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Finance

That number is shocking to me.  I for one think high frequency trading is a perversion of our capital markets.  People will argue that it provides liquidity but at what cost?  Read the full article over at Quartz.

“Although the SEC isn’t saying as much, experts think it’s a sign that high-frequency trading are flooding the market with orders, overwhelming the average retail or institutional investor.”

“High frequency trading firms have been known to flood the market with orders, trying to determine the price institutional or retail investors are offering, then cancel 90% of them a split-second later. This can artificially alter the price of a security, netting high-frequency traders profits at the expense of their counterparties. True, those profits are small—often just pennies. But over time, these firms make millions of dollars.”

I like Charle Schwab’s and Walt Bettinger’s solution:

“A penalty on excessive cancellations, rigorous enforcement of rules regarding information access, and a top-to-bottom study of the NYSE’s 40-year-old Market Data System would be good places to start,”

 

Buffett on Career Risk:

“Wall Street abhors a commercial vacuum.  If the will to believe stirs within the customer, the merchandise will be supplied – without warranty.  When franchise companies are wanted by investors, franchise companies will be found – and recommended by the underwriters.  If there are none to be found, they will be created.  Similarly, if above-average investment performance is sought, it will be promised in abidance – and at least the illusion will be produced.

Initially those who know better will resist promising the impossible.  As the clientele first begins to drain away, advisors will argue the un-soundness of the new trend and the strengths of the old methods.  But when the trickle gives signs of turning into a flood, business Darwinism will prevail and most organizations will adapt.  This is what happened in the money management field.”

 

Buffett on how to manage a portfolio (in this case the Washington Post’s Pension):

“(5) My final option – and the one to which I lean, although not at anything like a 45-degree angle – is mildly unconventional, thereby causing somewhat more legal risk for directors.  It may differ from other common stock programs, more in attitude than in appearance, or even results.  It involves treating portfolio management decisions much like business acquisition decisions by corporate managers.

The directors and officers of the company consider themselves to be quite capable of making business decisions, including decisions regarding the long-term attractiveness of specific business operations purchased at specific prices.  We have made decisions to purchase several television businesses, a newspaper business, etc.  And in other relationships we have made such judgments covering a much wider spectrum of business operations.

Negotiated prices for such purchases of entire businesses often are dramatically higher than stock market valuations attributable to well-managed similar operations.  Longer term, rewards to owners in both cases will flow from such investments proportional to the economic results of the business.  By buying small pieces of businesses through the stock market rather than entire businesses through negotiation, several disadvantages occur: (a) the right to manage, or select mangers, is forfeited; (b) the right to determine dividend policy or direct the areas of internal investment is absent; (c) ability to borrow long-term against the business assets (versus against the stock position) is greatly reduced; and (d) the opportunity to sell the business on a full-value, private-owner basis is forfeited.

These are important negative factors but, if a group of investments are carefully chosen at a bargain price, it can minimize the impact of a single bad experience, in say, the management area, which cannot be corrected.  And occasionally there is an offsetting advantage which can be of very substantial value – but for which nothing should be paid at the time of purchase.  That relates to the periodic tendency of stock markets to experience excesses which cause businesses – when changing hands in small pieces through stock transactions – to sell at prices significantly above privately-determine negotiated values.  At such times, holdings may be liquidated at better prices than if the whole business were owned – and, due to the impersonal nature of securities markets, no moral stigma need be attached to dealing with such unwitting buyers.

Stock market prices may bounce wildly and irrationally but, if decisions regarding internal rates of return of the business are reasonably correct – and a small portion of the business is bought at a fraction of its private-owner value – a good return for the fund should be assured over the time span against which pension fund results should be measured.

It might be asked what the difference is between this approach and simply pick stocks a la Morgan, Scudder, Stevens, etc.  It is, in large part, a matter of attitude, whereby the results of the business become the standard against which measurements are made rather than quarterly stock prices.  It embodies a long time span for judgement confirmation, just as does an investment by a corporation in a major new division, plant or product.  It treats stock ownership as business ownership with the corresponding adjustment in mental set.  And it demands an excess of value over price paid, not merely a favorable short-term earnings or stock market outlook.  General stock market considerations simply don’t enter into the purchase decision.

Finally, it rests on a belief, which both seems logical and which has been borne out historically in securities markets, that intrinsic business value is the eventual prime determinant of stock prices.  In the words of my former boss: ‘in the short run the market is a voting machine, but in the long run it is a weighing machine.'”

A nice analysis of moats by Credit Suisse.  Report embedded below – followed by Buffett’s quotes on moats.  Note the Value Creation Checklist on p. 52 of the analysis.

Warren Buffett on Economic Moats

“What we refer to as a “moat” is what other people might call competitive advantage . . . It’s something
that differentiates the company from its nearest competitors – either in service or low cost or taste or
some other perceived virtue that the product possesses in the mind of the consumer versus the next best  alternative . . . There are various kinds of moats. All economic moats are either widening or narrowing – even though you can’t see it.”

— Outstanding Investor Digest, June 30, 1993

“Look for the durability of the franchise. The most important thing to me is figuring out how big a moat  there is around the business. What I love, of course, is a big castle and a big moat with piranhas and crocodiles.”

— Linda Grant, “Striking Out at Wall Street,” U.S. News & World Report, June 12, 1994

“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the
durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”

— Warren Buffett and Carol Loomis, “Mr. Buffett on the Stock Market,” Fortune, November 22, 1999

We think of every business as an economic castle. And castles are subject to marauders. And in
capitalism, with any castle . . . you have to expect . . . that millions of people out there . . . are thinking
about ways to take your castle away.  Then the question is, “What kind of moat do you have around that castle that protects it?”

— Outstanding Investor Digest, December 18, 2000

“When our long-term competitive position improves . . . we describe the phenomenon as “widening the moat.” And doing that is essential if we are to have the kind of business we want a decade or two from now. We always, of course, hope to earn more money in the short-term. But when short-term and longterm conflict, widening the moat must take precedence. ”

— Berkshire Hathaway Letter to Shareholders, 2005

“A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns . . . Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all . . . Additionally, this criterion eliminates the business whose success depends on having a great manager.”

— Berkshire Hathaway Letter to Shareholders, 2007

 

Found via Punchcard Investing Blog

Seth_Klarman_Views_(24_pgs) June 2013

I’ve been meaning to read this for a while – I can’t remember where I came across this or who I owe credit to for originally posting this but thank you.  This is probably the best piece I’ve read all summer, maybe all year.

For this blog post I originally started jotting down excerpts from this speech that resonated with me.  I quickly realized that I was writing down everything – literally re-transcribing the entire speech.  I would have copied and pasted the whole thing for you, dear reader, but this appears to be a scanned copy of a printed document.

Anyway, give it a read – don’t be daunted by the 24 pages, it’s actually a very quick read and it is well worth your time.

Enjoy.

This month’s quarterly letter consisted of two separate essays authored by Ben Inker and James Montier.  Jeremy Grantham, GMO’s usual commentator, decided to have one less summer deadline and put his efforts into taking on a “tougher topic” for a later letter – can’t wait to see what that will be.  Anyway, below are some elements of the letters that resonated with me…

Ben Inker – What the *&%! Just Happened?

  • Since 2009 it has been difficult to avoid making money in the financial markets. Nominal bonds, inflation linked bonds, commodities, credit, equities, real estate – everything – has  been bid up as a consequence of the very low expected returns of cash. And this gives today’s markets a vulnerability that has not existed through most of history. Today’s valuations only make sense in light of low expected cash rates. Remove that expectation, and pretty much every asset across the board is vulnerable to a fall in price, as the rising real discount rate plays no favorites. [emphasis is Inker’s not mine]
  • Under normal circumstances, a rising real discount rate would probably come on the back of rising inflation or stronger than expected growth, which are diversifiable risks in a portfolio. But May’s shock to the real discount rate came not because inflation was unexpectedly high or because growth will be so strong as to lift earnings expectations for equities and other owners of real assets, but because the Fed signaled that there was likely to be an end to financial repression in the next few years. And because financial repression has pushed up the prices of assets across the board and around the world, there is unlikely to be a safe harbor from the fallout, other than cash itself.
  • I would like to say that having warned investors of this problem, we were able to spare our clients losses in this environment. But most of the reason we have been complaining about this issue as loudly and continuously as we have is that there is no good way out

James Montier – The Purgatory of Low Return

  • Finds nearly every asset class expensive, calling this a “‘foie gras’ bubble as investors are being force-fed higher risk assets at low prices”.  He even cites Brian Sack of the New York Fed: A primary channel through which this effect takes place is by narrowing the risk premiums on the assets being purchased. By purchasing a particular asset, the Fed reduces the amount of the security that the private sector holds, displacing some investors and reducing the holdings of others. In order for investors to be willing to make those adjustments, the expected return on the security has to fall. Put differently, the purchases bid up the price of the asset and hence lower its yield. These effects would be expected to spill over into other assets that are similar in nature, to the extent that investors are willing to substitute between the assets. These patterns describe what researchers often refer to as the portfolio balance channel.
  • “… if you don’t know what is going to happen, don’t structure your portfolio as though you do!”
  • The only scenario under which treasuries do “well” is one with outright deflation! In essence, in the
    absence of a strong view on deflation, you neither want to be long, nor short, treasuries. You just don’t want to own any.
  • Ultimately, if you own bonds as insurance you must ask yourself how much you are
    paying for that insurance, because insurance is as much a valuation-driven proposition as anything else in investing
  • Remember that leverage can never turn a bad investment into a good one, but it can turn a good investment into a bad one (by forcing you to sell at just the wrong point in time).
  • Be Patient. This is the approach we favour. It combines the mindset of the concentration “solution” – we are simply looking for the best risk-adjusted20 returns available, with a willingness to acknowledge that the opportunity set is far from compelling and thus one shouldn’t be fully invested. Ergo, you should keep some “powder dry” to allow you to take advantage of shifts in the opportunity set over time. Holding cash has the advantage that as it moves to “fair value” it doesn’t impair your capital at all.
    Of course, this last approach presupposes that the opportunity set will shift at some point in the future. This seems like a reasonable hypothesis to us because when assets are priced for perfection (as they generally seem to be now), it doesn’t take a lot to generate a disappointment and thus a re-pricing (witness the market moves in the last month). Put another way, as long as human nature remains as it has done for the last 150,000 years or so, and we swing between
    the depths of despair and irrational exuberance, then we are likely to see shifts in the opportunity set that we hope will allow us to “out-compound” this low-return environment. As my grandmother used to chide me, “Good things come to those who wait.”

A nice article from the WSJ about the lack of compelling investments at the moment and the pain of holding cash (link)

The author mentions the fact that the king of value investing himself, Warren Buffett is holding “his biggest cash hoard ever” with $49 billion sitting on the books.  That’s a lot of cash but I’d like to see it as a relative measurement (say as a percentage of Berkshire’s assets or investable assets) to get a better sense for how cautious the Oracle really is.

Perhaps my favorite part of the article is when the author alludes to the value of cash over and above its paltry interest rate: it’s optionality.

Mr. de Vaulx adds that cash is dry powder, worth more than people think because it lets him buy cheaply once stocks decline — as overvalued stocks typically do. Like-minded investors realize they may have to wait months or more, as happened in the late 1990s, when broad stock indexes began a surge to record levels that most tech stocks still haven’t seen again. Value investors suffered then but were vindicated when prices collapsed.

This reminds me of a GMO white paper published by James Montier in 2011 – I think its a good time to dust that off and post it here for you, dear reader.

An oldie but a goodie from James Montier, back when he was with Dresdner Kleinwort Wasserstein.

Montier outlines the seven sins:

  1. Forecasting (Pride)
  2. The illusion of knowledge (Gluttony)
  3. Meeting companies (Lust)
  4. Thinking you can outsmart everyone else (Envy)
  5. Short time horizons and over trading (Avarice)
  6. Believing everything you read (Sloth)
  7. Group based decisions (Wrath)

Honorable mention: the illusion of control, the possibility of having too much choice, and benchmarking

Montier provides a brief summary on each of these sins but goes on to dedicate a chapter to each:

This collection of notes aims to explore some of the more obvious behavioural weaknesses inherent in the ‘average’ investment process.

► Seven sins (common mistakes) were identified. The first was placing forecasting at the very heart of the investment process. An enormous amount of evidence suggests that investors are generally hopeless at forecasting. So using forecasts as an integral part of the investment process is like tying one hand behind your back before you start.

► Secondly, investors seem to be obsessed with information. Instead of focusing on a few important factors (such as valuations and earnings quality), many investors spend countless hours trying to become experts about almost everything. The evidence suggests that in general more information just makes us increasingly over-confident rather than better at making decisions.

► Thirdly, the insistence of spending hours meeting company managements strikes us as bizarre from a psychological standpoint. We aren’t good at looking for information that will prove us to be wrong. So most of the time, these meetings are likely to be mutual love ins. Our ability to spot deception is also very poor, so we won’t even spot who is lying.

► Fourthly, many investors spend their time trying to ‘beat the gun’ as Keynes put it. Effectively, everyone thinks they can get in at the bottom and out at the top. However, this seems to be remarkably hubristic.

► Fifthly, many investors seem to end up trying to perform on very short time horizons and overtrade as a consequence. The average holding period for a stock on the NYSE is 11 months! This has nothing to do with investment, it is speculation, pure and simple.

► Penultimately, we all appear to be hardwired to accept stories. However, stories can be very misleading. Investors would be better served by looking at the facts, rather than getting sucked into a great (but often hollow) tale.

► And finally, many of the decisions taken by investors are the result of group interaction. Unfortunately groups are far more a behavioural panacea. In general, they amplify rather than alleviate the problems of decision making.

► Each of these sins seems to be a largely self imposed handicap when it comes to trying to outperform. Identifying the psychological flaws in the ‘average’ investment process is an important first step in trying to design a superior version that might just be more robust to behavioural biases.