What if it is 1982 all over again?

[giofranchi]

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.

 

Well txitxo,

I won’t speak about the Dark Energy endeavour… but I hope that studying and acquiring businesses will prove to be, at least, a little bit profitable!!  :)

 

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. 

 

Take a look at the attachment: it is from the FFH's 2011AGM, and it shows the Hamblin Watsa Investment Performance in common stocks, with and without equity hedging. On a 5, 10, 15 years basis, the performance with equity hedging is significantly superior to the one without equity hedging. Even on a 15 years basis, the strategy with equity hedging returned 2,4% per year more than the strategy without hedging, which is big! On a 5 years basis, the strategy without hedging got literally killed! 

You may object that FFH can’t invest only in small caps. And you would be right: they are compelled to invest in medium and large cap stocks. So, is it possible that, if you invest in small caps and hedge, your performance will suffer, while, if you invest in medium and large caps and hedge, your performance will be much better? Is that what your model suggests? If so, why are you investing in FFH without hedging? I wouldn’t define FFH a small cap!

 

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.

 

That's exactly why I am hedging!!

 

giofranchi

 

2011AGM_Hamblin_Watsa_Investment_Performance.pdf

[giofranchi]

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.

 

berkshiremystery,

you make me breathe a sigh of relief: if Mohnish says AIG is out of his circle of competence, I cannot really be blamed to give up on AIG. Even if I will miss a big winner!

 

giofranchi

[txitxo]

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.

 

Well txitxo,

I won’t speak about the Dark Energy endeavour… but I hope that studying and acquiring businesses will prove to be, at least, a little bit profitable!!  :)

 

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. 

 

Take a look at the attachment: it is from the FFH's 2011AGM, and it shows the Hamblin Watsa Investment Performance in common stocks, with and without equity hedging. On a 5, 10, 15 years basis, the performance with equity hedging is significantly superior to the one without equity hedging. Even on a 15 years basis, the strategy with equity hedging returned 2,4% per year more than the strategy without hedging, which is big! On a 5 years basis, the strategy without hedging got literally killed! 

You may object that FFH can’t invest only in small caps. And you would be right: they are compelled to invest in medium and large cap stocks. So, is it possible that, if you invest in small caps and hedge, your performance will suffer, while, if you invest in medium and large caps and hedge, your performance will be much better? Is that what your model suggests? If so, why are you investing in FFH without hedging? I wouldn’t define FFH a small cap!

 

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.

 

That's exactly why I am hedging!!

 

giofranchi

 

  You, of all people, will understand very well why I invest in FFH. This is not a normal stock investment. Imagine that the eurozone breaks up and the new peseta or lira depreciate by 50%. Your foreign stock holdings would appreciate by 100%. Those are taxable capital gains. And imagine the new government sets the new tax rate, for "speculators", at  50%. If you sell a stock, you would lose 25% of your capital even if its price in dollars (or euros) didn't change. After a few years I am sure that the capital gains tax rate will go down, but in the aftermath of an euro exit anything can happen. So if you have to put a fraction of your money in a stock which you will not be able to sell in 10 years, even if the euro breaks up and the world markets sink like the Titanic, which one would you choose? LUK or FFH? I hope that the eurozone survives and, in the future, I'll be able to redeploy the money in FFH to more productive investments. But these are exceptional times and one should chop off as many nasty tails as possible. 

 

Thanks for the FFH attachment. This sort of qualitatively agrees with my simulations.  When you don't have much money to invest, you can always live in "P/E~7 land" and buy a basket of stocks which have valuations similar to those of a market bottom. That gives you considerably downward protection (although sometimes they can go to P/E~4).  So in principle you don't have to worry much about what the general market is doing. You stay fully invested, buy some omeprazole at market crashes, and see your money grow. Only rarely you cannot find ANY company to invest in, and have to go to cash. That's pretty much what Walter Schloss did.

 

But if you manage billions, like Watsa, the market for the large caps is much more efficient, and such valuations only exist at panics.  Investors at that altitude have to buy what they can, and go to cash when they don't find anything or hedge when the valuations are so-so. Managing when to buy, when to go to cash, and when to hedge is a high form of art.  In any case, if you look at the returns in the FFH table, you see that the first 10 years, the returns for the unhedged stocks was slightly higher than for the hedged ones. And that's for Watsa, who is the world champion of hedging. I bet almost any other investor would see a serious underperformance unless they used margin to pump up their alpha, exposing themselves to a major blow up.

 

My impression is that almost anybody managing up to few million could theoretically reproduce or at least get close to what Walter Schloss or the early Buffett did  (the main limiting factors are character and discipline). Just choose 4 or 5 screens, e.g. Graham's enterprising investor formula, Graham net-nets, Graham Defensive Investor and Piotroski. Or design your own value screens using realistic backtesting. Avoid too thinly traded issues (or slippage will kill you) and aim for a portfolio of at least 55 stocks. Move among the major world markets to make sure you always have enough stocks to buy (this is crucial). Do not try to rebalance monthly or commissions will eat you up. Just sell and buy 1 stock every week, that'll ensure you keep them a bit longer than 1 year to avoid short terms capital gain taxes. If you do that consistently, I don't know whether you'll get 20% a year, but I guarantee that you'll put  most mutual fund managers to shame.

 

But doing what Watsa, Berkowitz or the late Buffett do? No way of putting that into a mathematical formula. That's like painting the Sixtine Chapel or composing Mahler's Resurrection Symphony.

 

[giofranchi]

In any case, if you look at the returns in the FFH table, you see that the first 10 years, the returns for the unhedged stocks was slightly higher than for the hedged ones.

 

txitxo,

maybe I misunderstood you, but on a 10 years basis the table shows a much better performance with equity hedges than without equity hedges...

 

My impression is that almost anybody managing up to few million could theoretically reproduce or at least get close to what Walter Schloss or the early Buffett did  (the main limiting factors are character and discipline). Just choose 4 or 5 screens, e.g. Graham's enterprising investor formula, Graham net-nets, Graham Defensive Investor and Piotroski. Or design your own value screens using realistic backtesting. Avoid too thinly traded issues (or slippage will kill you) and aim for a portfolio of at least 55 stocks. Move among the major world markets to make sure you always have enough stocks to buy (this is crucial). Do not try to rebalance monthly or commissions will eat you up. Just sell and buy 1 stock every week, that'll ensure you keep them a bit longer than 1 year to avoid short terms capital gain taxes. If you do that consistently, I don't know whether you'll get 20% a year, but I guarantee that you'll put  most mutual fund managers to shame.

 

Well, of course I tried to do that... and it never really worked! But I guess it never worked JUST FOR ME.  I don’t see any kind of edge in such a strategy, and I do not really like to put money in something I don’t understand, just because a screen says it is cheap. So, maybe, I didn’t try hard enough!!!

Anyway, as far as I am concerned, that’s not investing. That’s trading with a value-based system. And I know some successful traders, but none who employs only value screens. Yet again, that might be because they manage too much money…

 

Talking about Mr. Buffett, I have read all The Buffett Partnership Letters… twice. Describing a workout (Sanborn Map), already in 1960 he wrote: “Last year mention was made of an investment which accounted for a very high and unusual proportion (35%) of our net assets…”. That doesn’t look like a diversified portfolio! At the end of 1961 his net assets under management were $3.210.568,59, and he was already talking about “control” situations: “Sometimes, of course, we buy into a general with the thought in mind that it might develop into a control situation. If the price remains low for a long period, this might very well happen… We are presently acquiring stock in what may turn out to be control situations several years hence.” And in the January 18, 1963 letter he described the investment in Dempster Mill Manufacturing Company: and, as far as I am concerned, that’s investing! In 1963 he managed $9,4 millions, about $70 millions in inflation-adjusted dollars. I have never read anything about screens, but, if he happened to use them, he probably did so for just few years: in 1963 his capital under management was already too much!

 

If I may ask, I am genuinely curious: what kind of returns did you achieve in the last five years, employing your screens?

 

giofranchi

 

[premfan]

Great thread. Keep it going!

[txitxo]

In any case, if you look at the returns in the FFH table, you see that the first 10 years, the returns for the unhedged stocks was slightly higher than for the hedged ones.

 

txitxo,

maybe I misunderstood you, but on a 10 years basis the table shows a much better performance with equity hedges than without equity hedges...

 

Well, from the table, the total return for the *first* 10 years, as I said in my message, that is, between December 31 1995 and December 31 2005  was 1.172**15/1.142**5= 5.57 times the initial investment for the hedged strategy, whereas for the unhedged one it was 1.148**15/1.069**5=5.68 times. Even for Watsa, and going through the 2000 crash, hedging may take a while to pay off.

 

My impression is that almost anybody managing up to few million could theoretically reproduce or at least get close to what Walter Schloss or the early Buffett did  (the main limiting factors are character and discipline). Just choose 4 or 5 screens, e.g. Graham's enterprising investor formula, Graham net-nets, Graham Defensive Investor and Piotroski. Or design your own value screens using realistic backtesting. Avoid too thinly traded issues (or slippage will kill you) and aim for a portfolio of at least 55 stocks. Move among the major world markets to make sure you always have enough stocks to buy (this is crucial). Do not try to rebalance monthly or commissions will eat you up. Just sell and buy 1 stock every week, that'll ensure you keep them a bit longer than 1 year to avoid short terms capital gain taxes. If you do that consistently, I don't know whether you'll get 20% a year, but I guarantee that you'll put  most mutual fund managers to shame.

 

Well, of course I tried to do that... and it never really worked! But I guess it never worked JUST FOR ME.

 

It usually does not work for most people. Have a look at the mechanical investing forums. Typical causes are too frequent trading, choosing screens which are backtesting flukes or not diversifying enough. But the worst one is handpicking stocks from the screen.  Screens work statistically. Some of the companies look like utter crap which no self-respecting value investors would touch with a 10-feet pole. Imagine explaining why you bought that to your clients, specially if the company later goes belly up. However, often enough it turns out that utter crap is just crap, and instead of selling for P/B=0.25, it goes to P/B=0.5 and you make 100% on it. The really cheap stocks are the ones that not even value investors will buy.

 

I don’t see any kind of edge in such a strategy, and I do not really like to put money in something I don’t understand, just because a screen says it is cheap. So, maybe, I didn’t try hard enough!!!

Anyway, as far as I am concerned, that’s not investing. That’s trading with a value-based system. And I know some successful traders, but none who employs only value screens. Yet again, that might be because they manage too much money…

 

Well, your comments illustrate where my edge is. I am not interested in winning the value investor purity award. But I think I understand how  value investing works, from a mathematical point of view. And although this may sound like sacrilege to many people in this board, my impression is that most of the stuff about intrinsic value, Mr. Market, margin of safety, etc. is just nice folklore. You ask 2 competent investors to estimate the value of company and you'll get 4 different opinions. It is not just a question of appraisal error. Valuations can differ by a huge amount. Sometimes very competent people short a company while others are buying it. Do you know any value investor which hits 100% of its pitches, no matter how large the margin of safety he uses? And has anybody figured out which economical or mathematical law ensures that prices converge towards a quantity that nobody agrees about? No, of course. But the facts are clear: value investing works. Why?

 

  I think that what Graham and others found is that there are a few little corners in the stock parameter space where markets tend to temporarily misprice companies. Probably due to a combination of herding and some faulty wiring in our system 1 (I loved Kahneman's book). If you buy stocks in that area the statistical mispricing will correct itself eventually (because markets are efficient in the long run, that's Graham "weighting machine") and you'll beat the indexes. So you can read the balance sheet, talk to the CEO, visit the premises, and taste their products.  But in the end, even if you don't know about it, the crucial part which will determine your results is where in the stock parameter space you are sampling from.

 

And there *are* people out there using value screens. I remember reading that Jim Grant and Renaissance Technologies were buying Net-nets. There are many fundamental funds which are quantitative-based. But like I said before, the more money you manage, the most difficult it is to outperform using this approach because large caps are much more efficiently priced. 

 

 

Talking about Mr. Buffett, I have read all The Buffett Partnership Letters… twice. Describing a workout (Sanborn Map), already in 1960 he wrote: “Last year mention was made of an investment which accounted for a very high and unusual proportion (35%) of our net assets…”. That doesn’t look like a diversified portfolio! At the end of 1961 his net assets under management were $3.210.568,59, and he was already talking about “control” situations: “Sometimes, of course, we buy into a general with the thought in mind that it might develop into a control situation. If the price remains low for a long period, this might very well happen… We are presently acquiring stock in what may turn out to be control situations several years hence.” And in the January 18, 1963 letter he described the investment in Dempster Mill Manufacturing Company: and, as far as I am concerned, that’s investing! In 1963 he managed $9,4 millions, about $70 millions in inflation-adjusted dollars. I have never read anything about screens, but, if he happened to use them, he probably did so for just few years: in 1963 his capital under management was already too much!

 

Well, congratulations on reading Buffet letters twice! That makes you a true value investor. I obviously am not implying that Buffett, Schloss and Graham were running  screens on their iPads and buying 50-stock portfolios (although that is not so far away from what Schloss did in practice, if we substitute Value Line issues for the iPad). What links those three investors is the "good price, fair company" approach. You can approximate that with a system like the one I described. Later, Buffett changed to "good company, fair price". That's a totally different game.

 

If I may ask, I am genuinely curious: what kind of returns did you achieve in the last five years, employing your screens?

 

giofranchi

 

  You must be really curious, to request quotes of unverified performance in an anonymous forum. Anyway: about 10% above the August 1st 2007 level, most of the money and most of the time in European Small caps. Some friends recommended me in 2011 that I set a public record of my performance, so in a few years we may be able to truly settle this discussion. And what about you, Giofranchi? How well have you done with your hedges? They certainly would have been a nice thing to have in August 2007.

[ERICOPOLY]

But the facts are clear: value investing works. Why?

 

Because it is nothing at all more than... buy low / sell high.

 

Implicitly you must be doing a valuation appraisal to understand "high" vs "low", therefore... value investing.  So the father of value investing stumbled upon something that had been known for a very long time...

[ExpectedValue]

But the facts are clear: value investing works. Why?

 

Investing is just like writing insurance.

 

When you buy a value stock, you're really just writing an insurance policy against a business from going bust. The market usually overestimates the likelihood of this occurring and has historically paid a pretty good premium to insurers for this.

 

But that's not the only risk in the market you can write insurance against. You could easily write insurance on companies being able to continuously grow their earnings. A lot of guys have tried that and unfortunately, the frequency of catastrophes (growth slowdowns/earnings disappointments) and the premiums available weren't enough to compensate you for that risk. That doesn't have to be true all the time though. There are going to be times when those premiums fluctuate and shift.

 

http://www.highway6.com/grabs/Screen%20Shot%202012-08-02%20at%209.10.40%20PM.png

 

The blue line is Russell 1000 Value (IWD), the red line is Russell 1000 Growth (IWF). Over that period, value has underperformed, especially coming out of the financial crisis.

 

^ Now this is just for a broad, representation of value based upon quantitative factors. So you might be a good stock picker and do better than that.

 

[twacowfca]

But the facts are clear: value investing works. Why?

 

Because it is nothing at all more than... buy low / sell high.

 

Implicitly you must be doing a valuation appraisal to understand "high" vs "low", therefore... value investing.  So the father of value investing stumbled upon something that had been known for a very long time...

 

 

"Make no investments without a full acquaintance with their nature and condition, and select such investments as have intrinsic value."

 

-- Benjamin ________.  Test: fill in the blank without conducting a search.  :)

[racemize]

Franklin?

[twacowfca]

Franklin?

 

    Yes.  :)

 

[ERICOPOLY]

Franklin?

 

    Yes.  :)

 

That was a good quote!

 

I like this comment from Jeremy Grantham:

 

The idea that a bigger safety margin is better thana smaller one, that cheaper is better than more expensive,that more cash is better than less cash, deserves, in modernparlance, a “Duh!” It is just rather obvious, and going onabout it for 850 pages can get extremely boring.

 

http://www.scribd.com/doc/30407102/GMO-Grantham-Quarterly-Apr10

[txitxo]

Buffett was already in control type situations in 1957. The other interesting thing about it is that his investment philosophy didnt change in > 50 years.

 

During the past year we have taken positions in two situations which have reached a size where we may expect to take some part in corporate decisions. One of these positions accounts for between 10% and 20% of the portfolio of the various partnerships and the other accounts for about 5%. Both of these will probably take in the neighborhood of three to five years of work but they presently appear to have potential for a high average annual rate of return with a minimum of risk.

 

I was going to answer this in detail, but I found that somebody else had already done it:

http://can-turtles-fly.blogspot.com.es/2011/12/warren-buffetts-evolution-and-his-three.html

[giofranchi]

And what about you, Giofranchi? How well have you done with your hedges? They certainly would have been a nice thing to have in August 2007.

 

txitxo,

you are surely very good at what you are doing! Congratulations! You talk exactly like the nuclear engineer friend of mine is used to talking. And he is very successful too. So, I do not doubt that your method has great merit and that it deserves to be studied.

 

Actually, I wasn’t hedged in 2007. I was worried and I moved to blue chip stocks: BRK.B, KO, JNJ, PG and XOM. In 2008 they behaved better than the market, but they were down nonetheless… After they recovered, at the end of 2010, I sold them fortunately with a profit, and moved to owner-operated companies, which are the businesses I really like. Don’t get me wrong, KO, JNJ, PG; XOM, etc. are awesome businesses, but… what do I really know about them? Who am I really partnering with? When my firm starts a new business idea, I want to know everything there is to know about it, and I want to be sure the right people are in charge. So, I reasoned, why invest differently? As you might have guess by now, Mr. Singleton of the former Teledyne Inc. is my “role model”!

 

By the way, have you read “The Magic Formula” by William Poundstone? It is interesting to note that Claude Shannon, a great scientist, at the end of his life could have boasted a wonderful track record in the stock market (not far from Buffett’s track record!). He ran a very concentrated portfolio, of which the greatest majority of funds (by far!) was invested in Teledyne Inc.! So, a scientist like you, invested in an owner-operated company, the way a business person like me would do, and was very successful! That gives me hope…

 

My company engages in structural engineering for civil and infrastructural developments, and manages a for profit Master School at the Politecnico of Milan University. They are both low margins businesses, but what gets to the bottom line is all free cash (maintenance capital expenditures are almost nil, and also growth is very cheap). So, I extract cash from not too good businesses and try to redeploy it buying very good businesses at attractive valuations. In a sense, I am copying what Mr. Buffett did with Dempster Mill Manufacturing and many times again during his career! Unfortunately, I am not that successful…

I judge our results based on the increase of my firm’s equity at the end of each year. So, my investments return is not the only part of the equation: the earnings from our operations matter a lot too. Until now we have done pretty well, but we are still young and unproven: we got incorporated in 2004 with little capital, started operations in 2005, and I began investing our original capital plus the first retained earnings in 2006. Right now the business environment in Italy is dire… Results from our operations will surely suffer! Fortunately, I work with permanent capital and I don’t have to worry about redemptions. I ask for Mr. Watsa (FFH), Mr. Einhorn (GLRE), Mr. Loeb (TPOU), Mr. Steinberg (LUK), Mr. Marks (OAK), Mr. Flatt (BAM), Mr. Tisch (L), and Mr. Biglari (BH) to help me!! ;D

 

 

Probably due to a combination of herding and some faulty wiring in our system 1 (I loved Kahneman's book).

 

I could not agree with you more! ‘Thinking Fast and Slow’ is a terrific reading!!!

 

giofranchi

[txitxo]

And what about you, Giofranchi? How well have you done with your hedges? They certainly would have been a nice thing to have in August 2007.

 

txitxo,

you are surely very good at what you are doing! Congratulations! You talk exactly like the nuclear engineer friend of mine is used to talking. And he is very successful too. So, I do not doubt that your method has great merit and that it deserves to be studied.

 

Actually, I wasn’t hedged in 2007. I was worried and I moved to blue chip stocks: BRK.B, KO, JNJ, PG and XOM. In 2008 they behaved better than the market, but they were down nonetheless… After they recovered, at the end of 2010, I sold them fortunately with a profit, and moved to owner-operated companies, which are the businesses I really like. Don’t get me wrong, KO, JNJ, PG; XOM, etc. are awesome businesses, but… what do I really know about them? Who am I really partnering with? When my firm starts a new business idea, I want to know everything there is to know about it, and I want to be sure the right people are in charge. So, I reasoned, why invest differently? As you might have guess by now, Mr. Singleton of the former Teledyne Inc. is my “role model”!

 

By the way, have you read “The Magic Formula” by William Poundstone? It is interesting to note that Claude Shannon, a great scientist, at the end of his life could have boasted a wonderful track record in the stock market (not far from Buffett’s track record!). He ran a very concentrated portfolio, of which the greatest majority of funds (by far!) was invested in Teledyne Inc.! So, a scientist like you, invested in an owner-operated company, the way a business person like me would do, and was very successful! That gives me hope…

 

My company engages in structural engineering for civil and infrastructural developments, and manages a for profit Master School at the Politecnico of Milan University. They are both low margins businesses, but what gets to the bottom line is all free cash (maintenance capital expenditures are almost nil, and also growth is very cheap). So, I extract cash from not too good businesses and try to redeploy it buying very good businesses at attractive valuations. In a sense, I am copying what Mr. Buffett did with Dempster Mill Manufacturing and many times again during his career! Unfortunately, I am not that successful…

I judge our results based on the increase of my firm’s equity at the end of each year. So, my investments return is not the only part of the equation: the earnings from our operations matter a lot too. Until now we have done pretty well, but we are still young and unproven: we got incorporated in 2004 with little capital, started operations in 2005, and I began investing our original capital plus the first retained earnings in 2006. Right now the business environment in Italy is dire… Results from our operations will surely suffer! Fortunately, I work with permanent capital and I don’t have to worry about redemptions. I ask for Mr. Watsa (FFH), Mr. Einhorn (GLRE), Mr. Loeb (TPOU), Mr. Steinberg (LUK), Mr. Marks (OAK), Mr. Flatt (BAM), Mr. Tisch (L), and Mr. Biglari (BH) to help me!! ;D

 

 

Probably due to a combination of herding and some faulty wiring in our system 1 (I loved Kahneman's book).

 

I could not agree with you more! ‘Thinking Fast and Slow’ is a terrific reading!!!

 

giofranchi

 

  Giofranchi, I am a scientist but no Claude Shannon...he was truly a genius, and he had an excellent and privileged understanding of technology, that's a real competitive advantage.

 

  2008 was pretty bad, things were dropping like crazy...what looked like solid companies were going bankrupt...luckily we had some cash and added significantly to the portfolio at the end of 2008. Then stocks fell even further in 2009...I really wished I had a hedge at that time, long term performance be damned. But suddenly, everything went up like a rocket after March 2009. And as Conan said, (well it was actually Nietzsche, but it sounds cooler when said by Conan) "what does not kill you makes you stronger". If you survive through a crash like that, still as a novice in investing, nothing else will scare you out of the markets in the future.

 

By the way, García-Paramés from Bestinfond started in a position very similar to yours, he was investing Acciona's money, also an infrastructure company, when it was still called Entrecanales. 

 

In any case, as I've told my family, our "safety", long-term portfolio in case I could not keep investing with the current system, is to put everything into L, LUK, FFH, MKL, BAM, SHLD, BRK + Bestinfond...so we think quite alike. I'm sure you'll do very well with your portfolio...you have chosen very good companions to help you with it.

[twacowfca]

 

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.

 

I like your posts very much tixtxo.

 

As you spend much of your time trying to understand what dark energy is, I spend considerable time trying to comprehend what gray matter is and related subjects.  :)

 

Warren hasn't permanently changed his style.  His shift to buying and holding large caps that are great businesses (think Coke) coincided not only with the growth in assets managed, but also with a change in the US tax code in the 1980's that made it inefficient for corporations to buy and then flip stocks two or three years later after they went up.

 

Warren, has continued to use the go anywhere buy a basket of apparent bargain stocks strategy that you describe.  In 2000 and 2001 he put most of his personal portfolio into Us REITS that were yielding about 10% after 1999 when the large cap great businesses in BRK's portfolio had earnings yields of about 3%.

 

Then, in 2002 - 2003, he rotated much of his personal holdings into a market basket of beaten down Korean value stocks.  Just before the financial bubble popped in 2008, Warren put most of his non BRK holdings into short term US Treasuries.

 

:)

[matjone]

"Warren, has continued to use the go anywhere buy a basket of apparent bargain stocks strategy that you describe.  In 2000 and 2001 he put most of his personal portfolio into Us REITS that were yielding about 10% after 1999 when the large cap great businesses in BRK's portfolio had earnings yields of about 3%.

 

Then, in 2002 - 2003, he rotated much of his personal holdings into a market basket of beaten down Korean value stocks.  Just before the financial bubble popped in 2008, Warren put most of his non BRK holdings into short term US Treasuries."

 

One thing I have always wondered - where does the media get this information about what Buffett is doing in his brokerage account?  I know sometimes he mentions things in passing during interviews but I wonder how much of it is speculation. 

[racemize]

I think it is just from his comments, e.g., recently he said he had JPM in his personal account.  I think I also read some of his comments on the HK stuff he was buying earlier this century.

[giofranchi]

Something to think about and he hasnt used hedges for fifty+ years.

 

“Who buys this stuff? For Japan’s corporate zombies it is evident that equity serves only as a sop for the banks and other debt holders. Mazda trades for just 11% of sales and at a 40% discount to book. That might make it look cheap, but it has little relevance if company management has to persistently issue more and more shares to keep the bankers from pulling the plug. It might be that Ben Graham’s value style of investing only worked so well in the 1930s because American firms had purged themselves of debt liabilities. It is my contention that value does not mix well with debt.”

Hugh Hendry – April 2012

 

We all know the two pictures attached: in the 1930s US total debt / GDP (first picture) declined rapidly and it remained relatively low for the next 50 years. Then, in 1998 it was almost back up to the 1933 level. Also, in 1998 security prices were very high, and, with a very brief exception at the beginning of 2009, they have always stayed at historical high levels. So, at the end of the century, for the first time in almost 70 years we had both very high debts and very high security prices. And what followed is the second picture: BRK was killed by Gold… a almost completely useless, but glittering!!, cube of 67 feet in each direction.

 

Those managers who really outperformed in the 1998 – 2011 stretch, Mr. Watsa (who loaded the boat with CDS), Mr. Einhorn (who shorted Lehman in 2008), Mr. Ackman (who shorted MBIA), Mr. Burry (CDS), etc., saw value differently.

 

Shalab, I agree with you, when you say that Mr. Buffett has always been opportunistic. And right now the best way to be opportunistic, as far as I am concerned, and AS LONG AS WE HAVE BOTH HIGH DEBTS AND HIGH SECURITY PRICES, is:

- to be long north America,

- to be long the stocks of undervalued, owner-operated companies,

- to be long (just a little bit) gold,

- to be short small cap growth stocks,

- to be short highly leveraged stocks.

 

Maybe BAC is different from Mazda… maybe not… I don’t really know. So, I stay away.

 

giofranchi

US_Debt_-_GDP.pdf

BRK_XOM_GOLD.pdf

[txitxo]

 

I like your posts very much tixtxo.

 

As you spend much of your time trying to understand what dark energy is, I spend considerable time trying to comprehend what gray matter is and related subjects.  :)

 

Warren hasn't permanently changed his style.  His shift to buying and holding large caps that are great businesses (think Coke) coincided not only with the growth in assets managed, but also with a change in the US tax code in the 1980's that made it inefficient for corporations to buy and then flip stocks two or three years later after they went up.

 

Warren, has continued to use the go anywhere buy a basket of apparent bargain stocks strategy that you describe.  In 2000 and 2001 he put most of his personal portfolio into Us REITS that were yielding about 10% after 1999 when the large cap great businesses in BRK's portfolio had earnings yields of about 3%.

 

Then, in 2002 - 2003, he rotated much of his personal holdings into a market basket of beaten down Korean value stocks.  Just before the financial bubble popped in 2008, Warren put most of his non BRK holdings into short term US Treasuries.

 

:)

 

I think that Warren Buffett's genius lies in always choosing the best possible investing strategy given the circumstances. ¿Little money to invest? Buy cigar butts, Korean or otherwise ¿Lots of money, unfavorable tax environment? Buy outstanding business with outstanding managers which you never have to sell ¿Absurdly huge amounts of money? Buy business which absorb large quantities of cash flow: Burlington Northern. 

 

Thanks for your comments, twoc. I read with pleasure your postings. Good luck understanding grey matter. That's way more complicated that Dark energy...

 

 

 

[Liberty]

I just want to say that it's always nice to see civil discussions here. Not that it's out of the ordinary here -- most discussions are very respectful. But it's still nice to see that it doesn't descend into ad hominem and such.. It's certainly not like that on many other internet forums :)

[cogitator99]

I agree, very civil. Certainly an interesting discussion.

 

I just curious, I notice a lot of value guys tend to cluster around the value firms like MKL, FFH, LUK. To those who hold these companies, what % of your port do you commit to these guys? Let's set aside BRK for now, because I would guess 80+% of the people on this forum own it (or have owned it).

 

 

[twacowfca]

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!

 

Yes! But . . . "Never smile at a crocodile!"

 

      ------ Captain Hook

[tombgrt]

They do have an awful lot of teeth... Thank you for the reminder twacowfca.  ;)

[ValueDan38]

Although my long-term investment results were clearly above average, I finally realized that in most environments I could never hope to match the few true super-stars.

 

As a result, for the last 22 years, over half of our managed assets have been in owner-operated companies like BRK, FFH, LUK, etc.  The advantages have been superior returns, relative safety and less trading, which results in lower taxes and less work.

 

This board of many like-minded and wise members has been a good source of ideas concerning these gems.  If I find any new companies managed by the “best allocators of capital”, I plan to share these ideas with you and hope that many of you will do the same for us.

 

Dan