My Investment Philosophy

Update: My philosophy has evolved since this post was first written. One day, I may include my investing checklist on this page, but it is still evolving as well. Until then, these 2 quotes best summarize the process I try to follow.

“If only one word is to be used to describe what Baupost does, that word should be: 'Mispricing'. We look for mispricing due to over-reaction.” -Seth Klarman

“In my opinion, there are two key concepts that investors must master: value and cycles. For each asset you’re considering, you must have a strongly held view of its intrinsic value. When its price is below that value, it’s generally a buy. When its price is higher, it’s a sell. In a nutshell, that’s value investing.

But values aren’t fixed; they move in response to changes in the economic environment. Thus, cyclical considerations influence an asset’s current value. Value depends on earnings, for example, and earnings are shaped by the economic cycle and the price being charged for liquidity.

Further, security prices are greatly affected by investor behavior; thus we can be aided in investing safely by understanding where we stand in terms of the market cycle. What’s going on in terms of investor psychology, and how does it tell us to act in the short run? We want to buy when prices seem attractive. But if investors are giddy and optimism is rampant, we have to consider whether a better buying opportunity mightn’t come along later.” –Howard Marks

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Buffett Warned Us in 2003, Few Listened - by Todd N Kenyon

Warren Buffet foresaw the current financial disaster more than five years ago. I pulled out his 2002 Chairman’s Letter, wherein he addresses derivatives and their potential to scuttle the entire financial system. Here are some key passages:

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“Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.”

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“In recent years, some huge-scale frauds and near-frauds have been facilitated by derivatives trades. In the energy and electric utility sectors, for example, companies used derivatives and trading activities to report great “earnings” – until the roof fell in when they actually tried to convert the derivatives-related receivables on their balance sheets into cash. “Mark-to-market” then turned out to be truly “mark-to-myth.””

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“Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.”

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“Charlie and I believe, however, that the macro picture is dangerous and getting more so. Largeamounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.”

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“In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

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There’s much more, available on the Berkshire website. Warren and Charlie have made some additional comments at the 2007 annual meeting. Munger:

“As sure as God made little green apples this will lead to big trouble in due time. This will lead to a result we have been expecting for some time.”

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On the math models used by Wall Street: “They’re all crazy.” “Very smart people do very dumb things” and that just because people “have high IQs” does not prevent them from creating financial models that are “at least 50% twaddle.”

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On Berkshire’s underwriting standards: “We only write fire insurance on concrete bridges that are covered by water.”

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Buffett: “Not too many years ahead you will get disruption. Predicting when is something we can’t do…(It will reward) those with cash and guts.”

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Munger: “Will Rogers said, ‘Learn not to pee on an electrified fence without actually doing it.”

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Alas, heeding that last one would’ve saved Wall Street many times.

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The financial system is built upon leverage. Its very existence depends on lack of correlation - the requirement that bad things don’t all happen at once: that depositors don’t make a run on the bank, insurance liabilities aren’t all claimed at once, derivative contracts don’t all go the same way at the same time, mortgages don’t all default at once. However, as Buffett says and I also heard Bill Ackman paraphrase, when the stuff hits the fan, everything correlates. That’s where we are now.

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If you took on too much risk, levered up too much, didn’t prepare for the day when everything correlates… well then adios. See ya. Buh-bye.

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Buffett and Munger were not so much prescient as good students of market history and innately conservative. They’d seen it all before in one form or another. I return to Galbraith from his book “A Short History of Financial Euphoria”:

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“The rule is that financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design, one that owes it distinctive character to the aforementioned brevity of the financial memory. The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets.”

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Obviously Bear, Lehman, Freddie, Fannie, AIG, WaMu, Countrywide, on and on, went with the “lesser adequacy” model.

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Related previous post: Excerpt from Buffett's 2002 Annual Letter

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Professor Sanjay Bakshi's Lectures

Professor Sanjay Bakshi has posted some of his lectures on his blog, Fundoo Professor:
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Lecture 01
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Lecture 02
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Lecture 03
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Lecture 04

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Lecture 05

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Lecture 06

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Lecture 07

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The Perils of the “Mindless Imitation of One’s Peers”

Mr. Buffett made some comments when speaking to a group from Notre Dame in 1991 that are relevant to what's going on today:

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The last thing I want to show you, before we get onto your questions, is an ad that was run June 16, 1969, for 1,000,000 shares of American Motors. This is a reproduction from the Wall Street Journal of that day. Now does anybody notice anything unusual about that ad?

[Guesses from audience.]

Everybody in that ad has disappeared. There are 37 investment bankers that sold that issue, plus American Motors, and they are all gone. Maybe that’s why they call them tombstone ads. Now the average business of the New York Stock exchange in 1969 was 11 million shares. Average volume now is fifteen times as large. Now here’s an industry whose volume has grown 15 to 1 in 20 years. Marvelous growth in the financial world. And here are 37 out of 37, and those are some of the biggest names on Wall Street, and some of them had been around the longest, and 37 out of 37 have disappeared. And that’s why I say you ought to think about [the long-term durability of a business?] because these people obviously didn’t.

These were run by people with high IQs, by people that worked ungodly hard. They were people that had an intense interest in success. They worked long hours. They all thought they were going to be leaders on Wall Street at some point, and they all went around, incidentally, giving advice to other companies about how to run their business. That’s sort of interesting.

You go to Wall Street today, and there’s some company the guy hadn’t heard of two weeks before and he’s trying to sell you. He will lay out this computer run of the next 10 years, yet he doesn’t have the faintest idea of what his own business is going to earn next week!

Here are a group of 37. And the question is, how can you get a result like that? That is not a result that you get by chance. How can people who are bright, who work hard, who have their own money in the business – these are not a bunch of absentee owners – how can they get such a bad result? And I suggest that’s a good thing to think about before you get a job and go out into the world.

I would say that if you had to pick one thing that did it more than anything else, it’s the mindless imitation of one’s peers that produced this result. Whatever the other guy did, the other 36 were like a bunch of lemmings in terms of following. That’s what’s gotten all the big banks in trouble for the past 15 years. Every time somebody big does something dumb, other people can hardly wait to copy it. If you do nothing else when you get out of here, do things only when they make sense to you. You ought to be able to write “I am going to work for General Motors because ... “I am buying 100 shares of Coca Coals stock because...” And if you can’t write an intelligent answer to those questions, don’t do it.

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Wintergreen Fund: Semi-Annual Report

The market has not discriminated between high-quality and low-quality companies; virtually every stock has declined. Generally, markets reward solid, stable companies, but this year even the best companies have suffered. The movement from easy credit to little or no available credit has restricted normal business operations and slowed down speculation. We believe companies with the following three characteristics are great long-term destinations for investor capital, even though the short-term quotations are less than favorable: solid businesses that generate cash; businesses with pricing power; and businesses with rational management who create value for their shareholders.

A favorite story of mine as a child was “The Little Engine That Could” by Watty Piper. In this story, a long train needed help to get over a large mountain. Various railroad engines that had the capacity to move the train refused to help. They said the job was too big and difficult for them, and the mountain was too steep. The engines that were designed to haul heavy freight would not attempt to move the huge train. Eventually a small engine that didn’t appear to have the necessary get-up-and-go was asked for assistance and that small engine agreed to try to help the large train. Using all of its power and repeating ‘I think I can, I think I can’, the small engine got the freight train up to the top of the mountain. As the train went down the tracks on the far side of the mountain to deliver toys and treats to the children who had been waiting, the little engine repeated the phrase, ‘I thought I could, I thought I could’.

In this global market that looks too big for anyone or anything to bring it back to a more stable environment, I think that solid analysis of companies and careful accumulation of underpriced stocks has the potential to yield great rewards. Like the little engine that put its head down and worked at its assignment, the pursuit of fundamental research coupled with an appreciation of the consistency of human behavior should identify the securities that I believe will survive and thrive in the future. Now is the time when some of these companies are on sale. Although no one knows precisely when, it is inevitable that these wild bargain prices will at some point in time come to a close. When that happens, and with the benefit of 20-20 hindsight, many investors will wish they had accumulated a bigger stake in these bargain companies.

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The Art of Short Selling

A friend (thanks Andrew) recommended an excellent book about short selling and fundamental analysis called The Art of Short Selling by Kathryn Staley. I also recommend the book and a video of a talk she gave at the Notre Dame Center for Accounting Research and Education:
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Book ----- Video

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Smart Taxes: An Open Invitation to Join the Pigou Club – By N. Gregory Mankiw

As an economics educator, I have always been fascinated by topics about which there is a large gap between the beliefs of economists and those of the general public. For example, economists are generally supportive of free trade among nations, while the public is more skeptical. Economists oppose rent control, while much of the public supports the policy.

In these and other cases where economists and mere muggles don’t see eye-to-eye, you shouldn’t be surprised to hear that I am quick to side with my fellow economists. I like to think that this reaction is more than mere professional solidarity but is, instead, a symptom of my commitment to rational thought. Unlike most people, who spend their time thinking about their children, local sports team, or favorite sitcom, economists have devoted much of their lives to thinking about such things as international trade and rent control. That fact may make us boring at cocktail parties, but it does have some offsetting benefits. It is not a stretch to believe that more thought about an issue leads to more reliable conclusions. As a result, I feel comfortable with conclusion that, regarding these issues, economists are right and the general public is just ill informed.

My topic for today is a policy about which there is a particularly large gap between economists and the public: Pigovian taxation. In particular, I want to talk about taxes on energy-related products, such as gasoline taxes. Not long ago, the economist Steve Levitt, coauthor of the best-seller Freakonomics, wrote on his blog, “For a long time I have felt the price of gasoline in the United States was way too low. Pretty much all economists believe this.” Levitt then went on to argue for higher taxes on gasoline. At about the same time, Speaker of the House Nancy Pelosi had precisely the opposite perspective. She announced “a series of hearings to address rising gas prices—focusing on the causes, the burdens they put on American families and businesses, and solutions.”

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Related site: Greg Mankiw's Blog

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CERN fires up new atom smasher to near Big Bang

It has been called an Alice in Wonderland investigation into the makeup of the universe - or dangerous tampering with nature that could spell doomsday.

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Whatever the case, the most powerful atom-smasher ever built comes online Wednesday, eagerly anticipated by scientists worldwide who have awaited this moment for two decades.
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The multibillion-dollar Large Hadron Collider will explore the tiniest particles and come ever closer to re-enacting the big bang, the theory that a colossal explosion created the universe.

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The machine at CERN, the European Organization for Nuclear Research, promises scientists a closer look at the makeup of matter, filling in gaps in knowledge or possibly reshaping theories.

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YouTube video mentioned in article: Large Hadron Rap

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Follow-up (9/10/2008) after initial start: Into the wild blue yonder

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Related previous post: Known and unknown unknowns

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Ruane, Cunniff & Goldfarb Investor Day Transcript

Ruane, Cunniff & Goldfarb Investor Day

May 16, 2008 – St. Regis Hotel, New York City

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Buffett's Best Man

IN CONTRAST TO THE showman-like Buffett, Munger shuns the spotlight. But he draws a smaller, more fanatical cult that seeks inspiration from his intellectual omnivorousness. "There are few people who consider acquiring knowledge their life's study -- he's an exemplar," says Chris Davis, of the $65 billion Davis Funds. "Buffett will understand something on a micro level," adds hedge fund star Mohnish Pabrai, "but Munger will understand how it fits into the world looking a decade out." Pabrai suggests that if you gave an IQ test to their respective fan clubs, Munger's would beat Buffett's "by quite a few points." Whoever would win, with the market choppy and both partners getting up in years, investing acolytes were eager to catch Munger on one of his rare public appearances -- and we were glad to catch him for an even rarer interview.

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When he spoke with SmartMoney, Munger was relatively humble; he brushed aside the idea that he's the man behind Buffett, allowing only that "my utility was not zero." That utility may be more important than ever if Munger's gloomy outlook turns out to be correct. "Even with the market down, every investment class, on average, is liberally priced," Munger says, and the prospects for good returns are "modest" at best. His formula for success in a tough market (or any market) flies in the face of conventional wisdom: "Load up" by making big bets on the handful of businesses that could be winners. "People say the whole secret of investing is diversification," Munger told Berkshire investors earlier this year, but that idea is "ass-backwards."

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When picking winners out of the herd, of course, it helps to have Buffett- or Munger-caliber acumen. Munger insists that involves little more than common sense -- the kind that comes from educating yourself broadly across multiple disciplines. Unlike other investors, Munger says, he and Buffett are careful not to overestimate what they know: "It's a disaster if you don't know the edge of your competency." They work hard at avoiding investing "asininities" and "possess a vast ability to dis-learn" when their assumptions prove false. And they keep enough cash on hand to act quickly -- since good investments don't swim by that often, Munger explains, "you have to be the man standing by a river with a spear." How to recognize those opportunities? That's where omnivorousness comes in. "Learn your gaps, and fill them," he says. "If you get three textbooks on a subject and skim them, it's a good start. That's what I do."
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Sadly enough, that's not what most investors do, so it's little wonder that a certain world-weariness is one of Munger's hallmarks in his fifth decade at Buffett's side. "If Aristotle were alive today, he'd be a grumpy old man," Munger sighs, explaining that the Greek philosopher would be seeing the same mistakes made over and over. "Maybe that's some of the problem with me."

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To view Mr. Munger's Caltech appearance, see this post: Video: A Conversation with Charlie Munger

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The best way to learn more about Mr. Munger and the 'Latticework of Mental Models Approach' to life and learning: Poor Charlie's Almanack

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