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Sogo Shosha

Date: 2020-09-09

Not quite a whale, and pretty small investment, but interesting nonetheless. As usual, people are trying to read all sorts of things into this investment, from bullishness on Japan, bearishness on the U.S., the U.S. dollar, inflation hedge / exposure to natural resources etc. It almost feels like nobody ever reads anything Buffett writes. He doesn't base investments on themes like inflation or economic views or views on foreign currency exchange rates.

But anyway, one can only assume that Buffett feels that these Japanese trading companies are decent businesses with decent managements trading at attractive prices.

Foreign Investments
This investment really reminds me of his Korean stock trade a while back. He said he was flipping through a Korean company handbook and noticed that a lot of stocks were trading at very low valuations. It seemed like he didn't need to dig into the details of every company to know that they were cheap enough and buying a basket would be profitable. This shosha investment kind of feels like that.
I remember noticing a while back in a photo or video of Buffett in his office that the Japan Company Handbook was sitting on his desk. So you knew he was flipping through that thing one company at a time looking for bargains. This may have been how he found this group. I would not be surprised if he has been reading all the annual reports of the big Japanese companies for years. Why wouldn't he, with so much capital to allocate?

First of all, I won't go into too much detail about the Japanese trading companies. They all have English annual reports on their websites, and you can just read about them on Wikipedia etc.

But I have to say my first reaction was not positive. I think many of us who are familiar with the Japanese market were a bit surprised. One pro said he was "disappointed".

What does he see?!
Anyway, first, let's see what Buffett may be seeing. Since he bought five stocks, this is clearly not about any individual company or management.

Let's just look at the big picture on these names. This table below is current as of early September 2020.
Since he has been accumulating these stocks for the past year or so, the most recent annual report he would have seen last year would have been for the year-ended in March, 2019 or more likely 2018 (as English versions of annual reports come out late). I have highlighted the March 2019 year figures, but he may have evaluated things based on 2018 figures too.
Prices haven't moved much (except Itochu), they are within sort of the range they have been for the past couple of years. So the table just compares everything to current prices.
In short, what he was seeing was a group of companies earning double-digit ROEs with single-digit P/Es and P/Bs below 1 (except Itochu). Where can you get that combination? Maybe in some emerging markets. These are blue-chip companies with solid reputations, at least socially (banks and shosha were the two industries that parents traditionally wanted their fresh college grads to join).

Initial Reaction
So just by the numbers, this makes total sense. No mystery here. It is exactly the sort of thing Buffett would jump into.

What about the reputation of incompetent Japanese management? That's what I would worry about most. Japanese management is and has been improving over the past few years, but I can't say I would be completely comfortable with management there, particularly in the big companies.

There are many cultural reasons why management in Japan has been so inept over the years. Things like seniority, lifetime employment, constant annual rotations of staff and the short put nature of employee positions have been really detrimental to companies there. I do have first-hand experience with this. It is getting better, I hear, but if you remember how a Korean airlines flight went down because it was culturally unacceptable for a co-pilot to point out an error to the pilot, cultural factors can be quite destructive.

In Japan, one of the big ones is the notion of seniority. Meritocracy is increasing over there, but there is still a notion that older people know better so must be respected and not challenged. A lot of this gets mixed in with the natural tendency to defend your own turf. This combination may make it difficult for energetic, creative, competent young people to move up to benefit the company. Also, the lifetime employment 'promise' makes it difficult to make room for more competent employees. This combination of lifetime employment and seniority can be lethal in a fast changing, dynamic world.

The other big problem is that a lot of large companies tended to want to rotate people every three years to give them a broad experience to prepare them for senior positions at HQ. I remember dealing with some of these employees in NY and was shocked at how things worked. They come over to NY knowing nothing about finance, for example, and they speculate using firm capital not knowing what they are doing. Of course, by the time they start to understand what is happening, they are 'rotated' out to London or somewhere else. So they barely get to understand anything before moving on and they eventually end up at the head office, not really knowing much.
There were some trading companies that were close to blowing up or had to merge because they were on the verge of bankruptcy, and given my first-hand observations, that was no surprise at all. Did I tell you about one of the trading companies that would call our swap desk every day and ask for anything above a certain LIBOR spread? And they were indifferent to the risk; they didn't care. They mechanically just bought anything above a certain hurdle rate. I used to get invited sometimes to client dinners and I heard it directly too; they don't care about the risk, just give them something with this yield. They are willing to take whatever risk is implied in that given yield. Why this rate? Oh, that's our funding rate. Oh. Well, you have to take some risk, then. That's OK. Do you care what kind of risk you take? No, we just need to clear our funding rate. But structured products can be very risky. That's OK, we like structured products. etc... You get the point. It was crazy.
This is one reason, by the way, why I thought a lot of the criticism against the banks during the financial crisis was baloney; a lot of these clients knew what they were doing, knew the risk they were taking. Or they simply didn't want to hear anything. They just wanted certain things regardless of the risk. Of course, I was never a salesman so would simply state facts, and they were like, OK. That's fine with us. Scary stuff. I'm sure things are better now (but I wonder. I just finished the GE book, and Immelt sounds very much like a clueless salaryman! Frightening. Except GE may have been worse; how is all of that stuff not fraud?!).

Of course, I am making all these sweeping, generalized statements, but here's another thing that you may have noticed. Some Japanese corporations do really well globally, particularly the manufacturers. If you look at Toyota, Canon, Sharp and many others, they have tended to do well in the past (although a lot of them are now under pressure from Korean / Chinese competitors). They succeeded because they mastered their craft in Japan and exported around the world and eventually built plants around the world implementing their techniques.

But if you look at the businesses that tried to expand globally through acquisitions and / or the financial/service companies, they have failed miserably. The Japanese tend not to be great acquirers. Well, data show that this is true everywhere and anywhere; M&A tends not to work out well. But I always had the sense that it was worse for the Japanese when they venture overseas.

As I mentioned above, I just finished the GE book, and it's funny how Immelt sort of acted like a Japanese salaryman; they just want to get the deal done no matter the price, and people are afraid to challenge the 'senior' person. In big companies, so often, things are decided by politics, so you can't afford to upset people. If you think a deal is bad, why would you risk your own career and point it out?

This goes on to the next part of the problem in Japanese companies, and that's the short-put aspect of the employment contract. Again, there has been some change, but in general, Japanese companies are not known for paying outsized bonuses for success (well, you can argue that the Americans are very good at paying outsized bonuses for failure), so this discourages risk-taking. Why bother? If you step up and try to do something big and it succeeds, you get a nice pat on the back and maybe a small bonus. But if you fail, this can be detrimental. They may transfer you out of your job and send you to corporate Siberia. We've all read about the madogiwazoku. They can be like those empty rooms with no windows that we read about, but more often it is probably some transfer to some branch somewhere that nobody wants to go to.
Although the long-call nature of U.S. business can create problems, the short-put structure of Japanese employment can be troublesome too.

Anyway, enough of this. Things have probably changed a bit. The above problems usually manifested itself in low profits, low margins and low ROE in Japan, as businesses pursued market share at all costs, spent money building facilities for their employees, created companies where the main company can dump unnecessary workers etc.

But at least in the above table, we can see that ROE has been decent in these trading companies in the recent past.

BPS Growth
OK, so we see that the stocks are cheap on a P/B basis. If we are going to evaluate something on a P/B basis, unless we are expecting liquidation, we have to look at how BPS has grown. So here is a quick table that shows the BPS of these companies; most recent, 2015 and 2010 figures, so we can see how BPS has grown for these companies in the past 5 and 10 years. I also added stock prices for the same time frame so we can compare.

BPS Growth of Buffett's Shoshas

Itochu is pretty good; they have grown BPS 11.2%/year over the past decade and 5.5%/year over the past five. This may even be better than BRK! (I didn't look). Stock price returns are not bad either. The other ones? Not so impressive, but including dividends, most of them look decent on a 10-year BPS growth basis, actually. (Stock price change excludes dividends).
Anyway, moving on...

I will spend some time over the next few weeks reading the annual reports of these companies, so maybe I will post more about them if I find anything interesting.

But first, I took a quick look at Itochu. Itochu has been one of the top trading companies for years, and has a reputation of being a little more modern and 'hip' than some of the others which were part of a zaibatsu. Shosha as part of a zaibatsu makes you wonder where their real interests are; are they trying to make money for the shareholders? Or do they have a specific role to fill as part of the industrial group which would force them to do things that might not be economically rational? They also might seem a little more traditional / conventional, which is not a complement when it comes to Japanese business.
This is a great chart from the 2020 annual report. But this is illegible, so I cut it up below so you can see the tables below.

It's hard to see, but the below tables are what's at the bottom of the above table. They show the stock price and valuation of the stock every year from 2011 through 2020. And you can see that the stock has always been really cheap; single digit P/E's and trading at around BPS.

Despite this, their historical returns are pretty decent.

A cheap stock that has grown nicely over time is sort of a no-brainer, if you believe in the quality of the earnings and accounting values of book.

Trading companies are hard to analyze. I have spent time on them in the past, and they were usually just big, black boxes. They have evolved over the years from a purely import / export business to more of an investment business. A lot of investments, though, are related to their client businesses. For example, a company might buy a farm that produces products to export to Japan, or may invest in an oil field that will export oil to Japan etc.

There was a little block in the 2020 annual report explaining how they differ from private equity funds.

Here's another snip showing the ROE of Itochu going back to 2011. This is very unJapan-like, with double-digit ROEs for the whole period.

...and here's a nice snip showing labor productivity. But I am not so sure how relevant this is as they are investing more. Investments will increase profits and may not necessarily increase number of employees. Kind of like Berkshire Hathaway; not all employees are directly related to the revenues the holdings produce.

...and here is a snip of all the medium-term plan targets and results in the recent past. They have achieved most of their goals.

As Buffett explained about his IBM and Petrochina investments, he likes it when managements say they will do something and they accomplish it. IBM used to succeed in hitting all their goals too, which was one reason Buffett was attracted to the stock (which didn't work out in that case).

So Itochu looks very interesting. This doesn't count as much of an analysis, though, as you would have to go and dig into the balance sheet and see what's in there and how they're valued. Buffett said the accounting is good, but I think he means that many of these companies report under IFRS or GAAP standards and are audited by major accounting firms (well, this was true with GE and Enron too, not to say shosha are either of those).

Marubeni took a big writedown in 2020, so you never know when these things will happen. I don't think we have enough information to make our own estimate of what these things are worth. So you have to just look at and use what we have. And I guess that would be cash flows and dividends. You can't really fudge those.

This is kind of interesting, and as I said, I will spend some time looking at these companies. But I am not at this point jumping with excitement about buying these names. If any, Itochu is certainly interesting. The others? Not sure.

A lot of these companies talk about wanting to invest for the future, but you can't just wake up one day and decide that you are now suddenly a venture capitalist. Marubeni has a fixed amount they said they want to invest in new businesses, which is kind of frightening. When you say you want to invest X in a certain sector, it makes management want to fulfill that regardless of the opportunity. Why would you want to do that? Maybe 0 is the best course of action.
I probably told you guys about a supplier in Japan who told me that certain period-ends, they get a big influx of new orders. Why? Clients say they have money left over in their budgets and if they don't use them up, it will be cut next year. Nobody wants their budgets to be cut! Makes sense for the division, but a nightmare for shareholders!

Some of these annual reports eerily resemble Immelt's nonsensical ramblings about investing in the future and technology too. Scary.

Shosha investments in the past have been related to their clients; buying a factory that manufactured goods for them or a client, buying mines, oil fields, refiners, processors or farms that exported supplies to Japan etc. So there was this expertise and some proprietary knowledge behind those investments.

But venture capital? I'm not sure how that would work. It might work! But it might not. Who knows.

Anyway, I will probably follow up with more posts because this is sort of interesting.

Is Buffett Really Bearish?!

Date: 2020-08-20

So, with Buffett dumping airlines, JPM and not jumping into the markets in March, is he really all that bearish? His cash keeps piling up to the frustration of long time Buffett fans.

March Decline
First, I would have to say that the March decline was pretty quick. It crashed, and the market bounced back pretty quickly. Plus, what crashed are the stocks that are going to have a lot of problems. What rallied are beneficiaries. I would have loved to buy MSFT, GOOG, AMZN or whatever, but those didn't really tank all that much.
Plus, for a company like BRK, you would want to take advantage of any distress to get involved, but as Buffett said, with the stimulus package, the phone wasn't ringing all that much. There may be opportunities within each of the private holdings too, and we know there is a lot of pain in just about every wholly owned business at BRK.
Buffett Bearish?
A while back, I argued that this increase in cash does not necessarily reflect a bearish view on Buffett's part. OK, maybe it's not super-bullish. But it's not outright bearish, either.
First, I said the accumulated cash pretty much corresponds to the rise in float; since the mid-1990s, cash and fixed income investments always approximated the amount of float. Also, just because Buffett doesn't buy stocks doesn't mean BRK is not fully exposed; some of his former stock holdings are now wholly-owned subsidiaries. Just because they are no longer publicly listed equities doesn't mean we can't participate in intrinsic value growth of the business. We still own the equity. Same with outright purchases of other listed and unlisted businesses.
To show this, a while ago I posted how BRK is fully exposed despite the high cash balance. First, I added up the stock holdings, and then to that, I added the net worth of our subsidiaries; the railroads, utilities, and manufacturing, services and retail, and it all added up the the full value of BRK's shareholders' equity.
I showed that the high cash holdings of BRK is not a drag on future potential returns as it would be in a mutual fund. If a mutual fund had a high cash holding, yes, then it would lag in a bull market. Not so BRK.
Since manufacturing, services and retail is no longer itemized on the balance sheet, I can't do this, but if you net out the cash, cash equivalents and fixed income securities with float, you will see that what you have left is still equity ownership in the various businesses; the cash is not necessarily a drag on returns on this basis. Of course, if the cash was invested in higher returning securities, future returns would be higher.
But it's still fair to say BRK has 100% equity exposure.
Here are a couple of tables to illustrate this.

Liquid Assets = Float
First, check out the liquid assets (cash and cash equivalents plus fixed income investments) against float. This is just an approximation of float using the 2 or 3 items shown on the consolidated balance sheet so may not match what Buffett calls float, but it is close enough.

This ratio is on the far right of the below table labelled, "Liquid / float". Since 1999 or so, it's been remarkably stable at around 1. Someone asked about this at a recent annual meeting and Buffett said there is no relationship. It is a head-scratcher because it seems to match perfectly over time.

By the way, the cash and cash equivalents include only what is at the top of the balance sheet and excludes cash held in railroad / utilities (for simplicity, and most cash is in the insurance segment anyway).
Stocks to Total Shareholders Equity
Some insurance companies like MKL and Y use their equity portfolio to shareholders' equity ratio to show how much stock market exposure they have. This, for BRK, is in the column labelled "Stocks to sheq". It is amazing to think it was above 100% before the Gen Re merger. BRK back then was a leveraged play on Buffett's stock-picking skills, and any investment in bonds offered free incremental points on ROE above all that. No wonder why returns were so high back then.
Since then, the stock portfolio (including equity method investments) has averaged 52% of BRK's total shareholders equity. Despite the huge cash holdings, note that the year-end figure was 62%, and at the end of the 2Q2020, it was 56% despite the portfolio taking a big hit this year. This is higher than the 52% average since 1998. I use the average since 1998 because the beast was a different animal pre-Gen Re.

So, this piece of evidence doesn't really show any bearishness on Buffett's part, or at least compared to the last 20+ years.

BRK Balance Sheet Stuff

This next table shows some other ratios. Investment leverage is used by insurance companies too, total investments versus total shareholders equity. This is not really all that relevant for BRK because insurance is only one part of the business.
Investment Portfolio
But let's look at the portfolio in a conventional way. We will add the cash, cash equivalents and stock portfolio and see how that breaks down.
The column labelled "equity %" shows how many percent of total investments was invested in stocks (including equity method).
And, check it out! This also averaged 52% since 1998, and at year-end 2019, this was 65%, and was 58% at the end of 2Q2020.

Buffett bearish? Well, according to this piece of evidence, not really. Or, at least, not all that much more than in the past 20 years.

Maybe this is a little tautological but liquid assets as a percent of total investments is also below historicals, and also liquid assets vs. total shareholders equity is also lower: 51% average since 1998, but 34% and 41% at year-end 2019 and 2Q2020, respectively.

By the way, for those who say Buffett has lost his touch, what do we call AAPL? At $470/share, the gain to BRK on this buy is $83 billion! This is not how much it's worth now, but how much BRK has gained on the position of around 250 million shares. That's as much as the total shareholders equity BRK had as recently as 2004, and also as much as the gains on all of the other holdings as of the end of 2019 (so before the recent decline in most of these holdings).

This is the table from the annual report, excluding AAPL.

I admit I have been an AAPL naysayer for years. Part of this multiple expansion is probably due to a shift in the business model from a hardware, consumer electronics business to more services. I have no idea how this will pan out over the years, but I do notice more and more people living their lives in a very Apple-centric way.

People are frustrated that Buffett continues to accumulate cash. The cash just gets bigger and bigger and it makes Buffett seem more and more bearish. But as you can see from the above, the cash balance may grow, but so does BRK. So on a relative basis, the cash balance hasn't really been growing all that much. Judging from this analysis, you can't really conclude that Buffett is any more or less bearish than he has been in the last 20 years. But that won't stop people and the press from obsessing over this 'nominal' figure. Oh well...

Tsunami etc.

Date: 2020-08-19

Yes, it's a tsunami. Tsunami of liquidity. A fiscal tsunami. Both at the same time. People seem baffled at the strength of the stock market; they keep saying the market is 'divorced from economic reality' and things like that. Others say this is a big bubble waiting to implode.

I don't mean to argue that the market is always right or anything like that, but the market is reacting to some massive, massive stimulus and liquidity injection. Some of that is bound to leak into the stock market. As I said earlier about Covid-19, this is forcing governments around the world to try to offset the negative effects of the virus. And as usual, they are going to overdo it. And this, in turn, will lead potentially to a really massive bubble.

As of now, with S&P 500 forward P/E of 23, or whatever they say, it doesn't really seem all that bubblish. Too, the median P/E ratio of S&P 500 companies on a forward basis is around 18.5x vs. a 15.2x average since 1982, I think. So that is not that crazy looking either, given much lower interest rates now than most of this time period.
People say the S&P 500 forward P/E is as high as it was back in 1999/2000, but don't forget, interest rates were a lot higher back then. Also, the median P/E is much lower than that, which is again, just like 1999/2000. And if you remember 1999/2000, if you didn't own the bubble stocks, you actually did really well throughout the 2000-2002 bear market. It is very possible that this will happen again. Many of the frothy names can have large declines, maybe the S&P 500 index even goes down 50% or more, and people who didn't own the most expensive stocks might actually still do well. So, don't let people scare you out of the market with this talk of market P/E's. If you are happy with what you own and how they are valued, hold on and things should be fine (like it was in 1999/2000).

This rickety house can symbolize a highly levered equity fund vulnerable to a bear market, but when I saw this picture, the first thing I thought of was all the shorts being steam-rolled by this tsunami (or simultaneous tsunamis).

Greenblatt and Marks
Anyway, I wouldn't necessarily put this in a category of good news; some would say this is really bad news. But a recent Howard Marks note talked about all the reasons why current market valuations might be reasonable; that the current tech companies leading the market actually has really good, strong business models. Also, Joel Greenblatt was on Bloomberg TV the other day saying we are not in a bubble like 1999/2000 for the same reason; that the recent market leaders have real business models and are really good businesses that might actually deserve high valuations.
While not pointing to any individual names, I have been thinking the same thing over the years.

Buffett, Gold and JPM
So, as usual, the financial media is going crazy over the fact that Buffett bought ABX. Most of them didn't even mention that this could be a Ted or Todd pick and not a Buffett pick. Also, he dumped a bunch of JPM, which is actually kind of surprising. Not sure what is going on there. Maybe it's a valuation play as BAC is cheaper. I think Dimon is a much better CEO than Moynihan (who hasn't really been tested yet, whereas Dimon has been through many crises). Maybe BAC has a longer runway as Dimon has health issues. I don't know. Maybe he is a lot more worried about this pandemic than most of us.

Anyway, back to the market. So yes, it's kind of acting contrary to the expectations of many, but not really. If you look at the market leaders, they are really doing well earnings-wise. Sure, this may be a one-time bump for some of these names, but for the most part, Covid-19 is only accelerating what was going to happen anyway (move to cloud, retailers dying off etc...). So there is nothing wrong with being in companies who have been enjoying a tailwind for years and then suddenly gets a big gust from behind.

As for consumption, as Dimon said, some unemployed, I think he said 60%+, were making even more money from the $600/week assistance than they were making when employed. So that explains the consumption figures. Of course, this is not sustainable forever (new plan hasn't been passed yet as of now).

I have been spending more time recently looking at things to do due to the extraordinary nature of the what is happening, but I have to say nothing is really jumping out at me.

I am tempted, of course, to jump into airlines, hotels, real estate, energy, anything travel-related and some other areas hit hard, but nothing is really jumping out at me. If you like any of these businesses and believe in them for the long term and are fairly sure they will survive this crisis without too much dilution, then it's a great idea to buy.

But the problem is that most of the above businesses are not in areas I would have been interested in pre-crisis. So if I got into any of them now, they would just be 'trades'. I would get in, hold until normalization, and then get out. They would not be situations where I would want to buy and hold forever. So that makes me a little hesitant.
Election Stuff
There is a lot of uncertainty about the elections. But as usual, I would say, look back at all the other times we were worried about something. We should never forget 2016 election day. What about the fiscal cliff? All sorts of problems, uncertainties over the years.
So, as usual, I would just say ignore it all. I don't want to talk about politics here as there is plenty of other places to talk about it, and I don't think I have anything to add to what everybody is saying anyway.
But I would say that whatever people worry about, I wouldn't worry too much about it. Whether it's pharmaceutical stocks when Clinton got elected, insurance companies with Obama, financial stocks when Elizabeth Warren was looking good etc. Whenever you have big moves on those worries, as traders, it's actually probably a good idea to trade against it.

I am reading this new book about GE, Lights Out, and it is terrifying. I'm only 1/3 way through it but it sort of confirms what we suspected all along, but at least for me, it's a lot worse than I thought.

If you always wondered why Buffett always spoke so highly of Immelt and GE but never bought stock (other than emergency financial crisis financing), this would help explain it. I've always wanted to love GE, and it was always on my to-do list to do a detailed analysis of GE and even buy some shares at some point, but it never got to that point because of Immelt. He came across to me as this rah-rah cheerleading type; the kind of manager I would not want to put money with. And his denials and lies throughout the crisis was worrisome too (I didn't realize how much he was lying, though...)

And Immelt apparently still blames Welch, but jeez, the guy ran the place (into the ground) over 16 years; that's enough time to fix things, and many of the big moves / mistakes were his own. It's like a 40 year old man blaming his parents for his behavior.

I am still looking at it and wanting to jump in, but it is quite scary.

Long Book Excerpt
So, during this pandemic, I have been reading a lot as usual, and I started reading an old book that I am embarrassed to say I've never read before.

Paths to Wealth Through Common Stocks

This is a Philip Fisher book. I think Philip Fisher is sort of underrated compared to Benjamin Graham. Everyone (including me) always talks about Security Analysis and Intelligent Investor, but not everyone talks about Common Stocks and Uncommon Profits or this book.

That's probably for a good reason. First of all, Graham was the first in setting the ground rules of value investing so comprehensively. But on the other hand, I feel that Fisher has had more of an impact on Buffett (and he admits it) than even many Buffett followers realize. Buffett is still referred to as a 'value' investor, and 'value' is still viewed as things with low P/E ratios and P/B ratios. But Buffett has for decades been saying that he would much rather pay a fair price for a decent business than a good price for a mediocre business (OK, I totally butchered that one, but I'm a little rusty, you see...).

Anyway, I was reading it and this whole section made me jump out of my seat as I immediately thought of quite a few people I would need to send this book to:

The Economists Go out -- The Psychologists Come In
I have already commented on the strange tendency of the supposedly forward-looking financial community so often to fail to recognize a changed set of circumstances until the new influence has been in existence for years. I believe this is why the man who attempted to forecast the course of general business was regarded as so important a factor in the making of investment decisions during all of the 1940's and much of the 1950's. Even today, a surprising number of both investors and professional investment men still believe that the heart of a wise investment policy is to obtain the best business forecast you can. If the outlook is one of expanding business, then buy. If the outlook is for a decline, sell.

Many years ago there was probably considerably more merit to such a policy than there could possibly be today. The banking structure was weaker. There was no assurance it would be shored up by the government in times of real trouble -- a process bound to produce a massive dose of inflation. There was no tax system of a type that can hardly fail to produce strong inflationary spending whenever business (and therefore federal tax revenues) are at abnormally low levels. No public opinion had crystallized to assure that whenever business levels dipped sharply, the government would take strong countermeasures to stem the tide. Finally, the industrial base was much more narrow. The large number of industries in today's complex economy that bear little relationship to each other in their basic characteristics probably assures that even without the actions of government, modern business recession would be somewhat less severe than its former counterpart. Some industries would be enjoying unusual background conditions enabling them to expand, while the majority might be in a declining phase. This tends somewhat to stabilize the economy as a whole.

All this means that a depression is of less significance to the investor than it was many years ago. It does not mean knowing what business is going to do would not be quite useful information to have. But having such information is not vital for obtaining magnificent results from common stock investments. Simple arithmetic should show this. When a stock market decline coincides with a fairly sizable economic slump as happened in 1937 to 1938 or 1957 to 1958, most stocks sell off from 35 to 50 percent. The better ones then recover when the slump ends and usually go on to new high levels. Even in the greatest slump of all time, only a small percentage of all companies failed, that is, went down 100 per cent. Most of these companies were companies which had had fantastic amounts of debt and senior securities placed ahead of their common. After one of the wildest speculative booms ever known, much of it financed by borrowed money, the average stock slumped 80 or 90 per cent. In contrast, when stocks rise over a period of years, even the most casual study of stock market history shows many figures of a very much greater order of magnitude. Compared to the temporary declines, usually of 35 to 50 per cent, that frequently accompany depressions, the outstanding stocks (those of the unusually well-run companies that have maneuvered themselves into growth fields) go up several hundred per cent, stay at these levels, and then go still higher. Many can be found for which a decade's progress can be measured in multiples of 1000 per cent rather than 100 per cent.

From the standpoint of obtaining results, I have noticed that investors who place heavy emphasis on economic forecasts in the making of investment decisions usually fall into one of two main groups. Those who are inclined to be cautious by nature can nearly always find an impressive sounding forecast that for quite plausible and persuasive reasons makes it appear that important economic difficulties lie ahead for the business community. Therefore, they seldom take advantage of opportunities when they present themselves and, on balance, these missed opportunities mean the economic forecasts have done them considerable harm. The other group are the perpetual optimists who can always find a favorable forecast to satisfy them. Since they always decide to go ahead with whatever action they are considering, it is hard to see how all the time they spend on business forecasting does much good.

More and more investors are coming to recognize the wisdom of making their decisions about common stocks largely on the basis of such outright business factors as appraisal of the quality of the management and the growth potential of the individual company's product line. These things both can be measured with a fair degree of preciseness and have a far greater influence on how good a long-range investment will be...

This book was published in 1960, and it is amazing as it still applies to this day; there are still people who think that predicting the economy accurately will lead to superior investment results.

Anyway, this is a fascinating time to be living in. This pandemic is really terrible and I hope we at least find some sort of treatment to take death off the table. I feel this is the key to normalization rather than vaccines. Of course, a vaccine would be great, but it is probably unrealistic to expect one to come within a year. If we can figure out how to treat the worst cases, and this treatment becomes widely available, this would sort of turn Covid-19 into something like the flu.

But who knows, really.

As for stocks, there is certainly a lot of trading opportunities, but for us long term investors, I would stick to things that have secular growth potential. I don't really feel that excited about buying the dip on something in a long term downtrend. Not to say those can't be great trades. I would rather buy the dip on things in long term uptrends. If things are in secular downtrends but got a bump up due to this, then that's probably a great time to sell.

As for the market, it may seem like it's crazy, but keep in mind the amount of stimulus and liquidity injected into the system. It's not just lower interest rates. Also, people keep talking about overoptimism about the virus, but if you look at hotels, airlines etc., the market is clearly not all that optimistic about anything returning to normal any time soon.

Also, keep in mind that a lot of the big winners this year are making a lot of money; revenues are growing at incredible rates, profits etc. Other than the cloud players, look at COST, WMT, TGT etc. What is happening is that the smaller operators are suffering. Fast food is taking share away from the independent restaurants. As those are closed, if you want to eat out, you have fewer choices so you end up at CMG or QSR (Popeye's). A lot of the eating out money is moving to eating at home (groceries, again, COST, WMT, TGT etc...).
If airline and hotel stocks were making new highs, then I would think the market is nuts. But that's not what's happening. You have to sort of look under the hood to see what's going on, but of course, that's too much work for most! I get it.

Also, a lot of the revenues / profits that were not listed (small, mom-and-pop restaurants / stores) are moving to listed companies; as independents go under, the only ones left standing are the big ones, and often those are listed companies.

So there is a lot about this market that does make sense. This is not to say the market is always right, or that the valuations of each of these businesses at this point is correct. I am just pointing out that it may not be as crazy as some suggest. Airlines and hotels, REITS are down, and they are down big. Cloud players, stay-at-home beneficiaries are up big. What is so crazy about that? I don't know.

Also, I think there has been a lot of tech adoption from the never-adopters. I see all these posts about kids teaching their grandparents how to use a tablet, how to get on a Zoom call with family, how to chat on FB, Line, or how to use email. People (many of them seniors) who only used land-line phones and didn't know how to turn on their TV (well, I have trouble with that too with so many remotes and buttons...) are chatting with their kids / grandkids on Skype on their tablets. They are learning how to order things online.

A lot of this will be permanent. When things clear, many of these newbies will keep using their new devices and will continue to shop in their new ways. Not all of them, of course, and maybe not as often as right now. But this has caused an increase in this market for sure.
As for all the talk about how things will never go back to the way it was, that people will never go to conventions ever again, and that client visits will never happen again as Zoom calls work just as well, and offices will decline as people get used to working from home, I think, is rubbish. People always extrapolate what they see. Sure, it may take some time to get back to normal, but things will get back to normal, eventually.
Surely there will be some permanent changes for the better, utilizing things we have learned during this time, and that's great. But I wouldn't expect a lot of this stuff to be permanent by any means.


Date: 2020-05-20

It's been quite a few weeks since my last post. I haven't really changed my thoughts since then, but maybe the economic impact of this will have more than a blip on the long term charts after all.

So far, the economy seems to be doing much worse (or will soon) than the stock market. The initial decline was shocking, but not at all unexpected. The recovery rally is kind of incredible too.

As I watch all these commentators, I realize nobody really has any idea. The commentators / pundits that survive a long time are masters at saying things that will make them look 'correct' in hindsight later on. You make enough calls and predictions, you will at least be able to pick one and say you were right. Also, they are very careful to word their comments so that they can't be called out for being wrong. 'If this happens, then this will happen, if that happens, then that might happen...' etc. You say enough of that, and you will be right about something, eventually... It's kind of a joke, but whatever.

Buffett and Airlines
A lot of things have happened since my last post, including the virtual BRK annual meeting. Nothing really new or unexpected, as usual, but one thing that may have shocked people was how Buffett dumped all his airline stocks. We are supposed to be long term investors, and are not supposed to be reacting to headlines, however scary.

But if you look at their income statements and realize that their revenues are down 90% and may be down for a year or more, it's hard to imagine them surviving. Most of them will be out of business by the end of the year or long before that. The government will have to bail them out, but that will be costly. Either they will have to take on a lot of debt that will take years to pay off, or they will have to issue a lot of equity, basically wiping out current shareholders.

Many businesses will not survive this, and even if they do, there will be big losses to equity investors.

A lot of restaurants will go out of business too, but mostly the independent ones. Major chains, especially fast food and fast casual should be fine.

Retailers are out too, for the most part. A lot of retailers should probably not even exist, and this pandemic is just accelerating what is going to happen anyway. The Micrsoft CEO, Nadella, said that there was two years worth of virtualization in two months since the pandemic. I think that's the case with retailers. This will just accelerate the demise of retailers with flawed (or out of date) business models.

No Bargains?
One thing Buffett said was that he didn't really see any bargains during the decline in March. We know from the 2008-2009 crisis that Buffett is not really a trader, so he is not going to be buying the lows on big down days, necessarily. So on fast declines with quick rebounds, he is not going to get much done.

If you look at what's going on, the stocks that were really hit are the ones that you don't really want to own, necessarily. Airlines, real estate, retail, travel-related stocks etc. And the ones you want to own didn't really get cheap. I can see Buffett piling into things like Amazon or Google if they were dumped with the bath water, but they weren't, really. Neither was Microsoft. Not sure what he thinks of Netflix, but that wasn't dumped either.

So crappy stocks got cheap, but as Buffett said, the way to succeed in the stock market (or at least not lose money) is "don't buy crummy businesses". And there are a lot of them out there now.

People also view Buffett as being 'bearish' because he sold stocks, and he is still sitting on a growing cash balance. He did mention during the meeting that he has a lot of cash, but he has a lot of equity exposure too. I wrote about it a while back, but his equity exposure is not limited to his listed equity portfolio. Kraft is not included in his list of stock holdings, but he still owns it. Same with Burlington Northern, and his many other operating companies (some of which were listed until recently). If you add it all up, BRK is still fully exposed and is not as conservative as it seems if one were to look only at his listed equity portfolio and cash balance.

Which leads to the next thing being talked about a lot these days (as it has been for the last few years).

Value Investing is Dead?
One thing people need to keep in mind about value investing is that the way the general press talks about it and the way investors talk about it are completely different. The press just looks at nominal valuation and that's it. There is no concept of what something should be worth, and whether it is trading above or below that. They don't understand the concept of intrinsic value. Indexes split between growth and value don't help either.

Value investing used to be about low P/E's and things like that, I suppose, but the more modern approach is what something is trading at versus intrinsic value. This is not that modern, actually, as Buffett has been saying that for many decades.

Here is something from the second edition of Graham's Securities Analysis. This is in the section where he discusses the difference between investment and speculation.

It may be helpful to elaborate our definition from a somewhat different angle, which will stress the fact that investment must always consider the price as well as the quality of the security. Strictly speaking, there can be no such thing as an investment issue in the absolute sense, i.e., implying that it remains an investment regardless of price. In the case of high-grade bonds, this point may not be important, for it is rare that their prices are so inflated as to introduce serious risk of loss of principal. But in the common-stock field this risk may frequently be created by an undue advance in priceso much so, indeed, that in our opinion the great majority of common stocks of strong companies must be considered speculative during most of the time, simply because their price is too high to warrant safety of principal in any intelligible sense of the phrase. We must warn the reader that prevailing Wall Street opinion does not agree with us on this point; and he must make up his own mind which of us is wrong.
Nevertheless, we shall embody our principle in the following additional criterion of investment:
An investment operation is one that can be justified on both qualitative and quantitative grounds

I would look at the opposite of this example and say that many cheap stocks may not necessarily be safe. Would you buy junk bonds just on yield? Nope. Someone showed me years ago a quantitative report basically showing that the valuation of a stock is pretty much determined by it's credit quality (I don't know if there was an adjustment for long-term growth or returns on capital), but it made sense to me. The industrial cyclicals were always 'cheap', like steel, auto manufacturing etc. And consumer stocks were always expensive.

Anyway, today, I think a lot of this gap between value and growth just may be reflecting huge secular changes in the economy. You can say AMZN is overpriced and BBBY is cheap. But really, who would short AMZN and go long BBBY?

MKL Dumping Stocks
On the 1Q earnings call, MKL said they dumped a few stocks they thought would be hugely affected by Covid-19. Here are the stocks they dumped:

Anheuser-Busch Inbev ADR 00.00%13,000-13,000-100%
CDK Global Inc 00.00%176,897-176,897-100%
Discovery Communications 00.00%117,000-117,000-100%
Dollar Tree Inc 00.00%123,100-123,100-100%
Hasbro, Inc 00.00%364,000-364,000-100%
Kraft Heinz Co 00.00%68,000-68,000-100%
Rockwell Automation Inc 00.00%140,100-140,100-100%
Scotts Miracle-Gro Co 00.00%422,000-422,000-100%
Unilever PLC ADR 00.00%1,527,600-1,527,600-100%
United Health Group Inc 00.00%599,000-599,000-100%

This is as of end the March, and they may have dumped more things in April. Buffett dumped airline stocks in April, so that dumpage doesn't show up on his 13-F, which is here, by the way:


Filing Date: 2020-05-15

Namedollar amt%port#shareschange%chg
APPLE INC 62,340,60935.52%245,155,566

BANK AMER CORP 19,637,93211.19%925,008,600

COCA COLA CO 17,700,00110.09%400,000,000

AMERICAN EXPRESS CO 12,979,3917.40%151,610,700

WELLS FARGO & CO NEW 9,276,2105.29%323,212,918

KRAFT HEINZ CO 8,056,2054.59%325,634,818

MOODYS CORP 5,217,6582.97%24,669,778

JPMORGAN CHASE & CO 5,196,0302.96%57,714,433-1,800,499-3%
US BANCORP DEL 4,563,2332.60%132,459,618

DAVITA HEALTHCARE PARTNERS I 2,897,5491.65%38,095,570-470,000-1%
BANK OF NEW YORK MELLON CORP 2,686,4871.53%79,765,057

CHARTER COMMUNICATIONS INC N 2,367,6841.35%5,426,609

VERISIGN INC 2,307,9641.32%12,815,613-137,132-1%
DELTA AIR LINES INC DEL 2,050,9351.17%71,886,963976,5071%
SOUTHWEST AIRLS CO 1,910,2181.09%53,642,713-6,5000%
VISA INC 1,701,8230.97%10,562,460

GENERAL MTRS CO 1,551,8720.88%74,681,000-319,0000%
LIBERTY MEDIA CORP DELAWARE 1,446,4330.82%45,711,345-240,000-1%
COSTCO WHSL CORP NEW 1,235,5720.70%4,333,363

MASTERCARD INC 1,192,0400.68%4,934,756

AMAZON COM INC 1,039,7860.59%533,300-4,000-1%
PNC FINL SVCS GROUP INC 880,4310.50%9,197,984526,9306%
UNITED CONTL HLDGS INC 699,0730.40%22,157,608218,9661%
SIRIUS XM HLDGS INC 654,1490.37%132,418,729-3,857,000-3%
KROGER CO 570,4750.33%18,940,079

M & T BK CORP 556,6650.32%5,382,040

AMERICAN AIRLS GROUP INC 510,8710.29%41,909,000-591,000-1%
GLOBE LIFE INC 457,2780.26%6,353,727

LIBERTY GLOBAL PLC 434,2290.25%26,656,968-481,000-2%
AXALTA COATING SYS LTD 415,6890.24%24,070,000-194,000-1%
TEVA PHARMACEUTICAL INDS LTD 384,2480.22%42,789,295-460,000-1%
RESTAURANT BRANDS INTL INC 337,7820.19%8,438,225

STORE CAP CORP 337,4250.19%18,621,674

SYNCHRONY FINL 323,8600.18%20,128,000-675,000-3%
STONECO LTD 308,4100.18%14,166,748

GOLDMAN SACHS GROUP INC 296,8410.17%1,920,180-10,084,571-84%
SUNCOR ENERGY INC NEW 236,1950.13%14,949,031-70,0000%
OCCIDENTAL PETE CORP 219,2450.12%18,933,054

BIOGEN INC 203,4400.12%643,022-5,425-1%
RH 171,6380.10%1,708,348

JOHNSON & JOHNSON 42,8930.02%327,100

PROCTER & GAMBLE CO 34,6940.02%315,400

MONDELEZ INTL INC 28,9460.02%578,000

VANGUARD INDEX FDS 10,1830.01%43,000

SPDR S&P 500 ETF TR 10,1550.01%39,400


PHILLIPS 66 00.00%227,436-227,436-100%
TRAVELERS COMPANIES INC 00.00%312,379-312,379-100%

Insurance Companies
By the way, insurance companies are going to hurt for a while. People keep saying that business disruption doesn't cover pandemics, or that it requires physical damage etc. But the way things work in this country, that doesn't matter. We have enough lawyers with a poorly structured incentive system so insurance companies can get bogged down in years and years of lawsuits. Even if insurance companies win, who knows how much all of that is going to cost.

Plus, interest rates are now 0% all the way out to 5 years, and 1% to 20 years. That's going to be painful, and makes BRK's float basically worthless. Yes, this may be temporary, but we have been saying that for more than 10 years now. I have always suspected we will follow Japan in terms of interest rates. I didn't expect a pandemic to cause rates to go to zero, though.

I still think BRK, MKL and others are great investments for the long haul, but there are serious issues for them out there for sure.

JPM and other banks are going to take some huge credit losses. There is no way around that. One rule of thumb is that credit card losses will follow the unemployment rate. Unemployment got up to 10% during the financial crisis, and sure enough, JPM's credit card charge-offs peaked at 10% or so. Total charge offs were 5%, I think, back then.

Unemployment is now over 15%, and headed to 20%. JPM has $160 billion in credit card loans, so credit card charge-offs can get over $30 billion. Total credit losses may get to 10% and they have around $1 trillion in loans outstanding. Who knows, really.

JPM is still the best managed big bank and they will get through this for sure, but they face some very serious problems. I think the view expressed during the 1Q conference call (expecting rebound in second half of the year) is way too optimistic.

Even if we start to reopen the economy, we can't really have a real recovery as a lot of events won't come back, and restaurant / bars / retailers will run at 30-50% capacity.

An interesting thing to look at is Sweden. They didn't have a hard lockdown like the U.S. and European countries, but their economy is taking a hit anyway. Reopening the economy doesn't mean we are all going to go back to the way we were right away. Many people tell me that they won't change anything even if the economy reopens until they get a vaccine. This could be years away.

I tend to believe things will normalize when we get a treatment that makes Covid-19 far less fatal. If we take that off the table, people will start to get back to normal.

I have no idea about these things, but I tend to think the odds of us finding a treatment is far higher than us finding a vaccine (there is a chance we may never find a vaccine).

Anyway, the mitigating factor to the above bank credit disaster is the amount of money being injected into the economy. I don't know if people are going to use their stimulus / Covid-19 help checks to pay off their credit card (they seem not to be paying their rent), but it will have some positive impact on bank credit, I assume (and hope). Well, but don't assume because...

Is the Market Being Rational?
So, people are saying that the market is being too optimistic about a return to normal, but it's hard to tell. The market is full of stocks with different exposure. If the airline stocks got back to their highs, I would agree that the market is being too optimistic. But that hasn't happened; not even close. Same with retailers. And restaurant stocks. OK, Amazon, Netflix, and others are going to new highs, but I doubt that is reflective of the market's optimism about a return to normal.

So when the markets move, I think we have to look by sector, and by stock, to see what they're expecting. It makes no sense to look at the index itself.

What to do?
When this started, I told people the same thing I always told them. Ignore the headlines and just think 3-5 years ahead. This works, though, for people with diversified portfolios. I wouldn't know what to say if they owned a lot of airlines, hotel and other travel related businesses, or other areas that may not recover so quickly. I have no idea.

I haven't owned any retail stocks in a long time (except BRK, which is the closest thing to a retailer I own), and the only restaurant stocks I own are CMG, QSR and SHAK. Well, SHAK was never cheap so it's a token position that is not significant; it's more of a moral support, I like this company, kind of position. CMG was a large position that I scaled back and had to do again as it went over $1,000. It's not a cheap stock, and I have no idea why it's above $1,000; maybe they are going to take market share after many of their competitors go out of business within a few months). Oops, after writing this, I just realized I do own Costco. So I lied. I own Costco and have no problem with it. I will hold on to it. Yes, it's expensive, but I really like the business for all the reasons we've all heard already a gazillion times.

If you own the S&P 500 index, it doesn't really matter. Many companies will go bust, but that happens all the time. Some big banks, AIG and FNM went bust (or was massively diluted) during the financial crisis and yet the S&P 500 index was fine. It should be fine over the long term this time too, but many of the components won't be.

As usual, just don't invest based on the headlines. OK, evaluating your holdings on long term potential incorporating Covid-19 might not be a bad idea (like Buffett's dumping of airlines), but I would be careful about that too.

One thing is for sure. You really don't want to go chase Covid-19 stocks. You can buy AMZN, NFLX, MSFT thinking these are the pandemic-proof stocks, but the worst time to buy stocks is when everyone piles into them for the same reason (I wouldn't short them either!). For example, I wouldn't touch Zoom stock, of course.

Things are Interesting
I have to admit I have sort of been lazy about my investments over the past few years, kind of just let it go... Looking for things to do wasn't all that interesting as things got expensive.

But things are getting interesting again. I haven't read through so many conference calls and 10-Q's in a long time, and it's been fun. I have to say, though, that the 10-Q's only reflect a small portion of what's happening as the 1Q included the relatively healthy January and February. NYC shut down in mid-March. So there was only 2 weeks of really bad data included in 1Q. The 2Q reports are going to be really scary, but I can't wait to sift through that stuff.

Maybe this will lead to more blog posts. That would be fun, as I do enjoy this process. Until now, though, things are more interesting, but nothing really stands out to me. The really devastated industries are just 'too hard' for now, like cruise lines, airlines, casinos, and the solid businesses that you want to own are not cheap (AMZN, MSFT, COST etc...).

So to those who feel that ETFs and the indexing bubble has lead to a lack of differentiation in the evaluation of individual stocks, it is quite obvious that this is not the case at all. I've always maintained that this is not the case. Sure, there may be excess valuation in some large cap index stocks where index funds are 'forced' to buy regardless. I think overall, crummy stocks are cheap and higher quality stocks are expensive.

OK, banks and insurance companies are cheap now, and not all of them are crummy. But there are massive uncertainties they are facing now. The market is probably wrong and these stocks are probably too cheap.

Who Cares What Mr. Market Thinks!

Date: 2020-03-02

So, the market has gone crazy. People ask me about the market and the impact of the COVID-19 and I keep saying it doesn't matter. But with the market acting like this, it's hard for people to agree with me. The markets make the news, the market creates the sentiment etc. and I can't fight that. That's OK, as it doesn't really matter to me.

But I had a really interesting conversation recently, and I did some illustrative work and thought it was interesting so decided to make a post about it.

Every time people worry about these things, whether it's a trade war, Brexit, 9/11, fiscal cliff, coming recession/depression, war or whatever, I say the same thing. If something is not going to have a long term impact on the intrinsic value of businesses, it doesn't matter.

If you own a restaurant on a beach and the weather forecast shows a hurricane approaching, are you going to rush to sell the restaurant before the hurricane hits? Are you going to lower the selling price because you know the hurricane is going to hit and you are going to lose a few days or possibly weeks of business? Of course not! So why would you do the same with stocks?

I think most will agree that COVID-19 is temporary. We just don't know how bad it's going to get before we get it under control (I still think there is way more COVID-19 even here in NYC than anyone thinks, because frankly, people are just not being tested. Plus I don't think the government is going to be truthful about this; I was living in Battery Park City during and after 9/11 and the EPA lied to us about the safety of the air. Christy Whitman admitted she lied to us about the safety of the air (she denies knowing the truth at the time, but I don't believe that at all). Forgot who, but someone said that the government had to balance the risk of causing a panic and the abandonment of downtown NYC (to the detriment of real estate prices downtown) with the 'minor' risk of people getting sick from inhaling toxic fumes. This is especially true when the known risks were also known to be far off into the future, long after elected politicians are out of office (so won't need to take any of the heat). So this was not really about public safety but more about social control. Not that different from China, are we?)

But in my recent discussion, I had trouble getting across that the intrinsic value of the restaurant is not going to be impacted by the coming hurricane. Yes, they will lose business, and will probably have to repair some damage (even though that should be insured). Of course, in the hurricane example, there is a possibility that it wipes out the whole beachside town and it takes years to rebuild. But most market exogenous events in the past ten or twenty years weren't of the magnitude to destroy everything (in aggregate) for years.

Current P/E
So when I say it doesn't matter about COVID-19, I don't mean to say there will be no impact. I just mean that there is no impact on the intrinsic value of businesses in general 5, 10 or 20 years out.

If people value stocks on current P/E ratios, then yes, there will be an impact on stock prices. If you value a stock at 10x P/E and think it's going to earn $1 this year, but COVID-19 will cause it to earn $0.50 instead, then you might think the stock is only worth $5.00 instead of $10.00. But if you think this dip in earnings is temporary, you would still think the stock is worth $10.00.

P/E ratios are just a short-cut to calculating future discounted cash flows, so it sort of makes no sense to price a stock on current year estimates if there is a one-time factor involved.

Intrinsic Value
So this is the part I had a hard time describing. I guess non-financial people (unfortunately including many in the financial press) have a hard time grasping the idea that intrinsic value of a business is the discounted present value of all future cash flows. This person argued that the market looks only at earnings over the next year or two, but not fifty years out. Yes, this is true. But intrinsic value has nothing to do with what the market is looking at. Intrinsic value is a mathematical truth as long as the inputs are correct (or reasonable enough). Intrinsic value is 100% independent of Mr. Market's opinion. Well, Mr. Market does set the discount rate to some extent.

When people slap a P/E ratio on a stock, they are basically discounting all future cash flows back into the price of the stock; they may just not know it or understand it. The P/E ratio is just a shortcut valuation method.

If you value a stock at 10x earnings, you are basically pricing in a 10% earnings yield going out into perpetuity.

So first of all, we have to understand that regardless of what the 'market' is looking at, or what the pundits say on TV, a business is simply worth the present value of all future cash flows. We can argue whether that's earnings, dividends, free cash flows or whatever. But the idea remains the same.

Here's the thing I did to try to illustrate how non-eventful recessions and exogenous events are to the intrinsic value of businesses in general (but alas, this illustration failed to get the point across in this case even though the person is a highly trained engineer! No wonder why Mr. Market is so irrational!).

Simple Model
So, here's the illustrative model. Let's say the market has an EPS of $10/year, and the discount rate is 4%. In this table, I just took the earnings for the next 10 years and discounted it back to the present at 4%, and then added a residual value at year 10 based on a 25x P/E ratio (or 4% discount rate), and discounted that back to the present and added them together. Of course, this would give the market a present value of 250.

I think most of you have no problem with any of this. For illustrative purposes, the details don't really matter, and I have no earnings growth built in here either.

Now, let's say COVID-19 causes the global economy to stop for 3 months, and companies earn no money at all for three months. Of course, many businesses will lose money (retailers, hotels, airlines), but others will continue at a lower rate but may not lose money in aggregate. Remember, the S&P 500 (and predecessors) has shown a profit every single year since the 1800s, and that includes the great depression, world wars, great recession etc. So this is not a stretch.

Plugging in $7.50 for year one earnings instead of $10.00 would negatively impact intrinsic value of the market for sure. There is no doubt about it.

Let's quantify that. I copied the above table into another one so we can look at it side-by-side.

If the above scenario holds, the intrinsic value of the market would go down less than 1%.

First Year Earnings $7.50 Instead of $10.00

Way too optimistic you say? OK, so let's say the S&P companies make no money for six whole months. What does that do to intrinsic value?

Let's take a look!

First Year Earnings $5.00 Instead of $10.00

This scenario would dent intrinsic value by less than 2%.

OK, screw that. Too optimistic. Let's say that the economy is wiped out for a whole year, and the S&P companies make no money for a whole year. Remember, this didn't happen even during the great depression or great recession (or during the 1918 flu etc.).

First Year Earnings $0.00 Instead of $10.00

Still too optimistic? OK. Zero earnings for two years, then.

Zero Earnings for First Two Years

Ah, now we are starting to hurt the market. With zero earnings for the first two years, intrinsic value is knocked down by 7.5%. Ouch. That hurts.

Here are some more:

Zero Earnings for First Three Years

Zero Earnings for First Four Years

So, with the market down more than 12%, it is like the market is discounting no earnings for the next four years! Nuts!
When the pundits say that the market is or isn't done discounting the risk of COVID-19 or a coming recession, you can see how that sort of comment is total nonsense. It is based on Keynes' beauty contest. They are just saying that people didn't expect a recession or negative event earlier this year, and now these things are here so the market therefore must go lower as the market lowers their expectations.

But this has nothing, really, to do with intrinsic value or expectations thereof. It is just based on pundits guessing what Mr. Market would do based on the headlines.

Of course, I would be the first to admit that if an event did occur that would cause the S&P500 companies to not earn any money for a whole year, two years or three years, it would cause a drop in the market far in excess of the decline in intrinsic value. That would have to be quite a scary event!

Again, this is just a simple illustrative model. There are other reasons why the market can be down. The market may simply have been overly optimistic / overvalued, and this has triggered a 'normalization' of valuations. Maybe the market needs to increase the discount rate to account for the increasing risks that were not considered in the past. Maybe this will actually cause some sort of permanent reduction in the profitability of corporations in general going forward.

But remember, we all had the same thoughts every time something happens. We all see some permanent negative change that explains a lower stock market. For example, after 9/11, the thought was that the world would never be the same, and that increased security measures will permanently reduce global growth potential and profitability.

Again, the market makes the news, and the market creates the explanations, not the other way around. We all try to model the facts to explain what is going on in the market to maintain the two illusions that 1. the market is always right, and 2. that we know what's going on. We wrap the market volatility tightly into these rational-sounding wrappers, pleased at having figured it out, secure in the knowledge that we know what's going on.

OK, so I lied. The above tables clearly show that there is a negative impact on intrinsic value by even temporary business interruptions. But the magnitude is not nearly as much as the market usually moves.

Index arbitrage traders make money because the futures contract fluctuates much more widely than the fair value of the contract. Debt / credit traders make money because credit spreads fluctuate (or at least used to) much more widely than the credit quality of companies. And value investors make money because stock prices fluctuate much more widely than intrinsic value of the underlying businesses.

Of course, I am not calling a bottom in the market, or trying to say that markets won't or shouldn't fluctuate based on the headlines. We can be pretty sure there will be more wild days to come. Markets can be up or down 1000, 2000 points on news. I still expect photos of empty streets in NYC at some point before this is over with the market down a lot on those images. NYC is only starting to test this week, so when more cases are found, subways will be empty too, and of course the market will be down on that.

But I have no idea, actually. It's sort of what I expect (and have been expecting since early February).

On the other hand, check out the VIX index. In my trader days, this was my favorite indicator. As Munger says, always invert. You don't usually make money being short in a market with the VIX at a high level, and it's as high as it's been in the past few decades. This is no guarantee that the market can't go lower, of course.

But anyway, who cares what Mr. Market thinks!

Coronavirus, Munger etc.

Date: 2020-02-14

Munger is looking and sounding great at the DJ annual meeting (I wasn't there; just watched the video). His 'wretched excess' seems to be more about private equity and venture capital than the public stock market. In fact, he said that tech stocks now are not like the Nifty Fifty stocks (he mentioned Home Sewing (?) trading for 50x earnings, and said that the current big tech companies are better businesses).

Munger also said he would never buy or short TSLA. As I wrote in a response somewhere on this blog, I can't believe how many people got caught in a short squeeze on this stock. If people don't care about the valuation of a company, then obviously, a really expensive stock can get much more expensive. Trying to short that is like trying to short soybeans during a drought. You know with 100% confidence that the price will mean revert at some point, but there is no way to tell when it will revert and how high it can get before reverting. I saw this in Japan in the 1980s, in the U.S. in the late 1990s etc.

I've said this here many times before, but for the stock market to be in a real bubble, at these interest rates, the P/E ratio would have to get up to 50x or some such. Who knows, this might even happen. One of the greatest traders of all time recently said that this might happen; the NASDAQ could double from here if we have another late 1990s-type bubble, which is possible with the current, ongoing massive stimulation combining low rates and huge budget deficits. How can this massive stimulation on a historical scale not be matched by an equivalently massive bubble?

Of course, I would not invest with that expectation, but if it happened, it would not surprise me at all. Remember, from my previous analysis, I would find it completely normal and not at all out of line if the market P/E averaged 25x over the next 10 years... and that may include times the market trades at 50x P/E, and times it trades at 10x P/E. But we just can't know when these levels are reached; only that it is probable that they will be reached.

Again, this is not my prediction at all; I would not invest expecting such an outcome. I am just making a single statement that seems reasonable from the data I've seen.

The market seems to fluctuate with each breaking news about the coronavirus, but I view it as a non-event. As value investors, we care about what a business is going to be worth five, ten years out, so it doesn't matter how bad this coronavirus gets. Well, unless it gets really, really bad. I didn't take any action, but my instinct during SARS was to just buy all the Asian stocks that were hit hard, especially airlines (Cathay etc.).

I feel the same way now. If the market tanks further on coronavirus (well, I know we are at highs recently but...), just stay sane and buy what becomes cheap and available. As Munger says, keep your head as others lose theirs (well, he was quoting Kipling).

But wait, I am no expert, so let's just say this does get really bad, like the 1918 Spanish Flu. That was bad. 50 million people died around the world back then including 675,000 Americans. Quick googling shows that the world population at the time was around 2 billion, and the U.S. population was around 100 million. So the flu killed 2.5% of the world population and 0.7% of the U.S. population. A similar event now would kill 193 million people around the world, and 2.3 million Americans.

That would be quite a shocking event. By the way, did you know that the flu has killed 12,000-61,000 per year since 2010 in the U.S.? Between 291,000 - 646,000 people die of the flu around the world each year. I don't mean to trivialize the coronavirus. We have to do what we can to stop it, of course.

Anyway, let's take a look at the economic impact of such a worst case scenario (well, I know, there can be worst cases than 1918, of course. I am a big fan of The Walking Dead, 28 Days Later, World War Z, Shaun of the Dead etc... )

This is the chart of deaths from the 1918 flu from the CDC website. Not easy to read, but I think the deaths peaked in the 4th quarter of 1918.

Deaths from the 1918 Flu

Now, hold this image in your head while you look at the next chart. I couldn't find anything to take a close-up view of this, but if you look at GDP from 1915-1920, there is no real visible blip.

Same with the stock market. Close-up views of the market between 1915-1920 also doesn't really show much worth responding to in terms of stock market activity. There really is no visible or actionable blip as far as I can see. Again, you can google for a close-up and you won't really find anything, I don't think.

Of course, coronavirus is a terrible thing and it is disrupting a lot of people's lives. There is no doubt there is a huge impact to many people all over the place.

But as investors, we have to keep our cool and not freak out over every new data point. There is no doubt that the numbers will rise over time, and I honestly don't believe at all that there is no coronavirus in NYC, for example. I think the odds of that are ZERO. There is no way that there is no coronavirus here. It's just that we don't know yet how many we have, as apparently, NYC still doesn't have a test for it so has to send samples down to Atlanta. Plus, most people I know do NOT go to the hospital for a fever and a cough. I certainly don't, unless there is a reason to do so, or else I am told to.

So honestly, nobody knows how much is already here in NYC, and how much it is spreading. We won't know for a long time, and we may never know.

This can get worse, may peak out soon, or they may come up with a vaccine soon too. Who knows.

Many argue that the globalized supply chain will make the impact of this flu worse than previous cases, but there are positives about globalization too, like communication and technology, that might make responding to the virus much more effective. But again, who really knows.

I just don't think it's worth spending too much time on.

Well, actually, I am not bullish or bearish. I just am. But if I had to guess, I tend to think these 'events' are hugely bullish. This is sort of true for most exogenous events. Why? Because governments / central banks tend to overreact. We are so afraid of negative economic impacts that they will overcompensate. This often leads to bubbles, which is usually not good.

Think about the bubble in Japan in the 1980s; much of that was a response to the yen-shock (Plaza accord of 1985); the fear that the strong yen will destroy the Japanese economy contributed to the bubble in the late 1980s there. In fact, the same sort of FX bickering between the US and the UK contributed to the 1920s bubble. Greenspan's fear of Ravi Batra's Great Depression contributed a lot to the bubble in the late 1990s (and the various meltdowns from Russia, Turkey, Asia, LTCM etc. all of these contributed to the bubble as the Central Bank(s) overcompensated).

This happened again after the Great Recession, and will now happen again due to fears that the coronavirus will plunge us into a recession (and was sort of happening due to fears that the trade wars will kill the economy).

So every time something bad happens, it has just been enormously bullish, every time. Of course, this can't go on. At some point, we will start pushing on a string, and the old tricks will stop working. That is also a certainty. And bubbles will pop every now and then, but only after a bubble becomes a real bubble, usually.

But, we can't really know when this (the end) will happen. Unless you are sure that we have reached the end of the line, you have to asssume that these negative events will just be hugely and incorrectly overcompensated for resulting in huge rallies everywhere.

Anyway, this is not really a bullish proclamation on my part. I will remain neutral (but invested), but just an observation.

Malone Interview (CNBC), Iger Book, Bubble Watch

Date: 2019-11-30

People keep talking about how crazy the market is, up more than 25% this year. It's a big year to be sure. But on the the other hand, even though the market has been decent in recent years, it hasn't been particularly bubblicious.

To put the 25% return into context, I think it's a good idea to look at it over 2 years or 3 years. Since the end of 2017, for example, the market has return an annualized 8.4%/year. Pretty good to be sure. Since the end of 2016, its up around 12%/year. Going back five years, it's up 8.8%/year (these figures exclude dividends).

Not bad at all, but not bubble-like either. If you were going to train an AI machine to look for bubbles, you would look at valuations (interest rate adjusted), sentiment etc. But one of the biggest factors that I would include would be historical returns over various time frames; strong performance reinforces the positive loop of increasing positive sentiment -> higher prices -> better-looking historical returns -> increasing optimism and 'proof' (both statistical and social) of the greatness of stocks etc.

The 10-year return is10.9%/year,but that's off a depressed level due to the great recession. Over 20 years, the market has gone up only4%/year.

Here is a table of the S&P 500 index change over various time periods.

S&P 500 Annualized Returns Through November 2019 (excl. dvd)

1-year return: 25.30%
2-year return: 8.39%
3-year return: 11.95%
4-year return: 11.34%
5-year return: 8.81%
10-year return: 10.91%
20-year return: 3.87%
30-year return: 7.55%
50-year return: 7.31%

S&P 500 Annualized Returns Through December 1999 (excl dvd)

1-year return: 19.53%
2-year return: 23.05%
3-year return: 25.64%
4-year return: 24.28%
5-year return: 26.18%
10-year return: 15.31%
20-year return: 13.95%
30-year return: 9.67%
50-year return: 9.36%

This is pretty insane. The annualized return over 5 years to December 1999 was 26%! And we are sort of freaking out that the market is up over 25% year-to-date in a single year, and not even double digits annualized over 2 years.

So anyway, that's why it doesn't really feel like a bubble. People aren't quitting their jobs (to trade stocks), buying new cars (with their capital gains), bigger houses and things like that we saw back in 2000. Most people I talk to still tend to hate stocks, the financial crisis still fresh in their minds.

Iger Book

I just finished the Iger book, and it was also a pretty great read. Iger seems like a genuinely nice guy. CEO's tend to have an image of not being nice guys, so it's great to see someone like him make it to the top. It's possible to be decent, honest and honorable and still do well.

Buffett did mention DIS as one of the well-managed companies (along with GE at one point); his relationship with DIS goes back to when DIS bought Capital Cities during the Eisner years (and Iger was working for Thomas Murphy / Dan Burke). And I think it goes even further back than that, actually.

It's fascinating to read about the events that we've been reading about in the newspapers from the people that were involved. This one involves Buffett / Murphy / Burke, Steve Jobs, George Lucas, Pixar and a lot of what is going on in media today. This connects (unintended) to the Malone interview below.

Anyway, this book is a quick read so go get it. By the way, I have not subscribed to Disney+ yet as I am big into Netflix and there is just so much stuff there that I can barely scratch the surface of what I want to watch (by the time I cancelled the DVD part of my Netflix subscription, I had more than 400 DVD's in the queue). My favorite things are the European cop dramas (French, Belgian, German, Norwegian etc.), the Indian and Japanese shows, and of course many U.S.-based shows too. I just watched The Irishman which is really good (creepy is the special effects to make these close-to-80 year olds look middle-aged), but at the same time I also thought, gee, do we really need another wise-guy movie?

OTT Tangent
People keep talking about the competition in direct-to-consumer streaming and how increasing competition will hurt Netflix etc. This is probably true to some extent; when Netflix was the only game in town, that's one thing, but with many participants jumping in, that's another story altogether.

On the other hand, when you think about it, this is not really an either-or world. People aren't going to sit there and debate whether to switch from Netflix to Disney+ or Apple. Netflix charges $14/month or some such thing, and Disney+ is even cheaper.

A lot of people are still paying $100/month or more for the conventional video package ( I dropped that a couple of years ago mostly because I don't watch most of the channels (ESPN, for example), but what bothered me even more was that they were charging me $14/month for each cable box in the house, which seemed ridiculous to me. Those things can't cost more than $100 (look at Roku at $20; and if it actually does cost more than $100, it's for functionality that I don't need), and they are charging $14/month forever; this makes absolutely no sense.

If you cut the chord, you have $100/month in video budget you can allocate (you still need to pay for the internet), so you can have Netflix, Hulu, Disney+, HBO and a few other things and still be under $100...

Malone Interview
There are a few annual events that are really exciting to me. Of course the Berkshire annual meeting (I just watch the video later), annual report, JPM annual report etc.

And another one of those is the CNBC John Malone interview by David Faber. Faber is one of the few people (of the reporters/anchors), if not the only one, who seems to understand the market and business.

Anyway, I jotted down some notes while watching the recent interview (done during the Liberty Media investor day). This is not everything, though, but a large part of it. He also talked about regulation, GOOG etc, for example, so go check out the video.

Here are Malone's thoughts on various topics:

Who is best positioned in streaming right now?
Malone answered by rephrasing the question to, "Who will be around in five years?"
Disney and Netflix.

Disney has great content, a great global brand, but doesn't have a large direct relationship with customers so must piggy back on those who do, like Verizon.

Netflix, so far in the lead, good base / revenue stream.

Apple may surprise. Slim content, but has great distribution in their direct customer relationships. They offer free for one year to buyers of AAPL products etc...
AAPL has optionality; see how it goes and decide how much they want to spend (how much they can afford).

HBO is a decent service, but doesn't have the revenue stream to match Netflix.
AMZN has a totally different monetization strategy so... not primary biz.
Content is for marketing. AMZN may evolve to become a bundler of others' content

Tech companies want to be the platform, get info on customers, be gateway,
let others waste money on content.

DIS will be successful.

Direct relationship w/ customer in scale with growth and pricing power is a powerful business model.
DIS knows they need direct consumer relationship.

HBO Max: HBO content budget was $2bn/year.
If you want HBO, you already have it, so not much gain in new customers in the U.S.? Malone doesn't see the growth. Maybe even attrition.
HBO budget is not enough to protect for the long term. Takes years to develop content internationally. Don't own rights to intl distribution. Problem seeing scale at HBO to get to top of direct consumer biz. HBO is the same as it's been for 25 years. If you want it, you already have it so where is the growth?HBO may capture wholesale spread (as big bundle moves to direct).

ATT will face challenges. Historically has been the biggest dog in every fight, but not now, and not in this space (streaming media). About scale and globality. Need global scale, or won't get enough scale to compete in this space. This will be the challenge for ATT, HBO. FANG companies are all global. If you're only in the U.S., how do you compete?

Sports is glue that keeps big bundle together... will eventually blow up. Not sure when... big bundle still overpriced due to sports content...

Content Cost
At some point, hail Mary passes for some will prove to not be working so content cost will moderate. Some will fail (and stop spending) etc...

NFLX will have to moderate spend at some point. Bundling of these services will happen too. Distributors may bundle too, if it reduces churn etc... will evolve like traditional cable. Comcast offers Netflix etc.

Cord cutting will level off. Erosion won't stop completely, though...

Cutting video increases margins at cable companies as margins for broadband is higher. Happening naturally.

Satellite will end up serving people with no other options, rural etc.

Linear TV will lose subscribers, ads, but as you get direct relationships, value of ads go up as you know more about customers. Ad rev potential goes up; more focused ads etc. Have to fight decline in reach due to decline of big bundle. Provide content direct through app and sell content to others etc. Random access via app; if you subscribe to Discovery Channel, you get stuff through app too (not everything).

Cable industry changed when congress changed retransmission constraints; Margins started to go down. Content providers were able to extract more and more...

Will be profitable for people with unique situations, consistent, stable demand, pricing power, level of uniqueness... those businesses ultimately gets regulated.

Discovery owns content globally, generating free cash, need to migrate to direct to consumer.
Malone bought more stock this week (November 2019). Discovery will solve issues. Stock is dramatically undervalued. Malone bought $75 mn worth of stock. Growing, generating free cash. Market cap to levered free cash flow, cheapest on screen... They own all their content, generates tons of cash, investment grade b/s, they are growing while others are shrinking (5.5x cash flow). Cheap for good company...
Malone paid $28.03/share.

They have no global presence. Lot of content is bought. CBS is totally dependent on sports rights so not sure about long-term profitability. Not sure if CBS has enough power to carry all the channels.
VIA underinvested for many years, bought back stock at high prices, tactical mistake.
How important is MTV, Nickleodean to distributors? Question sustainability of model, and also they are U.S. only.

Yes, stock is historically cheap, but... licensing out content to others. Ice cube melts faster when you don't put content on your own channel.

CBS/VIA needs to get global for long term sustainability. Find niche, glue to make customers sticky. Something unique.

Lions Gate
Sold LionsGate; didn't see them execute strategy of using library/content to drive Starrs. They focused too much on selling content instead of driving their own distribution.

Need global scale, or niche in small area that big guys don't care about to survive.

Wired and Wireless Together
Liberty Global followed strategy based on belief that combination of wired and wireless would lead to synergies. Turned out to be true. Belgium, Holland (combined with Vodaphone). Once they built scale, they were able to acquire. Synergies were real and very substantial.

In U.S, for Charter, same idea. Keep growing until they understand the economics of a combination. At the moment, not far along enough on that path. Once scale is achieved, think about building own network. Hybrid tranmission over time. Could be joint ventures, mergers etc.

Malone interested in Altice, but Patrick wants control etc...

Not an expert, but doesn't understand Uber, how is scale going to make it profitable? Like selling hot dogs at a loss and making it up in volume. Can't see how scale changes economics. Can't understand why Dara took job.

Worries about attack on success and wealth in this country.
Worries about where country is going.

If Warren wins, wealth destruction will exceed wealth transfer. Has places in Ireland, Canada, Bahamas etc... (that he can escape to), but Malone rather stay here, be optimistic about balance.

Malone is Libertarian, would vote for Bloomberg.

Trump has right strategy, but not the right guy; he doesn't build a team. A lot of people that worked for him trying to take him down now.

What It Takes, Dimon, Twitter etc.

Date: 2019-11-14

Recently, I've gotten some emails asking about the blogger email updates. I googled around (again) recently for a solution and couldn't find one, and also looked at some mass email services and they aren't free over a certain number of subscribers.

So, as has been suggested here by some over the years, I just set up a Twitter account to announce when I have a new post.

My handle is:@brklninvestor

I know many of you are not on Twitter, so I will figure out an email solution too, eventually.

Dimon on 60 Minutes
Jamie Dimon was on 60 Minutesthis past Sunday. He is still one of my favorite CEOs and is great to watch. I thought his response to the question about running for president was pretty funny; "I thought about thinking about it..." That reminds me of one of my favorite Dr. Who lines (from the Eleventh Doctor, Matt Smith), "Am I thinking what I think I'm thinking?"

Anyway, in this environment, there is no way people like Dimon or Bloomberg would gain any traction in the Democratic party. I think either of them would make great presidents, but it just won't happen. No chance at all, unfortunately.

When Lesley Stahl mentioned the bailout of the banks during the crisis, Dimon should have pointed out that it wasn't really a bailout; all the money was paid back with interest (at least the major banks paid it all back). Schwarzman in the book below talks about how he cautioned Paulson about this; to try to avoid the use of the term bailout as it could become a problem if that word stuck. To this day, I still talk to people who think that the banks were "bailed out". They think that the government just gave the banks free money with no strings attached. They are often surprised to hear that the money has been paid back in full, with interest.

Having said that, the definition of "bailout" seems to be to offer financial assistance to an entity on the brink of collapse, so maybe TARP was a bailout. But still...

When asked about CEO pay, Dimon said, "what do you mean?", or something like that. It was clear he was trying to just avoid the question. To say he has nothing to do with his own compensation, while it may be technically true, wasn't really convincing to people who wouldn't understand. He could have just agreed that CEO pay is too high in this country, and that it should be dealt with at the tax level but probably shouldn't be resolved legislatively or whatever. No need to dodge the question. There is nothing wrong with saying that high income people should pay more in taxes (at higher rates), and that some of the crazy loopholes that reduce tax rates for the rich should be closed etc. He is not running for public office, so he is not taking any risk in saying stuff like that.

But anyway, it was nice to see him on 60 Minutes. Although I am progressive on many issues, I find the current anti-corporation sentiment to be unfortunate. Companies can only change their image by their actions. More and more companies are acting like they are the solution rather than the problem, which is good.

The markets are kind of crazy. I don't mean this rally, necessarily. A lot of this rally is just recovery from last year's drop and valuations are still in a zone of reasonableness, so I am not at all alarmed by it or worried about it.

I mean the way the markets react to every Trump tweet, or nowadays, Elizabeth Warren ideas. I like Elizabeth Warren a lot, actually, even though she seems to hate Dimon and everything Wall Street.

Whenever the markets tank when Warren's poll figures go up, just remember what happened on election day in 2016; the markets freaked out and tankedwhen it realized Trump is going to be our next president. But before the next morning, the market took off and hasn't looked back.

Remember what happened to health care stocks in 1992 (Hillary-care), and 2009 (Obama-care). When widely publicized problems hit the market, it is very hard to predict what will happen. Howard Marks would call reacting to these headlines first-level thinking.

First of all, we don't know if Warren is going to be nominated. Even if she is, we don't know if she will beat Trump. Even if she wins, we don't know how much of her plan can be executed successfully (will she run to the center for the general elections? Will she take a more prudent, realistic course of action once in the White House? I'm not saying her ideas are bad or impractical, but she can calibrate her goals according to the reality she confronts once she's there).

There are so many levels of "unknowns" that it makes no sense, really, to try to discount these things so far ahead.

Anyway, if any of these things move the markets too far in any direction, it's probably a great time to take advantage of it and go the other way.

Growth vs. Value
I hear and read about this all the time, and I totally get it and agree. I am a believer in mean-reversion. On the other hand, there are secular realities hidden in these figures too. For example, Bed, Bath and Beyond (BBBY) is one of my favorite stores and was one of my favorites in terms of management. I followed them closely for years, and eagerly looked forward to their annual reports. But it was always a pretty expensive stock. When it finally started getting cheap, it seemed to have lost it's way.


Maybe I am putting in the bottom in this stock, but these days, it's hard to figure out what this company is trying to be. Not too long ago, you would walk into a BBBY and then, suddenly, in the middle of the store, there would be like a miniature supermarket, with potato chips, cereal and whatnot. I was like, what?

It's like the newspaper business. As Buffett says, if you wouldn't start the business from scratch today, then it's probably not a good business. And if it's not a good business, you probably don't want to own the stock.

Again, I loved BBBY for many years (and it's just luck that it hasn't been a part of my portfolio), but it's hard to think of a reason for it to exist. A lot of what they sell is exactly the sort of thing Amazon is very good at selling, and for lower prices. Stores like Target are also selling similar things for competitive prices, so I guess it's a similar story where Target/Walmart/CostCo and others (Amazon) are killing the category killers; same as CD stores, book stores, toy stores etc.

This is not to say necessarily that we should go long AMZN and short BBBY, JCP and other retailers (well, that's been a great trade for a long time!). It's more of a question about how much of this growth versus value is the usual cyclical thing that will eventually mean-revert, and how much of it is secular destruction of multiple industries (I don't think most retailers will recover).

This is a fascinating story. I really admire the vision and conviction of Masayoshi Son. He is fun to watch and follow, and I have always wondered when and if I should buy Softbank stock. There were many reasons to buy it, especially the usual discount to the sum-of-the-parts valuation and things like that.

But one thing that has always bothered me was his almost reckless aggressiveness. I guess that's a good thing for someone in that area, but it was always a little too scary for me. I remember watching him in an interview, laughing at the fact that the price of Softbank stock went down 99% (or whatever percentage it was). I don't want the steward of my capital laughing about something like that. It is definitely not funny to me.

Also, the sheer size of some of these investments makes it highly unlikely that they can achieve high rates of return over time. Yes, Alibaba was a huge home run. So was Yahoo Japan and some others. But what were their capitalizations when the investments were made? I don't think they were valued at $40-50 billion. How much money were they losing? Probably not billions. Things are truly insane these days.

Thankfully, that unicorn bubble, at least, seems to have popped for the moment.

Great Book
And by the way, the original intent of this post was about a book. I just finished Schwarzman's book, What it Takes: Lessons in the Pursuit of Excellence and thought it was great. This is not a book you want to be reading in the company of your progressive friends (most of my friends and neighbors are progressive; many are even democratic socialists). Even some conservatives roll their eyes at a guy who throws himself expensive birthday parties and puts his name on library buildings. But I don't care about that. Not everyone has to be like Buffett or Munger.

But what I can say is that after all these years on and following Wall Street, I've mostly heard good things about Blackstone. When they IPO'ed, I followed closely and it was clear that they are a really well-run shop. At the time, Fortress Investment Group was the other private equity firm to go public before Blackstone, and I was really not all that impressed after following them for a while. Their performance was not great, hedge fund was not doing well etc. But Blackstone was at a totally different level.

Whether its their conference calls, presentations, it was all done very, very well.

The only reason I never bought the stock was that, like others, I was worried about the huge increase in AUM at all of these alternative asset managers. How are they going to maintain the high rates of return with ever-increasing AUM and ever-increasing competition, not to mention the corresponding ever-increasing prices? Schwarzman, in the book, makes the case that size has become an advantage for them; they get first call (or are the only call), often because they are the only ones that could close a deal of certain sizes.

I had the chance to grab some shares at under $4.00 during the crisis, but then there were many other things that were cheap too... But still, knowing what a solid shop it was, I shoulda grabbed some shares then. I guess one rule should be that any time a well-run company is trading for the price of an option, one should buy at least some shares!

Special Situations Trade
By the way, I should also mention that these private equity firms are in the process of converting from partnerships to corporations; this expands the range of potential buyers (institutions that wouldn't or can't own partnerships), which would serve to increase liquidity and most likely valuations of these companies.

I know many of us berk-heads think private equity is nothing but leveraging and cost-cutting, but I still think these guys have a high quality shop.

One thing that surprised me was how hard it was for Schwarzman / Peterson when they first started up, sending hundreds of letters to investors with no response, visiting potential investors and getting rejected for months on end. This reminded me of what Barbara Corcoran said in an interview once. The interviewer asked her what the difference between a good broker and a bad broker was, and she said the great brokers know how to take 'no'. If they can't close a deal, they move on to the next one and keep going. The bad ones aren't good at taking 'no', and it wears them down; they get discouraged and it impacts them too much to keep going.

I'm sure we've all seen examples of this. A friend once told me a relative wrote a novel, sent it to a publisher and it got rejected and they gave up writing and blames the over-commercialized, corporate-controlled, dumbed-down American culture for their failure as a novelist (and the friend agreed with that). I was a little shocked. So you write one novel, send it to one publisher, it gets rejected and it's all over? Well, I don't know anything about writing novels and have no idea how that world works, so I didn't say anything.

But I was thinking back to the many famous novelists who kept getting rejected from publisher after publisher, writing story after story before getting published. I think Haruki Murakami got published on his first try, but those are probably rare cases.

Going back to Schwarzman, even with his credibility / reputation (and Peterson by his side), they struggled to get Blackstone off the ground. You can imagine how much work it's going to take to get anything done without that sort of advantage.

Having said all that, it is an autobiography so we hear everything from his side. I'm sure there are people with tales out there somewhere he doesn't want told (and this goes for someone like Buffett too!).

But, it's still a good read.

Bubble Yet?

Date: 2019-09-27

People still speak of bubbles a lot, bubble in the bond market, stock market, unicorns etc. But I still don't really see a bubble except in certain areas of technology. Otherwise, things seem to be in a normal range to me, except interest rates. They do seem a bit low, but having said that, I still see 4% as a decent 'normalized' long term rate for the U.S. (as I have said here before many times).

TheValuation Sanity Check shows the Dow trading at 20.6x current and 16.4x forward P/E, and the Berkshire portfolio (largest holdings) trading at 17.4x and 14.3x their current and forward earnings. Browsing down that page, there is nothing really alarming about anything, really. Some things look expensive, but nothing insane.

Also, here are some charts I plucked off the internet. The first bunch is from the JP Morgan Asset Management's Guide to the Markets. This is a nice report that they put out every quarter, and is fun to flip through.

These charts too show nothing really crazy.

I keep hearing people talk about how crazy it is that the market is up 20% this year, but given that a lot of that is recovering from losses last year, it doesn't sound crazy to me.

Also, people keep saying that the returns of the last 10 years suggests the market is overvalued. But again, given that the much of the returns is recovering from the financial crisis bear market, I think it's irrelevant. If the market had double digit returns over 10 years from a market high, then I would be more inclined to agree; something bad might be about to happen.

But this is clearly not the case here. In fact, from the October 2007 high, the market has gone up less than 6%/year (excluding dividends), and 3.4%/year since the 2000 peak. This is hardly the long term performance figures you see in a real bubble.

I won't look for them, but look at the similar figures for the 2000 peak, Nikkei 1989 peak etc. It is very different from today.

S&P 500 Index Forward P/E Ratio

The above forward P/E chart shows a normal range, nothing alarming. Of course, people will argue that the market has been consistently overvalued for the past 25 years so this is not indicative of anything. But interest rates are a lot lower now than in the past too, and this chart doesn't show any abnormally high P/E level due to lower rates. I suppose one can argue about the validity of EPS estimates a year out. That is certainly a valid point.

Forward P/E and Future Returns

This X-Y plot of forward P/E ratio versus future returns show potential returns solidly in the positive. I did something similar using Shiller's CAPE ratio and found similar results.

One year forward returns based on P/E

My analysis goes back to 1985, so is longer term than the JPM study (which goes back to 1994), but hasn't been updated (a couple of years shouldn't make a difference!).

MSCI World vs. S&P 500 Index

These charts show nothing extraordinary either. Yes, the U.S. market is doing really well versus the rest of the world. But who cares, right? Unless you are some sort of mean-reversion trader, it's not really relevant. I too tend to like investing in U.S. businesses, mostly because I live here and have access to all the filings, conference calls and things like that, and I do feel U.S. companies are more responsive to shareholders and the system works better (compared to Japan, for example, where I have very little faith that managements care about shareholders).

Median P/E Ratio
And here's something I found. The S&P 500 is market-cap weighted, so the index P/E ratio tends to be influenced by the large cap stocks. When you have a bunch of large caps that are overvalued, it tends to push up the P/E ratio of the whole index.

To get a more 'typical' P/E ratio of the random stock, a median P/E can be more useful, as half the companies would be more expensive, and half would be cheaper than this level.

I found this chart in Yardeni's September report: Yardeni P/E report

Here's the median forward P/E ratio:

Again, nothing spectacular here. Looking at this (and the other charts), if someone is net short the market, you would have to examine their brains. Why would anyone be net short in a market like this? It doesn't really make sense to me.

Just flip through these charts again, and imagine you are the head of the trading desk at a hedge fund or bank somewhere. And say some guy is massively net short the market. You ask him why he is so short, and he tells you that it's because the market is way overvalued. What would you say? Would you feel comfortable going home and sleeping well? Of course, this trader may contribute to reducing the overall exposure of your desk, but don't think of it that way as you can always adjust your market exposure with futures.

If you think of it this way, it's sort of insane.

The other non-bubble thing is that you don't hear people talking about the market at all. Usually, in a real bubble, people really like to talk about the stock market in situations where that is not normal. A couple of years ago, everyone was talking about bitcoin. I don't hear much about that anymore these days.

Also, the news flow is so negative these days, whether it be Brexit, Trump tweet, U.S./China trade, Iran... Wherever you look, it's just bad, scary news. And yes, the market responds by going down, but it comes right back up. This is not to say that the market will always come back up. We will have a bear market at some point.

But if you are net short and all these 'favorable' developments to your position is not making you money, that's kind of a serious problem. What happens when any of these things resolves itself? What if we do get a blowoff that has happened in most other bubble tops (2007 top was not really a bubble in terms of valuations, so bear markets can happen from normal valuations too).

Value-Growth Gap
The other thing is the huge gap between growth and value stocks. I am not that big a fan of this as the division seems arbitrary and kind of meaningless. But what is encouraging is that despite this slightly higher valuation of the overall market, the gap between value and growth seems to suggest that one can avoid a lot of pain by being more in the value area than growth.

Back in 2000 when the market was actually really overvalued, value investors did fine despite a 50% drop in the S&P 500 index as the drop was driven mostly by expensive companies going down in valuation. I think value stocks actually went up back then.

This may be true this time around too.

Market Timing
Most of us value investors don't believe in market timing at all. It is so amusing to watch the market go down 200 pts (or more) on a tweet only to reverse itself within a day or two by another tweet. Why anyone would trade based on this stuff is beyond me. I am a believer that headlines almost never mark turning points in the market. If the market is making a new high and then plunges on some negative headline, you can bet that that high will not be a high of any significance. I have seen various attempts over the years to analyze peaks and troughs in the market and matching it with news headlines; there usually is no headline that marked the top or bottom of a market.

It's just silly to try to figure out when the next bear market will happen.

There is one thing, though, that I would watch out for. If the U.S. market goes into a situation like the Japanese stock market in 1989, then I would obviously react. I would definitely lighten up equity holdings (still on a case-by-case basis based on valuations, of course) and maybe even consider buying puts, going short or whatever (OK, maybe not as I watched many bears lose a lot of money in 1998-2000 period only for them to be proven right but already having lost too much money made no money on the decline).

In any case, it would be a valuation call; I would lighten up when I can't accept the valuation levels. And it would be by each individual holding, not some vague notion about the directions of the overall market or economy.

Japanification of Markets?
The other worry is the Japanification of global markets. We were all baffled by the low interest rates in Japan for decades, and here we are with multiple countries and trillions of dollars in debt trading with negative interest rates.

Many commentators thought it won't happen here, and yet here we are with long term rates under 2%.

What about the stock market? Can the U.S. go into a bear market like Japan's that lasts 30 years? This sort of thing worries me too a little. We can't say it won't ever happen here as we were wrong about interest rates. Well, I've actually been in the camp of "lower for longer" so am not really all that surprised by how low our interest rates are.

But it would not be fun if the market went into a 30-year bear market.

Here's why I don't think it would happen, at least any time soon:

There are many other problems, but those are just some big ones off the top of my head... You may think of better reasons why Japan has been stuck for so long.

None of these are true in the U.S. That doesn't mean we can't go into a 30-year bear market, of course. But it just seems to me that it is not likely at the moment.

Hard Left Turn in Politics?
Others worry about the progressive left; Leon Cooperman joked the other day that if Elizabeth Warren gets elected, the market won't open. I understand that fear, and as a big fan of JP Morgan, I totally get it.

I am actually pretty progressive myself (I used to be conservative but have been moving left over time), but I wouldn't worry about this at all.

First of all, we really have no idea what's going to happen. We don't even know who is going to be the democratic candidate; it's possible that someone else not even running now will come up out of nowhere (well, not sure if that's possible, actually, but we still have a long time to go).

We do know that Warren is as progressive as she presents herself, so this may not apply, but it's possible that she runs hard left to take Sanders' and other voters only to run back towards the middle if she wins the nomination.

We don't know what she can accomplish even if elected, right? This is a president, not a dictator. Did FDR or Kennedy destroy the country? I haven't looked at the market action around their elections, but I don't really think there is a big, visible dent or bend in the long term charts based on who was president.

So this is certainly a risk factor, but my guess is that things, as usual, will not turn out the way we expect even if Warren wins the election. It's a complex model and things aren't going to be so easy to predict.

JPM 2018 Annual Report, Website etc.

Date: 2019-04-04

JPM's annual report is out, and maybe a good time for another post here. I know it's been a few months. Honestly, I have been coasting recently on what's been working and haven't been digging around too much in the stock market. Most of my time recently has been spent on programming, having taken on a few freelance gigs for fun (and beer money).

Anyway, I have updated my website. A lot of things there were broken, but everything broken there was just due to the Google and Yahoo Finance APIs being shut down completely. This is really annoying. There are a lot of books out there on AI, data science, quantitative finance and all that, and a lot of them depend on those APIs, so it's like those books are worthless now. Well, not really... you just have to find an alternative source of data. But who wants to deal with that hassle?

Anyway, the website is

The Market Today
One of my favorite pages there is this one:Valuation Sanity Check

People are still talking about how overvalued the stock market is and how it has to go down, and how valuations do matter and that perma-bulls are saying valuations don't matter.

Well, I have been telling people to ignore those people for the past few years, and I, for one, would not say that valuations don't matter. Valuations do matter. The higher the valuation, the lower the future returns. Duh. This is not rocket science. This is no different than bonds. The higher the bond price, the lower the yield, the lower the future return.

Where I disagree with the bears is their conclusion: that if the market is overvalued, then the market must go down. (I am not arguing that markets won't ever go down; they will with 100% certainty. But I doubt anyone can tell us with any consistent accuracy when it will!)

I also quantified this and put the data on the website.

Future returns in an overvalued market

I didn't update it, but since the market has been up, the conclusion would be the same or better. Plus, the analysis uses decades of data, so a couple of years is not going to make a difference.

As for all the worries and concerns, Buffett's 2018 letter has a great section called "American Tailwind", and it basically says that the market has done well over the past 77 years and there were always things to worry about, but the market did pretty well. Maybe more on that in another post.

Anyway, the home page shows the trailing P/E ratio of the S&P 500 index at 21x, and forward P/E of 17x. This may seem high to some of us who started in the stock market business when interest rates were around 8%. They are now much lower than that. I've said in posts that with a "normalized" interest rate of 4% over the next decade, I would not be surprised if the market P/E averaged 25x P/E. So a 21x P/E is not at all alarming or shocking to me, and the 17x forward P/E actually looks pretty attractive, even assuming that forward estimates tend to be over-estimated.

Also, looking at the Valuation Sanity Check page, the Dow 30 stocks seem to be trading at 17.5x 2019 estimates and 15.4x 2020 estimates. The Berkshire stocks (just the stocks listed in the annual report) are trading at 15.4x and 13.4x 2019 and 2020 estimates.

Again, there are issues of the validity of 'estimates', but even still, these figures are nowhere near bubble levels.

My thoughts about the market hasn't changed at all in the past year. Yes, it was a little scary in the fourth quarter of last year, but I was not that particularly worried as none of my work (as shown in previous blog posts) has shown any rubber band stretched to it's limit that must snap back.

OK, anyway, maybe more on that another time. Going on to my next pet peeve...

Google and Yahoo have no obligation to continue their finance data APIs, of course. But what is really annoying is how expensive simple financial data is. It has always been so, and Google/Yahoo made it affordable (or, well, free) for the little guys without big corporate budgets. But that is gone now.

As the world continues to move towards open source and open data (look at this great source of free data related to NYC: NYC Open Data), the financial industry continues to be closed and expensive.

There was an article in the FT today about people (even rich corporate users) complaining about stock exchanges gouging them on price for access to basic data.

As I see it, stock exchanges are basically public utilities. I don't think they should be profit-making entities so long as they are given a legal monopoly (or oligopoly or whatever).

It's just makes no sense that we stock market traders/investors must go through the exchanges to trade and the exchanges then accumulate and use that data and sell them for profit. It just makes no sense at all. This stuff should be public information and easily available to the public in various forms. It doesn't cost that much money to provide an API where people can access this information. We can see they are already making tons of money on exchange fees etc.

So this is just nuts.

OK, so it's not a huge issue for me as stock prices / data is not a big part of what I do. As you know, I am more about listening to conference calls and reading 10-K's and stuff. The only time I use financial data was when I was putting stuff up on the website for fun; I don't need that stuff to invest (and that's why I haven't paid for any data service, and don't really plan to).

The idea of open-source is that if you make the information free and widely accessible, more people can play with it and more ideas can come out of it.

OK, enough of that...

JPM 2018 Letter
No offense to Mr. Buffett, but I sort of look forward to Dimon's letter more than Buffett's these days. Buffett still writes great letters and I read them as soon as they come out. But I feel like I am very familiar with what he has to say and there are usually no surprises, and I am not sure I really learn anything from reading them lately.

But Dimon's letters are much more granular and deal with a lot of specific, current issues etc.

Anyway, I don't plan on going into detail here as you can just go read it yourself (and I know many of you won't, but I don't care... it's your loss if you don't!).

Here are my usual favorite charts.

Dimon Tenure Performance
These tables are really great; they show how Dimon has done as a CEO.

For reference, BRK BPS grew +9.5%/year from 1999-2018 and +10.0%/year from 2004-2018. So you can see that JPM has done better than BRK in both time periods, which is kind of shocking when you think about the fact that one period includes the popping of the internet bubble in 1999/2000, and both time periods include the financial crisis. (BRK time periods are based on year-ends, so don't match up exactly, but whatever...)

Below is the same look but based on the stock price instead of TBPS. BRK's stock price appreciated around +9.3%/year in both time periods (1999-2018, 2004-2018). This is kind of insane.

Social / Political Issues
I will not repeat them here, but Dimon goes on in great detail about how we can make things better here in the U.S. It's too bad that our system does not allow for people like Dimon to become president. He would make an incredible one.

Anyway, he does caution us away from the creeping socialism and rising progressives from the far left. I am actually very sympathetic to this recent movement even though I am a hard-core capitalist. But I can see how it can be dangerous for us to veer too hard to the left and destroy things that have worked for us.

But the fact is that what has worked for "us" hasn't really been working for a very large number of people.

It's been a while, but I haven't really changed my mind on anything at all. Nothing new to report, really. The market looks fine. No bubble at all as far as I'm concerned. Maybe not cheap, but not really that expensive either.

The way stock exchanges use data as profit centers is deeply disturbing and is not consistent with what I think of as their mandate as virtual public utilities. The whole system of exchanges charging money for data, and a whole industry of data vendors runs contrary to the worldwide trend everywhere else of open-source and open-data.

OK, way back in the old days when you needed expensive mainframes to manage this stuff, it may have been understandable. But with technology where it is today, this whole data industry setup and cost makes no sense at all. The industry must be laughing their way to the bank as costs keep going down and the prices they charge keep going up.

JPM continues to do well and it looks like in may ways they are disrupting themselves, which is really great. It assures (or increases the odds) of their continued success.

They have come a long way since I opened my first bank account at Chase many years ago.

I probably told this story here before, but I'll tell it again. When I had my first job in the city, I needed to open a bank account somewhere so my employer can deposit my paycheck.

I figured all big banks are the same, so I went to the World Trade Center (near where I worked and lived) and walked into Citibank. There was a reception desk at the front and I said I wanted to open a bank account.

A big-haired girl, loudly chewing gum and filing her nails barked at me, "I'm on break. Come back later...". She was sitting at the reception desk/booth. I was shocked at how rude she was, so I just walked across the hall to Chase and said the same thing, and someone immediately came and helped me out. Chase was not that much better; it was pure chance that the Citi employee was on break and Chase's wasn't.

This is the only reason why I started at Chase. Unbelievable. But that's how big banks were back in the 90's. Just terrible. Like the post office.

Anyway, JPM is no longer no-brainer cheap like it was when this blog first started (2011), but it still seems pretty cheap.

Why BRK?

Date: 2018-11-22

Every now and then, BRK comes up in conversations with people (and often with people not in the business) and the topic becomes, what to do with BRK post-Buffett. I tell them I own BRK and plan to own it for a long time, and sometimes I wonder why myself.

Too Big
First of all, it's really big now so it's going to be hard to grow the way they used to. With a market cap of more than $500 billion, it's going to be hard to keep growing at a high pace. This used to be sort of the cap in big company capitalizations; a lot of the bit techs went to $500 billion in 1999/2000 before they all came crashing down. The barrier today seems to be $1 trillion; Maybe these $1 trillion companies hit that wall and come crashing down. Who knows.

In any case, BRK is just too big to get too much alpha going forward.

Buffett is not so young anymore, so the historical performance is getting increasingly less relevant; Buffett created the performance of the last half a century, but he is clearly not going to lead the charge for the 50 years. This doesn't mean BRK can't outperform.

Buffett hired some great managers to help manage the equity portfolio, but their historical performance is sort of irrelevant too. Those guys posted great returns with a much, much smaller capital base. They will eventually inherit a $200 billion+ equity portfolio. If they want to stay focused, they will need to invest in companies they can buy $10-20 billion worth of. And there aren't a lot of those. Their universe will be no bigger than the one Buffett is fishing in now, so it's hard to imagine they will improve on what Buffett can do with this size.

Returns Not So Great Lately
And people say that BRK hasn't even been performing all that well lately, underperforming in the past five years. The rolling five-year BPS growth vs. the S&P 500 index total return has been negative for the last five years in a row (through 2017):

2013 -4.0%
2014 -3.9%
2015 -2.3%
2016 -3.2%
2017 -2.7%

People often point to this to show that the era of BRK outperformance is over.

But this sort of misses the fact that back in 2008, the S&P 500 was down -37% while BRK's BPS declined only -9.6%. So in a sense, the S&P 500 index had a lot of catching up to do compared to BRK. Looking only at the above table of the last five years misses a lot of crucial information.

Having said that, it's true that the supergrowth of BRK ended back in 1998, but has been a steady grower since then.

Check out the below log chart since 1980. You can see two clearly different eras in terms of performance. 1980-1998 was just amazing, but 1998-2018 has been much more modest (data just happened to be available since 1980 as I was playing with daily data; no cherry-picking start/end points. Good enough for this analysis).

BRK, Log Scale Since 1980

BRK's BPS grew +28%/year from 1980 through 1998 vs. +18%/year for the S&P 500 index for an outperformance of 11%/year. BRK's stock price rose +33%/year in that period, beating the index by 15%/year.

Since then, things have flattened out a little, but the returns aren't that bad at all.

BRK vs. S&P 500
I haven't updated this table in a while, but let's take a look at BRK's performance against the S&P 500 index (total return) in various time periods.

BRK vs. S&P 500: Various Time Periods

Of course, we know how great the performance has been since 1965. But check out the past five years. On a BPS basis, BRK underperformed the S&P 500 total return, but outperformed based in BRK's stock price.

If you look at all the time periods, though, BRK has outperformed both on a price and BPS basis in most time periods.

This year, it just so happens that the 2007-2017 is the same as the 10-year comparison so be careful to not double count...

But to me, more interesting than looking at the past 5 and 10 year returns (which are no doubt important), is to look at 'through-cycle' performance.

The lower part of the above table shows returns from various market peaks (year-end basis). You will see that on a BPS basis, BRK has outperformed the S&P 500 index since the 1989, 1999 and 2007 market peaks, and also on a price basis in most of those time periods.

The 1998-2018 BRK log price shows a more modest pace of growth than the 1980-1998 period, but you will see that BRK has still grown 10%/year since then, bettering the S&P 500 index (including dividends) by 3%/year on a BPS basis and 2%/year on a price basis. Not like it used to be, but not bad! (How many funds can you name that has done as well?)

So all this talk of Buffett not performing well is not so relevant to me.

It looks funny to have both 1998 and 1999 in there, but 1999 is there as a market peak, and 1998 for sort of a momentary peak in relative performance of BRK, and sort of the end of the high-growth era for BRK.

Why BRK?
Despite the size, and the potential risk of a post-Buffett BRK, why do I still like BRK? First of all, the recent performance, I don't think, is as bad as people make it out to be. They are still outperforming in most time periods, especially from various market peaks.

There is something about BRK that makes me more comfortable than owning the S&P 500 index, even with the post-Buffett risk. The first thing is that BRK will probably not do anything irrational or stupid. This is not an assurance we get when investing in the S&P 500 index. The index committee will add bubble-ish stocks at bubble-ish prices. BRK will not be 'forced' to buy stocks just because they are 'big'. They will only buy stuff when it is high quality and is priced rationally. These are two things that the S&P 500 index committee do not seem to care about too much.

Sure, this inflexibility with regard to price and quality will be a drag on performance during certain time periods (like now, and back in the late 1990s), but I would feel more comfortable when my money manager is not chasing big stocks.

Also, check out the below chart. It's just the S&P 500 index since 1980 along with the BRK/S&P 500 index ratio. I just wanted to see, visually, how BRK has performed (price-wise) versus the index over time.

And what I see is kind of interesting.

S&P 500 Index and BRK/SP500 Ratio Since 1980

BRK seems to not do too well in late periods of raging bull markets (like the late 1990s) but seems to pick up a lot of relative performance during rocky times. This is kind of important for conservative investors. Whatever you think of the stock market now, there are pockets of bubbliness, and if that pops, it wouldn't surprise me if BRK has another big step up in relative performance like in the two circled periods above.

This sort of makes sense, right? As BRK doesn't have a whole lot of exposure to FANG/FAANG stocks. And if the market does decline a lot, that will provide a lot of opportunities for BRK to deploy cash so you are kind of sitting on cash optionality by owning BRK.

Yes, BRK declined 50% during the crisis, no better than the S&P 500 index, but if you look at the above table and charts, you will see that BRK does ratchet up relative performance during tough times. So just comparing peak-to-trough drawdowns sort of misses some important information.

By the way, here are some large declines in BRK stock over their history (from the 2017 Letter to Shareholders):

Stunning Discovery
OK, maybe not. But I just noticed something. Look at the above chart again; BRK price / S&P 500 index ratio. If you look at this chart, you will notice that the uptrend is pretty consistent and linear. OK, I am not going to go back and put a regression line on it (too lazy), but you can sort of imagine a straight line going through it from the mid-90's even through today.

Here is the chart again with the line I sort of see (this is not a regression line, but one I just drew by hand). The lower chart is the BRK/S&P index ratio:

And, importantly, there is no kink, bend or flattening after 1998!.

What does that mean?! It means the rate of BRK's outperformance against the index has been pretty consistent and hasn't tapered off at all!

The ratio will measure the 'rate' of outperformance, not the absolute difference.

Here's what I mean. The above chart is based on prices, but I will look at BPS growth instead as the prices data is a little too spikey (and too sensitive to start/end points). As we saw above, in the period 1980-1998, BRK's BPS grew at a rate of 28.2%/year versus 17.7%/year for the S&P 500 index (total return), for an outperformance of 10.5%/year. Since then, BRK's BPS grew 9.5%/year vs. 6.2%/year for the index for an outperformance of 3.3%/year. Looks like big degradation in relative performance.

But the linearity of the above ratio chart made me look at this another way. The 1980-1998 28.2%/year is 1.6x the index return, and the 1998-2017 BPS growth of 9.5%/year is 1.5x the index return!

So, from now on, I am inclined to answer the question, "How do you think BRK will perform vs. the S&P 500 index in the future?" with, "I think it will do 1.5x better!".

Nonsense? Maybe. But it looks interesting to me. This is the danger with playing with charts.

Optionality at Low Cost
Moving on. This is not a new idea, but we can see all the cash at BRK as optionality (even though I have long said that the cash is matched pretty closely to float so wonder how much of the cash is actually immediately deployable. Some of the float might be 'fast', meaning maybe they actually can deploy a lot of that cash and run down the float if necessary).

A lot of funds held a lot of cash since the crisis and have severely underperformed the index. The worst fund managers have actually been net short since the crisis and have catastrophically posted negative returns for years on end. Sure, these guys had plenty of opportunity because they were short; if the market went down, they could profit on the decline and then use the profits to go long and make even more money! But, those guys were neither prudent nor rational, and it is unlikely they will ever be able to make up the damage as it is just too big to overcome.

And yet, here, we have BRK with all that cash and it seems like they haven't sacrificed all that much in terms of performance. That is really amazing when you think about it.

By the way, BRK has $97 billion of cash/cash equivalents on the balance sheet just looking at the Insurance and Other segment. This makes people say that Buffett is bearish the stock market. Well, it's true that Buffett has been having trouble finding stuff to buy, but that doesn't necessarily make him 'bearish'. There is a difference between not finding things to buy, and being bearish (and expecting a market decline).

One thing that occurred to me when thinking about this huge amount of cash and short term investments on the b/s is how small the investment in fixed maturity securities is: $18 billion.

So first of all, the amount of cash/cash equivalent sort of seems to me like more of a bearishness or unwillingness to buy bonds than stocks. There is only $18 billion worth of bonds in the insurance segment versus, what, $200 billion in stocks? That's not bearish stocks to me, that's more like, bearish bonds!

Not to mention BRK has been net purchasers of stocks; not the act of a bear.

Here's the other thing. When we look at insurance companies, we often look at investment leverage. For me, since I like risk, I look at the percent of shareholders equity invested in stocks. Markel looks at and talks about that, as it's a big source of their expected BPS growth.

So I think about BRK in the same way. Forget about cash vs. float and all that stuff for now.

Let's just look at how levered BRK equity is to 'equity'.

First of all, the portfolio (including KHC) is $219 billion at the end of 3Q 2018. That's against $379 billion in total shareholders equity (including minority interest). So the ratio of shareholders equity invested in stocks is 58%. That's a lot higher than any other insurance company, and I think higher than MKL has been recently (maybe they are much higher now; too lazy to check now).

Of course, this is not like the old BRK, but not at all overly conservative either.

Now, keep in mind that BRK has a lot of unlisted businesses. For example, the various businesses in the railroad, utilities and energy used to be listed companies. If these were still listed, they would be included in equities. As far as growth potential is concerned, other than not having to mark to market, these businesses are basically no different than the equity portfolio (ignore the advantages of wholly owned businesses etc.).

So from the 'leverage' point of view, we can add this to the equity portfolio. The book value of this segment is $96 billion. With a similar argument for the Finance and Financial Products segment, we can add another $24 billion.

Sum that up and you get 'equity investments' of $339 billion. That's against total shareholders equity of $379 billion. So that's already like 90% of BRK's shareholders equity invested in equity of businesses. That's really not all that bearish!

This, by the way, doesn't even include the other unlisted businesses, the Manufacturing, Service and Retailing Operations (MSR), which is the 'other' in the Insurance and Other segment. BRK doesn't disclose the balance sheet in detail for this segment, but in 2016, BRK equity in the MSR segment was $92 billion or so. Add this to the above $339 billion and you get $431 billion worth of equity investments at BRK against it's shareholders equity of $379 billion.

This is why you get equity-like returns on BRK despite BRK having so much cash/cash equivalents on the balance sheet. This is hardly the balance sheet of a bearish CEO.

I haven't even touched valuation here, but from all of the above, I like BRK a little more now than I have liked it in recent years.

I don't want to time the market and call a peak or anything. I have made it clear that even though we may enter a bear market or have a severe correction at any time, there doesn't seem to me to be a strong case to be made for an extended bear market in the U.S. at the moment (famous last words... I know!)

But the more frothy things seem (well, less so now with the October/November corrections), the more interesting BRK becomes for the above reasons.

AND, it is possible that you won't give up much in terms of performance to buy this 'optionality', with, of course, the greatest investor of all time ready to pounce if we have any big disruption in the market. And we can't forget that BRK has a lot more levers to pull than most conventional funds or even hedge funds; they can buy private businesses too, or do add-on deals to augment the many businesses they already own.

Plus, all that cash on the balance sheet doesn't mean it's as much a drag on BRK's performance as people make it out to be.

As for a post-Buffett world, I think what we need is intense rationality and discipline not to do stupid things. We know BRK is not going to jump into Bitcoin, or buy into bubble stocks (I fear we may find AMZN in the 13-F at an entry price of $3000 some day; that may be a sell signal!), panic and sell out stocks during a crisis or anything like that. And they will not be subject to quarter-to-quarter performance pressure in fear of redemptions. Many of these (and other) advantages are enough to keep me comfortable with BRK for a long time.

Also, even though BRK is not growing the way it used to, and it doesn't look like they are outperforming as much against the index, it looks like a lot of this is due to lower returns in the market in general as the rate of outperformance has been remarkably consistent even after 1998.

By owning BRK, you sort of get paid at least market performance while you wait for the optionality to be exercised!

BRK Corporate Governance, MSFT, Market Volatility etc.

Date: 2018-11-15

So Buffett finally buys some JPM. He owned a bunch in his PA years ago and said it would be a conflict to own both JPM and WFC within BRK, or some such thing. I guess recent events (WFC scandals) have made him change his mind (as he may be starting to dump WFC). I've been a big fan of JPM for years, so naturally, I like this move. I wonder if Jamie Dimon would ever make it onto BRK's board; he would be a great fit there and would give the board some real, hands-on expertise in the financial industry (there is plenty of talent there, but noone with Dimon's experience/background).

This is the 13-F that was just filed (includes only positions over $1 billion):

Market Cap to GDP
Someone asked in a comment the other day what I thought about the market cap to GDP ratio, Buffett's once favorite stock market valuation indicator. This, like many other valuations measures, is really dependent on interest rates. If you believe (like I do) that interest rates drive the valuation of assets, then prices are high when rates are low and vice versa. So, of course, if interest rates are low, the market cap to GDP ratio will be high. But that tells us nothing about the valuation of asset prices as it has to be compared to interest rates. Plus, it doesn't really tell you anything about interest rates either. (A lot of bears like to point to 'overvalued' indicators, like this market cap to GDP, P/E, CAPE, EVITDA/EV, Dow-to-Gold ratio etc. But often, it's all the same thing, so it's like double counting. They all point to one thing: asset levels are high because interest rates are low. But, people still think of these above factors as separate, discrete pieces of evidence to show the market is overvalued.)

Not to mention, many U.S. companies are growing globally, so their sales and earnings from non-U.S. business will be capitalized in the U.S. stock market while the GDP will not include those new territories. If a U.S. company merges with a European company, the stock market valuation may well increase (while GDP does not). Also, when Yahoo owned Alibaba as Alibaba took off, the U.S. market cap of Yahoo (and therefore the U.S. stock market) increased (with no increase in GDP).

So in that sense, I don't think it's a relevant measure of anything these days. I still like to adjust interest rates to what we might think is a normalized rate, and then price assets off of that.

BRK Corporate Governance
Again, from the comment section, someone mentioned an analyst or author that is comparing BRK to fraudulent companies; BRK's corporate governance standard is comparable to historical frauds (ENR etc.).

Well, I am preaching to the choir here, and maybe I am just an ignorant, blind, cool-aid drinking BRK groupie, but every time I read these comments, I think it's ridiculous. It just takes a little bit of common sense to figure out the difference between BRK and the big corporate frauds in the past.

First of all, just for fun, I took a quick look at the corporate governance score of BRK on the Yahoo Finance page, and was surprised at the high score: 9 out of 10!
Corporate Governance
Berkshire Hathaway Inc.s ISS Governance QualityScore as ofNovember 1, 2018is 9.The pillar scores are Audit: 1; Board: 10; Shareholder Rights: 8; Compensation: 6.
Corporate governance scores courtesy ofInstitutional Shareholder Services (ISS).Scores indicate decile rank relative to index or region. A decile score of 1 indicates lower governance risk, while a 10 indicates higher governance risk.
Not bad! But then, reading further, I realized that 10 means high risk, lol... Oops. So it is, in fact, the way I thought it would be. Just to be sure, I checked this at the ISS website.

From the ISS website:

Governance QualityScore uses a numeric, decile-based score that indicates a companys governance risk relative to their index or region. A score in the 1st decile (QS:1) indicates relatively higher quality governance practices and relatively lower governance risk, and, conversely, a score in the 10th decile (QS:10) indicates relatively higher governance risk. Companies receive an overall QualityScore and a score for each of four categories: Board Structure, Compensation/ Remuneration, Shareholder Rights, and Audit & Risk Oversight.

WFC, by the way, with all it's scandals, has a QualityScore of 1.

Out of curiosity, I looked at MSFT and check this out:
Microsoft Corporations ISS Governance QualityScore as ofNovember 1, 2018is 1.The pillar scores are Audit: 1; Board: 1; Shareholder Rights: 1; Compensation: 3.

OK, and check this out from the proxy:
The vast majority of our global employees participate in an annual anonymous poll. Here is a selection of results:


That sounds crazy too, for a large corporation. I don't know how 'real' this is, as we all know how people may be 'nudged' to fill out surveys in ways favorable to management. Well, they say it's anonymous, so OK, maybe it's legit.

I have become in recent years a big fan of MSFT, both as a user and an investor.

My MSFT Experience
I have been tied to MSFT for most of my career as company PC networks were usually run on Microsoft and desktops were usually Windows NT or whatever. Of course, we also had Unix machines running the serious stuff, but most office work, spreadsheet work and whatnot were done on Windows machines.

After going out on my own, I stuck to Windows, but I got increasingly frustrated at how often Windows would crash/freeze. Some days, I thought I spent more time waiting for things than actually doing any work. And then they killed XP (which I had on some of my old machines).

A programmer friend suggested I look at Linux, so I did. I installed Linux on my old laptop and eventually one of my old PC's, and I loved it. It was rock-solid and stable, like the Sun workstations (Unix) I used to work with that you never had to reboot or restart. I was seriously contemplating switching everything over to Linux and ditching MSFT altogether.

One thing holding me back was that a lot apps written for Windows is not available in Linux (well, you can still run Windows apps with Wine, but I was a little skeptical/worried that there would be issues if there was another layer). Otherwise, I loved everything about Linux. I use GIMP now all the time for photo processing (like the Buffett photo in my last post), Libre Office is great and is getting better etc. Plus my Linux machines never just randomly go into these long updates.

Well, one of my favorite things is how easy it is to run cron jobs in Linux versus Windows; I really hate the Windows task manager. A lot of other things are just so much easier to do off the command line in bash (although Powershell is getting pretty powerful, but it's so clumsy/clunky, I don't feel like learning how to use it properly).

Back to Windows
But OK, I never abandoned Windows. But what sucked me back in and made me abandon the idea of switching over completely to Linux was Windows 10. I was skeptical, but upgraded all my Windows machines to Windows 10 (forgot when), and I have been very happy. Yes, if you are not careful and don't set your 'active' time, it can go into long update cycles rendering your computer unusable until the updates are done. This is forced so you can't stop it. But you can tell Windows what hours of the day you will not be using the machine, so the forced updates will happen in those inactive hours.

OK, small problem.

But since switching to Windows 10, I have had very, very few problems I used to have. Random crashing, random freezing etc. I have not had that occur much at all and it's been a pleasant surprise.

Also, Windows 10 comes with Ubuntu bash so if you like Linux command line stuff, you can do it all in a bash terminal right on the Windows 10 machine and in those drives/folders that Windows runs on (goodbye cygwin?!).

The other major thing that drew me back to Windows is OneDrive. I used to do work on my home desktop and my laptop, and I used to have to email files back and forth to work on them. You can use Google Drive, Dropbox, Box etc. to sync files on your various machines, but I never got around to doing that with the above, and I didn't like how Google Drive seemed to keep altering my files (especially programs) when I uploaded them.

But OneDrive was so easy and is basically already set up from the get-go in Windows 10. Now my most active folders are on OneDrive, I never have to worry about syncing anything; it's all done automatically.

I think this is one of the big things that got me tied to Windows now.

Plus, I am playing with Azure now and it is very easy to create Linux instances (basically virtual machines in the cloud) so you can write bots and set them up to run as cron jobs and your tasks will be done whether your PC/laptop is on or not. Plus they have databases and many other cloud services (I use Amazon too, but mostly for fun/experimenting).

So when you think about how all of this is integrated and everything works great with each other, you can see how excited I am about MSFT. A programmer relative told me a few years ago that MSFT sucked for most of their existence, but that with C#, Azure and other cool things, they are becoming a really incredible company. (I am also experimenting with C# but haven't created anything for actual use). Of course, at the time, I didn't really look into it or understand.

Anyway, this is sort of relevant, right? As IBM just bought Red Hat, which is a Linux business. Anyway, I still love Linux and have a Linux box sitting next to my main Windows 10 machine. Linux will continue to grow, and behind the scenes, Linux runs everything, and will run even more going forward.

And check this out. I just recently noticed that Stanley Druckenmiller is big into MSFT:

So he is probably seeing and hearing the same things I am talking about. Well, OK, I have no idea why Druckenmiller is long MSFT. But I would assume it has something to do with what I'm talking about.

Oh yeah, and I really enjoyed Nadella's book:Hit Refresh.

With the FANG/FAANG stocks so popular, who knows, maybe MSFT is the tortoise that surprises everyone!

Back to BRK
OK, so there is probably not much I need to say on how silly it is to criticize BRK's corporate governance. Check this out from the BRK 2018 proxy:

This list doesn't show a group of people who really need the money. I think the average compensation for a big company director is something close to $300,000. If you wonder why so many board members seem to be yes-men to the CEO, this may be one reason why; it's good money! Don't rock the boat, keep quiet and keep cashing your checks!

It's clear from the above table that BRK directors are not there for the money. And sure, they are friends with Buffett so are they really independent? I would rather have directors that understand Buffett and BRK well, and have enough of a spine to express themselves if they see something they don't like.

There is a lot more to say on this but one of the biggest arguments in support of BRK's structure is that Buffett himself is the largest shareholder of BRK, so if this was a fraud, who is he defrauding? Himself? That's laughable. He takes a $100,000 salary but the bulk of his wealth is created by BRK's stock.

This is the opposite of most situations, where managements own token amounts of stock (and dump their stocks whenever they exercise their options) and pay themselves massive amounts of money. When you own very little stock but pay yourself huge amounts, I think that incentivises fraud more. Don't you think?

When a CEO has 99% of their wealth tied up in a stock, that is stronger than any corporate governance factor I can think of.

But corporate governance specialists, critics and academics don't seem to understand that. They would rather check the boxes on what they inflexibly think of as good corporate governance practice and that's it. I guess part of it is laziness, and part of it is just practicality.

Institutions that own a large number of companies can't possibly evaluate that many CEOs, BODs, etc. so they need some simple measure to save time. Like P/E ratios, maybe. Those that don't know how to evaluate businesses may have to depend on P/E ratios to evaluate cheapness, but if you know how to evaluate businesses, P/E ratios often don't really matter (as they don't tell the whole story, like, in the case of BRK!).

I mentioned this in the comments section of another post, but the other issue is that Buffett is so hands off the businesses to the point of abdication. But this is misleading. We all know Buffett watches numbers like a hawk. He said he gets faxed sales figures every day from various businesses and he looks at them carefully every day.

What he means when he says he is hands off is that he doesn't micromanage. He doesn't insist on seeing every ad before airing. He doesn't want to interview and approve every new hire. He is not going to approve every paint job of a store, or pricing/marketing strategy of each business. He is not going to approve each detail of every budget for every line of business.

But this doesn't mean that he isn't watching every penny that goes in and out of the businesses. We all know that all of the free cash of a business is sent to Omaha, so if something is wrong, he will know right away.

For the businesses where things may get funky, like the insurance businesses, those are highly regulated, and Buffett is very closely monitoring those businesses and is very involved as he says, with big blocks of business (talks to Jain several times a day etc...).

As for transparency, I don't know. I never thought BRK lacked transparency. It could disclose more, of course, but I never thought of BRK as a complete black box or anything like that. Major business lines are presented clearly and in detail. Some of the non-insurance businesses might be opaque, but each of them are just too small to disclose separately.

Some fuss is made about the Sokol incident, but those things will happen every now and then to any company. Goldman Sachs has a lot of legal and compliance infrastructure, is highly regulated and constantly audited, and yet we now have the 1MDB scandal. So I don't know that the Sokol incident proves anything about BRK either way. You have to look at the big picture and see the kinds of problems they've had over the years, and the record is pretty good. Will another scandal happen? Yes. These things will happen. It's how management deals with it that will determine the fate of BRK, and I have faith that they will deal with any issues in the future promptly.

As Munger says, it's all about incentives, and I think BRK people are properly incentivized.

Remember what Buffett said after the crisis. He said that there was a regulator who had one job, and that was to regulate FNM and FRE, I think. And they failed. So just because you have someone watching and regulating, if the incentives are not correct, you are going to have problems.

Market Volatility
So, I was a little irked when the market was down 600 points the other day when I was on my way out of the house. I know I don't really care, but still, at the back of my mind, I think, is this it? Is this the end of capitalism? Are we going to go down 90% like we did in 1929-1932? OK, I wasn't that worried, actually.

But it made me curious. Why are we so scared of big market moves like this? 600 points is a little more than 2%. Back in the late 1980s and early 1990s, a 2% move would have been a 50 point move. 600 points is psychologically shocking because Black Monday was a 500 point drop. So it feels like Black Monday again (that was before my time!).

I tend to buy into narratives I don't really care about. The HFT/quants are making the markets more volatile. ETFs, especially leveraged ETFs are making the markets more volatile. More regulation in the markets and the resulting decrease in liquidity (thinner bid/ask from market-makers/specialists) are making the markets more volatile etc...

I go, hmm... OK. Probably true. But whatever. Doesn't matter to me.

But sometimes, I suddenly think, wait a minute. Is all of this true?!

Let's take a look!

First of all, let's just take a look at the market's volatility on a rolling 100-day basis. This is what derivatives traders would call the 100-day historical volatility. I looked at this going back to 1950. All of the following charts include data up to this past Monday (11/12/2018).

So, looks pretty normal. Even with the big moves in the past few weeks, nothing out of the ordinary here. In fact, I would have guessed things were pretty wild since Trump was elected, but if you look back to even 2012, 100-day vols have been in a normal range. It certainly doesn't feel that way.

OK, so maybe vols don't tell the whole story. Let's look at some other things.

We've had a few days where the market was down more than 2% recently. Or it feels like it happens a lot. So, I looked to see how often the market went down more than 2% on the day. To make it a readable chart, I just summed up how many times the market declined by more than 2% in the past 200 days.

Here's that chart:

So yes, it's a little elevated, but nothing really out of the ordinary. Look at the period during the crisis! Also, look at the mid to late 1990s, even before the bubble collapsed.

What about those days the market opens down 800 points and closes up 300, or some such crazy thing? It seems like that sort of thing happens a lot these days. If I had to guess, I would tell you that that happens more often these days than in the past.

To measure that, I just subtracted the day's high from the day's low and divided it by the day's close, and then took a 100-day average of that.

Here is that chart going back to 1962 (hi-lo data only goes back to 62):

...and surprisingly, this too is in a very normal range, and far below the levels of even the mid-90s (I guess the day traders used to make this really wide). Nothing out of the ordinary here.

And let's look at the number of days in the past 100 days that the day's range exceeded 2%.

Totally normal range. Nothing out of the ordinary.

JPM is now a BRK stock. Get Jamie on the board! He would be the person I trust most next to Buffett.

BRK scores low on corporate governance, but so what? Look at the incentive structure, which is more important than committees, bureaucracies like compliance/legal departments etc.

People who write to complain about BRK are people who just don't understand, or just use BRK to grandstand and gain attention by making astounding claims against consensus (this is why people like to say "the market is going to crash 50%!", or "the market will get to 500,000!"). So ignore those people.

Microsoft is pretty awesome. I never made a post about it as an investment; I should have when I started to get interested, but oh well. Maybe eventually, but I don't really have anything to add to MSFT in terms of financial analysis/valuation.

And, the markets seem like they are crazy and more volatile than ever, but the above charts don't bear that out. People, the press, keep freaking out over 2% moves as if they are 10% moves. The markets, despite all the things that should make markets more volatile than ever, are just as volatile as they ever were and no more. So relax!

Has Buffett Lost It?!

Date: 2018-11-04

Wow. Apple (AAPL) was a $28 billion position at the end of 2017, with 167 million shares, but now BRK owns 252 million shares as of the August 13-F (November will be out soon), for a position size of $47 billion then and $52 billion now (as of 11/4/2018).

That sounds crazy as it's the largest position ever, and it's a 'tech' company. OK, maybe it's a consumer products company and not a tech company. Either way, wow, that's a big bet, exceeding 10% of the market cap of BRK. Well, for focused investors, 10% is not such a big deal, and even 25% of the equity portfolio may not be that crazy as AAPL isn't some obscure micro-cap, or over-leveraged industrial cyclical or anything like that.

But, I am not the biggest fan of AAPL, so it is interesting. Coming right off his IBM miss, I guess many shareholders would be a little surprised.

Of course, I don't recommend it, but this is an easy position to hedge against; you can just short AAPL shares against whatever BRK owns.

Here is the 13-F from August; I only show positions of more than $10 billion here:

You can get the whole sorted table here.
(oops, the above link shows an error for some reason. You can click 'website' below and then just go to the 13-F section and click BRK).

I know a lot of stuff on the website is broken. When I have time, I will fix it and maybe add some stuff to it. When Google finance/Yahoo finance dropped their financial data API's, a lot of things broke and it got to the point where I would have to pay for data to update stuff, and I don't want to do that. I recently noticed that a form of the Yahoo Finance API is back up, so I will be able to update some stuff, but I will have to rewrite a lot of the code, so I am in no rush to do it at the moment (I have a lot of work I need to do for others etc... this stuff goes to the back of the queue, unfortunately).

The bull and bear argument has been the same for years, so I don't want to get into it again here, but I feel like AAPL has sort of been chasing the crowd lately rather than leading it or disrupting it like they used to during the Jobs years. But again, this would get the AAPL fans all fired up and angry, so maybe I'll leave it at that. I'll just say that moving up to higher end products to make up for declining growth momentum reminds me of retailers/restaurants that hid declining traffic/unit volumes by moving up-market or raising prices. It works for a while until people finally say, no mas, and will no longer pay high prices. Sort of reminds me of J. Crew, P&G etc.

The Markets
The markets have been going nuts too. Well, I don't mean to imply that Buffett has gone nuts, really. AAPL has a strong brand name/franchise, high returns on capital, decent margins, too-strong balance sheet, repurchases a lot of shares etc. So a lot of the boxes are checked in this case. Can't blame someone for buying a company like that.

The markets can be down hundreds of points overnight, but then be up hundreds by the close (if not an hour after the open), and vice versa. It has always been meaningless to stare at the market during the day (and futures overnight), but it seems even more so these days. I guess bots can be part of it. Risk parity is probably also a part of it. Leveraged ETF's. In any case, it's important to remember that we shouldn't be responding to markets. You should never be selling anything when the market is down 800 points. That's just obvious. If anything, if you have something to buy, you should be buying. But if you sit there and stare at the markets or otherwise follow it too closely, all sorts of bad thoughts can go through your mind. If it is too upsetting or scary, just turn off the TV, or don't look at the market for a while. It's like the weather in Amsterdam; if you don't like it, just wait. It will change. (Did I get that right?)

Interest Rates
I hear all the time that interest rates are going up so the market must go down, but all of my work in previous bubble posts were based on the baseline assumption that the 'normalized', sustainable long term interest rate is probably around 4.0%. Using a lot of historical data, I showed that if the long term rate averages 4% over the next 10 years, the market could easily average a P/E ratio of 25x over that time frame. This is not a prediction, of course. It's just an observation based on history: if it's not different this time, and if interest rates average 4% over the next 10 years, then, based on history, a 25x P/E would be completely normal.

Yes, this is basically the Fed model, which has been a subject of debate if not completely discredited by some. One debate is that the relationship between P/Es and interest rates held only for a brief period in time and not for the whole 100+ years of recent history, but my feeling is that since interest rates were regulated for much of the early 20th century, it's hard to say if there is any meaning in the lack of correlation going too far back in history. The other argument is that P/E or E/P is 'real' whereas bond yields are not. But this argument only strengthens the above argument. A low E/P is even more attractive than a low bond yield as the E will increase with inflation whereas the bond yield will not. And comparing earnings yields to the TIPS yield (which would take care of the real versus nominal problem) would just be silly as the TIPS yield 10 years out is 1.2%, suggesting a P/E multiple of 83x.

So, watching the market throw conniptions because interest rates went above 3.0% didn't worry me at all. I thought, OK, well, whatever. All else equal, higher rates may equal lower equity prices, so people dump stocks when rates go up. But as I've said in my bubble posts, I don't see the rubber band stretched at all, so the market is not in need of a violent correction. Of course, if we are on our way to 6-8% long term rates, then that's a different story.

When markets go crazy like this, people tend to ask me about hedging. Well, first of all, hedging is something to do before the market goes down, not after. It's interesting that people start to want to hedge after the market starts to go down and volatility goes up (hedging costs go up).

I've spent a lot of time in the derivatives business, and a lot of it is about hedging. There are a lot of good and valid hedges; interest rates, FX, commodity prices etc. But when it comes to the stock market, a lot of hedging is baloney. Some large institutions may use futures to synthetically adjust their asset allocation (sometimes cheaper than selling stocks, paying taxes and buying something else).

But when it comes to just directional hedging of the stock market, I think more money has been lost trying to do that over the years than any money actually lost in the stock market. I know for sure that if you try to hedge a stock portfolio with futures, options or swaps, it's going to cost you. If you need to hedge your portfolio using any of these, most of the time, you are just better off lightening up your position and forget about hedging. If you feel like you need to hedge your portfolio with put options, you probably just own too much.

If you hedge all the time, it's going to be very costly. I'm not going to do it, but just go look at some put option quotes on the S&P 500 index, for example. And imaging rolling that over every three months, or every year. It is not cheap at all. And if you think you can time it and put on hedges only during risky times, well, that usually doesn't work out either. Some very good investors thought the market was expensive a few years ago and hedged their portfolios and it was a disaster. Even the smartest can't time their hedges.

If you look at how wealth is built up over the years, most of the time, it's been created by people who hold very good assets for very, very long periods of time. Nobody gets rich by being very good hedgers of their portfolios. OK, there are some hedge fund managers who have done it over the years, but that's pretty rare. Most other people, if you look at the richest people list, just own good assets and don't try to get in and out according to how they feel about the market or the economy.

In a sense, people like Buffett and Bill Gates are kind of lucky in that they can't get in and out of their positions anyway, even if they wanted to. Imagine Gates calling Goldman Sachs, "I want to put on a zero-cost collar on Microsoft because I don't like where we are going in this economy!". Nope. Won't happen. I know hedging CEO holdings used to be a big business for derivatives desks a while back; maybe it still is. But if you look at the guys who create tremendous wealth, most of the time, they just own and hold onto great assets for long periods of time.

Real estate wealth is built the same way (but they get leverage, and their buildings are not marked to market so they never get margin-called; that's a huge advantage versus leverage in the stock market). They can't just buy and sell futures, options or swaps against their holdings. And they can't trade their buildings short-term either.

As I've said before, the stock market suffers a sort of "curse of liquidity". Since you can just liquidate your entire portfolio by pushing one button on your iPhone (OK, well, maybe not some rich people, but many of us can...), it is easy for us to do stupid things. And you can see how much you are losing every second of the day on your iPhone. You can't do that with real estate; there is no way to tell exactly what it is worth until you put it on the market and get some bids. In other words, there is no manic-depressive Mr. Market knocking on your door every micro-second in real estate (unlike stocks) tempting you into doing stupid things. So 1. there is no stupid-behavior-inducing signals (crashing prices) and 2. there is no way to act immediately on impulse in the real estate market. Most people would do better in the market if they treated their equity portfolio like their home.

What a total disaster GE is. I've always admired GE and it was one of those companies that I really wanted to like and wanted to own, but it never quite worked for me. First of all, Jeff Immelt must be the worst CEO of all time. OK, there are CEOs that bankrupted companies, committed fraud etc. So in that sense, maybe he's not the worst. But as a non-criminal, blue-chip CEO, he's got to be one of the all-time worst. And it's not just about the stock price; the businesses are just horrible. It looks like he stood up and got hit with a left hook, ducked to avoid the next shot only to get a big upper-cut to his chin. Whatever he did seemed just wrong.

I remember when Buffett was talking about CEOs, and this was around the time that Irene Rosenfeld sold the frozen pizza business for cheap and overpaid for Cadbury. He was talking about how many CEOs are great operators but many have issues with capital allocation. We all thought he was talking about Rosenfeld, but it didn't occur to me that he was probably also talking about Immelt.

He often said how wonderful Immelt was as a CEO but never actually bought GE stock (or in any size that I can recall; it was never a top holding), and I always wondered about that. In hindsight, well, he was probably also talking about Immelt.

GE is really tempting now at under $10, and the CEO is a really good one, but I'm not sure how GE gets out of this. Frankly, I haven't taken a close look at this in a while; maybe I will. If I find anything interesting, I will probably make a post here. But I just don't like (and never liked) the businesses these guys are in. It's mind-boggling how Immelt just seemed to run the other way than the world was moving.

Has Buffett Lost His Mind?!
OK, so back to Buffett. Has he lost it? Is he buying more AAPL shares? Does he need intervention? Should he undergo some tests to make sure he is OK?

I have no idea. I'm sure he is fine, and all accounts (from the annual meeting etc., and is interviews on TV) seem to indicate he is fine.

I guess AAPL is so big because it's the first time in a long time that he really got to like something and it was large enough so that he can actually buy a ton of it. Remember, he was capped at 10% on Wells Fargo due to bank regulations.

I own BRK, and I don't really like AAPL, but I'm not going to hedge out the AAPL piece.

We'll see.

JPM 2017 Annual Report (JPM)

Date: 2018-06-14

It's been pretty quiet around here. This post has been sitting in the queue for a long time, so I figure I'll just get it out now.

Things seem to be pretty fully priced. When I first started this blog back in 2011, banks / financials were cheap, analysts were bearish, the public hated banks (well, they still do) and Occupy Wall Street was in full force. That was one of the reasons I started the blog in the first place, to say that not all banks are evil, and no, banks aren't dead etc.

I still feel the same about the market as I've been saying for the last couple of years. I am not really bullish or bearish, but I have no problem with valuations and don't really see a bubble, except in certain areas.

Yeah, it was scary when the market was down more than 1,000 points earlier this year. But I was not really all that worried. If this is a bubble and a top, it's one of the most timid bubbles of all time. At least that's what I think. Most bears talk about how much the stock market has rallied since the low, and I think that is nonsense.

If a stock goes from $100 to $50, and then back up to $100, is it really overbought? It might be. But not necessarily. If you look at previous bubbles, markets appreciated a LOT from the previous high. In this case, we are not that far above the 2007 peak.

Anyway, that's my view. I know many don't agree, but who cares, really.

Also, people seem to be freaking out that interest rates are rising. But all my bubble posts used 4% as the 'normalized' long term interest rate, and the market is not expensive, in my mind, even with interest rates at 4%, let alone 3%. So that, to me, is not yet a big concern. Of course, interest rates can overshoot due to higher than expected cyclical inflation. But that doesn't really concern me all that much. Sure, the market will tank on each interest rate uptick, but since the rubber band is not that stretched (in terms of the relationship between P/E and interest rates), there is no need for the market to go down all that much.

Buffett also keeps saying that stock market valuations are driven by interest rates. Critics say comparing earnings yield to bond yields is wrong as it compares 'real' versus 'nominal'; bond yields don't adjust to inflation but earnings yields do (over time as earnings will increase with inflation).
This is true, but if you make that argument, then maybe earnings yields have to be compared to the TIPs bond yields, which is 'real'.

10-year TIPs yields around 0.9% these days, so to compare real-versus-real, the stock market should be trading at 111x earnings. But don't forget, company earnings grow with the economy over time and not just with inflation, so stocks still have a 2% or so advantage over TIPs even at 111x P/E.

But of course, this is all just theoretical mumbo-jumbo. I wouldn't tell anyone with a straight face that the market should be trading at 100x P/E. I wouldn't pay that either, and if the S&P 500 index was trading that high, even I (the avid non-market-timer) would be long a boatload of puts!

Moving on...

I watched the annual meeting and his long interview on CNBC and it was great as usual. But honestly, I don't remember the last time a question was asked and the answer wasn't something I would have guessed. The letter to shareholders too was the usual, and like others, I was surprised at how short it was. He is getting old so regardless of what he says, he is probably slowing down a little.

What might happen, and might be really cool, is if others contributed to the letter. Maybe Todd/Ted/Ajit /Greg can contribute a section in some way. That would be interesting, and would be a nice transitional thing to do.

The latest thing in the press is about Facebook and privacy. One thing I don't understand is that when we joined Facebook, we sort of all assumed we will have no privacy there. That's why I don't have my real birthday there, no credit card information nor my social security number. I remember upsetting some people when I didn't put my real photo on the profile page. Well, my fear was that not too far in the future, people would be walking around with something like Google Glass, and they will know immediately who I am because of the facial recognition app that will no doubt be installed on it. The glasses will automatically see my face and do a search, find my image and profile (either from Facebook, Google+, LinkedIn or wherever.

If you are tagged even once on a public photo, the engine will be able to identify you anyway, even if your profile photos show a picture of Dexter Morgan. Once they know your name, the app will search through Linkedin, find out what you do and then maybe scan Glassdoor to estimate what you make etc... All of this will show up on the glasses, and will do so for anyone that is looked at. Creepy stuff. But that day is inevitable, I think. One day the IRS will get hacked; you will be sitting in the subway with your hi-tech glasses and look around and you will see the tax returns of every face you focus on. This is certain to happen, eventually. I have no doubt about that. This is the sort of thing that scares me. (but then again, I have nothing to hide, so I don't really care. It's just creepy)

But anyway, I was kind of surprised at all this outrage about FB; what did people expect? You fill out a questionnaire or do those silly trivia games and are shocked that someone is using that data?!

Actually, it seems like it is not affecting too many people, so maybe it's just the press going crazy over it and making more of a big deal out of it than your average FB user.

I still think mobile phone companies and credit card companies know far more about you than FB; those guys know where you are, what you spend money on going back decades etc. Creepy. But that's been true for a long time.

Anyway, as usual, the JP Morgan annual letter is a great read. No need to elaborate much on it, but as usual I love the charts they put in it and in the proxy. These are charts I've been following for years, even before they started to put them regularly in the reports.

Conference call
By the way, I usually listen to the JPM conference calls every quarter. There is a lot to learn from them, and when Dimon is on, he is usually pretty blunt, so fun (and educational) to listen to.

But one thing that I wonder about is the format. When you listen to some of the high-tech conference calls, what's cool is that some of them totally drop the summary and go right to Q&A. Do we really need someone to read off the highlights from each slide? I would rather that be cut and have a longer Q&A session, or have topics not covered in the slides. It seems kind of silly that someone just reads off something we all have already.

Amazon's meeting protocol is interesting. I think they spend 20 or 30 minutes reading the material (at the meeting) before they start discussing stuff. Obviously, there would be no need to have a conference call and be silent for the first 30 minutes... Maybe just release the documents 30 minutes sooner or whatever (I know they release it before the call, but just increase the time in between, maybe). Give people time to go over it so on the conference call, they can just focus on the Q&A, and maybe a short comment just highlighting important things.

But I don't know. Maybe the analyst community likes it that way as they have to sit through a bunch of these during earnings season and they like that slow time in the beginning so they can flip through the slides etc. But for others, it's a tedious section to sit through...

I haven't changed my mind about bitcoin at all, and no, I haven't gone out and secretly bought some "just in case". Nope. Didn't do that and don't plan to. I continue to side with Buffett on this. And he had a good point in the interview/annual meeting: these things with no intrinsic value and where people can only make money if more people come into; people get angry when you speak out against it as they need people to come in for the price to go up.

I remember the anger and emotion when people spoke against gold too. But you never really see value investors get upset when bears talk down value stocks.

Hedge Funds
What's up with these big hedge funds? I don't know. I am a fan of the big hedge funds, generally, but many have been doing horribly in recent years. I am especially shocked how bad Einhorn is doing, as he seems to be making the same mistake that the big funds made back in the 1997-2000 rally. If you remember, guys like Julian Robertson and Stanley Druckenmiller had trouble back then, as shorting expensive stocks and buying value didn't work for a few years back then. One would think people wouldn't repeat that mistake, and yet, Einhorn is short a bubble basket.

Anyway, his analysis is probably right, and those stocks will probably go down or be valued more realistically at some point. But the problem is you could have argued that with Amazon and Netflix for years. Who is to say it has to 'normalize' within the next twelve months? And if it doesn't, the stocks can be up another 30%, 50%, or 100%. If the market is ignoring fundamental valuation, that just means something trading at 100x P/E can just as easily go to 200x P/E. Why would you want to get in front of that!? I don't know. But these guys are way smarter and richer than me, so who am I to say.

Average Holding Period of Stocks
People often talk about the average holding period of stocks, and how that has been shortened dramatically. I tend to think that analysis is flawed, as many of those figures use trading volume as one of the factors. Well, with all that HFT trading going on where portfolios can turn over 100% in minutes, that sort of skews the data. Just because a bunch of quants start trading with average holding periods in micro-seconds, that doesn't really affect the rest of us who still like to own stocks for 5, 10 or 20 years.

But anyway, not a big deal.

Ian Cumming/Leucadia
I realized way after the fact that Ian Cumming passed away earlier this year. I don't go to many annual meetings, but I will never forget the last LUK annual meeting with Cumming/Steinberg. I wrote about it here.

Not long after that, Leucadia changed it's name to Jefferies Financial Group and ticker symbol back to JEF. Oh well. I guess that reflects the reality that LUK is not really LUK anymore (and wasn't after the merger).

OK, so most of these are self-explanatory but let's look at some of the charts from the JPM 2017 annual report.

JPM is doing well against comps in terms of cost and return on tangible book.

Classic Dimon; snip from annual report:

I was recently at a senior leadership offsite meeting talking about bureaucracy. We heard bureaucracy described as a necessary outcome of complex businesses operating in complex international and regulatory environments. This is hogwash. Bureaucracy is a disease. Bureaucracy drives out good people, slows down decision making, kills innovation and is often the petri dish of bad politics. Large organizations, in fact all organizations, should be thought of as always slowing down and getting more bureaucratic. Therefore, leaders must continually drive for speed and accuracy to eliminate waste and kill bureaucracy. When you get in great shape, you dont stop exercising.
Meetings. Internal meetings can be a giant waste of time and money. I am a vocal proponent of having fewer of them. If a meeting is absolutely necessary, the organizer needs to have a well-planned, focused agenda with pre-read materials sent in advance. The right people have to be in the room, and follow-up actions must be well-documented. Just as important, each meeting should only run for as long as it needs to and lead

I love these two quotes. I worked at a large company and it's so true. People tend to spend more time building and defending bureaucracies than building businesses at big places. Dimon talks about having war rooms to tackle urgent issues. Part of why that's so great is because the teams are put together for specific projects, and are presumably disbanded after the task is done.

The problem with big companies, oftentimes, is that a section or group is set up to deal with certain issues, but when those 'issues' are resolved or are no longer issues, the group or department, have to invent other reasons to keep existing. Or sometimes they don't even have to do that; the department survives with underemployed people doing nothing all day long (I have seen this). They can't shut down these divisions because there is no place for the managers to go, and they can't be demoted. With ever expanding companies, this is an issue as you have to sort of create more and more of these divisions that worthy employees can be promoted into.

There probably shouldn't even be departments/divisions at all. Teams should just exist temporarily for specific tasks and that's it. Once you create a department, it just creates incentive for the head of that department to get bigger, and of course, they will resist change when the environment changes. So ban divisions!

But of course, that's easier said than done. I am not a manager, so it's easy for me to say!

Moving on...

From Proxy:


1TSR assumes reinvestment of dividends

The Firm has demonstrated sustained, strong financial performance
We have generated strong ROTCE over the past 10 years, while more than doubling average tangible common equity (TCE) from $80 billion to $185 billion, reflecting a compound annual growth rate of 10% over the period.


We have delivered sustained growth in both TBVPS and EPS over the past 10 years, reflecting compound annual growth rates of 10% and 19%, respectively, over the period.
ROTCE and TBVPS are each non-GAAP financial measures; for a reconciliation and further explanation, see page115. On a comparable U.S. GAAP basis, for 2008 through 2017 respectively, return on equity (ROE) was 4%, 6%, 10%, 11%, 11%, 9%, 10%, 11%, 10% and 10%, and book value per share (BVPS) was $36.15, $39.88, $42.98, $46.52, $51.19, $53.17, $56.98, $60.46, $64.06 and $67.04.
Excludes the impact of the enactment of the Tax Cuts and Jobs Act of $2.4 billion (after-tax) and of a legal benefit of $406 million (after-tax). Adjusted net income and adjusted EPS are each non-GAAP financial measures; for further explanation, see page115.

Anyway, there is not much more to say about JPM than to say that they continue to be doing really well. Their performance since 2008 is amazing no matter how you slice it; who would have guessed this performance back in 2008 as the financial market started to melt down?

I know I spent more time talking about random stuff than JPM, but whatever... I just want to get this out now so...

Barnes & Noble (BKS)

Date: 2018-01-05

I love books, and out of all the retailers out there in the past five, ten years, I've spent more time at BKS than anywhere else. It used to be Tower Records or J&R Music World, but now that they are all gone, BKS is one of the only other retailers that I actually enjoy being in (and, of course, some independent bookstores).

Bitcoint tangent
By the way, I don't care, really, either way about bitcoin, but did you guys notice something really interesting? The financial guys that really love bitcoin are some of the guys that either blew up or closed funds due to poor performance. The two most prominent fund manager bitcoin boosters are like that. It almost feels like they are so happy to have found their Hail Mary pass. And the most prominent guys that have good performance and didn't blow up tend to be the guys that don't like bitcoin and think it's stupid, a bubble or whatever.

Think about that for a second. Oh, and that former hedge fund guy, after bitcoin plunged put his new bitcoin hedge fund on hold (buying high and selling low?). Now wonder he didn't do well with his hedge fund; if you're going to be making decisions based on short term volatility like that, you are bound to get whipsawed and lose money.

This is interesting because we can never really understand and know everything. But it is useful to know who you can listen to and who you should ignore. Sometimes, this saves a lot of time!

Back to BKS
But what has been shocking to me, after having spent hours at BKS over the past few years, is how inefficiently run it seems to be. I am always surprised at how many employees there are walking around, or just standing there doing nothing at all. I'll call them floaters. Sometimes, desperate looking employees come up and ask me if I need any help as if they have to fill a quota on how many people they help.

Recently, even before the holiday rush, I saw two BKS employees leaning against the hand-railing playing with their phones. I went to look for some books, came back, and they were still there. Doing nothing at all; not even greeting.

And what about those 'greeters' at the top and bottom of those escalators? They remind me of the Japanese department stores in the 80's; those uniformed employees with handkerchiefs held against the escalator handrail, bowing to customers as they get on and off. Yes, BKS has the equivalent of that, in 2017! Sometimes they stand so close to the escalator that it seems dangerous as it blocks people from getting off... I almost tripped when someone stopped right at the top of the escalator to ask a question. Last fall, I saw two people at the bottom of the escalator. Do we really need so many greeters? (and why are they all white?! Even in diverse Brooklyn, all of the employees are white, except for security guards and cleaning staff. Is BKS so old-fashioned to think that only white people have college degrees and are capable of working at BKS? This is 2017, not 1830. Come on!).

With 600+ stores, these greeters and floaters can be very costly. I can't imagine them making less than $15/hour. At 8 hours a day and 600 stores, one of those floaters (I call them that because they just float around doing nothing) can cost the chain $26 million/year. You get two of those, and that's $50 million/year.

To put this into context, the bookstore (excluding NOOK losses) had operating income of $91 million in 2017 (ended April 2017).

Of course, this may be a little too simple; not all stores will have elevator greeters etc., and operators will point to K-Mart/Sears as an example of what would happen if you cut too much in costs (and how financial people are clueless). But that's an extreme case, I think. It doesn't mean there isn't room for improvement at BKS. I know that they respect their 'booksellers' and want that community bookstore feeling with tons of friendly and knowledgeable employees to help people buy books. But it seems a little over the top and outdated to me. But I'm not a retailer so...

The other thing is that when you walk into a BKS, it's like walking into the 1970's; there is no technology anywhere. OK, there probably is in the POS system and in the back somewhere, distribution etc. But otherwise, the absolute lack of technology is kind of stunning.

Japan is not known for running efficient retailers (there are some good ones, like 7-11, Uniqlo, Muji etc.), but even in Japan there was this cool thing at a large bookstore:

It's a section where customers can search for things on their own. At BKS, when you ask someone anything, most of the time they go to a machine and do a search. I always wish they had one available for customers so we can do it ourselves. It would free up a lot in terms of labor. Even the New York subways have huge touch-screens so you can find and get information.

Here's the other thing. I notice long BKS checkout lines and wonder why that hasn't been automated. I would think books, due to their relative uniformity, would be the easiest product to implement self-checkout.

And here's the embarrassing thing; even the public libraries have self-checkout now. I love the public libraries and don't mean to knock them, but you don't expect those quasi-governmental, non-profit organizations to be at the forefront of technology. Those self-checkouts are really great. I used to hate waiting in line to check out books at the libraries. Now it is very easy and fast. And self checkouts would mean noone trying to sell you anything! I used to always have this awkward conversation, saying no, I don't need a card, and no, I don't want you to have my email address or mailing address etc...

Also, most of the time when you see someone ask a BKS employee a question, it's "where are the cookbooks?" or some other thing. Any high school coding club could set up a touch screen floor-map of a store pretty easily. I always wondered why there isn't one of those set up by the front door, elevator and escalators. Technology is getting cheaper and cheaper. And BKS seems to be one of the best places to implement some of this stuff. They also have so much datathat they would be able to use (just saving what is searched by customers would give a hint to buyers).

The other issue is pricing. Even if you are a member and get a 10% discount, the prices on most books are still much higher than on Amazon if you are a prime member (and get free delivery). Amazon built their business on the Costco model, but BKS memberships seems like a half-hearted attempt at that. There doesn't seem to be a real economic benefit to being a BKS member (if AMZN books are still way cheaper than BKS member prices, why bother?!).

If they are going to do it, why not jack up the membership rates and lower member book prices? Why not match online prices like Best Buy? (isn't that how BBY recovered?).

Anyway, I don't know. It's really frustrating to watch this ice cube melt as I really do like BKS and don't want them to go under. But if they keep their head in the sand and try to keep up with this, they are not going to survive, and that would be a bummer for me (where would I hang out in a mall or when I have to wait for someone when they shop?!).

There are a bunch of other things, like, why is their CD/DVD section still so big, and prices so high? Do people actually buy things there? Every time I see those sections, I walk through it and I don't think I've ever seen anyone in there. I saw very few people in there during the holiday season, but usually it's empty or one or two people at most... What's up with that?

I know retailers are dangerous for private equity and activists, but it just seems like there is so much low-hanging fruit there that I can't imagine someone not making money off of gaining control.

Having said that, I don't own any (and have never owned) shares, yet. It is definitely a melting ice cube so I would be careful. But still...

Is Buffett Bearish?!

Date: 2017-11-22

This is going to be a short post. It's just another one of those things that hit me in the head, like, duh!

I read all the time that even Buffett is bearish the stock market as he is stockpiling a ton of cash. He has close to $100 billion in cash (and equivalents) on the balance sheet now. The idea is that the market is so expensive he is not finding things to buy (even though he is still buying Apple).

I took it for granted and sort of agreed, thinking that maybe he is just saving up for a really huge deal.

Still, something about this bothered me and didn't sit well. I was catching up my 10-Q's and just read BRK's 3Q and saw these giant numbers on the balance sheet, and something else struck me too, right away. Loss and LAE is up to $100 billion!

And that immediately reminded me of one of my old posts where I contended that Buffett never allows cash, cash equivalents and fixed income investments to fall very far below float (old-timers will remember this). In other words, the idea that the low cost "float" is invested in stocks and operating businesses, to me, is baloney. Well, cash/capital is fungible so you can't say float isn't invested in stocks. But still, I noticed this and made a big deal out of it. Well, sort of.

Anyway, I just created a new spreadsheet going back to 1995 to see if what I said is still true (well, there is no reason the historical data would change, of course).

And here it is:

Berkshire Hathaway Cash and Fixed Income vs. Float

I shouldn't be surprised at this as I noticed this myself a few years ago. But check it out. I think people think Buffett is bearish because he used to say that he wants $20 billion of cash on the balance sheet at all times for emergency liquidity. And when cash gets over that amount, it is assumed that this is 'firepower' for the next mega-deal.

By the way, my float is not the same float as Buffett's. For simplicity, I only include Loss/LAE and unearned premiums.

Anyway, check it out. All of that cash and cash equivalent increase is basically just matching the growth in float! And to the extent that cash and cash equivalents have grown quicker than float reflects the reduction in fixed income holdings (from $36 billion in 2009 to $22 billion now), which is more of an indication of Buffett's bearishness on bonds.

The column all the way to the right is just the cash, cash equivalents and fixed income investments as a percentage of my lazily calculated float. You will see that it has been close to 100% since 1995, and I think it was true going further back. The average over this period is the 105% you see at the bottom of the table.

Anyway, the next time someone tells you that Buffett is bearish; just look at his cash stockpile, you can say that is more reflective of his bearishness on bonds (bond balance down, cash up), and the rest is backing up the float, as he has been doing since at least 1995.

Bubble Watch X

Date: 2017-11-16

The title of this post is pronounced, "Bubble Watch Ten", not "Bubble Watch Ex". So don't sound uncool in public by calling it Bubble Watch Ex...

So the bears keep saying we are in overvalued territory and we will see a huge correction soon. On the other hand, we got guys like Dan Loeb really bullish. As usual, there are a lot of smart guys on each side.

This got me thinking a lot about why the bears have got it so wrong for so long (so far... they will eventually be right! I remember (before my time, but I read about it) how Joe Granville, one of the prominent technicians of the 1970's called for a crash in the market with the Dow at 800. He was proven correct; only problem is the market crashed from 2700 to 2200, so it didn't help at all that he was short from 800. Oops.)

What bubble?
One of the first things that come to mind when hearing all this bubble talk is that, to me, the stock market still doesn't feel at all like a bubble. OK, there may be some pockets of excess. But in general, I'm not getting the sense of a bubble. Nobody asks me about stocks. Nobody brags about their stock winnings. I am not reading about people quitting their jobs and playing the market to make a living (one of my biggest dollar wins on the short side ever was when I short Apple a while back when articles about people quitting their jobs and living off of their Apple stock gains started popping up, and they were on TV laughing at the skeptics saying that they 'just don't get it' (I am hearing/reading that now about Bitcoin, though! Japanese housewives, young people doing nothing but trading bitcoin and convinced they will never have to work again).

I don't hear any of that talk relating to the stock market. At all.

Plus, here's the other thing. People keep talking about how great the market has performed in recent years as another sign of a bubble.

But the problem with that, to me, is that a lot of that is just regaining what we lost during the crisis. If a stock tanks 50% and then doubles the next day, is the stock really overbought? I dunno.

Check out this long term chart of the S&P 500 index. I made it a log chart so we don't go, oh my god, it's parabolic! I do believe that parabolic patterns tend to collapse, but it is useless over long time periods.

And ignore the font and background color stuff... I was just playing with Excel, which I haven't used in a long time. But due to various issues (OneDrive being one of them), I have gone back to using Microsoft products and am trying to relearn this stuff. Google sheets is great, but very buggy and frustrating to deal with.

Anyway, if you look at the 1929 bubble, the market went far above it's previous peak. Just eye-balling, the market sort of peaked out at around 10 in 1910 or so, and then rallied to 31 in 1929. That's more than a triple of the old high. Before black monday the S&P 500 rallied to 330 before crashing, and the old high was around 100, so again, the market more than tripled before tanking. During the 1999/2000 bubble, the market went to 1500. If you use the old high of 330, the market rose by 4.5 times. if you use the 1993/1994 area high of 500, the market basically tripled that.

During the Nikkei bubble, the Nikkei rose from 8,000 (the early 1980's high) to 40,000 for a five-bagger in less than a decade. But a five-bagger off the old high, not bear market low.

Where are we now? The previous high was around 1,500 for the S&P, and it's now at close to 2,600. So it hasn't even doubled. And that's a high from 17 years ago. Even using the recent pre-crisis date of 2007, that's more than 10 years.

S&P 500 Index -> 4500!
I am no expert on bubbles, but to me, this is not a bubble. I would call this stock market a bubble if we tripled the old high, or if the S&P went to 4500 or something like that.

Yeah, you heard it hear first. S&P 500 index at 4500. That's what I would call a bubble.

This is sort of consistent with my idea that the market P/E would have to get to 50x for me to be convinced that the market is in bubble territory. You can read my old posts on why that is (based on interest rates. And don't forget, I use what I consider to be 'normalized' interest rates, not current levels).

So, if you ask me, I see no bubble at this point. At all.

Real Fed Funds
The other thing that popped into my head the other day was the comment, "Never short the market with negative real fed funds rate!". For no reason at all, this comment popped into my head and I couldn't get it out. This kept bugging me. The idea made a lot of sense, but I wasn't sure exactly where it came from. Of course, we all know not to "fight the fed", so this is a version of that, I suppose.

So when I got the time, I decided to just plot the real fed funds rate, and below is the chart:

And here's the thing. It seems like in recent history, the market has basically never gone into a serious bear market or crash with the real Fed Funds rate in negative territory. This makes logical sense. A negative FF rate means money is easy, and when money is easy, asset prices tend to go up. Shorting into that, I guess, is like fighting a tsunami with a teaspoon. Why would anyone do that?!

People keep saying that owning stocks at these levels is speculating, not investing. And yet, some of the folks who say that lose money when the market rallies, which means they are short. I don't know about you, but for me, shorting is speculating and has nothing to do whatsoever with investing. People seem not to understand the asymmetric risk/return involved in shorting versus just owning stocks.

Static versus Dynamic Models
Here's the other baffling thing. Much of the world seems still to be stuck in the world of static economic models. If something goes up, they must go down. If an expected return is low, the price must eventually decrease (ignoring the fact that expected return can remain low for a long, long time).

This all reminded me of an old book that confused a lot of conventional thinkers, and I think people who haven't read it should read it. Even now:

The Alchemy of Finance

(for some reason, my Amazon bookstore is dead... oh well. I haven't looked at it in a while and now it's just totally gone. I must have missed an email or two from Amazon (probably thought it was spam and ignored it)).

30 years later, it seems like economists still think the old way and haven't really modernized. I suppose there have been new developments in behavioral economics, but I don't really see much of it when people talk about the market and economy; they all still sound like they did back in the 1980's.

But then again, I guess it doesn't really matter all that much, because most people we see or hear about are asset gatherers and spend most of their time telling people what they want to hear. They don't really care as long as they can gather assets. The ones incorporating new models and making money won't talk about it.

Anyway, I think the Soros book is very timely right now as we probably are in the midst of some sort of virtuous circle. I admit this can't go on forever and things will eventually turn.

But figuring out when it will turn is something nobody will be able to do. If I had to guess, you know what I would say. I already made a case in previous posts that a market P/E of 50x or more would indicate to me a clear and present danger of a serious bubble. And now with the added analysis of a S&P 500 index at 4500 (this is not a forecast or projection!), that to me would also indicate a serious possibility of a bubble.

This Time is NOT Different
The bears always say, "This time is not different. Bulls like to think this time it's different". Well, I dunno. I am not necessarily bullish (I am a market perma-agnostic!), but I too agree that this time is not different.

I believe the market would have to get to bubble levels before we are at risk of a serious bear market. Also, in addition to the market and P/E levels I mention above, I will now also keep an eye on the real Fed Funds rate as the market has never in the past entered a serious bear market or crash with negative FF rates.

So no, this time is not different at all. And if it's not different, we shouldn't see a big bear or crash any time soon (famous last words! I know the market will start to tank right after I hit the "publish" button, but that's OK!).

...Oh, and by the way, as I was cleaning out a bunch of spam in the comments section, I accidently deleted a bunch of valid comments. Sorry about that. As you know, I don't delete comments from real commentors, even if they disagree with me, criticize, or whatever...

Bitcoin, Marks

Date: 2017-09-13

It's been a long time since posting last. I've gotten comments and emails wondering where I've gone. Actually, nothing has changed and it hasn't been a conscious decision to scale back here at all. I've been wanting to post.

Part of it may be that I was a little busy. I have been getting involved in volunteering here and there and sometimes it takes up a little more time than expected, and before you know it, you have no time for other stuff. Not to mention I have so many things I like to do, like coding/programming, reading etc.

The other reason for not posting much, I guess, is that things haven't really changed all that much. Maybe I'm coasting on things that I like that are doing well. I still like most of what I've talked about here and there hasn't been any reason to change anything.

Anyway, what triggered this post is another great memo from Howard Marks. If you are curious about bitcoin, or what to do about the markets (overvalued?), you should read this. Of course, most readers here probably already read it.

Howard Marks memo

This memo is fascinating because it deals with two things that I have been thinking about a lot over the past few years (OK, I haven't really thought about bitcoin all that much, actually, but I have been getting the indicators that it is indeed a bubble; people I know telling me it is going to $100,000 and are probably already calculating their net worth based on that price. At least that's what it feels like).

The Market
I haven't really changed my mind about the market at all. I've written a lot about what I think and nothing has really changed. The market is still expensive, and interest rates are still low. I still think a reasonable 'normalized' interest rate (10 year) is around 4.0%. And in that environment, stocks are still not expensive.

A lot of smart people are saying that it is way too expensive using some long term average, like the past century. Well, my view is that to use that as the norm, one would also have to assume that the average interest rate in the next century will be like the last century, and that's not at all a given. So in that sense, we can't really say what the average P/E ratio is going to be in the next century, let alone the next decade.

One argument is that low interest rates haven't helped Japanese stocks. This is an interesting thought and I may take a close look at that at some point as I did spend some time in Tokyo this summer. It is really an interesting, fascinating place. But it can also be incredibly frustrating too.

What To Do
Howard Marks writes about the options investors have at this point in an overvalued, late cycle market. He has a problem with people saying to do nothing and invest as usual. He makes a great argument but I sort of wonder about that.

Maybe it's different in fixed income versus equities; in fixed income there isn't much upside but a lot of downside. In the stock market, there is huge upside to offset huge downside.

Marks says that we do have to do something here, whether it be to lighten up, reduce return expectations, or some of the other things he lists (I agree we have to accept lower prospective returns; there is no arguing against that).

First of all, one problem with this discussion has to do with who you are. If you are an equity fund manager, hedge fund, pension manager, asset allocator, individual investor (IRA, 401K, young person, old person) etc.

My guess is that for most people, do nothing should be fine. As Buffett said a while back, the stock market returned 10%/year in the last century, but most people who owned stocks didn't come close to that. Why? Because they kept getting in and out of the market trying to outsmart it.

When you think about that, it makes you wonder whether getting out or lighten up when you think the market is expensive is a wise decision. As I've said often before, when you look at the returns of the folks who do try to allocate capital according to forecasts, they haven't done all that well.

You can call this discipline, to get in and out according to the risk in the market. But go back to the fifties when dividend yields dipped below interest rates, which was unheard of. It's easy to imagine someone getting out of the market promising to keep discipline and go back in only when dividends yields are higher than interest rates (they would have finally gotten back in in the past few years!).

If you are young and are 100% in stocks in your IRA, that's fine. Even if you are not so young, it should be fine too as long as you understand the markets can be volatile and prospective returns are probably not going to be as high as in the past.

Keep in mind, the difference between stocks and bonds. If you are 100% invested in a great stock, say, Berkshire Hathaway, and you are worried about the market and want some spare cash just in case the market takes a dip. Well, if you are 100% invested in BRK, you are part owner of a heck of a lot of cash (on the balance sheet) and cash flow. If the market tanks, BRK will benefit. BRK will be buying. Would you not be better off letting the folks at BRK take advantage of the dip than you? Well, if the markets really tank, it's true that you might be able to get better deals (as you are probably more nimble).

But even if you stay 100% invested in BRK, they will take advantage of the dip and you will benefit.

Think about if you own a bond. If you own a BRK bond, you may not benefit on a dip in the market. BRK's bond value probably will not increase after a dip and recovery whereas the stock may very well come out bigger and stronger (maybe BRK's credit improves afterward, but probably not so much).

If you owned a high-yield bond and there is a dip, this mechanism wouldn't really work either, I don't think. A dip might hurt high-yield bonds more so you get killed, and the issuer may not come out the other side stronger as it's credit is not that strong to start with so may not be able to take advantage of a market dip to grow.

Old Greenblatt Memo
After the financial crisis, Joel Greenblatt posted a great comment on the Gotham website. He said that the mistake was not that people didn't see the crisis and didn't get out of the market in 2007. The mistake was that people owned too much stocks so that when it went down 50%, they panicked and sold out at the bottom.

He said that you should own an amount of stocks where a 50% drop won't be too upsetting to you. If you have a $100,000 stock portfolio, and a $50,000 mark-to-market loss would upset you, then you shouldn't have $100,000 in stocks. Many people invest too much assuming the bell will ring at the top so they will be able to get out.

I think the same applies today. It is not a mistake to be heavily invested (as long as you understand that markets will fluctuate, and will not return 10%/year going forward), as long as a 50% drop (and noone can predict when this will happen) won't be too upsetting to you.

If you are worried, lighten up, but lighten up because you think you might have too much exposure to stocks, not because you think you will be able to get back in at a better price later on because that probably won't happen.

The most interesting part of Howard Marks' memo is about bitcoin. He was apparently bombarded by emails after his previous memo when he said that the bitcoin is a Ponzi scheme.

Of the folks supporting bitcoin is the dynamic duo from FRMO, Murray Stahl and Steven Bregman. Marks spoke at length about bitcoin with them.

Here is the FRMO letter to shareholders where they talk about crytocurrencies:

FRMO letter

If you are on the fence about bitcoin, go read this FRMO letter, and then read the Howard Marks letter. You will get a really good overview and arguments of both sides.

I have to say as much as I love technology, I don't get this one. Jamie Dimon said the other day that this was a fraud. That may be a strong word for it. I don't know if there is really any intent to defraud; these people probably actually believe it can be a real currency alternative, in which case it's not really fraud. But maybe it is fraud. Who knows.

What I don't get is that they say that central banks can print as much money as they want, but we know the supply of bitcoin going out into the future; there can't be more than that produced.

But who said that the bitcoin is going to be the only alternative cryptocurrency? The U.S. dollar has value because it is backed by the U.S. government (but nothing else), and nobody can just buy a printer and just start printing them. You can't just print your own, private dollars either. Well, I guess you can (via gift certificates, frequent flier miles, bonus points etc.).

The whole point of something valuable is it's universal acceptance. Gold, too, has a limited supply, but it has been accepted as a store of value for centuries. I have no idea where gold prices will go, but it will probably stay 'valuable' for many years to come.

But bitcoin? People lose bitcoins because they lose their USB drive that held the code, some exchange gets hacked and people lose bitcoins. If someone hacked a U.S. bank and took people's money, the FDIC would back it up. What kind of insurance or guarantee comes with bitcoin? What if one day it just doesn't work or you can't get access to it. Who do you call? What if there is a flaw in the system? Are bitcoin fans well-versed enough in the technology to figure out what went wrong?

If I woke up and my bank's website wasn't there, I can walk to a branch. If the branch isn't there, I can go to another branch, or the headquarters office. If it's not there, I can call the State bank regulator or other regulator to ask what happened and try to retrieve my money.

What's the equivalent in the bitcoin world? Who really runs it? Yes, they say nobody (or everybody). But that too is kind of scary.

China just said they are going to shut down bitcoin exchanges, and Japan announced the other day that gains and losses from bitcoin trading/investing will count as other income (I think that's what it was) and will be taxable. They said that this includes purchases with bitcoin. If you buy something with bitcoin, then you have to pay taxes on the gain.

Now, think about that for a second. How complicated is that going to be? Every time you use your bitcoin to buy something, you are going to realize a taxable gain?! What kind of payment mechanism or currency is that? That's just crazy.

OK, bitcoin supporters would argue that this will not happen because bitcoin is not trackable. There will be no 1099 or anything like that associated with it so the IRS (or the Japanese equivalent) will never know. I don't know about that. It would be surprising if they did nothing and let it stay this way; then nobody would ever pay taxes in a few years!

It's kind of incredible that so many people have jumped on the bitcoin bandwagon before the governments around the world have figured out what to do with it. Just letting it alone is a low probability scenario, I think. More likely is something like what Japan did; make it a taxable item, whatever it is. I'm kind of surprised that people aren't looking at this also as a gambling vehicle. I don't know much about gambling laws, but bitcoin as it works now sure looks like a vehicle for gambling to me.

In any case, I haven't changed my views about bitcoin. It's an odd curiousity. Kind of interesting. But without knowing how the laws will handle it, there is no way to determine if it has any real value. At least that's what I think even though there are many people smarter than me that believe in it.

If I miss this party, well, it won't be the first. If I don't understand it, I'll just stay away.

Anyway, we'll see what happens!

Bubble Watch

Date: 2017-05-25

Shiller said the other day that the market can go up 50% from here. OK, so I fell for it and clicked to watch the CNBC video. This was sort of a surprising comment coming from the creator of the CAPE ratio, one of the main indicators bears use to argue that the market is way overvalued.

Of course, this is not Shiller's forecast or expectation. In fact, he says that this is very unlikely, but it is possible. His point was simply that the CAPE ratio is 30x now, and in the 1990's it went up to 45x. So if that happened again, that's a 50% increase.

This is totally possible, especially now. I would not invest in the market with that expectation, of course. Actually, I would invest with the opposite expectation (when pressed, Shiller said the market is more likely to go up 50% than down 50%).

Trailing P/E
Let's put the CAPE aside for now and just look at regular trailing P/E's. Back in 1999, that went up to 30x, and in 1987, it went up to 21.4x (this is from the Shiller spreadsheet).

We keep hearing from the bears that the market is as expensive as it was during previous peaks, so we are in dangerous territory; they say we are in a bubble.

OK. That is possible.

But in previous posts, I argued that if 10 year rates stabilize at 4% over time (it's at 2.3% now), it is possible that the market P/E can average 25x during that period. Maybe the market fluctuates around that average, so the market can easily trade between 18x and 33x P/E without anything being out of whack. (Buffett also said at the recent annual meeting that if rates stay around this area, then the stock market could prove to be very undervalued at current levels.)

So we have a problem. This 18-33x P/E range puts the market in bubble territory according to the bubble experts. But we are saying here that if rates stay at 4%, that's the normal range the market should trade at.

So then, how can we tell when we are in bubble territory?

Since we are using interest rates to value the stock market, we will have to interest rate adjust our bubble levels too.

Interest Rate Adjusted Bubble P/E
So just looking back at 1999 and 1987, here are the indicators at the time:

PE EY 10yr
1987 21.4x 4.7% 8.8%
1999 30.0x, 3.3% 6.3%

Both 1987 and 1999 had the feel of a rubber band stretching and then snapping. You will see that the earnings yield was 4.1% lower than the 10 year rate in 1987 and 3% lower in 1999.

Right now, the P/E ratio is 23.4x, for an earnings yield of 4.3% versus the 10-year rate of 2.3%. So it's a full 2.0% higher, not lower. But even I think 2.3% on the 10 year is too low. I use 4.0% these days for what I think is a non-bubbled up, unmanipulated-by-the-Fed, sustainable, normalized rate.

Using this spread, long term rates would have to go up to 7-8% for me to worry about an overstretched rubber band snapping.

How about the stock market? How high would it have to go before I think we are really in bubble territory?

With interest rates at 2.3%, we can't deduct 3% or 4% from it to get a bubble-level earnings yield.
So we'll look at it as a ratio. In 1987, earnings yield got to as low as 0.53x the bond rate (4.7%/8.8%) and in 1999 it got to 0.52x (3.3%/6.3%)

Using the current 2.3% 10-year rate, earnings yield would have to get to 1.2% for me to really think that maybe we are in a stock market bubble. That comes to 83x P/E! At that level, trust me, even I won't be talking much about long term investing, and would probably be net short with a bunch of put options too.

But wait, let's not use 2.3% because we all know that's too low. Let's use my normalized 4%. Even with a 4% bond yield, earnings yield would have to get to 2% to be considered really bubble level. That is a P/E ratio of 50x. That's more than a double from here.

So for me, the market would have to actually more than double from here before I see it as really bubbly. (If you want to see what a real bubble is like, look at Bitcoin!)

Narrow Market
The other thing I hear a lot is that the market is up only because of the very few hot tech stocks like the FANG stocks. They make it sound like the market would be doing nothing without them. Maybe.

But just as a quick check, I compared the S&P 500 index (ETF: SPY) to the S&P 500 equal-weighted index (ETF: RSP); the super-large caps would have no more impact than the smallest S&P 500 companies.

Check this out:
(The blue line is the RSP, green is SPY)

SPY versus RSP Long Term

SPY versus RSP 10 Years

SPY versus RSP 5 Years

In all of the above time periods, the RSP outperforms SPY, which I don't think would be the case if it was only a few of the super-large caps that is pulling the S&P 500 index up.

Just for fun, I looked at the S&P 500 index versus the Russell 2000 index too. If only a few super-large caps were pulling up the averages, then obviously, the S&P 500 index should be outperforming the Russell 2000 too. The blue line is the Russell 2000, and the green line is the S&P 500 index.

S&P 500 Index versus Russell 2000 - 5 Years

S&P 500 Index versus Russell 2000 - 10 Year

Here too, I don't see the S&P 500 outperforming in a big way lead by the supers. To the contrary, the S&P 500 index is behind the Russell in the 10 year period.

I had no idea what I would see when I put up these comparisons. Looking at them now, I am a little disappointed in active managers who claim that they are underperforming because they don't own the FANG stocks; the above shows that maybe that's not the issue.

Anyway, that's another ongoing topic here.

All of this stuff, I just do sometimes to satisfy my own curiosity; not to make any claims either way. I have no idea what the market will do, but I don't believe we are in a stock market bubble at all. OK, if interest rates got up to 7-8% and valuations are still here in the 23-24x P/E area (trailing basis), then yes, I would agree we have a valuation problem.

Otherwise, it would take a market P/E of 50-80x for me to think we are in a stock market bubble (and I would put on shorts and load up on puts! But even then, I wouldn't expect an immediate payoff. If the market took off like that, it would be very hard to pick the top).

Otherwise, we are just, in terms of stock market valuation, in the "zone of reasonableness", to borrow Buffett's phrase from a few years ago.

Also, keep in mind, this 50-80x P/E ratio range is not a target, of course. That's where it has to go before you convince me we are in a stock market bubble.

Also, this doesn't mean the market can't enter a bear market at any time. There was no interest rate / earnings yield rubber band in 1929 and 2007.

High Fees

Date: 2017-05-19

So, I was taking to a friend who has a million dollars in a large cap stock fund. The fund happens to be the Fidelity Magellan fund. The fund is very famous for being the ship that Peter Lynch navigated. But years later, it's just another generic, closet-index/large cap fund. I don't follow mutual funds too closely, but my initial thought was that there is basically no chance of Magellan outperforming the S&P 500 index over time.

And, of course, the expense was almost 1%. That is kind of shocking.

When you read gambling and trading books, they always tell you not to think of money as real money. When you are betting in poker and you see the $70,000 of cash in the pot as a BMW, you will make really bad decisions and will play poorly. If you see the loss on your portfolio as two years of your kid's college education, you will freak out and make irrational moves. (Actually, if you really need that cash for your kid's education in the near future, then maybe you should freak out, and maybe you shouldn't have that cash in risk assets!)

But let's do the opposite now. I said to the friend, gee, well, do you have a reason to believe that the Magellan fund will outperform the S&P 500 index over time? Not really. OK, then why are you basically writing a check for $10,000 per year? That's almost $1,000/month. That's a lot of money for a retired person. Why would you write a $1,000 check every single month for nothing?

In ten years, that's $100,000 gone. Poof. For absolutely no reason at all. That's more than most people have in their IRA's.

It's hard to notice these things as they are just deducted from the account so you don't actually write a check every month. If you did, you would probably think about it a lot harder.

1% Too High?
Mutual fund fees are too high for most funds. There are some funds that may be worth the fee, especially some of the value funds with long term track records.

But with expected equity returns of around 5-6% going forward, we have to wonder about 1% fees. It's one thing charging 1% fees in a 10% equity return world, but it's a whole different world now. Maybe fees should be restructured so that the fee is minimized to cover overhead and bulk of fee comes from outperforming a benchmark index. I don't know. I actually don't own any funds so it's not really an issue for me, but something interesting to think about.

Speaking of high fees and having watched the Berkshire Annual Meeting video, it reminded me of a fund with really high fees.

Some people believe that there is no bad publicity, but in this case, maybe it was bad publicity. David Winters of the Wintergreen Fund criticized Coke for their egregious stock compensation plan and even criticized Warren Buffett for not speaking out against the plan and even went so far as to sell Berkshire Hathaway stock in a huff saying that Warren Buffett no longer looks out for his shareholders.

This was kind of shocking for a few reasons. First of all, when Winters talked about the massive wealth transfer, his number was totally off. I talked about it here, and Buffett said the numbers were also way off. So it means either that Winters is not a very good analyst, or is simply dishonest and threw out a huge number deliberately to get attention. I don't know which is worse, but either way is not very encouraging for his shareholders (take your pick: incompetence or dishonesty). He also sold off Berkshire Hathaway because of this. This seemed to me he was taking all of this personally and getting too emotionally involved. I don't know. But that's what it seemed like.

This lead Buffett to mention at an annual meeting that Winters charges very high fees for bad performance. Ouch. A lot of people love to go on CNBC because it's free advertising. But sometimes it backfires, particularly when you criticize a giant with no track record to back it up (and charge fees much higher than anyone else!).

First of all, this all happened in 2014. Winters sold his BRK in the 1Q of 2014. His fund is in red, BRK is blue and the S&P 500 index is the green line.

The Wintergreen Fund had assets of $1.6 billion in Dec 2007, but still had more than $1.2 billion as recently as the end of 2013. But as of the end of 2016, AUM was down to $300 million. There is some AUM in the institutional class too but that is down a lot too.

Here is the performance of the fund:

That's a pretty huge underperformance no matter how you slice it.

OK, that's not so uncommon these days with active managers underperforming.

But here's the shocker. Look at the fees charged on this fund:

That's 2%! First of all, the fund underperforms in all long term time periods. In a 5-6% return equity world, the fund is basically charging 33%-40% of expected return! But that's assuming the fund keeps up with the index, which historically hasn't been the case. If the fund lagged 1%/year on a gross basis that comes to more like 40-50% of expected returns going to the manager. That's truly insane.

And looking at this on a real cash basis, if you had $1 million in this fund, you would be writing a check for almost $20,000 per year! That's some real money. Over 10 years, that's $200,000!? You had better be sure someone will outperform the index if you are going to be writing checks that big every year.

One may argue that the benchmark is wrong; Wintergreen owns non-U.S. stocks. Actually, as an investor, that shouldn't matter. The fund doesn't have an explicit mandate that they must invest internationally or anything like that. If they invest in non-U.S. stocks, it has to be because they think non-U.S. stocks are more attractive; that they will outperform U.S. stocks. Or else why bother, right? So in that sense, benchmarking against a completely neutral S&P 500 is fine.

It's kind of crazy what people get away with.

I know people will immediately respond by saying, yeah, but you like all those alternative managers with even higher fees! Well, most alternative guys charge too much too, but the ones I tend to like do have really good long term records.

Mutual Funds Sticky
Here's the thing about mutual funds versus alternative funds. I think a lot of mutual fund assets are really sticky due to the indifference of many investors. They just leave it and don't think about it, which is the correct approach to investing, generally. But the downside is that many don't realize how much is being sucked out of their net worth from these fees for no return.

Hedge funds, private equity funds, on the other hand, have investors who are more active in tracking performance etc. If you perform poorly, you will lose assets more quickly and go out of business as many hedge funds have seen in the last few years. Mutual funds can last forever on dreadful performance.

And speaking of KO, it was also in 2014, I think, that Kent (KO CEO back then) started talking about zero-based budgeting. I was skeptical about this at the time; a lot of CEO's would just grab the latest buzzword and throw it in their presentations just to show how hip they are to the current state of the world (Now it seems to be AI, machine learning, big data etc... Well, that's all over Dimon's letter too, but financials have been big into these areas for a while...).

Anyway, KO is too big for most to make a run at it so there is no real sense of urgency there so you know nothing is going to happen, not to mention the arrogance there from a century of dominance. I have made the case that for anything to change at KO, it's going to have to come from the outside. Internal people will not be able to make big changes; they can't pull off the band-aid as it would hurt too many 'friends'.

Look at margin trends since they claimed they started using zero-based budgeting:

Analysis of Consolidated Statements of Income
Percent Change
Year Ended December 31,



2016 vs. 2015
2015 vs. 2014
(In millions except percentages and per share data)



Cost of goods sold







Selling, general and administrative expenses



Other operating charges








Operating margins are actually down from 2014. So much for zero-based budgeting!

Munger indicated that a $150 billion deal would be huge for Berkshire Hathaway, so it is unlikely that BRK could make a run for KO on it's own. But in some sort of combination with BUD, KHC or some other 3G entity, who knows what will happen.

Berkshire Hathaway Annual Meeting Last Question
By the way, the last question on the Yahoo video was about CEO's social responsibility; should companies move jobs overseas to increase profits at the expense of local communities, domestic jobs etc.?

This was really a good question and I think about that sort of thing all the time. Do we always have to be the most efficient and lowest cost at all times? Do we really need to be increasing productivity all the time? Why can't we come to some stable status quo and not keep trying to grow or increase profits all the time?

And I always seem to go back to Japan. Japan is a country where companies usually do act responsibly and really doesn't want to fire people. And Japan is in terrible shape, I think, large due to that. Long time Canon CEO, Fujio Mitarai, explained that Japan can't compete well in many industries because they operate under the system of corporate socialism. The Japanese government won't provide unemployment and other social safety nets; Japanese corporations are expected to take care of redundant workers (by not firing them) etc.

You can protect people for a while like that, but at some point, the burden gets too big and the corporation will collapse.

Panasonic was one of those intensely socially responsible companies; Konnosuke Matsushita, the founder, strongly believed that it was the responsibility of the company to take care of their employees. He never wanted to fire anyone. It's a great concept and noble, but I don't believe it works.

McIlhenny Company (Tabasco sauce) was like that early on; they had an island they wanted to be self-sustaining. They wanted their employees to live there, they built schools, stores etc. But over time it just doesn't work. I think Henry Ford, Hershey and others tried similar things too when it was believed that if they created a company town with everything necessary for employees to raise a family and live comfortably, they can create a sort of self-sustaining utopia.

It just doesn't work. It also reminds me of the pre-Thatcher Britain; it didn't work at the national level either.

And besides, more of a threat to the domestic work force than globalization is technology. I haven't done much research in the area, but technology is probably more responsible for job losses than globalization (moving production to low wage countries).

And do we really want to limit or stop technology? Japan will make large advances in that area due to their shrinking population. They need nurses and other workers to take care of the increasingly aging (and dwindling) population.

If the U.S. slows technological progress for the sake of maintaining low unemployment, then the Japanese will ultimately rule the future and we will have a large, unemployed (and unemployable) population.

Related to all this, just by chance, I happen to be reading the new Kasparov book. I'm not done with it yet, but it is really fascinating. True, he's a former chess world champion so what does he really know? He is a voracious reader and runs around meeting and talking to interesting people all over the world so he has interesting insights into many things.

He points out that every time we have technological advancement, people fear this or that. For example, the elevator operators union had 17,000+ membersin 1920. The technology existed in 1900 but wasn't widely used (automatic elevators) until 1930 due to people's fear of riding operator-less elevators (similar to fear of driverless cars today; but people's fear is not what is holding back driverless cars today...).

Anyway, I am not a believer in holding anything back for the sake of maintaining employment; it will only delay the day of reckoning, and at that point the negative impact might be much worse.

Since technology is advancing so quickly, retraining won't be able to keep up, so something like a universal basic income is probably the only way to go at some point. I know I sound like a communist when I say that, but I can't think of any other way.

Anyway, this veers far away from the topic of this blog, so let's get back on topic.

If you are one of those people who have a bunch of mutual funds in your IRA/401K or whatever, I would actually go in and do the work to calculate how much you are actually paying in real dollars. Is it really worth it? Same with financial advisors. When fees are just deducted from your account, you may not realize how much you are paying. Calculate what your are paying. Is it really worth it?

Let's say you have $5 million and most of it is in tax-free money market funds and the S&P 500 index funds. With a 2% fee, that's $100,000 per year! Why would anyone pay that? Is it really worth it? Can your advisor really pick stocks and funds better than some simple passive portfolio?

I don't know. When you look at it in real dollars like that, it is really insane.

Fairfax India Holdings (FFXDF)

Date: 2017-05-03

This is one of those things that I looked at before and never posted, so here it is. Actually, I didn't write much about it, it was just sitting in my queue.

I know Munger likes China more than India, but I think India is very interesting. I don't think I have to say much about it as it is not a new idea. And yes, India has problems that China doesn't have (democracy that can actually hold back progress unlike in the authoritarian China where the government can just basically do what it wants). But India is still fascinating, especially with all the things going on over there now (pro-business government for the first time etc).

Anyway, as usual, before that, check this out from the Fairfax 2016 Letter to Shareholders.

Here's the long term investment performance of Fairfax (not the India entity):

And what happened in 2016:

...and the summary overall for the period 2010-2016:

Their equity hedge has been very costly, basically a total disaster. Their hedges cost them $4.4 billion since 2010. Since it was a hedge, you have to look at it on a net basis with the longs; that's a $1.7 billion loss. Still pretty awful. This is during a period the S&P 500 index went up 12.5%/year. In 2010, they had $4.5 billion in stocks. If this was unhedged and their stocks kept up with the market, it would have added $4.5 billion to their net value instead of losing $1.7 billion; that's a swing of $6.2 billion! That's huge given their common equity in 2010 of around $8 billion ($8.5 billion at end of 2016).

It's fair to say, though, that if the portfolio wasn't hedged, it might have been smaller than $4.5 billion; the portfolio might have been sold down for risk management purposes.

Since 2007, Fairfax has still outperformed (price basis) the S&P 500 index and all of the so-called Berk-a-likes:

This chart (and other charts), by the way, are updated every day at theBrooklyn Investor website.

Anyway, over the long term, they have done well, so it's not fair to focus just on this one mistake (even though it's a huge one). Many CEO errors cause their companies to go bust, and that hasn't happened here, or anything even close to that.

Here is the other 'bet' Fairfax has on:

This bet doesn't look so interesting these days, but the important point is that the downside in these bets are known and small. It's one of those "if you're wrong you don't lose too much but if you're right you can make a ton" deals. Needless to say, the equity portfolio hedge was not that kind of bet!

Expensive Market
Anyway, I still have conversations about this sort of thing and hear all the time about the markets being expensive, people being confused as to what's going on.

One hedge fund executive (wasn't clear what position was; not sure if he had investment experience/responsibilities) was on CNBC the other day and it was stunning because the comments were based on such extraordinarily static analysis, talking about the uncertainties in the market, how things were expensive etc.

And it reminds me of a book that I plan to reread (if I can find it!). When I read it years ago, it was incredibly eye-opening, and it feels like a lot of people have forgotten about this sort of thinking. The book is by George Soros, one of the greatest of all time:

The Alchemy of Finance

He talks about reflexivity, and it sort of differentiates the traditional economists viewpoint based on static analysis versus his more dynamic view of the world based on reflexivity. (This book is more of interest to traders than long term investors).

For example, if the market goes up, most people assume it must go down because it is overvalued. Economists base their views on supply/demand balance so they think things must trend towards equilibrium. Most comments I hear these days tend to be in this camp.

Soros' view is that in fact, an expensive market can make a market even more expensive. Why? Because if markets go up and gets overvalued, then financing costs go down and can encourage more profit-making and increased earnings, which can drive prices even higher. Economists wouldn't consider this factor. This is in fact what happened in Japan too in the late 1980's.

I think Soros talks about the REIT boom/bust of the 1970's in this book; maybe it was somewhere else. But the above is exactly what happened.

Anyway, I am going to dig up a copy of this; it must be somewhere around here in one of these boxes or piles of books.

Mean Reversion
Sort of related to the above, here's another thing I hear all the time: mean reversion. I too believe in mean reversion. But there are tradable/investable mean reversions and untradable/uninvestable mean reversions.

Values mean revert, usually. As a value investor, we can buy undervalued stocks and assume mean reversion will enhance our returns. This is investable mean reversion. As long as you are not leveraged, you can just wait for the market to prove you right.

Shorting overvalued stocks is also a mean-reversion trade, but it is untradable. Ask anyone who was or is short Tesla, Amazon, Netflix. Oh, remember L.A. Gear? Or U.S. Surgical? Anything in 1997-2000? Those are untradable because you will get killed trying to short that stuff even if mean-reversion will eventually kick in. Nobody has that kind of staying power.

So what kind of mean reversion do you want? You want mean reversion that happens OFTEN. You want mean-reversion that is tradable.

Not exactly a mean reversion trade, but take index arbitrage. You go long stocks and short future against it (or vice versa). You know from history that the premium/discount fluctuates over time. But you also know that this spread will not diverge too far apart, and you know that at expiration, your long and short will offset and you can realize the spread perfectly with very little risk. That's a spread you can trade safely. (In fact, one of Soros' early strategies was to arb gold prices between New York and London. I think a long distance phone connection was that era's version of a direct optical fiber connection to exchanges today)

How about options volatility? For shorter dated options, trading volatility works too. You may or may not make money, but volatility cycles are often not that long so you can capture volatility by trading options. You may need some staying power, though, because sometimes you sell volatility at 30% and it goes to 40% or 50%. But you know that eventually, these panic levels will subside at some point for much lower volatility.

What about stat arbs? These guys too, especially the high-frequency guys, are trading mean-reversion. The one mentioned in the Thorp book, I think, was based on 2-week returns in stocks. Stat arbs these days turn over their portfolios multiple times in a day (I am guessing, but we had high turnover a long time ago; I am assuming it's much faster now), which implies a high level of mean-reversion; each trade is not expected to last very long. Things diverge and revert very quickly.

This has two big advantages (well, probably more but let's keep it simple); first, with so much frequency you have that many more data points. With that many trades, you are that much more likely to make money. With time span so short, the risk of divergence, or spreads widening out even more, is minimal.

Imagine trying to trade inefficiencies in the stock market based on tick data where trades last for minutes. What is the risk? Hint: tiny on each trade, and since you do so many trades, you are well-diversified and if your data is correct, you are more likely to realize the 'edge'.

Now imagine trying to trade inefficiencies in the stock market where people misprice P/E ratios on individual stocks. The expected duration of a trade can be years (the P/E ratio inefficiency probably will not correct within the next week or even month. Unlikely even in the next year; how many years have TSLA, NFLX and AMZN been overvalued?). Now think of the range of stock prices that a mispriced stock can trade at over that time span. Now you see how huge the risk is.

Of course, sometimes you can see some sort of deterioration in a company, some manic blowoff or some other 'timing' device that might help you nail a short of an overvalued company. But you see how trading just on valuation on the short side is going to be tough game.

The Market
Let's take all of the above thoughts and apply it to the overall market. People always talk about mean reversion of the market P/E ratio, profit margins and things like that.

Are these factors tradable? If the stock market went to 20-30x P/E and then went down to 8-10x and then went up to 20-30x and kept doing that many times over the years (averaging out at 14-15x), then it turns into a tradable idea. You can set ranges too and calculate probable outcomes and manage risk accordingly.

But looking at long term data, that's not really the case. It's more like these things happen very rarely and over long periods of time. Most people talk about what happened in 1929, 1968, 1987, 2000 or whatever. I think it was Buffett (but may have been Munger) who said that to bet on something that happened just a few times over the last 100 years does not sound like a good idea.

Again, the same questions apply: when is the expected reversion? What is the risk? If the reversion is not expected in the short term (next week, next month, within the year etc...), then what is adverse move against you going to cost?

Interest rates mean revert too, but look at the rates in the past 100, 200 years. If you want to realize any 'edge' in the long term mean-reversion of interest rates, you have to play for decades, and the reversion may not even occur within a single generation.

Back to Fairfax India
Emerging markets haven't been so hot in recent years, but I don't think there is any doubt that that is where a lot of growth is going to come from over the next few years. Much of that growth will be captured by global firms to be sure, so owning global companies will give you exposure without having to invest in emerging markets.

But it's fun to have some direct investment overseas when there is an interesting opportunity. I don't think FFDXF is a unique opportunity right now in terms of value/pricing, but it is an interesting opportunity in that you can co-invest with a successful manager in an investment vehicle focused on India that combines listed stocks and private investments. There are not too many of those ideas.

The option to invest in private deals expands the universe of potential investments so increases the odds of finding winners. The closed nature of this vehicle (not an ETF, mutual fund or hedge fund/partnership) allows them to focus on the long term and not worry about liquidity and short term performance.

With these advantages and with a management that we understand that agrees with out own views on investing makes this an interesting opportunity.

Of course, the value approach to investing is not universally accepted, and Fairfax has its own fair share of long-time critics. So this is only interesting to those who appreciate the Fairfax track record and what they are trying to do in India.

India Macro
Here are some charts from the FFXDF marketing slides from a couple of years ago. You can get all of this at the SEDAR website:

SEDAR link to FFXDF filings

Nothing really new here, but just to refresh:

One huge headwind in the global economy is demographics; this is a problem everywhere, Japan, China, Europe and even the U.S. to a lesser extent than the others.

And this is India:

A lot of potential for growth in India, and recently trending well:

Singapore II?
Watsa compares what can happen in India going forward to Lee Kuan Yew's Singapore starting in the 1960's. Singapore is a great example of a successful nation, and Munger brings it up all the time too. But we have to remember that Singapore was a tiny island city-state with a population of less than 2 million (in the early 1960's), and a current population of less than 6 million. The area of Singapore is smaller than New York City.

It's one thing to rebuild and lead a nation of 2 million, but it's an entirely different matter to try to do the same with a country with a population that exceeds a billion. Try banning chewing gum in a huge country like India with a 1 billion+ population!

But OK, we get the analogy. Maybe India can't repeat Singapore's performance, but with the right policies, they can still do really well.

Past Performance
These things may not be as indicative of future performance as we'd like to think, but here is the track record of Watsa's India investment management team. They have done really well, but we have to keep in mind that the results are very volatile. We are talking about an emerging market, and a highly concentrated portfolio. Plus not much has happened since 2007 (a lot of volatility!).

One thing that Fairfax fans may not like is the management fee structure. This seems kind of normal in the investment world; 1.5% management fee and 20% incentive fee (but only after 5% hurdle). In this day and age, it might sound a little steep. Maybe it's not so bad when you consider that it is partially a private equity fund.

Why not ETF?
Well, if India is so interesting (and I don't mean in the timing sense, by the way. I don't follow India closely enough to tell you even what the sentiment is like, but I think emerging markets overall here has been out of favor), and the fees are too high, why not go with and indexed ETF?

That may be a good idea. I haven't looked in detail at any of the India ETF's, but emerging market ETF's tend to be packed with large, inefficient, formerly state-run enterprises. Plus who knows when the government dumps (IPO's) a large, stodgy, bureaucratic, inefficient state-run organization onto the market for non-differentiating index funds to blindly buy into (this could be one of your funds!).

I think the inefficiencies in these markets tends to favor the active investor.

Plus, here, you are betting on the continued success of the Fairfax/Watsa investment approach. You don't get that in an index.

Speaking of emerging market funds, it seems like emerging markets have grown at a higher pace than mature economies for decades, and yet how come there aren't really any good emerging market funds with good long term track records? Mark Mobius was a big star back in the 1990's. Last time I looked, his funds' performance was not very good. I wonder about that. Maybe it's something I should look at in another post. I am always intrigued by the idea of emerging markets, but am almost never sure what to do about it! (uh oh... reading too many Watsa reports... the exclamation point is contagious!).

There was a time in the late 1980's and early 1990's when all you had to do was to own the telephone companies in each of the emerging markets and you could earn hedge fund-like returns (any ADR with a 'com' (not '.com') in the name would have worked).

Anyway, this may not be for everybody, and it will probably be pretty volatile but it's an interesting thing to keep an eye on, or tuck into your portfolio somewhere and just forget about it and check back in a few years.

JP Morgan 2016 Annual Report (JPM)

Date: 2017-04-07

I haven't posted much about JPM recently as it's still basically the same story. Great CEO building an awesome company performing really well etc. After even a couple of posts, they are basically the same.

But since I haven't been too active here recently, I figured why not? Let's take a look at this. There is a lot to learn here, not just about banking and the economy, but about markets and investing too.

So first of all, let's look at how well JPM has done in recent years. And it's not just because of the huge bull market since 2008. If you look at the performance figures below, they go back to 2004, and the performance chart in the proxy is from 2007, which is the benchmark I use to get 'through-the-cycle' returns.

Anyway, Dimon's Letter to Shareholders is really good so go read it if you haven't done so already. I sort of look forward to this one even more than Buffett's lately.

Check out the total return of JPM stock over various time periods:

This is really crazy given what has happened since 2000 and particularly after 2007. Back in 2000, I don't think anyone would have guessed JPM stock would outperform the S&P 500 index over the next 16 years. People were bearish the financials after the collapse of the 1999/2000 internet bubble, especially JPM which had a large investment bank attached to it with trillions in notional derivatives outstanding. For years, JPM has been considered the first domino in the coming financial collapse.

And yet, look at that! Yes, bears will argue that JPM got bailed out during the crisis etc. I've talked about that a lot here so won't go into it too much, but I disagree. I agree that the government bailed out the whole system, which is what it should do (that's what the Fed is for, and that's what the government has the power to do in extraordinary situations). But I don't think JPM was in any danger unless the whole system itself collapsed, in which case nothing would matter anyway.

So let's look at the performance of the company itself:

This is just totally insane. TBPS has increased even more than the stock (total return).

Here's a chart from the proxy that is indexed to 2007:

That's a 10.5%/year return since 2007. That's crazy. Let's say you knew that the worst financial crisis would come and almost destroy the country. People would have called you an idiot if you said, "Fine. I don't care. My stock will return 10.5%/year over the next 9 years!". In fact, I did own JPM and didn't sell in front of it, even when cracks appeared. I didn't sell any during or immediately after either.

Investment Lessons
And here's sort of the lesson on investing. It was widely known that Dimon was a super-competent manager when he took over Bank One. I think he was already considered at the time one of the best managers in finance. When he left Citigroup, many thought C would collapse because Dimon was the detail guy that made sure everything was OK. Sandy was a big picture guy while Dimon chased after the details. No Dimon == noone looking at the details => eventual blowup. (I heard this from someone that was there at the time and watched how they worked up close too.)

But a lot of people didn't invest in JPM because it was a large money-center bank and banking cycles tended to be severe. Everyone remembers the banking crisis of the 1970's and the late 80's/early 90's.
So the thought was 'thanks, but no thanks'. I confess I was one of those. I've owned Bank One since forever and JPM too, but never allowed it to become a huge position because of that. (On the other hand, I would not mind being 100% in Berkshire Hathaway, even though BRK has gone down 50% on a number of occasions).

In 2007, bank stocks were expensive and we were at the tail end of a very long credit cycle. Contrary to the claims of some best-selling books, the leverage built upon shrinking credit spreads was pretty well-known within the industry. It would have been wise to not be too exposed to financials at this point.

But, when you own a great business run by great people, it is often better off to ride out the cycles than to try to time them. And that's another lesson here with JPM stock. This is not really hindsight trading either, as I would have told you back in 2007 (and I think I did even though this blog was not in existence back then) that JPM and GS would be the survivors in any crisis, and they would come out the other end bigger and stronger (as Charlie Munger says about how great companies grow; they grow in bad times, just like Rockefeller, Carnegie and everyone else did).

The argument back in 2007 really focused a lot on the notional derivatives outstanding at JPM. This was one of the major red flags that kept some investors away. I have managed derivatives before so understood that notional amounts outstanding is not a measure of risk. When you are a big banker and dealer, you end up with huge amounts of notionals outstanding because, for example, if you issue bonds for an issuer, you sometimes do interest rate swaps to accommodate the client's cash flow needs. Same with FX. As a major FX dealer, you often use swaps as a tool to help risk-manage clients' risk exposure. Those 'straight' swaps often have very little risk.

Cyclical or Secular?
The other lesson is that markets have cycles. After the financial crisis and after JPM has shown its resilience and management competence, it traded cheaply for a long time. Even the most prominent bank analysts would say things like, "Yes, it's cheap, but there is no reason to own it as regulations make it hard for them to make money...". I've heard that argument over and over again post-crisis.

But these folks held a linear, static model in their heads. They didn't realize, or underestimated how the industry would adjust to new regulations and requirements. If the regulatory capital burden got too heavy in a line of business, they would drop it. They can cut expenses. They can reprice products as new regulations apply across the industry. Sure, they may not get back to bubble-era returns, but banks don't need to to be good investments.

Maybe this was due to the short-term nature of Wall Street; with regulatory headwinds and low interest rates, bank stocks were simply not recommendable.

Either way, long term value investors look to invest in great businesses at reasonable (or cheap if available) prices.

And interestingly, now,hedge funds and others seem to be piling into banks. Nobody wanted JPM at $20 or even $40, and now they are piling in at over $80! And people say the market is efficient, picked over etc.?

I think all of this sort of just illustrates the cyclical nature of markets. The key in successful investing is being able to see the difference between cyclical and secular. It's true that this is very hard a lot of the time. But I never thought banking itself was in secular decline. Every year, Dimon has shown how much business needed to be done over the long term in banking.

Regulations tend to be cyclical too as the pendulum can swing wildly from one extreme to the other. We are now seeing the pendulum start to swing back the other way. As Dimon says, a lot of this can be done (simplify regulations) without congressional action.

By the way, I have a lot to say about this, maybe in future posts, but I do believe that this max exodus out of hedge funds too is cyclical, as is the move towards machines (vs. people) / indexing. I do believe that most hedge funds probably don't deserve to exist, and machines will more and more take over money management, but I think it will still be very cyclical. We have seen this before in the past; move to quantitative money management, indexing vs. active, hedge funds vs. index etc...

Buffett and WFC
And this sort of thing explains why Buffett has been buying WFC for all these years, even right before the crisis. I always heard comments like, "doesn't Buffett see this big trouble brewing? This huge storm? Doesn't he understand that the era of big banks is over?". He has been buying before, during and after the crisis at 'high' prices.

He focuses on what a business can earn on a normalized basis over time, so he doesn't care about the short term outlook. He doesn't care about what other people say. He doesn't worry about downturns as strong institutions should be managed to survive and grow in such situations. Trading in and out to avoid such dips is a loser's game.

2x Tangible Book
Dimon says it was a no-brainer to buy back stock at 1x tangible book, but says this year that it still makes sense to buy back stock at 2x TBPS. That would be over $100/share!

That sounds insane. Who would have even guessed JPM would be closing in on $100 just a couple of year ago?

Assuming a 50% payout ratio on $6.00 or so in EPS, that would be $3.00/share in dividends. Using a $100/share price, that's a 3% dividend yield. Assuming JPM grows along with the economy (4% nominal), that's an expected total return of 7%/year against what I would assume a normalized long term rate of 4% (actual is 2.3%). As a sanity check, EPS grew around 4%/year from 2007 to 2016.

OK, students will immediately jump on me and argue that earnings growth should be 6.5%/year for a 9.5%/year return (50% retention at 13%). Well, JPM is a big bank so it may not be able to grow that much more than GDP over time, so let's just say earnings grow at nominal GDP. That would just mean that payouts would be higher as capital can't be invested at a 6.5% growth rate.

In that case, payouts may be 70%. On a $6/share EPS, a 70% payout is a $4.20/share dividend for a yield of 4.2% (again, at a $100 stock price). 4.2% dividend yield plus 4% growth is 8.2% expected return.

This reminds me of Buffett talking about how he bought a stock yielding more than the financial products the company was selling.

Of course, as we wait for things to normalize, bad debt may normalize too; JPM is sort of over-earning in the sense that credit trends are really good now. This has probably bottomed out and should head higher. I don't think there are any time bombs at JPM, but it will sort of be a race on the economy picking up steam and interest rates normalizing versus credit trends bottoming out.

But of course, stocks never trade at what they are supposed to trade at. Which leads to my next digression.

Models and Odds: Ed Thorp Book
I was actually going to make this a whole separate post; maybe I still will. But writing the above got me back to thinking about models, odds and things like that.

This goes back to the argument about stocks being expensive or not, wondering about being short because the market is overpriced and losing money for years on end etc.

I just finished this book by Ed Thorp: A Man for All Markets

And I have to say it's one of the best books I've read in a long time. It's not a manual like Securities Analysis or the Greenblatt books, but an autobiography. But it is a fascinating read. Some may be disappointed by the lack of mathematical details, but this is not meant to be that sort of book. In any case, the math involved in what he talks about is widely available now anyway. But the thinking that went behind figuring all this out is fascinating.

Other than his adventures in Las Vegas, I've been involved in just about every area he talks about in the book, from options, warrants, convertible bonds, closed-end funds, even the Palm stub trade, statistical arbitrage etc. (One thing he fails to mention about the Palm trade is that even though it looks like the market is inefficient, in some cases, there is no stock to borrow to implement the trade; rebates go through the roof and reduces or takes away potential profit etc... The stock lending side is often not as visible).

For Buffett fans, there is a whole chapter on Warren Buffett, which is fun to read. They knew each other and Buffett even checked him out over dinner long ago. Thorp also invested in Berkshire Hathaway but moved his money elsewhere as returns went down as BRK got larger.

One interesting fact that Thorp mentions is that the Buffett partnership returned 29.5%/year, gross, in the 12 years from 1956-1968 versus 19%/year for small caps stocks and 10% for large caps. I knew Buffett made his money buying small/microcaps back then, but it was surprising that a good half of the outperformance came from the small cap bias. Maybe I should not have been surprised. But anyway, I did take note of that as I read the book.

OK. Back to models. Early in my career, I spent a lot of time creating models; economic models, stock market valuation models, statistical models, single stock valuation models, technical trading systems, mean-reversion trading models (early stat-arb) etc...

And what struck me while reading the Thorp book was the difference between the typical economist who creates models and the traders that write models.

Economists plug in all these numbers and tell you that the economy should do this or that, and that the market should be valued here or there. And sometimes, they get all caught up in their models and think they are absolutely right and get their head handed to them. I've seen this happen time and again. One benefit of working at a large firm was that I sat through many presentations (people pitching big banks to fund their proprietary trading models/ideas). And a lot of the ideas lacked real world common sense.

And then you read what Thorp did. For example, he created the option model before or at the same time as Black-Scholes etc. This model told you what an option or warrant was theoretically worth. But the model would have been useless if there wasn't a way to capture the price difference. You can hedge the option by trading the stock and capture any mispricing.

All of the strategies that Thorp was involved in had very specific odds attached to them, including the possibility of adverse outcomes. What are the odds of this or that? What happens when you are on an expected, normal losing streak? You have to have enough capital to be able to stay in the game. Traders' models usually have a "what if this happens, or what if that happens? what are the odds of this or that happening?". Economist models are like, "This is what will happen and all the back-testing proves it will happen... we have calculated to the seventh decimal places using 30 models and they all confirm we are right". If you ask them, but what if reality deviates from the model? They say, "it won't because we are right".

Even some investors I respect had a huge hedge on their equity book that lost them tons of money. It made sense on the surface; stocks are expensive so we must hedge our equity exposure. The problem is that, as I have shown in previous posts, overvaluation is a very poor reason to go short the market or put on hedges (well, it might make sense to do some hedging).

I've seen the bubble in Japan in 1989 and the U.S. bubble in 1999 and I would guess that most people who correctly identified those as bubbles didn't make money when the markets collapsed. It was stunning how many funds were hurt during the late stages of the bubble and weren't around to capitalize when they were proven correct.

The problem with overvalued markets is that the odds of a blow-off are pretty high, and when things blow off, the more expensive things are, the higher they go. So, if you own a bunch of value stocks and hedge using the S&P 500 index or some other market cap-weighted index, you will probably be destroyed as the expensive large caps will go up the most. (This reminds me of something I did long ago; I owned some value stocks that went up 20-30% so was proud of myself, but was short Starbucks against it and that doubled... Oops. So much for hedging a value portfolio with a growth/mo-mo stock).

There was an interesting article recently that said that a bubble isn't a bubble unless the market has gone up 100% over a period of two or three years or something like that.

This is why people like Thorp would not make directional bets on the market. One can easily observe that markets are expensive, but what is the edge that that specific observation brings to you? I remember Buffett telling someone, when shown a chart of how overvalued the stock market is, that it's just a squiggly line and it can go this way or that way, who knows which way it would go? That seemingly 'clueless' response is much wiser than it seems on the surface.

If you hedge using market-cap weighted indices or go net short, can you survive a real bubble-like blow-off? What are the odds of such an event occuring? Is it really zero? I bet that this is not even incorporated in most models or the thinking of most investors. Of course, most of the quant funds would have this worked out (or hedged out); quants don't like to take risks that they can't hedge.

On the other hand, if you are a long manager, do you need to care about the odds of a correction? No, because if you own solid stocks that won't go bust (like owning JPM from 2007-2016), then corrections don't really matter. You just ride it out. The only way the market can break you is if the companies you own actually go out of business. Otherwise, you may just have to wait longer to realize value. But otherwise, there is not that much risk. This is not true when you are short, of course; it is much easier and probability of survival higher for a long to live through a bear market than the other way around.

Cheap Labor
Back to JPM. The great thing about JPM is that we get all of this for so cheap. OK, 'cheap' may be offensive to average folks out there earning normal salaries. So I shouldn't say that too much. But still, cheap is cheap. We paid Dimon 0.1% of profits. Compare that to other financials! (from the proxy). Let's not get into hedge fund fees here.

...also from the proxy:

And for the Berk-heads here, a familiar new face on the board:

OK, this is getting way too long. There is a lot more in Dimon's Letter to Shareholders so go read it. I may post more about it later (but maybe not), but let me just get this post out before more time goes by without a post!

Buffett on Valuation

Date: 2017-03-02

Buffett was on CNBC the other day and it was very interesting as usual. Well, most of what he says is not new.

Not in Bubble Territory
Anyway, he was asked about the stock market and since so many people keep saying that the stock market is overvalued or that it's in a bubble, I found it interesting that he says that, "we are not in a bubble territory or anything of the sort now."

He said that:

This agrees with the charts/analysis I've been posting here relating P/E ratios with interest rates.

I know there are quants who say this is wrong, that P/E ratios can't be compared to interest rates (we discussed this in the comments section of one of my posts about P/E's). I understand that argument, but history shows that the market does in fact use interest rates to value the stock market however theoretically wrong it may be, and the greatest investor of all time does so too.

What if?
OK, many commentators and pundits are baffled at this huge rally in the stock market thinking it's insane and taking the market to extreme valuations. I have been posting here for a while that the valuations aren't all that extreme given the interest rate environment, even if you assume interest rates go up a lot from here.

Well, Buffett says if rates get up to 7-8%, then stocks are really expensive. But will rates get up that high? Even though I'm not an economist and have no idea what interest rates will do (actually there is no relationship between the two), I tend to believe that interests rates will get to 4-5% at most, on average.

So, let's play a simple what if game. This is not a prediction or anything, just a scenario that sounds plausible and is not at all a stretch.

What if GDP growth is stuck, more or less, at the 2% level? Maybe Trump gets it up to 3%, but a lot of people don't think that is possible (except Jamie Dimon who thinks we can go much higher in terms of growth). And let's say that inflation does tend towards the 2% level. That gets us to a nominal GDP growth of 4% or so over time.

Let's also assume that long term rates do revert to the level of nominal GDP growth. Then long term rates would get to 4%. Of course, there will be overshoots in both inflation, GDP growth and interest rates. But over time, it's not hard to imagine interest rates averaging 4%. Total debt levels, demographics etc. make it hard to imagine higher nominal GDP growth.

So using the earnings yield-bond yield model, let's assume that the earnings yield tracks closely to the long term interest rate of 4%. That means, over time, that the P/E ratio can average 25x in this environment.

Right now, 25x P/E ratio just seems super-expensive to many people because they look at the past 100 years and the stock market hasn't stayed at the 25x level for very long and has more often signaled a major market top than anything else.

But given the above scenario, it's not really inconceivable that the market P/E gets up to this level for an extended period of time. Some will argue that Japan has had lower interest rates and has been unable to sustain a high P/E ratio, but Japan has a lot of problems at the micro level too (companies not allowed to cut costs in their system of "corporate socialism" where large corporations are expected by the government to carry the burden of unproductive, unnecessary workers).

S&P 500 at 3250, DJIA at 29,000
The consensus EPS estimate for the S&P 500 index is $130. OK, I know that this will come down throughout the year, but that's what we have now so let's just use it. I'm not making a prediction or anything, just conducting a simple thought experiment.

Using the above, future average P/E of 25x, that would put the S&P 500 index at 3250!. Using the same percentage increase, that would take the DJIA to 29,000!

Believe me, that sounds just as stupid to me as it does to you. I'm just making simple assumptions and plugging in numbers. My own personal experience (anchoring?), however, makes these figures hard to swallow.

But you see, it doesn't take much for the market to get up so high, and I am using a 4% interest rate, not 2.3%! So a large increase in interest rates is already built in.

Sure, inflation can get out of control and rates can go higher. I am just trying to figure out a long term, stable-state, through-the-cycle sort of scenario, and 4% rates and 25x P/E ratio just seems normal in that sense. OK, so we can expand that to 5% rates and 20x PE; so let's just say rates can get to 4-5% and P/E ratios to 20-25x without it being stretched in any way.

Again, this sounds crazy and sort of feels like 'new era' thinking and Irving Fisher's "permanently high plateau". I know. Every time I make a post like this, I feel like I am putting in the top. But this doesn't feel like justifying anything new. In fact, I am insisting that things will go back to the way they always were; P/E ratios will be driven by interest rates, interest rates will be determined by nominal GDP growth rate etc.

I'm not making any outrageous assumptions like real GDP growing 4%/year or earnings growing 15%/year into perpetuity or anything like that.

And keep in mind that in this scenario, this is just the future 'average'. The markets can get much higher than 25x P/E in a manic phase and much lower in times of panic.

In fact, this has already been happening. The stock market has been overvalued in the eyes of many since the 1990's and hasn't reverted back to 'normal' levels in a long time. I think the error is that many look at raw P/E's and don't account for interest rates.

Not to be Bullish
And by the way, I have been saying this sort of thing over the past few years not because I am bullish; I am actually an agnostic (but bullish over the long term). I say this stuff to counter a lot of the "market is overvalued so it must go down!" argument and to caution people (and myself) to stay the course and act rationally.

Some funds claim to use a lot of sophisticated models and they write great reports, but at the end of the day, they are just net short the market (and have been for years!). That's just gambling; betting all their client's money on a single trade. Crazy.

Trust me, I get the same queasy feeling you do when I type 25x P/E. I honestly don't know what I would do with the S&P 500 index at 3000. I know I would be very uncomfortable (if it happened within the next year or two).

So I'm not really being a Pollyanna.

When considering this stuff, it becomes less of a mystery why Buffett would spend $20 billion buying stocks since the election (or including some buys just before). And it becomes a big mystery why anyone would want to be net short this market (unless you are a short term trader who will be in and out as markets rally, like some hedge funds do etc...).

Sanity Check
And by the way, when all this talk of high P/E's make you nervous, just go check out my valuation sanity check page at the Brooklyn Investor website. This is updated after the close every day.

Sanity Check

I often look here to make sure I am not seeing the trees looking like the Nifty Fifty. When I see 20x or 30x P/E ratios on the S&P 500 index, I look at individual stocks to see if I see the same thing. If I do, maybe I worry. If I don't, I don't worry at all and assume the high market P/E is due to large cap, speculative names trading at high P/E's and/or hard-hit industries dragging down the 'E', or some of both.

Speaking of the Nifty Fifty, in the Bogle book I mentioned here the other day (Bogle book), he mentions a Jeremy Siegel study that showed that 50 nifty stocks bought at the start of 1971, near the peak, marginally outperformed the market over the subsequent 25 years. Nifty Fifty returned 12.4%/year versus 11.7%/year for the stock market.

That's kind of crazy. Even if you bought the Nifty Fifty at near the top, you would've beaten the market over the next 25 years, returning an above average 12.4%/year. By average, I mean the market returned 10%/year in the past 100 years or so.

Pzena Q4 Commentary
Pzena Investments posted their Q4 commentary and it follows up on their theme of the value cycle, and it is very interesting.

Check it out here.

Anyway, it shows that value has started to outperform again but that we are still early in the value cycle. Check out the tables and charts below.

I thought that was really interesting and I tend to agree with it. As much as I agree with Bogle and Buffett about indexing, there does seem to be a big, extended move in that direction which would have impact on valuations of individual securities, so it seems to make sense that maybe individual stock pickers can start beating indexes again (but don't bet on many being able to do so).

I still have a lot to say (or at least think about) in terms of fund managers, but that will have to be in a future post.

Six Sigma Buffett, Taxes, Fund Returns etc.

Date: 2017-02-14

Whenever I read about Buffett and other great managers, what I tend to see all the time are things like, "xx has beaten the market y out of z years; the odds of that happening are 1 in 5,000!" or some such thing. Not too long ago, there was an article about managers with outstanding performance and the screen was based on who beat the market five years in a row, ten years in a row or something like that.

But for me, I tend not to care about that at all. In fact, I would rather invest with someone who only beat the market seven out of the last ten years but with a wider and more consistent margin than someone that beat the market ten years in a row, and only with a small margin.

So that got me thinking about what I should look at. Well, when I say that, I don't mean that I would use this stuff to choose investment managers since I don't really invest in funds at all. What I mean, I guess, is that if I don't like the above 'beat the market x out of y years', what is a better indicator?

Tax Digression
But before that, I just happened to be reading the 1986 Berkshire Hathaway letter to shareholders and came across this comment about taxes. Trump is expected to do something about taxes and I heard Buffett or Dimon mention somewhere recently that any tax cut will be competed away by the market implying that it won't make a difference to investors. Anyway, this is what he wrote about it back in 1986 after the last big tax change:


The Tax Reform Act of 1986 affects our various businesses in
important and divergent ways. Although we find much to praise in
the Act, the net financial effect for Berkshire is negative: our
rate of increase in business value is likely to be at least
moderately slower under the new law than under the old. The net
effect for our shareholders is even more negative: every dollar
of increase in per-share business value, assuming the increase is
accompanied by an equivalent dollar gain in the market value of
Berkshire stock, will produce 72 cents of after-tax gain for our
shareholders rather than the 80 cents produced under the old law.
This result, of course, reflects the rise in the maximum tax rate
on personal capital gains from 20% to 28%.

Here are the main tax changes that affect Berkshire:

o The tax rate on corporate ordinary income is scheduled to
decrease from 46% in 1986 to 34% in 1988. This change obviously
affects us positively - and it also has a significant positive
effect on two of our three major investees, Capital Cities/ABC
and The Washington Post Company.

I say this knowing that over the years there has been a lot
of fuzzy and often partisan commentary about who really pays
corporate taxes - businesses or their customers. The argument,
of course, has usually turned around tax increases, not
decreases. Those people resisting increases in corporate rates
frequently argue that corporations in reality pay none of the
taxes levied on them but, instead, act as a sort of economic
pipeline, passing all taxes through to consumers. According to
these advocates, any corporate-tax increase will simply lead to
higher prices that, for the corporation, offset the increase.
Having taken this position, proponents of the "pipeline" theory
must also conclude that a tax decrease for corporations will not
help profits but will instead flow through, leading to
correspondingly lower prices for consumers.

Conversely, others argue that corporations not only pay the
taxes levied upon them, but absorb them also. Consumers, this
school says, will be unaffected by changes in corporate rates.

What really happens? When the corporate rate is cut, do
Berkshire, The Washington Post, Cap Cities, etc., themselves soak
up the benefits, or do these companies pass the benefits along to
their customers in the form of lower prices? This is an
important question for investors and managers, as well as for

Our conclusion is that in some cases the benefits of lower
corporate taxes fall exclusively, or almost exclusively, upon the
corporation and its shareholders, and that in other cases the
benefits are entirely, or almost entirely, passed through to the
customer. What determines the outcome is the strength of the
corporations business franchise and whether the profitability of
that franchise is regulated.

For example, when the franchise is strong and after-tax
profits are regulated in a relatively precise manner, as is the
case with electric utilities, changes in corporate tax rates are
largely reflected in prices, not in profits. When taxes are cut,
prices will usually be reduced in short order. When taxes are
increased, prices will rise, though often not as promptly.

A similar result occurs in a second arena - in the price-
competitive industry, whose companies typically operate with very
weak business franchises. In such industries, the free market
"regulates" after-tax profits in a delayed and irregular, but
generally effective, manner. The marketplace, in effect,
performs much the same function in dealing with the price-
competitive industry as the Public Utilities Commission does in
dealing with electric utilities. In these industries, therefore,
tax changes eventually affect prices more than profits.

In the case of unregulated businesses blessed with strong
franchises, however, its a different story: the corporation
and its shareholders are then the major beneficiaries of tax
cuts. These companies benefit from a tax cut much as the
electric company would if it lacked a regulator to force down

Many of our businesses, both those we own in whole and in
part, possess such franchises. Consequently, reductions in their
taxes largely end up in our pockets rather than the pockets of
our customers. While this may be impolitic to state, it is
impossible to deny. If you are tempted to believe otherwise,
think for a moment of the most able brain surgeon or lawyer in
your area. Do you really expect the fees of this expert (the
local "franchise-holder" in his or her specialty) to be reduced
now that the top personal tax rate is being cut from 50% to 28%?

Your joy at our conclusion that lower rates benefit a number
of our operating businesses and investees should be severely
tempered, however, by another of our convictions: scheduled 1988
tax rates, both individual and corporate, seem totally
unrealistic to us. These rates will very likely bestow a fiscal
problem on Washington that will prove incompatible with price
stability. We believe, therefore, that ultimately - within, say,
five years - either higher tax rates or higher inflation rates
are almost certain to materialize. And it would not surprise us
to see both.

OK, the last paragraph is kind of interesting too. Buffett said he bought $12 billion in stocks after the election so I guess he is not so worried about the fiscal position of the U.S.

Back to fund performance stuff...

Comparing Two Distributions
I said that I don't care for the 'beat the market x out of y years' idea. So that got me thinking about the simple high school statistics problem of comparing two normal distributions. I am aware of the argument against using normal distributions in finance, but I don't really care about that here. I am just looking for some simple descriptive statistics. I'm not creating a derivatives pricing model to price an exotic option for a multi-billion dollar book where modeling errors can cause huge losses. So in that sense, who cares. Normal distribution is fine for this purpose.

Plus, I am not so interested in factor models that try to assess fund manager skill. Some people use factor models and whatever is left over is what they define as 'skill'. Well, say the model cancels out 'quality' as a factor and doesn't give the manager credit for it; what if the manager intentionally focused on quality investments? Should he not get credit for it? Having said that, I don't know much about these models so whatever... I don't get into that here. Whatever factor exposures these managers have, I assume the manager intentionally assumed those risk factors to gain those returns.

Basically I just want to compare two distributions and see how far apart they are. It's basically the question, is distribution A, with 99% confidence, the same as distribution B? In other words, are the two distributions different with any degree of statistical significance? Or are we just looking at a bunch of noise resulting from totally random chance?

The simple comparison of two distributions is:

standard deviation of the difference between two means (Std_spd) =

Sqrt[(Vol_A^2/n)+ (Vol_B^2/n)]

where: Vol_A = standard deviation of distribution A and
n = number of samples

So the z-score would be:
(mean_A - mean_B) / Std_spd

And then you can just calculate or look up the probability from this z-score.

Looks good. This would tell me how significantly different a manager's return is versus the market.

But the problem is that these two distributions are not independent. In your old high school statistics text book, the example is probably something like number of defective parts in factory A versus factory B. Obviously, those distributions would be independent.

This is not so in the stock market. A fund manager's returns and the stock market's return are not independent. Hmm... Must account for that.

The answer to that goes back to my derivative days; calculating tracking error. Sometimes fund managers or futures traders wanted to use one index to hedge against another. An example might be (in the old days!) an S&P 100 index option trader wanting to hedge their delta using the S&P 500 index futures. Does this make sense? What is the tracking error between the two indices? Does it matter? Is the tracking error too big for it to be an effective delta hedge? How about using the S&P 500 futures to hedge a Dow 30 total return swap? TOPIX index swap with the Nikkei 225 futures?

Anyway, the calculation for tracking error simply makes an adjustment by making a deduction for correlation (getting square root of the covariance).

So, the above formula becomes:

Sqrt[(Vol_A^2/n)+ (Vol_B^2/n) - ((2 * Vol_A * Vol_B * correlation(A,B)) / n)]

Using this formula, I calculated all this stuff for the superinvestors, just for fun.

I just wanted to know simple things like, is it harder to outperform an index by 10% per year over 10 years, or by 3% per year over 20? Or something like that. The Buffett partnership was only 13 years, and Greenblatt's Gotham returns in the Genius book is only 10 years. But the spread is so wide that it is yugely anomalous to achieve, or is it? This is sort of what I wanted to know. It normalizes the outperformance spread versus the length of time the outperformance lasted.

Few Standouts
A few of the standouts looking at it this way, not surprisingly:

For the Graham and Doddsville superinvestors, I looked first at the "beat the market x out of y years" to see the probability of that happening assuming a 50% chance of beating the market in any given year. And then I'll compare the two distributions as described above. At the end, I also added Lou Simpson's returns from the 2004 Berkshire letter.

Keep in mind that just because a manager is not in the 4-5 sigma range, that doesn't make them bad managers. Some of these numbers are just insanely off-the-charts and can't be expected to happen often.

Anyway, take a look!

Buffett Partnership (1957-1969)
Beat the market 13 out of 13 times: Chance of occuring: 0.012% or 1 in 8,192.

Given that Buffett partnership gained 29.5%/year with a 15.7% standard deviation while the DJIA returned 7.4%/year with a 16.7% standard deviation and the Partnership had a 0.67 correlation, the partnership returns is 6.0standard deviations away from the DJIA. 6 standard deviations make the partnership returns a 1 in 1 billion event.

What's astounding is that the standard deviation of Buffett's returns is actually lower than the DJIA.

BRK 1965-2015
Beat market 40 out of 51 years: 0.003% chance or 1 in 35,000

BRK S&P500
Return 19.3% 9.7%
std 14.3% 17.2%
correl 0.61

4.8 std, 1 in 1.3 million

This uses book value, which may not be fair as not everything in BPS is marked to market (over 51 years). Using BRK stock price, it would be a 3.2 std event, or 1 in 1,455. But this too may not be fair as the volatility of the price of BRK is more a function of Mr. Market than Mr. Buffett. This may be true of all superinvestor portfolios, but in the case of BRK, there is a penalty in that we are looking at the volatility of a single stock (BRK), and not the underlying portfolio. Single stock volatility is usually going to be much higher than that of a portfolio.

Munger 1962-1975
Beat the market 9 out of 14 years: 21% chance or 1 in 5

Munger DJIA
return 19.8% 5.0%
std 33.0% 18.5%
correl: 0.73
#years: 14

2.4 std, 1 in 122.

Sequoia 1970-1983
Beat the market 8 out of 14 years: 40% chance or 1 in 2.5

Sequoia S&P 500
return 17.2% 10.0%
std 25.0% 18.1%
correl 0.65

1.4 std or 1 in 12.

This is the in-sample period; the period included in the Superinvestors essay.

Sequoia 1970-2016
Beat the market 26 out of 47 years, 28% chance or 1 in 3.6

Sequoia S&P500
return +13.7% +10.9%
std 19.3% 17.1%
corr 0.67

1.3 std or 1 in 10

Sequoia 1984-2016
This is the out of sample period; the period after the essay.

Beat the market 18 out of 33 years, 36% chance or 1 in 3

Sequoia S&P500
return 11.9% 10.9%
std 16.0% 16.6%
corr 0.73

0.5 std or 1 in 3

Sequoia 2000-2016
And just for fun, a recent through-cycle period starting in 2000. They have been underperforming the market since 2007, though.

Beat 9 out of 17 years, 50% chance or 1 in 2.

Sequoia S&P500
return 7.3% 4.5%
std 13.7% 18.1%
correl 0.69

0.9 std or 1 in 5

Walter J. Schloss 1956-1983
Beat the market 22 out of 28 years, 0.2% chance, or 1 in 540

WJS S&P500
return 21.3% 8.4%
std 19.6% 17.2%
corr: 0.75

5.2 std or 1 in 9.4 million

Tweedy, Browne Inc. 1968-1983
Beat the market 13 of 16, 1.1% chance or 1 in 94

Tweedy S&P500
return 20.0% 7.0%
std 12.6% 19.8%
corr: 0.71

3.7 std or 1 in 9,300

Pacific Partners Ltd. 1965-1983
Beat the market 13 of 19 years, 8% chance or 1 in 12

Pacific S&P500
returns 32.9% 7.8%
std 60.2% 17.2%
corr: 0.37

1.9 std or 1 in 35

Gotham 1985-1994
Beat the market 9 out of 10 times: 1.1% or 1 in 93 chance

3.8 std, 1 in 14,000

Lou Simpson (GEICO: 1980-2004)
18 out of 25 years. 2.2% chance or 1 in 46.

return 20.3% 13.5%
std 18.2% 16.3%
corr: 0.74

2.7 std, 0.4%, 1 in 288

So that was kind of interesting. It just reaffirms how much of an outlier Buffett really is. There is a lot to nitpick here too, so don't take these numbers too seriously. I used standard deviation of annual returns, for example. I suspect some of these correlations may be higher if monthly or quarterly returns were used.

This sort of thing may be useful in picking/tracking fund managers. At least it can be one input. For example, it gives you more information than the Sharpe ratio; whereas the Sharpe ratio doesn't care how long the fund has been performing, the above analysis takes into account how long someone has been performing as well as by how much. But yeah, Sharpe ratio is trying to measure something else (return per unit of risk taken).

Anyway, as meaningless as it may be, it's one way of seeing if it's harder to create a long term record like Buffett (1965-2015) or a shorter super-outperformance like Greenblatt (1984-1994). This analysis says that Buffett's 1965-2015 performance is a lot more unlikely to be repeated (well, at least on a BPS basis; using BRK stock price, Greenblatt's performance is more unlikely!).

I sliced up Sequoia Fund's return into various periods for fun as it is the only continuous data (other than BRK) out of the Graham and Doddsville Superinvestors. I was going to look into their performance since 1984 a little more deeply, but this took a little more time than planned (despite the automation of a lot of it; well, debugging and fixing takes time, lol...).

So maybe I will revisit the Sequoia Fund issue in a later post. My hunch is that the Superinvestor returns were achieved on a much lower capital base so the universe of potential investments were much larger than what Sequoia (and others) are looking at now despite their efforts to keep AUM manageable.

Also, you will notice that comparing the two distributions gives a more nuanced or accurate picture of the performance than just looking at how many years someone has outperformed; it incorporates the spread, correlation, volatility etc...

Anyway, I guess that's enough for now...

Bogle Book, Indexing etc.

Date: 2017-02-01

I have watched and listened to John Bogle for years and always thought he was great, but I never read any of his books. I understand his message and agree with him for the most part. But the other day while I was browsing the library, I came across this book and just grabbed it and decided to read it even though I have a big stack of books that I started and have yet to finish.

There is nothing new in here in terms of message (active managers don't outperform, costs is primary determinant of performance over time; low cost beats high cost in every category, every time period etc...), but it is still amazing to read with all the tables and facts laid out.

Every time non-industry people ask me about stocks and how to learn about them, I go through the usual books that we've all read. I noticed, though, that if they are not in the industry, or not a true market fanatic, people don't ever read the books you recommend.

I understand telling someone to read all of the Berkshire Hathaway letter to shareholders going back to 1977 (available for free, I tell them, at the BRK website) seems like such a tedious thing that no normal, non-financial person would actually do it.

From now on, I think, I will just direct them to this book. It's that good, and it would answer most questions I typically get in the usual 'cocktail party' conversation about markets.

As for stock picking, from now on, I will tell them to just pick stocks based on what you like and believe to be truly good businesses at reasonable valuations. Even overpriced is OK as long as it is kept small and it's not bubble-like; compensate for the assumption of price risk by keeping dollar exposure low. But keep most of the equity exposure indexed (OK, BRK is fine too, but most people won't know what to do when something happens to Buffett, and may not want to deal with the volatility/uncertainty related to the headlines).

Expensive Stocks
Every once in a while, you just come across businesses that you think are just really, really great, as a customer and as a business analyst. For me, that was Chipotle Mexican Grill (CMG). I bought some a while ago and did very well with it, even selling out at the top once and buying back in at a low and then selling out again (most recently in late 2014). I know others who have owned Starbucks (SBUX) forever, and I kick myself for not owning that one too. I go there way more often than I'd like to admit, and when you travel, there is never a SBUX anywhere that doesn't have a long line in the morning. And often, it's the only place to get a bagel and coffee.

(By the way, this section has nothing to do with the Bogle book!)

So, on those occasions where you actually see and verify for yourself a great business in action, and the price is reasonable, or even a little on the high side, I say go for it. Own it and hold it for as long as it's good. We value investors are usually afraid of high P/E stocks because we remember 1999/2000 and many high P/E disasters.

Value investors who run value funds might get into trouble owning such growth stocks, but for individuals managing their own money, why not?

I know this goes against the idea of having discipline, but if most of someone's equity exposure is indexed and they 'play' with a small portion of their portfolio on their own picks, it's probably not a bad idea. Plus, those opportunities don't come up all that often. That's all the more reason to go for it.

Worse is actually going out and trying to find stocks that will go up; buying stuff that you have no idea about etc. At least with some businesses, you have a strong idea about their competitive position etc. What you absolutely don't want to do is to bend that rule and overpay for things just because everyone says it's the next Chipotle, Starbucks, Facebook or whatever. Forget about those "this is the next..." stocks. Only go for the ones that you really understand. The "this is the next..." argument is a shortcut; it allows people to pump stocks with minimal bandwidth. Who's adrenaline doesn't start to flow when you hear about the next CMG, or next Buffett? (Well, I do some of that here...).

Market Timing
Bogle is also anti-market timing, and that's been a constant theme on this blog too. Market timing is a waste of time unless you are a Druckenmiller-type active trader. But market timing when you are supposed to be allocating assets / investing doesn't make much sense.

I was thinking of this the other day, seeing a lot of market-timers doing horribly in recent years. A lot of people have horrible performance because they were short the market for the past few years.

Gambler's Fallacy
And I realized that this "the market is expensive so it must go down. Therefore, I am short"-type manager is falling for the gambler's fallacy. OK, well, not exactly. With the gambler's fallacy, for example, if a coin toss results in heads ten times in a row, people tend to believe the next one must be tails. But the fact that the coin landed on heads ten times in a row doesn't affect the probability of the next coin toss. Each coin toss is independent. Regardless of how many times you had heads in a row, the odds on the next flip is still 50/50.

In the stock market, this is not true. The higher the market goes, the more expensive it gets, and the lower the prospective returns will be. So the probability distribution of going forward returns actually shifts lower; the probability of a loss increases as the market gets more expensive.

So this is not an accurate analogy. But for me, it still is interesting because when the stock market is expensive, my temptation is to ask, when the market is this expensive, what tends to happen in the following year? Greenblatt does this and mentions it just about every time he is interviewed. And even in the past few years, using 30 years of data, I think, his prospective returns one year out from the then current valuation has always been positive.

Even many of the bears have long term expected returns that are positive, but just low. Yet they are short. Even more recently with negative long term expected returns, it is usually low negative. So maybe -2%/year or some such. In that case, it's still better to invest in corporate bonds or other fixed income at something higher than that to earn a positive return than shorting the market. What if the market went into a bubble like in 1999/2000? The stock market valuation is nowhere near that silliness. If the market did rally like that, it would put a lot of those bearish funds out of business.

Now, what are the odds of some sort of blow-off like that? Versus what are the chances of an imminent collapse/bear market? These are things that you usually don't hear about, and to me, are the more relevant statistics to look at if you insist on timing the market. And I suspect those are some things that the more successful quant funds are good at evaluating (and therefore don't lose money being net short for multiple consecutive years!).

Hasty Generalization?
The other related and more precise fallacy is the fallacy of hasty generalization or maybe faulty causality. Actually, I'm not sure this is the right one, but let's use it. Initially I was thinking it was fallacy of composition, but my understanding is a little bit different there. I'm referring to the fallacy of assuming that since all bank-robbers had guns, that all gun-owners must be bank robbers.

We all look at these long term valuation charts and go, hey look!, the market P/E was over 20x before 1929, 1987 and 1999! So, the thinking goes, the market is now over 20x P/E so a crash must be imminent! But then we tend not to look at all the people who own guns that are not bank robbers.

Also, when someone says that the stock market is 90% percentile to the expensive side, there is a tendency to want to believe that there is a 90% chance that the market will go down in the future. Well, if the market is 90% percentile to the expensive side over the past 100 years, then it means that the market will be valued at a lower level 90% of the time in the next 100 years if the same conditions occur.

Anyway, since I was so curious about the year-forward returns and was worried about the declining interest rate bias of Greenblatt's sample (as he uses the past 30 years), I decided to look at this data for myself.

First let's look at Greenblatt's time span. That would be starting around 1985 or 1986.

Just so we can actually see the data, I will use annual figures. I will look at the P/E ratio (as reported) of the stock market at the beginning of the year and compare it to how the market did during that year (actually, the P/E ratio of the end of the previous year is used).

Using Greenblatt's time period and looking at years when the stock market started with a P/E ratio of over 20x, here are the results:

P/E level of over: 20
Number of up years: 11
Total # years: 15
Percent up years: 73.33%
Average change: 5.5%


The data excludes total return for 2016, but we know it was more than 11%, so the results would be even stronger. From the above, when the market started the year with a P/E ratio of over 20x, the market was still up more than 70% of the time, for an average gain of 5.5%. Sure, 5.5% is lower than the 10% or so long term average.

But if you own a fund that is short and is losing money with the market going up, it makes no sense. Actuarially speaking, it makes no sense to short the market just because the P/E ratio is over 20x. Any middle schooler would know this is a bad bet to make.

Oh, and this only looks at the period since 1985. Interest rates have been declining so there has been a huge tailwind. So let's look at the same table over a longer time period.

Here is the analysis using data since 1871:

P/E level of over: 20
Number of up years: 14
Total # years: 20
Percent up years: 70.0%
Average change: 5.9%


And I was sort of surprised that using data that goes all the way back, the results aren't all that different. This includes periods of increasing and decreasing interest rates, so you can't say the data is biased due to a bond bull market tailwind. You can still argue that it is biased by a U.S. bull market tailwind, though.

So yes, my gambler's fallacy analogy is not accurate, but check it out. If someone says that the coin landed heads ten times in a row so the next flip must be tails, you'd think he is an idiot. But if you are short the market because the market is overvalued at 20+x P/E ratio, you are even more of an idiot because at least the coin flipper and real fallacious gambler has a 50% chance of being right whereas if you are short a 20x P/E market, you only have a 30% chance of being right!

That's kind of surprising.

What happens if we do the above with a 25x P/E threshold?

Since 1871:

P/E level of over: 25
Number of up years: 5
Total # years: 8
Percent up years: 62.5%
Average change: 8.3%

Since 1985:

P/E level of over: 25
Number of up years: 3
Total # years: 6
Percent up years: 50.0%
Average change: 5.7%

The average change is still up. Since 1985, the market was up only 50% of the time in years the market started at a 25x or higher P/E ratio. But these figures are questionable as there isn't enough data points to be significant.

Even the earlier figures are questionable with only 15 or 20 years in the sample size.

All Months, not just year-end
Just to be thorough, I reran all of the above using all months, not just year-end. I looked at all months where the P/E ratio was over 20x or 25x and what the total return was 12 months later.

PE >= 20

Since 1871:
P/E level of over: 20
Number of up years: 139
Total # years: 223
Percent up years: 62.3%
Average change: 3.5%

Since 1985:
P/E level of over: 20
Number of up years: 111
Total # years: 162
Percent up years: 68.5%
Average change: 4.8%

PE >= 25

Since 1871:
P/E level of over: 25
Number of up years: 58
Total # years: 96
Percent up years: 60.4%
Average change: 5.1%

Since 1985:
P/E level of over: 25
Number of up years: 54
Total # years: 90
Percent up years: 60.0%
Average change: 5.2%

Using all months, you still get positive expected return with P/E's over 20x and 25x over the next 12 months, with the market rising 60%-70% of the time. I think markets are usually up 70% of the time, 12 months after any given month.

This sort of shows you why it doesn't make too much sense to point to an 'overvalued' stock market, go short and stay short. There are people who have been net short for years and it's amazing to think anyone would do so given the above statistics.

It also explains why Buffett and others can keep buying stocks even as many 'experts' claim the market is way overvalued and due for a correction. Buffett is a numbers and odds guy so I'm sure all of the above figures, at least intuitively, are in his head.

Anyway, the next time someone tells you that they are short because the market is expensive, run away! If they have your money, get it back.

But as usual, this is not to say that the market won't correct at some point. It will correct, as it always does.

So, why am I advocating indexing here on a value investing, stock-pickers blog? I don't know. That's a good question. I do believe that most funds over time will not outperform the market so I do believe that indexing is probably right for most people. But do I believe that the market is totally efficient? Well, no. I am a big fan of Buffett, Greenblatt and many others who have outperformed over time.

The stats in Bogle's book are amazing. He shows how top performing funds almost always revert to the mean, even in the long term.

I was going to post more about this here, but this is already getting long and I would like to get this out, so my next post will be about funds, indexing and things like that. Just my random thoughts on the subject.

I was thinking about the above analysis and was playing around with Python and ended up writing a script to calculate all of that. I loved how Greenblatt always said the market is valued at so-and-so percentile and the going forward expected return from these levels is x%. And he uses 30 years as his history and it always sort of nagged at me that the entire sample period was during a huge decline in interest rates. The above work sort of comforts me.

Oh yeah, and on Trump. Hmm. What can I say. We live in interesting times. I binged House of Cards last year and loved it, but nowadays, it seems like truth is stranger than fiction (fiction has to make sense!).

Am I worried? Well, I am worried about all sorts of things, but although I may be wrong, I am not that worried about economic issues. I am not expecting some huge infrastructure binge or anything like that. All that was needed is just a leaning in the other direction from over-regulation. Just the lifting of some of that pressure, and not even a lot of deregulation, I think, is enough to lift business sentiment.

I am comforted by the fact that Trump is surrounding himself with people I respect (business world people, not the alt-right), and I hope they will be listened to.

As for the tweeting and big pronouncements, I do think a lot of that is posturing. He is a negotiator so it's to his advantage to start at the extreme and then work his way down.

At least that's my hope. That' what I hope he's doing. But we can't be sure.

We shall see.