Going Dutch, The Benefits of Sound Money

Dutch Cunning

In the second half of the seventeenth century the tiny Dutch Republic was besieged by all of the great nations of the time. Yet, despite being continually faced with invasion by Spain and France and naval blockade by England, the Hollanders survived and prospered aided by a cunning and thoroughly deceitful strategy.

They always paid their debts.

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Bulletin Boards are Bad for Your Wealth

Buyer Beware of the Boards
 
Lots of us, including me, frequent investment related bulletin boards discussing shares and such stuff. They’re full of like-minded people, offering opinions on various investments. If it’s what you’re into they're fun, informative and can generate lots of useful ideas.

They can also be extremely damaging to your investment returns. Bulletin boards are exactly the wrong way to discover investment information unless you know precisely what you’re doing.

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You Can’t Trust the Experts with Your Investments

Investment Experts Make You Poor

In a complex world we increasingly have to rely on experts such as lawyers, doctors and scientists to guide us. We expect them to get things right most of the time and we sue the hell out of them if they don’t. In the world of investment, though, we get something different. They get it wrong most of the time, are never held accountable and generally argue that they actually didn’t get it wrong anyway and, if they did, it wasn't their fault.

Meanwhile people listen to these “experts”, take their advice, almost hero worship them at times and mostly get poorer while they make money at our expense. Who are the smart ones in this relationship?

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Unemotional Investing is Best

Emotionally Braindamaged People Make Better Judgement Calls on Money

Behavioral economists see humans exhibiting irrationality when it comes to dealing with money all the time. The suspicion is that this behaviour is adaptive – out in the jungle it pays to be risk adverse when approaching a snake if the last time you did so you got bit. In the stockmarket this is potentially exactly the wrong thing to do, as the stocks that did less well last year are more likely to do better this one.

Proving this isn’t easy but a remarkable experiment using emotionally braindamaged people has provided further evidence that the hypothesis may well be correct.

Trying to untangle cause and effect is difficult, but if emotions are key to this maladaptive investing approach then at least one experiment suggested itself: find yourself some people who don’t experience emotions and see how they perform in a risky environment. This is exactly what Baba Shiv and colleagues (1) tried out but rather than sticking their subjects in a room with a bunch of snakes – psychology generally frowns on experiments that lead to participants dying these days – they went for a more traditional approach involving coin tossing.

Gambling on a Favourably Rigged Game

There is an unfortunate class of people who have suffered a type of brain damage which causes them to exhibit no emotions whatsoever. These people are pretty much unable to operate in the world around them as, lacking any understanding of social cues, they’re unable to interact with other people. What the experiment tested out was whether or not a group of such people would behave differently to more emotional investors in the light of investment success or failure.

The experiment was pretty simple – each subject was given $20 and a coin. On each toss of the coin they risked $1 with a $2.50 reward for guessing correctly but they had the option of not gambling and keeping the dollar. They walked away with their winnings.

So over twenty rounds if you chose not to gamble at all you would walk away with $20. However, this would be profoundly irrational because the win-loss ratio was weighted in the former’s favour. With average luck by gambling on every round you would have walked away with $25 with only a 13% chance of getting less than the starting value.

Unemotional Gambling Wins

The researchers speculated that normal investors would become more risk adverse if they lost on a previous round while, if their hypothesis was correct, the emotionless subjects would continue to gamble, being unaffected by the previous snake bite. This was exactly the finding – “normal” participants were significantly less likely to take a risk having just been burned while it made no difference to the emotionless participants. The latter group walked away with the average $25 that probability would predict while the emotionally handicapped ones got less.

So it seems that the emotional group were unable to ignore their feelings of loss after each failure and became more risk adverse while the unemotional group simply carried on playing the odds. Hence those people with a full grip on their feelings failed to capitalise on a game clearly rigged in their fashion – a description, many of us would argue, equally applicable to the stockmarket over long enough periods.

Inexperience Loses, Once More

Added to John List’s experiments suggesting that experience in markets can help people overcome trading biases, this suggests that less experienced stockmarket investors need to find ways of leaving their feelings at home before risking their capital in a jungle where snakes are all too common. As usual, the emotional and inexperienced investor is at most risk from stockmarkets.

I guess learning to embrace your inner snakes isn’t easy.


(1) Investment Behavior and the Negative Side of Emotion
Baba Shiv, George Loewenstein, Antoine Bechara, Hanna Damasio, and Antonio R. Damasio
Psychological Science, Vol. 16, No. 6, 2005

Alpha and Beta – Beware Gift Bearing Greeks

A Land of Giants and Dwarves

Anyone involved in the stockmarket for any length of time will eventually come up against the concepts of Alpha and Beta. The terms are freely bandied about as though they can explain the mysteries of the investing universe without, unfortunately, any corresponding explanation of actually what they are.

The best way to think of Alpha and Beta is to imagine a world populated by an inordinate number of very tall and very short people. Everywhere you go you’re either tripping over them or being stood on and squished. As usual the securities industry has latched onto a useful tool and started to use it in an automated, mindless and value destroying way. Of course, the value being destroyed isn’t theirs, it’s ours.

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The Rediscovered Ben Graham

Occasionally this interwebnet thingy throws up a bit of a gem. So I’m delighted to have found The Rediscovered Ben Graham, hidden in the bowels of John Wiley & Sons website. A link has been added to the Links section.

These are a series of lectures given by Graham at the Columbia Business School in 1946. There’s a fair amount in here that’s not relevant any more – like the appropriate treatment of war profits (although you never know) – but much that is. Here are a few samples …

Ben Graham lived in not entirely politically correct times (his firm was, even in the fifties, just about the only one on Wall Street that employed Jews – its first non-Jewish employee was some bloke called Warren Buffett). His metaphor for how to regard the stockmarket is both spot on and condescending:

The correct attitude of the security analyst toward the stock market might well be that of a man toward his wife. He shouldn’t pay too much attention to what the lady says, but he can’t afford to ignore it entirely. That is pretty much the position that most of us find ourselves vis-à-vis the stock market.

He was sound on short-term investor psychology, where nothing much changes:
 

… it is interesting to see how unpopular companies can become, merely because their immediate prospects are clouded in the speculative mind.

Prescient on index tracking, thirty years ahead of the launch of Vanguard:

Furthermore, there is nothing to prevent the investor from dealing with his own investment problems on a group basis. There is nothing to prevent the investor from actually buying the Dow-Jones Industrial Average, though I never heard of anybody doing it. It seems to me it would make a great deal of sense if he did.

Wryly amusing on the virtues and otherwise of security analysts:

It seems to me that Wall Street analysts show an extraordinary combination of sophistication and naiveté in their attitude toward speculation. They recognize, and properly so, that speculation is an important part of their environment. We all know that if we follow the speculative crowd we are going to lose money in the long run. Yet, somehow or other, we find ourselves very often doing just that. It is extraordinary how frequently security analysts and the crowd are doing the same thing. In fact, I must say I can’t remember any case in which they weren’t. (Laughter.)

And acutely accurate on human nature:

In one important respect we have made practically no progress at all, and that is in human nature. Regardless of all the apparatus and all the improvements in techniques, people still want to make money very fast. They still want to be on the right side of the market. And what is most important and most dangerous, we all want to get more out of Wall Street than we deserve for the work we put in.

Worth a browse.

Bill Bernstein v Joe Nocera

William Bernstein rarely writes on his Efficient Frontier website these days, more’s the pity, but he’s been moved to do so by Joe Nocera’s take on the victims of Bernie Madoff: It’s time our elected officials dragged the investment industry, kicking and screaming, into the modern era.

In his 13th March piece in the New York Times Nocera opined (I quote at length):

I suppose you could argue that most of Mr. Madoff’s direct investors lacked the ability or the financial sophistication of someone like Mr. Hedges. But it shouldn’t have mattered. Isn’t the first lesson of personal finance that you should never put all your money with one person or one fund? Even if you think your money manager is “God”? Diversification has many virtues; one of them is that you won’t lose everything if one of your money managers turns out to be a crook.

“These were people with a fair amount of money, and most of them sought no professional advice,” said Bruce C. Greenwald, who teaches value investing at the Graduate School of Business at Columbia University. “It’s like trying to do your own dentistry.” Mr. Hedges said, “It is a real lesson that people cannot abdicate personal responsibility when it comes to their personal finances.”

http://www.nytimes.com/2009/03/14/business/14nocera.html?_r=1&pagewanted=all

To summarise: Madoff’s victims conspired in their own downfall.

Bill Bernstein begs to disagree:

Well, Joe, no, that is not what diversification means to me. “Diversification” does mean not putting all your eggs in one basket, but not in the sense that you imply. Diversification is spreading your bets among a very large number of securities …

And it also certainly shouldn’t mean diversifying among advisors….

Think about it, Joe. Do you “diversify” among doctors, lawyers, dentists, plumbers, or accountants? Most people do not, nor do they have to….

Bluntly put, there’s no chance that your doctor, dentist, or attorney is a high-school dropout. Your stockbroker, however, just might be….

The highly idiosyncratic strategies of many hedge funds are especially problematic. I would have few qualms about restricting the purchase of these products to only the most sophisticated institutional investors, with no individual ownership allowed through brokerage or fund-of-fund channels….

It’s time our elected officials dragged the investment industry, kicking and screaming, into the modern era.

http://www.efficientfrontier.com/ef/0adhoc/nocera.htm (go read it).

To paraphrase: your average investment advisor is likely to be less qualified that your average plumber. Would you trust your life savings to the guy who fiddles with your fawcet?

Bravo Bill. Bravo.

Hedge Funds Ate My Shorts

Poor Investors, Rich Managers

For someone with a sceptical, not to say cynical, view of the global securities industry the trials of the hedge funds over the past year has at least raised a hollow laugh. Managers of hedge funds have traded on their ability to make so-called absolute returns – profits – regardless of whether markets were rising or falling. In return for this they received extortionate fees and eye watering bonuses. So now that we’re facing difficult economic times and nasty falling markets how have they done?

Pretty damn well actually. Most of them have retired, leaving their investors nursing huge losses. Don’t worry, though, they’ll be back to rip us off some more just as soon as people forget.

Absolute Returns “Guaranteed”

At root the ability of hedge funds to generate absolute returns was dependent on their ability to invest across a wide range of, supposedly, uncorrelated asset classes and to go short as well as long. Going short essentially means selling shares or other stuff you haven’t got and then buying them back later, hopefully at a lower price, and pocketing the difference.

Given these advantages hedge funds were supposedly just as likely to make money in falling markets as rising ones. Hedge funds would, obviously, be able to outperform other sorts of funds that could only invest in restricted sets of asset classes and, often, were not allowed to short the market to any significant degree. Yet hedge fund valuations have collapsed over the last year along with the rest of the markets. In fact many hedge funds have done worse than the market, a remarkable effort under the circumstances. So what went wrong?

The Law of Large Numbers

There’s an iron rule in the markets. As soon as someone finds a model that makes money they’ll squeeze it until the pips start howling. And then they’ll squeeze some more. And they’ll keep on squeezing until the model stops working. Which it will, because the Law of Large Numbers makes it inevitable.

The Law of Large Numbers means that the more money there is in any given fund or sector the more difficult it becomes to make excess returns. If you have a few thousand to invest and you’re a good analyst it’s easy enough to find a home for the money by buying a few shares in a cheap company or shorting an expensive one.

However, if you have thousands of millions to put away there are far less places where you can put it. This became a problem for the hedge funds – as they became more and more successful and got larger and larger amounts of money to invest it became more and more difficult to find places to put it and, hence, to generate the kind of returns they marketed themselves upon.

Hedge Trimmers

At the same time, spotting a trend, other companies jumped on the bandwagon to the extent that you only had to slap the label “hedge” on anything and people threw money at it. Hell, they tried to give my gardener a couple of million when all he wanted was a loan for a hedge trimmer. He got a really nice one, mind you.

In the end it seemed that pretty much the whole industry was playing a single game – shorting financial stocks and going long on commodities with other people’s money. Ours mainly, it turns out. Which went really, really, really well until – suddenly – it didn’t. At which point all the things that had been pushing up hedge fund valuations went into reverse, with predictably nasty consequences.

Commodities, Banks and Gearing

Firstly commodity prices simply got out of line with the real-world needs. Oil hit nearly $150 a barrel despite the reality that there was so much of it sloshing around that there wasn’t enough room to store it. Although waves of hot money can sustain market prices at stupid levels for long periods of time they must eventually fall victim to basic economics.

So, no sooner were highly paid and brilliantly educated oil market analysts confidently predicting oil would be at $200 a barrel within weeks than – guess what? The price collapsed, of course. With it went one of the hedge funds’ props. Once the valuations started going in reverse and hedge funds started to sell out the collapse in commodity prices accelerated, making the problem worse.

Meanwhile, governments worldwide were struggling with the ongoing financial crisis and eventually, about a year after everyone else, noticed that the hedge funds were shorting the banks like crazy, destabilising their prices and exacerbating the problems. So a number of countries suddenly banned the shorting of bank stocks. Whereupon many of the hedge fund managers threw their toys out of their prams, started crying and complained that it “wasn’t fair”. This knocked away the second leg of the hedge funds’ strategy and was very amusing into the bargain.

As the underlying investments collapsed hedge funds were forced into waves of price insensitive selling. In essence this meant that they were forced to sell assets at any price in order to raise cash. Why?

Well, the third leg of the hedge funds’ strategy was gearing – borrowing lots of money to invest in buying commodities and shorting financials, secured on the underlying valuations of said investments. As these collapsed the need to find money to unwind their gearing meant that assets had to be sold at any price. As the hedge funds’ valuations dropped investors got cold feet and started to redeem their investments, which meant the funds had to sell more assets in order to pay them. And so, one by one, the dominoes toppled.

Cue stockmarket collapses.

Ponzi Revisited (Again)

Now many funds have either been forced to shut down, paying out a fraction of their previous worth, or to stop allowing redemptions, effectively locking in their investors while awaiting a resumption of normal service, whatever that means. Big fees, I imagine. All of which basically proves that any business model that achieves exceptional returns will attract competition and that competition will eventually ensure that the exceptional returns disappear. Done unwisely the exceptional returns may turn into exceptional losses.

So, what was originally a smart idea executed by smart people, eventually ended up as a giant Ponzi scheme in which the funds received extraordinary levels of remuneration for doing no more than copying each other. Typical fees were 5% of the fund value and 20% of the profits. Every single year. Based on these fees average hedge fund managers would have needed to provide returns nearly on a par those of the greatest investors of all time in order to allow their investors to achieve the same returns they could have got in an index tracker.

Go figure.

The Follies of the Robber Barons

Not all of the hedge fund industry has been a disaster for everyone, however. The really smart hedge fund managers have made a fortune by listing their funds on the stockmarket at the peak of their valuations.

Investors should always avoid Initial Public Offerings (IPO’s) or flotations – when companies first get listed on the stockmarket. This is because the people selling the companies know more about what’s going on than the new investors and they’re not likely to be selling something on the cheap. Especially when they’re as savvy as Hedge Fund managers. This was never going to end well for the buyers of these stocks.

So the leading Hedge Fund managers floated their companies at the top of the market in 2007, took out a fortune in cash and have left their investors holding massive losses. Many of these managers bought the giant folly homes that line the Connecticut Turnpike, originally built by the great robber barons of the early twentieth century. It’s all very apt.

As ever, of course, those who forget their history are doomed to repeat it.

Dear Auntie, Why Are My Bonds Bubbling?

Bonds should be Boring Beasts

There are many reasons why your bonds might be exhibiting unusual levels of excitement, but normally they only respond to two things – changes in peoples’ perception of creditworthiness or changes in interest rates. You don’t say which species you’ve got but my guess is these are government bonds, currently flavour of the month. As government bonds are boring beasts, apt to spend much time snoozing in the sun, only occasionally rousing to move around a little, Auntie feels that this calls for an explanation.

Roughly, there are two species of bonds: those issued by governments and those issued by corporations. They both pay a fixed amount of money – interest – to their holders each year for a specified number of years before they are redeemed at “par” where “par” is the price they were issued at. So if you buy a bond and own it until it’s redeemed – to “maturity” – then you know exactly what your return on it’ll be. So a bond is a debt that pays interest and eventually is repaid.

Bonds and Interest Rates

Bonds are mostly issued at round number of currency units so the calculations are easy. For instance, the (imaginary) US Treasury 8% 2019 bond is a government bond paying 8% a year on its $100 issuance price (that’s $8 a year for each bond) until 2019 when it would be redeemed at $100. The interest rate on a bond is always a bit higher than the current national interest rate, to encourage people to buy it, so this would probably have been around 6% when this bond was issued.

Although the amount of interest on your bond is the same every year the price of it’ll vary depending on, as previously mentioned, investors’ concerns over the creditworthiness of the bond issuer and general interest rates. General interest rates are set by governments or central banks and if, say, they reduce the general interest rate by 1% you would roughly expect the interest rates paid by bonds to also decrease by 1% (that’s a rule of thumb, though: bond prices respond to buying and selling and the different between national interest rates and bond yields varies over time).

Bond Yields

As a bond pays exactly the same amount of interest every year for the interest rate on the bond to decrease the price of the bond must increase. So, if the interest rate is changed from 6% to 5% then the price of the bond quoted above at 8% will, roughly, change to pay out 1% less – 7%, technically known as the ‘nominal yield’. As the bond still pays out $8 per year then the price must rise to ($8/7% =) $114.28.

What’s more tricky is the “yield to maturity” which takes into account the interest you get every year plus the bond redemption price. Taking this same example if you buy the bond at $114.28 in 2009 you’ll receive $8 every year for ten years – a total of $80. However, you’ll then receive $100 from the government when it buys back the debt. So you’ll get a total of $180 if you hold the bond to maturity. This is also known as the discount rate.

Note that the closer you get to the maturity date the closer nominal yield will move to the maturity yield because it’s increasingly certain that’s what you’ll receive. It’s a bit more difficult to calculate the yield to maturity than the nominal yield but you can look up in the newspapers or use a bond yield calculator (googling will find you loads). Whatever it is you know it with nearly 100% certainty for the best government bonds.

Misbehaving Bonds

Sometimes bonds get a bit skittish and their prices don’t move with interest rates. In fact sometimes the little beasts do exactly the opposite. This’ll usually be because investors are worried about whether the bond issuer will be able to afford to pay the interest due. If they can’t then they are said to have “defaulted” on the bonds.

Most government bonds are less risky and more creditworthy than corporate bonds if for no other reason than governments can ultimately print money to pay the interest. However, this isn’t always possible and plenty of countries have defaulted on their bonds – Russia in 1998 being the last major example when oil prices crashed and caused its revenues to collapse.

Usually the reaction to this by investors is to stick the country in the naughty corner until it promises not to do it again. It’s unlikely any major industrialised nation would ever default so the debt of the United States, France, Germany, United Kingdom, etc is the most valuable, least risky and most expensive.

Corporate Bonds are riskier than Government Bonds

Corporate bonds are cheaper than government bonds (where “cheaper” means more interest) because companies are more likely to default. Also, corporate bonds are considered safer than shares in the same company because they’ve precedence over shares when it comes to any assets of the company – if the company goes bust bondholders rank ahead of shareholders in the pecking order for anything that’s left over (but may be behind other debt holders of different kinds).

One downside of bonds is that their total return in nominal terms is fixed when they’re bought, unlike shares in a company that have no fixed return. Although shareholders lose everything if a company goes bust they also “share” in the earnings of the company for as long as the company exists.

Banks, Bonds and Bankruptcy

Financial institutions like banks are among the largest issuers of corporate bonds. Unfortunately many banks are also now on the naughty step because they stupidly lent all their money to poor people, with no jobs, who bought big houses at outrageous prices and then went bankrupt. Investors are worried that these losses mean the banks may default on their bond payments.

Currently, then, there’s a big gap between the prices of the bonds of industrialised nations and those of large corporations. Governments have cut interest rates to stimulate lending which has dried up because the silly banks have no money and this has caused a steep reduction in yields on government bonds. At the same time investors have become very scared about the prospects for many companies and have shied away from investing in corporate bonds and shares which has meant that they have tended to put even more money in government bonds, driving up their price still further.

Beware Bubbling Bonds

So if your bonds are bubbling it’s likely that they’re government bonds, issued by a major industrial nation, and that they’re enjoying the so-called “flight to quality”. Unfortunately this doesn’t mean they’re a good investment right now. This is because risk and return are linked and expensive bonds aren’t likely to produce high rates of future return. In fact it’s quite likely that, on some medium term timescale that not even Auntie can guess at, they’ll be very poor investments from the current level, when many government interest rates are hovering around 0%.

Mass issuance of bonds by governments to pay for banking bail outs may also lead to an increase in inflation and bonds do very badly in an inflationary environment because their yields and total returns are fixed (the yield to maturity). If you’ve a bond paying a fixed amount every year and inflation rises rapidly the real value of your investment will be destroyed. Inflation linked government bonds, paying out a variable interest rate linked to the rate of inflation, do exist but these tend to be expensive. It’s also noticeable that those tricky governments aren’t issuing many of these, usually a sure indication that they’re concerned about inflation going forward.

Little scamps, aren’t they?

Balance Your Portfolio

Auntie would always recommend people to have some proportion of their investments in low-cost government bond funds. The wisdom of this approach has been shown over the last few years when they’ve been a good bulwark against the trials and tribulations of the stockmarket. At the current levels, though, they’re unusually risky investments and prudent investors might consider a small rebalancing of their portfolios away from government debt towards high quality corporate debt or broad based passive equity investment to be the safest option at the moment.

Love and Best Wishes, Auntie.

Clairvoyant Value

51 Years of Value Beating Growth

It’s a kind of truism in the markets that value stocks outperform growth stocks. However, it’s pretty hard to get demonstrable evidence of this. Arnott, Li and Sherrerd (2008) have come up with an interesting take on the problem. Instead of projecting forward they’ve gone back in time and looked at how companies performed in comparison to their historic earnings multiples.

By looking at this so-called clairvoyant value – analysing in hindsight – they’ve been able to show that the suspicion is correct and value stocks do outperform in terms of actual returns. However they’ve also shown that the market is generally pretty accurate in identifying growth companies – it’s just lousy at valuing them correctly.

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Is Intrinsic Value Real?

Intrinsic Value Means Different Things to Different People

The doyen of all value investors is Ben Graham, whose investing style was based around the concept of “intrinsic value”. For Graham intrinsic value was fundamentally about buying companies trading below NTAV (see Shoot the Company – Valuing By Assets). However, his most famous pupil, Warren Buffett, has redefined the concept to mean something rather different.

So if intrinsic value means something different to different people and changes its meaning over time, what’s the use of it? Is it real or illusory?

Margin of Safety

Ben Graham’s heyday was the 1930’s and 1940’s when he trashed the markets by averaging a return of around 20% a year. Brilliant though he was he still nearly went out of business in 1930 after he geared up to take advantage of cheap stocks following the Wall Street Crash. The subsequent second wave collapse nearly wiped him out, although with the aid of a timely loan he was able to make his, and his investors’, losses back in the next two years. He was ever after wary of gearing.

For Graham intrinsic value was about buying a company for less than it was worth, based on its net assets. His aim was to buy companies with a sufficient margin of safety so that if the company’s performance was less good than expected there would still be the underlying asset value to rely on. On the other hand if the company’s performance was better than expected the price would respond positively.

In those decades you could hardly give stocks away to Americans, stunned and made risk adverse by the collapse of the markets in ’29 and ’31. There were swathes of companies meeting Graham’s criteria at valuation levels that haven’t been seen again until, well, now. Even now it’s a lot more difficult to find decent stocks trading at a discount to net tangible asset value. (And Graham actually set an even tougher hurdle than this, a discount to net tangible current assets – excluding anything that couldn’t instantly be turned into cash).

Buffett Continues the Graham Way

Warren Buffett is Graham’s most famous pupil and initially made his money by trading the Graham way – although characteristically he put his own stamp on this style by savagely curtailing the number of stocks he held. When Graham shut up shop Buffett set up his partnerships and continued on until the end of the sixties.

At that point he shut the partnerships down because he could no longer find the cheap stocks that he and Graham had made their money with. He was dead right of course – it was nearly twenty years before markets rose again in real terms. His disappointed investors wound up with a bunch of cash and a few shares in some unknown failing textiles company called … Berkshire Hathaway.

Intrinsic Value Mutates

From 1970 onwards Buffett’s style of investing changed and with it the definition of intrinsic value. This seems to have part been a response to the changes in the market and part due to the influence of his partner, Charlie Munger. What they now started to do was to look for companies with the ability to grow their earnings in the long-term.

Arguably this was a switch from a value investing to a growth investing style. However, there’s a crucial difference between normal growth investing and Berkshire type growth investing: the target companies must have some feature about them that means long-term earnings growth is assured, this is not speculative. Buffett says that growth and value are both part of the valuation equation and central to this is intrinsic value, modern style – the feature required in investments to make this long-term growth realistically achievable.

Long-Term Growth is not Predictable

The problem with this, as any investor knows, is that predicting a company’s earnings from one year to the next is just about impossible. (At the moment they can’t even do it from week to week). So it’s important to note that Berkshire doesn’t expect smooth growth in earnings on its investments, but it does expect to see a substantial growth in earnings over time. The concept of intrinsic value is essential to this – a Buffett and Munger type investment is one that’s trading a significant discount to intrinsic value.

The word “significant” is, well, significant – intrinsic value is not an absolute number that you can pin down. It’s a range of possible values which are largely dependent on the long-term ability of the company to grow its earnings. Because future earnings growth is always dependent on stuff that’s, err … in the future, this can only be, at best, estimated.

Intrinsic Value and Moats

This should give some clues to what intrinsic value is about. The investment has to be a company that can pretty well guarantee a long-term increase in earnings over and above what you’d expect the market to provide (otherwise you might as well invest in an index tracker). Yet as future earnings are, by definition, an unknown this suggests some interesting requirements about the nature of the target company.

What type of company can virtually guarantee a long-term increase in earnings? Well, in Buffett terminology, it’s a company which provides something essential and has a defensive moat that prevents competitors from muscling in. Any company serving a market in which competitors can easily enter will eventually struggle to grow at more than the market rate – this is simply Adam Smith’s invisible hand in operation as competition drives down prices and margins. So any company with real intrinsic value has some kind of moat.

Looking at Berkshire’s main investments it’s pretty easy to identify the kinds of stuff this translates to. Coca Cola’s brand and distribution network is nigh on impossible to break down. The Nebraska Furniture Mart is the biggest distributor of its kind in the Mid-West and uses its buying power to get stock cheaply and pass on the savings to its customers. Sees Candy has the best customer service reputation of any business in its class. Berkshire’s insurance companies use their financial power to either beat the opposition on price or, when necessary, to refrain from quoting in order to not make losses on policies. Buffett will even incentivise staff not to write business on some occasions.

Intrinsic Value and Margin of Safety

These moats are simple but powerful and properly managed they provide companies with enormous long-term competitive advantages when backed by a management prepared to ignore short-term fluctuations. However, there is a problem with this: generally any company with such a built-in advantage will trade at a premium to other companies on the stockmarket. They’re expensive and this expense destroys the margin of safety which Graham would have insisted on.

Buffett also insists on a margin of safety. So how does he square this circle?

Stockmarkets are Dumb

Remember that he’s looking for a discount to intrinsic value where intrinsic value is the long-term value of the earnings stream that the company can generate. However, the stockmarket, being a creature with no memory and precious little intelligence, generally values companies based on short-term earnings. Which means that sometimes, although not often, the premium that well-moated companies trade at disappears.

One of Buffett’s maxims is that he prefers to buy great companies at fair prices than fair companies at cheap prices: a recognition that companies with a high intrinsic value will rarely trade at really cheap prices. However, a great company going through a temporary blip may occasionally trade at a fair price and by buying that company at such a price he gains access to the long-term earnings stream that it will provide when normal service is resumed.

Because history shows that, for anything other than dying industries, normal service will be resumed. Humans overweight the short-term and underweight the long-term. By effectively ignoring this and buying companies trading at a discount to intrinsic value Berkshire obtains access to a long-term income stream at a discounted price.

Intrinsic Value works in the Long-Term

There is one caveat to this – the company must do something that will continue to be required for a long time. Buying a cheap company in a dying industry is exactly the wrong thing to do. Which is ironic because, of course, that’s exactly what Berkshire Hathaway was when Buffett bought into it. Still, his investors aren’t complaining even though their stock has seen significant paper losses this year. Buffett and Munger are still investing with their eyes on the next twenty years, ignoring the short-term chaos in the markets and focusing fiercely on intrinsic value.

There’s a lot of it about, if you’re good and brave enough to spot it.

The Death of Homo economicus

Active Stockmarket Investment is not for the Inexperienced

Economists and political philosophers from Adam Smith to John Stuart Mill long held fast to the idea of the human being as a rational creature, one wishing to maximise their own self-interest at least effort and risk to themselves. This creature – dubbed Homo economicus by its opponents – is some kind of perfect calculating machine, weighing up risks and rewards and making logical choices in its own self-interest.

Basically it’s what an economist imagines themselves to be. Like Mr. Spock without the ears, green blood, mind melding and curious eyebrows.

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Gold!

Inflation, Insurance and Warren Buffett's Dad

From King Midas to Gordon Brown gold has always attracted legendary behaviour – although the latter’s sale of the UK’s gold reserves at a cyclically low price looks with hindsight to have been, well, less than optimal. All right, it was completely rubbish. Still, the nature of the stuff fascinates people. It’s bright and shiny, heavy and it doesn’t tarnish. And people are willing to pay good money for it. What’s not to like?

However, gold really isn’t the stuff of basic investment. It has no intrinsic value, creates no cashflows and pays no dividends. It can go radically out of fashion, sometime for decades and it doesn’t have much commercial use beyond adorning rap artistes and gilding lilies.

As an asset class it’s a very odd thing to invest in.

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Fundamental Indexing Can’t Save You from Aliens

(But Can Protect You From Nearly Everything Else)

William Bernstein, in The Four Pillars of Investing, states: “About once every generation, the markets go barking mad. If you are unprepared, you’re sure to fail”.

As indices crumble and even experienced investors start to capitulate the stockmarkets are flashing a big message to anyone with an appreciation of stockmarket history and the ability to ride out the storm. Welcome to the test of our generation.

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Sir Hugh Invents the Share and Gets Lost

What's a Share?

In 1553 Sir Hugh Willoughby set sail from England to Russia with the intention of opening the first trade route between the two countries. The idea behind his venture, the Muscovy Company or, to give it its full name (deep breath) The Mystery and Company of Merchant Adventurers for the Discovery of Regions, Dominions, Islands, and Places unknown, wasn’t unusual for the time. All across Europe explorers and merchants were sailing into the unknown in a quest for fame and, particularly, fortune.

The Muscovy Company, though, was unusual in another way. It was the first recognisably modern corporation.

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