Monday, September 30, 2013
Great Michael Price Interview
http://www.marketfolly.com/2013/06/michael-prices-presentation-from-london.html
Monday, September 23, 2013
2013 Pabrai Investment Funds Annual Meeting Notes
I had the honor to attend the Pabrai Investment Funds annual meeting in
Chicago this past Saturday. It was a great learning experience. Mohnish
did a fantastic job and it was really fantastic of him to take the time
answering investors' questions both during the meeting and after the
meeting. Truly a remarkable man!
Here are my notes:
General Comments:
Mohnish commented on the performance of the funds first. Most of the funds handsomely beat the best index by a considerable margin (except for PIF 4, still beat the best index but by a small margin). Only 1 out of 200 fund mangers can beat the S&P by more than 3% annually and Mohnish’s certainly done that. The funds have done better than the market this year both as of 6/30 and as of 8/31.
Value Proposition:
Update on the Japanese Net Net:
The Pabrai funds invested in a basket of Japanese net net starting October 2010. Mohnish has exited all the positions with a realized gain of 2.2% including dividends, or 1.4% annualized. To me, this is surprising as the Japanese market has advanced significantly since October 2010. In search of explanation, Mornish referred to a few quotes from Ben Graham from the 1940 edition of Security Analysis. Here is one:
"It may be pointed out, however, that investment in such bargain issues needs to be carried on with some regard to general market conditions at the time. Strangely enough, this is a type of operation that fares best, relatively speaking, when price levels are neither extremely high nor extremely low."
Mohnish expanded on this by stating that when the market bottoms it's much better to buy quality companies that have fallen precipitously with the market rather than focus on net-nets. When the market flies, net-nets are also ignored because investors shift their focus to both quality companies and story stocks.
Examples include Hibiya Engineering and Ryoyo Electro. Both were trading below NCAV at the time of his investment, generating profits as well as positive and consistent cash flows. Managements of both companies were also repurchasing shares. Hibiya ended up just a little bit profitable and Ryoyo turned out be a -15% loss.
Question and Answer:
1. Further comments on the Japanese net net investments. Why did the funds exit all net net positions? Is Ben Graham right about net-net not working in a trending market?
Mohnish said he wanted to have the optionality of cash and he wasn't comfortable at the level of cash holdings Therefore he exited the net net basket. He also mentioned that the market's skeptical about Japanese companies' managements' willingness and ability to unlock value for shareholders.
2. Question on the equation Mohnish used in net net: Net Asset + Long Term Bond - All Liabilities. Is long term bond double-counted?
Long term bond here is not long term debt. It refers to the fixed income investments on the balance sheet as assets. They can be converted to cash easily.
3. Question regarding the commercials played during the meeting.
There are two more commercials coming up. He can't answer this one.
4. Thoughts on market for the rest of 2013? What is the minimum investment for the funds?
No idea what the market will do for the rest of 2013 and he won't even try. Minimum investment in the Pabrai funds now is $2.5 million.
5. Question regarding concentration versus diversification.
Mohnish moved from 10/10 allocation model (10 ideas each 10%) to 10/5/2. During December 2008, so many stocks are trading at bargain price and they are coming in so fast and furious so he didn't have the time to figure out which one to pass. The funds invested 2% in each. Then as the market advances, his 14th or 15th position will not be as good as his top positions. He wants to have the flexibility to make those 2% and 5% bets but generally will limit the position size to 10%.
6. In a recent book about John Templeton, Mohnish wrote some comments about how he traveled to different business schools and talked to the students about companies with amazing financials. What are the companies?
Mohnish said he is clueless about that. Maybe he needs to reread what he wrote. (laughter)
7. As a result of the Japanese net net investment, did you add anything to the checklist and if so, what is it?
He made the addition of when buying a basket of net net, make sure the market is not too high, not too low. ( I didn't quite catch this exactly) He found it very hard to believe that the net net investments only resulted in a 2.2% gain including dividends. It seems so obvious at the time of the investment.
8. Question on net net and checklist, do you look a lot into management and if so, what do you look at? What's your thought on management's capital allocation decisions?
The checklist is created by looking at his mistakes and other investors' mistake and coming up with ad-hoc questions that should've been asked prior to the investment. He then categorized these questions into a few baskets such as leverage, management. In terms of management, he looks at factors such as ownership percentage, alignment of interest, and management compensation. He also looks at management's capital allocation record but management rarely allocates capital perfectly and it's ok if the investment is compelling. He's made a lot of investment in companies whose management is not very good at allocating capitals.
9. It seems like most of your holdings are large cap blue chips stocks. Going forward, are you planning to switch to more small cap and mid caps?
Mohnish said that most of his investments are not in large cap blue chips stocks. He would love them to convert to blue chips though. His approach is opportunistic because he is not pursuing after a specific asset class. It happens to be during the past year or so, he has invested in a few blue chips but that could change a year from now.
10. Two part question. What's your thought on post crisis ROE of banks? How do you incorporate macro into your investment analysis?
There are both headwinds and tailwinds for the banks. The tailwinds include less competition for big banks and technology advancement that cut labor cost. The headwind is higher capital requirement and stricter regulation but he thinks that's good for the banks in the long run.
In general, you will always better off focusing on the micro than the macro. For example, there's a McDonald's close to his house and he's fascinated by the efficiency of the drive through operation. If you look at that business, does an increase in the interest rate or unemployment rate impact that business as much as an opening of an In & Out next door? Obviously the latter has a larger impact.
11. What are your thoughts on activism? Do you follow any activist investors?
Mohnish said he's always been skeptical about the activist's impact on business. He thinks in general, activism is overrated. It's not easy to force changes in public companies. It's an acrimonious way to go through life. He will be much better off without being involved in activism. He does not follow any activist investors.
12. When you invested in Delta Financial, the sentiment for mortgage business was high, how do you balance investor enthusiasm with true value of the business?
Investing in Delta Financial is a straight stupid mistake, not sentiment driven. He basically made a basic mistake by not appropriately assessing the downside. You'll make errors all the time in this business. You have to focus on the specific of business, not the sentiment and macro.
13. Would you taper or not taper? What are your thoughts on Indian Rupees?
Mohnish said "so you ask me to be the Fed Chair? Good thing I'm not." All jokes aside, he would be on the side of Bernanke. The fall of Rupee is interesting. To some extent, he thinks it is an overdose to skepticism. But it doesn't matter what the Rupee does, if you invest in India, you still want to focus on micro.
14. Questions on Japanese net net, did you factor in the liquidity issue before your investment?
The net net investments he made in Japan were not the absolute cheapest and they are not very liquid. It took the funds a year to get in and another year to get out. The problem is, most net net situations are with micro cap and small cap companies and they are inherently not as liquid as large caps.
15. How did you get started in the investment management business?
Mohnish said prior to his launch of the partnership, he had a few years of good returns with his money and he was giving stock tips to his friends. His friends suggested him to start a partnership to make it more official. So Mohnish started the partnership with 8 other friends' money. He was still running a business and a day job back then. To him, managing a million does not requirement too much extra work. When he set up the partnership, he wanted to set it up in the fairest way possible. He actually guaranteed the principle for his early investors and he took it out later. If you are interested in creating an investment business, you should start by creating a track record that is audited so you can show it to your investors. If you beat the indices consistently, people will swim to you.
16. If you were to go back to when you started, what would be the things you advice to read? And if you don't look at the macros so much, how did you come up with these international investments.
Each person is different. But he found Manual of Ideas and Corner of Berkshire and Fairfax very helpful. There are other good resources out there and it's better to copy other's ideas. Japanese net net was his original idea and we all know how it ended up (laughter).
17. At this time last year, Apple was going up everyday up to around 700 and someone during the meeting last year asked you if you would buy Apple. Why did you not buy apple?
Apple is a fantastic business with an incredible franchise. What keeps him away from Apple is because it is in an industry with rapid changes. The second thing that dissuade him, Apple is a super large cap and you are not going to find 2x, 3x returns in large cap blue chips. You will find better opportunities in smaller caps.
18. Do you use options and futures? How do you make the decision, based on fundamental analysis or technical analysis because fundamental tells you what to buy and technical analysis tells you when to buy and when to sell?
Don't use options or futures. Makes decisions based on fundamentals only.
19. I was wondering in general, what are your take on Europe (especially the financials)?
In general, it is very likely that many opportunities exist in Europe. There are many opportunities out there but he doesn't understand the country dynamics or the businesses. It may not be a bad place to start if the country is going through stress. Especially European companies with revenues from all across the globe.
20. What are your thoughts process behind keeping your funds closed?
The funds are closed because he can't find anything to buy and he thinks he has more capital than ideas. If that shifts sometimes in the future when he has more ideas than capital, he'll open up the fund. Furthermore, he has no incentives to increase the asset under management, unlike the other investment managers. The other thing he would prefer to do is to raise money at the right time. Historically when the funds got massive inflows when the funds were performing well and got no inflows when the funds were performing poorly. He was desperate in raising capitals back in late 2008 and early 2009 and was not successful. However, at the peak of 2007, investors are throwing money in. The less, be patient and be ready when opportunities arrive.
21. I didn't quite catch this one but it was related to the comparing some investment to Berkshire Hathaway and which is a better investment in his opinion.
Mohnish said he's glad he's not benchmarked against Berkshire. Buffett has the disadvantage of size but he should be able to beat the S&P 500. He hopes Warren will do better.
22. What is your strategy in terms of picking out the ideas for further research when you go through the holdings of others? And how have you used the checklist to rule out ideas that can potentially turn out to be mistakes? If you had used the checklist, would you have invested in Delta Financials?
That's a good problem to have in the first place. You can trim the list by picking out the ones they have the highest convictions.
There are many examples that the checklist prevented him from investing in an idea but most of his ideas don't even get to the checklist phase. In the last 14 months, he has looked at many many things and for one thing or another, he turned them down. He also has conversation with other money managers and very often, during these conversations, the ideas are killed. The checklist is used to highlight the things that he has thought about. If he had run the checklist, he wouldn't have bought Delta Financials.
23. Question on the checklist, are you concerned that your may have raised the bar too high?
He doesn't think the checklist list has raised the bar to high. Any companies he run the checklist on will have some issues. The checklist is not too demanding. He's sure many many things that he passed on will end up doing well. The thing that usually stops him is the downside, which may never materialize. But that's the kind of things you should look at prior to making an investment decision.
24. What are your thought on selling? Does the rise or fall of interest rates change the discount rate you use?
Typically he sells at 90% of intrinsic value. The interest rate doesn't really affect the discount rate he uses. In general, a discount rate of 6%-9% should be ok.
25. This question comes from an equity research analyst. Have you ever been tempted to short?
He said he has not been tempted to short at all. He thinks shorting can be a way to make money but the timing is too tricky, you can be right but it can take a long time to prove it. Also the maximum gain you can get is 100% but the maximum loss is unlimited
Here are my notes:
General Comments:
Mohnish commented on the performance of the funds first. Most of the funds handsomely beat the best index by a considerable margin (except for PIF 4, still beat the best index but by a small margin). Only 1 out of 200 fund mangers can beat the S&P by more than 3% annually and Mohnish’s certainly done that. The funds have done better than the market this year both as of 6/30 and as of 8/31.
Value Proposition:
- No management fees, only performance fees.
- Pabrai family is the 2nd largest investor.
- High watermark.
- No leverage, no margin loans, no short positions.
- Great investor base ( a worth-noting one in my opinion). Most investors did not panic and redeem during bad times.
- HAVEN'T MADE A MISTAKE FOR A FEW YEARS.
- Few big ideas during 2011 and 2012 generated good returns.
- Fully exited the Japanese net net basket investments (see below).
Update on the Japanese Net Net:
The Pabrai funds invested in a basket of Japanese net net starting October 2010. Mohnish has exited all the positions with a realized gain of 2.2% including dividends, or 1.4% annualized. To me, this is surprising as the Japanese market has advanced significantly since October 2010. In search of explanation, Mornish referred to a few quotes from Ben Graham from the 1940 edition of Security Analysis. Here is one:
"It may be pointed out, however, that investment in such bargain issues needs to be carried on with some regard to general market conditions at the time. Strangely enough, this is a type of operation that fares best, relatively speaking, when price levels are neither extremely high nor extremely low."
Mohnish expanded on this by stating that when the market bottoms it's much better to buy quality companies that have fallen precipitously with the market rather than focus on net-nets. When the market flies, net-nets are also ignored because investors shift their focus to both quality companies and story stocks.
Examples include Hibiya Engineering and Ryoyo Electro. Both were trading below NCAV at the time of his investment, generating profits as well as positive and consistent cash flows. Managements of both companies were also repurchasing shares. Hibiya ended up just a little bit profitable and Ryoyo turned out be a -15% loss.
Question and Answer:
1. Further comments on the Japanese net net investments. Why did the funds exit all net net positions? Is Ben Graham right about net-net not working in a trending market?
Mohnish said he wanted to have the optionality of cash and he wasn't comfortable at the level of cash holdings Therefore he exited the net net basket. He also mentioned that the market's skeptical about Japanese companies' managements' willingness and ability to unlock value for shareholders.
2. Question on the equation Mohnish used in net net: Net Asset + Long Term Bond - All Liabilities. Is long term bond double-counted?
Long term bond here is not long term debt. It refers to the fixed income investments on the balance sheet as assets. They can be converted to cash easily.
3. Question regarding the commercials played during the meeting.
There are two more commercials coming up. He can't answer this one.
4. Thoughts on market for the rest of 2013? What is the minimum investment for the funds?
No idea what the market will do for the rest of 2013 and he won't even try. Minimum investment in the Pabrai funds now is $2.5 million.
5. Question regarding concentration versus diversification.
Mohnish moved from 10/10 allocation model (10 ideas each 10%) to 10/5/2. During December 2008, so many stocks are trading at bargain price and they are coming in so fast and furious so he didn't have the time to figure out which one to pass. The funds invested 2% in each. Then as the market advances, his 14th or 15th position will not be as good as his top positions. He wants to have the flexibility to make those 2% and 5% bets but generally will limit the position size to 10%.
6. In a recent book about John Templeton, Mohnish wrote some comments about how he traveled to different business schools and talked to the students about companies with amazing financials. What are the companies?
Mohnish said he is clueless about that. Maybe he needs to reread what he wrote. (laughter)
7. As a result of the Japanese net net investment, did you add anything to the checklist and if so, what is it?
He made the addition of when buying a basket of net net, make sure the market is not too high, not too low. ( I didn't quite catch this exactly) He found it very hard to believe that the net net investments only resulted in a 2.2% gain including dividends. It seems so obvious at the time of the investment.
8. Question on net net and checklist, do you look a lot into management and if so, what do you look at? What's your thought on management's capital allocation decisions?
The checklist is created by looking at his mistakes and other investors' mistake and coming up with ad-hoc questions that should've been asked prior to the investment. He then categorized these questions into a few baskets such as leverage, management. In terms of management, he looks at factors such as ownership percentage, alignment of interest, and management compensation. He also looks at management's capital allocation record but management rarely allocates capital perfectly and it's ok if the investment is compelling. He's made a lot of investment in companies whose management is not very good at allocating capitals.
9. It seems like most of your holdings are large cap blue chips stocks. Going forward, are you planning to switch to more small cap and mid caps?
Mohnish said that most of his investments are not in large cap blue chips stocks. He would love them to convert to blue chips though. His approach is opportunistic because he is not pursuing after a specific asset class. It happens to be during the past year or so, he has invested in a few blue chips but that could change a year from now.
10. Two part question. What's your thought on post crisis ROE of banks? How do you incorporate macro into your investment analysis?
There are both headwinds and tailwinds for the banks. The tailwinds include less competition for big banks and technology advancement that cut labor cost. The headwind is higher capital requirement and stricter regulation but he thinks that's good for the banks in the long run.
In general, you will always better off focusing on the micro than the macro. For example, there's a McDonald's close to his house and he's fascinated by the efficiency of the drive through operation. If you look at that business, does an increase in the interest rate or unemployment rate impact that business as much as an opening of an In & Out next door? Obviously the latter has a larger impact.
11. What are your thoughts on activism? Do you follow any activist investors?
Mohnish said he's always been skeptical about the activist's impact on business. He thinks in general, activism is overrated. It's not easy to force changes in public companies. It's an acrimonious way to go through life. He will be much better off without being involved in activism. He does not follow any activist investors.
12. When you invested in Delta Financial, the sentiment for mortgage business was high, how do you balance investor enthusiasm with true value of the business?
Investing in Delta Financial is a straight stupid mistake, not sentiment driven. He basically made a basic mistake by not appropriately assessing the downside. You'll make errors all the time in this business. You have to focus on the specific of business, not the sentiment and macro.
13. Would you taper or not taper? What are your thoughts on Indian Rupees?
Mohnish said "so you ask me to be the Fed Chair? Good thing I'm not." All jokes aside, he would be on the side of Bernanke. The fall of Rupee is interesting. To some extent, he thinks it is an overdose to skepticism. But it doesn't matter what the Rupee does, if you invest in India, you still want to focus on micro.
14. Questions on Japanese net net, did you factor in the liquidity issue before your investment?
The net net investments he made in Japan were not the absolute cheapest and they are not very liquid. It took the funds a year to get in and another year to get out. The problem is, most net net situations are with micro cap and small cap companies and they are inherently not as liquid as large caps.
15. How did you get started in the investment management business?
Mohnish said prior to his launch of the partnership, he had a few years of good returns with his money and he was giving stock tips to his friends. His friends suggested him to start a partnership to make it more official. So Mohnish started the partnership with 8 other friends' money. He was still running a business and a day job back then. To him, managing a million does not requirement too much extra work. When he set up the partnership, he wanted to set it up in the fairest way possible. He actually guaranteed the principle for his early investors and he took it out later. If you are interested in creating an investment business, you should start by creating a track record that is audited so you can show it to your investors. If you beat the indices consistently, people will swim to you.
16. If you were to go back to when you started, what would be the things you advice to read? And if you don't look at the macros so much, how did you come up with these international investments.
Each person is different. But he found Manual of Ideas and Corner of Berkshire and Fairfax very helpful. There are other good resources out there and it's better to copy other's ideas. Japanese net net was his original idea and we all know how it ended up (laughter).
17. At this time last year, Apple was going up everyday up to around 700 and someone during the meeting last year asked you if you would buy Apple. Why did you not buy apple?
Apple is a fantastic business with an incredible franchise. What keeps him away from Apple is because it is in an industry with rapid changes. The second thing that dissuade him, Apple is a super large cap and you are not going to find 2x, 3x returns in large cap blue chips. You will find better opportunities in smaller caps.
18. Do you use options and futures? How do you make the decision, based on fundamental analysis or technical analysis because fundamental tells you what to buy and technical analysis tells you when to buy and when to sell?
Don't use options or futures. Makes decisions based on fundamentals only.
19. I was wondering in general, what are your take on Europe (especially the financials)?
In general, it is very likely that many opportunities exist in Europe. There are many opportunities out there but he doesn't understand the country dynamics or the businesses. It may not be a bad place to start if the country is going through stress. Especially European companies with revenues from all across the globe.
20. What are your thoughts process behind keeping your funds closed?
The funds are closed because he can't find anything to buy and he thinks he has more capital than ideas. If that shifts sometimes in the future when he has more ideas than capital, he'll open up the fund. Furthermore, he has no incentives to increase the asset under management, unlike the other investment managers. The other thing he would prefer to do is to raise money at the right time. Historically when the funds got massive inflows when the funds were performing well and got no inflows when the funds were performing poorly. He was desperate in raising capitals back in late 2008 and early 2009 and was not successful. However, at the peak of 2007, investors are throwing money in. The less, be patient and be ready when opportunities arrive.
21. I didn't quite catch this one but it was related to the comparing some investment to Berkshire Hathaway and which is a better investment in his opinion.
Mohnish said he's glad he's not benchmarked against Berkshire. Buffett has the disadvantage of size but he should be able to beat the S&P 500. He hopes Warren will do better.
22. What is your strategy in terms of picking out the ideas for further research when you go through the holdings of others? And how have you used the checklist to rule out ideas that can potentially turn out to be mistakes? If you had used the checklist, would you have invested in Delta Financials?
That's a good problem to have in the first place. You can trim the list by picking out the ones they have the highest convictions.
There are many examples that the checklist prevented him from investing in an idea but most of his ideas don't even get to the checklist phase. In the last 14 months, he has looked at many many things and for one thing or another, he turned them down. He also has conversation with other money managers and very often, during these conversations, the ideas are killed. The checklist is used to highlight the things that he has thought about. If he had run the checklist, he wouldn't have bought Delta Financials.
23. Question on the checklist, are you concerned that your may have raised the bar too high?
He doesn't think the checklist list has raised the bar to high. Any companies he run the checklist on will have some issues. The checklist is not too demanding. He's sure many many things that he passed on will end up doing well. The thing that usually stops him is the downside, which may never materialize. But that's the kind of things you should look at prior to making an investment decision.
24. What are your thought on selling? Does the rise or fall of interest rates change the discount rate you use?
Typically he sells at 90% of intrinsic value. The interest rate doesn't really affect the discount rate he uses. In general, a discount rate of 6%-9% should be ok.
25. This question comes from an equity research analyst. Have you ever been tempted to short?
He said he has not been tempted to short at all. He thinks shorting can be a way to make money but the timing is too tricky, you can be right but it can take a long time to prove it. Also the maximum gain you can get is 100% but the maximum loss is unlimited
Thursday, September 19, 2013
Behavioral Biases and Value Traps
Value investing is a tricky blend of art and science. The science part is usually quantifiable with information obtained from annual reports, proxy statements, industry surveys and various other sources. The art part of value investing generally involves a decent and sometimes even an uncomfortable amount of judgment to be made about the future of the business involved. The best value investors are as much as a great scientists as they are fabulous artists. However, even the best of best fall into value traps. Just think about Warren Buffett's acquisition of Berkshare Hathaway and Seth Klarman's purchase of Hewlett Packard. Naturally, one may ask, if even the sharpest minds are ensnared by mirage-like value traps occasionally, are they just unavoidable?
Unfortunately, the answer is yes. If you live close to the ocean, you will get wet one day. Value investors search for bargains in a sea of beaten-down stocks. Some are no brainers, some are value gems, and some are value traps. The one common and defining characteristics of these stock, is cheapness, which is the reason why value investors are enthralled. Sadly, there are a variety of reasons why they are on sale and it is not obvious how to differentiate between the legitimate ones and the twaddling. The only way to never get yourself into one of these situations is to shop somewhere else, but that would potentially lead us out of our circle of competence.
Common characteristics of value traps are discussed many times on gurufocus, readers can search the key words "value traps" and many articles will pop up, my favorite one is :
http://www.gurufocus.com/news/171556/avoiding-value-traps-a-four-question-test
The behavioral biases that make value investors prone to catching "falling knives", however, have not been examined extensively.I venture to contribute my two cents on this subject because as I look back to some of the worst investment decisions that I have made (e.g Radio Shack, Nokia), all of them involved the interactions of at least a few cognitive and emotional biases, or what Charlie Munger called the Lollapalooza Effect. The confluence of these biases is so powerful that it is almost impossible to escape once you are in. The most rational way to cope with situations like this, is to understand the biases in force and to develop a strategy of mitigation. While almost every behavioral bias can be related to investing in value traps, I found the following ones particularly powerful:
Anchoring: Investors are likely to have a anchor price prior to making an investment decision. It is not necessarily a bad thing if you have the right anchor. For experienced value investors, the anchor price should undoubtedly be the conservatively estimated intrinsic value of the whole business. However, novice investors often commit the mistake of anchoring to the wrong price such as the 52-week high per share price or even the previous all-time high price. I still vividly remember 3 years ago, prior to Research In Motion's precipitous drop, I bought RIMM at a little over $50 per share (now BBRY) because I naively anchored myself to RIMM's 52-week high of more than $80 per share. Our brain releases Dopamine at the anticipation of rewards. Dopamine’s role was to for us to act to get the reward, so we would not miss out. Therefore, if we set the anchor wrong, we will be temped to react in order to reap the imaginary rewards. In this case, my imaginary reward was about thirty dollars based on my wrongfully chosen anchor price and my brain pushed me to act so that I would not miss the reward. In hindsight, this is all amusing but when you experience it the first time, it's real and powerful. As stated above, to overcome the anchoring bias, or more precisely, to set up the right anchor, we should use the conservatively estimate intrinsic value as our anchor price. Failure to do so will likely result in unsatisfactory results.
Availability Bias: Investors estimate future outcomes based on how easily past events can be recalled. This is especially dangerous when past memories are biased or incomplete. An investor may select investments based on promotional advertising or a shout-out from Jim Cramer, both of which are often easily retrieved because they are inherently more memorable. An investor may also exhibit the availability bias when choosing to invest in a stock because he or she incorrectly estimates the preferences of others based on his or her own preference. Many value traps are stocks of companies such as Radio Shack and Nokia with great brand names. If you are an investor and you like to shop at Radio Shack or you like Nokia phones, you are prone to extrapolate that others should also like Radio Shack or Nokia when in reality they don't, or at least not as much as you do. I purchased Nokia more than years ago for this exact reason. I had always liked Nokia's cellphones and I know a few other close friends in China who are die-hard Nokia supporters. Therefore, I thought the business deterioration is not as bad as other investors thought. Boy, what a lesson that was. The availability bias combined with the confirmation bias (I diligently looked for information that confirmed my belief), and the conservatism bias (I put more emphasis on Nokia's past record) created my worst investment loss. I am still a fan of Nokia but now my memories with Nokia are indeed bitter and sweet. This episode of my investment fiasco taught me to disassociate my feelings towards the target company and conduct more diligent research before making an investment decision
Conservatism bias: Investors subconsciously place more emphasis on old information and place less value on new information. The human brain is wired to resist changes. Assumptions or events that have worked well during the past tend to be continually applied to new situations. With regards to value traps, this bias kicks in when an investor cling to a particular view usually regarding a previously successful business and react slowly to information that could signal a change in trend or underlying business fundamental. Recent examples include Kodak, Nokia, Radio Shack, and Hewlett Packard. These are iconic brands that were once dominating in their respective fields. Investors, who had previously followed the stocks of these companies may think the brands name remain intact or not as tarnished as the general public thinks. Hewlett Packard is a great example. The old information will suggest that HP is a great brand with a decent market share in the PC market; companies are still purchasing HP laptops for business uses; Free Cash Flow is still positive and the valuation multiples are low compared to historical averages. The new information will tell you that HP is still a great brand, but the growth of smartphones and tablets is gradually eroding PC's market; gross profit is declining; free cash flow is declining due to the increase in capital expenditures as well as the increasing number of acquisitions. If you are subject to the conservatism bias, you will shrug off the new information, which signals fundamental changes in the business, and put more weight on the old information, which suggests HPQ is cheap. I did not buy HPQ but I was very tempted because Seth Klarman had a large position in it. I overcame my temptation by intentionally paying more attention to the new information, especially with the declining margin, and the increasing number of acquisition, which are often characteristics of a value trap.
Confirmation bias: Investors subconsciously seek evidences that confirms to their own beliefs and ignore disconfirming evidences. As a result, this bias can often result in terrible decision making because prejudiced information tends to skew an investor's perception, leaving him or her an incomplete picture of the situation. This bias is probably the most widely known bias because it has been discussed extensively. However, in my opinion, most investors who are aware of this bias nonetheless suffers from it because it is just too damn hard to disapprove yourself. Frequently, there are many seemingly attractive things about value traps. They are cheap; they have loyal customers; they are doing xyz to turn themselves around. Going back to my Nokia experience, once I purchased the stock, I started to seek all kinds of information that will justify my position such as the increase in the number of windows phone apps and positive online comments from loyal Nokia fans. I subconsciously defied disconfirming evidence such as Nokia's declining market share. When I realized that I was suffering from psychological biases and objectively reassessed the situation, I sold my shares at a substantial loss. Charlie Munger has summed up the antidote to the confirmation bias nicely in his speech to USC graduates:" One of the great things to learn from Darwin is the value of the extreme objectivity. He tried to disconfirm his ideas as soon as he got'em. He quickly put down in his notebook anything that disconfirmed anything that disconfirmed a much-loved idea. He especially sought out such things. Well, if you keep doing that over time, you get to be a perfectly marvellous thinker instead of one more klutz repeatedly demonstrating first-conclusion bias."
Overconfidence bias: Investors think they know more than they do or they can interpret information better. You can overestimate your ability of predicting the future, the probability of the success of your investment thesis, or the role skill played in your investment performance. Value investors tend to be humble. However, when making investment decisions, a value investor may indeed overestimate his ability to predict the outcome. Even the greatest investor, Warren Buffett, suffered from this bias when he made investment in US Airways, Berkshire Hathaway, and Hochschild, Kohn and Co. In each case he may have overestimated the probability of a positive outcome and underestimated the speed of deterioration of the underlying business. Seth Klarman said the following when interviewed by Charlie Rose: “You need to balance arrogance and humility…when you buy anything, it’s an arrogant act. You are saying the markets are gyrating and somebody wants to sell this to me and I know more than everybody else so I am going to stand here and buy it. I am going to pay an 1/8th more than the next guy wants to pay and buy it. That’s arrogant. And you need the humility to say ‘but I might be wrong.’ And you have to do that on everything.” There is no easy way to conquer the overconfidence bias. Learning from past mistakes will certainly be beneficial and figuring our why the company is selling cheap if you think it is undervalued may well worth the time.
Over the a very long time period, avoiding major losses is almost necessary if an investment wants to achieve superior returns. Value traps have been producing the most devastating losses even for renowned investors. The analysis of the aforementioned behavioral biases is by no means intended to prevent an investor from buying value traps. Behavioral finance is based on theories and we all know that "in theory there is no difference between theory and practice but in practice there is," to quote Yogi Berra. All we can do is to be cognizant of these biases and minimize their influence on us. I stumbled upon this reminder list from Charlie Munger while doing some research for this article:
I don't think I can come up with anything better than this. Any investor who can incorporate the above list into the investment process should do fine over the long term.
I think the best way to think about how to deal value traps is to adopt Charlie Munger's wit - "why fret too much about what you can't fix, just put your heads down and do your best." Since we can't tell the market to stop throwing us value traps, we'll have to deal with whatever Mr. Market is offering us with diligence and competence. If the odds are in our favor, over a long time period, we will do reasonably well. Let's accept that value traps are inevitable and all we can do is to try our best to minimize our losses that arise from investing in value traps. To achieve that, I think it is essential to understand
(1) Common characteristics of value traps and
(2) Behavioral biases behind investing in value traps.
Common characteristics of value traps are discussed many times on gurufocus, readers can search the key words "value traps" and many articles will pop up, my favorite one is :
http://www.gurufocus.com/news/171556/avoiding-value-traps-a-four-question-test
The behavioral biases that make value investors prone to catching "falling knives", however, have not been examined extensively.I venture to contribute my two cents on this subject because as I look back to some of the worst investment decisions that I have made (e.g Radio Shack, Nokia), all of them involved the interactions of at least a few cognitive and emotional biases, or what Charlie Munger called the Lollapalooza Effect. The confluence of these biases is so powerful that it is almost impossible to escape once you are in. The most rational way to cope with situations like this, is to understand the biases in force and to develop a strategy of mitigation. While almost every behavioral bias can be related to investing in value traps, I found the following ones particularly powerful:
- Anchoring
- Availability bias
- Conservatism bias
- Confirmation bias
- Overconfidence bias
Anchoring: Investors are likely to have a anchor price prior to making an investment decision. It is not necessarily a bad thing if you have the right anchor. For experienced value investors, the anchor price should undoubtedly be the conservatively estimated intrinsic value of the whole business. However, novice investors often commit the mistake of anchoring to the wrong price such as the 52-week high per share price or even the previous all-time high price. I still vividly remember 3 years ago, prior to Research In Motion's precipitous drop, I bought RIMM at a little over $50 per share (now BBRY) because I naively anchored myself to RIMM's 52-week high of more than $80 per share. Our brain releases Dopamine at the anticipation of rewards. Dopamine’s role was to for us to act to get the reward, so we would not miss out. Therefore, if we set the anchor wrong, we will be temped to react in order to reap the imaginary rewards. In this case, my imaginary reward was about thirty dollars based on my wrongfully chosen anchor price and my brain pushed me to act so that I would not miss the reward. In hindsight, this is all amusing but when you experience it the first time, it's real and powerful. As stated above, to overcome the anchoring bias, or more precisely, to set up the right anchor, we should use the conservatively estimate intrinsic value as our anchor price. Failure to do so will likely result in unsatisfactory results.
Availability Bias: Investors estimate future outcomes based on how easily past events can be recalled. This is especially dangerous when past memories are biased or incomplete. An investor may select investments based on promotional advertising or a shout-out from Jim Cramer, both of which are often easily retrieved because they are inherently more memorable. An investor may also exhibit the availability bias when choosing to invest in a stock because he or she incorrectly estimates the preferences of others based on his or her own preference. Many value traps are stocks of companies such as Radio Shack and Nokia with great brand names. If you are an investor and you like to shop at Radio Shack or you like Nokia phones, you are prone to extrapolate that others should also like Radio Shack or Nokia when in reality they don't, or at least not as much as you do. I purchased Nokia more than years ago for this exact reason. I had always liked Nokia's cellphones and I know a few other close friends in China who are die-hard Nokia supporters. Therefore, I thought the business deterioration is not as bad as other investors thought. Boy, what a lesson that was. The availability bias combined with the confirmation bias (I diligently looked for information that confirmed my belief), and the conservatism bias (I put more emphasis on Nokia's past record) created my worst investment loss. I am still a fan of Nokia but now my memories with Nokia are indeed bitter and sweet. This episode of my investment fiasco taught me to disassociate my feelings towards the target company and conduct more diligent research before making an investment decision
Conservatism bias: Investors subconsciously place more emphasis on old information and place less value on new information. The human brain is wired to resist changes. Assumptions or events that have worked well during the past tend to be continually applied to new situations. With regards to value traps, this bias kicks in when an investor cling to a particular view usually regarding a previously successful business and react slowly to information that could signal a change in trend or underlying business fundamental. Recent examples include Kodak, Nokia, Radio Shack, and Hewlett Packard. These are iconic brands that were once dominating in their respective fields. Investors, who had previously followed the stocks of these companies may think the brands name remain intact or not as tarnished as the general public thinks. Hewlett Packard is a great example. The old information will suggest that HP is a great brand with a decent market share in the PC market; companies are still purchasing HP laptops for business uses; Free Cash Flow is still positive and the valuation multiples are low compared to historical averages. The new information will tell you that HP is still a great brand, but the growth of smartphones and tablets is gradually eroding PC's market; gross profit is declining; free cash flow is declining due to the increase in capital expenditures as well as the increasing number of acquisitions. If you are subject to the conservatism bias, you will shrug off the new information, which signals fundamental changes in the business, and put more weight on the old information, which suggests HPQ is cheap. I did not buy HPQ but I was very tempted because Seth Klarman had a large position in it. I overcame my temptation by intentionally paying more attention to the new information, especially with the declining margin, and the increasing number of acquisition, which are often characteristics of a value trap.
Confirmation bias: Investors subconsciously seek evidences that confirms to their own beliefs and ignore disconfirming evidences. As a result, this bias can often result in terrible decision making because prejudiced information tends to skew an investor's perception, leaving him or her an incomplete picture of the situation. This bias is probably the most widely known bias because it has been discussed extensively. However, in my opinion, most investors who are aware of this bias nonetheless suffers from it because it is just too damn hard to disapprove yourself. Frequently, there are many seemingly attractive things about value traps. They are cheap; they have loyal customers; they are doing xyz to turn themselves around. Going back to my Nokia experience, once I purchased the stock, I started to seek all kinds of information that will justify my position such as the increase in the number of windows phone apps and positive online comments from loyal Nokia fans. I subconsciously defied disconfirming evidence such as Nokia's declining market share. When I realized that I was suffering from psychological biases and objectively reassessed the situation, I sold my shares at a substantial loss. Charlie Munger has summed up the antidote to the confirmation bias nicely in his speech to USC graduates:" One of the great things to learn from Darwin is the value of the extreme objectivity. He tried to disconfirm his ideas as soon as he got'em. He quickly put down in his notebook anything that disconfirmed anything that disconfirmed a much-loved idea. He especially sought out such things. Well, if you keep doing that over time, you get to be a perfectly marvellous thinker instead of one more klutz repeatedly demonstrating first-conclusion bias."
Overconfidence bias: Investors think they know more than they do or they can interpret information better. You can overestimate your ability of predicting the future, the probability of the success of your investment thesis, or the role skill played in your investment performance. Value investors tend to be humble. However, when making investment decisions, a value investor may indeed overestimate his ability to predict the outcome. Even the greatest investor, Warren Buffett, suffered from this bias when he made investment in US Airways, Berkshire Hathaway, and Hochschild, Kohn and Co. In each case he may have overestimated the probability of a positive outcome and underestimated the speed of deterioration of the underlying business. Seth Klarman said the following when interviewed by Charlie Rose: “You need to balance arrogance and humility…when you buy anything, it’s an arrogant act. You are saying the markets are gyrating and somebody wants to sell this to me and I know more than everybody else so I am going to stand here and buy it. I am going to pay an 1/8th more than the next guy wants to pay and buy it. That’s arrogant. And you need the humility to say ‘but I might be wrong.’ And you have to do that on everything.” There is no easy way to conquer the overconfidence bias. Learning from past mistakes will certainly be beneficial and figuring our why the company is selling cheap if you think it is undervalued may well worth the time.
Over the a very long time period, avoiding major losses is almost necessary if an investment wants to achieve superior returns. Value traps have been producing the most devastating losses even for renowned investors. The analysis of the aforementioned behavioral biases is by no means intended to prevent an investor from buying value traps. Behavioral finance is based on theories and we all know that "in theory there is no difference between theory and practice but in practice there is," to quote Yogi Berra. All we can do is to be cognizant of these biases and minimize their influence on us. I stumbled upon this reminder list from Charlie Munger while doing some research for this article:
- Look for disconfirming evidence – killing your own ideas
- Emphasize factors that don’t produce lots of easily available numbers
- Under-weigh extra vivid experience and overweigh less vivid experience. Same with recent events i.e cool off
- Remember the lesson: I idea or a fact is not worth more merely because it is easily available to you.
- There’s no logical answer in some cases except to wring the money out and go elsewhere
I don't think I can come up with anything better than this. Any investor who can incorporate the above list into the investment process should do fine over the long term.
Saturday, September 14, 2013
Should You Hold on to Your Wallet Now?
As I am writing this article, the S&P 500 has advanced 3.37% so far in September, bringing total year-to-date price return to 18.36% and year-to-date total return to 20.18%. It seems like investors are having a good year with the index is only a little more than 1% away from all time high. The question is, where are we going next?
We have seemingly compelling arguments from both the bulls and the bears. I'll not waste the readers' time in listing out the arguments out there. Instead of picking a side based upon what various market experts masterfully opined on CNBC, I'd rather follow the wisdom of one of my favorite investors-Howard Marks:
"We may never know where we're going, but we'd better have a good idea where we are."
The Most Important Thing Is... Having a Sense for Where We Stand
It is by no means easy to figure out where we stand in terms of the cycle and act accordingly. Fortunately, Howard provides us with "The Poor Man's Guide to Market Assessment", which I shall use in an attempt to take the temperature of the market. The full list can be found in Chapter 15 of Howard's book "The Most Important Thing." Essentially this list contains pairs of market characteristics and for each pair, we will check the one that we think is applicable to today's market. At the end of this exercise, we should be able to have a sense of where we stand. Below is a summary of my analysis of his list:
http://www.gurufocus.com/shiller-PE.php
Category 1 3 5
Economy: Vibrant Neutral Sluggish
Outlook: Positive Neutral Negative
Lenders: Eager Neutral Reticent
Capital markets: Loose Neutral Tight
Terms: Easy Neutral Restrictive
Interest Rates: Low Moderate High
Spreads: Narrow Moderate Wide
Investors: Optimistic Neutral Pessimistic
Equity Owners: Happy to hold Neutral Rushing for the exits
Equity Sellers: Few Moderate Many
Markets: Crowded Neutral Starved for attention
Funds: New Ones Daily Neutral Only the best can raise money
Recent Performance: Strong Moderate Weak
Equity Prices High Moderate Low
Respective Returns: Low Moderate High
Risk: High Moderate Low
Popular Qualities Aggressiveness Neutral Caution and discipline
Total Counts: 12 4 1
Score: 12*1+4*3+1*5=29
Maximum Score: 85
Score %: 29/85= 34%
Obviously 34% is just an estimate, we can easily shift some categories from score 1 to 3. However, as value investors, we would rather err on the side of caution. Hence, for the items that I am not entirely sure of, I chose the more conservative characteristic.
When interpreting the result, the lower the percentage score is, the more cautious a prudent investor should be. At the peak of the crisis, I think we are not too far from the maximum score. Things have improved dramatically since then. To me, 34% implies that this is a time for us to take a more defensive stand and this is consistent with Howard's recent observation that "the race to the bottom isn't on, but we are getting closer." Of course the future of the stock market is unknowable but there are many things that I think we can comfortably say knowable, just to name a few.
(1). Interest rates are going to rise and we all know how it will impact the price of all assets classes.
(2). Corporate profits as % of GDP is unlikely to stay above 10% for a sustained period of time.
(3). Both the Schiller P/E and Total Market Cap as % of GDP indicate potential overvaluation and reduced implied returns for equity investors.
(4). The U.S's debt problem is still looming and has not gotten any better.
None of the above knowables bodes well for the equity market. However, that doesn't mean we will have a so-called correction. It means we need to apply a higher level of prudence when managing our money, or other people's money given what we know.
I want to end this discussion with the last paragraph of Chapter 15 of "The Most Important Thing." Here, Howard shrewdly observes:
"Markets move cyclically, rising and falling. The pendulum oscillates, rarely pausing at the "happy medium," the midpoint of its arc. Is this a source of danger or of opportunity? And what are investors to do about if? My response is simple: Try to figure out what's going on around us, and use that to guide our actions.
We have seemingly compelling arguments from both the bulls and the bears. I'll not waste the readers' time in listing out the arguments out there. Instead of picking a side based upon what various market experts masterfully opined on CNBC, I'd rather follow the wisdom of one of my favorite investors-Howard Marks:
"We may never know where we're going, but we'd better have a good idea where we are."
The Most Important Thing Is... Having a Sense for Where We Stand
It is by no means easy to figure out where we stand in terms of the cycle and act accordingly. Fortunately, Howard provides us with "The Poor Man's Guide to Market Assessment", which I shall use in an attempt to take the temperature of the market. The full list can be found in Chapter 15 of Howard's book "The Most Important Thing." Essentially this list contains pairs of market characteristics and for each pair, we will check the one that we think is applicable to today's market. At the end of this exercise, we should be able to have a sense of where we stand. Below is a summary of my analysis of his list:
- Economy: The U.S economy is still "muddling through" with unemployment still at 7.3% (August) and estimated growth of GDP at merely 1.6%. I think it is neither vibrant nor sluggish.
- Outlook: This is a market characterized by plenty of uncertainty mingled with cautious optimism.
- Lenders: If we use Thomson Reuters' PayNet Small Business Lending Index as a proxy, it looks like lenders are becoming more eager as the index is at a level just around 115, much higher what it was at the bottom of the recent crisis (65) and not far from what it was prior to the crisis (130).
- Capital Market: Using the Total Credit Market Borrowing and Lending data available from the Federal Reserve as a proxy, I think we are neither tight nor loose. Credit market borrowing and lending has picked up considerably since 2009 (negative $539 billion) to about $1.5 trillion at the end of 2012 (last full year data available). However, compared to the pre-crisis level of $4.5 trillion, I think we are still at a neutral stage, but probably not for too long.
- Terms: Here we can talk about the terms of mortgage, corporate long term debt and etc. In terms of mortgage, it is pretty clear that lenders are very selective when initiating mortgages. Banks have been very strict in the arrangement of corporate debt covenants. Therefore, it seems to me that the loan terms are closer to the restrictive side.
- Interest rates and spreads: Low. Not much explanation needed.
- Investors: American Association of Individual Investors publishes survey result of individual investors on a regular basis on its website (http://www.aaii.com/sentimentsurvey). The latest result shows that 45.5% of investors are bullish, 29.9% are neutral and 24.6 % are bearish. Overall, individual investors are bullish.
- Equity Owners: The Fed has forced equity owners to hold their equity positions.
- Equity Sellers: With no better places to go, I would argue that the number of equity sellers are relatively few.
- Markets: Using the trading volume of the S&P 500 as a rough proxy, the market is neither too crowded nor starving for attention at August's average trading volume of 3,069,868,600. During panic months such as March 2009 and October 2008, average trading volume were above 7,000,000,000.
- Funds: According to Hedge Fund Research, "total hedge fund launches in the trailing 4 quarters ending 2Q 2013 totaled 1144, the highest total since nearly 1200 funds launched in the trailing 4 quarters ending 1Q08."
- Recent performance: Strong.
- Assets prices, respective returns, and risk: Both the Shiller P/E and the total market capitalization as % of GDP imply a high equity price and low implied returns, and hence, relatively high risk. Below are links to gurufocus' market valuation tools.
http://www.gurufocus.com/shiller-PE.php
- Popular qualities: Consumer discretionary and financial sectors have been leading the way in the market advance so far this year. Although the technology sector (which usually is perceived to be a sector for aggressive investors) has been a laggard year to date, many investors (of course not value investors) are paying a lot attention to and a hefty premium for stocks with promising futures such as Salesforce,Tesla, Linkedin, Stratesys, and 3D Printing. This indicates aggressiveness.
Category 1 3 5
Economy: Vibrant Neutral Sluggish
Outlook: Positive Neutral Negative
Lenders: Eager Neutral Reticent
Capital markets: Loose Neutral Tight
Terms: Easy Neutral Restrictive
Interest Rates: Low Moderate High
Spreads: Narrow Moderate Wide
Investors: Optimistic Neutral Pessimistic
Equity Owners: Happy to hold Neutral Rushing for the exits
Equity Sellers: Few Moderate Many
Markets: Crowded Neutral Starved for attention
Funds: New Ones Daily Neutral Only the best can raise money
Recent Performance: Strong Moderate Weak
Equity Prices High Moderate Low
Respective Returns: Low Moderate High
Risk: High Moderate Low
Popular Qualities Aggressiveness Neutral Caution and discipline
Total Counts: 12 4 1
Score: 12*1+4*3+1*5=29
Maximum Score: 85
Score %: 29/85= 34%
Obviously 34% is just an estimate, we can easily shift some categories from score 1 to 3. However, as value investors, we would rather err on the side of caution. Hence, for the items that I am not entirely sure of, I chose the more conservative characteristic.
When interpreting the result, the lower the percentage score is, the more cautious a prudent investor should be. At the peak of the crisis, I think we are not too far from the maximum score. Things have improved dramatically since then. To me, 34% implies that this is a time for us to take a more defensive stand and this is consistent with Howard's recent observation that "the race to the bottom isn't on, but we are getting closer." Of course the future of the stock market is unknowable but there are many things that I think we can comfortably say knowable, just to name a few.
(1). Interest rates are going to rise and we all know how it will impact the price of all assets classes.
(2). Corporate profits as % of GDP is unlikely to stay above 10% for a sustained period of time.
(3). Both the Schiller P/E and Total Market Cap as % of GDP indicate potential overvaluation and reduced implied returns for equity investors.
(4). The U.S's debt problem is still looming and has not gotten any better.
None of the above knowables bodes well for the equity market. However, that doesn't mean we will have a so-called correction. It means we need to apply a higher level of prudence when managing our money, or other people's money given what we know.
I want to end this discussion with the last paragraph of Chapter 15 of "The Most Important Thing." Here, Howard shrewdly observes:
"Markets move cyclically, rising and falling. The pendulum oscillates, rarely pausing at the "happy medium," the midpoint of its arc. Is this a source of danger or of opportunity? And what are investors to do about if? My response is simple: Try to figure out what's going on around us, and use that to guide our actions.
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