Jeremy Grantham – 10 Timeless Investing Lessons

Johnny HopkinsJeremy Grantham Comments

One of the firms we watch closely here at The Acquirer’s Multiple is GMO and its co-founder, Jeremy Grantham. Grantham successfully predicted numerous financial asset bubbles. He warned against the dot-com bubble and vulnerability in the U.S. stock market leading up to the financial crisis. Over the years his shareholder letters have provided valuable insights for investors. One of my favorites is his 2012 letter in which he provides ten timeless investing lessons under the heading – Investment Advice from Your Uncle Polonius(#).

Here’s an excerpt from that letter:

For individual investors setting out on dangerous investment voyages.

1. Believe in history. In investing Santayana is right: history repeats and repeats, and forget it at your peril. All bubbles break, all investment frenzies pass away. You absolutely must ignore the vested interests of the industry and the inevitable cheerleaders who will assure you that this time it’s a new high plateau or a permanently higher level of productivity, even if that view comes from the Federal Reserve itself. No. Make that, especially if it comes from there. The market is gloriously inefficient and wanders far from fair price but eventually, after breaking your heart and your patience (and, for professionals, those of their clients too), it will go back to fair value. Your task is to survive until that happens. Here’s how.

2. “Neither a lender nor a borrower be.” If you borrow to invest, it will interfere with your survivability. Unleveraged portfolios cannot be stopped out, leveraged portfolios can. Leverage reduces the investor’s critical asset: patience. (To digress, excessive borrowing has turned out to be an even bigger curse than Polonius could have known. It encourages financial aggressiveness, recklessness, and greed. It increases your returns over and over until, suddenly, it ruins you. For individuals, it allows you to have today what you really can’t afford until tomorrow.

It has proven to be so seductive that individuals en masse have shown themselves incapable of resisting it, as if it were a drug. Governments also, from the Middle Ages onwards and especially now, it seems, have proven themselves equally incapable of resistance. Any sane society must recognize the lure of debt and pass laws accordingly. Interest payments must absolutely not be tax deductible or preferred in any way. Governments must apparently be treated like Polonius’s children and given limits. By law, cumulative government debt should be given a sensible limit of, say, 50% of GDP, with current transgressions given 10 or 20 years to be corrected.) But, back to investing …

3. Don’t put all of your treasure in one boat. This is about as obvious as any investment advice could be. It was learned by merchants literally thousands of years ago. Several different investments, the more the merrier, will give your portfolio resilience, the ability to withstand shocks. Clearly, the more investments you have and the more different they are, the more likely you are to survive those critical periods when your big bets move against you.

4. Be patient and focus on the long term. Wait for the good cards. If you’ve waited and waited some more until finally a very cheap market appears, this will be your margin of safety. Now all you have to do is withstand the pain as the very good investment becomes exceptional. Individual stocks usually recover, entire markets always do. If you’ve followed the previous rules, you will outlast the bad news.

5. Recognize your advantages over the professionals. By far the biggest problem for professionals in investing is dealing with career and business risk: protecting your own job as an agent. The second curse of professional investing is over-management caused by the need to be seen to be busy, to be earning your keep. The individual is far better-positioned to wait patiently for the right pitch while paying no regard to what others are doing, which is almost impossible for professionals.

6. Try to contain natural optimism. Optimism has probably been a positive survival characteristic. Our species is optimistic, and successful people are probably more optimistic than average. Some societies are also more optimistic than others: the U.S. and Australia are my two picks. I’m sure (but I’m glad I don’t have to prove it) that it has a lot to do with their economic success.

The U.S. in particular encourages risk-taking: failed entrepreneurs are valued, not shunned. While 800 internet start ups in the U.S. rather than Germany’s more modest 80 are likely to lose a lot more money, a few of those 800 turn out to be today’s Amazons and Facebooks. You don’t have to be better; the laws of averages will look after it for you.

But optimism comes with a downside, especially for investors: optimists don’t like to hear bad news. Tell a European you think there’s a housing bubble and you’ll have a reasonable discussion. Tell an Australian and you’ll have World War III. Been there, done that! And in a real stock bubble like that of 2000, bearish news in the U.S. will be greeted like news of the bubonic plague; bearish professionals will be fired just to avoid the dissonance of hearing the bear case, and this is an example where the better the case is made, the more unpleasantness it will elicit.

Here again it is easier for an individual to stay cool than it is for a professional who is surrounded by hot news all day long (and sometimes irate clients too). Not easy, but easier.

7. But on rare occasions, try hard to be brave. You can make bigger bets than professionals can when extreme opportunities present themselves because, for them, the biggest risk that comes from temporary setbacks – extreme loss of clients and business – does not exist for you. So, if the numbers tell you it’s a real outlier of a mispriced market, grit your teeth and go for it.

8. Resist the crowd: cherish numbers only. We can agree that in real life as opposed to theoretical life, this is the hardest advice to take: the enthusiasm of a crowd is hard to resist. Watching neighbors get rich at the end of a bubble while you sit it out patiently is pure torture.

The best way to resist is to do your own simple measurements of value, or find a reliable source (and check their calculations from time to time). Then hero-worship the numbers and try to ignore everything else. Ignore especially short-term news: the ebb and flow of economic and political news is irrelevant. Stock values are based on their entire future value of dividends and earnings going out many decades into the future. Shorter-term economic dips have no appreciable long-term effect on individual companies let alone the broad asset classes that you should concentrate on. Leave those complexities to the professionals, who will on average lose money trying to decipher them.

Remember too that for those great opportunities to avoid pain or make money – the only investment opportunities that really matter – the numbers are almost shockingly obvious: compared to a long-term average of 15 times earnings, the 1929 market peaked at 21 times, but the 2000 S&P 500 tech bubble peaked at 35 times! Conversely, the low in 1982 was under 8 times. This is not about complicated math!

9. In the end it’s quite simple. Really. Let me give you some encouraging data. GMO predicts asset class returns in a simple and apparently robust way: we assume profit margins and price earnings ratios will move back to longterm average in 7 years from whatever level they are today. We have done this since 1994 and have completed 40 quarterly forecasts. (We started with 10-year forecasts and moved to 7 years more recently.) Well, we have won all 40 in that every one of them has been usefully above random and some have been, well, surprisingly accurate.

These estimates are not about nuances or PhDs. They are about ignoring the crowd, working out simple ratios, and being patient. (But, if you are a professional, they would also be about colossal business risk.) For now, look at the latest of our 10-year forecasts that ended last December 31 (Exhibit 1). And take heart. These forecasts were done with a robust but simple methodology. The problem is that though they may be simple to produce, they are hard for professionals to implement. Some of you individual investors, however, may find it much easier.

10. “This above all: to thine own self be true.” Most of us tennis players have benefited from playing against nonrealists: those who play to some romanticized vision of that glorious September day 20 years earlier, when every backhand drive hit the corner and every drop shot worked, rather than to their currently sadly atrophied skills and diminished physical capabilities. And thank Heavens for them. But doing this in investing is brutally expensive.

To be at all effective investing as an individual, it is utterly imperative that you know your limitations as well as your strengths and weaknesses. If you can be patient and ignore the crowd, you will likely win. But to imagine you can, and to then adopt a flawed approach that allows you to be seduced or intimidated by the crowd into jumping in late or getting out early is to guarantee a pure disaster. You must know your pain and patience thresholds accurately and not play over your head.

If you cannot resist temptation, you absolutely MUST NOT manage your own money. There are no Investors Anonymous meetings to attend. There are, though, two perfectly reasonable alternatives: either hire a manager who has those skills – remembering that it’s even harder for professionals to stay aloof from the crowd – or pick a sensible, globally diversified index of stocks and bonds, put your money in, and try never to look at it again until you retire. Even then, look only to see how much money you can prudently take out.

On the other hand, if you have patience, a decent pain threshold, an ability to withstand herd mentality, perhaps one credit of college level math, and a reputation for common sense, then go for it. In my opinion, you hold enough cards and will beat most professionals (which is sadly, but realistically, a relatively modest hurdle) and may even do very well indeed.

Good luck. Uncle Polonius

(#) Polonius, a character in Hamlet, a verbose, self-important advisor to the King, was clearly intended to be a real loser, but curiously in the end Shakespeare couldn’t resist making most of his ponderous advice actually useful and memorable. His famous speech to his son Laertes who is embarking on a dangerous sea voyage to France (from Denmark) is reproduced as an Appendix. (Hamlet makes genocidal if rather unintentional war on the Polonius family, accounting for Laertes, his sister Ophelia, and poor Polonius himself: a clean sweep.)

You can read the full letter here.

Picking Growth Stocks Is Much More Difficult Than Picking Value Stocks – Bloomberg

Johnny HopkinsValue Investing News Comments

Here’s an interesting article by Nir Kaissar at Bloomberg that suggests picking growth stocks may be much more difficult than picking value stocks.

Here’s an excerpt from that article:

Picking stocks is famously difficult. But just how difficult is one of the oldest arguments in finance.

New York Times columnist Jeff Sommer reopened the debate last week with a piece describing a recent study by an Arizona State University business professor, Hendrik Bessembinder.

Bessembinder looked at the performance of publicly traded stocks in the U.S. from 1926 to 2016 and discovered that most of them failed to keep up with one-month Treasury bills. In fact, Bessembinder found that only 4 percent of stocks accounted for all the net wealth created by the market during the period, and 50 of those stocks accounted for 40 percent of that net wealth.

As my Bloomberg View colleague Barry Ritholtz rightly pointed out on Tuesday, those numbers suggest that “hunting for the market’s biggest winners” is even more difficult than investors probably realize.

But it’s not clear that investors must pluck the next Facebook or Amazon to succeed at picking stocks. Perhaps there are more promising places to hunt.

I was struck by the fact that Bessembinder’s fabulous 50 stocks resemble a portfolio of growth stocks. Four of the five so-called FANG stocks are among them — Facebook, Apple, Amazon and Google parent Alphabet.

Also, while seven of the 50 no longer trade, the other 43 fetch prices befitting the most sought-after companies. They have a weighted average price-to-book ratio of 6.5, a price-to-earnings ratio of 33 and a price-to-cash flow ratio of 16.2. That’s higher than or equal to the same measures for the S&P 500 Growth Index, which has a P/B ratio of 5.5, a P/E ratio of 24.6 and a P/CF ratio of 16.2.

Pay to Play

The 50 stocks that account for 40 percent of the net wealth created by the market since 1926 fetch a high price.

It’s odd, however, that those 50 stocks were responsible for so much of the market’s wealth creation given that growth stocks have historically been poor performers. Consider that the Fama/French US Value Research Index returned 12.9 percent annually from July 1926 through 2016, including dividends, while the Fama/French US Growth Research Index returned 9.4 percent.

Bessembinder’s study doesn’t distinguish between growth and value stocks, but one possible explanation is that, among growth stocks, the losers more than compensate for the wealth created by the winners.

There’s some evidence for that proposition. Consider small-cap stocks, for example — an obvious place to hunt because they represent a huge pool of potential future winners. Small caps have historically outpaced larger stocks. The Fama/French US Small Neutral Research Index returned 13.1 percent annually from July 1926 through 2016, while the Fama/French US Large Neutral Research Index returned 10.2 percent.

Tough Game

The modest historical returns for small-cap growth stocks suggest that it’s a dicey place to pluck winners.

But that premium for owning small caps was generated by value stocks, not growth. The Fama/French US Small Value Research Index returned 14.9 percent annually from July 1926 through 2016, while the Fama/French US Small Growth Research Index returned just 8.6 percent. The rolling 10-year returns for small-cap growth stocks were also persistently below those for value.

Playing Catch-Up

The returns from small-cap growth stocks have been persistently lower than those from value.

Those numbers suggest that there are more losers lurking among growth stocks than value. Or that the penalty for picking the wrong growth stocks is harsher than the penalty for picking the wrong value stocks.

Value investors Wes Gray and Jack Vogel have a similar hunch. They ran 1,000 simulations of randomly selected growth and value stock portfolios and measured their performance using data from 1963 to 2013. They found that the worst-performing value portfolio beat the best-performing growth portfolio. They also found that the distribution of outcomes among growth portfolios was wider than that of value portfolios. Here, too, their simulations imply that picking growth stocks is more difficult than picking value stocks.

That may explain why some of the most revered stock pickers have been value investors. Warren Buffett, John Templeton, Peter Lynch, Bill Miller, and of course the father of value investing, Ben Graham, have all professed to pay close attention to stocks’ prices, among other factors.Don’t get me wrong. I’m not suggesting that picking the winners is easy. But maybe some winners are easier to spot than others.

You can read the original article at Bloomberg here.

Charlies Munger – The Ultimate Investing Principles Checklist

Johnny HopkinsCharles Munger Comments

As an investor it’s important to remember that there is no secret formula or simple blueprint for success in the stock market. However, with hard work, patience and diligent analysis you can put the odds in your favor. One of the best starting points for a successful journey in investing can be found in the book, Poor Charlie’s Almanack. In which you will find An Investing Principles Checklist that encapsulates the successful approach used by one of the world’s greatest investors, Charles Munger.

Here is an excerpt from the book:

Since human beings began investing, they have been searching for a magic formula or easy recipe for instant wealth. As you can see, Charlie’s superior performance doesn’t come from a magic formula or some business-school-inspired system. It comes from what he calls his “constant search for better methods of thought.” a willingness to “prepay” through rigorous preparation, and from the extraordinary outcomes of the multidisciplinary research model. In the end, it comes down to Charlie’s most basic guiding principles, his fundamental philosophy of life. Preparation. Discipline. Patience. Decisiveness. Each attribute is in turn lost without the other, but together they form the dynamic critical mass for a cascading of positive effects for which Munger is famous (the “lollapalooza”).

An Investing Principles Checklist:

Risk – All investment evaluations should begin by measuring risk, especially reputational
 Incorporate an appropriate margin of safety
 Avoid dealing with people of questionable character
 Insist upon proper compensation for risk assumed
 Always beware of inflation and interest rate exposures
 Avoid big mistakes; shun permanent capital loss

Independence – “Only in fairy tales are emperors told they are naked”
 Objectivity and rationality require independence of thought
 Remember that just because other people agree or disagree with you doesn’t make you right or wrong – the only thing that matters is the correctness of your analysis and judgment
 Mimicking the herd invites regression to the mean (merely average performance)

Preparation – “The only way to win is to work, work, work, work, and hope to have a few insights”
 Develop into a lifelong self-learner through voracious reading; cultivate curiosity and strive to become a little wiser every day
 More important than the will to win is the will to prepare
 Develop fluency in mental models from the major academic disciplines
 If you want to get smart, the question you have to keep asking is “why, why, why?”

Intellectual humility – Acknowledging what you don’t know is the dawning of wisdom
 Stay within a well-defined circle of competence
 Identify and reconcile disconfirming evidence
 Resist the craving for false precision, false certainties, etc.
 Above all, never fool yourself, and remember that you are the easiest person to fool

Analytic rigor – Use of the scientific method and effective checklists minimizes errors and omissions
 Determine value apart from price; progress apart from activity; wealth apart from size
 It is better to remember the obvious than to grasp the esoteric
 Be a business analyst, not a market, macroeconomic, or security analyst
 Consider totality of risk and effect; look always at potential second order and higher level impacts
 Think forwards and backwards – Invert, always invert

Allocation – Proper allocation of capital is an investor’s number one job
 Remember that highest and best use is always measured by the next best use (opportunity cost)
 Good ideas are rare – when the odds are greatly in your favor, bet (allocate) heavily
 Don’t “fall in love” with an investment – be situation-dependent and opportunity-driven

Patience – Resist the natural human bias to act
 “Compound interest is the eighth wonder of the world” (Einstein); never interrupt it unnecessarily
 Avoid unnecessary transactional taxes and frictional costs; never take action for its own sake
 Be alert for the arrival of luck
 Enjoy the process along with the proceeds, because the process is where you live

Decisiveness – When proper circumstances present themselves, act with decisiveness and conviction
 Be fearful when others are greedy, and greedy when others are fearful
 Opportunity doesn’t come often, so seize it when it comes
 Opportunity meeting the prepared mind; that’s the game

Change – Live with change and accept unremovable complexity
 Recognize and adapt to the true nature of the world around you; don’t expect it to adapt to you
 Continually challenge and willingly amend your “best-loved ideas”
 Recognize reality even when you don’t like it – especially when you don’t like it

Focus – Keep things simple and remember what you set out to do
 Remember that reputation and integrity are your most valuable assets – and can be lost in a heartbeat
 Guard against the effects of hubris and boredom
 Don’t overlook the obvious by drowning in minutiae
 Be careful to exclude unneeded information or slop: “A small leak can sink a great ship”
 Face your big troubles; don’t sweep them under the rug

Interview With Tobias Carlisle – Outlook Business

Johnny HopkinsTobias Carlisle Comments

Great interview with our Founder Tobias Carlisle at Outlook Business.

Here’s an excerpt from that interview:

There are very few lawyers who end up as full-time investors. Maybe because they have figured out that the grass is indeed greener on their side. Investing is not a sure thing but litigation or liquidation sure is. Tobias Carlisle then is an exception of sorts. He not only moved from Australia where he was a mergers and acquisitions lawyer to the United States, he also has authored multiple books on investing, the most prominent being Deep Value.

The strategies underlined in his books also drive his investments at Carbon Beach Asset Management. Besides his books, Carlisle’s work has a wide following through his websites The Acquirer’s Multiple and Greenbackd. Like many others, Carlisle too caught the investing bug after reading Warren Buffett’s Berkshire Hathaway shareholder letters.

Carlisle believes those letters are the best business education anybody can get from the greatest investing mind of several generations. As we interview him on a pleasant Tuesday morning at the Playa Vista neighbourhood of Los Angeles, Carlisle like many deep value investors can’t help but smile over the fact that for him the turning point in the market was supposed to be five years ago.

First off, what is magical about the magic formula…

It definitely beats the market, so that is magical, and its simplicity that leads to market-beating returns is extraordinary. Joel Greenblatt had this idea that Warren Buffett’s investment strategy could be reduced to simple ideas. One of them is value and he uses Ebit on enterprise value to determine that, and the other is profitability or quality and he uses return on invested capital to calculate that. This essentially measures how much money a company makes for each dollar invested in it. He ranks all the companies on valuation and then again on the profitability and quality.

The cheapest of the combined ranking leads to market-beating returns. That is an amazing proposition because Buffett is the greatest business analyst alive and probably the greatest of several generations. That the quantitative part of what he does can be reduced to such a simple strategy is magical, I think.

And what’s the reality? You have come up with a superior version of the magic formula in some sense, and you say that if only you focused only on cheapness, it is good enough for you to beat the market.

I saw those returns and I looked at the companies that it chose, and I thought that a lot of those companies tended to be companies at the top of their business cycle. So, if you’re looking at something at the pinnacle of the business cycle, it might tend to look profitable, but that is sort of a historical measure. All the energy companies looked very profitable just before they went through the 2008 recession, but their earnings weren’t representative of their typical earning power.

I had this idea that if we got rid of that — it might be introducing some sort of error, but if we got rid of that error — then we could generate better results. When you test the proposition, what you find is that just looking at value alone leads to better returns. The question often asked is: what does quality or the return on invested capital bring to the party? I think what it does is at periods of the very top of the business cycle, when there is a sort of mania for stocks, the very profitable companies do tend to keep up with the market. It does help you for short periods of time at the tail-end of manias to do better. But it does not work well over the full period, over a full-period business cycle from peak to trough to peak.

But even when you look at cheapness alone during periods of exaggerated earnings, the stocks will look cheap if you ignored the name and if you ignored the fact that it is a commodities company. Then, on the measures such as earnings yield, it will look extraordinarily cheap, won’t it?

The difference is that you are not purposefully selecting for these very high profitability companies, so it just removes that error. So now you have a basket of companies, some of which are very profitable and others are not so profitable, and that just tends to balance up the portfolio. What happens is that some of those profitable companies recover quite quickly. The phenomenon that I look for is depressed earnings and depressed valuation, then you look for that return to normalised earnings and the closing of the discount. The two things together give you market-beating returns.

Does this have limited application outside the US? If you look at Brazil or Russia, commodity businesses will be the bulk. This means that the counterforce may just be 20-30% of the market. In this case, will your version of the magic formula really work?

It is something that I was concerned about too. But there has been some research done in the last two or three years. It seems to be a phenomenon that persists in every single market and I think the reasons are pretty simple to understand. Often these companies are depressed because there is some short-term issue with them and all you’re doing is buying them at the time when people are worried about the business. As that shock moves away, the business seems to improve, or the underlying commodity starts doing a little bit better. Basic materials, energy, iron ore are depressed at the moment. I think it’s a pretty good time to buy those sort of companies but that remains to be seen.

The relationship between stock market return to GDP growth is either non-existent, or slightly negative because very high growth countries have their stocks bid up very expensively.

Does the Acquirer’s Multiple work for the same reason?

It relies primarily on mean reversion. You buy a company at its scariest, at its worst point in the business cycle. Every time you look at these companies, you know exactly why they are so cheap. I could give you all the reasons why these particular companies are going out of business, and in many cases the reasons will be right. But in enough cases in a portfolio, the market has simply overreacted. Given two or three years to these companies to recover, they just get back. But because you’re starting from such a depressed valuation, you make good returns. That is the nature of deep value.

There was a period during Graham’s time or during the Great Depression, when the statistical approach really worked. Then there is a period defined by the rise of Buffett that also coincides with the period when America went through a big boom, quality companies came up, brands thrived. Now, are these winning strategies really defined by the economy at a particular point in time? For example, if you applied Graham’s approach during the 80s and 90s, would it have yielded similar results?

The problem with cigar-butts is that they are always going to be small companies. It’s the nature of the way it is calculated. There has to be a very significant portion of liquid assets on the balance sheet — cash, inventory or receivables. They have to have fewer liabilities than those liquid assets. That’s cutting out a lot. Big companies don’t qualify often on that measure. Furthermore, of the residue, you’re only supposed to buy two-thirds of that number.

Thus, by definition they must be very small companies. That is not future proof, and as the search methods get better, those sort of opportunities have disappeared, unequivocally so.

The Acquirer’s Multiple doesn’t have that problem because it scales, and we can apply it in different ways. We can apply it on an absolute basis, so we’re not going to pay more than a certain multiple. Or we can just find the cheapest 10% stocks in the market whose valuation make it valuable overtime. But we’re always looking at the cheapest portion of stocks in the market by that metric. So, it should continue to work, although it goes through periods when it doesn’t work as well. The last seven years have been one of those periods in the States. It’s a momentum market at the moment and those periods come around every ten years or so.

But is there any logical reason why this has happened in the last seven years? It’s a fairly large time period to justify a stock not reflecting its true value.

I think these are new paradigm periods where some new technology comes to the fore and that seems to spur investments. In the boom times it tends to be the more glamorous companies that do better. Tesla is a good example of that at the moment. Even Amazon. Although it is a fantastic business, you pay a lot for it. So people wouldn’t have capital for smaller, undervalued, boring businesses. These boring and undervalued businesses seem to be the ones that will lose to whatever is the flavour of the moment. It’s really only dedicated deep value investors who are looking at those kinds of businesses. Long periods of underperformance come around about once a generation for businesses like these. We had one in the late 1990s — this is the worst one since the late 1990s, there will be more in the future. There is probably a reasonably good period for value coming up though.

While there is proof that the magic formula and several other quantitative parameters work, isn’t it natural that if something becomes popular, its efficacy should diminish over a period of time?

The reason that value in general and as the subset of the magic formula in the Acquirer’s Multiple will continue to work is because they go through periods of extensive underperformance, and people have a very low threshold for pain when it comes from underperforming. If you are underperforming, and the market does well, you tend to shift into what the market is doing. It is the constant renewal of people coming in and going out that creates the big discount for deep value. When that big discount exists, it does tend to start working again. They call it a pain trait — the more pain a strategy extracts from you, the less likely you are to stick with it and the more likely it is to outperform.

But it has led to some real pain for value investors. A lot of deep value investors have seen fund flows and redemptions. So how do you see this playing out?

This happened during the dotcom boom when lots of value investors who had very good long-term reputation, including Buffett, were damned. Like I said, underperformance causes people to leave and join the momentum group, and eventually, that will turn around. I thought it would turn around a little bit sooner, but it hasn’t and I don’t see any signs of it turning around anytime soon. But they say it’s darkest before dawn. Often that’s an indication that there is some sort of change coming. Probably, it would require a crash because in a crash, momentum will be hit the most. That’s because if you are a new investor, you see something that has gone up a lot, and you think that’s what will continue to do well. And when things crash, they’re very quick to leave, they go the other way.

On the contrary, people who are buying undervalued stocks are buying on yield basis, buying the assets and the earnings. If you’re buying them cheaply, then you’re probably prepared to hold them until they reach their fair value at least. I think there’s some sort of turn coming along but if you ask me when it would have happened, I would have said, five years ago.

Michael van Biema says that value investors at times don’t seem to realise that if the value realisation or unlocking doesn’t happen, the business itself is undergoing a degeneration. Since you’re a quantitative investor, do you take that into account?

I have quantitative accounts, and we have a special situations fund as well, which is a totally different approach. Special situations are more Graham-like in the sense that you have to find things that are mispriced in the market. There are lots of different strategies covering a broad range of things that we think about. The biggest one we have at the moment is long Yahoo and short Alibaba, because Yahoo owns a chunk of Alibaba. If you take out Alibaba from the valuation of Yahoo, there is no value to describe the rest of Yahoo. It definitely has some value — $16 billion in cash, some real estate, Yahoo business has Yahoo Japan and those businesses are worth something. For a $50 Yahoo stock, you get another $10-20 in value.

We definitely think about the qualitative aspects in those sorts of transactions. Alibaba is very expensive. I think their accounting is opaque. Yahoo is much more transparent, and much cheaper. And if the market goes down, I want to be short Alibaba and long Yahoo. We look at other things too. In the quantitative side, we want to make sure the cash flows are in sync with the accounting earnings and that we are not buying at the top of the cycle. We’re trying to find things where valuation matches the true earning power of the company, which is more of a qualitative kind of estimation.

Is there any optimal portfolio size? When you use quantitative measures, the list of underperforming companies may be pretty huge…

There are different ways of constructing. It’s one of those funny occasions where the academic view based on the efficient market theory, and the value investing view tends to fall around the same number, which is 30. At 30, adding additional stocks doesn’t add much diversification. You can go down to as few as 20. Between 20-30 it moves between 90% of the benefits to 95% and then to capture the last 5%, you need to go to 100. But when people are constructing portfolios they’re trying to achieve different things. If they are trying to maximise the amount of money they can get into it, then more stocks is better. If you’re trying to maximise the performance, then fewer stocks is better. Thirty seems to give the best balance of quantity and performance. If there is fewer than that, it gets very volatile. More than that, your performance is going to get closer to the underlying index.

Does the expectation of secular growth pose a threat to mean reversion across stocks?

There are a few interesting bits of research that I have seen, one of them is the relationship between stock market return to GDP growth, which is what you expect if the country as a whole is growing very quickly — you would expect that the stock market is growing very quickly too. It turns out that that’s not actually the case. The relationship between stock market return to GDP growth is either non-existent, or slightly negative. The reason seems to be very high growth countries have their stocks bid up very expensively, because there is a lot of optimism about future performance. They get too expensive, and then it’s like a high growth stock that is too expensive.

So returns are front-ended?

Right. And the opposite is also true of all the slow growing countries. If you see data from 1980s to 2010, China hasn’t had a great stock market performance and China is one of the fastest growing countries in the world. Britain hasn’t had rapid growth in GDP, but it has had a very good stock market performance in that period. So GDP growth and stock market performance aren’t closely correlated. I think it is always valuation that drives return.

It doesn’t matter whether the margins are growing or if they are very high. If growing margins is what identifies a future star, then very high margins identifies something that is more stable and sustained

Have you looked at the effectiveness of various financial parameters in driving performance?

Valuation ratios have done well individually, but financial ratios work best in combination because each one looks at a different aspect of the business of the company. There are plenty of quantitative investors who use stock price momentum, which also work very well. It seems to be predictive. Companies with the higher stock price performance are not the most expensive ones that you might expect; they tend to be from the bottom to the middle who have done very well over the year or so, because they have just recovered. If you buy them, you do see another year or so of outperformance. It just means that the market is identifying something in those businesses that’s not obvious yet in the financial statements. It’s an interesting metric, but it’s not one that we use because we think of ourselves as value investors. I can understand value and see how it moves, but I don’t fully understand momentum.

Are there any parameters that are particularly effective in judging quality or franchise power?

I look at the size of the gross margin and how much money the company makes on each product that it sells. There are two ways to examine that. One of them is to see if they have a very high margin, and the other is to see if they have a growing margin. Either of those is the true test of whether you can sell your product for much more than what it costs to make. If you can, that is the sort of thing that encourages competitors to enter, to make it cheaper or sell for more. If you can sustain that, then that is the best measure of the quality and potential profitability of a company. The sort of companies that identify with these are exactly what you would expect: Procter and Gamble, Google and so on. The companies that get eliminated are commodity-based businesses because they have no pricing power, they can’t sustain their margins, neither can they grow their margins overtime. It doesn’t really matter whether the margins are growing or whether they are very high. I think if growing margins is what identifies a future star, then very high margins is identifying something that is more stable and sustained.

How do you view net-nets as a strategy especially in the context of India, where the regulatory ambience is not very conducive for companies to liquidate? Companies just lie low; they don’t go into liquidation, like in the US.

Net-nets are a terrible reflection on the company. But you are not buying the business, you are buying the asset, the balance-sheet value, you’re hoping for some improvement in the fortunes of the business. You use it as a proxy for value. The returns to net-nets in the US haven’t traditionally been through liquidations, they have been through mean reversion. They just get too cheap. It doesn’t take much for them to get over that barrier but they’re always terrible businesses. They just don’t get that cheap if they’re not. Net-nets are not typically buy and hold sort of investments. This is why I like the Acquirer’s Multiple a little bit better, because you can find companies that have fundamental ideas with a sort of valuation to match. Given five or six years, you can see some very good returns. You have to remember that nets-nets aren’t very great businesses, when they start looking good, they need to be sold.

Is there a framework to look at value embedded in highly leveraged companies? What could be the trigger points to buy them?

The price-to-book identifies those businesses. When people buy cheap on price-to-book basis, they think they are getting lots of machinery very cheap. But what they’re getting is a very, very leveraged balance sheet, with not very much equity capital, and they are buying a tiny little sliver of that. The way that you would look at whether it could survive or not is to make sure that it has interest coverage ratios, and hope that there is some fundamental improvement in the business.

The problem with highly leveraged companies is that sometimes, their value is not in the equity but in the debt. If the debt is traded and if you have that mechanism for getting control of the debt, then the value might be realised if you go into liquidation — and for some sort of restructuring. It is difficult to predict where the value will end up flowing. So if you are a shareholder, you could end up valueless, even if the infrastructure project itself is very valuable, the cash flow might falter and you won’t end up with anything.

It’s not something that I do because you can do without unnecessary financial risk. You don’t need to take that risk as an investor when you can find companies that are cash rich and are still generating strong operating earnings relative to what you are paying, even though those operating earnings might not be enough to make them a high return on investment capital business. But then you are almost by definition getting cheap assets, cheap cash flow, cheap operating earnings. If they survive, they tend to start doing a little bit better. I think you can get better safer returns doing that, than by buying high leverage companies.

You can read the original interview at Outlook Business here.

This Week’s Best Investing Reads

Johnny HopkinsValue Investing News Comments

Here’s are some of this week’s best investing reads:

New Highs Should Be Bought, Not Sold (The Irrelevant Investor)

Why Won’t You People Panic Already? (The Reformed Broker)

Income Alpha (A Wealth of Common Sense)

Cryptocurrencies & Blockchain – Longs, Shorts, or Trading Sardines… (Wexboy)

U.S. investors see a correction coming — and are ready to buy the dip (Globe & Mail)

Some Market Myths Hurt Investors (Bloomberg)

Where In The World Do You Find Compounding Growth At Value Prices? (WealthTrack)

Why is Value Investing So Difficult? (Behavioural Investment)

Skills vs. Behavior (Collaborative Fund)

The Guru Myth: Dan Solin’s Investing Secrets (Advisor Perspectives)

Ask Ariely: On Denying Donuts, Car Conversations, and Curbing Confidence (Dan Ariely)

Myths, Markets and Easy Money (Dataroma)

Whitney Tilson is shutting down his hedge fund (CNBC)

The Difference Between Open-Minded and Close-Minded People (Farnam Street)

Factor Timing Investigation: Interest Rates, Value Spreads, and Factor Premiums (Alpha Architect)

James Montier – Here’s How Soros Successfully Safeguards Against Making Recurring Mistakes

Johnny HopkinsJames Montier Comments

As investors we all pat ourselves on the back, telling ourselves how smart we are when a stock that we picked outperforms. At the same time we can find dozens of reasons, excluding our own poor judgement, when another stock pick gets hammered.

The reason in behavioral investing terms is called self-attribution bias. Self-attribution bias is our habit of attributing good outcomes to our skill as investors, while blaming bad outcomes on something or somebody else. We know that mistakes are inevitable in investing so the question is, how can we safeguard ourselves against making repeated mistakes.

One answer can be found in the book, The Little Book of Behavioral Investing, by James Montier. Montier demonstrates a simple method used by investors like George Soros to successfully safeguard against making recurring mistakes.

Here’s an except from the book:

Sports events are a great example of this kind of thinking. For instance, psychologists looked at the explanations offered in the sports pages to study the presence of attribution bias among athletes. In evaluating an athlete/ coach’s opinion of his performance, they ask themselves if the performance was due to an internal factor (i.e., something relative to the team’s abilities) or an external factor (such as a bad referee).

Unsurprisingly, self-attribution was present. Seventy-five percent of the time following a win, an internal attribution was made (the result of skill), whereas only 55 percent of the time following a loss was an internal attribution made.

The bias was even more evident when the explanations were further categorized as coming from either a player/ coach or a sportswriter. Players and coaches attributed their success to an internal factor more than 80 percent of the time. However, internal factors were blamed only 53 percent of the time following losses.

The same thing happens when it comes to investing. It is all too easy for investors to dismiss poor results as examples of bad luck. On some occasions this may well be the case, but on others bad analysis may be the root cause.

In a recent speech, David Einhorn of Greenlight Capital pointed out, “When something goes wrong, I like to think about the bad decisions and learn from them so that hopefully I don’t repeat the same mistake.” He goes on to provide an example of a mistake he once made. In 2005 he recommended buying MDC holdings, a homebuilder, at $67 per share. In the following four years, MDC dropped about 40 percent. As Einhorn stated, “The loss was not bad luck; it was bad analysis. ” Simply put, he failed to understand the importance of the big picture, in this case the U.S. housing and credit bubble.

Sadly, few of us are as introspective as Einhorn. So to combat the pervasive problem of self-attribution we really need to keep a written record of the decisions we take and the reasons behind those decisions—an investment diary, if you will. Keeping an investment diary may sound daft, but George Soros did exactly that. In his Alchemy of Finance he writes “I kept a diary in which I recorded the thoughts that went into my investment decisions on a real-time basis. . . . The experiment was a roaring success in financial terms—my fund never did better. It also produced a surprising result: I came out of the experiment with quite different expectations about the future.”

Having kept such a diary, we then need to map the outcomes of the decisions and the reasons behind those decisions into a quadrant diagram, like the one shown below. That is, was I right for the right reason? (I can claim some skill, it could still be luck, but at least I can claim skill), or was I right for some spurious reason? (In which case I will keep the result because it makes the portfolio look good, but I shouldn’t fool myself into thinking that I really knew what I was doing.) Was I wrong for the wrong reason? (I made a mistake and I need to learn from it), or was I wrong for the right reason? (After all, bad luck does occur and price volatility dwarfs fundamental volatility in our world.)

Only by cross-referencing our decisions and the reasons for those decisions with the outcomes, can we hope to understand when we are lucky and when we have used genuine skill, and more importantly, where we are making persistent recurrent mistakes.

Mohnish Pabrai – The Secret To Finding Your Next 100-Bagger

Johnny HopkinsMohnish Pabrai Comments

100-Baggers are the holy grail of investing. These are stocks that return $100 for every $1 invested and they’re extremely rare. However, the secret to capturing your next 100-Bagger can be found in a presentation that Mohnish Pabrai did with the folks at Google earlier this year. The answer came when Pabrai was asked a unrelated question regarding whether he shorts stocks.

Here’s an except from that presentation:

I have never shorted a stock in my life. I will go to my grave without ever having shorted a stock. I would suggest you follow that same mental model. If the only thing you learn over here is to give up shorting, if you are a shorter, then I think that would be an hour well spent.

So it’s a great question, So each of us I think has a limited quota of 100-Baggers that will show up in a portfolio. I think I have had more than my quota of 100-Baggers that I was smart enough to buy but too dumb to hold. And there’s a long list. I used to own [Inaudible] Bank in ’94. I don’t know, it was 150 times. I probably got like 30% return after 5 years. Sold it. Blue Dart. There’s two 100-Baggers I did capture.

I owned Amazon in 2002 I think at $10 a share. I think it was 10 percent of our portfolio then and I got 40% in a few months and I was out. So what I have learned is that don’t sell the compounders when they get fully priced and don’t sell the compounders when they get overpriced. Only sell the compounders when it’s absolutely obvious to you that it’s egregiously priced.

The big money is in riding the compounders but you have to try to get in on them at a reasonable valuation and you have to be right on the fact that they are compounders. It’s a forgiving business, you can be wrong quite a few times and still be ok. I was able to at a point in time get to where Google was just at the edge of making it so we’ve made it, which is great, and that’s the key. You want to ride the compounders for long periods.

Is Value Investing Dead? It Depends on How You Measure It – WSJ

Johnny HopkinsValue Investing News, Wes Gray Comments

Here’s a great article by Wes Gray at the Wall Street Journal which demonstrates that value investing is not dead. It just depends on which metrics you use to measure its performance. Wes Gray is the CEO and CIO of Alpha Architect, a quantitative asset manager based near Philadelphia.

Here’s an excerpt from that article:

Is value investing dead? It’s a question that has been on the minds of financial pros and investors alike.

On the surface, one measure used to gauge the success of value stocks puts the efficacy of value investing into question. But there is much more to it than just those numbers.

I’ll explain by starting with this example. Over the last 10 years (June 1, 2007 to June 30, 2017) a generic portfolio of the cheapest stocks (labeled “Generic Value (P/B)” in the chart below) based on price-to-book ratios earned a compound annual total return of 2.44%, compared with the S&P 500’s total return of 7.10%. And to make matters worse, the generic value portfolio achieved the returns with nearly twice the volatility (29% vs. 15% annualized).

Clearly, value investing, as proxied by a portfolio that buys cheap stocks based on price-to-book ratios, ate crow over the past 10 years. Why?

For one thing, it is because nearly 40% of this price-to-book generic value portfolio was concentrated on financial stocks going into the financial crisis. We all know how that ended for the value portfolio.

But price-to-book is only one measure of value. Would other measures tell a different story about the performance of value investing?

I looked at the performance of a generic value strategy that buys stocks based on price-to-earnings ratios (as opposed to price-to-book) over the past 10 years. P/E ratios have been shown to be more effective than P/B ratios. Surprisingly, this portfolio actually beat the S&P 500 total return index–earning a compound annual return of 8.24% vs. the S&P’s 7.10% performance.

To be sure, value investing based on alternative metrics hasn’t exactly knocked the cover off the ball, but it has certainly kept pace with the general market, albeit via a bumpier road (volatility on the P/E value portfolio was higher than the S&P 500).

The academic literature is still battling it out over whether the extra returns associated with value investing are attributable to higher risk or mispricing. The reality is that the answer to the question of why value stocks earn higher expected returns is probably “both.” Value stocks earn higher expected returns because they are riskier: These companies often operate in highly competitive industries or industries that are engaged in disruption (e.g., retailers facing Amazon). So value companies are intrinsically more risky.

However, even bad businesses bought at great prices can make a great investment. This line of reasoning leads to the mispricing argument for the premiums associated with value investing–investors throw the baby out with the bath water.

The debate as to why value investing generates higher expected returns than other forms of investing will rage on, but one thing is clear: Value investing is extremely painful and difficult to hold through thick and thin.

To illustrate this fact, I charted the five-year rolling spreads between two generic value strategies (price-to-book and price-to-earnings) against the S&P 500 Total Return Index. A positive reading means value outperformed over the five-year trailing period; a negative reading implies the opposite. (The results run from June 30, 1952 to June 30, 2017.)

The chart highlights multiple five-year periods where a value investor can expect to be underwater relative to the S&P 500. Talk about pain. Imagine underperforming the market over a five-year cycle, and possibly enduring this pain on multiple occasions over a lifetime of investing. On the flip side, over this time period generic value with P/B ratios earned 14.05%, generic value with P/E ratios earned 15.94%, and the S&P 500 earned 10.85%.

So patience is certainly awarded. But it does imply that an investor needs to endure the pain to get the gain.

You can read the original article at The Wall Street Journal here.

Prem Watsa – Here’s Why Value Investors Take A Long-Term View

Johnny HopkinsPrem Watsa Comments

One of my favorite Prem Watsa presentations was one he did for the Ivey School of Business in 2011. The key takeaway that I took from this interview was Watsa’s view on the importance of taking a long term view in investing. Watsa says, “Who knows what will happen in three months or six months or a year.” He adds, “Our company is not run on a one-year basis or two year basis.”

During the presentation Watsa was asked how he deals with criticism from shareholders when purchases are taking longer than expected to work out. Watsa provides the following illustration on exactly what it means to be a successful value investor and sticking to your long term view. Here’s an edited transcript from that presentation:

75:23. My question is, I was reading that in 2001 Fairfax received a lot of criticism for specific takeovers and I was wondering during those times how do you deal with that criticism and does it ever affect your decision-making going forward.

That’s a very good question. In 1998-99 we bought two big companies in the United States and and it took forever to turn them around. They were turnarounds. Took forever to turn them around. So we thought we’d turn them around in two or three years. We have a combined ratio that we have. It’s a metric that you look. Took us more like five and six years.

So Crum & Forster was a company we bought in ’98 and I remember our shareholders. Quite a few in the United States. One lady said to me, you made a mistake. Why don’t you just admit you made a mistake. You buy a lot of good companies she said but this one was a mistake. And I said you may be right but it’s like a baseball game. There’s nine innings. After the third innings you haven’t lost a game or the fourth innings.

So here’s what happened in that company. Today Crum & Forster, we paid $680 million for that and it’s an example of focusing on the long-term. We paid $680 million in 1998. By the end of 2010 we had dividends of $1.5 billion and the company still has $1.2 billion dollars of statutory capital. So $680 million, $1.2 billion, after we’ve taken out $1.5 billion. So it took us a long time. It took us forever to turn it around but we just focused on it. Worked hard. People who turned it around were outstanding. We had some really good people who worked in that company and so we just took a longer time. So our view has always been in our company. We don’t give any guidance, no guidance.

Business is a long term deal. Who knows what will happen in three months or six months or a year. So we say if you’re a shareholder of ours you’re thinking long term. Because we really don’t know how to do well in three months or six months. Our company is not run on a one-year basis or two year basis. So we take it over a long time, over the long term.

We started with a book value per share of $1.50 US or $2 Canadian and our book value today it’s about, at the end of September, $400. So that’s a compound growth rate of 25%. But there were many time periods during that time period where the compound rate would have been 3 or 4 percent. But long term you put it all together and it’s a pretty good rate.

Here is the presentation starting at the transcribed section above:


Successful Investing Is Achieved By Studying Other Successful Investors Who Do Things Very Differently To You – Bill Nygren

Johnny HopkinsBill Nygren Comments

One of the value investing firms that we follow closely here at The Acquirer’s Multiple is Oakmark Funds and portfolio manager, Bill Nygren. Nygren is a value investor who focuses on companies trading at what he considers to be a substantial discount to their true business value. He has been a manager of the Oakmark Select Fund since 1996, Oakmark Fund since 2000, and the Oakmark Global Select Fund since 2006.

In a recent interview with Outlook Business Nygren explains why successful value investing is about doing something differently to most investors, and studying other successful investors, who do things very differently from you. Here’s an excerpt from that interview:

You describe your approach as that of a private equity (PE) firm in public market investing. Can you elaborate on that?

What you see today in most public market investors is a momentum focus on stock price and earnings. Most investors are trying to outguess each other about what a company is going to earn in the next quarter, or for those who call themselves long term, in the next year. What we do is quite different; we look at a company and try to project what it will look like five to seven years from now. We also think about how the balance sheet is likely to change, and how each division of the company might be different from what it is doing today.

Some of those divisions might need money, some might be revitalised in ways that can get them a reasonable return or, in case that doesn’t happen, get them sold. We try to estimate how public investors might look at this company differently five to seven years in the future. When you think about it, this is not very different from what a PE investor does: trying to find a company that in the market today is worth significantly more than what investors are paying for it.

Certainly, there are important differences here. We don’t want to invest in a company unless we think the right management is in place to maximise that value seven years from now. A PE firm will often begin by removing the existing management and putting its own people. We don’t do that. Liquidity is obviously very different, you make a private equity investment and you can make a guess as to how the value has changed. But there is no liquidity unless the company is sold or it goes public. You rely on the estimates of the value. Compare that to our fund, where everyday you can see the price of that is based on what each of the securities are trading at in the marketplace.

The fees, too, are different. A typical PE firm is charging 2% of assets and 20% of profits, whereas our fees are just below average. For the mutual fund industry, it is less than 1% of assets or a fraction of 1% and 0% of profits. We provide liquidity, better disclosure of holdings and lower fees, but the thought process is similar to that of a PE firm.

Tell us your experience as an investor — the biggest mistakes and lessons you’ve learnt.

When people talk about their biggest mistakes, what always comes to mind is the investment that you made where you were too optimistic and the stock price went down significantly. Were you to ask me our bigger mistakes, they would be not getting over the hump to make the investment in companies that went up by multiples of the price when there was an opportunity to invest in them. For us, that is Google when it became public, or Apple when we bought it in Oakmark Fund but weren’t quite confident to buy it in Oakmark Select, and then you watch it go up seven-fold or more than that right now.

Those are the big mistakes — the things that you should have invested in that went up by multiples and met your criteria, but you paused and decided against making that investment.

How has your evolution been as a value investor? What does and doesn’t work according to you?

As a value investor, you always have to be doing something that most investors aren’t doing. When I started in the business, even a simple screen of ranking an industry on P/E basis on forward earnings produced interesting results.

A lot of people weren’t doing this. You could see that some of those companies were 15x earnings, while some were at 8x earnings. In some cases, the few that were at 8x didn’t look very different from the ones at 15x. During my early years, very simple quantitative screens created value and produced interesting output. Today that screening is so easy to do that everybody is doing it, which is why the outcomes aren’t very interesting. You have ETFs where the computers are programmed to just buy the lowest P/E companies.

The definition of value always has had to be somewhat fluid to be more advanced than what other people are doing. For us today, it’s less about saying this company is at 10x earnings in an industry that is at 15x, more about saying this company does not look cheap on a P/E basis but if you think about the following adjustments, it would be cheap.

Who are your role models in investing? You’ve previously talked about Michael Steinhardt as your role model, but isn’t he at the other end of the spectrum?

That is right. But I’ve always found it interesting that most value investors like to read only about other value investors. If you ask any value investor about their investment hero, Warren Buffett will be on the top of their list. He is on top of our list too, but once you’ve read seven books on Buffett, is the eight one going to add more value?

Would not reading about somebody else, who did things very differently from you but who also succeeded tremendously, be more valuable? I find that I learnt a lot by reading about some of the hedge fund managers such as Michael Steinhardt, Paul Tudor Jones and George Soros, all of whose approach was very different from what ours is. Perhaps you may find one thing from their approach that is consistent with your own philosophy.

One of the things that Michael Steinhardt famously relied on was variant perception. On every company he had a position in, he knew what the bulls and bears thought, and why his point of view was different. Sometimes, as value investors, we don’t spend enough time doing that. We assume that if a company has a low P/E, or a low price to book, that’s enough to conclude it’s cheap. But we’ve learnt by studying Steinhardt that we can add value in our process even in a stock that looks statistically cheap by stating our different and distinct point of view. Anybody at Oakmark will be able to tell you what our variant perception is of a stock that we own.

There is a famous picture of Paul Tudor Jones with a piece of paper on his bulletin board that says ‘Losers average losers’. As value investors, we always want to believe that the stock is overreacting to bad news. A typical analyst report goes: This is a disappointing quarter but my value estimate fell only 5% while the stock fell 15%, so it’s a lot cheaper than what it was yesterday. This led us to do a lot of research into our own ideas. When the fundamentals start deviating from what our analysts had projected, averaging down on those names tend to not work. It made us alter how we thought a little bit more, which for us is certainly more valuable than learning what Warren Buffett eats for breakfast.

What Warren does — buying great businesses that are run by good people, buying and holding, thinking about long term — is still the core of our investment approach. Nothing pleases me more than when somebody says that what we do at Oakmark is very similar to Buffett. At the same time, that doesn’t mean we can’t learn from people who do things very differently from what we do.

You can read the full interview here.

Here’s How Successful Investors Dampen Down Their Investing ‘Cocaine Brain’ – Pabrai, Spier

Johnny HopkinsGuy Spier, Mohnish Pabrai Comments

As investors we all know the excitement we feel when we come across what we think is an undervalued opportunity that seems to have been overlooked by most other investors. The feeling of exhilaration that we get is called “cocaine brain.” Neuroscientists have found that the prospect of making money stimulates the same primitive reward circuits in the brain that cocaine does.

The only problem with ‘cocaine brain’ is that it often leads investors to overlook the negative aspects of the opportunity as they’re overcome with the prospect of making thousands of dollars.

Fortunately, there is a solution used by Mohnish Pabrai and Guy Spier to dampen down your ‘cocaine brain’ and it can be found in the book The Checklist Manifesto: How to Get Things Right by Atul Gawande. This same book is referred to by Michael Mauboussin as ‘superb’ in his paper called – Managing the Man Overboard Moment – Making an Informed Decision After a Large Price Drop. His paper provided answers on how to keep your emotions in check in the face of adversity, which includes making informed decisions after a large price drop in one of the stocks your holding.

The Checklist Manifesto includes a discussion with Pabrai and Spier on their process for dealing with these exciting investment decisions using a systematic approach that helps to curb their emotions. Here’s an excerpt from that book:

Recently, I spoke to Mohnish Pabrai, managing partner in Pabrai Investment Funds in Irvine, California. He is one of three investors I’ve recently met who have taken a page from medicine and aviation to incorporate formal checklists into their work.

All three are huge investors: Pabrai runs a $500 million portfolio; Guy Spier is head of Aquamarine Capital Management in Zurich, Switzerland, a $70 million fund. The third did not want to be identified by name or to reveal the size of the fund where he is a director, but it is one of the biggest in the world and worth billions.

The three consider themselves “value investors”—investors who buy shares in underrecognized, undervalued companies. They don’t time the market. They don’t buy according to some computer algorithm. They do intensive research, look for good deals, and invest for the long run. They aim to buy Coca-Cola before everyone realizes it’s going to be Coca-Cola.

Pabrai described what this involves. Over the last fifteen years, he’s made a new investment or two per quarter, and he’s found it requires in-depth investigation of ten or more prospects for each one he finally buys stock in. The ideas can bubble up from anywhere—a billboard advertisement, a newspaper article about real estate in Brazil, a mining journal he decides to pick up for some random reason. He reads broadly and looks widely. He has his eyes open for the glint of a diamond in the dirt, of a business about to boom.

He hits upon hundreds of possibilities but most drop away after cursory examination. Every week or so, though, he spots one that starts his pulse racing. It seems surefire. He can’t believe no one else has caught onto it yet. He begins to think it could make him tens of millions of dollars if he plays it right, no, this time maybe hundreds of millions.

“You go into greed mode,” he said. Guy Spier called it “cocaine brain.” Neuroscientists have found that the prospect of making money stimulates the same primitive reward circuits in the brain that cocaine does. And that, Pabrai said, is when serious investors like himself try to become systematic. They focus on dispassionate analysis, on avoiding both irrational exuberance and panic. They pore over the company’s financial reports, investigate its liabilities and risks, examine its management team’s track record, weigh its competitors, consider the future of the market it is in—trying to gauge both the magnitude of opportunity and the margin of safety.

The patron saint of value investors is Warren Buffett, among the most successful financiers in history and one of the two richest men in the world, even after the losses he suffered in the crash of 2008. Pabrai has studied every deal Buffett and his company, Berkshire Hathaway, have made—good or bad—and read every book he could find about them. He even pledged $650,000 at a charity auction to have lunch with Buffett. “Warren,” Pabrai said—and after a $650,000 lunch, I guess first names are in order —“Warren uses a ‘mental checklist’ process” when looking at potential investments. So that’s more or less what Pabrai did from his fund’s inception. He was disciplined. He made sure to take his time when studying a company. The process could require weeks. And he did very well following this method—but not always, he found. He also made mistakes, some of them disastrous.

These were not mistakes merely in the sense that he lost money on his bets or missed making money on investments he’d rejected. That’s bound to happen. Risk is unavoidable in Pabrai’s line of work. No, these were mistakes in the sense that he had miscalculated the risks involved, made errors of analysis. For example, looking back, he noticed that he had repeatedly erred in determining how “leveraged” companies were—how much cash was really theirs, how much was borrowed, and how risky those debts were. The information was available; he just hadn’t looked for it carefully enough.

In large part, he believes, the mistakes happened because he wasn’t able to damp down the cocaine brain. Pabrai is a forty-five-year-old former engineer. He comes from India, where he clawed his way up its fiercely competitive educational system. Then he secured admission to Clemson University, in South Carolina, to study engineering. From there he climbed the ranks of technology companies in Chicago and California. Before going into investment, he built a successful informational technology company of his own. All this is to say he knows a thing or two about being dispassionate and avoiding the lure of instant gratification. Yet no matter how objective he tried to be about a potentially exciting investment, he said, he found his brain working against him, latching onto evidence that confirmed his initial hunch and dismissing the signs of a downside. It’s what the brain does.

“You get seduced,” he said. “You start cutting corners.” Or, in the midst of a bear market, the opposite happens. You go into “fear mode,” he said. You see people around you losing their bespoke shirts, and you overestimate the

He also found he made mistakes in handling complexity. A good decision requires looking at so many different features of companies in so many ways that, even without the cocaine brain, he was missing obvious patterns. His mental checklist wasn’t good enough.

“I am not Warren,” he said. “I don’t have a 300 IQ.” He needed an approach that could work for someone with an ordinary IQ. So he devised a written checklist.

Apparently, Buffett himself could have used one. Pabrai noticed that even he made certain repeated mistakes. “That’s when I knew he wasn’t really using a checklist,” Pabrai said.

So Pabrai made a list of mistakes he’d seen—ones Buffett and other investors had made as well as his own. It soon contained dozens of different mistakes, he said. Then, to help him guard against them, he devised a matching list of checks—about seventy in all. One, for example, came from a Berkshire Hathaway mistake he’d studied involving the company’s purchase in early 2000 of Cort Furniture, a Virginia-based rental furniture business.

Over the previous ten years, Cort’s business and profits had climbed impressively. Charles Munger, Buffett’s longtime investment partner, believed Cort was riding a fundamental shift in the American economy. The business environment had become more and more volatile and companies therefore needed to grow and shrink more rapidly than ever before. As a result, they were increasingly apt to lease office space rather than buy it—and, Munger noticed, to lease the furniture, too. Cort was in a perfect position to benefit. Everything else about the company was measuring up—it had solid financials, great management, and so on. So Munger bought.

But buying was an error. He had missed the fact that the three previous years of earnings had been driven entirely by the dot-com boom of the late nineties. Cort was leasing furniture to hundreds of start-up companies that suddenly stopped paying their bills and evaporated when the boom collapsed.

“Munger and Buffett saw the dot-com bubble a mile away,” Pabrai said. “These guys were completely clear.” But they missed how dependent Cort was on it. Munger later called his purchase “a macroeconomic mistake.”

“Cort’s earning power basically went from substantial to zero for a while,” he confessed to his shareholders.

So Pabrai added the following checkpoint to his list: when analyzing a company, stop and confirm that you’ve asked yourself whether the revenues might be overstated or understated due to boom or bust conditions.

Like him, the anonymous investor I spoke to—I’ll call him Cook—made a checklist. But he was even more methodical: he enumerated the errors known to occur at any point in the investment process—during the research phase, during decision making, during execution of the decision, and even in the period after making an investment when one should be monitoring for problems. He then designed detailed checklists to avoid the errors, complete with clearly identified pause points at which he and his investment team would run through the items.

He has a Day Three Checklist, for example, which he and his team review at the end of the third day of considering an investment. By that point, the checklist says, they should confirm that they have gone over the prospect’s key financial statements for the previous ten years, including checking for specific items in each statement and possible patterns across the statements.

“It’s easy to hide in a statement. It’s hard to hide between statements,” Cook said.

One check, for example, requires the members of the team to verify that they’ve read the footnotes on the cash flow statements. Another has them confirm they’ve reviewed the statement of key management risks. A third asks them to make sure they’ve looked to see whether cash flow and costs match the reported revenue growth.

“This is basic basic basic,” he said. “Just look! You’d be amazed by how often people don’t do it.” Consider the Enron debacle, he said. “People could have figured out it was a disaster entirely from the financial statements.”

He told me about one investment he looked at that seemed a huge winner. The cocaine brain was screaming. It turned out, however, that the company’s senior officers, who’d been selling prospective investors on how great their business was, had quietly sold every share they owned. The company was about to tank and buyers jumping aboard had no idea. But Cook had put a check on his three-day list that ensured his team had reviewed the fine print of the company’s mandatory stock disclosures, and he discovered the secret. Forty-nine times out of fifty, he said, there’s nothing to be found. “But then there is.”

The checklist doesn’t tell him what to do, he explained. It is not a formula. But the checklist helps him be as smart as possible every step of the way, ensuring that he’s got the critical information he needs when he needs it, that he’s systematic about decision making, that he’s talked to everyone he should. With a good checklist in hand, he was convinced he and his partners could make decisions as well as human beings are able. And as a result, he was also convinced they could reliably beat the market.

I asked him whether he wasn’t fooling himself.

“Maybe,” he said. But he put it in surgical terms for me. “When surgeons make sure to wash their hands or to talk to everyone on the team”—he’d seen the surgery checklist —“they improve their outcomes with no increase in skill. That’s what we are doing when we use the checklist.”

21 Timeless Investing Lessons From Bruce Berkowitz

Johnny HopkinsBruce Berkowitz Comments

Bruce Berkowitz is the Founder and Chief Investment Officer of Fairholme Capital Management, and President and a Director of Fairholme Funds, Inc. In 2010 Berkowitz was named as the 2009 Domestic-Stock Fund Manager of the Year by Morningstar as well as the Domestic-Stock Fund Manager of the Decade (2000-2009), also by Morningstar. Most recently, he was named 2013’s Money Manager of the Year by Institutional Investor Magazine.

Over the years Berkowitz has provided investors with an abundance of value investing insights, here are twenty one of his best timeless investing lessons:

1. We tend to be more about the jockey than the horse. It’s important to understand how people are going to behave under stress. You don’t have to predict the future if you know the company has the assets and management to do well in difficult times. That’s when the seeds for exceptional performance are planted.

2. At some point in a business cycle one has to get greedy. And the time to get greedy is when everybody is running for the hills with fear. And that is usually a great time to get the greed going. And we’ve become greedy. Less cash. More concentrated investments. Bigger percentage of investments. My definition of skills is knowing when you’re lucky and taking advantage of that luck. And we’re very lucky right now.

3. Cash is the equivalent of financial Valium. It keeps you cool, calm and collected.

4. I think our philosophy makes a lot of sense. We’re doing nothing more than what the wealthiest individuals in the world have done. We act like owners. We focus on very few companies. We try and know what you can know. We try and only buy a few companies which we believe have been built to last in all environments. We recognize that you only need a few good ideas in a lifetime to be fabulously wealthy. We’re always trying to wonder what can go wrong. We’re very focused on the downside.

5. What worries me is knowing that it’s usually a person’s last investment idea that kills them. As you get bigger, you put more into your investments. And, that last idea, which may be bad, will end up losing more than what you’ve made over decades.

6. There are two ways you can invest: You can try to predict or you can react. We react. We look for stressed situations and buy if appropriate.

7. The goal of the fund is long-term growth of capital without taking lots of risk. That’s it in a nice easy sentence.

8. We’ve always done very well when we can use sixth-grade math on the back of a postcard to show how inexpensive something is relative to its free cash. Once we start getting more sophisticated trying to prove something rather than see if we can disprove it by killing the business we get into trouble. We’re looking to pay 10x free cash flow or less, period. If you find those and you can’t kill the business, you should be buying all day long.

9. There’s no question that getting the macro picture right is hugely valuable—I just wish I were capable of doing it. When it comes to macro events, you can either predict or react. I’ve proved time and again that my crystal ball is horrible, so my focus has to be on reacting to extremes in individual securities by selling at high valuations and buying at low valuations.

10. We spend a lot of time thinking about what could go wrong with a company — whether it’s a recession, stagflation, zooming interest rates or a dirty bomb going off. We try every which way to kill our best ideas. If we can’t kill it, maybe we’re on to something. If you go with companies that are prepared for difficult times, especially if they’re linked to managers who are engineered for difficult times, then you almost want those times because they plant the seeds of greatness.

11. We usually hold less than 20 positions at a time, so no one would ever say we’re a place to put all your money, but we behave as if that’s what people have done. So we think it’s reasonable to have some cash around for emergencies, as Buffett says, why risk what you need for that which you don’t need?

12. We used to think having cash was a byproduct of not having enough to do. But the older I get, the more I see it as a strategic asset. It allows us to take advantage of those great opportunities that come up from time to time. We’re just behaving like the companies we like to invest in.

13. Our inclination remains to run from the popular and embrace the hated where prices tend to reflect such mistrust.

14. We use a lot of grapevine ideas, asking people what they’ve finished buying that might be interesting. Why wouldn’t you look at what other great investors have found?

15. At the end of the day, investing is about one person has to take the responsibility of pulling the trigger, and group-think always dummies down to the lowest common denominator, and so, you ignore the crowd

16. The negatives are all uncertainty about the future. And what I try and do is focus on the facts of today.

17. We don’t have a rigid process, but there are always linkages. My first investment 20 years ago was Fireman’s Fund. Studying Jack Byrne’s resuscitation of GEICO before going to Fireman’s Fund led me to Berkshire Hathaway and this guy Warren Buffett. Then during the banking crisis in the early 1990s I looked at many banks, but chose Wells Fargo because Warren Buffett owned it.

18. we look at a company’s free cash flow relative to its price. Ideally, we look for a free cash flow yield of 10% or better

19. You know, our brains are wired for overreaction and momentum, and follow the crowd. So, Fairholme, our tagline is, “Ignore the crowd.” And another one of our lines is, you know, “Count what matters.” So we count the cash.

20. We don’t have a problem with cyclicality. Wall Street still looks for certainty in areas that are uncertain. We feel good about lumpiness. We just try to be cash counters if you can buy something at 5 x free cash with limited chance of permanent impairment, even if it earns only half of what we thought, that’s okay.

21. The good thing about investing is that you don’t have to do everything to be successful. There are plenty of different ways to make money.

This Week’s Best Investing Reads

Johnny HopkinsValue Investing News Comments

Here’s some of this week’s best investing reads:

Overcoming Your Demons (Collaborative Fund)

How NYU teaches MBA Students about Bitcoin (The Reformed Broker)

Market Complexity Could Trigger the Next Crash (Visual Capitalist)

Are You a Better Investor? (Jason Zweig)

All or Nothing Analysis (The Irrelevant Investor)

Episode #72: Radio Show: Investor Sentiment – What is it Telling Us About this Bull’s Length? (Meb Faber)

You Need To Do What Others Don’t (MicroCapClub)

Imagine It’s September 2007 (Safal Niveshak)

Tech Investing Outside of Silicon Valley, w/ David Tisch – [Invest Like the Best, EP.55] (The Investor’s Fieldguide)

The Coming Bear Market? (Advisor Perspectives)

Investing with a Patient, Long-Term View – (John Rogers – Ariel Investments)

What It’s Like To Be A Value Investor In A Growth Market – (Wally Weitz – Weitz Funds)

How Millennials Can Prepare For the Next Financial Crisis (A Wealth of Common Sense)

Academic Research Insight: Does Gender Matter on Wall Street? (Alpha Architect)

History’s Lessons (Harvard Business School)

Little Things Mean a Lot (Cliff’s Perspective)

Undervalued Ceragon Networks FCF/EV Yield 10%, ROE 14% – Small & Micro Cap Stock Screener

Johnny HopkinsStocks Comments

One of the cheapest stocks in our Small & Micro Cap Stock Screener is Ceragon Networks Ltd (NASDAQ:CRNT).

Ceragon Networks Ltd (Ceragon) is a wireless backhaul specialist company providing wireless backhaul solutions that enable cellular operators and other wireless service providers to deliver voice and data services, enabling smart-phone applications.

A quick look at Ceragon’s share price history over the past twelve months shows that the price is down 22%, but here’s why the company is undervalued.

The following data is from the company’s latest financial statements, dated June 2017.

The company’s latest balance sheet shows that Ceragon has $34 Million in total cash and cash equivalents. Further down the balance sheet we can see that the company has $8 Million in short-term debt and no long-term debt. Therefore, Ceragon has a net cash position of $26 Million (cash minus debt).

If we consider that Ceragon currently has a market cap of $160 Million, when we subtract the net cash totaling $26 Million that equates to an Enterprise Value of $134 Million.

If we move over to the company’s latest income statements we can see that Ceragon has $22 Million* in trailing twelve month operating earnings which means that the company is currently trading on an Acquirer’s Multiple of 6.03, or 6.03 times operating earnings. That places Ceragon squarely in undervalued territory.

The Acquirer’s Multiple is defined as:

Enterprise Value/Operating Earnings*

*We make adjustments to operating earnings by constructing an operating earnings figure from the top of the income statement down, where EBIT and EBITDA are constructed from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries and sectors possible, and, by excluding special items–income that a company does not expect to recur in future years–ensures that these earnings are related only to operations.

It’s also important to note that if we take a look at the company’s latest cash flow statements we can see that Ceragon generated trailing twelve month operating cash flow of $21 Million and had $8 Million in Capex. That equates to $13 Million in trailing twelve month free cash flow, or a FCF/EV Yield of 10%.

In terms of Ceragon’s annualized Return on Equity (ROE) for the quarter ending June 2017. A quick calculation shows that the company had $118 Million in equity for the quarter ending March 2017 and $124 Million for the quarter ending June 2017. If we divide that number by two we get $121 Million. If we consider that the company has $16.7 Million (ttm) in net income, that equates to an annualized Return on Equity (ROE) for the quarter ending June 2017 of 14%.

It’s also worth considering that Ceragon currently has revenues of $333 Million (ttm), and while they’re not at record highs in the past five years, it’s important not to overlook the company’s operating income of $22 Million (ttm), net income of $16.7 Million (ttm), and free cash flow of $13 Million (ttm), which are all at five-year highs. Also notable are the significant reductions in capex, down from $15 Million in 2012 to just $8 Million (ttm).

In terms of Ceragon’s current valuation, the company is trading on a P/E of 9.9 compared to its 5Y average of 41.5**, a P/B of 1.3 compared to its 5Y average of 1.2**, and a P/S of 0.5 compared to its 5Y average of 0.4**. The company has a FCF/EV Yield of 10% (ttm) and an Acquirer’s Multiple of 6.03, or 6.03 times operating earnings. Ceragon also has an annualized Return on Equity (ROE) for the quarter ending June 2017 of 14% (ttm). All of which indicates that Ceragon is undervalued.

** Morningstar

About The Small & Micro Cap Stock Screener (CAGR 22%)

Over a full sixteen-and-a-half year period from January 2, 1999 to July 26, 2016., the Small & Micro Cap stock screener generated a total return of 3,284 percent, or a compound growth rate (CAGR) of 22.0 percent per year. This compared favorably with the Russell 3000 TR, which returned a cumulative total of 265 percent, or 5.7 percent compound.

The One Thing All Value Investors Can Do To Get You Halfway Home – Irving Kahn

Johnny HopkinsInvesting Strategy Comments

One of our favorite value investors here at The Acquirer’s Multiple is Irving Kahn. Kahn was the Chairman at Kahn Brothers Group which he founded in 1978. He began his career in the value investing business shortly before the stock market crash of 1929, and, in the 1930s, he served as Benjamin Graham’s teaching assistant at Columbia Business School.

The Kahn Brothers’ investment philosophy evolved from Graham’s original “discount to net asset purchase” model into a contrarian value strategy focusing on margin of safety and capital appreciation over long periods of time.

One of the best interviews with the Kahn brothers was with the Ivey Value Investing Class in 2005 and there’s one part in particular that encapsulates the mindset required to be a successful value investor. Here’s an excerpt from that interview:

25.57 The only thing I can say is we maintain a really strict contrarian approach. So if something is very popular and everybody loves it and we’re buying it we have to say to ourselves what are we doing wrong here. Because I’d say half of the price of a common stock is ‘fashion’ basically so what we’re doing is we’re buying long skirts at the thrift shop when mini skirts are in favor. So we’re buying the long skirts for a dollar or two and then waiting till long skirts come back into Saks and if you can do that you’re halfway home you know you’re almost halfway home if you can just stick to being a contrarian.


Is It Better To Buy The Stock And Watch The Price Drop Or Not Act And Watch The Price Soar? – Daniel Kahneman

Johnny HopkinsCharles Munger, Daniel Kahneman, Warren Buffett Comments

One of the most common predicaments facing investors is that they’ve analysed a stock, it meets with the investors criteria, and now it’s time to pull the trigger and buy the stock. But something happens, the investor ums and ahs and delays the decision to buy. Next thing you know three months later the value of the stock has risen by 15% and the investor regrets their decision not to purchase the stock. This feeling of regret is common with investors particularly when the stock’s price soars upwards after failing to make the purchase.

If it’s any consolation this same feeling of regret is also common for the great investors. Charles Munger has been previously quoted as saying, “The most extreme mistakes in Berkshire’s history have been mistakes of omission.” In fact earlier this year Warren Buffett admitted that not investing in Apple sooner was Berkshire Hathaway’s biggest mistake.

So what is an investor supposed to do? Is it better to buy the stock and watch the price drop or not buy the stock and watch the price soar. One of the answers can be found in Daniel Kahneman’s book – Thinking Fast & Slow. Kahneman is a psychologist notable for his work on the psychology of judgement and decision-making, as well as behavioral economics, for which he was awarded the 2002 Nobel Memorial Prize in Economic Sciences (shared with Vernon L. Smith). In 2015, The Economist listed him as the seventh most influential economist in the world.

In his book, Kahneman provides us with some great illustrations on whether acting or not acting on an investment decision fills investors with more regret.

Here’s an excerpt from the book:

Decision makers know that they are prone to regret, and the anticipation of that painful emotion plays a part in many decisions. Intuitions about regret are remarkably uniform and compelling, as the next example illustrates.

Paul owns shares in company A. During the past year he considered switching to stock in company B, but he decided against it. He now learns that he would have been better off by $1,200 if he had switched to the stock of company B.

George owned shares in company B. During the past year he switched to stock in company A. He now learns that he would have been better off by $1,200 if he had kept his stock in company B.

Who feels greater regret?

The results are clear-cut: 8% of respondents say Paul, 92% say George.

This is curious, because the situations of the two investors are objectively identical. They both now own stock A and both would have been better off by the same amount if they owned stock B. The only difference is that George got to where he is by acting, whereas Paul got to the same place by failing to act. This short example illustrates a broad story: people expect to have stronger emotional reactions (including regret) to an outcome that is produced by action than to the same outcome when it is produced by inaction.

This has been verified in the context of gambling: people expect to be happier if they gamble and win than if they refrain from gambling and get the same amount. The asymmetry is at least as strong for losses, and it applies to blame as well as to regret. The key is not the difference between commission and omission but the distinction between default options and actions that deviate from the default. When you deviate from the default, you can easily imagine the norm—and if the default is associated with bad consequences, the discrepancy between the two can be the source of painful emotions. The default option when you own a stock is not to sell it, but the default option when you meet your colleague in the morning is to greet him. Selling a stock and failing to greet your coworker are both departures from the default option and natural candidates for regret or blame.

In a compelling demonstration of the power of default options, participants played a computer simulation of blackjack. Some players were asked “Do you wish to hit?” while others were asked “Do you wish to stand?” Regardless of the question, saying yes was associated with much more regret than saying no if the outcome was bad!

The question evidently suggests a default response, which is, “I don’t have a strong wish to do it.” It is the departure from the default that produces regret. Another situation in which action is the default is that of a coach whose team lost badly in their last game. The coach is expected to make a change of personnel or strategy, and a failure to do so will produce blame and regret.

The asymmetry in the risk of regret favors conventional and risk-averse choices. The bias appears in many contexts. Consumers who are reminded that they may feel regret as a result of their choices show an increased preference for conventional options, favoring brand names over generics. The behavior of the managers of financial funds as the year approaches its end also shows an effect of anticipated evaluation: they tend to clean up their portfolios of unconventional and otherwise questionable stocks. Even life-or-death decisions can be affected.

Imagine a physician with a gravely ill patient. One treatment fits the normal standard of care; another is unusual. The physician has some reason to believe that the unconventional treatment improves the patient’s chances, but the evidence is inconclusive. The physician who prescribes the unusual treatment faces a substantial risk of regret, blame, and perhaps litigation. In hindsight, it will be easier to imagine the normal choice; the abnormal choice will be easy to undo. True, a good outcome will contribute to the reputation of the physician who dared, but the potential benefit is smaller than the potential cost because success is generally a more normal outcome than is failure.

Value Stocks So Cheap – We Can Only Hope Now Is Like March 2000

Johnny HopkinsValue Investing News Comments

Here’s a great article at Forbes written by John Buckingham, Chief Investment Officer of Al Frank Asset Management, that reports some positive signs for value investors.

The five trading days just completed was our kind of week, as despite another missile fired over Japan by North Korea, the equity markets moved nicely higher, with the major market averages again hitting all-time highs and Value having a little time in the sun. Indeed, the Russell 3000 Value index advanced 2.24%, compared to a 1.18% increase in the Russell 3000 Growth index and a gain of 1.63% in the S&P 500. No doubt, investors were relieved that Hurricane Irma did not pack as powerful a punch in Florida as initially feared…

…but Value’s outperformance was, not surprisingly, correlated with a spike upward in interest rates,…

Bloomberg Finance

Big Rebound in Interest Rates

…which was precipitated by an easing of investor fears and, perhaps more importantly for the long term, an increase in the outlook for inflation…

Bloomberg Finance

Inflation Shows A Modest Pickup

…which should keep the Federal Reserve on track to again hike its target for the Federal Funds rate,…

Bloomberg Finance

Futures: Fed May Not Be Finished in 2017

…an occurrence that historically has boded well for the kind of stocks that we have favor, both in the short term…

Bloomberg Finance and Professors Eugene F. Fama and Kenneth R. French

Change in Fed Funds Rate

…and in the long term!

Bloomberg Finance and Professors Eugene F. Fama and Kenneth R. French

Fed Liftoff & Value

Certainly, anything can happen as we move forward, and we remain in the seasonally less favorable September/October time period, but we continue to see no reason to alter our long-term enthusiasm for our broadly diversified portfolios of undervalued dividend payers. And on the subject of Value, it was nice to see Mark Hulbert (one of the smartest analysts/columnists we know!) write last week, “Value stocks are now cheaper than ever — with only one exception.

That exception came at the top of the internet bubble in early 2000. Few investors remember that in the subsequent bear market, in which the S&P 500 lost 49%, many value stocks actually rose in price.

Value stocks, of course, are those that are most out-of-favor among investors, as indicated by a low price-to-book ratio. They are the opposite of growth stocks — those that trade with the highest such ratios.

Consider the spread between the valuations of the average growth and value stock. According to an analysis provided to me by Kent Daniel, a finance professor at Columbia University, the average large-cap value stock’s price-to-book ratio is barely half that of the average among large-cap growth stocks. Among small-cap stocks, value is even cheaper relative to growth.

This spread is much wider than average. Since 1959, according to Daniel, the average value stock’s price-to-book ratio has been only a third less than that of the average growth stock. The only other time when value was any cheaper than now came as the internet bubble reached its peak. Then, average value stock’s price-to-book ratio dropped to even less than half that of the average growth stock.

This wide spread between growth and value is of more than just idle significance. Researchers have found that value stocks tend to perform particularly well over the ensuing 15 years, relative to growth stocks, whenever — like now — the value spread is widest.”

As Mark Twain once said, “History doesn’t repeat itself, but it does rhyme!”

Bloomberg Finance

We Hope Now Is Like March 2000

You can read the original article at Forbes here.

8 Exceptional Investing Lessons That Have Stood The Test Of Time – Philip Fisher

Johnny HopkinsPhilip Fisher Comments

One of the best investing books ever written is Common Stocks and Uncommon Profits by Philip Fisher. According to Forbes this book was the first investment book ever to make The New York Times bestseller list. As a testament to the book, on the cover is a quote by Warren Buffett saying – “I am an eager reader of whatever Phil has to say, and I recommend him to you.” Such is Buffett’s reverence for Fisher that he later described his own investing strategy as being 15% Fisher and 85% Benjamin Graham.

While the entire book is a must read for all investors, following is an eight point summary from the book that encapsulates Fisher’s investment philosophy:

This then is my investment philosophy as it has emerged over a half century of business experience. Perhaps the heart of it may be summarized in the following eight points:

1. Buy into companies that have disciplined plans for achieving dramatic long-range growth in profits and that have inherent qualities making it difficult for newcomers to share in that growth. There are so many details, both favorable and unfavorable, that should also be considered in selecting one of these companies that it is obviously impossible in a monograph of this length to cover them adequately.

2. Focus on buying these companies when they are out of favor; that is, when, either because of general market conditions or because the financial community at the moment has misconceptions of its true worth, the stock is selling at prices well under what it will be when its true merit is better understood.

3. Hold the stock until either (a) there has been a fundamental change in its nature (such as a weakening of management through changed personnel), or (b) it has grown to a point where it no longer will be growing faster than the economy as a whole.

Only in the most exceptional circumstances, if ever, sell because of forecasts as to what the economy or the stock market is going to do, because these changes are too difficult to predict. Never sell the most attractive stocks you own for short-term reasons.

However, as companies grow, remember that many companies that are quite efficiently run when they are small fail to change management style to meet the different requirements of skill big companies need. When management fails to grow as companies grow, shares should be sold.

4. For those primarily seeking major appreciation of their capital, de-emphasize the importance of dividends. The most attractive opportunities are most likely to occur in the profitable, but low or no dividend payout groups. Unusual opportunities are much less likely to be found in situations where high percentage of profits is paid to stockholders.

5. Making some mistakes is as much an inherent cost of investing for major gains as making some bad loans is inevitable in even the best run and most profitable lending institution. The important thing is to recognize them as soon as possible, to understand their causes, and to learn how to keep from repeating the mistakes.

Willingness to take small losses in some stocks and to let profits grow bigger and bigger in the more promising stocks is a sign of good investment management. Taking small profits in good investments and letting losses grow in bad ones is a sign of abominable investment judgment. A profit should never be taken just for the satisfaction of taking it.

6. There are a relatively small number of truly outstanding companies. Their shares frequently can’t be bought at attractive prices. Therefore, when favorable prices exist, full advantage should be taken of the situation. Funds should be concentrated in the most desirable opportunities. For those involved in venture capital and quite small companies, say with annual sales of under $25,000,000*, more diversification may be necessary. For larger companies, proper diversification requires investing in a variety of industries with different economic characteristics. For individuals (in possible contrast to institutions and certain types of funds), any holding of over twenty different stocks is a sign of financial incompetence. Ten or twelve is usually a better number.

Sometimes the costs of the capital gains tax may justify taking several years to complete a move toward concentration. As an individual’s holdings climb toward as many as twenty stocks, it nearly always is desirable to switch from the least attractive of these stocks to more of the attractive. It should be remembered that ERISA stands for Emasculated Results: Insufficient Sophisticated Action.

7. A basic ingredient of outstanding common stock management is the ability neither to accept blindly whatever may be the dominant opinion in the financial community at the moment nor to reject the prevailing view just to be contrary for the sake of being contrary. Rather, it is to have more knowledge and to apply better judgment, in thorough evaluation of specific situations, and the moral courage to act “in opposition to the crowd” when your judgment tells you you are right.

8. In handling common stocks, as in most other fields of human activity, success greatly depends on a combination of hard work, intelligence, and honesty. Some of us may be born with a greater or lesser degree of each of these traits than others. However, I believe all of us can “grow” our capabilities in each of these areas if we discipline ourselves and make the effort.

While good fortune will always play some part in managing common stock portfolios, luck tends to even out. Sustained success requires skill and consistent application of sound principles. Within the framework of my eight guidelines, I believe that the future will largely belong to those who, through self-discipline, make the effort to achieve it.

*Common Stocks and Uncommon Profits was originally published in 1958. $25,000,000 in 1958 had the same buying power as $212,528,169 in 2017. Annual inflation over this period was about 3.69%.