2013 END NOTES

2013 was fast as probably each year when you get older and especially when you have small kids.

It was a mixed bag for me - stock picking was almost 1.5x better than market but excessive hedge position, obviously, materially lowered the returns. I cannot complain – mid teens with low downside risk is quite good (longs were covered with 1.5x index shorts for most of the year). I would settle for 10% pa with limited risk given the elevated valuations because of high margins and multiples.

As I wrote before, this year I have spent little time on my portfolio. Probably, it was in the spirit of Charlie Munger (documented by Value Investing World): “We use a lot of experience and do it [investment returns] in our heads. We don’t like complexity and we distrust other systems and think it many times leads to false confidence. The harder you work, the more confidence you get. But you may be working hard on something that is false. We’re so afraid of that process so we don’t do it.” Devil is in the details and footnotes but more and more I notice that the first hour of reading gives 80% of thesis. The most important is if I can build a constructive opposite thesis – if I feel that something was overdone with price movement, I act. When I see that insiders are on my side, position gets bigger.

Almost all returns came from 2 boring cellular telcos. No moat, no profit (almost no). Value investors were skeptical. However, in such cases, holding period is not forever and IRRs are quite good. I hope (a very important word) that UNTK and EZPW will be similar.

Macro is another topic hated by value investors. It is an interesting time when long-term interest rates are going up together with homebuilders. Mr. Market is saying that higher interest rates will not affect the recovering housing market.  The money printing was reduced by ~10% and its annualized run rate now totals ~6% of US GDP, while interest rates went up 40-80%. That was a price discovery of roughly 7 months, which will continue.

TNX is 10Y yield, TYX is 30Y yield and XHB - homebuilders.

Many many investors think like me; therefore, it is not that contrarian and quite painful at the same time while it should be painful when alone. They think and act with hedging their portfolios and keep on fighting the last war. Understandably, perma-bears continue to capitulate. Hugh Hendry did that in kind of a funny way. He thinks it will get much much worse but it will get better before that, which is worth a try to gamble. Those who were unhedged are definitely winning, so far. WEB is among them but he is in his own long-term game (he is not exiting the market before crash like the most intend to do). Correct me if I am wrong but the last three horsemen standing are John Hussman, Gary Shilling and Hoisington. Still await for G. Shilling's 2014 outlook, which should come in the first weeks of January. It should be an interesting read because he ended his 2013 mid year views: “So here’s my “risk-off” quartet: short stocks and commodities, long the dollar and Treasuries.” So far, so bad…

I will speculate that surprisingly the world cannot withstand a higher long term interest rates and a complete stop to QE would not anyhow influence rates (I am talking about longer term as in a short term market would correct and people would fly to safety).

This year I started to practice a basket of “option” stocks (stocks, which are priced like options, usually close to $1). I will see if my stock picking instincts are worth a dime as so far the score is 0:2 (thanks to PNCL and GAXC; long DM and ABM.L). However, mathematically, I am sure I should continue. I will decide after 10 or so attempts and positions should be closer to 0.5% (now larger) for now. On the positive note, such things absorb natural inclination towards activity and gamble - modern man needs variety and to have at least some fun. Discipline is boring and painful.

After writing this, I got a little better regarding my short XHB position (hurting in the last few weeks). It is painful but feels like a right thing to do given another interest rates run up attempt, which I believe (a very important word) to be another fake. I should at least reduce it at $28, though. I am afraid for pent up demand and normal household formation, does not matter how slow it is. Something similar to what is going on with autos.

I am intrigued about NLY. LOJN is coming back to a trade-able range.

A few reminders:

> Next crash will come from something not known or too obvious.

> General trend of the market is up - roughly 3/4 of the time. White men will do everything to preserve status quo and inflation is the key element of this. 

> The world has not deleveraged, yet (it is beautiful but takes very long or another 3-6 years, remember EU bank leverage ratios…).

It is getting too long, so Happy New Year!

FOR BEGINNERS (PART II)

I. Business

I. a) Understanding of Business

The key in stock picking is not to lose your principal amount. This can be achieved investing only in sound businesses at sensible prices. The first part of the dilemma is distinguishing good business from mediocre and the second one is valuation. When you get a grasp on business quality, you can delve into “average” businesses having full knowledge of the situation and what you are doing.

Micro economy or bottom-up approach is what leads to the overall macro picture because macro is a sum of micro units. Some industries are doing better and some units are doing better than others inside an industry. This is common sense. How to distinguish a good from bad?

A quick way to filter is looking at the return on invested capital (profit / capital needed to run the business) (10-year numbers). High profit margins (profit / sales) could be another hint [NB: a very distant break-even point can also very a powerful competitive advantage; e.g. think of Coca Cola making 1c from every serving…]. High values in both parameters should lead you to good businesses. It sounds simple but really common sense – if you can charge high margins, you must be doing something great for you customer (they still buy from you) and are better than competitor (they cannot offer anything better), and if you can pay back invested capital quickly and reinvest generated money at high return rates, this means that you have a lot of invisible / unquantifiable capital and value. Now you just have to make sense of those invisible things. [NB this does not mean that high capital requiring industries are bad investments – they are of a different kind, like financial companies, and could be very profitable investments]

The trick is to find out what is invisible and determine if it is sustainable (i.e. cannot be destructed by capital and creativeness). In other words, profits are protected by moats (Buffett’s vocabulary) or competitive advantages (Michael Porter), which are continuously under assault of creative destruction.

Moats or Competitive Advantage 

“[What counts is] competition from the new commodity, the new technology, the new source of supply, the new type of organization... competition which... strikes not at the margins of the profits and the outputs of the existing firms, but at their foundations and their very lives.”  Capitalism, Socialism and Democracy by Joseph Schumpeter

The topic of business moats / competitive advantages is one of the most interesting in business studies. The basic concept is easy to grasp (I will try to make some sense of it below), however, life is a dynamic process and new moats are emerging while old, supposedly sustainable ones, are becoming must-haves and ubiquitous elements of businesses. And really, the key concept here is sustainability.

It is important to remember that if the best possible management meets the worst industry / business, the latter will prevail. Think about textiles – does it make a difference if you can buy a 2-times more efficient machine, which can be bought by anybody? Such a “first mover” (or machine buyer) advantage can last for a few months, which does not bode well for sustainability.

So, what can make a firm unique and having capacity to take money profitably from its customers for long time? There are 2 aspects: a) industry structure; and b) business specific features.

If we still remember that industry is stronger than management, industry structure becomes crucial for determining predictability of profits. It is common sense that if you have fewer competitors, profits can be larger. When there are 2 or 3 remaining, nice things can happen to profits, especially if those remaining in action can demonstrate pricing discipline or, in other words, agree on pricing without discussing the subject, which is illegal.

Without going into great detail, I will give you reference where you can dig further. First of all, Michael Porter developed a useful chart of 5 forces (all charts are borrowed from M. Mauboussine & K. Bartholdson paper “Measuring the Moat”).

After practicing this chart on a few businesses, you should develop a useful habit of running any industry fundamentals through such lenses. One of the key concepts to discuss is barriers of entry. Obviously, if they are high, there will be less competition.

There are different layers and twists, some concepts are dependent on each other or complimentary but I think that the list provided below is a useful checklist:

== cost advantage (think about: economies of scale, location, process, access to unique resource, proprietary process, quick learning curve, etc.)

== proprietary product / service and / or technology / process (think about: patents, brands, regulatory licenses, contracts; the key test for brand strength is if it can charge a higher price; in other words – captivity induced by habit; yes, business can create habits)

== switching cost (key word here again is captivity; changing vendor is always a hassle – psychological, monetary, time, training, very important component and low % of total cost, etc.)

== network effects (value of products and services increases with the number of users – build a critical mass and let the snowball grow by itself)

== capital requirements (apart of obvious, think also about advertising spending)

== access to distribution / selling channel (best is if the channel is created in-house – think of multi layer marketing, Coca Cola sign is usually max 50m from you on the street, etc.)

== government regulation (government is famous and very capable of creating monopoly monsters but the best thing is to have many small concessions than one big and easy removable)

== expected retaliation (balance sheet strength is very important here)

Please let me know if you know how to improve the list.

Note that efficiency and differentiation are absolutely essential in any business.

Finally, company specific moats (in addition to industry situation) and the strongest moats are usually combinations of many smaller moats and factors. In value investing slang it is called lollapalooza effect. You will definitely be a better person if you read these 2 pieces:

Elementary Wordly Wisdom or Artof Stock Picking by Charlie Munger (there are only about 100 models worth studying which cover almost all life tricks)

Practical Thought AboutPractical Thought by Charlie Munger (Coca Cola case study) (email me for a photocopy from Of Permanent Value)

INVESTMENT PHILOSOPHY

In 10 words: Margin of safety. Circle of competence. Preparation. Discipline. Judgement. Patience.

I read a lot for the last couple of years (approaching 10,000 hours) and mainly value investing literature and various investor market commentaries. Below is the list of tenets which stayed on in my mind and keep on coming back.

Not ranked, numbered for future reference: 

1. Model – Mr. Market metaphor is simple and powerful. You are dealing with an ever evolving crowd system. (HT Ben Graham)

2.  Circle of competence - lean towards simple, expand and know it. (HT Buffett)

3. 50c dollars - you need margin of safety because you do not really know much. Value and price are different things and opportunity arises when they diverge. (HT Buffett, Klarman)

4. Activity bias - you must be a gentleman of leisure as you do not have to do anything on any given day and feel great about that. (HT Buffett, Pabrai)

5. Duration (long term) - synchronize expectations with pace of life - business does not change in a day or even in a month. Three years is enough but not universal. Patience is a great, unappreciated and unrecognized edge. (HT Pabrai)

6. Duration (short term) - nobody went bankrupt by taking quick 30% gains, especially when you have offsetting short term losses. This depends on your conviction, though, and is a good test.

7. Volatility is your friend because provides opportunity to enter and exit. (HT Buffett)

8. Beta is nonsense because 50% down stock is twice cheaper, i.e. less risky also twice. (HT Buffett)

9. 52 week highs and buy & hold are for Buffett because he has too much money and lack of time. He was much much more active 60 years ago and he admitted publicly that he would behave differently with only $1m in capital. 

10. Macro - follow the macro situation and FMV of the market, which consists of a set of micro. 

11. Discounting - think what market knows (discounts) (HT Ken Fisher)

12. Big is VERY rarely mispriced. (HT Buffett)

13. Mispricing - it always depends on supply and demand - forced sellers is a good sign but how to know that. Why security is cheap? What is a bear story? (HT Klarman)

14. Risks - try to kill the business and first discuss bad things rather than merits. (HT Berkowitz)

15. Shorting - yes, it is an asymmetrical bet but index short is safer. You can profit on both ways: up and down, which is the essence of absolute returns but always remember that Mr. Market can remain irrational a lot longer than you can stay solvent. 
16. News - beware the writer's bias to attract audience. (HT Mark Sellers)

17. Get a sense of proportions and context in any numbers - billion is not always huge, a 5% miss may not justify EV drop of 25%. (HT Ken Fisher)

18. Diversification - size of bets is proportional to your edge, conviction and expertise. Normal position is 10% of investable assets and do not expect to initiate more than 1 or 2 in a normal year (vs. market crash year).

19. Cash - I always feel better with 20-30% of investable assets in cash. Index shorts are also future cash for cheap stocks when markets are reasonably priced (as if that would be so easy – this topic probably deserves a separate post).

20. Sustainable competitive advantage - study moats and look for lollapaloozas, identify headwinds and tailwinds, invert. (HT Munger)

21. Know yourself well (misjudgments and mental capacity). Psychological awareness and stability can be your edge. Maintain stock lists and document your process - it is guaranteed that you will forget important things. (HT Munger)

22. Reading  –  it is an easy test to determine if you can invest on your own. In this business you can earn more money reading and thinking rather than meeting and talking. (HT Buffett)

23. Numbers – you have to love numbers, which is another easy test.

24. Gold – silver is better because it has more practical uses. If India (1/4 of annual gold demand vs. closer to 1/8 for silver’s global jewelry demand) suddenly changes its preference, gold will tank. This article provides a very good perspective on the subject.

FOR BEGINNERS (PART I)

Today I will start a series of articles providing good foundation for anyone willing to study and practice investing.

If anyone had introduced me to value investing 10 years ago, I would have been able to engage into things I love (or "retire") much earlier. Yes, early independence is of the significant importance to me. Who would not love to have the best boss in the world – yourself? If you are not interested in becoming independent early, you should stop reading this immediately.

I did not have such a mentor and had to find book-mentors on my own instead. Accidentally, I was able to compound at ~20% from my graduation (bought a flat in 1996) but I could have done better than that. At 23% compound rate, 50c turns into $1m in 70 years. We need to remember that we will be living longer. Think about the cost of trading-up to a more expensive brand instead of getting "good enough", especially at a young age. Consequences are huge. Compounding is great.

Thus, if you know anyone who is tireless in reading, did not start smoking when the entire class did, is not afraid of numbers, and is open-minded, please make him a favor and introduce value investing. You either get the value thing in 10 minutes or you do not get it ever. There is always a chance to propel someone's life.

What is value? It is a philosophy of life. Live within means, study life, and leave everything to civilization (except of a few millions for your off-springs). In simple terms, value is buying $1 worth things for 50c. It is really possible but not easy.

There are very few essential things which you should understand (you must study life continuously, though). In W. E. Buffett’s opinion, there should be only 2 classes in a business school: I) how to understand and value business, and II) psychology and how stock markets work. I will post a collection of articles and list books potentially leading to your personal nirvana.

One man said that without value thing in life you are like a one-legged-man in an ass kicking contest. He also said that if you mix raisins with turds, you still get the same thing. This value thing is lots of fun, also. You will find about harems, naked swimming, badminton, and ...what a heck, search for yourself.