many funds. The severe drawdown in 2008 and massive run-up in 2009 showed once again that it is better to fail conventionally than to succeed unconventionally. With many funds still below high water marks, their urgency for near-term performance in 2010 is greatly magnified. How can these fund managers properly invest with a long-term view when a short-term sword of Damocles hangs precariously above? Can these Mr. Magoo pretenders make it another year? And so career risk, business risk, and behavioral finance, rather than the best interests of their investors, comes to the fore.

With 2010 shaping up to be another interesting year, my view remains that the potential big-picture range and probability of outcomes have widened considerably, although the expected value or average represented through the market may appear narrow. With all the dislocations, machinations, and interventions, the potential energy in the markets is building once again. Exactly how and when the kinetic shifts occur remain an unknown, but the set up to dramatic changes appears to be in place. Expect the water to be choppy.

One related area that has become a topic of increasing attention, just to pick one out of the hat, is that of exchange rates, namely the call coming from some corners for China to let their currency float. From my perspective, it is not analytically prudent to draw a line in the sand on the issue due to the tricky and ever present law of unintended consequences. There are many interpretations even for concepts far simpler than floating and fixed rate frameworks, but let’s venture through. Regarding these unintended consequences, I would like to humbly present the following words as food for thought.

I often see politicians on the news putting the issue in binary terms, as right versus wrong, as good versus bad, as us versus them. This may prove to be a great disservice. Indeed, our country has outsourced many jobs, and low level ones at that. But this means we have also outsourced our unemployment and social unrest. Can you imagine what our unemployment number would look like if the capital base and employee base that supplies our goods just from China were simply put inside the US? Would it surprise you that this would approach Great Depression numbers? The migrant workers and unemployed masses of the Great Depression actually do exist today. But it simply goes unnoticed here because that too has been outsourced!

Conversely, what I have never seen a politician ever mention in the exchange rate debate is the likely resulting inflation. Why not? The average person is already stretched and living paycheck to paycheck. The group that will be impacted the most, which is that same group to which politicians pander, will find costs for basic items moving further out of range. Does it make sense that twenty pairs of tube socks from China are available for $8 retail? For every dollar prices for these tube socks move up to reflect true domestic and rate adjusted costs, a dollar less is available for other necessities. Such limited financial resources create an increasingly desperate zero sum game. Do I buy food or do I buy school supplies for the kids? If exchange rates do float and there is inflation, what will be the call to action then? Who will be the scapegoat? This may result in further finger pointing and a resurgence of social unrest, trade tariffs, trade barriers, and protectionism. This will be part of a negative reflexive process that may have much more severe and unfortunate consequences. But no one is talking about that.

If you are intellectually honest, you have to admit this is not a simple scenario to figure out for which this discussion barely scratches the surface and does not do justice.

As such, I present the following parable not as an answer, but as a surprisingly liberating approach for the analytical mind. It is a story my father told me a long time ago.

“Seh-Ong Ji Ma”
(Seh-Ong’s Wise Horse)

There was a farmer named Seh-Ong that had a beautiful and strong horse. The neighbors complimented, “You are so lucky to have such a beautiful and strong horse.” The farmer replied, “We’ll see.”

Days later, the horse ran away from the farm and could not be found. The neighbors wailed, “You are so unlucky to have lost such a beautiful and strong horse.” The farmer replied, “We’ll see.”

Days later, the farmer’s horse returned, but had brought back seven other wild horses that were equally beautiful and strong. The neighbors complimented, “You are so lucky to have so many beautiful and strong horses.” The farmer replied, “We’ll see.”

Days later, the farmer’s son was attempting to train one of the wild horses, fell off the horse, and broke his leg. The neighbors wailed, “You are so unlucky to have your son break his leg.” The farmer replied, “We’ll see.”

Days later, the king’s army came through to take all the able-bodied young men for war. The neighbors complimented, “You are so lucky to have your son spared from the war.”

The farmer replied, “We’ll see.”

For me, this is one of the most powerful, simple, and elegant lessons of life and, therefore, investing.

Read Kevin Byun's Q1 2010 Denali Investors letter.

Download Kevin's 2009 presentation at Columbia Business School.

Read an excerpt of our exclusive interview with Kevin.

Posted by manualofideas at 09:20 PM | Permalink | Comments (0)

By Nadav Manham

This article about the sale of Net-a-Porter appeared in the back of Friday's WSJ Marketplace section.

What a new media success story. In 2000 Natalie Massenet was a fashion journalist with an idea to sell luxury clothing over the web. There were many doubters and haters. Fashion journalists were not supposed to do such things. They were supposed to be fashion journalists, which meant they were supposed to produce the words that went in between all those lucrative advertisements.

Fast forward to today. Those advertisements are not so lucrative any more. But well-executed online retailing in a specific niche is (see Amazon, Zappos, etc.). Once of Massenet's great insights was that she did not completely leave the journalism businesses, she just transferred it to a different platform. From the WSJ article:

Lately, however, the big luxury brands have made digital retailing a higher priority, having recognized that shoppers are increasingly willing to buy very expensive products on the Web. But selling $1,000 dresses online is different from hawking groceries or second-hand books: Customers want an editorial element, a guiding hand to replace the in-store salesperson and signal what's in style, which is where Net-a-Porter has carved out its niche.

The Web site, which says it has been profitable since 2004 and reported sales of about £120 million for the fiscal year ended Jan. 31, has established itself as an interactive shopping fashion magazine, publishing 52 weeks of editorial content each year alongside its designer clothes sales operation.

"It's just as much a magazine as it is a store," said Ms. Massenet in an interview. "That really has served us well, because when you're online you lose the offline experience of walking into a store."

I doubt that Net-a-Porter is being studied in journalism schools, but it should be. I believe it represents one of the futures of the media business. The definition of "journalism" will become much more fluid, and the basic skillset of journalists, with a little adaptability, will continue to be in demand.

Update: Mrs. Massenet has been reading her Investor's Consigliere. Maybe. Here she is in today's Financial Times:

"I think there will be an increasing convergence between content and commerce . . ."

The author of this post is president of Elera Advisors LLC, an investment advisory company focused on value-oriented manager selection. Mr. Manham is a Manual of Ideas contributor and editor of The Investor's Consigliere.  

Posted by manualofideas at 03:56 PM | Permalink | Comments (0)

Interesting info on the shipping industry for all the contrarians out there...

(apn Photo/Frank Hormann)

"On today's Planet Money:

So there was a big shipping bubble that inflated about the same time the housing bubble did. It grew for some similar reasons -- a go-go economy, easy credit, a belief that prices never decline, etc. And, like housing, it's now turned ugly.

Ships that cost more than $100 million a few years back now go for $40 million -- and the rates for freight have fallen accordingly. Ship owners have gone bust, and their ships have been taken by the bank and sold at auction.

Also on the podcast: The Gorton's fisherman, and what the shipping bust has to do with torn fiber-optic lines in Singapore."

Posted by manualofideas at 03:48 PM | Permalink | Comments (0)

Perhaps no other government policymaker has suffered as much reputational damage due to the housing collapse as former Federal Reserve Chairman Alan Greenspan.  Mr. Greenspan has defended his record in recent months and recently published a paper outlining his views regarding the housing bubble and subsequent crash.  In Mr. Greenspan’s view, Fed policy actions had little to do with the crash.

One of the investors Michael Lewis highlighted in his recently published book, The Big Short, is Michael Burry who ran the Scion Capital hedge fund from 2000 to 2008.  Mr. Burry was one of the first investors to spot the growing housing bubble and to devise a strategy to profit from the eventual collapse.  Mr. Burry published an op-ed article in the New York Times yesterday that sheds some light on the attitudes that convinced policymakers that no bubble was forming:

I have often wondered why nobody in Washington showed any interest in hearing exactly how I arrived at my conclusions that the housing bubble would burst when it did and that it could cripple the big financial institutions. A week ago I learned the answer when Al Hunt of Bloomberg Television, who had read Michael Lewis’s book, “The Big Short,” which includes the story of my predictions, asked Mr. Greenspan directly. The former Fed chairman responded that my insights had been a “statistical illusion.” Perhaps, he suggested, I was just a supremely lucky flipper of coins.

Mr. Greenspan said that he sat through innumerable meetings at the Fed with crack economists, and not one of them warned of the problems that were to come. By Mr. Greenspan’s logic, anyone who might have foreseen the housing bubble would have been invited into the ivory tower, so if all those who were there did not hear it, then no one could have said it.

That’s Not a Real $100 Bill!

This is vaguely reminiscent of the old joke regarding two economists walking down the street and noticing a $100 bill lying on the sidewalk.  One economist leans down to pick it up, but the other economist says that doing so would be pointless.  If the $100 bill was real, someone else would have already picked it up.

Mr. Burry was able to pick up many “$100 bills” by being alert regarding the building crisis and figuring out ways in which he could profit from the eventual crash.  Meanwhile, economists like Mr. Greenspan obviously failed to recognize the building crisis.  At some point, those who were wrong about the housing bubble should simply step up and admit that they missed the warning signs.

While the free market is efficient most of the time, it does not follow that major inefficiencies cannot exist.  Such inefficiencies appear all the time in the stock market and can also occur throughout the economy at times.  Economists would better serve the public interest by studying the methods of those who were able to spot the housing crash rather than to explain it away as a “statistical illusion”.

Click on this link to read Michael Burry’s New York Times op-ed article

 The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.  

Posted by manualofideas at 02:49 PM | Permalink | Comments (0)

By Nadav Manham

This article about Hulu in yesterday's NY Times contained the following interesting excerpt:

Mr. Kilar [Jason Kilar, Hulu's CEO] points to his company’s new profitability as evidence of the success of Hulu’s business model — collecting various types of video in one place and making it free, supported by ads. Revenue topped $100 million in 2009 and could reach that number this year by early summer, he said.

“Aggregation works for consumers,” he said. “It makes it easier to find and discover and enjoy premium content, and it works for advertisers, because with that aggregation you get greater reach.” 

Once upon a time aggregators were called middlemen, and if they happened to be the wrong race or religion they often faced physical risk from those on either side of their middleman function. "We break our backs growing the crops but the grain wholesalers make all the money" and "Why, if that merchant doesn't make any of the goods he sells, does he make so much money?" were (and in some corners still are) common refrains.

The answer is in Kilar's succinct description of the double-barrelled economics of aggregators. A successful middleman aggregator offers consumers low searching costs to find a given product, be it food, dry goods, media, whatever. It correspondingly also offers suppliers the cheapest per-consumer exposure to their products, even if they have to share actual or "virtual" shelf space with other suppliers. As a middleman aggregator grows it benefits from economies of scale, which improve both barrels of the business model.

As the article notes, Viacom has taken its shows off Hulu. It's the equivalent of a fashion designer refusing to supply its clothing to a department store and opening a standalone boutique instead. It will be interesting to see whether Viacom sticks to this strategy or capitulates and returns its content to Hulu or another aggregator.

Some of the best moats in business, in media but elsewhere too, are middleman aggregators of one sort or another. Google is the ultimate in modern media, Wal-Mart is the ultimate in modern retail. Before Google it was monopoly newspapers, which aggregated news and ads for readers at low cost, and aggregated consumers for advertisers at lowest costs. Before Wal-Mart it was the urban department store.

Even buildings can be aggregator middlemen. The Chicago Merchandise Mart, the jewel in the crown of the Kennedy family's business interests for over half a century, aggregated wholesale goods buyers and suppliers from all over the country. The Brill Building in New York aggregated buyers and suppliers of music.

If you can spot a middleman aggregator moat in its early stages you can make a lot of money. The key is to look at Kilar's two metrics: low discovery costs for buyers and high reach for suppliers.

The author of this post is president of Elera Advisors LLC, an investment advisory company focused on value-oriented manager selection. Mr. Manham is a Manual of Ideas contributor and editor of The Investor's Consigliere. 

Posted by manualofideas at 05:33 PM | Permalink | Comments (0)

In the just-released monthly issue of Downside Protection Report, editor John Mihaljevic, CFA and The Manual of Ideas research team highlight their latest top two monthly investment ideas. Each stock is judged to have strong downside protection and above-average upside potential.

The first featured idea of the month is a recently public insurance company with a strong niche presence in the attractive agribusiness segment. The company appears grossly mispriced as a result of the recent conversion from a mutual company to a publicly held corporation. Due to the quirky structure of the conversion, investors in the recent IPO not only received a claim on the cash invested in the IPO but also on the company's existing assets and business. This produced an unusual opportunity to buy a well-established, well-run insurer at roughly one-half of tangible book value. Not surprisingly, insiders bought shares in the IPO, and the company has rushed to repurchase stock almost immediately after issuing it in the IPO. The shares are still available in the public market at only a modest premium to the IPO price -- though probably not for long.

The second featured idea is a multi-billion dollar competitive energy company that generates electric power primarily via coal-fired power plants. The shares trade at less than one-half of tangible book value, even without ascribing any value to the company's multi-billion dollar net operating loss carryforwards, which should be available to offset income taxes for several years. The company continues to generate positive free cash flow and has an unlevered balance sheet. The shares trade at 2.4 times estimated 2010 EBITDA and a 15% estimated free cash flow yield.

Read Downside Protection Report now.

 

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