Value-Stock-Plus

by Sham Gad

This article’s headline, a direct quote from Berkshire Hathaway Vice Chairman Charlie Munger, cuts right to the heart of the matter: If you are not investing based on fundamental valuation principles, you are not investing. You may think you are, but Ben Graham had another term for it: speculation.

Intelligent investing defined

As Graham stated in the book Security Analysis:

An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.

Graham’s definition implies that a true investment is made only when you have the right data and reasoning, followed by a suitable price that ensures a margin of safety. Putting capital to work any other way is, by its nature, speculative.

Value investors focus not on their performance in a bull market, but on their perseverance during a bear market. In his 1961 partnership letter, Warren Buffett expressed this crucial point when he told his partners, “I would consider a year in which we decline 15% and the [Dow Jones] average 30% to be much superior to a year when both we and the average advanced 20%.” Most investors don’t fully grasp this investing approach, and the result is inferior long-term performance relative to the benchmarks.

Speaking of bear markets, in the 1960s, Buffett invested more than 30% of his assets in one company, American Express, during that company’s worst scandal. While everyone else was running, Buffett stood still, because he was confident in his data and reasoning.

Always remember that price is what you pay and value is what you get. A fantastic business like Google is undervalued at one price, fairly valued at another, and overvalued at yet another. At the current price, investors in Google are sacrificing a margin of safety and betting on the continuance of very high growth rates, which we know simply cannot go on forever. It’s one thing for a company like Google to double profits from $2 billion to $4 billion, but it’s much more difficult to go from $20 billion to $40 billion.

When you bet, bet big

Few words have influenced me more than these:

Truly outstanding investment opportunities occur only occasionally. In general, the better they are, the rarer they are. Such opportunities are normally long-term in their maturation and by careful study can be foreseen long before they come to the attention of most investors. … The very highest profit potentials occur whenever there is a convergence of two or more primary causes.

These sound like homespun words of wisdom from Graham or Buffett, but they aren’t. They come from silver analyst Jerome Smith in his book Silver Profits in the Seventies, more than 30 years ago. Smith was referring to silver, but his words also characterize the qualities of superior investments that true value investors seek to exploit.

Smith is right: Really good investment ideas are rare. So when you find one, bet big. If your thorough analysis is correct and the price is right, you should have no hesitation in investing heavily. One need look no further today than Mohnish Pabrai and the Pabrai Investment Funds. Pabrai currently manages about $600 million or so, up from $1 million in 1999. About 80% of that total is parked in just eight to 10 of Pabrai’s best investment ideas, including Pinnacle Airlines and IPSCO . The result is a 29% net annualized return since inception, meaning that a $100,000 investment back in 1999 is worth almost $800,000 today.

Simply put, if your convictions won’t allow you to put 10% of your assets in one investment, you probably don’t need to have even 1% of your assets invested. But that’s why such obvious investments are so rare, and when your data and reasoning are correct, be sure to take advantage of the opportunity.

Buying good businesses at bargain prices allows the investor to ride out a storm relatively unscathed. But sound investing is not easy. The key is to train yourself to be unemotional about the market and maintain an unwavering level of discipline. History has shown that there will always be periods of prosperity followed by periods of economic contraction. That will never change. If you invest with the aim of keeping your capital, the upside will take care of itself.

There is no magic formula for forecasting equity crashes

by Tony Jackson – FT.com

Even among those perennially sunny souls, the equity strategists, there is a touch of gloom around. The credit game is up, it seems, so the equity game cannot be far behind. It is only a question of time, and not much of it.

Yet the Dow went through 14,000 last week and the S&P 500 hit an all-time high. Granted, that is in depreciated dollars. But it still seems a funny way to express apprehension.

Let us look closer at what some of the strategists are saying. The most popular bearish argument comes from Morgan Stanley. In simple terms, it says equity markets tend to crack on average six months after credit markets do. This time round credit first weakened in February, so mind out for August.

For all I know, it might indeed work out that way. The trouble with the argument, though, is that no rationale is offered for how the mechanism works. We have only an average drawn from selected historic observations.

The markets have always been drawn to the magic of fixed periods, for reasons that elude me. Chartists are fond of the Kondratiev cycle that says depressions occur every 50 years. But Kondratiev’s theory was based on data from the 16th to 19th centuries. Why should the economy of the internet work to the same timetable as that of the oxcart?

Morgan Stanley points to the way credit spreads widened ahead of the crashes of 1987 and 2000. But today, credit and equities are more closely connected.

Credit and equity analysts sit alongside each other at the investment banks. Hedge funds routinely short a company’s equity while going long of its bonds, or vice versa. It is no longer a matter of two separate investment communities viewing the world differently. The same community is observing the two asset classes and drawing different conclusions.

Why? A possible – if familiar – explanation comes from one of the few bullish banks still around, Citigroup. In recent years, we have seen “one of the biggest arbitrage trades in financial market history” – the massive use of cheap debt to buy cheaper equity. The arbitrage gap still exists, so the bull market is intact.

Citigroup flourishes a chart showing the global earnings yield on equities and a notional global BBB bond yield. At the last market peak in 2000, the bond yield was nearly 9 per cent and the earnings yield only just over 3 per cent. No wonder, as Citigroup observes, that private equity didn’t join that particular party. The sums didn’t remotely add up.

At present, the yield on both has converged to about 6 per cent. This is not quite a steal any more, but is not that different from the conditions of the past two-and-a-half years. Citigroup hazards a guess that for the arbitrage train to be derailed, BBB bond yields might have to rise by two percentage points, or earnings yields fall by the same amount.

BBB bond yields have certainly been rising, through a combination of higher real yields and wider spreads. But 200 basis points is not on the cards quite yet. As for an earnings yield of 4, that would involve the price-earnings ratio rising from its present 17 or so to 25, which is a very bullish scenario.

So everything is all right, then? Well, not really. The price of money is only one factor in the equation. Another is liquidity – which, as they say, is only another name for risk.

And there are all kinds of tell-tale signs that lenders are becoming more risk-averse. In such times, the wall of money argument becomes meaningless – think of the Japanese equity market after the 1990 crash.

One other word of warning. Citigroup takes it as a bull point that, whereas in the last bull market, all the big acquisitions were for equity, today they are still predominantly for cash. But when trouble hits, that could be profoundly bearish in itself.

At the peak of the M&A cycle, companies inevitably overpay. Think of two examples last time, Vodafone and Marconi. The first used equity, the second debt. The first survived and the second was destroyed.

One of the props for the credit markets just now is the absence of corporate defaults. Just wait, though, till some of those big cash mergers start turning turn ugly. I distrust pat formulas for when the credit bust will hit equities. But I don’t doubt it will – eventually.

Copyright The Financial Times Ltd. All rights reserved.

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities — that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future — will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight.

There’s a problem, though: They are dancing in a room in which the clocks have no hands.

From Berkshire Hathaway 2000 Chairman’s Letter

by Sham Gad

Jesse Livermore has long been hailed as one of the most flamboyant market speculators of all time. He became popular for making and losing several multi-million dollar fortunes and short-selling (selling stocks ahead of buying them) during the stock market crashes in 1907 and 1929. Known by epithets such as “Boy Plunger”, “The Great Bear”, and “The Wall Street Wonder”, Jesse Livermore has left behind a working philosophy for those involved in trading securities. Ironically, Livermore lost all his money in trading and attributed his losses to the non-adherence to his own rules.

“When I am bearish and I sell a stock, each sale must be at a lower level than the previous sale. When I am buying, the reverse is true. I must buy on a rising scale. I don’t buy long stock on a scale down, I buy on a scale up.

“One should never permit speculative ventures to run into investments. Don’t become an Involuntary Investor. Investors often take tremendous losses for no other reason that that their stocks are bought and paid for.”

“No one man, or group of men, can make or break a market today. One may form an opinion regarding a certain stock and believe that it is going to have a pronounced move, either up or down, and eventually be correct in his opinion but will lose money by presuming or acting on his opinion too soon. The point I would here emphasise is that after forming an opinion with respect to a certain stock — do not be too anxious to get into it. Wait and watch the action of that stock for confirmation to buy. Have a fundamental basis to be guided by.”

“Markets are never wrong — opinions often are. The latter are of no value to the investor or speculator unless the market acts in accordance with his ideas.”

“It is foolhardy to make a second trade, if your first trade shows you a loss. Never average losses.”

“As long as a stock is acting right, and the market is right, do not be in a hurry to take a profit. You know you are right, because if you were not, you would have no profit at all. Let it ride and ride along with it. It may grow into a very large profit, and as long as the action of the market does not give you any cause to worry have the courage of your convictions and stay with it.”

“Profits always take care of themselves but losses never do. The speculator has to insure himself against considerable losses by taking the first small loss.”

Source: Lettters to Shareholders of BRK

Warren Buffett, probably the greatest investor of his generation, rarely communicates his investment ideas in writing to the general public.

And why should he? If someone has that extra edge when it comes to making money from the stock markets, he would rather use it for himself rather than go around sharing it. But once a year, he makes an exception to the rule and does give out his way of thinking through the annual letter he writes to the shareholders of Berkshire Hathaway.

Other than this he has given many speeches over the years, which have given the general public some idea of the way he thinks. Here are a few of these gems which he has shared with his shareholders over the years through his letters and speeches.

1. Buy the business and not the stock

The speech titled, ‘The Superinvestors of Graham and Doddsville,’ delivered to the students of Columbia Business School in 1984, remains the most famous speech that Buffett ever made.

This speech was delivered at a seminar held to celebrate the 50 years of the publication of Benjamin Graham and David Dodd’s book Security Analysis. Benjamin Graham was Warren Buffett’s Guru at Columbia School and all the years that Graham taught there Buffett was his only student to have got an A+ grade.

And Buffett, as we all know, has surely lived up to that grade. This speech elucidated his firm belief in the principle of value investing. Value investors, he said, “search for discrepancies between the value of a business and the price of small pieces of that business in the market.” Hence, the only thing they are bothered about is “how much is the business worth?”

As Buffet said in the speech, “He’s not looking at quarterly earnings projections, he’s not looking at next year’s earnings, he’s not thinking about what day of the week it is, he doesn’t care what investment research from any place says, he’s not interested in price momentum, volume or anything. He’s simply asking: What is the business worth?”

And hence, as Buffett points out in the speech about value investors. “While they differ greatly in style, these investors are, mentally, always buying the business, not buying the stock.”

As we all know, the question ‘how much is a business worth?’ is not easy to answer and depends on how closely the investor follows the business of the company he is investing in and the understanding he has of that particular line of business.

Buffett himself follows this and does not invest in businesses he does not understand. Information technology is one sector he has consciously stayed away from even at the height of the technology boom.

2. Buy when the stock prices are low

One of the peculiar things about stock markets is the fact that investors like to buy when the markets are doing well and the stock prices are on their way up. This is not the best way to invest given the fact that in everyday life we like to buy more of something only when the prices are low.

Buffett explains this point in his letter to the shareholders for the year 1997. “A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices?”

“These questions,” he goes on, “of course, answer themselves. But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the ‘hamburgers’ they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.”

3. For investors as a whole, returns decrease as motion increases

Getting into stock because everyone around you is and hoping to make money from it money successfully is not everyone’s cup of tea. As more and more investors get into the same stock, and price rises, the chances of making money from the stock go down.

In his 2005 letter Buffett wrote, “Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: he lost a bundle in the South Sea Bubble, explaining later, ‘I can calculate the movement of the stars, but not the madness of men.’ If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: ‘For investors as a whole, returns decrease as motion increases.’”

4. There is a thin line separating investment and speculation

Buffett explains this beautifully in his letter to the shareholders in the year 2000. “The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money.”

“After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities — that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future — will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.”

Only Long-Term Players are gaining, Short-term players miss bourse party!

Source: ET

Benchmark indices may be leaping into newer orbits, but cashing in on the rising market is turning out to be tricky — even for some of the seasoned investors — as the market is changing its leaders like a banana republic. The Sensex on Thursday closed at a new high of 15092.04, touching 15,112.22 intra-day, up 181.42 points. Even the NSE Nifty ended at a new high of 4,446.15, up 1.3% or 59 points.

These are impressive numbers. But, day traders and short-term investors, who take two days to a one-month call to play the market, are finding it extremely difficult to make decent money. Every day, it seems to be a different set of stocks that push up the indices. Infosys Technologies, which was one of the major contributors when the market hit a record high in February, has now been underperforming benchmark indices for more than three months. But that has not stopped the onward march of the bulls, who have zeroed in some other stocks.

With the market refusing to acknowledge any negative news — be it a ratings downgrade of a key stock, slowdown in loan demand, or a glut of new shares from IPOs — investors seem better off ignoring fundamentals for the time being.

“Because of the volatility and a limited number of sectors participating in the upswing, only those investors who have been sitting on their investments would have made huge profits. Short-term players would have to be extremely lucky in spotting the trend every time so as to be able to make big money,” “I think only a small section of the market has been able to benefit from the recent rally,” said Motilal Oswal, chairman of the brokerage Motilal Oswal Securities. “Because of the volatility and a limited number of sectors participating in the upswing, only those investors who have been sitting on their investments would have made huge profits. Short-term players would have to be extremely lucky in spotting the trend every time so as to be able to make big money,” he said, adding there were too few long-term investors in the market at the moment.

Mr Oswal is not exactly talking about small investors. A head of derivatives desk at a foreign broking firm recently took short positions in steel futures and went long on cement stock futures, going purely by fundamentals. Cement futures rose, but so did steel futures, thus narrowing his profits.

by Whitney Tilson – FT.com