What if it is 1982 all over again?

[giofranchi]

"I believe that the best way to manage money is to go long and short stocks. My theory is that if the 50 best stocks you can come up with don’t outperform the 50 worst stocks you can come up with, you should be in another business."

- Julian Robertson

 

And again, from the beginning:

 

"The wise investor will disregard the day-by-day fluctuations of the stock market or real estate market and base his buying and selling on these long periods of rise and fall. Above all, and I repeat it again and again—he must have liquid capital in time of depression to buy the bargains and then he must sell before the next crash. It is difficult if not impossible to do this but the conservative longtime investor who follows the general rule of buying stocks when they are selling far below their intrinsic value and nobody wants them, and of selling his stocks when people are bidding frantically for them at prices far above their intrinsic value—such an investor will pretty nearly hit the bull’seye."

- The Great Depression, A Diary

 

I am not talking about market timing. I am talking about margin of safety. When there is not enough margin of safety, I think the way to invest is the one Mr. Robertson suggests. Exactly what Mr. Watsa is doing right now. To go long aggressively in a secular bear market, without any protection, stocks must be “selling far below their intrinsic value and nobody wants them”, or a HUGE margin of safety baked into the market. Exactly what Mr. Watsa did at the beginning of 2009.

 

Regarding Europe, I would still be cautious: if Mr. Hendry is right, France is just a year away from nationalising its banks… and it won’t be pretty! On this regard, please check out what Charles Gave has to say (see attachment).

 

giofranchi

 

 

Daily+7.25.12.pdf

[petec]

txitxo, interesting post and intuitively right, imho.  But you write as though this is is a public, or at least numeric, indicator, rather than a subjective one.  Is it, or have I misread you?  Would be very interested to know how you calculate it and what companies of this sort you see out there now.

[tombgrt]

And I agree with twacowfca; BRK > FFH at this point in time

 

I do not agree.

 

1) Mr. Watsa is 20 years younger than Mr. Buffett: FFH > BRK,

2) Mr. Watsa has to work with much less capital than Mr. Buffett: FFH > BRK,

3) Mr. Watsa is fully hedged: don’t get me wrong, it is not that “value investing” doesn’t work, value investing is the only way of investing, but, in a secular bear market, when valuations are high, and there is a mountain of debt in the system ($70 trillion of G10 debt is the collateral for $700 trillion in derivatives… 1200% of global GDP… mind numbing!), it is “INVESTING” that does not work! FFH > BRK,

4) FFH relies on insurance much more than BRK: and I like insurance in a bear market, people always need protection, in good and in bad times, what saved the day at BRK in 2008 were the insurance operations: “Most of the Berkshire businesses whose results are significantly affected by the economy earned below their potential last year, and that will be true in 2009 as well. Our retailers were hit particularly hard, as were our operations tied to residential construction. In aggregate, however, our manufacturing, service and retail businesses earned substantial sums and most of them – particularly the larger ones – continue to strengthen their competitive positions. Moreover, we are fortunate that Berkshire’s two most important businesses – our insurance and utility groups – produce earnings that are not correlated to those of the general economy. Both businesses delivered outstanding results in 2008 and have excellent prospects.” Warren Buffett. And I like what Mr. Watsa said in the most recent Q2 2012 Earnings Call: “As I said in the first quarter call, we are growing again. The large catastrophe losses in 2011, very low interest rates and the reduced reserve redundancies means that there is no place to hide in the industry. Combined ratios have to drop well below 100% for the industry to make a single-digit return on equity with these low interest rates.” FFH > BRK,

5) FFH trades at 1,2 x book value, while FFH trades at 1,05 x book value: FFH > BRK,

6) BRK is less leveraged, and therefore less risky than BRK: BRK > FFH.

 

Where does this leave us? FFH 5, BRK 1.

 

Of course, you might object it is too simple a thesis. Quoting Sam Zell: “I philosophically believe

that if you can't delineate your idea in one or two sentences, it's not worth doing. I'm the Chairman of everything and the CEO of nothing, which means that the people who work for me come to see me with ideas all day long. My criterion is if they can't concisely explain their idea, then I throw them out of my office and tell them to come back when they can. Simplicity is critical.”

 

giofranchi

 

 

 

1) Don't care about that. In fact, today Buffett has only "limited" influence on the future BV growth that BRK will achieve. I can also sell my stake and put it in FFH at any time or the other way around. I don't have to be in one of the two for 20 years. (But I also don't pay taxes on return.)

2) Sure. But it's not like Prem is working with a 9-numbers figure either. He has billions to look after as well.

3) Can't really compare both in that way. FFH is more leveraged and needs the hedges in this environnement, it's not just a macro bet. And I'd say that BRK's mountain of cash is a nice hedge as well.

4) This is hard to quantify. I believe that BRK will do just fine in almost any market. Sure, they would suffer more in a recession or market downturn but would it really matter for intrinsic value in 10 years?

5) One is almost completely insurance, the other also has many operations like BNSF, Marmon, Lubrizol, Netjets, See's Candies, ... Hardly comparable based on BV!

 

Even without Buffett, BRK is worth much more than 1xBV. I'm not sure how much FFH would be worth without Watsa. I also know for a fact that BRK's future growth is far more certain than FFH's. FFH's growth is more sensitive to Prem's future successes and failures.

[giofranchi]

 

 

1) Don't care about that. In fact, today Buffett has only "limited" influence on the future BV growth that BRK will achieve. I can also sell my stake and put it in FFH at any time or the other way around. I don't have to be in one of the two for 20 years. (But I also don't pay taxes on return.)

2) Sure. But it's not like Prem is working with a 9-numbers figure either. He has billions to look after as well.

3) Can't really compare both in that way. FFH is more leveraged and needs the hedges in this environnement, it's not just a macro bet. And I'd say that BRK's mountain of cash is a nice hedge as well.

4) This is hard to quantify. I believe that BRK will do just fine in almost any market. Sure, they would suffer more in a recession or market downturn but would it really matter for intrinsic value in 10 years?

5) One is almost completely insurance, the other also has many operations like BNSF, Marmon, Lubrizol, Netjets, See's Candies, ... Hardly comparable based on BV!

 

Even without Buffett, BRK is worth much more than 1xBV. I'm not sure how much FFH would be worth without Watsa. I also know for a fact that BRK's future growth is far more certain than FFH's. FFH's growth is more sensitive to Prem's future successes and failures.

 

tombgrt,

Mr. Zell would have liked your answer very very much!! Simple, but true and clear ideas! Thank you very much.

 

1) I like BRK very much. Generally, though, I don’t like a business without an owner, who takes responsibility for all that really matters. First of all, obviously, allocation of capital. I really view the act of buying into a business like partnering with its owner. If Buffett’s responsibilities in BRK and his influence on BRK’s future will be less and less important, as far as I am concerned, that is a minus, not a plus.

5) Generally speaking, I like to compare any business, based on “Future book value”. That’s to say current book value + future earnings – future dividends. Only when this approach really doesn’t make sense, I use “owner’s earnings” yield (high-tech, bio-tech, etc.: obviously, I don’t invest in high-tech, bio-tech, etc.!).

Stealing from “Accounting for Value” by prof. Stephen Penman of Columbia Business School, I like to think of the value per share of a business as the sum of the following parts:

 

Value per share = Book value + Value from short-term accounting + Value from long term growth (or Value of speculative growth)

 

What could materially differ from BRK to FFH is the last part: Value from long term growth. Of course, with BRK at 1,2 x book value and with FFH at 1,05 x book value, the market is already assigning no value to the speculative growth of both companies. Certainly, you may judge BRK’s Value of speculative growth worthier than the one of FFH, because BRK also owns BNSF, Marmon, Lubrizol, Netjets, See’s Candies, etc., but I am not so sure. First, it is called Value of speculative growth, because any growth is just that: speculative. Second, I guess it is not easy at all to make a $200 billion company grow.

 

giofranchi

 

[ERICOPOLY]

these 22x Shiller PE10 ratio that's been casually tossed around.

 

Sure, the Schiller P/E ratio scare is all about earnings profit margins reverting to normal.  However, if BAC profit returns to normal then the stock goes sky high from here  :D  So look, mean reversion is basically the last thing I fear.

 

ERICOPOLY,

I wasn’t talking about BAC. I simply won’t invest in mega-cap financial companies that I do not understand. No matter what their shares’ price is. If you understand BAC, the way certainly Mr. Berkowitz does, you will make a lot of money, along with Berkowitz and others. Glad for you!

 

Instead, I was talking about market valuations.

 

Fair enough regarding the overall market valuations.

 

However, I replied with the BAC example because of your "greater values elsewhere" comment -- it sounded like you are surprised that others believe they are finding greater values elsewhere, so I wanted to illustrate for you an example in BAC.  During mid-2006 through early-mid 2009 I was 100% in FFH (most of the time) -- but today, I literally believe there are greater values elsewhere:

 

Nonetheless, I keep reading sentences like the following: “I sold my shares in FFH, because I found greater values elsewhere.” So I ask you: Why on earth won’t you be invested in Fairfax Financial in 2017?

 

[giofranchi]

Thank you ERICOPOLY, I really get your point!

You know, I think I have the 'forma mentis' of a business owner, which is slightly different from the one of a money manager: and I guess certain kind of investments will always be difficult for me (for instance, BAC or AIG today), even though I do believe they will turn out to be great winners… It is either a case of emotional stupidity, or a case of too narrow a circle of competence… most probably it is both!! :(

 

giofranchi

[txitxo]

txitxo, interesting post and intuitively right, imho.  But you write as though this is is a public, or at least numeric, indicator, rather than a subjective one.  Is it, or have I misread you?  Would be very interested to know how you calculate it and what companies of this sort you see out there now.

 

  It is a numeric indicator, but I'd rather not give the exact details. My research shows that once the fraction of expensive crap reaches 3% of your stock universe, the returns for a value investing strategy are ~-1% on average, with a large scatter. It is basically a coin toss. It is not worth being invested in that situation. The indicator is getting close to 6% now, that only happened before  in 1999 and 2007. In Europe the indicator is still below 3%.

 

I got my inspiration from James Montier's "Joining the Dark side: Pirates, Spies and short sellers", so people with access to a reasonably good stock screener could reproduce his screen.

[txitxo]

    Thanks for the Gave paper, Giofranchi. It is an interesting viewpoint, but certainly not a contrary one. People expect very bad news from Europe, and therefore European stocks are very cheap, way cheaper than American stocks. Can they go down 40% from this point? Certainly. But if they do, they will get to secular bear market valuations. On other other hand, US stocks need to go down by 40% just to be where European stocks are now. You'll need another 40% drop to make an undisputed bottom. That's why I only trust FFH in NA, I consider it as an inflation protected bond in a safe currency.

 

  Benjamin Roth's book is fascinating. But his investing advice is based on hindsight. You never know for sure what is going to happen, so you have to choose the strategy which maximizes your returns a priori. Being hedged for long periods of time is no such strategy, unless you use lots of margin. And that's what almost killed Ben Graham's partnership in 29-31. After that near-death experience he "invented" value investing, which, almost by definition, should be the best way of sailing through a Great Depression.

 

  From a cold, mathematical point of view, what we do is just place bets with the odds in our favour. Nobody knows for sure whether a company is going to go up or down. We just use the knowledge, based on experience, that if you buy companies which

 

a) are much cheaper than comparable ones (e.g. intrinsic value much lower than market price)

b) have stable long term behaviour (a.k.a. moat),

 

and

 

c) you average over a large enough number of stocks (diversification)

d) and over a large enough stretch of time (long term)

 

you'll beat the index.

 

In fact if a) is cheap enough (cigar-butts) you don't need b).  It worked during Ben Graham's time and keeps working now because of how human beings are wired.

 

[twacowfca]

txitxo, interesting post and intuitively right, imho.  But you write as though this is is a public, or at least numeric, indicator, rather than a subjective one.  Is it, or have I misread you?  Would be very interested to know how you calculate it and what companies of this sort you see out there now.

 

  It is a numeric indicator, but I'd rather not give the exact details. My research shows that once the fraction of expensive crap reaches 3% of your stock universe, the returns for a value investing strategy are ~-1% on average, with a large scatter. It is basically a coin toss. It is not worth being invested in that situation. The indicator is getting close to 6% now, that only happened before  in 1999 and 2007. In Europe the indicator is still below 3%.

 

I got my inspiration from James Montier's "Joining the Dark side: Pirates, Spies and short sellers", so people with access to a reasonably good stock screener could reproduce his screen.

 

Good insights txitxo.

 

How does the expensive crap indicator now compare to 1999 (the mother of all bubbles)?

[giofranchi]

    Being hedged for long periods of time is no such strategy, unless you use lots of margin.

 

txitxo,

I am an engineer. I have always been very comfortable with mathematics. I don’t want to brag, but it’s a language a speak fluently. Some years ago I started doing something similar to what you are doing, with a nuclear engineer friend of mine. He is even more comfortable with mathematics than I am… actually I know few people who are as comfortable with mathematics as he is! And he is successful in the stock market, just like you probably are. After a while, though, I realized that what I really take pleasure in doing is to run a business, and to study how other businesses works, and to acquire the ones I like the most, little by little. If I could buy entire businesses, that’s what I would be doing 7 days a week, 24 hours a day… and I would gladly forget about the stock market! Unfortunately, I still don’t have enough capital to implement that strategy successfully. So, I am compelled to buy businesses in the stock market. And that’s exactly what they are: BUSINESSES IN THE STOCK MARKET. To believe that they are completely free from the stock market gyrations, as if they were private businesses, to me sounds just naïve and, most importantly, simply not true! So, when I buy businesses in the stock market during a secular bear market, I seek two margins of safety: the first one embedded in the price of the business itself, the second one embedded in the price of the whole stock market. Obviously, in a secular bull market the second margin of safety would be much less important! Probably, I would disregard it altogether!

According to what I believe is the actual margin of safety embedded in the market, I may decide to be 100% hedged, 70%, 50%, 30% hedged, or not be hedged at all. Right now I am 100% hedged, and I am just fine with it.

 

Please, follow me for a second. Take, for instance, Leucadia National: yesterday it closed at $21,68, while at March 31, 2012 its book value was $25,8. It’s trading at 0,84 x book value. Now take the June 30, 2012 GMO 7-Year Asset Class Return Forecasts: US small – 0,5%. You know how accurate the GMO 7-year Asset Class Return Forecasts track record is. As you told me, in a year or two anything could happen, but, if you consider 7 years, the market becomes a “weighing machine”. That leaves us on one hand with a company, which returned a 19,8% CAGR from 1979 to 2011, trading below book value, and on the other hand with a basket of US small-cap stock (Russell2000), which are priced to deliver a negative annual return for the next 7 years. Now, I know that Mr. Cumming is retiring in 2015, but Mr. Steinberg is 68 and, you know what? If he decides to retire at 75, like Mr. Cumming is going to do, it will be exactly 7 years from now!

At 0,84 x book value, Leucadia is priced to perform at least as good as in the past: 20% CAGR. But, let’s assume a 15% CAGR. We have already seen that the Russell2000 is priced to deliver a negative CAGR during the next 7 years. But, let’s assume a positive 5% CAGR.

If I invest now $10.000 in LUK and $10.000 in RWM, 7 years from now I will be left with $33.600 ($26.600 in LUK and $7.000 in RWM). That translates into a 7,65% CAGR on my original investment of $20.000. While the market, the Russell2000, delivered a 5% CAGR. I have beaten the market with very low risk.

Obviously, it gets even better if LUK performs in line with the past, and the Russell2000 performs in line with GMO forecasts: if that is the case, I would be delivering a 12,7% CAGR on my original investment of $20.000, running a very low risk!

And without any leverage!

 

It gets better and better, if you can invest in FFH, which employs this strategy, adding the benefit of float, “insurance leverage”, or the safest kind of leverage!

 

So, I agree with you that, if you want to achieve a 20% CAGR for the next 20 years, this strategy is not the one to follow. But, once again, if you really will achieve a 20% CAGR for the next 20 years… then you are in another league, and there is nothing of value I can say to you!

 

giofranchi

 

[giofranchi]

It should be added that, obviously, things in the stock market are much more chaotic and volatility is much greater! A market that decreases in value 0,5% each year for 7 years in a row is never heard of! And, if you are hedged, you can take advantage of any opportunity that may come your way during a market plunge. After the market has plunged, your hedges will be worth more, and you could double down in Leucadia. Furthermore, after the market has plunged, the margin of safety embedded in the price of the whole market will be much greater. So, instead of keeping a 100% hedged portfolio, you may decide to be only 50% or 30% hedged, depending on the severity of the market plunge.

 

giofranchi

 

[giofranchi]

ERICOPOLY,

I was wondering: any idea why Mr. Watsa is not investing in BAC or in AIG right now? I know they are outside my circle of competence and I stay away. But I agree with you that BAC is extremely cheap right now, and I wouldn’t mind being invested in BAC through FFH. Like I don’t mind being invested in JEF through LUK, even though I would never invest in JEF by myself. Like I don’t mind being invested in YHOO through Third Point Offshore, even though I would never invest in YHOO by myself.

Thank you very much!

 

giofranchi

 

[tombgrt]

Well Giofranchi, many owner-operator companies like LUK are reasonably to very cheap today. I recommend the annual letter of FRMO, released two days ago:

http://www.frmocorp.com/_content/letters/2012.pdf (Thanks to oddballstocks for mentioning it on Twitter).

 

While I think you are too aggressive with 20% CAGR for the next 7 years for LUK, you are forgetting that it is very very likely that LUK will trade much higher than 0,87xBV somewhere in that time period. Thus, this will boost eventual returns in a major way. If for example LUK trades at 1,4xBV somewhere between year 5 and 7, and compounds at only 12%, your return will already be +- as high as with a 20% CAGR and no price appreciation against BV.

I also believe this will be the case for other owner-operator companies. At some point investors will recognize their superiority once more and pay a premium, not a discount.

 

In this regard I also don't believe hedging is needed as those owner-operators will take advantage of major market corrections while you sit on your ass! Future CAGR will be higher because of short-term declines in valuation, not lower! :)

[giofranchi]

tombgrt,

thank you very much! I always read anything Murry Stahl writes with extreme interest and attention! He is just great!

 

Regarding LUK, I meant 20% CAGR in market price per share, not in book value. And my assumption was based on the fact that right now it is trading below book value, while usually it has traded far above book value!

 

Finally, I like the hedges right now, because in a deflationary scare, both LUK and BAM, which I currently own, will suffer. Mr. Watsa is worried about deflation… so am I! David Rosenberg, Gary Shilling, Lacy Hunt are worried about deflation… so am I! And, if that happens, I want to have the buying power to double down aggressively both in LUK and in BAM. Vice versa, if that never happens, I am comfortable accepting a lower return on my firm’s capital for a while.

 

giofranchi

 

[tombgrt]

Makes sense Giofranchi. You obviously have other people's capital to look after as well. All I need to do is take care of my capital and expectations. Big difference. :)

[txitxo]

 

Good insights txitxo.

 

How does the expensive crap indicator now compare to 1999 (the mother of all bubbles)?

 

The indicator was much higher in 2007 than in 1999, which was actually a relatively good time to be in the market for value stocks. The bubble did not affect all sectors. Now the US is getting pretty ugly, almost at the same level as early 2007. Canada is actually the most dangerous market I see, specially companies involved in energy and natural resources. There is a huge amount of optimism there. In Europe it's OK, still within the safe zone. In Japan is ridiculously low.

[giofranchi]

tombgrt,

Horizon Kinetics has just released its Q2 Commentary. Probably, you have already read it, but I attach it anyway. On page 10 they write: “The largest holding in many of our strategies, and that which probably attaches to the greatest number of predictive attributes, is Liberty Media Corporation.”

Do you own LMCA? I have nothing but the utmost respect for Mr. Malone, but I haven’t invested alongside him yet… He is 71, probably won’t go on compounding for the next 20 years, but, let’ say, 10 years, at the rate he is used to compounding capital, are perfectly fine with me!!

If you own LMCA, how do you value the company? You think it is undervalued right now?

Thank you very much!

Q2_2012_Horizon_Kinetics_Commentary.pdf

[ERICOPOLY]

ERICOPOLY,

I was wondering: any idea why Mr. Watsa is not investing in BAC or in AIG right now?

 

They purchased large positions in US banks in 2008/2009.  They chose WFC and USB.  I think they paid about $20 for WFC.  Then in 2011 WFC went as low as $22 and they didn't purchase more, so I reason they are not interested in adding more to that sector yet (US banks).  They added Bank of Ireland last year.

 

Mr. Watsa gave a speech a couple of years ago where he described valued investing as purchasing shares when companies run into a "temporary" problem.  Then the reiterated the word "temporary".  Okay, now I can see where BAC's problem is "temporary" (legacy loans + interest rates), I can see where AIG's problem is temporary (interest rates), but I can't see where RIM's problem is necessarily "temporary" (need to keep inventing in a very competitive space to survive).

 

 

[shalab]

Giofranchi - Italy has ton of owner(family) operated businesses but it seems to be an issue for the economy? Can you shed some light why that is the case.

[mhdousa]

ERICOPOLY,

I was wondering: any idea why Mr. Watsa is not investing in BAC or in AIG right now?

 

They purchased large positions in US banks in 2008/2009.  They chose WFC and USB.  I think they paid about $20 for WFC.  Then in 2011 WFC went as low as $22 and they didn't purchase more, so I reason they are not interested in adding more to that sector yet (US banks).  They added Bank of Ireland last year.

 

Mr. Watsa gave a speech a couple of years ago where he described valued investing as purchasing shares when companies run into a "temporary" problem.  Then the reiterated the word "temporary".  Okay, now I can see where BAC's problem is "temporary" (legacy loans + interest rates), I can see where AIG's problem is temporary (interest rates), but I can't see where RIM's problem is necessarily "temporary" (need to keep inventing in a very competitive space to survive).

 

Eric, are you still close to 100% BAC, or have you branched out at all?

 

[giofranchi]

Giofranchi - Italy has ton of owner(family) operated businesses but it seems to be an issue for the economy? Can you shed some light why that is the case.

 

Shalab,

I wish I knew!! No, really: the Italian economy remains a mystery to me!!

But, I think I see two main problems:

 

1) A COMPLETE LACK OF TRANSPARENCY: regarding Biglari’s compensation plan, and how he changed the rules, I was told “you don’t know what you are getting”… well, please don’t misunderstand me, but it made me smile… Come to Italy, then you will really understand the true meaning of unaccountability! North America is by far the place where you can find the greatest amount of reliable information. In that regard, Italy is still way way way behind… And how could you do business or invest without reliable information?

 

2) TOO BIG A GOVERNMENT: not just “big”, but also, which is even worse, “intruding”. Everyone looks for favors from politicians, because politicians are extremely powerful, even in business. I guess that is true worldwide, but we know how to take it to the extreme! I think in Italy we are still a socialist society at heart… and that is always very bad for business!

 

Ah! As an aside, the Euro clearly is not helping either: if I remember well, the one we are currently living trough is the fifth recession, since the Euro was introduced… Hey! 1 recession every 2,5 years… something is just not working!

 

Unfortunately, I can’t elaborate further… I have got too little, reliable information!!  ;D

 

giofranchi

 

[ERICOPOLY]

ERICOPOLY,

I was wondering: any idea why Mr. Watsa is not investing in BAC or in AIG right now?

 

They purchased large positions in US banks in 2008/2009.  They chose WFC and USB.  I think they paid about $20 for WFC.  Then in 2011 WFC went as low as $22 and they didn't purchase more, so I reason they are not interested in adding more to that sector yet (US banks).  They added Bank of Ireland last year.

 

Mr. Watsa gave a speech a couple of years ago where he described valued investing as purchasing shares when companies run into a "temporary" problem.  Then the reiterated the word "temporary".  Okay, now I can see where BAC's problem is "temporary" (legacy loans + interest rates), I can see where AIG's problem is temporary (interest rates), but I can't see where RIM's problem is necessarily "temporary" (need to keep inventing in a very competitive space to survive).

 

Eric, are you still close to 100% BAC, or have you branched out at all?

 

60% now.

[berkshiremystery]

ERICOPOLY,

I was wondering: any idea why Mr. Watsa is not investing in BAC or in AIG right now? I know they are outside my circle of competence and I stay away. But I agree with you that BAC is extremely cheap right now, and I wouldn’t mind being invested in BAC through FFH. Like I don’t mind being invested in JEF through LUK, even though I would never invest in JEF by myself. Like I don’t mind being invested in YHOO through Third Point Offshore, even though I would never invest in YHOO by myself.

Thank you very much!

 

giofranchi

 

 

Well,... remember... Mr. Watsa/FFH is indirectly invested in BAC,... through his stake in the Chou funds, but it's probably not worth to mention here because the percentage would be very tiny.

 

By the way,... I asked Mohnish personally in Toronto about his opinion about AIG,... whether he likes the company or set a value on them. He just said, that he hasn't an opinion, and AIG is not in the circle of competence. -- Anyway,... we might be able to peek into his next 13f very soon.

[txitxo]

 

txitxo,

I am an engineer. I have always been very comfortable with mathematics. I don’t want to brag, but it’s a language a speak fluently. Some years ago I started doing something similar to what you are doing, with a nuclear engineer friend of mine. He is even more comfortable with mathematics than I am… actually I know few people who are as comfortable with mathematics as he is! And he is successful in the stock market, just like you probably are. After a while, though, I realized that what I really take pleasure in doing is to run a business, and to study how other businesses works, and to acquire the ones I like the most, little by little. If I could buy entire businesses, that’s what I would be doing 7 days a week, 24 hours a day… and I would gladly forget about the stock market! Unfortunately, I still don’t have enough capital to implement that strategy successfully. So, I am compelled to buy businesses in the stock market. And that’s exactly what they are: BUSINESSES IN THE STOCK MARKET. To believe that they are completely free from the stock market gyrations, as if they were private businesses, to me sounds just naïve and, most importantly, simply not true! So, when I buy businesses in the stock market during a secular bear market, I seek two margins of safety: the first one embedded in the price of the business itself, the second one embedded in the price of the whole stock market. Obviously, in a secular bull market the second margin of safety would be much less important! Probably, I would disregard it altogether!

According to what I believe is the actual margin of safety embedded in the market, I may decide to be 100% hedged, 70%, 50%, 30% hedged, or not be hedged at all. Right now I am 100% hedged, and I am just fine with it.

 

Please, follow me for a second. Take, for instance, Leucadia National: yesterday it closed at $21,68, while at March 31, 2012 its book value was $25,8. It’s trading at 0,84 x book value. Now take the June 30, 2012 GMO 7-Year Asset Class Return Forecasts: US small – 0,5%. You know how accurate the GMO 7-year Asset Class Return Forecasts track record is. As you told me, in a year or two anything could happen, but, if you consider 7 years, the market becomes a “weighing machine”. That leaves us on one hand with a company, which returned a 19,8% CAGR from 1979 to 2011, trading below book value, and on the other hand with a basket of US small-cap stock (Russell2000), which are priced to deliver a negative annual return for the next 7 years. Now, I know that Mr. Cumming is retiring in 2015, but Mr. Steinberg is 68 and, you know what? If he decides to retire at 75, like Mr. Cumming is going to do, it will be exactly 7 years from now!

At 0,84 x book value, Leucadia is priced to perform at least as good as in the past: 20% CAGR. But, let’s assume a 15% CAGR. We have already seen that the Russell2000 is priced to deliver a negative CAGR during the next 7 years. But, let’s assume a positive 5% CAGR.

If I invest now $10.000 in LUK and $10.000 in RWM, 7 years from now I will be left with $33.600 ($26.600 in LUK and $7.000 in RWM). That translates into a 7,65% CAGR on my original investment of $20.000. While the market, the Russell2000, delivered a 5% CAGR. I have beaten the market with very low risk.

Obviously, it gets even better if LUK performs in line with the past, and the Russell2000 performs in line with GMO forecasts: if that is the case, I would be delivering a 12,7% CAGR on my original investment of $20.000, running a very low risk!

And without any leverage!

 

It gets better and better, if you can invest in FFH, which employs this strategy, adding the benefit of float, “insurance leverage”, or the safest kind of leverage!

 

So, I agree with you that, if you want to achieve a 20% CAGR for the next 20 years, this strategy is not the one to follow. But, once again, if you really will achieve a 20% CAGR for the next 20 years… then you are in another league, and there is nothing of value I can say to you!

 

giofranchi

 

  Let's just say that because of my professional experience, I could write a little book about the perils of overfitting and data mining. That's why I combine value investing with statistics. If you don't have a guiding framework you will find all kind of fake correlations in the data. That's probably what caused the quant implosion in 2008-2009.

 

  I've done many backtests, as realistic as possible, with different investing strategies, and I find myself time and again just reproducing Warren Buffet and Ben Graham insights in mathematical form. For instance, if you invest in small caps, almost any strategy similar to Ben Graham screens (cheap + financially sound companies) works beautifully. And that's basically how Graham, the early Buffett and Walter Schloss invested. You just go to the region of the stock space where it is easier to find unwarranted pessimism, sit there for a while and make out like a bandit. 

 

  However, the simulations also show that once you have a large pot of money to invest, it is very difficult to outperform just based on ratios. Every company is scrutinized to death by the market, and investing becomes an art, with very few high level practitioners. That's where you have to start worrying about moats, quality, etc. It is amazing to see how Buffett chose at every moment the optimal investing strategy for the amount of money he was managing.

 

  The simulations show that when you can invest in small caps, hedging and going to cash significantly damage the long term performance. You reduce the volatility, but also the returns.  Warren Buffett of course knew that in his 20's, without having to do any simulations, and he was always fully invested at the beginning of his partnership period, even when he was managing OPM. I also try to be fully invested at all times, but in the markets which offer me the best odds. Europe is much better than the US or Canada at this time.

 

In any case, I understand you,  Giofranchi. If your passion lies in analyzing business, go for it. After all, I spend most of my time trying to figure out what the heck Dark Energy is, a fascinating but not very profitable endeavor.

 

And by the way, I too gave a hard look to LUK the other day. Extremely tempting,  but I bought FFH instead. My models say that it is very likely that there will be better times to buy LUK during the next year.

 

[tombgrt]

tombgrt,

Horizon Kinetics has just released its Q2 Commentary. Probably, you have already read it, but I attach it anyway. On page 10 they write: “The largest holding in many of our strategies, and that which probably attaches to the greatest number of predictive attributes, is Liberty Media Corporation.”

Do you own LMCA? I have nothing but the utmost respect for Mr. Malone, but I haven’t invested alongside him yet… He is 71, probably won’t go on compounding for the next 20 years, but, let’ say, 10 years, at the rate he is used to compounding capital, are perfectly fine with me!!

If you own LMCA, how do you value the company? You think it is undervalued right now?

Thank you very much!

 

 

No, I don't own LMCA. Was going to read the letter later this week, always a great read! There are so many things investing-related that are worth reading that it tends to pile up at times.

 

I should mention that you won't get much value from me. I just started investing in late 2010 (I'm really nowhere yet) and am actually still a student. Hope to graduate in a month tho. ;) The hunt for the bargain and thirst for knowledge make my clock tick!