August 4, 2020

BRK Corporate Governance, MSFT, Market Volatility etc.

So Buffett finally buys some JPM. He owned a bunch in his PA years ago and said it would be a conflict to own both JPM and WFC within BRK, or some such thing. I guess recent events (WFC scandals) have made him change his mind (as he may be starting to dump WFC). I've been a big fan of JPM for years, so naturally, I like this move. I wonder if Jamie Dimon would ever make it onto BRK's board; he would be a great fit there and would give the board some real, hands-on expertise in the financial industry (there is plenty of talent there, but noone with Dimon's experience/background).

This is the 13-F that was just filed (includes only positions over $1 billion):




Market Cap to GDP
Someone asked in a comment the other day what I thought about the market cap to GDP ratio, Buffett's once favorite stock market valuation indicator. This, like many other valuations measures, is really dependent on interest rates. If you believe (like I do) that interest rates drive the valuation of assets, then prices are high when rates are low and vice versa. So, of course, if interest rates are low, the market cap to GDP ratio will be high. But that tells us nothing about the valuation of asset prices as it has to be compared to interest rates. Plus, it doesn't really tell you anything about interest rates either. (A lot of bears like to point to 'overvalued' indicators, like this market cap to GDP, P/E, CAPE, EVITDA/EV, Dow-to-Gold ratio etc. But often, it's all the same thing, so it's like double counting. They all point to one thing: asset levels are high because interest rates are low. But, people still think of these above factors as separate, discrete pieces of evidence to show the market is overvalued.)

Not to mention, many U.S. companies are growing globally, so their sales and earnings from non-U.S. business will be capitalized in the U.S. stock market while the GDP will not include those new territories. If a U.S. company merges with a European company, the stock market valuation may well increase (while GDP does not). Also, when Yahoo owned Alibaba as Alibaba took off, the U.S. market cap of Yahoo (and therefore the U.S. stock market) increased (with no increase in GDP).

So in that sense, I don't think it's a relevant measure of anything these days. I still like to adjust interest rates to what we might think is a normalized rate, and then price assets off of that.

BRK Corporate Governance
Again, from the comment section, someone mentioned an analyst or author that is comparing BRK to fraudulent companies; BRK's corporate governance standard is comparable to historical frauds (ENR etc.).

Well, I am preaching to the choir here, and maybe I am just an ignorant, blind, cool-aid drinking BRK groupie, but every time I read these comments, I think it's ridiculous. It just takes a little bit of common sense to figure out the difference between BRK and the big corporate frauds in the past.

First of all, just for fun, I took a quick look at the corporate governance score of BRK on the Yahoo Finance page, and was surprised at the high score: 9 out of 10!
Corporate Governance
Berkshire Hathaway Inc.’s ISS Governance QualityScore as of November 1, 2018 is 9. The pillar scores are Audit: 1; Board: 10; Shareholder Rights: 8; Compensation: 6.
Corporate governance scores courtesy of Institutional Shareholder Services (ISS). Scores indicate decile rank relative to index or region. A decile score of 1 indicates lower governance risk, while a 10 indicates higher governance risk.
Not bad! But then, reading further, I realized that 10 means high risk, lol... Oops. So it is, in fact, the way I thought it would be. Just to be sure, I checked this at the ISS website.

From the ISS website:

THE METHODOLOGY BEHIND THE SCORES
Governance QualityScore uses a numeric, decile-based score that indicates a company’s governance risk relative to their index or region. A score in the 1st decile (QS:1) indicates relatively higher quality governance practices and relatively lower governance risk, and, conversely, a score in the 10th decile (QS:10) indicates relatively higher governance risk. Companies receive an overall QualityScore and a score for each of four categories: Board Structure, Compensation/ Remuneration, Shareholder Rights, and Audit & Risk Oversight.

WFC, by the way, with all it's scandals, has a QualityScore of 1.

Out of curiosity, I looked at MSFT and check this out: 
Microsoft Corporation’s ISS Governance QualityScore as of November 1, 2018 is 1. The pillar scores are Audit: 1; Board: 1; Shareholder Rights: 1; Compensation: 3.
Amazing!

MSFT
OK, and check this out from the proxy:
The vast majority of our global employees participate in an annual anonymous poll. Here is a selection of results:


LOGO


That sounds crazy too, for a large corporation. I don't know how 'real' this is, as we all know how people may be 'nudged' to fill out surveys in ways favorable to management. Well, they say it's anonymous, so OK, maybe it's legit. 

I have become in recent years a big fan of MSFT, both as a user and an investor.

My MSFT Experience
I have been tied to MSFT for most of my career as company PC networks were usually run on Microsoft and desktops were usually Windows NT or whatever. Of course, we also had Unix machines running the serious stuff, but most office work, spreadsheet work and whatnot were done on Windows machines. 

After going out on my own, I stuck to Windows, but I got increasingly frustrated at how often Windows would crash/freeze. Some days, I thought I spent more time waiting for things than actually doing any work. And then they killed XP (which I had on some of my old machines).

A programmer friend suggested I look at Linux, so I did. I installed Linux on my old laptop and eventually one of my old PC's, and I loved it. It was rock-solid and stable, like the Sun workstations (Unix) I used to work with that you never had to reboot or restart. I was seriously contemplating switching everything over to Linux and ditching MSFT altogether. 

One thing holding me back was that a lot apps written for Windows is not available in Linux (well, you can still run Windows apps with Wine, but I was a little skeptical/worried that there would be issues if there was another layer). Otherwise, I loved everything about Linux. I use GIMP now all the time for photo processing (like the Buffett photo in my last post), Libre Office is great and is getting better etc. Plus my Linux machines never just randomly go into these long updates. 

Well, one of my favorite things is how easy it is to run cron jobs in Linux versus Windows; I really hate the Windows task manager. A lot of other things are just so much easier to do off the command line in bash (although Powershell is getting pretty powerful, but it's so clumsy/clunky, I don't feel like learning how to use it properly). 

Back to Windows
But OK, I never abandoned Windows. But what sucked me back in and made me abandon the idea of switching over completely to Linux was Windows 10. I was skeptical, but upgraded all my Windows machines to Windows 10 (forgot when), and I have been very happy. Yes, if you are not careful and don't set your 'active' time, it can go into long update cycles rendering your computer unusable until the updates are done. This is forced so you can't stop it. But you can tell Windows what hours of the day you will not be using the machine, so the forced updates will happen in those inactive hours. 

OK, small problem. 

But since switching to Windows 10, I have had very, very few problems I used to have. Random crashing, random freezing etc. I have not had that occur much at all and it's been a pleasant surprise.

Also, Windows 10 comes with Ubuntu bash so if you like Linux command line stuff, you can do it all in a bash terminal right on the Windows 10 machine and in those drives/folders that Windows runs on (goodbye cygwin?!). 

The other major thing that drew me back to Windows is OneDrive. I used to do work on my home desktop and my laptop, and I used to have to email files back and forth to work on them. You can use Google Drive, Dropbox, Box etc. to sync files on your various machines, but I never got around to doing that with the above, and I didn't like how Google Drive seemed to keep altering my files (especially programs) when I uploaded them. 

But OneDrive was so easy and is basically already set up from the get-go in Windows 10. Now my most active folders are on OneDrive, I never have to worry about syncing anything; it's all done automatically.  

I think this is one of the big things that got me tied to Windows now. 

Plus, I am playing with Azure now and it is very easy to create Linux instances (basically virtual machines in the cloud) so you can write bots and set them up to run as cron jobs and your tasks will be done whether your PC/laptop is on or not. Plus they have databases and many other cloud services (I use Amazon too, but mostly for fun/experimenting). 


So when you think about how all of this is integrated and everything works great with each other, you can see how excited I am about MSFT. A programmer relative told me a few years ago that MSFT sucked for most of their existence, but that with C#, Azure and other cool things, they are becoming a really incredible company. (I am also experimenting with C# but haven't created anything for actual use). Of course, at the time, I didn't really look into it or understand. 

Anyway, this is sort of relevant, right? As IBM just bought Red Hat, which is a Linux business. Anyway, I still love Linux and have a Linux box sitting next to my main Windows 10 machine. Linux will continue to grow, and behind the scenes, Linux runs everything, and will run even more going forward.

And check this out. I just recently noticed that Stanley Druckenmiller is big into MSFT: 



So he is probably seeing and hearing the same things I am talking about. Well, OK, I have no idea why Druckenmiller is long MSFT. But I would assume it has something to do with what I'm talking about.

Oh yeah, and I really enjoyed Nadella's book: Hit Refresh.

With the FANG/FAANG stocks so popular, who knows, maybe MSFT is the tortoise that surprises everyone!


Back to BRK
OK, so there is probably not much I need to say on how silly it is to criticize BRK's corporate governance. Check this out from the BRK 2018 proxy: 


This list doesn't show a group of people who really need the money. I think the average compensation for a big company director is something close to $300,000. If you wonder why so many board members seem to be yes-men to the CEO, this may be one reason why; it's good money! Don't rock the boat, keep quiet and keep cashing your checks!

It's clear from the above table that BRK directors are not there for the money. And sure, they are friends with Buffett so are they really independent? I would rather have directors that understand Buffett and BRK well, and have enough of a spine to express themselves if they see something they don't like.

There is a lot more to say on this but one of the biggest arguments in support of BRK's structure is that Buffett himself is the largest shareholder of BRK, so if this was a fraud, who is he defrauding? Himself? That's laughable. He takes a $100,000 salary but the bulk of his wealth is created by BRK's stock.

This is the opposite of most situations, where managements own token amounts of stock (and dump their stocks whenever they exercise their options) and pay themselves massive amounts of money. When you own very little stock but pay yourself huge amounts, I think that incentivises fraud more. Don't you think?

When a CEO has 99% of their wealth tied up in a stock, that is stronger than any corporate governance factor I can think of.

But corporate governance specialists, critics and academics don't seem to understand that. They would rather check the boxes on what they inflexibly think of as good corporate governance practice and that's it. I guess part of it is laziness, and part of it is just practicality.

Institutions that own a large number of companies can't possibly evaluate that many CEOs, BODs, etc. so they need some simple measure to save time. Like P/E ratios, maybe. Those that don't know how to evaluate businesses may have to depend on P/E ratios to evaluate cheapness, but if you know how to evaluate businesses, P/E ratios often don't really matter (as they don't tell the whole story, like, in the case of BRK!). 

Abdication/Transparency
I mentioned this in the comments section of another post, but the other issue is that Buffett is so hands off the businesses to the point of abdication. But this is misleading. We all know Buffett watches numbers like a hawk. He said he gets faxed sales figures every day from various businesses and he looks at them carefully every day.

What he means when he says he is hands off is that he doesn't micromanage. He doesn't insist on seeing every ad before airing. He doesn't want to interview and approve every new hire. He is not going to approve every paint job of a store, or pricing/marketing strategy of each business. He is not going to approve each detail of every budget for every line of business.

But this doesn't mean that he isn't watching every penny that goes in and out of the businesses. We all know that all of the free cash of a business is sent to Omaha, so if something is wrong, he will know right away.

For the businesses where things may get funky, like the insurance businesses, those are highly regulated, and Buffett is very closely monitoring those businesses and is very involved as he says, with big blocks of business (talks to Jain several times a day etc...).

As for transparency, I don't know. I never thought BRK lacked transparency. It could disclose more, of course, but I never thought of BRK as a complete black box or anything like that. Major business lines are presented clearly and in detail. Some of the non-insurance businesses might be opaque, but each of them are just too small to disclose separately.

Some fuss is made about the Sokol incident, but those things will happen every now and then to any company. Goldman Sachs has a lot of legal and compliance infrastructure, is highly regulated and constantly audited, and yet we now have the 1MDB scandal. So I don't know that the Sokol incident proves anything about BRK either way. You have to look at the big picture and see the kinds of problems they've had over the years, and the record is pretty good. Will another scandal happen? Yes. These things will happen. It's how management deals with it that will determine the fate of BRK, and I have faith that they will deal with any issues in the future promptly.

As Munger says, it's all about incentives, and I think BRK people are properly incentivized.

Remember what Buffett said after the crisis. He said that there was a regulator who had one job, and that was to regulate FNM and FRE, I think. And they failed. So just because you have someone watching and regulating, if the incentives are not correct, you are going to have problems. 


Market Volatility
So, I was a little irked when the market was down 600 points the other day when I was on my way out of the house. I know I don't really care, but still, at the back of my mind, I think, is this it? Is this the end of capitalism? Are we going to go down 90% like we did in 1929-1932? OK, I wasn't that worried, actually.

But it made me curious. Why are we so scared of big market moves like this? 600 points is a little more than 2%. Back in the late 1980s and early 1990s, a 2% move would have been a 50 point move. 600 points is psychologically shocking because Black Monday was a 500 point drop. So it feels like Black Monday again (that was before my time!).

I tend to buy into narratives I don't really care about. The HFT/quants are making the markets more volatile. ETFs, especially leveraged ETFs are making the markets more volatile. More regulation in the markets and the resulting decrease in liquidity (thinner bid/ask from market-makers/specialists) are making the markets more volatile etc...

I go, hmm... OK. Probably true. But whatever. Doesn't matter to me.

But sometimes, I suddenly think, wait a minute. Is all of this true?!

Let's take a look!

First of all, let's just take a look at the market's volatility on a rolling 100-day basis. This is what derivatives traders would call the 100-day historical volatility. I looked at this going back to 1950. All of the following charts include data up to this past Monday (11/12/2018).




So, looks pretty normal. Even with the big moves in the past few weeks, nothing out of the ordinary here. In fact, I would have guessed things were pretty wild since Trump was elected, but if you look back to even 2012, 100-day vols have been in a normal range. It certainly doesn't feel that way.

OK, so maybe vols don't tell the whole story. Let's look at some other things.

We've had a few days where the market was down more than 2% recently. Or it feels like it happens a lot. So, I looked to see how often the market went down more than 2% on the day. To make it a readable chart, I just summed up how many times the market declined by more than 2% in the past 200 days.

Here's that chart:




So yes, it's a little elevated, but nothing really out of the ordinary. Look at the period during the crisis! Also, look at the mid to late 1990s, even before the bubble collapsed.

What about those days the market opens down 800 points and closes up 300, or some such crazy thing? It seems like that sort of thing happens a lot these days. If I had to guess, I would tell you that that happens more often these days than in the past.

To measure that, I just subtracted the day's high from the day's low and divided it by the day's close, and then took a 100-day average of that.

Here is that chart going back to 1962 (hi-lo data only goes back to 62):




...and surprisingly, this too is in a very normal range, and far below the levels of even the mid-90s (I guess the day traders used to make this really wide). Nothing out of the ordinary here.

And let's look at the number of days in the past 100 days that the day's range exceeded 2%. 



Totally normal range. Nothing out of the ordinary.

Conclusion
JPM is now a BRK stock. Get Jamie on the board! He would be the person I trust most next to Buffett.

BRK scores low on corporate governance, but so what? Look at the incentive structure, which is more important than committees, bureaucracies like compliance/legal departments etc.

People who write to complain about BRK are people who just don't understand, or just use BRK to grandstand and gain attention by making astounding claims against consensus (this is why people like to say "the market is going to crash 50%!", or "the market will get to 500,000!"). So ignore those people.

Microsoft is pretty awesome. I never made a post about it as an investment; I should have when I started to get interested, but oh well. Maybe eventually, but I don't really have anything to add to MSFT in terms of financial analysis/valuation.

And, the markets seem like they are crazy and more volatile than ever, but the above charts don't bear that out. People, the press, keep freaking out over 2% moves as if they are 10% moves. The markets, despite all the things that should make markets more volatile than ever, are just as volatile as they ever were and no more.  So relax! 

Has Buffett Lost It?!

Wow.  Apple (AAPL) was a $28 billion position at the end of 2017, with 167 million shares, but now BRK owns 252 million shares as of the August 13-F (November will be out soon), for a position size of  $47 billion then and $52 billion now (as of 11/4/2018).

That sounds crazy as it's the largest position ever, and it's a 'tech' company. OK, maybe it's a consumer products company and not a tech company. Either way, wow, that's a big bet, exceeding 10% of the market cap of BRK.  Well, for focused investors, 10% is not such a big deal, and even 25% of the equity portfolio may not be that crazy as AAPL isn't some obscure micro-cap, or over-leveraged industrial cyclical or anything like that.

But, I am not the biggest fan of AAPL, so it is interesting. Coming right off his IBM miss, I guess many shareholders would be a little surprised.

Of course, I don't recommend it, but this is an easy position to hedge against; you can just short AAPL shares against whatever BRK owns.




Here is the 13-F from August; I only show positions of more than $10 billion here:



You can get the whole sorted table here.
(oops, the above link shows an error for some reason. You can click 'website' below and then just go to the 13-F section and click BRK).

I know a lot of stuff on the website is broken. When I have time, I will fix it and maybe add some stuff to it. When Google finance/Yahoo finance dropped their financial data API's, a lot of things broke and it got to the point where I would have to pay for data to update stuff, and I don't want to do that. I recently noticed that a form of the Yahoo Finance API is back up, so I will be able to update some stuff, but I will have to rewrite a lot of the code, so I am in no rush to do it at the moment (I have a lot of work I need to do for others etc...  this stuff goes to the back of the queue, unfortunately).

The bull and bear argument has been the same for years, so I don't want to get into it again here, but I feel like AAPL has sort of been chasing the crowd lately rather than leading it or disrupting it like they used to during the Jobs years. But again, this would get the AAPL fans all fired up and angry, so maybe I'll leave it at that. I'll just say that moving up to higher end products to make up for declining growth momentum reminds me of retailers/restaurants that hid declining traffic/unit volumes by moving up-market or raising prices. It works for a while until people finally say, no mas, and will no longer pay high prices. Sort of reminds me of J. Crew, P&G etc.

The Markets
The markets have been going nuts too. Well, I don't mean to imply that Buffett has gone nuts, really. AAPL has a strong brand name/franchise, high returns on capital, decent margins, too-strong balance sheet, repurchases a lot of shares etc. So a lot of the boxes are checked in this case. Can't blame someone for buying a company like that.

The markets can be down hundreds of points overnight, but then be up hundreds by the close (if not an hour after the open), and vice versa. It has always been meaningless to stare at the market during the day (and futures overnight), but it seems even more so these days. I guess bots can be part of it. Risk parity is probably also a part of it. Leveraged ETF's. In any case, it's important to remember that we shouldn't be responding to markets. You should never be selling anything when the market is down 800 points. That's just obvious. If anything, if you have something to buy, you should be buying. But if you sit there and stare at the markets or otherwise follow it too closely, all sorts of bad thoughts can go through your mind. If it is too upsetting or scary, just turn off the TV, or don't look at the market for a while. It's like the weather in Amsterdam; if you don't like it, just wait. It will change. (Did I get that right?)

Interest Rates
I hear all the time that interest rates are going up so the market must go down, but all of my work in previous bubble posts were based on the baseline assumption that the 'normalized', sustainable long term interest rate is probably around 4.0%. Using a lot of historical data, I showed that if the long term rate averages 4% over the next 10 years, the market could easily average a P/E ratio of 25x over that time frame. This is not a prediction, of course. It's just an observation based on history: if it's not different this time, and if interest rates average 4% over the next 10 years, then, based on history, a 25x P/E would be completely normal.

Yes, this is basically the Fed model, which has been a subject of debate if not completely discredited by some. One debate is that the relationship between P/Es and interest rates held only for a brief period in time and not for the whole 100+ years of recent history, but my feeling is that since interest rates were regulated for much of the early 20th century, it's hard to say if there is any meaning in the lack of correlation going too far back in history. The other argument is that P/E or E/P is 'real' whereas bond yields are not. But this argument only strengthens the above argument. A low E/P is even more attractive than a low bond yield as the E will increase with inflation whereas the bond yield will not.  And comparing earnings yields to the TIPS yield (which would take care of the real versus nominal problem) would just be silly as the TIPS yield 10 years out is 1.2%, suggesting a P/E multiple of 83x

So, watching the market throw conniptions because interest rates went above 3.0% didn't worry me at all. I thought, OK, well, whatever. All else equal, higher rates may equal lower equity prices, so people dump stocks when rates go up. But as I've said in my bubble posts, I don't see the rubber band stretched at all, so the market is not in need of a violent correction. Of course, if we are on our way to 6-8% long term rates, then that's a different story.

Hedging
When markets go crazy like this, people tend to ask me about hedging. Well, first of all, hedging is something to do before the market goes down, not after. It's interesting that people start to want to hedge after the market starts to go down and volatility goes up (hedging costs go up).

I've spent a lot of time in the derivatives business, and a lot of it is about hedging. There are a lot of good and valid hedges; interest rates, FX, commodity prices etc. But when it comes to the stock market, a lot of hedging is baloney. Some large institutions may use futures to synthetically adjust their asset allocation (sometimes cheaper than selling stocks, paying taxes and buying something else).

But when it comes to just directional hedging of the stock market, I think more money has been lost trying to do that over the years than any money actually lost in the stock market. I know for sure that if you try to hedge a stock portfolio with futures, options or swaps, it's going to cost you. If you need to hedge your portfolio using any of these, most of the time, you are just better off lightening up your position and forget about hedging. If you feel like you need to hedge your portfolio with put options, you probably just own too much.

If you hedge all the time, it's going to be very costly. I'm not going to do it, but just go look at some put option quotes on the S&P 500 index, for example. And imaging rolling that over every three months, or every year. It is not cheap at all. And if you think you can time it and put on hedges only during risky times, well, that usually doesn't work out either. Some very good investors thought the market was expensive a few years ago and hedged their portfolios and it was a disaster. Even the smartest can't time their hedges.

If you look at how wealth is built up over the years, most of the time, it's been created by people who hold very good assets for very, very long periods of time. Nobody gets rich by being very good hedgers of their portfolios. OK, there are some hedge fund managers who have done it over the years, but that's pretty rare. Most other people, if you look at the richest people list, just own good assets and don't try to get in and out according to how they feel about the market or the economy.

In a sense, people like Buffett and Bill Gates are kind of lucky in that they can't get in and out of their positions anyway, even if they wanted to. Imagine Gates calling Goldman Sachs, "I want to put on a zero-cost collar on Microsoft because I don't like where we are going in this economy!". Nope. Won't happen. I know hedging CEO holdings used to be a big business for derivatives desks a while back; maybe it still is. But if you look at the guys who create tremendous wealth, most of the time, they just own and hold onto great assets for long periods of time.

Real estate wealth is built the same way (but they get leverage, and their buildings are not marked to market so they never get margin-called; that's a huge advantage versus leverage in the stock market). They can't just buy and sell futures, options or swaps against their holdings. And they can't trade their buildings short-term either.

As I've said before, the stock market suffers a sort of "curse of liquidity". Since you can just liquidate your entire portfolio by pushing one button on your iPhone (OK, well, maybe not some rich people, but many of us can...), it is easy for us to do stupid things. And you can see how much you are losing every second of the day on your iPhone. You can't do that with real estate; there is no way to tell exactly what it is worth until you put it on the market and get some bids. In other words, there is no manic-depressive Mr. Market knocking on your door every micro-second in real estate (unlike stocks) tempting you into doing stupid things. So 1. there is no stupid-behavior-inducing signals (crashing prices) and 2. there is no way to act immediately on impulse in the real estate market. Most people would do better in the market if they treated their equity portfolio like their home.

GE
What a total disaster GE is. I've always admired GE and it was one of those companies that I really wanted to like and wanted to own, but it never quite worked for me. First of all, Jeff Immelt must be the worst CEO of all time. OK, there are CEOs that bankrupted companies, committed fraud etc. So in that sense, maybe he's not the worst. But as a non-criminal, blue-chip CEO, he's got to be one of the all-time worst. And it's not just about the stock price; the businesses are just horrible. It looks like he stood up and got hit with a left hook, ducked to avoid the next shot only to get a big upper-cut to his chin. Whatever he did seemed just wrong.

I remember when Buffett was talking about CEOs, and this was around the time that Irene Rosenfeld sold the frozen pizza business for cheap and overpaid for Cadbury. He was talking about how many CEOs are great operators but many have issues with capital allocation. We all thought he was talking about Rosenfeld, but it didn't occur to me that he was probably also talking about Immelt.

He often said how wonderful Immelt was as a CEO but never actually bought GE stock (or in any size that I can recall; it was never a top holding), and I always wondered about that. In hindsight, well, he was probably also talking about Immelt.

GE is really tempting now at under $10, and the CEO is a really good one, but I'm not sure how GE gets out of this. Frankly, I haven't taken a close look at this in a while; maybe I will. If I find anything interesting, I will probably make a post here. But I just don't like (and never liked) the businesses these guys are in. It's mind-boggling how Immelt just seemed to run the other way than the world was moving.

Has Buffett Lost His Mind?!
OK, so back to Buffett. Has he lost it? Is he buying more AAPL shares? Does he need intervention? Should he undergo some tests to make sure he is OK?

I have no idea. I'm sure he is fine, and all accounts (from the annual meeting etc., and is interviews on TV) seem to indicate he is fine.

I guess AAPL is so big because it's the first time in a long time that he really got to like something and it was large enough so that he can actually buy a ton of it. Remember, he was capped at 10% on Wells Fargo due to bank regulations.

I own BRK, and I don't really like AAPL, but I'm not going to hedge out the AAPL piece.

We'll see.

JPM 2017 Annual Report (JPM)

It's been pretty quiet around here.  This post has been sitting in the queue for a long time, so I figure I'll just get it out now.

Things seem to be pretty fully priced. When I first started this blog back in 2011, banks / financials were cheap, analysts were bearish, the public hated banks (well, they still do) and Occupy Wall Street was in full force.  That was one of the reasons I started the blog in the first place, to say that not all banks are evil, and no, banks aren't dead etc.

Market
I still feel the same about the market as I've been saying for the last couple of years. I am not really bullish or bearish, but I have no problem with valuations and don't really see a bubble, except in certain areas.

Yeah, it was scary when the market was down more than 1,000 points earlier this year. But I was not really all that worried. If this is a bubble and a top, it's one of the most timid bubbles of all time. At least that's what I think. Most bears talk about how much the stock market has rallied since the low, and I think that is nonsense.

If a stock goes from $100 to $50, and then back up to $100, is it really overbought? It might be. But not necessarily. If you look at previous bubbles, markets appreciated a LOT from the previous high. In this case, we are not that far above the 2007 peak.

Anyway, that's my view. I know many don't agree, but who cares, really.

Also, people seem to be freaking out that interest rates are rising. But all my bubble posts used 4% as the 'normalized' long term interest rate, and the market is not expensive, in my mind, even with interest rates at 4%, let alone 3%. So that, to me, is not yet a big concern. Of course, interest rates can overshoot due to higher than expected cyclical inflation. But that doesn't really concern me all that much. Sure, the market will tank on each interest rate uptick, but since the rubber band is not that stretched (in terms of the relationship between P/E and interest rates), there is no need for the market to go down all that much.

Buffett also keeps saying that stock market valuations are driven by interest rates. Critics say comparing earnings yield to bond yields is wrong as it compares 'real' versus 'nominal'; bond yields don't adjust to inflation but earnings yields do (over time as earnings will increase with inflation).
This is true, but if you make that argument, then maybe earnings yields have to be compared to the TIPs bond yields, which is 'real'. 

10-year TIPs yields around 0.9% these days, so to compare real-versus-real, the stock market should be trading at 111x earnings. But don't forget, company earnings grow with the economy over time and not just with inflation, so stocks still have a 2% or so advantage over TIPs even at 111x P/E.

But of course, this is all just theoretical mumbo-jumbo. I wouldn't tell anyone with a straight face that the market should be trading at 100x P/E. I wouldn't pay that either, and if the S&P 500 index was trading that high, even I (the avid non-market-timer) would be long a boatload of puts!

Moving on...

Buffett
I watched the annual meeting and his long interview on CNBC and it was great as usual. But honestly, I don't remember the last time a question was asked and the answer wasn't something I would have guessed. The letter to shareholders too was the usual, and like others, I was surprised at how short it was. He is getting old so regardless of what he says, he is probably slowing down a little.

What might happen, and might be really cool, is if others contributed to the letter. Maybe Todd/Ted/Ajit /Greg can contribute a section in some way. That would be interesting, and would be a nice transitional thing to do.

Privacy/Facebook:
The latest thing in the press is about Facebook and privacy. One thing I don't understand is that when we joined Facebook, we sort of all assumed we will have no privacy there. That's why I don't have my real birthday there, no credit card information nor my social security number. I remember upsetting some people when I didn't put my real photo on the profile page. Well, my fear was that not too far in the future, people would be walking around with something like Google Glass, and they will know immediately who I am because of the facial recognition app that will no doubt be installed on it. The glasses will automatically see my face and do a search, find my image and profile (either from Facebook, Google+, LinkedIn or wherever.

If you are tagged even once on a public photo, the engine will be able to identify you anyway, even if your profile photos show a picture of Dexter Morgan. Once they know your name, the app will search through Linkedin, find out what you do and then maybe scan Glassdoor to estimate what you make etc... All of this will show up on the glasses, and will do so for anyone that is looked at. Creepy stuff. But that day is inevitable, I think. One day the IRS will get hacked; you will be sitting in the subway with your hi-tech glasses and look around and you will see the tax returns of every face you focus on. This is certain to happen, eventually. I have no doubt about that. This is the sort of thing that scares me. (but then again, I have nothing to hide, so I don't really care. It's just creepy)

But anyway, I was kind of surprised at all this outrage about FB; what did people expect? You fill out a questionnaire or do those silly trivia games and are shocked that someone is using that data?!

Actually, it seems like it is not affecting too many people, so maybe it's just the press going crazy over it and making more of a big deal out of it than your average FB user.

I still think mobile phone companies and credit card companies know far more about you than FB; those guys know where you are, what you spend money on going back decades etc. Creepy. But that's been true for a long time.

JPM
Anyway, as usual, the JP Morgan annual letter is a great read. No need to elaborate much on it, but as usual I love the charts they put in it and in the proxy. These are charts I've been following for years, even before they started to put them regularly in the reports.

Conference call
By the way, I usually listen to the JPM conference calls every quarter. There is a lot to learn from them, and when Dimon is on, he is usually pretty blunt, so fun (and educational) to listen to.

But one thing that I wonder about is the format. When you listen to some of the high-tech conference calls, what's cool is that some of them totally drop the summary and go right to Q&A. Do we really need someone to read off the highlights from each slide? I would rather that be cut and have a longer Q&A session, or have topics not covered in the slides. It seems kind of silly that someone just reads off something we all have already.

Amazon's meeting protocol is interesting. I think they spend 20 or 30 minutes reading the material (at the meeting) before they start discussing stuff. Obviously, there would be no need to have a conference call and be silent for the first 30 minutes... Maybe just release the documents 30 minutes sooner or whatever (I know they release it before the call, but just increase the time in between, maybe). Give people time to go over it so on the conference call, they can just focus on the Q&A, and maybe a short comment just highlighting important things.

But I don't know. Maybe the analyst community likes it that way as they have to sit through a bunch of these during earnings season and they like that slow time in the beginning so they can flip through the slides etc. But for others, it's a tedious section to sit through...

Bitcoin
I haven't changed my mind about bitcoin at all, and no, I haven't gone out and secretly bought some "just in case". Nope. Didn't do that and don't plan to. I continue to side with Buffett on this. And he had a good point in the interview/annual meeting: these things with no intrinsic value and where people can only make money if more people come into; people get angry when you speak out against it as they need people to come in for the price to go up.

I remember the anger and emotion when people spoke against gold too. But you never really see value investors get upset when bears talk down value stocks.


Hedge Funds
What's up with these big hedge funds?  I don't know. I am a fan of the big hedge funds, generally, but many have been doing horribly in recent years. I am especially shocked how bad Einhorn is doing, as he seems to be making the same mistake that the big funds made back in the 1997-2000 rally. If you remember, guys like Julian Robertson and Stanley Druckenmiller had trouble back then, as shorting expensive stocks and buying value didn't work for a few years back then. One would think people wouldn't repeat that mistake, and yet, Einhorn is short a bubble basket.

Anyway, his analysis is probably right, and those stocks will probably go down or be valued more realistically at some point. But the problem is you could have argued that with Amazon and Netflix for years. Who is to say it has to 'normalize' within the next twelve months? And if it doesn't, the stocks can be up another 30%, 50%, or 100%. If the market is ignoring fundamental valuation, that just means something trading at 100x P/E can just as easily go to 200x P/E. Why would you want to get in front of that!?  I don't know.  But these guys are way smarter and richer than me, so who am I to say.

Average Holding Period of Stocks
People often talk about the average holding period of stocks, and how that has been shortened dramatically. I tend to think that analysis is flawed, as many of those figures use trading volume as one of the factors. Well, with all that HFT trading going on where portfolios can turn over 100% in minutes, that sort of skews the data. Just because a bunch of quants start trading with average holding periods in micro-seconds, that doesn't really affect the rest of us who still like to own stocks for 5, 10 or 20 years.

But anyway, not a big deal.

Ian Cumming/Leucadia
I realized way after the fact that Ian Cumming passed away earlier this year. I don't go to many annual meetings, but I will never forget the last LUK annual meeting with Cumming/Steinberg. I wrote about it here.

Not long after that, Leucadia changed it's name to Jefferies Financial Group and ticker symbol back to JEF.  Oh well. I guess that reflects the reality that LUK is not really LUK anymore (and wasn't after the merger).


JPM
OK, so most of these are self-explanatory but let's look at some of the charts from the JPM 2017 annual report.

JPM is doing well against comps in terms of cost and return on tangible book.










Classic Dimon; snip from annual report:

I was recently at a senior leadership offsite meeting talking about bureaucracy. We heard bureaucracy described as “a necessary outcome of complex businesses operating in complex international and regulatory environments.” This is hogwash. Bureaucracy is a disease. Bureaucracy drives out good people, slows down decision making, kills innovation and is often the petri dish of bad politics. Large organizations, in fact all organizations, should be thought of as always slowing down and getting more bureaucratic. Therefore, leaders must continually drive for speed and accuracy to eliminate waste and kill bureaucracy. When you get in great shape, you don’t stop exercising.
Meetings. Internal meetings can be a giant waste of time and money. I am a vocal proponent of having fewer of them. If a meeting is absolutely necessary, the organizer needs to have a well-planned, focused agenda with pre-read materials sent in advance. The right people have to be in the room, and follow-up actions must be well-documented. Just as important, each meeting should only run for as long as it needs to and lead

I love these two quotes. I worked at a large company and it's so true. People tend to spend more time building and defending bureaucracies than building businesses at big places. Dimon talks about having war rooms to tackle urgent issues. Part of why that's so great is because the teams are put together for specific projects, and are presumably disbanded after the task is done.

The problem with big companies, oftentimes, is that a section or group is set up to deal with certain issues, but when those 'issues' are resolved or are no longer issues, the group or department, have to invent other reasons to keep existing. Or sometimes they don't even have to do that; the department survives with underemployed people doing nothing all day long (I have seen this). They can't shut down these divisions because there is no place for the managers to go, and they can't be demoted. With ever expanding companies, this is an issue as you have to sort of create more and more of these divisions that worthy employees can be promoted into.

There probably shouldn't even be departments/divisions at all. Teams should just exist temporarily for specific tasks and that's it. Once you create a department, it just creates incentive for the head of that department to get bigger, and of course, they will resist change when the environment changes. So ban divisions! 

But of course, that's easier said than done. I am not a manager, so it's easy for me to say! 

Moving on...


From Proxy:


a2018proxyp46totalshareholde.jpg

1 TSR assumes reinvestment of dividends




The Firm has demonstrated sustained, strong financial performance
We have generated strong ROTCE over the past 10 years, while more than doubling average tangible common equity (“TCE”) from $80 billion to $185 billion, reflecting a compound annual growth rate of 10% over the period.

a2018proxychartsp45rotcea02.jpg



We have delivered sustained growth in both TBVPS and EPS over the past 10 years, reflecting compound annual growth rates of 10% and 19%, respectively, over the period.
a2018proxychartsptbvpsepsa03.jpg
 
ROTCE and TBVPS are each non-GAAP financial measures; for a reconciliation and further explanation, see page 115. On a comparable U.S. GAAP basis, for 2008 through 2017 respectively, return on equity (“ROE”) was 4%, 6%, 10%, 11%, 11%, 9%, 10%, 11%, 10% and 10%, and book value per share (“BVPS”) was $36.15, $39.88, $42.98, $46.52, $51.19, $53.17, $56.98, $60.46, $64.06 and $67.04.
2 
Excludes the impact of the enactment of the Tax Cuts and Jobs Act of $2.4 billion (after-tax) and of a legal benefit of $406 million (after-tax). Adjusted net income and adjusted EPS are each non-GAAP financial measures; for further explanation, see page 115.


Anyway, there is not much more to say about JPM than to say that they continue to be doing really well. Their performance since 2008 is amazing no matter how you slice it; who would have guessed this performance back in 2008 as the financial market started to melt down?

I know I spent more time talking about random stuff than JPM, but whatever... I just want to get this out now so...











Barnes & Noble (BKS)

I love books, and out of all the retailers out there in the past five, ten years, I've spent more time at BKS than anywhere else. It used to be Tower Records or J&R Music World, but now that they are all gone, BKS is one of the only other retailers that I actually enjoy being in (and, of course, some independent bookstores).

Bitcoint tangent
By the way, I don't care, really, either way about bitcoin, but did you guys notice something really interesting? The financial guys that really love bitcoin are some of the guys that either blew up or closed funds due to poor performance. The two most prominent fund manager bitcoin boosters are like that. It almost feels like they are so happy to have found their Hail Mary pass. And the most prominent guys that have good performance and didn't blow up tend to be the guys that don't like bitcoin and think it's stupid, a bubble or whatever.

Think about that for a second. Oh, and that former hedge fund guy, after bitcoin plunged put his new bitcoin hedge fund on hold (buying high and selling low?). Now wonder he didn't do well with his hedge fund; if you're going to be making decisions based on short term volatility like that, you are bound to get whipsawed and lose money.

This is interesting because we can never really understand and know everything. But it is useful to know who you can listen to and who you should ignore. Sometimes, this saves a lot of time!


Back to BKS
But what has been shocking to me, after having spent hours at BKS over the past few years, is how inefficiently run it seems to be. I am always surprised at how many employees there are walking around, or just standing there doing nothing at all. I'll call them floaters. Sometimes, desperate looking employees come up and ask me if I need any help as if they have to fill a quota on how many people they help.

Recently, even before the holiday rush, I saw two BKS employees leaning against the hand-railing playing with their phones. I went to look for some books, came back, and they were still there. Doing nothing at all; not even greeting.

And what about those 'greeters' at the top and bottom of those escalators? They remind me of the Japanese department stores in the 80's; those uniformed employees with handkerchiefs held against the escalator handrail, bowing to customers as they get on and off. Yes, BKS has the equivalent of that, in 2017!  Sometimes they stand so close to the escalator that it seems dangerous as it blocks people from getting off... I almost tripped when someone stopped right at the top of the escalator to ask a question. Last fall, I saw two people at the bottom of the escalator. Do we really need so many greeters? (and why are they all white?! Even in diverse Brooklyn, all of the employees are white, except for security guards and cleaning staff. Is BKS so old-fashioned to think that only white people have college degrees and are capable of working at BKS? This is 2017, not 1830. Come on!).

With 600+ stores, these greeters and floaters can be very costly. I can't imagine them making less than $15/hour. At 8 hours a day and 600 stores, one of those floaters (I call them that because they just float around doing nothing) can cost the chain $26 million/year. You get two of those, and that's $50 million/year.

To put this into context, the bookstore (excluding NOOK losses) had operating income of $91 million in 2017 (ended April 2017).

Of course, this may be a little too simple; not all stores will have elevator greeters etc., and operators will point to K-Mart/Sears as an example of what would happen if you cut too much in costs (and how financial people are clueless). But that's an extreme case, I think. It doesn't mean there isn't room for improvement at BKS. I know that they respect their 'booksellers' and want that community bookstore feeling with tons of friendly and knowledgeable employees to help people buy books. But it seems a little over the top and outdated to me. But I'm not a retailer so...

Technology
The other thing is that when you walk into a BKS, it's like walking into the 1970's; there is no technology anywhere. OK, there probably is in the POS system and in the back somewhere, distribution etc. But otherwise, the absolute lack of technology is kind of stunning.

Japan is not known for running efficient retailers (there are some good ones, like 7-11, Uniqlo, Muji etc.), but even in Japan there was this cool thing at a large bookstore:



It's a section where customers can search for things on their own. At BKS, when you ask someone anything, most of the time they go to a machine and do a search. I always wish they had one available for customers so we can do it ourselves. It would free up a lot in terms of labor.  Even the New York subways have huge touch-screens so you can find and get information.

Here's the other thing. I notice long BKS checkout lines and wonder why that hasn't been automated. I would think books, due to their relative uniformity, would be the easiest product to implement self-checkout.

And here's the embarrassing thing; even the public libraries have self-checkout now. I love the public libraries and don't mean to knock them, but you don't expect those quasi-governmental, non-profit organizations to be at the forefront of technology. Those self-checkouts are really great. I used to hate waiting in line to check out books at the libraries. Now it is very easy and fast. And self checkouts would mean noone trying to sell you anything! I used to always have this awkward conversation, saying no, I don't need a card, and no, I don't want you to have my email address or mailing address etc...

Also, most of the time when you see someone ask a BKS employee a question, it's "where are the cookbooks?" or some other thing. Any high school coding club could set up a touch screen floor-map of a store pretty easily. I always wondered why there isn't one of those set up by the front door, elevator and escalators. Technology is getting cheaper and cheaper. And BKS seems to be one of the best places to implement some of this stuff. They also have so much data that they would be able to use (just saving what is searched by customers would give a hint to buyers).

Pricing
The other issue is pricing. Even if you are a member and get a 10% discount, the prices on most books are still much higher than on Amazon if you are a prime member (and get free delivery). Amazon built their business on the Costco model, but BKS memberships seems like a half-hearted attempt at that. There doesn't seem to be a real economic benefit to being a BKS member (if AMZN books are still way cheaper than BKS member prices, why bother?!).

If they are going to do it, why not jack up the membership rates and lower member book prices? Why not match online prices like Best Buy? (isn't that how BBY recovered?).

Anyway, I don't know. It's really frustrating to watch this ice cube melt as I really do like BKS and don't want them to go under. But if they keep their head in the sand and try to keep up with this, they are not going to survive, and that would be a bummer for me (where would I hang out in a mall or when I have to wait for someone when they shop?!).

There are a bunch of other things, like, why is their CD/DVD section still so big, and prices so high? Do people actually buy things there? Every time I see those sections, I walk through it and I don't think I've ever seen anyone in there. I saw very few people in there during the holiday season, but usually it's empty or one or two people at most... What's up with that?

I know retailers are dangerous for private equity and activists, but it just seems like there is so much low-hanging fruit there that I can't imagine someone not making money off of gaining control.

Having said that, I don't own any (and have never owned) shares, yet. It is definitely a melting ice cube so I would be careful. But still...







Is Buffett Bearish?!

This is going to be a short post. It's just another one of those things that hit me in the head, like, duh! 

I read all the time that even Buffett is bearish the stock market as he is stockpiling a ton of cash. He has close to $100 billion in cash (and equivalents) on the balance sheet now. The idea is that the market is so expensive he is not finding things to buy (even though he is still buying Apple).

I took it for granted and sort of agreed, thinking that maybe he is just saving up for a really huge deal.

Still, something about this bothered me and didn't sit well. I was catching up my 10-Q's and just read BRK's 3Q and saw these giant numbers on the balance sheet, and something else struck me too, right away. Loss and LAE is up to $100 billion

And that immediately reminded me of one of my old posts where I contended that Buffett never allows cash, cash equivalents and fixed income investments to fall very far below float (old-timers will remember this). In other words, the idea that the low cost "float" is invested in stocks and operating businesses, to me, is baloney. Well, cash/capital is fungible so you can't say float isn't invested in stocks. But still, I noticed this and made a big deal out of it. Well, sort of.

Anyway, I just created a new spreadsheet going back to 1995 to see if what I said is still true (well, there is no reason the historical data would change, of course).

And here it is:

Berkshire Hathaway Cash and Fixed Income vs. Float

I shouldn't be surprised at this as I noticed this myself a few years ago. But check it out. I think people think Buffett is bearish because he used to say that he wants $20 billion of cash on the balance sheet at all times for emergency liquidity. And when cash gets over that amount, it is assumed that this is 'firepower' for the next mega-deal.

By the way, my float is not the same float as Buffett's. For simplicity, I only include Loss/LAE and unearned premiums.

Anyway, check it out. All of that cash and cash equivalent increase is basically just matching the growth in float! And to the extent that cash and cash equivalents have grown quicker than float reflects the reduction in fixed income holdings (from $36 billion in 2009 to $22 billion now), which is more of an indication of Buffett's bearishness on bonds.

The column all the way to the right is just the cash, cash equivalents and fixed income investments as a percentage of my lazily calculated float. You will see that it has been close to 100% since 1995, and I think it was true going further back. The average over this period is the 105% you see at the bottom of the table.

Conclusion
Anyway, the next time someone tells you that Buffett is bearish; just look at his cash stockpile, you can say that is more reflective of his bearishness on bonds (bond balance down, cash up), and the rest is backing up the float, as he has been doing since at least 1995.

Bubble Watch X

The title of this post is pronounced, "Bubble Watch Ten", not "Bubble Watch Ex". So don't sound uncool in public by calling it Bubble Watch Ex...

So the bears keep saying we are in overvalued territory and we will see a huge correction soon. On the other hand, we got guys like Dan Loeb really bullish. As usual, there are a lot of smart guys on each side.

This got me thinking a lot about why the bears have got it so wrong for so long (so far... they will eventually be right! I remember (before my time, but I read about it) how Joe Granville, one of the prominent technicians of the 1970's called for a crash in the market with the Dow at 800. He was proven correct; only problem is the market crashed from 2700 to 2200, so it didn't help at all that he was short from 800. Oops.)

What bubble? 
One of the first things that come to mind when hearing all this bubble talk is that, to me, the stock market still doesn't feel at all like a bubble. OK, there may be some pockets of excess. But in general, I'm not getting the sense of a bubble. Nobody asks me about stocks. Nobody brags about their stock winnings. I am not reading about people quitting their jobs and playing the market to make a living (one of my biggest dollar wins on the short side ever was when I short Apple a while back when articles about people quitting their jobs and living off of their Apple stock gains started popping up, and they were on TV laughing at the skeptics saying that they 'just don't get it' (I am hearing/reading that now about Bitcoin, though! Japanese housewives, young people doing nothing but trading bitcoin and convinced they will never have to work again).

I don't hear any of that talk relating to the stock market. At all.

Plus, here's the other thing. People keep talking about how great the market has performed in recent years as another sign of a bubble.

But the problem with that, to me, is that a lot of that is just regaining what we lost during the crisis. If a stock tanks 50% and then doubles the next day, is the stock really overbought?  I dunno.

Check out this long term chart of the S&P 500 index. I made it a log chart so we don't go, oh my god, it's parabolic! I do believe that parabolic patterns tend to collapse, but it is useless over long time periods.



And ignore the font and background color stuff... I was just playing with Excel, which I haven't used in a long time. But due to various issues (OneDrive being one of them), I have gone back to using Microsoft products and am trying to relearn this stuff. Google sheets is great, but very buggy and frustrating to deal with.

Anyway, if you look at the 1929 bubble, the market went far above it's previous peak. Just eye-balling, the market sort of peaked out at around 10 in 1910 or so, and then rallied to 31 in 1929. That's more than a triple of the old high. Before black monday the S&P 500 rallied to 330 before crashing, and the old high was around 100, so again, the market more than tripled before tanking. During the 1999/2000 bubble, the market went to 1500. If you use the old high of 330, the market rose by 4.5 times. if you use the 1993/1994 area high of 500, the market basically tripled that.

During the Nikkei bubble, the Nikkei rose from 8,000 (the early 1980's high) to 40,000 for a five-bagger in less than a decade. But a five-bagger off the old high, not bear market low.

Where are we now? The previous high was around 1,500 for the S&P, and it's now at close to 2,600. So it hasn't even doubled. And that's a high from 17 years ago. Even using the recent pre-crisis date of 2007, that's more than 10 years.

S&P 500 Index -> 4500!
I am no expert on bubbles, but to me, this is not a bubble. I would call this stock market a bubble if we tripled the old high, or if the S&P went to 4500 or something like that.

Yeah, you heard it hear first. S&P 500 index at 4500. That's what I would call a bubble.

This is sort of consistent with my idea that the market P/E would have to get to 50x for me to be convinced that the market is in bubble territory. You can read my old posts on why that is (based on interest rates. And don't forget, I use what I consider to be 'normalized' interest rates, not current levels).

So, if you ask me, I see no bubble at this point. At all.

Real Fed Funds
The other thing that popped into my head the other day was the comment, "Never short the market with negative real fed funds rate!".  For no reason at all, this comment popped into my head and I couldn't get it out. This kept bugging me. The idea made a lot of sense, but I wasn't sure exactly where it came from. Of course, we all know not to "fight the fed", so this is a version of that, I suppose.

So when I got the time, I decided to just plot the real fed funds rate, and below is the chart:



And here's the thing. It seems like in recent history, the market has basically never gone into a serious bear market or crash with the real Fed Funds rate in negative territory. This makes logical sense. A negative FF rate means money is easy, and when money is easy, asset prices tend to go up. Shorting into that, I guess, is like fighting a tsunami with a teaspoon. Why would anyone do that?!

People keep saying that owning stocks at these levels is speculating, not investing. And yet, some of the folks who say that lose money when the market rallies, which means they are short. I don't know about you, but for me, shorting is speculating and has nothing to do whatsoever with investing.  People seem not to understand the asymmetric risk/return involved in shorting versus just owning stocks.


Static versus Dynamic Models 
Here's the other baffling thing. Much of the world seems still to be stuck in the world of static economic models. If something goes up, they must go down. If an expected return is low, the price must eventually decrease (ignoring the fact that expected return can remain low for a long, long time).

This all reminded me of an old book that confused a lot of conventional thinkers, and I think people who haven't read it should read it.  Even now:

The Alchemy of Finance

(for some reason, my Amazon bookstore is dead... oh well. I haven't looked at it in a while and now it's just totally gone. I must have missed an email or two from Amazon (probably thought it was spam and ignored it)).

30 years later, it seems like economists still think the old way and haven't really modernized. I suppose there have been new developments in behavioral economics, but I don't really see much of it when people talk about the market and economy; they all still sound like they did back in the 1980's.

But then again, I guess it doesn't really matter all that much, because most people we see or hear about are asset gatherers and spend most of their time telling people what they want to hear. They don't really care as long as they can gather assets. The ones incorporating new models and making money won't talk about it.

Anyway, I think the Soros book is very timely right now as we probably are in the midst of some sort of virtuous circle. I admit this can't go on forever and things will eventually turn.

But figuring out when it will turn is something nobody will be able to do. If I had to guess, you know what I would say. I already made a case in previous posts that a market P/E of 50x or more would indicate to me a clear and present danger of a serious bubble. And now with the added analysis of a S&P 500 index at 4500 (this is not a forecast or projection!), that to me would also indicate a serious possibility of a bubble.

This Time is NOT Different
The bears always say, "This time is not different. Bulls like to think this time it's different". Well, I dunno. I am not necessarily bullish (I am a market perma-agnostic!), but I too agree that this time is not different.

I believe the market would have to get to bubble levels before we are at risk of a serious bear market. Also, in addition to the market and P/E levels I mention above, I will now also keep an eye on the real Fed Funds rate as the market has never in the past entered a serious bear market or crash with negative FF rates.

So no, this time is not different at all. And if it's not different, we shouldn't see a big bear or crash any time soon (famous last words!  I know the market will start to tank right after I hit the "publish" button, but that's OK!).

p.s.
...Oh, and by the way, as I was cleaning out a bunch of spam in the comments section, I accidently deleted a bunch of valid comments. Sorry about that. As you know, I don't delete comments from real commentors, even if they disagree with me, criticize, or whatever...


Bitcoin, Marks

It's been a long time since posting last. I've gotten comments and emails wondering where I've gone. Actually, nothing has changed and it hasn't been a conscious decision to scale back here at all. I've been wanting to post.

Part of it may be that I was a little busy. I have been getting involved in volunteering here and there and sometimes it takes up a little more time than expected, and before you know it, you have no time for other stuff. Not to mention I have so many things I like to do, like coding/programming, reading etc.

The other reason for not posting much, I guess, is that things haven't really changed all that much. Maybe I'm coasting on things that I like that are doing well. I still like most of what I've talked about here and there hasn't been any reason to change anything.

Anyway, what triggered this post is another great memo from Howard Marks. If you are curious about bitcoin, or what to do about the markets (overvalued?), you should read this. Of course, most readers here probably already read it.

Howard Marks memo

This memo is fascinating because it deals with two things that I have been thinking about a lot over the past few years (OK, I haven't really thought about bitcoin all that much, actually, but I have been getting the indicators that it is indeed a bubble; people I know telling me it is going to $100,000 and are probably already calculating their net worth based on that price. At least that's what it feels like).

The Market
I haven't really changed my mind about the market at all. I've written a lot about what I think and nothing has really changed. The market is still expensive, and interest rates are still low. I still think a reasonable 'normalized' interest rate (10 year) is around 4.0%. And in that environment, stocks are still not expensive.

A lot of smart people are saying that it is way too expensive using some long term average, like the past century. Well, my view is that to use that as the norm, one would also have to assume that the average interest rate in the next century will be like the last century, and that's not at all a given. So in that sense, we can't really say what the average P/E ratio is going to be in the next century, let alone the next decade.

One argument is that low interest rates haven't helped Japanese stocks. This is an interesting thought and I may take a close look at that at some point as I did spend some time in Tokyo this summer. It is really an interesting, fascinating place. But it can also be incredibly frustrating too.

What To Do
Howard Marks writes about the options investors have at this point in an overvalued, late cycle market. He has a problem with people saying to do nothing and invest as usual. He makes a great argument but I sort of wonder about that.

Maybe it's different in fixed income versus equities; in fixed income there isn't much upside but a lot of downside. In the stock market, there is huge upside to offset huge downside.

Marks says that we do have to do something here, whether it be to lighten up, reduce return expectations, or some of the other things he lists (I agree we have to accept lower prospective returns; there is no arguing against that).

 First of all, one problem with this discussion has to do with who you are. If you are an equity fund manager, hedge fund, pension manager, asset allocator, individual investor (IRA, 401K, young person, old person) etc.

My guess is that for most people, do nothing should be fine. As Buffett said a while back, the stock market returned 10%/year in the last century, but most people who owned stocks didn't come close to that. Why? Because they kept getting in and out of the market trying to outsmart it.

When you think about that, it makes you wonder whether getting out or lighten up when you think the market is expensive is a wise decision. As I've said often before, when you look at the returns of the folks who do try to allocate capital according to forecasts, they haven't done all that well.

You can call this discipline, to get in and out according to the risk in the market. But go back to the fifties when dividend yields dipped below interest rates, which was unheard of. It's easy to imagine someone getting out of the market promising to keep discipline and go back in only when dividends yields are higher than interest rates (they would have finally gotten back in in the past few years!).

If you are young and are 100% in stocks in your IRA, that's fine. Even if you are not so young, it should be fine too as long as you understand the markets can be volatile and prospective returns are probably not going to be as high as in the past.

Keep in mind, the difference between stocks and bonds. If you are 100% invested in a great stock, say, Berkshire Hathaway, and you are worried about the market and want some spare cash just in case the market takes a dip. Well, if you are 100% invested in BRK, you are part owner of a heck of a lot of cash (on the balance sheet) and cash flow. If the market tanks, BRK will benefit. BRK will be buying. Would you not be better off letting the folks at BRK take advantage of the dip than you? Well, if the markets really tank, it's true that you might be able to get better deals (as you are probably more nimble).

But even if you stay 100% invested in BRK, they will take advantage of the dip and you will benefit.

Think about if you own a bond. If you own a BRK bond, you may not benefit on a dip in the market. BRK's bond value probably will not increase after a dip and recovery whereas the stock may very well come out bigger and stronger (maybe BRK's credit improves afterward, but probably not so much).

If you owned a high-yield bond and there is a dip, this mechanism wouldn't really work either, I don't think. A dip might hurt high-yield bonds more so you get killed, and the issuer may not come out the other side stronger as it's credit is not that strong to start with so may not be able to take advantage of a market dip to grow.

Old Greenblatt Memo
After the financial crisis, Joel Greenblatt posted a great comment on the Gotham website. He said that the mistake was not that people didn't see the crisis and didn't get out of the market in 2007. The mistake was that people owned too much stocks so that when it went down 50%, they panicked and sold out at the bottom.

He said that you should own an amount of stocks where a 50% drop won't be too upsetting to you. If you have a $100,000 stock portfolio, and a $50,000 mark-to-market loss would upset you, then you shouldn't have $100,000 in stocks. Many people invest too much assuming the bell will ring at the top so they will be able to get out.

I think the same applies today. It is not a mistake to be heavily invested (as long as you understand that markets will fluctuate, and will not return 10%/year going forward), as long as a 50% drop (and noone can predict when this will happen) won't be too upsetting to you.

If you are worried, lighten up, but lighten up because you think you might have too much exposure to stocks, not because you think you will be able to get back in at a better price later on because that probably won't happen.

Bitcoin
The most interesting part of Howard Marks' memo is about bitcoin. He was apparently bombarded by emails after his previous memo when he said that the bitcoin is a Ponzi scheme.

Of the folks supporting bitcoin is the dynamic duo from FRMO, Murray Stahl and Steven Bregman. Marks spoke at length about bitcoin with them.

Here is the FRMO letter to shareholders where they talk about crytocurrencies:

FRMO letter

If you are on the fence about bitcoin, go read this FRMO letter, and then read the Howard Marks letter. You will get a really good overview and arguments of both sides.

I have to say as much as I love technology, I don't get this one. Jamie Dimon said the other day that this was a fraud. That may be a strong word for it. I don't know if there is really any intent to defraud; these people probably actually believe it can be a real currency alternative, in which case it's not really fraud. But maybe it is fraud. Who knows.

What I don't get is that they say that central banks can print as much money as they want, but we know the supply of bitcoin going out into the future; there can't be more than that produced.

But who said that the bitcoin is going to be the only alternative cryptocurrency? The U.S. dollar has value because it is backed by the U.S. government (but nothing else), and nobody can just buy a printer and just start printing them. You can't just print your own, private dollars either. Well, I guess you can (via gift certificates, frequent flier miles, bonus points etc.).

The whole point of something valuable is it's universal acceptance. Gold, too, has a limited supply, but it has been accepted as a store of value for centuries. I have no idea where gold prices will go, but it will probably stay 'valuable' for many years to come.

But bitcoin? People lose bitcoins because they lose their USB drive that held the code, some exchange gets hacked and people lose bitcoins. If someone hacked a U.S. bank and took people's money, the FDIC would back it up. What kind of insurance or guarantee comes with bitcoin? What if one day it just doesn't work or you can't get access to it. Who do you call? What if there is a flaw in the system? Are bitcoin fans well-versed enough in the technology to figure out what went wrong?

If I woke up and my bank's website wasn't there, I can walk to a branch. If the branch isn't there, I can go to another branch, or the headquarters office. If it's not there, I can call the State bank regulator or other regulator to ask what happened and try to retrieve my money.

What's the equivalent in the bitcoin world? Who really runs it? Yes, they say nobody (or everybody). But that too is kind of scary.

China just said they are going to shut down bitcoin exchanges, and Japan announced the other day that gains and losses from bitcoin trading/investing will count as other income (I think that's what it was) and will be taxable. They said that this includes purchases with bitcoin. If you buy something with bitcoin, then you have to pay taxes on the gain.

Now, think about that for a second. How complicated is that going to be? Every time you use your bitcoin to buy something, you are going to realize a taxable gain?! What kind of payment mechanism or currency is that? That's just crazy.

OK, bitcoin supporters would argue that this will not happen because bitcoin is not trackable. There will be no 1099 or anything like that associated with it so the IRS (or the Japanese equivalent) will never know. I don't know about that. It would be surprising if they did nothing and let it stay this way; then nobody would ever pay taxes in a few years!

It's kind of incredible that so many people have jumped on the bitcoin bandwagon before the governments around the world have figured out what to do with it. Just letting it alone is a low probability scenario, I think. More likely is something like what Japan did; make it a taxable item, whatever it is. I'm kind of surprised that people aren't looking at this also as a gambling vehicle. I don't know much about gambling laws, but bitcoin as it works now sure looks like a vehicle for gambling to me.

In any case, I haven't changed my views about bitcoin. It's an odd curiousity. Kind of interesting. But without knowing how the laws will handle it, there is no way to determine if it has any real value. At least that's what I think even though there are many people smarter than me that believe in it.

If I miss this party, well, it won't be the first. If I don't understand it, I'll just stay away.

Anyway, we'll see what happens!


Bubble Watch

Shiller said the other day that the market can go up 50% from here. OK, so I fell for it and clicked to watch the CNBC video. This was sort of a surprising comment coming from the creator of the CAPE ratio, one of the main indicators bears use to argue that the market is way overvalued.

Of course, this is not Shiller's forecast or expectation. In fact, he says that this is very unlikely, but it is possible. His point was simply that the CAPE ratio is 30x now, and in the 1990's it went up to 45x. So if that happened again, that's a 50% increase.

This is totally possible, especially now. I would not invest in the market with that expectation, of course. Actually, I would invest with the opposite expectation (when pressed, Shiller said the market is more likely to go up 50% than down 50%).

Trailing P/E
Let's put the CAPE aside for now and just look at regular trailing P/E's. Back in 1999, that went up to 30x, and in 1987, it went up to 21.4x (this is from the Shiller spreadsheet).

We keep hearing from the bears that the market is as expensive as it was during previous peaks, so we are in dangerous territory; they say we are in a bubble.

OK. That is possible.

But in previous posts, I argued that if 10 year rates stabilize at 4% over time (it's at 2.3% now), it is possible that the market P/E can average 25x during that period. Maybe the market fluctuates around that average, so the market can easily trade between 18x and 33x P/E without anything being out of whack. (Buffett also said at the recent annual meeting that if rates stay around this area, then the stock market could prove to be very undervalued at current levels.)

So we have a problem. This 18-33x P/E range puts the market in bubble territory according to the bubble experts. But we are saying here that if rates stay at 4%, that's the normal range the market should trade at.

So then, how can we tell when we are in bubble territory?

Since we are using interest rates to value the stock market, we will have to interest rate adjust our bubble levels too.

Interest Rate Adjusted Bubble P/E
So just looking back at 1999 and 1987, here are the indicators at the time:

               PE          EY       10yr
1987      21.4x      4.7%     8.8%
1999      30.0x,     3.3%     6.3%

Both 1987 and 1999 had the feel of a rubber band stretching and then snapping. You will see that the earnings yield was 4.1% lower than the 10 year rate in 1987 and 3% lower in 1999.

Right now, the P/E ratio is 23.4x, for an earnings yield of 4.3% versus the 10-year rate of 2.3%. So it's a full 2.0% higher, not lower. But even I think 2.3% on the 10 year is too low. I use 4.0% these days for what I think is a non-bubbled up, unmanipulated-by-the-Fed, sustainable, normalized rate.

Using this spread, long term rates would have to go up to 7-8% for me to worry about an overstretched rubber band snapping.

How about the stock market? How high would it have to go before I think we are really in bubble territory?

With interest rates at 2.3%, we can't deduct 3% or 4% from it to get a bubble-level earnings yield.
So we'll look at it as a ratio.  In 1987, earnings yield got to as low as 0.53x the bond rate (4.7%/8.8%) and in 1999 it got to 0.52x (3.3%/6.3%)

Using the current 2.3% 10-year rate, earnings yield would have to get to 1.2% for me to really think that maybe we are in a stock market bubble.  That comes to 83x P/E!  At that level, trust me, even I won't be talking much about long term investing, and would probably be net short with a bunch of put options too.

But wait, let's not use 2.3% because we all know that's too low. Let's use my normalized 4%.  Even with a 4% bond yield, earnings yield would have to get to 2% to be considered really bubble level.  That is a P/E ratio of 50x.   That's more than a double from here.

So for me, the market would have to actually more than double from here before I see it as really bubbly. (If you want to see what a real bubble is like, look at Bitcoin!)

Narrow Market
The other thing I hear a lot is that the market is up only because of the very few hot tech stocks like the FANG stocks. They make it sound like the market would be doing nothing without them. Maybe.

But just as a quick check, I compared the S&P 500 index (ETF: SPY) to the S&P 500 equal-weighted index (ETF: RSP); the super-large caps would have no more impact than the smallest S&P 500 companies.

Check this out:
  (The blue line is the RSP, green is SPY)

SPY versus RSP Long Term

SPY versus RSP 10 Years

SPY versus RSP 5 Years


In all of the above time periods, the RSP outperforms SPY, which I don't think would be the case if it was only a few of the super-large caps that is pulling the S&P 500 index up.

Just for fun, I looked at the S&P 500 index versus the Russell 2000 index too. If only a few super-large caps were pulling up the averages, then obviously, the S&P 500 index should be outperforming the Russell 2000 too.  The blue line is the Russell 2000, and the green line is the S&P 500 index.


S&P 500 Index versus Russell 2000 - 5 Years

S&P 500 Index versus Russell 2000 - 10 Year


Here too, I don't see the S&P 500 outperforming in a big way lead by the supers.  To the contrary, the S&P 500 index is behind the Russell in the 10 year period.

I had no idea what I would see when I put up these comparisons. Looking at them now, I am a little disappointed in active managers who claim that they are underperforming because they don't own the FANG stocks; the above shows that maybe that's not the issue.

Anyway, that's another ongoing topic here.

Conclusion
All of this stuff, I just do sometimes to satisfy my own curiosity; not to make any claims either way. I have no idea what the market will do, but I don't believe we are in a stock market bubble at all. OK, if interest rates got up to 7-8% and valuations are still here in the 23-24x P/E area (trailing basis), then yes, I would agree we have a valuation problem.

Otherwise, it would take a market P/E of 50-80x for me to think we are in a stock market bubble (and I would put on shorts and load up on puts! But even then, I wouldn't expect an immediate payoff. If the market took off like that, it would be very hard to pick the top).

Otherwise, we are just, in terms of stock market valuation, in the "zone of reasonableness", to borrow Buffett's phrase from a few years ago.

Also, keep in mind, this 50-80x P/E ratio range is not a target, of course. That's where it has to go before you convince me we are in a stock market bubble.

Also, this doesn't mean the market can't enter a bear market at any time. There was no interest rate / earnings yield rubber band in 1929 and 2007.

High Fees

So, I was taking to a friend who has a million dollars in a large cap stock fund. The fund happens to be the Fidelity Magellan fund. The fund is very famous for being the ship that Peter Lynch navigated. But years later, it's just another generic, closet-index/large cap fund.  I don't follow mutual funds too closely, but my initial thought was that there is basically no chance of Magellan outperforming the S&P 500 index over time.

And, of course, the expense was almost 1%.  That is kind of shocking.

When you read gambling and trading books, they always tell you not to think of money as real money. When you are betting in poker and you see the $70,000 of cash in the pot as a BMW,  you will make really bad decisions and will play poorly. If you see the loss on your portfolio as two years of your kid's college education, you will freak out and make irrational moves. (Actually, if you really need that cash for your kid's education in the near future, then maybe you should freak out, and maybe you shouldn't have that cash in risk assets!)

But let's do the opposite now.  I said to the friend, gee, well, do you have a reason to believe that the Magellan fund will outperform the S&P 500 index over time? Not really. OK, then why are you basically writing a check for $10,000 per year? That's almost $1,000/month.  That's a lot of money for a retired person. Why would you write a $1,000 check every single month for nothing?

In ten years, that's $100,000 gone. Poof.  For absolutely no reason at all. That's more than most people have in their IRA's.

It's hard to notice these things as they are just deducted from the account so you don't actually write a check every month. If you did, you would probably think about it a lot harder.

1% Too High?
Mutual fund fees are too high for most funds. There are some funds that may be worth the fee, especially some of the value funds with long term track records.

But with expected equity returns of around 5-6% going forward, we have to wonder about 1% fees. It's one thing charging 1% fees in a 10% equity return world, but it's a whole different world now. Maybe fees should be restructured so that the fee is minimized to cover overhead and bulk of fee comes from outperforming a benchmark index.  I don't know. I actually don't own any funds so it's not really an issue for me, but something interesting to think about.

Speaking of high fees and having watched the Berkshire Annual Meeting video, it reminded me of a fund with really high fees.

Wintergreen
Some people believe that there is no bad publicity, but in this case, maybe it was bad publicity. David Winters of the Wintergreen Fund criticized Coke for their egregious stock compensation plan and even criticized Warren Buffett for not speaking out against the plan and even went so far as to sell Berkshire Hathaway stock in a huff saying that Warren Buffett no longer looks out for his shareholders.

This was kind of shocking for a few reasons.  First of all, when Winters talked about the massive wealth transfer, his number was totally off. I talked about it here, and Buffett said the numbers were also way off. So it means either that Winters is not a very good analyst, or is simply dishonest and threw out a huge number deliberately to get attention. I don't know which is worse, but either way is not very encouraging for his shareholders (take your pick: incompetence or dishonesty). He also sold off Berkshire Hathaway because of this. This seemed to me he was taking all of this personally and getting too emotionally involved. I don't know. But that's what it seemed like.

This lead Buffett to mention at an annual meeting that Winters charges very high fees for bad performance. Ouch. A lot of people love to go on CNBC because it's free advertising. But sometimes it backfires, particularly when you criticize a giant with no track record to back it up (and charge fees much higher than anyone else!).

First of all, this all happened in 2014. Winters sold his BRK in the 1Q of 2014. His fund is in red, BRK is blue and the S&P 500 index is the green line.


The Wintergreen Fund had assets of $1.6 billion in Dec 2007, but still had more than $1.2 billion as recently as the end of 2013. But as of the end of 2016, AUM was down to $300 million.  There is some AUM in the institutional class too but that is down a lot too.

Here is the performance of the fund:



That's a pretty huge underperformance no matter how you slice it.

OK, that's not so uncommon these days with active managers underperforming.

But here's the shocker. Look at the fees charged on this fund:


That's 2%! First of all, the fund underperforms in all long term time periods. In a 5-6% return equity world, the fund is basically charging 33%-40% of expected return!  But that's assuming the fund keeps up with the index, which historically hasn't been the case. If the fund lagged 1%/year on a gross basis that comes to more like 40-50% of expected returns going to the manager. That's truly insane.

And looking at this on a real cash basis, if you had $1 million in this fund, you would be writing a check for almost $20,000 per year! That's some real money.  Over 10 years, that's $200,000!?  You had better be sure someone will outperform the index if you are going to be writing checks that big every year.

One may argue that the benchmark is wrong; Wintergreen owns non-U.S. stocks. Actually, as an investor, that shouldn't matter. The fund doesn't have an explicit mandate that they must invest internationally or anything like that. If they invest in non-U.S. stocks, it has to be because they think non-U.S. stocks are more attractive; that they will outperform U.S. stocks. Or else why bother, right? So in that sense, benchmarking against a completely neutral S&P 500 is fine.

It's kind of crazy what people get away with.

I know people will immediately respond by saying, yeah, but you like all those alternative managers with even higher fees!  Well, most alternative guys charge too much too, but the ones I tend to like do have really good long term records.

Mutual Funds Sticky
Here's the thing about mutual funds versus alternative funds. I think a lot of mutual fund assets are really sticky due to the indifference of many investors. They just leave it and don't think about it, which is the correct approach to investing, generally. But the downside is that many don't realize how much is being sucked out of their net worth from these fees for no return.

Hedge funds, private equity funds, on the other hand, have investors who are more active in tracking performance etc. If you perform poorly, you will lose assets more quickly and go out of business as many hedge funds have seen in the last few years. Mutual funds can last forever on dreadful performance.

KO
And speaking of KO, it was also in 2014, I think, that Kent (KO CEO back then) started talking about zero-based budgeting. I was skeptical about this at the time; a lot of CEO's would just grab the latest buzzword and throw it in their presentations just to show how hip they are to the current state of the world (Now it seems to be AI, machine learning, big data etc... Well, that's all over Dimon's letter too, but financials have been big into these areas for a while...).

Anyway, KO is too big for most to make a run at it so there is no real sense of urgency there so you know nothing is going to happen, not to mention the arrogance there from a century of dominance. I have made the case that for anything to change at KO, it's going to have to come from the outside. Internal people will not be able to make big changes; they can't pull off the band-aid as it would hurt too many 'friends'.

Look at margin trends since they claimed they started using zero-based budgeting:

Analysis of Consolidated Statements of Income
Percent Change  
Year Ended December 31,
2016

2015

2014

2016 vs. 2015
2015 vs. 2014
(In millions except percentages and per share data)
NET OPERATING REVENUES
$
41,863

$
44,294

$
45,998

(5
)%
(4
)%
Cost of goods sold
16,465

17,482

17,889

(6
)
(2
)
GROSS PROFIT
25,398

26,812

28,109

(5
)
(5
)
GROSS PROFIT MARGIN
60.7
%
60.5
%
61.1
%

Selling, general and administrative expenses
15,262

16,427

17,218

(7
)
(5
)
Other operating charges
1,510

1,657

1,183

(9
)
40

OPERATING INCOME
8,626

8,728

9,708

(1
)
(10
)
OPERATING MARGIN
20.6
%
19.7
%
21.1
%


Operating margins are actually down from 2014.  So much for zero-based budgeting!

Munger indicated that a $150 billion deal would be huge for Berkshire Hathaway, so it is unlikely that BRK could make a run for KO on it's own. But in some sort of combination with BUD, KHC or some other 3G entity, who knows what will happen.


Berkshire Hathaway Annual Meeting Last Question
By the way, the last question on the Yahoo video was about CEO's social responsibility; should companies move jobs overseas to increase profits at the expense of local communities, domestic jobs etc.?

This was really a good question and I think about that sort of thing all the time. Do we always have to be the most efficient and lowest cost at all times? Do we really need to be increasing productivity all the time? Why can't we come to some stable status quo and not keep trying to grow or increase profits all the time?

And I always seem to go back to Japan. Japan is a country where companies usually do act responsibly and really doesn't want to fire people. And Japan is in terrible shape, I think, large due to that. Long time Canon CEO, Fujio Mitarai, explained that Japan can't compete well in many industries because they operate under the system of corporate socialism. The Japanese government won't provide unemployment and other social safety nets; Japanese corporations are expected to take care of redundant workers (by not firing them) etc.

You can protect people for a while like that, but at some point, the burden gets too big and the corporation will collapse.

Panasonic was one of those intensely socially responsible companies; Konnosuke Matsushita, the founder, strongly believed that it was the responsibility of the company to take care of their employees. He never wanted to fire anyone. It's a great concept and noble, but I don't believe it works.

McIlhenny Company (Tabasco sauce) was like that early on; they had an island they wanted to be self-sustaining. They wanted their employees to live there, they built schools, stores etc. But over time it just doesn't work. I think Henry Ford, Hershey and others tried similar things too when it was believed that if they created a company town with everything necessary for employees to raise a family and live comfortably, they can create a sort of self-sustaining utopia.

It just doesn't work. It also reminds me of the pre-Thatcher Britain; it didn't work at the national level either.

And besides, more of a threat to the domestic work force than globalization is technology. I haven't done much research in the area, but technology is probably more responsible for job losses than globalization (moving production to low wage countries).

And do we really want to limit or stop technology? Japan will make large advances in that area due to their shrinking population. They need nurses and other workers to take care of the increasingly aging (and dwindling) population.

If the U.S. slows technological progress for the sake of maintaining low unemployment, then the Japanese will ultimately rule the future and we will have a large, unemployed (and unemployable) population.

Related to all this, just by chance, I happen to be reading the new Kasparov book. I'm not done with it yet, but it is really fascinating. True, he's a former chess world champion so what does he really know? He is a voracious reader and runs around meeting and talking to interesting people all over the world so he has interesting insights into many things.

He points out that every time we have technological advancement, people fear this or that.  For example, the elevator operators union had 17,000+ members in 1920. The technology existed in 1900 but wasn't widely used (automatic elevators) until 1930 due to people's fear of riding operator-less elevators (similar to fear of driverless cars today; but people's fear is not what is holding back driverless cars today...).

Anyway, I am not a believer in holding anything back for the sake of maintaining employment; it will only delay the day of reckoning, and at that point the negative impact might be much worse.

Since technology is advancing so quickly, retraining won't be able to keep up, so something like a universal basic income is probably the only way to go at some point. I know I sound like a communist when I say that, but I can't think of any other way.

Anyway, this veers far away from the topic of this blog, so let's get back on topic.

Conclusion
If you are one of those people who have a bunch of mutual funds in your IRA/401K or whatever, I would actually go in and do the work to calculate how much you are actually paying in real dollars. Is it really worth it? Same with financial advisors. When fees are just deducted from your account, you may not realize how much you are paying. Calculate what your are paying. Is it really worth it?

Let's say you have $5 million and most of it is in tax-free money market funds and the S&P 500 index funds. With a 2% fee, that's $100,000 per year! Why would anyone pay that? Is it really worth it? Can your advisor really pick stocks and funds better than some simple passive portfolio?

I don't know. When you look at it in real dollars like that, it is really insane.




Fairfax India Holdings (FFXDF)

This is one of those things that I looked at before and never posted, so here it is. Actually, I didn't write much about it, it was just sitting in my queue.

I know Munger likes China more than India, but I think India is very interesting. I don't think I have to say much about it as it is not a new idea. And yes, India has problems that China doesn't have (democracy that can actually hold back progress unlike in the authoritarian China where the government can just basically do what it wants). But India is still fascinating, especially with all the things going on over there now (pro-business government for the first time etc).

Anyway, as usual, before that, check this out from the Fairfax 2016 Letter to Shareholders.

Here's the long term investment performance of Fairfax (not the India entity):


And what happened in 2016:


...and the summary overall for the period 2010-2016:



Their equity hedge has been very costly, basically a total disaster.  Their hedges cost them $4.4 billion since 2010. Since it was a hedge, you have to look at it on a net basis with the longs; that's a $1.7 billion loss.  Still pretty awful. This is during a period the S&P 500 index went up 12.5%/year. In 2010, they had $4.5 billion in stocks. If this was unhedged and their stocks kept up with the market, it would have added $4.5 billion to their net value instead of losing $1.7 billion; that's a swing of $6.2 billion!  That's huge given their common equity in 2010 of around $8 billion ($8.5 billion at end of 2016).

It's fair to say, though, that if the portfolio wasn't hedged, it might have been smaller than $4.5 billion; the portfolio might have been sold down for risk management purposes.

Since 2007, Fairfax has still outperformed (price basis) the S&P 500 index and all of the so-called Berk-a-likes:


This chart (and other charts), by the way, are updated every day at the Brooklyn Investor website.

Anyway, over the long term, they have done well, so it's not fair to focus just on this one mistake (even though it's a huge one). Many CEO errors cause their companies to go bust, and that hasn't happened here, or anything even close to that.

Here is the other 'bet' Fairfax has on:


This bet doesn't look so interesting these days, but the important point is that the downside in these bets are known and small. It's one of those "if you're wrong you don't lose too much but if you're right you can make a ton" deals. Needless to say, the equity portfolio hedge was not that kind of bet!

Expensive Market
Anyway, I still have conversations about this sort of thing and hear all the time about the markets being expensive, people being confused as to what's going on.

One hedge fund executive (wasn't clear what position was; not sure if he had investment experience/responsibilities) was on CNBC the other day and it was stunning because the comments were based on such extraordinarily static analysis, talking about the uncertainties in the market, how things were expensive etc.

Reflexivity
And it reminds me of a book that I plan to reread (if I can find it!). When I read it years ago, it was incredibly eye-opening, and it feels like a lot of people have forgotten about this sort of thinking. The book is by George Soros, one of the greatest of all time:

   The Alchemy of Finance

He talks about reflexivity, and it sort of differentiates the traditional economists viewpoint based on static analysis versus his more dynamic view of the world based on reflexivity. (This book is more of interest to traders than long term investors).

For example, if the market goes up, most people assume it must go down because it is overvalued. Economists base their views on supply/demand balance so they think things must trend towards equilibrium. Most comments I hear these days tend to be in this camp.

Soros' view is that in fact, an expensive market can make a market even more expensive.  Why? Because if markets go up and gets overvalued, then financing costs go down and can encourage more profit-making and increased earnings, which can drive prices even higher. Economists wouldn't consider this factor. This is in fact what happened in Japan too in the late 1980's.

I think Soros talks about the REIT boom/bust of the 1970's in this book; maybe it was somewhere else. But the above is exactly what happened.

Anyway, I am going to dig up a copy of this; it must be somewhere around here in one of these boxes or piles of books.

Mean Reversion
Sort of related to the above, here's another thing I hear all the time: mean reversion. I too believe in mean reversion. But there are tradable/investable mean reversions and untradable/uninvestable mean reversions.

Values mean revert, usually. As a value investor, we can buy undervalued stocks and assume mean reversion will enhance our returns. This is investable mean reversion. As long as you are not leveraged, you can just wait for the market to prove you right.

Shorting overvalued stocks is also a mean-reversion trade, but it is untradable.  Ask anyone who was or is short Tesla, Amazon, Netflix. Oh, remember L.A. Gear? Or U.S. Surgical? Anything in 1997-2000? Those are untradable because you will get killed trying to short that stuff even if mean-reversion will eventually kick in. Nobody has that kind of staying power.

So what kind of mean reversion do you want? You want mean reversion that happens OFTEN. You want mean-reversion that is tradable.

Not exactly a mean reversion trade, but take index arbitrage. You go long stocks and short future against it (or vice versa). You know from history that the premium/discount fluctuates over time. But you also know that this spread will not diverge too far apart, and you know that at expiration, your long and short will offset and you can realize the spread perfectly with very little risk. That's a spread you can trade safely. (In fact, one of Soros' early strategies was to arb gold prices between New York and London. I think a long distance phone connection was that era's version of a direct optical fiber connection to exchanges today)

How about options volatility? For shorter dated options, trading volatility works too. You may or may not make money, but volatility cycles are often not that long so you can capture volatility by trading options. You may need some staying power, though, because sometimes you sell volatility at 30% and it goes to 40% or 50%. But you know that eventually, these panic levels will subside at some point for much lower volatility.

What about stat arbs?  These guys too, especially the high-frequency guys, are trading mean-reversion. The one mentioned in the Thorp book, I think, was based on 2-week returns in stocks. Stat arbs these days turn over their portfolios multiple times in a day (I am guessing, but we had high turnover a long time ago; I am assuming it's much faster now), which implies a high level of mean-reversion; each trade is not expected to last very long. Things diverge and revert very quickly.

This has two big advantages (well, probably more but let's keep it simple); first, with so much frequency you have that many more data points. With that many trades, you are that much more likely to make money. With time span so short, the risk of divergence, or spreads widening out even more, is minimal.

Imagine trying to trade inefficiencies in the stock market based on tick data where trades last for minutes. What is the risk?  Hint: tiny on each trade, and since you do so many trades, you are well-diversified and if your data is correct, you are more likely to realize the 'edge'.

Now imagine trying to trade inefficiencies in the stock market where people misprice P/E ratios on individual stocks. The expected duration of a trade can be years (the P/E ratio inefficiency probably will not correct within the next week or even month. Unlikely even in the next year; how many years have TSLA, NFLX and AMZN been overvalued?). Now think of the range of stock prices that a mispriced stock can trade at over that time span.  Now you see how huge the risk is.

Of course, sometimes you can see some sort of deterioration in a company, some manic blowoff or some other 'timing' device that might help you nail a short of an overvalued company. But you see how trading just on valuation on the short side is going to be tough game.

The Market
Let's take all of the above thoughts and apply it to the overall market. People always talk about mean reversion of the market P/E ratio, profit margins and things like that.

Are these factors tradable? If the stock market went to 20-30x P/E and then went down to 8-10x and then went up to 20-30x and kept doing that many times over the years (averaging out at 14-15x), then it turns into a tradable idea. You can set ranges too and calculate probable outcomes and manage risk accordingly.

But looking at long term data, that's not really the case. It's more like these things happen very rarely and over long periods of time. Most people talk about what happened in 1929, 1968, 1987, 2000 or whatever. I think it was Buffett (but may have been Munger) who said that to bet on something that happened just a few times over the last 100 years does not sound like a good idea.

Again, the same questions apply: when is the expected reversion? What is the risk? If the reversion is not expected in the short term (next week, next month, within the year etc...), then what is adverse move against you going to cost?

Interest rates mean revert too, but look at the rates in the past 100, 200 years. If you want to realize any 'edge' in the long term mean-reversion of interest rates, you have to play for decades, and the reversion may not even occur within a single generation.

Back to Fairfax India
Emerging markets haven't been so hot in recent years, but I don't think there is any doubt that that is where a lot of growth is going to come from over the next few years. Much of that growth will be captured by global firms to be sure, so owning global companies will give you exposure without having to invest in emerging markets.

But it's fun to have some direct investment overseas when there is an interesting opportunity. I don't think FFDXF is a unique opportunity right now in terms of value/pricing, but it is an interesting opportunity in that you can co-invest with a successful manager in an investment vehicle focused on India that combines listed stocks and private investments. There are not too many of those ideas.

The option to invest in private deals expands the universe of potential investments so increases the odds of finding winners. The closed nature of this vehicle (not an ETF, mutual fund or hedge fund/partnership) allows them to focus on the long term and not worry about liquidity and short term performance.

With these advantages and with a management that we understand that agrees with out own views on investing makes this an interesting opportunity.

Of course, the value approach to investing is not universally accepted, and Fairfax has its own fair share of long-time critics.  So this is only interesting to those who appreciate the Fairfax track record and what they are trying to do in India.

India Macro
Here are some charts from the FFXDF marketing slides from a couple of years ago. You can get all of this at the SEDAR website:  


Nothing really new here, but just to refresh: 

One huge headwind in the global economy is demographics; this is a problem everywhere, Japan, China, Europe and even the U.S. to a lesser extent than the others. 

And this is India:



A lot of potential for growth in India, and recently trending well:






Singapore II?
Watsa compares what can happen in India going forward to Lee Kuan Yew's Singapore starting in the 1960's. Singapore is a great example of a successful nation, and Munger brings it up all the time too. But we have to remember that Singapore was a tiny island city-state with a population of less than 2 million (in the early 1960's), and a current population of less than 6 million. The area of Singapore is smaller than New York City.

It's one thing to rebuild and lead a nation of 2 million, but it's an entirely different matter to try to do the same with a country with a population that exceeds a billion. Try banning chewing gum in a huge country like India with a 1 billion+ population!

But OK, we get the analogy. Maybe India can't repeat Singapore's performance, but with the right policies, they can still do really well.

Past Performance
These things may not be as indicative of future performance as we'd like to think, but here is the track record of Watsa's India investment management team. They have done really well, but we have to keep in mind that the results are very volatile. We are talking about an emerging market, and a highly concentrated portfolio. Plus not much has happened since 2007 (a lot of volatility!).






One thing that Fairfax fans may not like is the management fee structure. This seems kind of normal in the investment world; 1.5% management fee and 20% incentive fee (but only after 5% hurdle). In this day and age, it might sound a little steep. Maybe it's not so bad when you consider that it is partially a private equity fund.



Why not ETF?
Well, if India is so interesting (and I don't mean in the timing sense, by the way. I don't follow India closely enough to tell you even what the sentiment is like, but I think emerging markets overall here has been out of favor), and the fees are too high, why not go with and indexed ETF?

That may be a good idea. I haven't looked in detail at any of the India ETF's, but emerging market ETF's tend to be packed with large, inefficient, formerly state-run enterprises. Plus who knows when the government dumps (IPO's) a large, stodgy, bureaucratic, inefficient state-run organization onto the market for non-differentiating index funds to blindly buy into (this could be one of your funds!).

I think the inefficiencies in these markets tends to favor the active investor.

Plus, here, you are betting on the continued success of the Fairfax/Watsa investment approach. You don't get that in an index.

Speaking of emerging market funds, it seems like emerging markets have grown at a higher pace than mature economies for decades, and yet how come there aren't really any good emerging market funds with good long term track records? Mark Mobius was a big star back in the 1990's. Last time I looked, his funds' performance was not very good. I wonder about that.  Maybe it's something I should look at in another post. I am always intrigued by the idea of emerging markets, but am almost never sure what to do about it!  (uh oh... reading too many Watsa reports... the exclamation point is contagious!).

There was a time in the late 1980's and early 1990's when all you had to do was to own the telephone companies in each of the emerging markets and you could earn hedge fund-like returns (any ADR with a 'com' (not '.com') in the name would have worked).

Conclusion
Anyway, this may not be for everybody, and it will probably be pretty volatile but it's an interesting thing to keep an eye on, or tuck into your portfolio somewhere and just forget about it and check back in a few years.