Is the Bubble About to Burst?

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Q4 2016 Data

In an earlier post I referenced an excellent market valuation model that I found at the Philosophical Economics blog. To sum it up: the model projects the next 10 years of market returns by using the average investor allocation to equities. The theory is that most bull markets are fueled by rising valuations as investors move money from other asset classes into stocks. The model tells you how much “fuel” is out there to push equities higher.

The Q4 2016 number recently became available over at Fred. The current average equity allocation at the end of the year was 41.279%. Let’s plug this into the equation I referenced in my earlier blog post on this topic:

Expected 10 year rate of return = (-.8 * Average Equity Allocation)+37.5

(-.8 * 41.279) + 37.5 = 4.48%

We can therefore expect the market to deliver a 4.48% rate of return over the next ten years. Not particularly exciting, but not the end of the world either.

Market Timing

Most hedge fund letters this year emphasized how market valuations are at historic highs and take a cautionary approach to stocks. I agree with their spirit because I think everyone should always approach the market with caution. If someone cannot handle losing half of their money, then they have no business in the stock market. A drop of that magnitude can happen at any time no matter where valuations stand. That short-term risk is the very reason that stocks outperform other asset classes over the long-term.

If I were an alarmist, I would agree with some of the hedge fund letters and say: “The market hasn’t traded at these valuations since 2007! Get to the chopper!” This implies that we are on the brink of another historic meltdown in stocks. This is the prognostication that is often heard about stocks today. I think it is misleading.

Valuation simply predicts the magnitude of future returns over the long run. Higher valuations mean lower returns and lower valuations mean higher returns. That’s it. It does not predict what the market will do over the next 12 months. It does not mean that if you wait long enough, you’ll have an opportunity to buy when valuations are at more attractive levels. Anything can happen in the next year. There could be an oil embargo. A war could break out. Terrorists could strike. Our politicians could cause another crazy showdown that imperils the economy. Trump-o-nomics might actually work. Maybe it won’t. No one really knows and anyone who proclaims otherwise is lying.

It is tempting to look at market valuations as a tool to time the market. Wouldn’t it be great to sell in 2007 and buy in 2009? Get in when the market is depressed and get out when valuations rise and the market looks like it is due for a correction? My view is that market valuations should not be used as a market timing tool. When it comes to timing the market, I think Peter Lynch put it best when he said:

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” – Peter Lynch

This is great advice. Today’s market valuations may be at 2007 levels — but they were also around these levels in 2004 (S&P 500 up 8.99%), 1968 (up 7.32%), 1997 (up 25.72%) or 1963 (up 17.51%). It makes little sense to try to time the market based on valuation or refuse to participate simply because the market isn’t offering the kind of compelling bargains that it presented in 2009. The question is: is this 2007 or 1997?

Stopped clocks are always right twice a day. This is how I feel about the permanent bears. They certainly called it in 2008, but did they call the turnaround? How many of them have been predicting disaster for the last decade and have been proven wrong year after year? There is bound to be another meltdown at some point in the future, but there is no way to predict when that will happen. The wait can be long. While you wait, more money can be lost through unrealized gains than is lost in the actual correction. 2017 may be the year for a major market meltdown of and the end of the bull market. Perhaps. Taking the advice of the permanent bears will help you avoid it, but how much more money was lost listening to their advice since 2009? It doesn’t make sense to refuse to participate in the market simply because the market isn’t offering compelling valuations.

Valuation in a Vacuum

Stock market valuation doesn’t occur in a vacuum. One should always compare the expected returns in stocks against the expected returns in other asset classes. My view is that the best asset to compare stocks to is AAA corporate bonds. The way to think about stocks is as corporate bonds with variable yields. The question isn’t “is the market overvalued?” The question is “Do current earnings yields justify the risk of owning stocks when compared to the returns on safer asset classes?”

This is why interest rates drive the stock market.

“Interest rates act on asset values like gravity acts on physical matter.” – Warren Buffett

Below is a historical perspective of market valuation compared to the interest rates on corporate bonds. The expected 10 year S&P 500 return is derived from the equation described earlier in this post.

Year Expected 10 Year S&P 500 Return AAA Corporate Bond Yield Equity Risk Premium
2017 4.48% 3.05% 1.43%
2012 9.38% 3.85% 5.53%
2007 5.06% 5.33% -0.27%
2002 4.33% 6.55% -2.22%
1997 7.86% 7.42% 0.44%
1992 14.43% 8.20% 6.23%
1987 14.37% 8.36% 6.01%
1982 19.24% 14.23% 5.01%
1977 15.03% 7.96% 7.07%
1972 5.22% 7.19% -1.97%
1967 4.41% 5.20% -0.79%
1962 5.66% 4.42% 1.24%
1957 9.81% 3.77% 6.04%
AVERAGE 2.60%

Historical

As you can see, there are times when the market adequately compensates investors for the risk of owning stocks and there are times when it does not. It is also evident that there is a strong correlation between interest rates and future market returns. Higher interest rates mean that stocks need to deliver higher earnings yields, something that is usually achieved by a market correction that depresses P/E ratios and boosts earnings yields.

From this perspective, the market isn’t wildly overvalued. The current market valuation is largely in line with historical norms based on where interest rates are today.

That is the right way to think about stocks. It is folly to think “valuations are too high, therefore I will not participate because a correction is imminent.” That is short-term prognostication and it is typically wrong. No one knows what will happen over the next year and market valuations won’t provide the answer.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

“American Desperado” by Jon Roberts & Evan Wright

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Cocaine Cowboy

Years ago, I saw the documentary Cocaine Cowboys. The documentary was about the transformation of Miami from a sleepy vacation and retirement destination in the 1960s to a hub of drug trafficking and murder in the late 1970s and 1980s. The story was enthralling. It transcended a normal documentary and unfolded like an action movie. The characters include drug traffickers, hitmen, murderers, shady attorneys, the cops on the front lines and the reporters of the era who documented the carnage. The documentary is on Netflix if you want to check it out.

In the documentary, the two most fascinating characters to me were the drug smugglers, Jon Roberts and Mickey Munday. In the documentary, both were portrayed as largely non violent, which made them more appealing. In the documentary, it was the hitmen that were the savage and violent characters. Munday and Roberts were largely non-violent, which made them stand out. They appeared to be far more intelligent than the characters they were forced to associate with. While they were criminals, they weren’t psychopaths like many of the hitmen and drug kingpins that they were dealing with. When I heard that Jon Roberts wrote a book called American Desperado about his experiences, I was excited to read it.

I feel that this blog entry is incomplete without Jan Hammer

The Dark Side

The book revealed a much darker side to Jon Roberts’ persona than what was in the documentary. Jon admits that he is an evil person. His motto for his life was “evil is strong”. While in elementary school, he witnessed his father murder another man and suffer no consequences for it. The young Jon was amazed that in real life (unlike the movies), bad people frequently got away bad things. This was a truly terrible lesson to absorb at a young age. As Jon learned far too late in life, bad things do catch up with bad people. Karma is real.

The early childhood trauma and lack of a positive father figure propelled Jon on a criminal path. In his youth, he was a juvenile delinquent. He spent his time robbing people and reacting violently to anyone who crossed him. He abused drugs and alcohol. After being arrested, Jon was offered the opportunity to avoid lengthy prison time by enlisting in the military during the Vietnam War. In Vietnam, where he behaved like a murderous psychopath. For instance, there is a section of the book where he describes how to skin a person alive. The description is terrifying. His criminal career evolved from early experiences setting up drug deals with the intention of robbing people, drug dealing, to becoming embedded in the New York mafia and managing night clubs.

Jon had some clashes with made men and was tied to a murder. This led to a falling out with the mafia. Jon had to flee New York City to get away from the police and the mafia. Jon was able to leave the geography of New York and reinvent himself in a new location. He decided on Miami because he had family there. He begins in Miami by trying to live a straight life with a dog training business but quickly strays back into his criminal ways.

Drug Kingpin

Slowly in Miami, Jon evolves in the preeminent drug smuggler in the area. He estimates that his fortune at one point exceeded $100 million. He still engages in violent behavior. He alludes to murders during this time period, but it is not nearly as violent as his time in New York. Still, Jon is relatively tame compared to his counterparts at the time. His lifestyle is unbelievably decadent and he describes this in depth as well.

In one amazing incident, Jon organizes a trafficking operation on behalf of the CIA. He then contends that Barry Seal did this as well, which appears to be supported by evidence. Barry Seal later became an informant. The Colombian drug cartels also ask Jon to kill him. Later, they did this themselves without Jon’s help.

Eventually, Jon is arrested after the government obtains information acquired through an informant and close business associate of Jon’s, Max Mermelstein. He spends years living as a fugitive in both Colombia and Mexico. While in Mexico, he is arrested as a result of their version of America’s Most Wanted. He ultimately escapes from the Mexican prison and hides in the United States in Delaware, until he is ultimately arrested in the early 1990s.

Jon also has a son, whom he genuinely loves. Despite his seemingly tranquil family life in the 2000s, Jon knows deep inside that his demise is coming. He actually says that he spent his life in service of the devil and expects God to punish him with a painful death. Ultimately, Jon died of cancer in 2011.

Mickey Munday

The book left me with a still largely positive image of Mickey Munday. Unlike Jon, Mickey was truly non violent and an incredibly smart guy. He didn’t engage in any materialistic flashiness. He was involved in drug smuggling solely for the challenge and fun of it. He is incredibly innovative. In one amazing section of the book, it is described how Mickey developed a stealth boat after reading about the stealth bomber in a magazine. He equipped the boat with a silent drive and navigated at night without lights while he wore night vision goggles and the boat was invisible to radar. As a nice touch, he would ride the stealth boat while listening to Phil Collins’ In the Air Tonight on his headphones. Mickey didn’t do drugs and his main vice was milk and cookies. He was the most fascinating and likable character to me. I wish Mickey would write a book, as I would love to read more about him.

Recommendation

I liked the book, but I can’t recommend it to anyone who wants to read a book with a likeable protagonist. Jon is a scoundrel. With that said, he at least admits it and doesn’t try to sugar coat it. He is completely honest about the evil in his life. He was a murderer and likely a psychopath. I imagine watching his father commit murder seeped into him and left an impression which impacted his mentality throughout his life. At one point, he talks about the best way to kick someone’s face with a steel toed boot and you can detect that he actually enjoys it, as evidenced by the level of detail in his description. Amazingly, despite a lifetime spent in crime, the most horrific activities that Jon engages in are in Vietnam.

Despite Jon’s admitted evil, he is actually quite charming and at times very funny. A particularly humorous incident involves Jon and OJ Simpson, who apparently had an insatiable appetite for Jon’s drugs. After a drug binge, Jon must take Simpson to an airport on the morning of a game and leads Simpson through the airport in a wheelchair because he is unconscious and will not wake up.

Jon’s story is a fascinating one, but I was also left wondering how much of it was actually true because the stories are so extreme that some of them sound fabricated. To his credit, the co-author Evan Wright attempts to document as much as possible and offers his own commentary on the validity of Jon’s claims. Evan also conducted interview of Jon’s associates and those perspectives are also included in the book.

I can’t recommend this book to everyone, but if you can stomach reading the life of a truly evil man with extraordinary life experiences, then you should check it out.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

The Psychology of Human Misjudgment by Charlie Munger

This is a great speech given by Charlie Munger. Throughout the speech, Charlie runs through the common causes of human beings to misjudge.

I think it’s important for everyone to understand these concepts, but it’s particularly important for investors. The goal of an investor ought to be to take advantage of human misjudgment. With markets, you’re dealing with the collective judgment of human beings. To make any money, you have to be able to make good decisions and understand why other people are making comparatively bad decisions.

Whenever you find yourself coming to a conclusion about something, I think it’s a good idea to think about this speech and think about whether or not you are succumbing to these common misjudgments.

The common causes that Charlie summarizes in the speech are listed below:

  1. Under-recognition of the power of what psychologists call ‘reinforcement’ and economists call ‘incentives.’ Always think in terms of whether or not someone is gaining from a course of action and whether that lines up with your own goals. “Is my realtor just trying to maximize his commission, or is this house actually a decent value?” Never underestimate the power of incentives.
  2. Psychological denial. The inability of people to accept truths that are too painful to accept.
  3. Incentive-cause bias, or when the interests of two parties aren’t aligned.
  4. Bias from consistency and commitment tendency. This is sticking to your guns over “core beliefs” and refusing to change in the face of evidence to the contrary.
  5. Bias from Pavlovian association, or misconstruing past correlation as a reliable basis for decision-making.
  6. Bias from reciprocation tendency, including the tendency of one on a roll to act as other persons expect.
  7. Lollapalooza: bias from over-influence by social proof. Social proof is your desire to agree with other people for the sake of agreeing. The ultimate examples I can think of are both the real estate bubble and the dot-com bubble of the late ’90s. The prices made no sense, but everyone else was doing it.
  8. “To a man with a hammer every problem looks like a nail”. Economists are cited as an example of loving the efficient market hypothesis because the math was beautiful and that was what they were trained to use even though it was largely useless for the problem that they were tackling.
  9. Bias from contrast-caused distortions of sensation, perception and cognition. In other words, limiting yourself to your own experiences when making decisions instead of looking at the bigger picture.
  10. Over influence by authority. Valuing someone’s opinion more just because they’re an authority figure. Also known as the expert fallacy. You’re more likely to listen to someone in a suit than someone in a t-shirt and jeans.
  11. Bias from deprival super-reaction syndrome, including bias caused by present or threatened scarcity, including threatened removal of something almost possessed, but never possessed. I.e., the reaction of a dog when you try to remove its food or the reaction of the American public when Coca-Cola tried to change the flavor.
  12. Bias from envy or jealousy.  “It’s not greed that drives the world, but envy.” – Warren Buffett
  13. Bias caused by chemical dependency, such as drugs or alcohol.
  14. Bias from a gambling compulsion.
  15. Liking and disliking distortion. This is the tendency to agree with the opinions of someone just because you like them personally. Conversely, there is the same tendency to disagree with the opinions of someone you dislike just because you dislike them. In other words, not analyzing the actual merits of an opinion, but basing your thoughts on your attitude towards the person. You see this a lot in politics. When a President does something that the opposing party dislikes, think of the different reactions that would be caused in the same people if someone from their own party proposed the same course of action.
  16. Bias from the non-mathematical nature of the human brain. Letting yourself be fooled by statistical tricks.
  17. Bias from the over influence of extra vivid evidence. Not looking closely at something because the answer seems obvious. Look closer because the truth isn’t always obvious.
  18. Mental confusion caused by information not arrayed in the mind and theory structures, creating sound generalizations. In other words, you need models to understand the world. Your mind isn’t just randomly collecting scattered facts. They have to exist in some kind of structure to be useful.
  19. Other normal limitations of sensation, memory, cognition and knowledge.
  20. Stress-induced mental changes, small and large, temporary and permanent.
  21. Mental illnesses and declines, temporary and permanent, including the tendency to lose ability through disuse.
  22. Development and organizational confusion from say-something syndrome. In other words, it’s the idea that you feel you have to do or say something for the sake of doing it, not because it will actually achieve anything. Anybody who ever sat in a meeting in corporate America knows this truth. 90% of the people who say something in these meetings have nothing useful to say.
  23. Combinations of these tendencies. Examples cited include Tupperware parties, Alcoholics anonymous and open outcry auctions. All combine several of the psychological biases that Charlie previously described to obtain a result.

Before making a decision, take a step back and think about whether or not any of these biases are at work. The more we can avoid these biases, the better decisions we can make.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Ed Thorp: The Man Who Beat Las Vegas and Wall Street

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I just finished Ed Thorp‘s new book, A Man for All Markets, and give it a strong recommendation. Ed Thorp is a genius who mastered card counting, built the first wearable computer to beat roulette and created the first market neutral hedge fund. The book takes the reader on a fascinating adventure through Thorp’s Depression-era childhood, his academic career in mathematics, his successful assault on Las Vegas and his wildly successful career in the financial markets.

Lifelong Learning

One of the things that struck me about Edward Thorp was his enduring lifelong love of learning, which fueled much of his success. Edward Thorp didn’t have a one-dimensional interest in mathematics. He was constantly fascinated by new ideas which likely led him to study unconventional subjects such as gambling. In his childhood he experimented with radio, attempted to win mathematics competitions, conducted funny experiments (such as attempting to create a hot air balloon and playing a prank on a local swimming pool with red dye that turned the entire pool blood-red). These funny pranks and interests show a deeply inquisitive mind willing to learn new things. While few of us are anywhere near the intellect of Ed Thorp, that’s an important lesson to take away. Remaining curious and developing a lifelong love of learning is a positive attribute that we should all strive to achieve.

The Original Black Scholes

I never knew that Thorp developed the original black scholes model, but he developed this and used it to make money for himself in the 1960s. He wrote about it in a 1967 book about it along with other arbitrage strategies, Beat the Market . Thorp was looking for a way to successfully invest his money that he accrued through his gambling activities and best-selling book Beat the DealerHe tried stock picking and wasn’t pleased with it, looking instead for something more precise and scientific. He ended up employing his own brand of convertible arbitrage and his own version of the Black Scholes model, before Fisher Black and Myron Scholes wrote their 1973 paper about it. In 1997, Myron was awarded the Nobel prize for an insight that Thorp discovered first. While Fisher Black and Myron Scholes appeared to have engaged in outright theft of Thorp’s ideas, he is surprisingly cool and level-headed about it. I suppose the lesson of this is that it doesn’t pay to hold grudges and needlessly create enemies. In fact, Thorp maintained a good relationship with them and was pleased that they were able to prove his idea. In any case, Thorp put the ideas to work in the world’s first market neutral hedge fund, Princeton Newport Partners.

A Unique Perspective

Something I thoroughly enjoyed about the book was reading Ed Thorp’s outlook on financial and political issues. What was fascinating to me was how non-ideological Thorp’s approach is. It’s hard to pin him down as a conservative or liberal. He does not subscribe to any kind of orthodoxy. Thorp’s approach is pragmatic and relies primarily on logic.

For instance, when discussing welfare, Thorp isn’t opposed to welfare as would be standard conservative orthodoxy but he also doesn’t subscribe to the standard liberal worldview. Thorp’s attitude is that welfare and unemployment benefits are necessary, but believes that these individuals should be put to work as occurred during the Great Depression’s Works Progress Administration.

Thorp is certainly no friend of Wall Street and takes a critical eye towards the actions of investment banks. A standard liberal response would be to load up Wall Street with as many regulations as possible. A standard conservative response would be that laws created by Washington, DC (such as the community reinvestment act) forced the banks to take unnecessary risks and that they therefore are not directly responsible for the outcome of the crisis. Thorp acknowledges the bad behavior of banks and believes in sensible regulation, but thinks that we would do much better off by enabling shareholders to better combat bad behavior by the management of public companies rather than pursuing excessive regulation.

Thorp also has a very unique perspective on the 1980s junk bond boom. While acknowledging that Michael Milken was responsible for illegally enabling insider trading, he believes that Milken was not a target solely for his illegal acts. Milken’s illegal activity was magnified and pursued by the authorities because Milken financed an assault against the established corporate order. The established corporate order was far more entrenched politically and pleaded with politicians to shut him down. Thorp also has an unfavorable attitude towards Rudy Giuliani, whom he believes pursued these scandals less out of a sense of justice and more for political gain.

He’s also quite critical of the hedge fund industry, arguing accurately that hedge funds rarely deliver returns that justify their high expense ratios. This is quite ironic because Thorp launched one of the first modern hedge funds.

A Wild Trade

One of my favorite stories in the book involves an amazing trade that Thorp came across in 2000 at the height of the internet bubble. It is a story that could come straight out of Joel Greenblatt’s You Can Be a Stock Market Genius. It also gives insight into the level of financial insanity that fueled the internet bubble.

Back in March 2000, 3COM owned Palm Pilot. 3COM spun off 6% of its interest in Palm in an IPO. Due to the mania that was consuming market participants at the time, every technology or internet oriented IPO would immediately be bid up to an insane valuation on the first day of trading. Palm was no exception, but the level it was bid up to was truly absurd. After the first day of trading, the market valued the Palm IPO at $53.4 billion but valued the parent company (that owned the other 94% of Palm) at only $28 billion! In other words, the 6% share of Palm was valued more than the other 94% owned by 3COM plus all of 3COM’s other business interests. Thorp shorted Palm and went long in 3COM, in an incredible trade that would never have been possible if markets were efficient.

Investment Ideas

Thorp is a strong advocate for buying index funds, but he also offers a couple interesting ideas for investors to make above average returns.

The first fascinating idea is taking advantage of Savings & Loans that issue new equity. Thorp will open up a deposit account in a savings & loan that he suspects will eventually take a new equity offering public. Because depositors get a share of any new equity issue, Thorp then applies for a position in the new equity offer which typically sells for nearly double of the original price that Thorp paid for it. If he feels the savings & loan is well-managed, Thorp will hold onto the position for much longer periods of time. Thorp opens up multiple deposits in S&L’s throughout the country and then patiently waits for an equity offer. This was immensely profitable in the run up to the S&L crisis when S&L’s were hungry for new capital. The game has slowed down in recent years, but it sounds like those opportunities can still be identified.

The second idea is buying closed end funds at a discount and shorting closed end funds at a premium. This was an idea I was previously familiar with (Graham was an advocate of the strategy, at least the long portion of it). Closed end funds are publicly traded investment vehicles that can only be redeemed through trading activity. There are fixed number of shares and market participants determine the price. However, like a standard mutual fund, you can easily assign a net asset value to the shares. Unlike a mutual fund, you can’t redeem your investment at NAV, you have to sell it to someone in the open market at whatever they’re willing to pay.

In other words, there is no guesswork involved in determining the value of a closed end fund, but the shares trade openly and the price relative to the NAV frequently changes. Shares of closed end funds frequently trade at a significant discount or premium to their NAV. Efficient market types will say that these price discrepancies occur because the market is speculating on the riskiness or promise of the assets that the closed end fund owns. However, during the financial crisis, Thorp was able to acquire closed end funds that owned nothing but treasuries (an essentially risk free asset) at a substantial discount. Barron’s maintains a nice list of closed end fund NAVs and premium/discount that investors can take advantage of.

Bernie Madoff

A particularly fascinating passage in the book is one in which Thorp uncovers the Madoff scandal all the way back in 1990. While auditing investments for another firm, Thorp investigated Madoff because the firm had investments with Madoff. Thorp at first suspected that Madoff’s slow and steady returns every month (Madoff “earned” 1-2% every single month and never lost) might be fraudulent. Thorp confirmed this suspicion when, after checking with the exchanges, he confirmed that none of Madoff’s alleged trades actually happened. Thorp could have alerted the authorities back then, but he suspects they wouldn’t have done anything about it, so it wasn’t worth getting into the weeds. He’s right, of course. Harry Markopolos came to a similar conclusion and tried to alert the authorities about it and no one would listen (in fact, the SEC investigated and cleared Madoff of wrongdoing), and Harry spent years worrying that Madoff would try to take him out in some way. It sounds like Thorp made the prudent choice without making a big splash: advise his client to get out and lay low about the finding.

Conclusion

Edward Thorp is a living, breathing refutation of the efficient market hypothesis. He’s an iconoclast who refused to accept the conventional wisdom about markets or casinos. He had a lifelong love of learning which he allowed to pursue a fun (and profitable) adventure. His journey is a fascinating one that I thoroughly enjoyed. I recommend the book to anyone interested in a great story about a unique genius.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Domino’s: Mean Reversion in Action

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I love this story. Not simply because I love pizza (my philosophy is that even bad pizza is good pizza), but because it’s a great example of mean reversion in action. One should never write off a company that is struggling. Companies with a poor return on equity can take steps that can turn their situation around and often do.

By 2010, Domino’s stock was devastated. The stock was down 57% from 2005 to 2010. It was struggling with a battered and beaten brand in a boring industry. They successfully turned the situation around with some creative thinking and hard work. Since the strategy change, Domino’s is now up 1,453%. That beats the storied Amazon, which is up 557% over the same period. It all happened in a boring, conventional industry with a company that Wall Street wrote off.

Domino’s isn’t currently the kind of stock I would buy. It is currently trading at 42 times earnings. It’s a great company but I’m not getting any margin of safety from the investment. With that said, there were numerous opportunities in the 2010-2012 period when it had a solid margin of safety.

It is a story like this to keep in mind the next time a growth investor asks you “why are you investing in this crap?” Crap can turn to gold. It happens more often than is typically appreciated.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Chasing Perfection

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“Many shall be restored that now are fallen, and many shall fall that are now in honor.”

– Horace.  This is the opening quote in Benjamin Graham and David Dodd’s “Security Analysis”

Buffett & Munger

Warren Buffett started his career buying cheap stocks. These weren’t good companies, they were mediocre and bad companies that were ridiculously cheap. After the 1960s, his style evolved from buying cheap “cigar butt” stocks to finding quality companies at decent prices. “Quality” in the sense that the companies are capable of compounding wealth over long periods of time.

Buffett moved on to the new style of investing primarily as a matter of size. His wealth had advanced to a point where it was difficult to move in and out of companies when they were at 2/3 of their value and then sell when fully valued. He had to be able to park money and let it compound over long stretches of time. Another reason for the style change was via the influence of Charlie Munger. The quality companies that he purchased are now famous investments: The Washington Post, See’s Candies, Coca-Cola, Gillette, etc.

These were companies that had high returns on capital.  They were also businesses with competitive moats. No one will ever be able to make a beverage that can effectively compete with Coca-Cola.  Men will always shave with razors and Gillette is the most well-known brand.  People will always buy candy and See’s candy is a great brand. You’re not necessarily going to play it cheap on Valentine’s Day. No other paper will displace the Washington Post as the premiere newspaper of the Washington, D.C. metroplex.

Many value investors that were small in scale were able to achieve high compounded rates of return dealing with cigar butt stocks. They normally become too wealthy to nimbly move into and out of cheap stocks at the opportune times. A notable exception is Seth Klarman. Very few been able to duplicate Buffett’s returns at his size, or even fractions of his size. Buffett admits that size matters. In fact, he says that if he were running $1 million, he could achieve a 50% rate of return.

It’s Not As Easy As It Looks

Everyone saw what Buffett did and now wants to duplicate it. In retrospect, it seems obvious that the businesses Buffett bought would go on and continue earning their high returns on capital. But was it as obvious as it seems now with the benefit of hindsight? If it is so obvious, why have so few been capable of duplicating Buffett’s results?

The answer is competition. The forces of competition in a capitalist economy are relentless. Consider this: since 1955, 88% of Fortune 500 companies have moved on in one way or another. There were countless companies that had high returns on capital in Buffett’s time that looked invincible. I’m sure most former Fortune 500 companies looked invincible in their heyday, but 88% of them weren’t. Buffett was capable of identifying the companies that would survive and acquiring them at a good price. He made it look easy but it wasn’t.

Competition

Competition is relentless. Any business that achieves high rates of return is going to attract competition. Human nature makes us extrapolate whatever is happening in the present into the future, but this is typically folly.

Let’s say I invent a widget that costs 50 cents to make and generates $1 of revenue, a 100% rate of return. Naturally, other companies are going to try to make widgets.  They will undercut me in price.  The supply of widgets will also continuously increase until it meets the demand. Over time, the introduction of competition will reduce the rates of return. Think of what happened to any major industry and you see the forces of competition in action. This isn’t a flaw of capitalism, it’s a feature. It’s one that benefits the consumer.

The Market

The impact on the stock prices of companies of these competitive forces is even more extreme. The widget company earning 100% returns on capital is going to attract a lot of attention on Wall Street and will likely earn insane valuations. Therefore, not only do these companies have real-world economic pressures that will bring them down, their stocks typically become overvalued as well. The introduction of competition to a company with an overheated price is an explosive combination.

You can see this in the backtesting for mechanically buying “quality” stocks with high growth and returns . The returns aren’t linear like you would expect. The “best” decile doesn’t perform the best. Unlike the backtesting for value metrics — which typically show a linear relationship where the cheapest decile has the highest stock gains and then they decline from there — quality metrics typically show lumpy returns. Typically the best returns are somewhere in the middle. The companies in the highest decile “quality” metrics don’t deliver the higher rates of return. You can see this in backtesting for return on equity, return on invested capital, return on assets, growth in earnings per share, etc. The notable exception to this is gross profits to assets, as discovered by Robert Novy-Marx. Although now that it has been discovered, it is possible that this advantage may be arbitraged away in the upcoming years.

In an attempt to duplicate Buffett and try to elevate value investing above the dirty business of buying cigar butts, value investors are constantly trying to marry “quality” with “cheap”. They’re looking for companies with amazing managers, a competitive moat, high returns on capital . . . that also sell for a good price.

This might sound easy but it’s not. As I mentioned, 88% of the Fortune 500 from 1955 is now gone. I’ll bet they all thought they had a “moat”.

General Motors used to have a moat in the 1950s and 1960s (well, it was an entrenched oligopoly, but a form of moat nonetheless). Other companies that appeared at one time or another to have a moat were Bethlehem Steel, Kodak, Standard Oil, Western Union, The American Tobacco Company, Fairchild Semiconductor, RCA.  All of these companies eventually succumbed to the relentless forces of competition and were taken off their perch.

Buffett and Munger have an underappreciated genius in identifying these rare firms with strong moats and high returns on capital and then buying them at discounted prices. I don’t think this is something that can be replicated in any quantitative fashion. Joel Greenblatt attempted to do this in The Little Book That Beats the Market, with outstanding results. However, Tobias Carlisle discovered that the quality component of Greenblatt’s formula (return on invested capital) actually reduces the returns. You can read about this in Deep Value.  Simply using the “cheap” component of the magic formula actually achieves better results.

My thinking is that attempts to duplicate Warren Buffett and Charlie Munger actually leads to the under performance of value managers. It’s the reason that most value managers outperform the S&P 500, but can’t beat the lowest deciles of price-to-book and price-to-earnings.

The Good News

The obsession with quality creates many of the value investing bargains that I seek. The flip side of the relentless impact of competition on high return business is that low return businesses attract little attention. Low return, bad businesses aren’t necessarily dead. They may be at the end of a waning period in their industry in which many of their competitors are dying. The decline of competition will ultimately drive returns higher. A struggling business with a low ROE is trying to turn things around, likely by reducing their costs. If their strategy doesn’t drive returns higher, at the very least there will be very little competition and the existing competition may leave the market behind.

A good example of something like this is a stock like Archer Daniels Midland. It operates in a mediocre return business (ADM has a ROE of 7.77%, compared to a Buffett stock like Coke with an ROE of 15.92%), but attracts little competition due to the mediocre returns of the business and large investments necessary to penetrate the market. No one is going to make the massive investments in scale to duplicate ADM’s results for a relatively low ROE. Simultaneously, low ROE stocks will typically be ridiculously cheap at the end of a competitive cycle because they generate an “ick” reaction in most investors. “Ick” creates bargains.

The “Ick” Factor

I’m not opposed to quality investing. I just think it is far more difficult to implement than is typically appreciated.

If one is going to go down the “quality” road, I think it’s important that the stock have some level of an “ick” factor to the investing public. If a consistently high ROE stock with a competitive moat has what appears to be an attractive price, it’s important to ask why everyone else doesn’t see the value (particularly if your insight into the attractive price is achieved with DCF analysis).

A great quality investment needs to generate an “ick” to ensure you’re getting a good price. Some of the best Buffett buys had a massive temporary “ick” factor — like the salad oil scandal, New Coke, or GEICO’s massive losses in the mid-1970s. If the stock isn’t reaching out to you with an “ick” factor, it’s probably not really a bargain. If you find one of these stocks, my suggestion would be to only go after it if there is an “ick” factor and you’ve done sufficient research to know that the “ick” is temporary.

I’ll Stick With Cigar Butts

I’m not Warren Buffett. I’m not Charlie Munger. I’m not going to achieve their rates of return over long stretches of time.  The good news is that I don’t need to identify Buffett stocks to do well in the market, mainly because I’m operating with small sums of money and can behaviorally deal with temporary losses in the realm of cigar butts.

15% rates of return in the lowest value deciles of the market may not sound as sexy as the Buffett’s 19.2% returns on billions and billions of dollars in capital, but it is an excellent return to strive for and it’s one that can be obtained by operating in the lower valuation deciles with small sums of capital.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.  Full disclosure: my current holdings.

Long Term Capital Management and the Dangers of Debt

This is a good documentary about the ’90s hedge fund Long Term Capital Management (LTCM). If you want to learn more you should read Roger Lowenstein’s excellent bookWhen Genius Failed.

The story is a cautionary tale about leverage (leverage: what rich people call debt). LTCM was leveraged 25-1, meaning a 4% reduction in assets would kill the firm. That’s precisely what happened.

LTCM would make ‘safe’ bets and leverage up on those safe bets to amplify returns.  It worked great for years, until 1998 when the world defied the model with Russia’s default.

Leverage boosts returns but it blows up in your face when you are wrong, no matter how brilliant you are. Everyone gets things wrong.  That’s a part of life.  That’s a part of investing.  In the face of an error, the proper course of action is to pick up the pieces and move on.  Excessive leverage destroys the ability to do that, because one mistake will wipe you out.  LTCM had two Nobel Prize winners and one of the greatest bond traders of all time, John Meriwether.  If they can get things wrong, then anyone can.

Whenever I hear of the returns of Renaissance Technologies, I think of LTCM. Genius minds, complex mathematical models, massive returns and leverage. They may not be leveraged 25-1, but they are reportedly leveraged 17-1.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures. Full disclosure: my current holdings.

How to Overvalue a Company: Use Discounted Cash Flow Analysis

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Discounted Cash Flow Rationale

Discounted cash flow (DCF) analysis is the most popular method of business valuation.  It is taught extensively in most finance classes.  The goal is to find a reasonable price for a future stream of cash flows and compare it to a risk-free rate of return, usually US treasuries.

It’s also fraught with peril because it usually results in overvaluing businesses.  It is the preferred method of valuation in investment banking.  I suspect this is because investment bankers can easily game the numbers and make companies appear more valuable than they actually are.  Allow me to explain.

Apple Valuation (AAPL)

To show the power of assumptions, let’s try a real world valuation example.  Let go with Apple (AAPL) using this method.

Free Cash Flow

Let’s start with a fact: in the 2016 fiscal year, Apple’s free cash flow was: $65.844 billion in operating cash flow – $13.548 billion in capital expenditures = $52.296 billion in free cash flow

At the end of the 2016 fiscal year, there were 5.336 billion shares of Apple common stock.

$52.296/5.336 = $9.80 of free cash flow per share of Apple stock.

So what’s the value of $9.80 in discounted cash flow?  Let’s use DCF analysis to figure it out.

Zero Growth Example

For example 1, let’s take an extreme approach.  Let’s say Apple won’t grow at all (unlikely).  For the interest rate, we’ll use US treasuries.  The 10-year US treasury currently pays 2.38%.  Here is a link with a detailed explanation of the math.

If you want to do this quickly, Gurufocus has a calculator tool that you can use here.  Another nice shortcut is a formula that can be used in Microsoft Excel or in Google sheets.  Simply input the following formula into a cell:

=NPV(discount rate, cash flow 1, cash flow 2, etc.)

Now, let’s try to find the present value of a $9.80 stream of cash flows.  Based on no growth and 10 years of cash flows and using the 2.38% rate, we get a value for Apple of $86.30.

Growth and Different Discount Rates

2% Growth, 2.38% rate, 10 years = $96.02

What if instead of using the 10 year treasury as our base, we used the 10 year average AAA corporate bond yield, 2.96%

2% Growth, 2.96% rate, 10 years = $93.11

Terminal value

Most likely, Apple isn’t going to go out of business in 10 years.  For this reason, most DCF analysis adds a terminal value to the value after the 10 years of cash flows.  Let’s proceed with our assumption that there will be 2% growth for 10 years, then let’s say after 10 years the growth rate drops to 1%.

Present value of 10 years of cash flows + Terminal Value = $173.52

Now, what if we increased our assumptions?  Let’s say Apple grows by 5% a year, and then the terminal value grows earnings at 3% into the future?  Now the value goes up to $228.54!

With DCF analysis, you can make the data say whatever you want.  That’s great for investment bankers but it’s not very good for investors.

Conclusion

By messing around with different assumptions, I produced valuations for Apple that ranged from $86.30 to $228.54.  All of these assumptions are debatable.  You can’t say with any degree of certainty where interest rates are going, what Apple’s cost of capital will be, what their growth rate will be, how long the business will be viable, etc.  All of these are assumptions.  Also keep in mind that I produced this wide range of values with one of the the largest and most recognizable company in the United States.  If we can’t safely value Apple, how can we safely value a micro-cap stock?

For this reason, I avoid discounted cash flow analysis.  It is simply too easy to twist around the data with your assumptions and get the result you want.  If you want to find a margin of safety with DCF analysis, you’re going to find one.  I suspect that this is what the investment banking community does when they want to convince corporate managers to make acquisitions that may not be in the best interests of the acquirer.

A simple ratio (i.e., the stock trades at 10 times earnings) is a far more simplistic . . . and far more telling . . . statistic than DCF analysis.  The cheapness of something should hit you over the head and should be abundantly obvious.  If it’s not, move onto something else.  There are plenty of publicly traded companies.  Torturing the data to get the result you want is not a prudent path.

I prefer the Graham approach and focus on what’s actually known in the here and now without making so many assumptions about the future.  This is why the Grahamian balance sheet approach (because what’s more clear cut than the value of a balance sheet?) of net-net’s is a nearly foolproof method of investment.

For the goal of finding the present value of cash flows in analysis of stocks, I think a more useful metric is one that is more simple: price to free cash flow or enterprise value to free cash flow. If you can find a decent company like Apple trading at a price to free cash flow of 10 or less, then DCF analysis would likely yield a number close to the current price even with very conservative assumptions. It is probably then a good candidate worthy further research.

In the world of finance, there is a tendency to make things more complicated than they really are.  I like to keep things simple.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.  Full disclosure: my current holdings.

Seth Klarman Interview

This is a great interview between Charlie Rose and Seth Klarman.

Seth Klarman is a value investing legend.  What fascinates me about Seth Klarman is that he never moved beyond the “cigar butt” deep value style of investing, while many value investors eventually adopt the Buffett-Munger style of finding quality companies at attractive prices.  His out of print book, Margin of Safety, sells used on Amazon for $765.  Since the early 1980s, his fund (Baupost Group) has been able to achieve a 19% rate of return.  There are many great insights in this interview and it is well worth your time.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.  Full disclosure: my current holdings.

Your Politics and Your Portfolio Do Not Mix

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Your Political Opinions are Emotional

Political opinions are powerful forces. Usually, they are more influenced by emotions and passion than they are by facts. The enemy of good investing is human emotion. Human emotion fueled the internet bubble. Human emotion drove people to buy homes they couldn’t afford (it’s the American dream!). Human emotion took the Nasdaq to 5,000 in 2000 and took the stock market to a 15 year low in the spring on 2009. Most investors underperform because of their emotions.  They pile into stocks when they are overvalued and exit when they are at their most appealing level. Winning at investing isn’t about smarts, it’s about mastery of your emotions. If the market were made up of people like Spock, then Mr. Market wouldn’t be able to act so crazy. Fortunately the market is made up of people who are the opposite.

Making the Wrong Call

The emotional impact of politics is one of the key reasons it should be excluded from investment decisions. Case in point: I am sympathetic to a small government perspective. After the election of Barack Obama and a completely Democratic congress in 2008 during a financial crisis while the Federal Reserve was increasing the money supply like Weimar Germany, it was tempting for people of my orientation to think that the country was about to turn into a hyperinflationary socialist state. At this time it was more tempting than ever to shout “sell” from the rooftops.

Selling in late 2008 would have been a terrible mistake. It is a mistake made by many right wingers who loaded up on gold as they prepared for financial Armageddon. Since 2009, the S&P 500 is up 155%.  Gold is only up about 15%.  In 2009, the immediate year after the collapse, the S&P rose 28%.

Let’s examine another scenario. Let’s say you were someone of a more liberal orientation when Ronald Reagan was elected is in 1980. Many of the leading (liberal) economists of the time predicted that Reagan’s policies would be a complete failure.  They predicted that his fiscal policies would stoke instead of quell inflation. The Reagan years saw a 144% increase in the S&P 500.

The bottom line is that while you may try to convince yourself that your politics are hard grounded in facts and are as immutable as the laws of nature, you simply can’t use your political beliefs as a useful metric to predict future market returns. Your politics are grounded in emotion and for that reason they shouldn’t guide your investment thinking.

Does it Even Matter Who the President Is?

Nor do I think politics even matter that much to the economy. The popular news creates the impression that politics is the only thing that influences the economy, but the truth is that it doesn’t really matter all that much. American businesses are going to try to sell more products and be more productive no matter who is President.

My guess is that if Al Gore won the 2000 election, Alan Greenspan would have still cut interest rates in the wake of the internet bubble, homeowners would have still levered up, and the housing collapse was inevitable. Similarly, was Bill Clinton responsible for the surpluses and prosperity of the late 1990s, or was it simply a surge of computer-driven productivity gains that would have happened anyway?  The President and their party receive the credit for booms and the punishment for busts in the public’s mind, but their actual real world influence is limited.

Also, the United States political system is set up to resist radical change.  That may be frustrating when the President can’t implement their desired mix of policies, but it is a good thing for the health of the economy.  The Constitution is designed to derail radical change and it works most of the time.

Productivity

The Federal Reserve plays a more important role than the President in the direction of the economy. The Fed’s influence is still limited, though.  The Fed can only influence the short-term gyrations of the economy and the inflation rate. They can’t impact the long-run trend of the economy because the long-run trend is driven by productivity. Despite the attempts of policy makers to influence productivity, I doubt that public policy can have any impact at all on productivity rates.

Productivity seems to be driven more by the forces of capitalism and the abilities of managers than it is by policy.  I doubt that laws can make a country more productive any more than a law can change the weight on my bathroom scale.  Productivity is the true driver of economic performance and it appears to be out of the hands of policy makers.  That’s probably a good thing.

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Source: United States Department of Labor.  Productivity does not seem to care who the President is.

Right now we’re in a productivity slump and everyone is losing their minds over it. I think this productivity slump is much like the slump that occurred in the 1970s: it’s temporary. Much like the boom in productivity from 1995 to 2005 was also temporary. Productivity appears to be stubbornly mean reverting. It has a tendency to revert to its 2% long term trend and there is little we can do to change it.

There was a belief in the late 1990s that information technology had permanently increased the productivity rate.  That’s what the “New Economy” talk and hyper optimistic federal government budget projections were driven by.  It wasn’t permanent and productivity is reverting to the mean.  Similarly, the worry now is that the productivity slump is a sign of permanent stagnation in the US economy.  That’s probably just as wrong as the 1990s optimism was.  At some point in the next 10 years when productivity starts surging due to mean reversion, we’ll hear that we are in a new economic era of higher productivity driven by artificial intelligence, social media, cloud computing, 3-D printers, etc.  Then it will revert to the mean and everyone will start wondering if we are in a permanent slump again.

There is very little that politicians do to change desire of individuals and businesses to earn more money, which is really the driving force behind productivity.

Ignore It

The lesson of history seems to be that the safest long term bet is to leave your politics at home when making investment decisions.  There is a human tendency to believe that if there are people you disagree with in power, then the world must be headed to hell in a handbasket.  If there are people that you agree with in power, then there is a tendency to believe that manna will begin to come down from the heavens.  It’s your emotions talking and emotions are the enemy of capital gains.

Besides, your political beliefs should be deeply held as a result of moral conviction.  They shouldn’t be formulated based on the impact that a policy will have on the S&P 500.  They’re for the voting booth, not your portfolio.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.  Full disclosure: my current holdings.

I am a value investor. My outlook is inspired by the ideas of Benjamin Graham. This site is a real time chronicle of my portfolio and an outlet to share my ideas. I hope you enjoy.