Value-Stock-Plus

With the current state of the economy, there are many seemingly great deals available for investors who are willing to navigate the rough waters of the market. However, sometimes we can get caught up in our quest for the dollar and lose big. There are so many ways things can go very well — or horribly wrong — with the current market. So, be cautious as you evaluate those great deals and don’t jump the gun. In investing especially, patience is a virtue.

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Financial footnotes are like the fine print on an aspirin label. You need to read the fine print to realize that aspirin side effects include gastrointestinal bleeding. Financials footnotes are to companies as fine print are to drugs. For companies, their labels can be found in their SEC filings. Unfortunately, businesses are a lot more complex than drugs. Therefore, their footnotes are a lot longer than a paragraph of fine print on drug labels.

As I have mentioned before, footnotes contain some of the juiciest tidbits that management must disclose about the company but wouldn’t want to include in the financial statements. This is because the financial statements receive the greatest scrutiny from investors while financial footnotes tend to get ignored. The fact that footnotes have grown to an average of 12 pages per annual report or 10-K may have a role in deterring investors’ interest in the footnotes. Despite the length and potentially convoluted language used in the footnotes, it is absolutely crucial that an investor not skip the footnotes altogether. If you are short on time, at the very least scan the footnotes.

Financial footnotes are usually found in Management Discussion and Analysis (MD & A) in 10-Ks under Summary of Significant Accounting Policies. In 10-Qs, you can find them under the heading Recently Adopted Accounting Policies. Investopedia recommends scanning the second and last sentence of every disclosure so you can decide quickly whether you should pay more attention to certain disclosures. Always read the 10-Ks because full disclosure in 10-Qs is not yet a legal requirement.

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From 1997 Letter to Shareholders:

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, 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.

For shareholders of Berkshire who do not expect to sell, the choice is even clearer. To begin with, our owners are automatically saving even if they spend every dime they personally earn: Berkshire “saves” for them by retaining all earnings, thereafter using these savings to purchase businesses and securities. Clearly, the more cheaply we make these buys, the more profitable our owners’ indirect savings program will be.

Furthermore, through Berkshire you own major positions in companies that consistently repurchase their shares. The benefits that these programs supply us grow as prices fall: When stock prices are low, the funds that an investee spends on repurchases increase our ownership of that company by a greater amount than is the case when prices are higher. For example, the repurchases that Coca-Cola, The Washington Post and Wells Fargo made in past years at very low prices benefitted Berkshire far more than do today’s repurchases, made at loftier prices.

At the end of every year, about 97% of Berkshire’s shares are held by the same investors who owned them at the start of the year. That makes them savers. They should therefore rejoice when markets decline and allow both us and our investees to deploy funds more advantageously.

So smile when you read a headline that says “Investors lose as market falls.” Edit it in your mind to “Disinvestors lose as market falls — but investors gain.” Though writers often forget this truism, there is a buyer for every seller and what hurts one necessarily helps the other. (As they say in golf matches: “Every putt makes someone happy.”)

We gained enormously from the low prices placed on many equities and businesses in the 1970s and 1980s. Markets that then were hostile to investment transients were friendly to those taking up permanent residence. In recent years, the actions we took in those decades have been validated, but we have found few new opportunities. In its role as a corporate “saver,” Berkshire continually looks for ways to sensibly deploy capital, but it may be some time before we find opportunities that get us truly excited.

There is a good piece in a must-read book “The Investor’s Dilemma”, by Louis Lowenstein .

“Sitting on cash is better than doing something dumb. For value investors who invest in companies one by one, what happens when prices are so high that they cannot find value-not even a few good companies selling at decent discounts to intrinsic value? Happily for our study; if not for some of these funds, the beginning of 2004 was just such a period. In the year-end 2003 report of Longleaf Partners, Mason Hawkins described an intensifying struggle, because “little or no margin of safety exists in the prices of those businesses that meet our qualitative criteria.” Others were saying much the same thing.

Some of the funds were holding very large amounts of cash. Back in March 2000, even while the market generally was peaking, the presi­dents of First Eagle Global had cheerily noted that “so many stocks [were] below their ‘intrinsic’ value.” Four years later, First Eagle Global was 22 percent in cash or equivalents, and the Clipper and FPA Capital funds were 32 percent and 37 percent in cash, respectively. The increased cash holdings were not due to any predictions of a market decline, but because they couldn’t find anything cheap and worth buying. The yield on Treasuries was pitifully small, but it was better than doing “something dumb.” As Seth Klarman of the Baupost Group said in the year-end 2003 letter to his investors, his (value-oriented) hedge funds were heavily invested in cash solely as a “result of a bottom-up [and failed] search for bargains.”(Italics added)

This state of affairs among value managers is nothing new, of course. In 1987, as stocks soared in the months before the October crash, many Graham-and-Dodders were doing precisely the same thing: not finding good companies at reasonable prices, they held fistfuls of Treasury bills.”

In a great book “Benjamin Graham on Value Investing”, the author, Janet Lowe, writes on Ben Graham’s conviction of not-very-efficient markets.

““Investing in a market where people believe in efficiency” Buffett scoffed, “is like playing bridge with someone who’s been told it doesn’t do any good to look at the cards.”

In an interview just months before his death, Graham made his opinion quite clear. The interviewer asked Ben what he thought about academic research that supported the random-walk theory.

“Well, I’m sure (the professors) are all very hard-working and serious,” Ben mused. “It’s hard for me to find a good connection between what they do and practical investment results.”

He added, “I don’t see how you can say that the prices made in Wall Street are the right prices in any intelligent definition of what right prices would be.”

And finally, Ben concluded that even when correct information is available, there is no guarantee that investors will reach the best conclusion as to a stock’s worth. “To me (the efficient-market theory) is not a very encouraging conclusion because if I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.”

That same year in the Financial Analysts Journal, Ben reconfirmed his view on the subject.

“Common stocks have one important investment characteristic and one important speculative characteristic.” he wrote. “Their investment value and average market price tend to increase irregularly but persistently over the decades, as their net worth builds up through the reinvestment of undistributed earnings …However, most of the time common stocks are subject to irrational and excessive price fluctuations in both directions, as the consequence of the ingrained tendency of most people to speculate or gamble- i.e., to give away to hope, fear and greed.”

On a more humorous note, he expressed his point of view on the subject this way. “They used to say about the Bourbons that they forgot nothing and they learned nothing, and I’ll say about Wall Street people, typically, is that they learn nothing, and they forget everything.””

“The market can remain irrational longer than you can remain solvent.” – John Maynard Keynes

by Sham Gad

The markets are going through a historic transformation. During this process, all rationality goes out the window. Consider what happened to the tripling in price of credit swaps covering Berkshire Hathaway for a bet they made that doesn’t come due until 2019.

Valuations today simply mean nothing…in the short run. “Cheap” has taken on a whole new meaning. And if your business has any amount of meaningful debt, the market hates you even more.

Without a doubt the excessive decline in share prices has been exacerbated by the forced selling–from everyone. Mutual fund redemption’s are at an all time high. Pension funds are getting hit. And of course, our hedge fund brethren who decided to buy $15 dollars worth of stock for every dollar handed to them by investors.

I echo Buffett’s sentiments that years from now, certain businesses will be earning record profits. Nonetheless, while it’s a fools game to attempt to call a bottom, certain things must occur before the environment truly gets better going forward. Mr. Market is confused and it’s absurd to see nearly 1,000 point swings in a single day. At this point, a stable 1,000 advance in the market over the course of year would represent over a 12% return – something that every investor would take solace in.

Starting Point Matters

While we value investors prefer to concentrate our efforts in our very best ideas, I think one will do exceedingly well in today’s market by buying a less concentrated basket of excellent securities that are trading at magnificent discounts to their true value. Many large-cap companies today are trading at absurd valuations even when you normalize earnings over multi-year periods. ConocoPhillips is absurdly cheap and makes money even when oil is at $50. American Express is another.

Joel Greenblatt has done just this by simply buying hundreds of his Magic Formula stocks and going away. The irony in investing is that as markets tank and performance declines, it’s easier to invest going forward. Starting point matters. An amateur investor picking a basket of low P/E, strong balance sheet stocks today will likely produce better numbers over the next year or two than many seasoned pros. This merely a function of getting in at a much lower starting point.

While the re-capitalization of the big financial firms was a big step in the right direction (whether you agree with the actual plan or not, no plan at all would have caused unthinkable consequences), we still need to see:

1. Stabilizing Housing Prices – It’s amazing that homebuilders still continue to pump out new houses and even more amazing that no homebuilder has gone under. Supply of new homes need to cease.

2. Resumption of corporate M&A Activity – companies need to start taking their cash and putting it to work. When this happens, everyone on the sideline will take notice.

Now is not the time to be losing faith, but I wouldn’t expect much in the short run. Investors could be down another 10% to 15% before finally being vindicated.

The old adage that the market operates on greed and fear has been well-exemplified over the past few months. It is never savory to witness paper losses, and there are few fears as strong as losing one’s hard-earned money in a violent, abrupt market correction.  In an environment where FIIs have been selling their wares at fire-sale prices to meet margin calls and recapitalization requirements in their home countries (or to simply avert bankruptcy), it may seem that the time has come to book losses, exit the market and re-enter at a more opportune time. However, there are several logical reasons why it does not pay to overreact…read on to understand why.

1. Market Timing never wins

A natural human reaction to a sudden plunge in the markets would be to run for safety by reducing or liquidating one’s exposure. The base instinct is to stem loss of capital and eventually re-enter the market at a more favourable juncture. However, repeated studies have shown that market timing, i.e. trying to perfectly time entry and exit points, seriously damages investor’s long-term returns. As the historical long-term trend of the stock market has been upward, one must recognize that there are significant risks with trying to accurately time the market’s peaks and troughs in search of abnormal gains. This strategy typically results in:

i. High exposure to stocks at the peak of bull runs (just prior to a sell-off), and
ii. A reduction of holdings in a deep bear market, just before of a period of stellar appreciation.

Essentially, timing the market puts one at risk of selling low and buying high, and is a sure-fire way of guaranteeing disappointing returns. Perfectly timing entry and exit points sounds good in theory, but usually fails in practice. The direction of the market can change rapidly, and market rallies can occur suddenly and over very short periods. Further, attempting to move in and out of the market can be an extremely costly affair, particularly because a significant portion of the market’s gains over time tend to come in concentrated periods.  Missing out on just a handful of the best-performing days in the market may leave investors at a significant performance disadvantage compared to investors who remain fully invested for the long-term.
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Is this rate of return the result of the scintillating performance of the Indian economy over the last few years

Despite the carnage in the stock markets, if you had put in money in the MSCI India index 10 years ago, your annualized return would have been a healthy 12.78% (as on last Friday). If you had put in your money five years ago, your annualized return would be a respectable 11.97%. That’s well over the rate you would have earned on any fixed income instrument or on fixed deposits over the period, and since long-term capital gains are tax-free, your return would also have been tax-free.

Is this rate of return the result of the scintillating performance of the Indian economy over the last few years? That’s difficult to say, when you look at the other emerging markets that have annualized historical returns far exceeding those from MSCI India over the past 10 years.

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