Wednesday, August 29, 2007

In Nature’s Casino - Michael Lewis

It was Aug. 24, 2005, and New Orleans was still charming. Tropical Depression 12 was spinning from the Bahamas toward Florida, but the chances of an American city’s being destroyed by nature were remote, even for one below sea level. An entire industry of weather bookies — scientists who calculate the likelihood of various natural disasters — had in effect set the odds: a storm that destroys $70 billion of insured property should strike the United States only once every 100 years. New Orleanians had made an art form of ignoring threats far more likely than this; indeed, their carelessness was a big reason they were supposedly more charming than other Americans. And it was true: New Orleanians found pleasure even in oblivion. But in their blindness to certain threats, they could not have been more typically American. From Miami to San Francisco, the nation’s priciest real estate now faced beaches and straddled fault lines; its most vibrant cities occupied its most hazardous land. If, after World War II, you had set out to redistribute wealth to maximize the sums that might be lost to nature, you couldn’t have done much better than Americans had done. And virtually no one — not even the weather bookies — fully understood the true odds.

The World According To Eveillard


When stocks stagger, focus on the basics - Oak Value Fund


Marty Whitman and Third Avenue see opportunity

Mark Sellers: Irrational world of institutionalised money managers

Tuesday, August 28, 2007

Applying Behavioral Finance to Value Investing - Presentation by Whitney Tilson

Common Mental Mistakes
1) Overconfidence
2) Projecting the immediate past into the distant future
3) Herd-like behavior (social proof), driven by a desire to be part of the crowd or an assumption that the crowd is omniscient
4) Misunderstanding randomness; seeing patterns that don’t exist
5) Commitment and consistency bias
6) Fear of change, resulting in a strong bias for the status quo
7) "Anchoring"on irrelevant data
8) Excessive aversion to loss
9) Using mental accounting to treat some money (such as gambling winnings or an unexpected bonus) differently than other money
10) Allowing emotional connections to over-ride reason
11) Fear of uncertainty
12) Embracing certainty (however irrelevant)
13) Overestimating the likelihood of certain events based on very memorable data or experiences (vividness bias)
14) Becoming paralyzed by information overload
15) Failing to act due to an abundance of attractive options
16) Fear of making an incorrect decision and feeling stupid (regret aversion)
17) Ignoring important data points and focusing excessively on less important ones; drawing conclusions from a limited sample size
18) Reluctance to admit mistakes
19) After finding out whether or not an event occurred, overestimating the degree to which one would have predicted the correct outcome (hindsight bias)
20) Believing that one’s investment success is due to wisdom rather than a rising market, but failures are not one’s fault
21) Failing to accurately assess one’s investment time horizon
22) A tendency to seek only information that confirms one’s opinions or decisions
23) Failing to recognize the large cumulative impact of small amounts over time
24) Forgetting the powerful tendency of regression to the mean
25) Confusing familiarity with knowledge

Monday, August 27, 2007

Chou Funds Semi-Annual Report

Explorations in Common Sense and Common Nonsense

Team spirit turns hockey star into real estate czar


Thursday, August 23, 2007

The Effect of Discount Rates on Intrinsic Value

The discount rate you use in a discounted cash flow valuation can have a big effect on an intrinsic value calculation. To illustrate, let's use an example based on the following assumptions:
Earnings Per Share Year 0: $1.00
Growth Years 1-5: 12%
Growth Years 6-10: 10%
Growth Years 11-15: 8%
Growth Years 16-20: 6%
Growth Years 21-25: 4%
Growth Years 26-30: 2%
Under this scenario, the net present value of those 30 years worth of earnings is $45.65 using the current risk free rate of 6% (even though the current risk free rate is lower, it is prudent to use 6% as a minimum) as our discount rate.
However, if we change the discount rate to 10%, the value of that earnings stream is now only worth $26.43. Furthermore, if we bump the rate up to 15%, the net present value is knocked down to $15.40.
So, discount rates have a big effect on valuation and that means that interest rates (which help determine appropriate discount rates) have a big effect on valuation. And as if that doesn't make things difficult enough, here's another fact: you can't predict interest rates over time.
This is just further proof of the importance of only purchasing a security (or entire business) when you have a LARGE Margin of Safety between current price and intrinsic value, and it also stresses the fact that one should wait for a fat pitch before taking a swing while investing.

Markel's Investment Philosophy - from 2006 Annual Report


Stock Picks from a Berkshire-like Investor

Markel's Tom Gayner reveals the firm's picks and process. (video)

Monday, August 20, 2007

The Effect that Buying with a Margin of Safety has on Your Returns

A little math for a Monday morning:

Buy a stock at 50 percent (1/2) of intrinsic value, sell at 90 percent of initial intrinsic value:
IRR if it takes 2 years: 34.16%
IRR if it takes 3 years: 21.64%

Buy a stock at 67 percent (2/3) of intrinsic value, sell at 90 percent of initial intrinsic value:
IRR if it takes 2 years: 16.19%
IRR if it takes 3 years: 10.52%

Buy a stock at 50 percent (1/2) of intrinsic value, sell at 120 percent of initial intrinsic value (value increased):
IRR if it takes 2 years: 54.92%
IRR if it takes 3 years: 33.89%

Buy a stock at 67 percent (2/3) of intrinsic value, sell at 120 percent of initial intrinsic value (value increased):
IRR if it takes 2 years: 34.16%
IRR if it takes 3 years: 21.64%

It is interesting to note that buying a dollar's worth of value for $0.50 and selling it for $0.90 after 2-3 years, is the equivalent (on a return basis) of buying a dollar's worth of value for $0.67 and selling it for $1.20 after 2-3 years. This a good illustration of why you should require a larger margin of safety for a business that is not growing its intrinsic value, and be willing to pay a little more for a business that is growing its intrinsic value.

The Expert Mind

Wednesday, August 15, 2007

Wanted: Castles, Gold and Benevolent Rulers

Interview With Gifford Combs, Managing director and portfolio manager, Dalton Investments

Q: Given that context, where are you focused?

Berkshire Hathaway [ticker: BRK.A]. Think of it as the Rodney Dangerfield of companies in America.

The operating businesses are a superb collection that earn more than 25% on tangible net worth. They should be valued at 20 times earnings, or about $70 billion. I value the finance and utility businesses at 1½ times book value -- together they are worth about $26 billion.

The majority of the value at Berkshire is in the insurance entities, which hold virtually all of the investments. The insurance business depends upon the value one places on the $58 billion of "float," which are the non-interest-bearing liabilities of the insurance companies. Adjusting for the float and making allowances for deferred taxes, I value the insurance companies at nearly $200 billion. The total comes to more than $290 billion, or about $190,000 per share. More conservative assumptions about investment returns over time would lower that value; but it's hard to get to a number much below $150,000 per share.

Remembering a Classic Investing Theory

More than 70 years ago, two Columbia professors named Benjamin Graham and David L. Dodd came up with a simple investing idea that remains more influential than perhaps any other. In the wake of the stock market crash in 1929, they urged investors to focus on hard facts — like a company’s past earnings and the value of its assets — rather than trying to guess what the future would bring.

Monday, August 13, 2007

Warren Buffett on Diversification - 1966

(from Buffett’s 1965 letter to Partners)


Last year in commenting on the inability of the overwhelming majority of investment managers to achieve performance superior to that of pure chance, I ascribed it primarily to the product of: "(1) group decisions - my perhaps jaundiced view is that it is close to impossible for outstanding investment management to come from a group of any size with all parties really participating in decisions; (2) a desire to conform to the policies and (to an extent) the portfolios of other large well-regarded organizations; (3) an institutional framework whereby average is "safe" and the personal rewards for independent action are in no way commensurate with the general risk attached to such action; (4) an adherence to certain diversification practices which are irrational; and finally and importantly, (5) inertia.”

This year in the material which went out in November, I specifically called your attention to a new Ground Rule reading, "7. We diversify substantially less than most investment operations. We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could drastically change the underlying value of the investment."

We are obviously following a policy regarding diversification which differs markedly from that of practically all public investment operations. Frankly, there is nothing I would like better than to have 50 different investment opportunities, all of which have a mathematical expectation (this term reflects the range of all possible relative performances, including negative ones, adjusted for the probability of each - no yawning, please) of achieving performance surpassing the Dow by, say, fifteen percentage points per annum. If the fifty individual expectations were not intercorrelated (what happens to one is associated with what happens to the other) I could put 2% of our capital into each one and sit back with a very high degree of certainty that our overall results would be very close to such a fifteen percentage point advantage.

It doesn't work that way.

We have to work extremely hard to find just a very few attractive investment situations. Such a situation by definition is one where my expectation (defined as above) of performance is at least ten percentage points per annum superior to the Dow. Among the few we do find, the expectations vary substantially. The question always is, “How much do I put in number one (ranked by expectation of relative performance) and how much do I put in number eight?" This depends to a great degree on the wideness of the spread between the mathematical expectation of number one versus number eight.” It also depends upon the probability that number one could turn in a really poor relative performance. Two securities could have equal mathematical expectations, but one might have .05 chance of performing fifteen percentage points or more worse than the Dow, and the second might have only .01 chance of such performance. The wider range of expectation in the first case reduces the desirability of heavy concentration in it.

The above may make the whole operation sound very precise. It isn't. Nevertheless, our business is that of ascertaining facts and then applying experience and reason to such facts to reach expectations. Imprecise and emotionally influenced as our attempts may be, that is what the business is all about. The results of many years of decision-making in securities will demonstrate how well you are doing on making such calculations - whether you consciously realize you are making the calculations or not. I believe the investor operates at a distinct advantage when he is aware of what path his thought process is following.

There is one thing of which I can assure you. If good performance of the fund is even a minor objective, any portfolio encompassing one hundred stocks (whether the manager is handling one thousand dollars or one billion dollars) is not being operated logically. The addition of the one hundredth stock simply can't reduce the potential variance in portfolio performance sufficiently to compensate for the negative effect its inclusion has on the overall portfolio expectation.

Anyone owning such numbers of securities after presumably studying their investment merit (and I don't care how prestigious their labels) is following what I call the Noah School of Investing - two of everything. Such investors should be piloting arks. While Noah may have been acting in accord with certain time-tested biological principles, the investors have left the track regarding mathematical principles. (I only made it through plane geometry, but with one exception, I have carefully screened out the mathematicians from our Partnership.)

Of course, the fact that someone else is behaving illogically in owning one hundred securities doesn't prove our case. While they may be wrong in overdiversifying, we have to affirmatively reason through a proper diversification policy in terms of our objectives.

The optimum portfolio depends on the various expectations of choices available and the degree of variance in performance which is tolerable. The greater the number of selections, the less will be the average year-to-year variation in actual versus expected results. Also, the lower will be the expected results, assuming different choices have different expectations of performance.

I am willing to give up quite a bit in terms of leveling of year-to-year results (remember when I talk of “results,” I am talking of performance relative to the Dow) in order to achieve better overall long-term performance. Simply stated, this means I am willing to concentrate quite heavily in what I believe to be the best investment opportunities recognizing very well that this may cause an occasional very sour year - one somewhat more sour, probably, than if I had diversified more. While this means our results will bounce around more, I think it also means that our long-term margin of superiority should be greater.

A World of Winners, Warren's Way

How does he do it? Author Robert Hagstrom tried to compile Buffett's key investing strategies in his 1994 best-seller, The Warren Buffett Way: Investment Strategies of the World's Greatest Investor. With Hagstrom's book as a source, we at S&P Quantitative Services have put together a stock screen that picks companies using criteria similar to the legendary investor's growth-oriented style. S&P updates this screen on a semiannual basis, during February and again in August.

We have been running this screen for more than 12 years. Since its inception on Feb. 13, 1995, through July 31, 2007, the screen has had an annualized return of 15.69% vs. 9.28% for the Standard & Poor's 500-stock index. Year-to-date through July 31, 2007, the Buffett screen stocks outperformed the market, returning 7.69% vs. the 2.61% gain for the S&P 500 (all results are price appreciation only).

Friday, August 10, 2007

Ben Franklin's 13 Virtues

1. Temperance: Eat not to dullness and drink not to elevation.
2. Silence: Speak not but what may benefit others or yourself. Avoid trifling conversation.
3. Order: Let all your things have their places. Let each part of your business have its time.
4. Resolution: Resolve to perform what you ought. Perform without fail what you resolve.
5. Frugality: Make no expense but to do good to others or yourself: i.e. Waste nothing.
6. Industry: Lose no time. Be always employed in something useful. Cut off all unnecessary actions.
7. Sincerity: Use no hurtful deceit. Think innocently and justly; and, if you speak, speak accordingly.
8. Justice: Wrong none, by doing injuries or omitting the benefits that are your duty.
9. Moderation: Avoid extremes. Forebear resenting injuries so much as you think they deserve.
10. Cleanliness: Tolerate no uncleanness in body, clothes or habitation.
11. Chastity: Rarely use venery but for health or offspring; Never to dullness, weakness, or the injury of your own or another's peace or reputation.
12. Tranquility: Be not disturbed at trifles, or at accidents common or unavoidable.
13. Humility: Imitate Jesus and Socrates.

He committed to giving strict attention to one virtue each week so after 13 weeks he moved through all 13. After 13 weeks he would start the process over again so in one year he would complete the course a total of 4 times.

He tracked his progress by using a little book of 13 charts. At the top of each chart was one of the virtues. The charts had a column for each day of the week and thirteen rows marked with the first letter of each of the 13 virtues. Every evening he would review the day and put a mark (dot) next to each virtue for each fault committed with respect to that virtue for that day.

Naturally, his goal was to live his days and weeks without having to put any marks on his chart. Initially he found himself putting more marks on these pages than he ever imagined, but in time he enjoyed seeing them diminish. After awhile he went through the series only once per year and then only once in several years until finally omitting them entirely. But he always carried the little book with him as a reminder.

WCAM - Great First Impressions: Ten Signs of a Strong Company

Gurus On Board: Ask Bill Nygren -- The Answers

Bill Nygren: I believe the most critical part of value investing is following a disciplined buy and sell process. If that is a given, then yes, finding new ideas is the next most important thing. We buy stocks that meet 3 hurdles: significant discount to business value, business value grows at least at an average rate, and management aligned with shareholders.

Battle at Kruger

What do lions, a buffalo, and a crocodile have to do with investing and business? Pretty much nothing, but it is a good reminder that things aren't always as they seem.

A must see:

Buffett Is Invested in Rodriguez

Now that Barry Bonds has eclipsed Henry Aaron as No. 1 on the career home run list, baseball and its fans will watch with rapt interest in the next five or six seasons to see if Alex Rodriguez supplants Bonds. One of those fans is Warren E. Buffett, whose position in the financial world is similar to the one Rodriguez occupies in baseball.
“What’s nice about investing is you don’t have to swing at pitches,” Buffett said. “You can watch pitches come in one inch above or one inch below your navel, and you don’t have to swing. No umpire is going to call you out. You can wait for the pitch you want.”

Tuesday, August 7, 2007

The Secrets of the World's Richest Man

Mexico's Carlos Slim makes his billions the old-fashioned way: monopolies

“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful” - Warren Buffett

Where is there fear? Banks and mortgage-related companies are certainly two areas. Like USG and the quote above, it may again be fruitful to look to the Oracle of Omaha for ideas on where to look for mispriced opportunities.

Unlike other community banks, Bank of Granite has generated profits for more than 50 consecutive years. Famed investor Warren Buffett once called it the “most profitable community bank in America,” drawing worldwide attention to the Caldwell County bank.

After Buffet’s praise, “I had calls from England, Singapore and Tokyo wanting our published financial statements, and we had to hurriedly publish some more because we didn’t have enough,” Forlines recalls

Company Profile:

*This is not a recommendation to buy or sell a security. Please do your own research before making an investment decision.

Drywall Maker in Pain as Housing Suffers

When a business is trading at a lower price than several proven value investors (including Mr. Buffett) last bought shares, it is usually a good place to start your research.

USG is such a company and the NY Times recently wrote an short article about the company.

“Business is tough,” said William C. Foote, chairman and chief executive of USG. “The housing recession is entering the second year of what is likely to be a multiyear downturn.”

USG has cut 1,100 jobs during the last year and now employs about 14,000.

In some ways USG represents the reverse of the modern global economy. It faces no significant foreign competition because drywall is too bulky and low-value to be shipped very far. But USG likewise has little opportunity to send its product abroad to countries where home building is not currently depressed, holding the company hostage to domestic construction.

*This is not a recommendation to buy or sell a security. Please do your own research before making an investment decision.

Friday, August 3, 2007

A Buffett Disciple Shares His Secrets - Morningstar interview with Mohnish Pabrai

Michael Porter (2003 Presentation): The U.S. Homebuilding Industry and The Competitive Position of Large Builders

• Industry structure is a key driver of homebuilder profitability
- This tends to be lost amidst attention on fluctuations in interest rates and housing starts
• Overall industry structure is becoming more attractive
• Large multi-regional builders enjoy significant and growing
competitive advantages over smaller builders
• Market assessments of homebuilding stocks appear to be out of
line with other industries that have similar structural characteristics

Mark Sellers: Tend to overanalyse stocks? Bring out the dart-wielding monkey

Should you spend countless hours researching a stock before buying it, or just a few hours? The common wisdom is that the more time you spend on research, the better your investment results will be. But is this correct?

Making Money the Buffett Way

When an investor amasses $52 billion over half a century, humble stock pickers take note. When he's Warren Buffett, the homespun "Oracle of Omaha," it not only pays to heed his thinking, but it's fun.

Cash Flow Analysis: A Private Lesson from Staley Cates

Cates: When we do a longhand net present value calculation to discount back the free cash flows, we usually use eight years worth of cash flows at a particular assumed growth rate. Then [at the end of] year 8, we put the terminal multiple (almost always one that assumes no growth from that point forward) on the cash flows at that point. That is what values the remaining cash flows from the business beyond year 8. The main thing there is being very conservative since no one can really have a clue what will happen then.

Charlie Munger 2003 Speech: “Academic Economics: Strengths and Faults After Considering Interdisciplinary Needs”

As you might guess, I agreed to do this because the subject of getting the soft sciences so they talked better to each other has been one that has interested me for decades. And, of course, economics is in many respects the queen of the soft sciences. It’s expected to be better than the rest. It’s my view that economics is better at the multi-disciplinary stuff than the rest of the soft science. And it’s also my view that it’s still lousy, and I’d like to discuss this failure in this talk.

Charlie Munger 1994 Speech: “A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business”

I'm going to play a minor trick on you today - because the subject of my talk is the art of stock picking as a subdivision of the art of worldly wisdom. That enables me to start talking about worldly wisdom - a much broader topic that interests me because I think all too little of it is delivered by modern educational systems, at least in an effective way.

Psychology of Intelligence Analysis by Richards J. Heuer Jr.