Archive for March, 2012

Our macro thesis for investing in financial institutions was laid out earlier on in the following posts:

Tea with a macro-investor, thoughts on the financial sector

Tay Fund Commentary 2011

, and more specifically, our investment thesis for Bank of America,

The Compelling Case for Bank of America – Research Report

I feel somewhat vindicated that our scenario has played out as it has been thus far. However, let us not get too far ahead of ourselves as the recent run-up in banks has in large been due to

(1) the apparent orderly restructuring of Greek debt,
(2) the success hence far of the ECB’s LTRO refinancing operation, and its consequent effect of driving down the yields of sovereign debt,
(3) the latest results of the Federal Reserve’s bank stress test.

Indeed, it is this slew of good news that has led to a dramatic advance of the major indices since its October 2011 low, to achieving new highs in both the S & P 500 (1400 points), and the DJIA (13,000 points) not seen in years. Whether investor optimism is misplaced remains open to question. I however, continue to ignore economic forecasts as part of my investment framework, and have little faith but much distrust in the predictions of those who proclaim to know the future.

What I feel that investors should take heed of is the tendency of the markets to swing from a state to unwarranted pessimism, to one of unjustified optimism, and the short time frame in which it occurs. There are few certainties that exist in the market. However, the inclination of the masses to swing from extreme states of emotion is one that existed for centuries,  and is certainly in my view, one that can be counted upon reliably to repeat itself in the future, lest human nature changes (highly improbable).

With the markets assuming a “risk-on” position, it is perhaps prudent to take a moment to reflect whether the situation has improved to such an extent to justify such a dramatic increase in price levels. Unemployment has been slowly edging downwards, the housing market in the US is showing some signs of recovery after what was mostly certainly a depression (just the property market and its associated industries), and the European Union appears outwardly at any rate, to be getting its act together. However, on a note of caution, we are not out of the woods yet and there remains many headwinds that can derail the recovery.

My own personal view is that high quality equities in the US are priced at reasonable levels to give a satisfactory, if not unspectacular rate of return in the coming years. However, the recent run up in prices of financial institutions have made them far less attractive than they were 6 months ago. In the long run, I expect them to outpace the average return of the market. However, investors should bear in mind that  returns will be volatile, and further irrational advances in prices will skew the risk/reward ratio against the favor of the investor. If that happens sooner than later, will take appropriate steps to close our positions.

What I find more disconcerting are the price levels of lower quality companies, and more specifically, recent stock offerings of social media companies which trade in great multiples of what little earnings they generate. Paying for the promise of future earnings, especially one that is projected to grow generously is reminisce of the dot – com bubble. This investment strategy has worked out poorly over the years for the vast majority of the public, which has shown itself inclined to enter the market in droves at the very worst possible of times.

I would caution investors that investing in such issues would in no way qualify as an investment operation by Graham’s definition – “An investment operation is one which, upon thorough analysis promises safety of principal, and an adequate return.”

Admittedly, areas such as real estate, commodities such as gold and silver and common stock offerings are not my area of expertise. All I can say is “Be sure it’s yours before you go into it.”

I would like to end the letter cautiously optimistic. By a conservative standard, the S & P 500 is moderately valued. However, it’s encouraging to see that high quality companies paying a reasonable dividend yield can be purchased at some of their lowest price/earnings ratio in years, providing the chance of reasonable return over the next decade.

On the same thread of thought, I would caution investors against locking in their capital in long term bonds at record low rates. Although there may appear to exist a safety of principal, such investments offer little protection against inflation which I suspect that many people are underestimating. This will most certainly lead to a substantial loss in purchasing power over a protracted period of time. Ultimately, I do not believe that investors are being compensated adequately for the risk that they are tasked with assuming.


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Accurate as of 17 March 2012

Initial Net Asset Value: $10.00

Net Asset Value as of  March 17 2012: $12.02

Hypothetical Growth of $10,000 invested since September 2011 (NAV at September 2011 was $9.71)

* A total return index is an index that measures the performance of a group of components by assuming that all cash distributions (dividends) are reinvested, in addition to tracking the components’ price movements

Portfolio Net Asset Value will be updated monthly at the end of the third week of each month.

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Adapation from his 2012 shareholder, Warren Buffett explains why equities almost beat alternative investments most of the time. I hope you enjoy it.

By Warren Buffett

FORTUNE — Investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire Hathaway (BRKA) we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power — after taxes have been paid on nominal gains — in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.

From our definition there flows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability — the reasoned probability — of that investment causing its owner a loss of purchasing power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a nonfluctuating asset can be laden with risk.

Investment possibilities are both many and varied. There are three major categories, however, and it’s important to understand the characteristics of each. So let’s survey the field.

Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.

Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as these holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control.

Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as “income.”

For taxpaying investors like you and me, the picture has been far worse. During the same 47-year period, continuous rolling of U.S. Treasury bills produced 5.7% annually. That sounds satisfactory. But if an individual investor paid personal income taxes at a rate averaging 25%, this 5.7% return would have yielded nothing in the way of real income. This investor’s visible income tax would have stripped him of 1.4 points of the stated yield, and the invisible inflation tax would have devoured the remaining 4.3 points. It’s noteworthy that the implicit inflation “tax” was more than triple the explicit income tax that our investor probably thought of as his main burden. “In God We Trust” may be imprinted on our currency, but the hand that activates our government’s printing press has been all too human.

High interest rates, of course, can compensate purchasers for the inflation risk they face with currency-based investments — and indeed, rates in the early 1980s did that job nicely. Current rates, however, do not come close to offsetting the purchasing-power risk that investors assume. Right now bonds should come with a warning label.

Under today’s conditions, therefore, I do not like currency-based investments. Even so, Berkshire holds significant amounts of them, primarily of the short-term variety. At Berkshire the need for ample liquidity occupies center stage and will never be slighted, however inadequate rates may be. Accommodating this need, we primarily hold U.S. Treasury bills, the only investment that can be counted on for liquidity under the most chaotic of economic conditions. Our working level for liquidity is $20 billion; $10 billion is our absolute minimum.

Beyond the requirements that liquidity and regulators impose on us, we will purchase currency-related securities only if they offer the possibility of unusual gain — either because a particular credit is mispriced, as can occur in periodic junk-bond debacles, or because rates rise to a level that offers the possibility of realizing substantial capital gains on high-grade bonds when rates fall. Though we’ve exploited both opportunities in the past — and may do so again — we are now 180 degrees removed from such prospects. Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.”

The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else — who also knows that the assets will be forever unproductive — will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce — it will remain lifeless forever — but rather by the belief that others will desire it even more avidly in the future.

The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth — for a while.

Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof ” delivered by the market, and the pool of buyers — for a time — expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.”

Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce — gold’s price as I write this — its value would be about $9.6 trillion. Call this cube pile A.

Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?

Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers — whether jewelry and industrial users, frightened individuals, or speculators — must continually absorb this additional supply to merely maintain an equilibrium at present prices.

A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops — and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil (XOM) will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.

Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.

Our first two categories enjoy maximum popularity at peaks of fear: Terror over economic collapse drives individuals to currency-based assets, most particularly U.S. obligations, and fear of currency collapse fosters movement to sterile assets such as gold. We heard “cash is king” in late 2008, just when cash should have been deployed rather than held. Similarly, we heard “cash is trash” in the early 1980s just when fixed-dollar investments were at their most attractive level in memory. On those occasions, investors who required a supportive crowd paid dearly for that comfort.

My own preference — and you knew this was coming — is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. Farms, real estate, and many businesses such as Coca-Cola (KO), IBM (IBM), and our own See’s Candy meet that double-barreled test. Certain other companies — think of our regulated utilities, for example — fail it because inflation places heavy capital requirements on them. To earn more, their owners must invest more. Even so, these investments will remain superior to nonproductive or currency-based assets.

Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See’s peanut brittle. In the future the U.S. population will move more goods, consume more food, and require more living space than it does now. People will forever exchange what they produce for what others produce.

Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens. Metaphorically, these commercial “cows” will live for centuries and give ever greater quantities of “milk” to boot. Their value will be determined not by the medium of exchange but rather by their capacity to deliver milk. Proceeds from the sale of the milk will compound for the owners of the cows, just as they did during the 20th century when the Dow increased from 66 to 11,497 (and paid loads of dividends as well).

Berkshire’s goal will be to increase its ownership of first-class businesses. Our first choice will be to own them in their entirety — but we will also be owners by way of holding sizable amounts of marketable stocks. I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined. More important, it will beby far the safest.

This article is from the February 27, 2012 issue of Fortune.


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Since the blog’s inception in December in 2010, it has garnered over 15,000 views – something which I am both amazed and humbled at. Looking back, it has been an exhilarating journey of refining my mental models that I use to approach investing. Although the basics of what I do is still grounded firmly in the work of Graham and Dodd’s The Intelligent Investor & Security Analysis, experience has allowed me to refine their methodology to form my own investing style. The fact that The Intelligent Investor, which was published in 1949, is still relevant today is testament to the timelessness of his work. I recommend everyone who is interested in investing to read it from cover to cover as many times as possible (I own two copies of the book myself).

One of the things that I noticed over the years is that the average investor is poorly equipped in dealing with the barrage of financial choices with regards to what they should do with their money. The problem that plagues investors now is not a lack of information, but an overwhelming barrage of senseless and useless disinformation. I have increasingly come to the view that the average investor should not invest in common stocks. The average investor simply does not have the time nor the interest to engage in security analysis in a diligent and disciplined manner whatsoever. Speculation is not investing, and unless you are genuinely interested in it, the chances that you are going to outdo the market are slim at best. You should also give other speculative products, such as day trading and leveraged ETFs (or worst, double leveraged ETFs!!!),  which masquerade as investing a wide berth. Chances are if it’s too good to be true, it probably isn’t.

My views on investing in other assets such as commodities are property are best reflected in a letter written by Warren Buffett. You can check it out here.


Before I go onto what I think the average investor should do, I like to bring up a discussion point that I think many people miss out (it’s covered in great detail in the link above too). The phrase “Cash Is King” has been taken widely out of context by too many people. Cash is useful, especially when one is waiting for the right opportunity to deploy it. But as an asset class, cash is probably one of the worst investments ever. I had many people tell me that stocks are risky and that you risk losing your capital as a result of price gyrations, and for that reason, bonds or similar investments are safer because they promise safety of capital.

What investors are not taking into account here is the effect on inflation on their purchasing power. Even assuming a reasonably low average rate of inflation in the next few years of 3%, putting your money in fixed rate bonds, or in the fixed deposit at 1% guarantees a loss of purchasing power of 2% per annum. That might not sound like a lot.. but I hope the table below illustrates how corrosive inflation is.

2000 $10,000.00
2001 $9,800.00
2002 $9,604.00
2003 $9,411.92
2004 $9,223.68
2005 $9,039.21
2006 $8,858.42
2007 $8,681.26
2008 $8,507.63
2009 $8,337.48
2010 $8,170.73
Assuming Decline of Capital at 2% Per Annum

At the end of the day, what should the average investor do?

I am afraid I offer no shining insight into this matter, and my recommendations are the same as that laid you by Benjamin Graham in the 1950’s and more recently, a host of successful investors such as Warren Buffett & Yale Swensen. The dirty secret of the fund management industry is that most funds fail to even beat the index over an extended period of time. The very nature of the structure of funds are at fault, with most funds charging excessive fees that end up enriching their managers, not their shareholders.

My recommendation for the investors who wish to take a hands off approach is to find & invest your money regularly into low-cost index funds or ETFs of a similar nature. You should be very watchful of costs as some indices are poorly constructed and some fund companies charge very excessive fees as they eat into returns, especially over extended periods of time.

PS: Much of what I have covered in this post is featured in greater detail by the modern commentary of The Intelligent Investor written by Jason Zweig. I recommend you check it out for more information and research.


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