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!

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 V)

II. b) Market Valuation and Long-term Trend

Understanding of the current market level is essential for successful investing. It should provide guidance for your investment stance: is it advisable to be active or passive, hedged or fully long.

Alice Schroeder started her brilliant The Snowball, the best book about life of Warren Buffett, with a memorable lecture the value investing grandmaster gave to the wealthiest and successful businessmen back in 1999, a few months before an important market top.

In the long run economy grows because of fundamentals: population size and productivity change. Stock prices depend on profit size (% of GDP gives a good perspective, too) and multiple of earnings, which is dictated by prevailing interest rates and inflation expectations – gravity force of the market. Share price can go up via growing profits and expanding multiple. Dividend payback is also a very important part of the total investment return. That is a brief summary of how the markets work in the long term.

In 1999, W. Buffett made his first prediction in 30 years that market would grow by 6% annually for the next 17 years (he highlighted a period between 1964 and 1981 when Dow Jones Industrial moved from 874 to 875 while economy grew fivefold).

Dow Jones in July 30, 1999 - 10,655

Dow Jones in July 31, 2011 – 12,143

17.27% up in 12 years or 1.1% annual cumulative returns. Presently, it seems that W. Buffett was an optimist and based on his frequent and recent media appearances he still is. We have 5 years to go, so who knows… And you have to remember that he speaks his book.

From 1900 to 2011 S&P 500 generated 5% cumulative return (dividends provided another 4%+). Coincidentally, 4.8% is a historical S&P 500 profit growth rate and 6.2% is historical nominal GDP growth rate (Ed Esterling’s Crestmont Research website). Long term simple average inflation is 2.9%, population growth rate is 1.3%, therefore, the rest (or 2.0%) is productivity driven growth. Noteworthy, GDP growth is slowing down during the last 30 years because accumulated leveraged started to weight economy down.

Multiples awarded by Mr. Market or a fellow with fast swinging mood are probably the most unpredictable. Jeremy Grantham of GMO nicely put it in Risk Management and Investing Part II (Q1 2006):

“Exhibit 1, the “Exhibit of the Quarter,” shows the incredibly low volatility of the U.S. GDP, which two-thirds of the time has a volatility that is a mere ±1% around its long-term trend of about +3.5% a year real. This trend is stable because the economy is mean reverting, and bad times (like the 1930s) that produce spare capacity in both labor and capital are followed by strong times as the economy works to use up its excess resources. This ultra stable GDP engine can be thought of as the engine driving corporate profits and dividends. They in turn, although far less stable at a yearly level, follow the GDP in its mean reverting tendency towards a ‘normal’ level. Because of this, if you were clairvoyant in 1882 about the entire actual stream of corporate earnings and dividends until today, and used your clairvoyance to calculate a fair value, and then did the same for 1883 and so on for every year, it would produce a very stable trend of stock market fair value, as first revealed by Robert Shiller 18 or so years ago. Perhaps, not surprisingly, the volatility of this fair market value also stays within ±1% of its long-term trend two-thirds of the time. But what a contrast these two series are to the actual stock market, which manages to spend two-thirds of its time within only ±19% of fair value. This means that the market is 19 times as volatile as the underlying fundamentals would seem to justify! Understanding this 19 to 1 discrepancy would put us a long way along the road to understanding risk.”

A few highly respectable investors estimate that now fair market value of S&P is 900-1,000 (2012), which probably means that it is better to be cautious.

Media pays most of attention to short term forecasts, which are mainly based on estimated next year’s operating earnings. It may really look reasonable to apply 10-15 earnings multiple to a basket of equities, however, one has to remember that currently profits command unprecedentedly high share of the economy, which - history tells - should mean revert. Problem is that nobody knows when.

Stock market as % of GDP - Link

Inflation adjusted S&P 500 compared to the trend - Link

4 different methods (Tobin's Q Ratio including) compared to the trend - Link

Dollar value against stock returns - Link

Make your own conclusions but I am fully hedged. 

FOR BEGINNERS (PART IV)

III. Markets & Psychology 


Note that I skipped Parts II (Understanding of Business) and III (Business Valuation) because I want to work on them longer.

I would break down Markets & Psychology discussion in 3 sub-sections: a) market model parables; b) market valuation and long term trend; c) psychological misjudgments.

III. a) Market Model Parables.

W. E. Buffett referred to 3 chapters essential for investing. Those are:

1. Chapter 12. The State of Long-termExpectations from “The General Theory of Employment, Interest and Money” by John Maynard Keynes: 

“Or, to change the metaphor slightly, professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.”

2. Chapter 8. The Investor and Market Fluctuations from “The Intelligent Investor” by Benjamin Graham: 

“Let us close this section with something in the nature of a parable. Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. 

If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.”

3. Chapter 20. Margin of Safety as the Central Concept of Investment from “The Intelligent Investor” by Benjamin Graham. 

“The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, nonexistent at some still higher price.”

A dollar is worth a dollar. When you cannot say how much a thing is worth exactly, it makes sense to be careful and pay less. The concept of margin of safety was first introduced in investing in this chapter. It was routinely used in engineering though. Bridges are designed with backup systems and extra capacity to prevent failures.

4. I would add George Soros lectures to the list. It is an interesting read, can satisfy your philosophical needs and suppress a bias to act. 

“Let me state the two cardinal principles of my conceptual framework as it applies to the financial markets. First, market prices always distort the underlying fundamentals. The degree of distortion may range from the negligible to the significant. This is in direct contradiction to the efficient market hypothesis, which maintains that market prices accurately reflect all the available information.”

 “Second, instead of playing a purely passive role in reflecting an underlying reality, financial markets also have an active role: they can affect the so-called fundamentals they are supposed to reflect. That is the point that behavioral economics is missing. It focuses only on one half of a reflexive process: the mispricing of financial assets; it does not concern itself with the impact of the mispricing on the so-called fundamentals.”

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.

READING RECOMMENDATIONS (i)

Warren Buffett recently wrote great article about investing in gold.

"In God We Trust" may be imprinted on our currency, but the hand that activates our government's printing press has been all too human.

John Hussman is one of a must weekly readings. Over the weekend he put it simple but not too simple about the current recovery:

Each time underlying credit strains emerge, demand backs off as consumers and businesses become averse to spending. Then, each time central banks launch some massive new intervention, there is a jolt of pent-up demand that is interpreted as sustainable growth.