Day: October 7, 2022

Even Buffett Isn’t Perfect: What You Can — and Can’t — Learn from the World’s Greatest Investor is analysed in this article by Vahan Janjigian. This book has a catchy title. From the title, I initially thought the whole book is dedicated to analysing the mistakes made by Buffett, but it turns out that it is more like 95% of it devoted to what Buffett did right (which most devoted value investing followers would already know by heart), and only 5% on where Buffett went wrong. One good thing about this book is that it is an easy read, you can finish the book in say an hour. Another good thing about the book is its section on expensing of stock options. It clearly writes down exactly my thoughts on why I don’t think stock options should be expensed on issuance. Some key points: Diversification Berkshire’s portfolio is still concentrated despite its size. As of Dec 2006, more than half of its stock holdings are in just 4 companies: Coca-Cola, American Express, Wells Fargo, and Proctor & Gamble. Asset allocation Even though studies show that asset allocation is more important than security selection, that is more so for short-term returns (e.g. Brinson, Hood, and Beebower’s research conclude that > 90% of variation in quarterly returns over time was explained by asset allocation). If  you are investing for the very long-term (e.g. 30 years), stocks beat other asset classes. Discounted Cash Flows The book wrote that Buffett uses the risk-free rate to discount projected cash flows, and Buffett believes he does not need to account for risk in the discount rate since he consciously avoids stocks that he considers too risk. From my own reading of past writings of Buffett however, he did acknowledge that he doesn’t just use the risk-free rate, and he apparently does account for risk in the discounting. Momentum Strategies Narasimhan Jegadeesh and Sheridan Titman conducted a study on momentum strategies and found that investors can generate considerable profits by shorting stocks that had done poorly over the prior 6 months and buying stocks that had been doing well during that same period. This works best for investment horizons of about 12 months. Narasimhan Jegadeesh, Louis Chan, and Josef Lakonishok in a later study found that stocks that did well in the momentum strategy were the ones with the highest (yes highest) P/B ratios and were also the ones with the largest Standardized Unexpected Earnings (SUE). SUE is the difference between a company’s actual earnings per share and the consensus estimate divided by the standard deviation of all the analysts’ estimates. Momentum investing works only on average, and does not work in every single instance. Those who implemented momentum strategies in the late 1990s incurred big losses when they fell out of favour, but they can make profits during the dot-com sell off. Purchase Prices Forest River was speculated by RV Business to have been bought for more than $800M, just over 0.5 P/S. Iscar Metalworking was estimated to have been bought at 3.6x P/S and 11x P/E. PacifiCorp was bought by Berkshire’s MidAmerican Energy unit for 1.25x P/B. PacificCorp reported ROE of 9.7% for the fiscal year ended March 2006. Russell Corp (sporting goods) was bought by Berkshire’s Fruit of the Loom unit in August 2006 for $600M, which is less than 0.5 P/S. Berkshire assumed about $600M of additional debt. Mistakes Salomon Salomon traders rigged the U.S. Treasury bond auctions with full knowledge of Salomon’s management. General Re Bought at end of 1998 for $22B, increased Berkshire’s average float from $7B to $23B. Made underwriting losses, raised its rates, causing premiums earned to fall from 2000 to 2006. Had pretax underwriting loss of $1.9B due to September 11, 2001, this increased its cost of float. Buffett gave 3 learning points: Accept only risks you can properly evaluate Make sure the risks you accept are not  correlated with one another so that no single event threatens solvency No matter how profitable, don’t do business with bad people Buffett admitted that he was wrong when he thought General Re was practicing proper underwriting discipline and that reserve policies were conservative. Unwound and shut down General Re Securities, a unit that was engaged in derivatives trading. NetJets Because of shortages of aircraft, NetJets was forced to rely on expensive charter services to meet its contractual obligations. Planes must often be flown empty to pick up a customer (deadhead flights). Had two competitiors Flexjet (owned by Bombardier) and Flight Options (owned by Raytheon) which were more concerned in creating buzz for their planes than making profits. Pier 1 Imports Total store count had increased from 763 to 1074 from fiscal 1998 to 2003. Got killed by specialty retailers (Bed Bath & Beyond, Williams-Sonoma, Restoration Hardware, Pottery Barn, Cost Plus) and megadiscounters (WalMart, Target, Costco). Expensing Stock Options Companies must estimate how much options are worth when they are granted (e.g. using Black-Scholes), and expense the full amount on the income statement as the options vest. If the options are exercised and the company issued Treasury stock (stock that was authorized but not yet issued), the company received money from the employee and didn’t lose any money. If the options are exercised and the company purchased the shares from the open market, then the company would incur a real cash outflow equal to the market value of the shares minus what the company received from the employee. If the options are never exercised, there is no net effect to the company. Hence the true cost of the options depend on whether the options are exercised, when they are exercised, how the company chooses to meet its obligations, and potentially what the share price is at time of exercise. By expenses options early on, the expense can overstate / understate the true cost of the options. When the stock price falls, the true cost is less than what was originally expensed. When the stock price rises, the true cost can be much … Read more

I read this book “Invest Like a Dealmaker” by Christopher Mayer some time ago. It is a book on value investing, and goes through the standard value investing concepts Think about the whole business, not just the stock price. Think about cash flow, not earnings. Use EV/EBITDA to get a snapshot on value. Think about asset values (tangible assets are more precisely valued and provide investors with greater protection from loss). Focus on your downside. Margin of safety of 25% to 40% Characteristics of funds that beat the market (Mauboussin) Low portfolio turnover Portfolio concentration Value style with attention to price paid Geogrphic location not near Wall Street Limited time on macro forecasting A few big winners can overcome nasty big losses (Murray Stahl from Horizon Asset Management) Have a long holding period (Ron Muhlenkamp recommends a minimum time horizon of 3 years for the long-term dynamics of stocks to work in your favour). The market worries about the short term, that can be exploited to buy stocks with temporary setbacks but solid longer-term prospects. The way to win is to make very few mistakes. You play not to lose. When there’s nothing to do — do nothing (Dolce far niente). It’s all about the price you pay. Some other points below. On Top-Down Investing The book had two good quotes from Seth Klarman: There is no margin of safety in top-down investing. The top-down investors are not buying based on value; they are buying based on a concept, theme or trend. There is no definable limit to the price they should pay, since value is not part of their purchase decision. Paradoxically, a bottom-up strategy is in many ways simpler to implement than a top-down one. While a top-down investor must make several accurate predictions in a row, a bottom-up investor is not in the forecasting business at all. On Insider Transactions It mentioned some good points about insider transactions that I thought would be good to note down: Management can be the last to know that there is something seriously wrong with the company (e.g. the CEO of Countrywide Financial was giving bullish remarks till the last few moments 0f the company’s demise. From all accounts, he was genuinely shocked by what happened). Insiders sell for all sorts of personal reasons, the key is to look for divergence from normal behaviour. Be excited when insiders are buying at higher and higher prices. Insiders can’t predict the future (an example was given where Warren Buffett in May 1996 issued a statement in Berkshire’s B Shares prospectus, that the stock was not worth buying at that price, and the stock proceeded to double in two years). It also mentioned a book by George Muzea called “The Vital Few versus the Trivial Many”, I should read it when I get some time  On How Companies Create Value or Wealth Martin Whitman gave 4 ways: Growth of earnings from operations Free cash flow thrown off from operations Resource conversion activities (e.g. involves using your assets and liabilities in new ways). This includes M&A, changes of control, management buyouts, massive share repurchases, major financings, refinancings, restructuring, converting assets to higher uses, hidden assets can be sold, spinoffs, investment in new ventures in othe rindustries, corporate liquidations). Most investors analyse companies as a going-concern continuing its current activities and failed to recognise resource conversion activities. Access to capital markets on a super-attractive basis E.g. selling shares, using its high priced shares for acquisitions, borrowing money at very low rates Theory of Slack Chris Mayer has a theory that says owning companies that have lots of capacity — whether in excess cash or excess assets — and low amounts of liabilities — whethre in debts or pending litigiation or growing pension obligations — is a great way to make big profits in stocks. This slack is in and of itself a valuable commodity. My thinking is that how valuable the slack is depends on whether the company is able to utilise the slack to realise value. There may be inherent difficulties such as Buffett’s lament that even though See’s Candies’ ROE is high, they cannot inject cash into the business and achieve the same ROE, hence See’s excess cash still needs to flow to Berkshire for other investments. On How Contrarian Value Investing Makes its Money & Market Timing See my previous post here. On Hunting Grounds Where to look for investments: Look at what the greats are doing. Use the Net Tangible Asset Value (NTAV) screen Market cap greater than $150M (to screen out micro-caps) P/E > 1 (to screen out companies losing money) P/B < 1 D/E <= 0.3 NTA >= Market cap Use the screens in the Value Line investment survey Stocks with widest discount to book value. Stocks with P/E and P/NWC that are in the bottom of the Value Line universe. Spin-offs Read WSJ, Barron’s Look up the holdings of Claymore/Clear Spin-Off Exchange Traded Fund (CSD) Greenblatt’s Magic Formula Insider buying (see section on Insider buying above) Distressed investing during market crashes Stocks with decreasing shares outstanding A paper by Bali, Demirtas, and Hovakimian titled “Corporate Financing Activities and Contrarian Investment” found that you can beat the market by buying the cheapest 20% (by P/B) of the market whose shares outstanding are also falling. This would give a 5.5% edge per annum over the years they studied (1972 to 2002). On When to Sell Ralph Wanger of Columbia Acorn Fund (author of A Zebra in Lion Country)’s advice is to make the reason you buy a stock specific enough so you know when it is no longer true. Keep checking back with your reason, and sell when it is no longer true. On Competitive Dynamics Bill Miller talked about a book Nature: An Economic History by Geerat Vermeij, which found that efficiency in nature can be trumped by “aggregation of power”. The parallel to economics, is that small and efficient companies can often be crushed by bigger but less efficient companies. Greater profits with lower margins may be more … Read more

Whenever I make mistakes in trading (i.e. did not follow my trading plan), I like to deep dive to figure exactly why that happened, why did I take a certain action? What was I thinking? Why was I thinking that way? Was what I was thinking correct? Should my thinking be changed? How should I think about it the next time? How do I effect the change in thinking? What was I feeling? Why was I feeling that way? Should I be feeling that way? Is it driven by false beliefs or irrational beliefs with respect to how a market functions? How should that emotion response be modified for the next time I see the same scenario? How can that be effected? To answer all the questions above so as to effect positive change, you need to monitor your thoughts and feelings as you are trading, you need to have awareness of what is going on inside your mind. Whenever you think that you have made a bad trade (based on process, not P/L), quickly jot down what you were thinking and feeling that led to you taking the action. You can then use that during your trade review process to figure out needs to be done to improve your trading moving forward. -END-

Many people have no problems identifying the trend with their own methods, yet they have difficulties in pulling the trigger to capitalize on that trend. Why is that? And for those with no problems in pulling the trigger, they find themselves exiting too early (too early = earlier than what their trading plan dictates). Again, why is that? An Example From my own trading journal, I had this case where I was hesitating too much in pulling the trigger. As a result, I was late to trends, and ended up with positions at more risky spots. I actually noted down what I was thinking: Downtrend: It’s not clear whether it’ll go up or down, wait till it breaks support. Support broken: No stop nearby, let’s wait till it pulls back. Pulled back: Hmm its too close to the next support, wait till it breaks that support. 2nd support broken: No stop nearby, wait till it pulls back again. Price pauses: Price is in such a narrow range of 2-3 ticks, its too risky, it can breakout either way, let’s wait and see. Price breaks down: The downtrend has already moved so far, it may end soon, so its too risky to enter. Trend changes up on 1-min: Hmm, 3-min time frame the trend is still down, better not enter. Another example, it was an uptrend, but there was someone dumping large lots. So again my mind had this simultaneous reasons, one for going short / or not entering, and one for going long: Reason to go short / don’t enter – Natural resistance: There is someone dumping big lots, so it is risky to go long. Better not go long, it looks like it might turn down. Reason to go long – Trend: There’s a higher high, higher low, its an uptrend, should go long. You can see how dangerous the mind is in talking yourself out of trades. Unless price is breaking new highs or new lows into clear blue skies, it is very easy to be cluttered with previous market structure (e.g. support, resistance) which makes a clear trade difficult. Another Example In Jake Bernstein’s The Investor’s Quotient (2nd Edition), he also gave an excellent example of how internal thought processes and hesitations resulted in missed trades. The scenario was one where a buy signal was triggered after an extended move down. Thought processes that resulted in not taking the initial signal: Let’s wait for some more confirmation of the reversal. True, we had the reversal, but the volume wasn’t high enough. Let’s wait. If this was indeed a true reversal in trend, then we’ve got plenty of time to get in because trends run for a long period of time. The decline was so severe that I’m afraid to get in. I’d rather wait a few days to make sure the trend has changed. If I get in now, I might get stopped out on a test of the low. Thought processes that resulted in not entering on a retracement: Let’s wait a little longer to see if we can get in cheaper. The price has come back too far and the low will probably be broken Let’s wait until it penetrates its recent high (or low) to be sure that the test was passed. I’ll wait for the next upside breakout, that way I’ll be certain to buy with the trend. Thought processes for missing the breakout: Prices are too high. Now that the breakout has come and I know it’s real, I’ll wait for a pullback to the breakout area and buy in. Price then moves up without any retracement, then finally the trader couldn’t take it anymore, buys at the top, and gets chewed up. This is one reason why traders ignore top signals when they appear, because they have already thrown their discipline out the window. Possible Reasons Bernstein gave 5 possible reasons underlying such behavior: Unrealistic fear of losses Lack of self-confidence and positive attitude Inability to act as a result of negative learning Lack of appropriate learning with trading system Acceptance of inputs from contrary sources Psychological Process At Work Here’s my take on what’s happening. There are a number of psychological processes at work here. The process goes like this: When faced with what the market is playing out, based on all past experiences and beliefs, your emotional mind communicates its assessment through emotions. For most people that have not been consistently profitable, what is usually some form of anxiety: the anxiety of entering a position and getting it wrong, the anxiety of open profits disappearing, etc. Translated to words, when you are thinking whether to enter, your emotional mind is saying: “Don’t enter!”; when you are thinking of what you should be doing now with your open profit, your emotional mind is saying “Get out NOW before the profit disappears!”. Your logical mind is skilled at making up reasons. It looks for evidence that supports what your emotional mind wants to do. Once it finds some evidence that “makes sense”, your logical mind stops thinking (this is what Harvard psychologist David Perkins calls the “makes sense” stopping rule.) You then act out what your emotional mind has decided, i.e. you fail to pull the trigger, or you exit your winning trade prematurely. This leads to good trades being missed, superb winners being cut short, and finally you get into a negative self-blaming cycle. As you can observe from the process above, there are a few problems: The action you took wasn’t decided by your logical mind, it was decided by your emotional mind. You would think that you are taking an action based on a logical assessment of the situation, but your logical mind has been fooled into thinking so. At most points in time, there are always reasons for why the market should go up, and reasons for why the market should go down. This is the same be it fundamental or technical reasons, i.e. there are always +ve and -ve interpretations for both fundamental … Read more

Some time ago I was watching some interviews and articles on Mark Cuban‘s advice on investing. He has unconventional advice, which I actually agree wholeheartedly with. One main point is that he holds cash and only deploys it when he has an advantage. This resonates with Warren Buffett’s style of investing of waiting and preparing for the fat pitch. Here are some relevant quotes from Buffett: I call investing the greatest business in the world… because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! and nobody calls a strike on you. There’s no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it. We don’t get paid for activity, just for being right. As to how long we’ll wait, we’ll wait indefinitely. Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient. The one thing I will tell you is the worst investment you can have is cash…  Cash is going to become worth less over time. But good businesses are going to become worth more over time. And you don’t want to pay too much for them so you have to have some discipline about what you pay. But the thing to do is find a good business and stick with it. We always keep enough cash around so I feel very comfortable and don’t worry about sleeping at night. But it’s not because I like cash as an investment. Cash is a bad investment over time. But you always want to have enough so that nobody else can determine your future essentially. We have $16 billion in cash not because of any predictions [about a market decline], but because we can’t find anything that makes us want to part with that cash. We’re not positioning ourselves. We just try to do smart things every day, and if there’s nothing smart, then we sit on cash. A quick summary Mark Cuban’s points below. Pay Off Debt You are better off paying off any debt you have because that’s a guaranteed return [i.e. the return = the interest rate on your debt]. Create Transactional Value from Cash Cash has transactional value It is ridiculous to say that “if you just put your money in the bank, you are going to fall behind inflation”. Unless you know something specific, put your money in cash. In 2008, 2009, Cuban did his homework and piled into MLPs, M-REITS, and Australian Bonds (as a play on China). In 2011, Cuban felt there was going to be a lot of volatility, so bought out-of-the-money calls (on SPY and DIA) when the market cratered, and bought out-of-the-money puts when the market went up. Having that dry powder available when the market goes down and you see an opportunity, then you are ready to take it. Never put your money in something where you don’t have an information advantage. Take advantage of economic crises Every five years or so there is a bubble bursting or amazing deals available because of a change in the economy. Anyone who just kept their cash in the bank rather than in stocks over the past five to 10 years could be buying the home of their dreams for half price in most of the country. Buy in bulk If you offer to pay in cash, you can often get a discount, or you can save by buying in bulk. I look at my annual budgets for everything and anything, and I look to see where I can save the most money on those items. Saving 30% to 50% buying in bulk – replenishable items from toothpaste to soup, or whatever I use a lot of – is the best guaranteed return on investment you can get anywhere. Sleep well at night Cash is king – and works far better than Ambien when you want a good night’s sleep every night. Buy and Hold is a Suckers Game Right at the very moment when cash creates unbelievable opportunity, those who followed the buy and hold strategy have no cash. they can’t or won’t sell into markets this low, that kills the entire point of buy and hold. Diversification is for Idiots You can’t diversify enough to know what you are doing. Invest in Yourself Invest your time in yourself and becoming knowledgeable about the business of something you really love to do. You are going to get a far better return investing in your own skill set than you are taking a chance at the stock market. Take Advantage of Times of Uncertainty Booms are when the smart people sell. Busts are when rich people started on their path to wealth. You will know when that time is here for you because you will know your business inside and out. You will be ready because you will have been saving up for this moment in time. What to Look for in a Startup A unique product A motivated and educated team Knowledge of the market A demonstration that the big dream can work in practice