Contrarian Investment Strategies: The Next Generation - David Dreman

This book is a must read. It is loaded with research, statistics and data. It also talks in detail about the investor psychology. Have given the rules talked about in the book. The rules alone may not have the impact it should have. The points below are just for directing the reader to the book. Even if you do not agree to the points raised in the book, it will definitely give you another perspective to the stock market.

The major thesis of the book is that investors overact to events.

The over valuation of the "best" and the undervaluation of the "worst" stocks often go to the extremes - so much so that their earnings and other surprises affect "best" and "worst" stocks in a diametrically different way.

Betting on well-defined patterns of investor behaviour will give you higher probabilities-strongly backed by statistics-than any other method of investing in use today.

Rule 1: Do not use market-timings or technical analysis. These techniques can only cost you money.

Rule 2: Respect the difficulty of working with mass of information. Few of us can use it successfully. In-depth information does not translate into in-depth profits.

Rule 3: Don't make an investment decision based on correlations. All correlations in the market, whether real or illusory, will shift and soon disappear.

Rule 4: Tread carefully with current investment methods. Our limitations in processing complex information correctly prevent their successful use by most of us.

Rule 5: There is no highly predictable industries which you can count on analysts forecasts. Relying on these estimates will lead to trouble.  

Rule 6: Analysts forecasts are usually optimistic. Make the downward adjustment to your earnings estimate.

Rule 7: Most current security analysis requires a precision in analysts estimates that is impossible to provide. Avoid methods that demand this level of accuracy.

Rule 8: It is impossible, in a dynamic economy with constantly changing political, economic, industrial, and competitive conditions, to use the past to estimate the future.

Rule 9: Be realistic about the downside of an investment, recognizing our human tendency to be both overtly optimistic and overly confident. Expect the worst to be much more severe than your initial projection.

Earnings surprises, whether positive or negative, affect favored and out-of-favor stocks very differently. Surprise consistently results in above-average performance for our-of-favor stocks and below-performance for favored stocks

Rule 10: Take advantage of the high rate of analyst forecast errors by simply investing in out-of-favor stocks.

Rule 11: Positive and negative surprises affect "best" and "worst" stocks in a diametrically opposite manner.

Rule 12: 

(A) Surprises, as a group, improve the performance of out-of-favor stocks, while impairing the performance of favorites.

(B) Positive surprises result in major appreciation for out-of-favor stocks, while having minimal impact on favorites.

(C) Negative surprise result in major drops in the price of favorites, while having virtually no impact on out-of-favor stocks.

(D) The effect of an earnings surprise continues for an extended period of time.

Rule 13: Favored stocks under perform the market, while the out-of-favor companies outperform the market, but the reappraisal often happens slowly even glacially.

Rule 14: Buy solid companies currently out of market favor, as measured by their low price-to-earnings, price-to-cash flow or price-to-book value ratios, or by their high yields.

Rule 15: Don't speculate on highly priced concept stocks to make above-average returns. The blue-chip stocks that widows and orphans traditionally choose are equally valuable for the more aggressive businessman or woman

Rule 16: Avoid unnecessary trading. The costs can significantly lower your returns over time. Low price-to-value strategies provide well above market returns for years, and are an excellent means of eliminating excessive transaction costs.

Contrarian Stock Selection: A-B-C Rules

Rule 17: Buy only contrarian stocks because of their superior performance characteristics.

Rule 18: Invest equally in 20 to 30 stocks, diversified among 15 or more industries(if your assets are of sufficient size)

Rule 19: Buy medium- or large-sized stocks listed on the New York Stock Exchange, or only larger companies or the American Stock Exchange.

Five fundamental indicators can be used to supplement the three A-B-C rules of contrarian selection

Indicator 1. A Strong financial position

Indicator 2. As many favorable operating and financial ratios as possible

Indicator 3. A higher rate of earnings growth than the S&P 500 in the immediate past, and the likelihood that it will not plummet in the near future.

Indicator 4. Earnings estimates should always lean to the conservative side.

Indicator 5. An above-average dividend yield, which the company can sustain and increase.

These additional methods may not be for every investor, but you should be aware of them, since they represent some of the latest results from research.

Rule 20: Buy the least expensive stocks within an industry, as determined by the four contrarian strategies, regardless of how high or low the general price of the industry group.

Rule 21: Sell a stock when its P/E ratio (or other contrarian indicator) approaches that of the overall market, regardless of how favorable prospects may appear. Replace it with another contrarian stock.

I think 2 1/2 to 3 years is an adequate waiting period. If after that time the stock still disappoints , sell it.

Another important rule is to sell a stock immediately if the long-term fundamentals deteriorate significantly.

To Summarize : don't be stubborn, don't be greedy and don't be afraid to take small losses

Rule 22: Look beyond obvious similarities between a current investment situation and one that appears equivalent in the past. Consider other important factors that may result in markedly different outcome.

Rule 23: Don't be influenced by the short-term record of a money manager,broker,analyst, or advisor, no matter how impressive; don't accept cursory economic or investment news without significant substantiation.

Rule 24: Don't rely solely on the "case rate". Take into account the "base rate" - the prior probabilities of profit or loss

In each instance , the information in the particular case being examined should , where possible , be supplemented by evidence of the long term record of similar situations

Ex. Most buyers of hot ipo in the 1980s and 1990s focussed on the individual story and forgot that 80% of these issues had dropped in price after the 1962 and 1968 market breaks.

Rule 25: Don't be seduced by recent rates of returns for individual stocks or the market when they deviate sharply from past norms(the "case rate"). Long term returns of stocks (the "base rate") are far more likely to be established again. If returns are particularly high or low, they are likely to be abnormal.

Rule 26: Don't expect the strategy you adopt will provide a quick success in the market; give it a reasonable time to work out.

The Investor Overreaction Hypothesis makes these predictions:

1. "Best" stocks under perform the markets, while "worst" stocks outperform, for long periods.

2. Positive surprises boost "worst" stocks significantly more than they do "best" stocks.

3. Negative surprises knock "best" stocks down much more than "worst" stocks.

4. There are two distinct categories of surprise: event triggers(positive surprises on "worst" stocks, and negative surprises on "best"), and reinforcing events(negative surprises on "worst" stocks and positive surprises on "best"). Event triggers result in much larger price movements than do reinforcing events.

5. The differences will be significantly only in the extreme quantiles, with a minimal impact on the 60% of stocks in the middle.

Rule 27: The push towards an average rate of return is the fundamental principle of competitive markets.

Rule 28: It is far safer to project a continuation of the psychological reaction of investors than it is to project the visibility of the companies themselves.

Crisis Investing

Rule 29: Political and financial crises lead investors to sell stocks. This is precisely the wrong reaction. Buy during a panic, don't sell.

Rule 30: In a crisis, carefully analyze the reasons put forward to support lower stock prices-more often than not they will disintegrate during scrutiny.

Rule 31: (A) Diversify extensively. No matter how cheap a set of stocks looks, you will never know for sure that you aren't getting a clinker.

         (B) Use the value lifelines as explained. In a crisis, these criteria get dramatically better as prices plummet, markedly improving your chances of a big score.

         

Rule 32: Volatility is not risk. Avoid investment advice based on risk.

Small-Cap Contrarian Rules

Rule 33: Small-cap investing: Buy companies that are strong financially (normally no more than 60% debt in the capital structure for a manufacturing firm)

Rule 34: Small-cap investing: Buy companies with increasing and well-protected dividends that also provide an above-market yield.

Rule 35: Small-cap investing: Pick companies with above-average earnings growth rates.

Rule 36: Small-cap investing: Diversify widely, particularly in small companies, because these issues have far less liquidity. A good portfolio should contain about twice as many stocks as an equivalent large-cap one.

Rule 37: Small-cap investing: Be patient. Nothing works every year, but when smaller caps click, returns are often tremendous.

Rule 38: Small-company trading (e.g.Nasdaq): Don't trade thin issues with large spreads unless you are almost certain you have a big winner.

Rule 39: When making a trade in small, illiquid stocks, consider not only commissions, but also the bid/ask spread to see how large the total cost will be.

Rule 40: Avoid the small, fast-track mutual funds. The track often ends at the bottom of a cliff.

Psychology and Markets

Rule 41: A given in markets is that perceptions change rapidly

Major relief for Crompton Greaves

http://www.business-standard.com/article/opinion/major-relief-for-crompton-greaves-116030900600_1.html

The company has sealed a deal to sell its ailing international power business, which will help cut debt

Hamsini Karthik 

March 9, 2016 Last Updated at 22:21 IST

It has been back-to-back gains for Crompton Greaves. First, it firmed up on the demerger of its consumer business, which lit up its stock price by 12 per cent. Now, the sale of its international power business reaching a closure lifted its stock by nine per cent on the bourses on Wednesday.

The company's international business valued at €115 million or Rs 850 crore and sold to US-based private equity First Reserve International on a cash and debt free basis, will give the much-needed respite to Crompton Greaves. Most analysts were not attributing much value to the international power business, given its 20 quarters of cash-loss record. Earlier, expectations were that sale of this business would not fetch more than Rs 400-500 crore. However, now realising Rs 850 crore, analysts at Kotak Research attribute a fair value of Rs 40-45 a share to the power and industrials business (non-consumer business) against its earlier valuation of Rs 22-28 apiece. Motilal Oswal Securities, too, has revised its FY17 earnings per share target from Rs 3.8 for its non-consumer (power and industrials) business to Rs 5.3.

Although the money will come in a staggered manner, it will help Crompton cut its debt burden significantly from Rs 900 crore as on December 31, 2015 to nearly zero. Its management has guided for zero interest cost with the closure of the sale. Most importantly, the company’s profitability would get a boost. If these assets are excluded, the management said theoretically it would add Rs 350 crore to profits in FY16.

Following its sale, in FY17, while Crompton Greaves now expects to clock revenues of Rs 6,500 crore (down 35 per cent compared to FY15 revenues, largely due to sale of international power business) from the non-consumer businesses, net profit is pegged at Rs 325 crore; up 55 per cent compared to FY15. With the automation business also expected to be sold in FY17, its overseas exposure will be restricted to drives and rotating machines business, which are value-accretive. That said, the fate of Rs 1,200 crore worth of loans advanced by Crompton to its international entities is the only overhang, where it might have to take a write-off if no effective means of handling the same is discovered. For now, the Street is building in zero recovery from these.

Going ahead, with the budgetary push for infrastructure sector and prospects for the domestic non-consumer business inching up, FY17 holds promise for Crompton Greaves.

Re-rating for Crompton Greaves' consumer biz

http://www.business-standard.com/article/opinion/re-rating-for-crompton-greaves-consumer-biz-116030401176_1.html

Re-rating for Crompton Greaves' consumer biz

Focus on brand building, expansion of product basket and channels will aid earnings growth going forward

Sheetal Agarwal  March 04, 2016 Last Updated at 21:35 IST

Come March 16 and the Crompton Greaves stock will trade ex-consumer business - Crompton Greaves Consumer Products (CGCP). Most analysts are positive on the consumer business, which is likely to list sometime in April, and believe it has the potential to re-rate going forward. Consider this: CGCP is expected to list somewhere between Rs 100 to Rs 110 a share. But, some analysts such as Misal Singh of Religare Capital Markets ascribe a fair value of Rs 120 to Rs 140 to the consumer company, whereas Macquarie Capital and MOSL assign a value of Rs 140 and Rs 125, respectively. Crompton Greaves’ shareholders will get one share in CGCP for every share held; the current price of Crompton Greaves is Rs 141, which indicates the potential for value-unlocking.

Meanwhile, the new management is likely to step up focus on brand building, consumer-centric innovation and enhancing its reach to non-electrical channel such as e-commerce, multi-brand retail, among others, to boost the consumer business. Notably, against three per cent (as a per cent of sales) advertising and promotional spends incurred by Havells, CGCP spends only one per cent towards these activities.

The company plans to improve this going forward and leverage the brand ‘Crompton’ to increase its presence in appliances and switchgear segments. Its core products (fans, lighting, pumps) stand to gain from increasing income in the hands of consumers after the seventh pay commission as well as higher thrust on the rural economy. The company’s pumps business (20 per cent of revenues) also stands to gain from halving of excise duty on pumps from 12.5 per cent to six per cent in the recently announced Budget. In this backdrop, Macquarie Capital believes CGCP should trade at similar valuations to Havells on account of the former’s higher earnings growth expectations going forward. Assuming a listing price band of Rs 100-110, CGCP is valued at 18-19 times FY18 estimated earnings.

Havells, on the other hand, trades at about 25 times FY18 estimated earnings. CGCP’s revenues have grown 15 per cent over FY12-FY15, which is in line with industry. Analysts at MOSL believe the company could post 14 per cent revenue growth in FY17. However, Ebitda margins could come down a bit as CGCP scales up advertising, sales and promotional spends going forward. 

Strong brand identity, robust distribution network and healthy financials are some of the key strengths of CGCP, which aims to grow ahead of the industry. On the downside, half of CGCP's revenues are outsourced, which includes imports. Thus, its earnings are vulnerable to any sharp volatility in the rupee, which investors will have to keep an eye on.

Snippets from Berkshire Hathaway Inc 2015 letter

http://www.berkshirehathaway.com/letters/2015ltr.pdf

At Berkshire, we much prefer owning a non-controlling but substantial portion of a wonderful company to owning 100% of a so-so business. It’s better to have a partial interest in the Hope Diamond than to own all of a rhinestone.

Our flexibility in capital allocation – our willingness to invest large sums passively in non-controlled businesses – gives us a significant edge over companies that limit themselves to acquisitions they will operate. Woody Allen once explained that the advantage of being bi-sexual is that it doubles your chance of finding a date on Saturday night. In like manner – well, not exactly like manner – our appetite for either operating businesses or passive investments doubles our chances of finding sensible uses for Berkshire’s endless gusher of cash. Beyond that, having a huge portfolio of marketable securities gives us a stockpile of funds that can be tapped when an elephant-sized acquisition is offered to us.

Of course, a business with terrific economics can be a bad investment if it is bought at too high a price. 

We need shed no tears for the capitalists (whether they be private owners or an army of public shareholders). It’s their job to take care of themselves. When large rewards can flow to investors from good decisions, these parties should not be spared the losses produced by wrong choices. Moreover, investors who diversify widely and simply sit tight with their holdings are certain to prosper: In America, gains from winning investments have always far more than offset the losses from clunkers.

Finally, Jeremy Miller has written Warren Buffett’s Ground Rules, a book that will debut at the annual meeting. Mr. Miller has done a superb job of researching and dissecting the operation of Buffett Partnership Ltd. and of explaining how Berkshire’s culture has evolved from its BPL origin. If you are fascinated by investment theory and practice, you will enjoy this book.

Seth Klarman Year Ended Letter 2015

When somebody criticizes the stock I hold should I don the lawyer hat and defend it?. Lots of questions arise within me. Are they willing to learn from facts or am I just defending my ego ?. Are they trying to be genuinely friendly to me and trying to protect me ? Are all their stocks doing so well and only mine doing poorly ? Are their stocks in the ruins and they are trying to massage their egos by finding out there is a bigger fool out there ?

Ah whatever the reasons are , I feel that my energy is misdirected. I should not be spending energy on the defence of the stock or to refute the know-it-alls by being another know-it-all. I should rather spend my energy on researching the stock more, If I made a mistake, should sell it and look to live another day. If my process is right I should sit tight. I think Seth Klarman letter of 2015 is like a bible in the above scenario

Src : http://consensus-inc.com/002001i/knay1537/fin-com/0217fm-03.pdf

BAUPOST LIMITED PARTNERSHIPS 

2015 YEAR-END LETTER

“The whole problem with the world is that fools and fanatics are always so certain of themselves, and wiser people so full of doubts.” -- Bertrand Russell

Did we ever mention that investing is hard work – painstaking, relentless, and at times confounding? Separating relevant signal from noise can be especially difficult. Endless patience, great discipline, and steely resolve are required. Nothing you do will guarantee success, though you can tilt the odds significantly in your favor by having the right philosophy, mindset, process, team, clients, and culture. Getting those six things right is just about everything. 

Complicating matters further, a successful investor must possess a number of seemingly contradictory qualities. These include the arrogance to act, and act decisively, and the humility to know that you could be wrong. The acuity, flexibility, and willingness to change your mind when you realize you are wrong, and the stubbornness to refuse to do so when you remain justifiably confident in your thesis. The conviction to concentrate your portfolio in your very best ideas, and the common sense to nevertheless diversify your holdings. A healthy skepticism, but not blind contrarianism. A deep respect for the lessons of history balanced by the knowledge that things regularly happen that have never before occurred. And, finally, the integrity to admit mistakes, the fortitude to risk making more of them, and the intellectual honesty not to confuse luck with skill.

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Value investors must be strong and resilient, as well as independent-minded and sometimes contrary. You don’t become a value investor for the group hugs. Indeed, one can go long stretches of time with no positive reinforcement whatsoever. Unlike some other fields of endeavor, in investing you can do the same thing as yesterday but achieve completely different reported results. In the long run, the research and analysis you perform should overcome market forces; the fundamentals ultimately matter. But in the short run, markets can trump effort and insight. They move in unpredictable cycles, with investors stampeding this way and that. Businesses quickly come in and out of favor, and the same business can be valued by the market very differently in a matter of days, sometimes on the basis of new facts, but often because of mercurial investor perceptions or simply money flows

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It is critical for any investment firm to be built to take a pounding – structurally, financially, and psychologically. Investors must have a patient client base that allows for persistence during a bad year (or years), and an approach that limits risk while maintaining an appropriate balance between greed and fear. Greedily throwing caution to the wind is eventually disastrous, but fear-induced paralysis is not a recipe for success either. Investors must employ an investment philosophy and process that serve as a bulwark against a turbulent sea of uncertainty and then navigate through confusing and often conflicting economic signals and market head fakes. Amidst the onslaught of gyrating securities prices, fast and furious corporate developments, and an unprecedented volume of data, it is more important than ever to maintain your bearings. Value investing continues to be the best (and perhaps only) reliable North Star for those who are able to remain patient, long-term oriented, and risk averse.

While value investing is a demonstrated strategy for long-term investment success, it isn’t like being handed a treasure map. Rather, the value approach teaches you how to make your own map. And even then, the map doesn’t tell you precisely where to dig for treasure: it just points you in the proper direction.

Several years ago, a friend outside the industry asked me to mentor him in Graham and Dodd, and I provided voluminous reading material and coaching. He was intrigued and energized, he said, and declared himself a value investor. Three months later, he informed me that he was giving up. It didn’t work, he had determined. It turns out that not everyone has the patience and discipline to follow the one approach that has been demonstrated to deliver excess returns with limited risk over the long run.

Value investors gain clarity by thinking about their investments not as quoted stocks whose prices whip around on a daily basis, but rather as fractional ownership of the underlying businesses. In Benjamin Graham’s construct, Mr. Market sometimes becomes greedy, overpaying for your shares, and other times fearful, selling you his shares at bargain levels. Successful investors must possess the mindset to take advantage of Mr. Market’s bipolarity, and even come to appreciate it.

Two extremes of human nature, greed and fear, perpetually drive market inefficiency. Fear is primal, the effect of confronting the apparent loss of what you have. While your shares today still represent fractional ownership of exactly the same business as when they traded higher yesterday, people en masse are delivering the verdict that your shares are worth less. It is natural to panic at the possibility of further markdowns. But crucially, you have to find a way not to care or even to relish this eventuality. Warren Buffett has written that one should not invest in stocks at all if uncomfortable with the possibility of a 50% drawdown. The mistake some investors make is to accept the market’s immediate verdict as fact and not opinion, and become disappointed, even frustrated. For investment professionals, trepidation over poor performance can morph into fear of job loss. Career risk thus plays a role in their ultimate, and usually untimely, capitulation; even those who wish to be patient may worry that their employer or client will not share their resolve.

Paper losses can cause people to lose their bearings. When your portfolio is marked down sharply, it’s natural to fear losing the rest. Thinking about your net worth based on the latest stock quotes may superficially seem appropriate, because if you sold your shares today that’s all you would get. But investors must adopt more complex thinking. What you’re really worth is not what the market will pay today (that’s the erroneous assumption behind the efficient market hypothesis), but rather the true value of the securities you own based on such attributes of the underlying businesses as free cash flows, private market values, liquidation values, downside protection, and growth prospects. This is what Graham and Dodd taught and what we believe at Baupost.

When the market, in the absence of adverse corporate developments, drives an undervalued security down in price to become an even better bargain, that’s not reason for panic or even for mild concern but rather for excitement at the prospect of adding to an already great buy. When tempted to sell into a decline, investors must think not only about what they would be getting (the end of pain that accompanies the certainty of cash), but also what they’re giving up (a significantly undervalued security which, emotion aside, may be a far better buy than a sell at today’s market price). This is why relentless and thorough due diligence and deep fundamental analysis are so important. They give you the justifiable confidence to maintain your bearings – to hold on and consider buying more – even on the worst days in the market.

Greed, too, is deeply rooted within people. It is expressed through the drive to acquire more and more and the related angst felt when others are succeeding while you are not. This is what J.P. Morgan meant when he said “Nothing so undermines your financial judgment as the sight of your neighbor getting rich.” Or as Gore Vidal dryly noted, “Whenever a friend succeeds, I die a little.” The positive reinforcement from repeated stock market success can be a kill switch for risk aversion in that it tempts people into paying up and then holding on too long. A recent article in Vanity Fair about a looming bubble in Silicon Valley noted, “Collectively these start-ups have helped promote a culture of FOMO – or ‘fear of missing out,’ in Valley parlance – in which few [venture capitalists], who have their own investors to answer to, can afford to ignore the next big thing.”

Fear of missing out, of course, is not fear at all but unbridled greed. The key is to hold your emotions in check with reason, something few are able to do. The markets are often a tease, falsely reinforcing one’s confidence as prices rise, and undermining it as they fall. Pundits often speak of the psychology of markets, but in investing it is one’s own psychology that can be most dangerous and tenuous.

.......

Discipline isn’t something an investor should be turning on and off. There’s no point in being disciplined most of the time, only to toss the fruits away in a weak, distracted, or greedy moment. And there’s no such thing as being almost disciplined – even one moment of weakness can invite the wolves in, and it can also send a message. If you expect the members of a team to be disciplined, then letting down one’s guard on occasion is at first confusing, and then demoralizing, as the benefits from prior discipline are squandered. If excessive risk-taking is rewarded even once, there will quickly be no discipline at all

In the moment, public market investors have no ability to control investment outcomes, but they can control and improve their own processes. We never shoot for high near-term investment returns. Trying too hard to earn positive results, or assessing performance too frequently, can drive anyone into short-term thinking, herd-like behavior, and incurring higher risk. We do our utmost not to allow this to happen. We believe that by remaining focused on following a well-conceived process, we will make good risk-adjusted, long-term investments. And we know that if we do that, we will indeed earn good returns over time.

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While operating within the constraints of value investing principles, we are determined to look far and wide for opportunity, building our competencies over time based on learning and experience. We must neither be confined by a narrow mindset of what may or may not be undervalued, nor become so aggressive in pursuing opportunity that we deviate far beyond our circles of competence. I tell our team that we wouldn’t be doing our jobs if we remained locked in the past, buying only the melting ice cubes of previously good businesses now in decline as though technological change weren’t accelerating the obsolescence of entire industries. We would also be remiss if we failed to take advantage of new analytical tools and resources. We must consider new ways of thinking. We must continuously ask ourselves whether any investment under consideration is just too hard to properly assess: Is the fruit too high-hanging? In investing, there are no style points awarded for degree of difficulty. However, the complexity and opacity that may cause others to discard potential opportunities as “too hard” can drive market inefficiencies that result in opportunity for us. In 2015, we took a close look at “big data” technology as a research tool and potential “edge” for Baupost. While there are a number of applications that may be interesting over time, we continue to strongly believe that our investment success will ultimately depend not so much on big data as on big judgment.

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As with Pavlov’s dogs, in a bull market investors find certain actions repeatedly rewarded; their behavior thus becomes deeply ingrained. Amidst a relentless rally, almost anything you come close to buying but ultimately pass on goes higher, inducing you to be more aggressive. Similarly, anything you sold you probably sold too soon, even if it had met your price objective. In a bull market, focus on downside risk ceases to be shrewd discipline and instead becomes an albatross. Many are seduced into raising their appraisals, because doing so is rewarded. As if missing out on returns weren’t itself painful enough for “Type-A” money managers, it also causes underperformance that can frustrate clients and raise career risk. Bull markets don’t typically end until most have capitulated, at which point there is almost no one new left to buy.

Bear markets, of course, offer their own false “lessons,” but in the opposite direction. As prices fall, anything you previously sold turns out to have been a good sale; anything you bought was premature accumulation. When securities become “value-ish,” they at once become too tempting for the value-starved to avoid, yet still potentially toxic to one’s financial health. It takes a great deal of fortitude to set the bar at the consistently right place in all market environments. A bar that fluctuates with the tide is, in effect, no bar at all. Trading losses in a down market can turn investors into Mark Twain’s proverbial cat who once jumped on a hot stove: to this feline, all future stoves are also assumed to be worth avoiding. We haven’t been in a broad-based bear market since early 2009, although numerous sectors now seem to have entered one. We believe that value investing principles, great patience and discipline, a flexible mandate, a time-tested process, and the ability to hold cash, as well as decades of experience in a multitude of market environments, should serve us well in navigating through.

.........

It’s obviously far better to be alive today than 50 or 100 years ago. But optimism isn’t an investment strategy. Growth isn’t always profitable growth, and the returns from investments are typically determined more by the price paid than the growth rate. Whether any of these favorable trends are fruitfully investable is unclear. While we may all be better off decades from now, it’s reasonable, in light of the numerous concerns discussed earlier, to expect a bumpy ride.

.........

A fiduciary should think more about the safety of an entire portfolio than about any individual holding. Is Baupost willing to make an investment that has a meaningful, even significant probability of loss, if the expected value – the weighted amount and probability of gain and loss – is hugely positive? The answer is yes. All positions involve a degree of risk; any investment can go sour, and any probability assessment can be wrong. We manage the risk of loss in any single position by sizing appropriately based on historical experience as well as by striving for prudent diversification. Every day, businesses we own are making countless decisions they believe will offer positive expected value to shareholders in excess of their firms’ cost of capital. It doesn’t make sense to own businesses which do that, yet be unwilling to do it ourselves.

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A Short Framework For Investing Your Own Money by Kerr Neilson

https://www.platinum.com.au/journal/fundamentals-of-investing/a-short-framework-for-investing/

A Short Framework For Investing Your Own Money

by Kerr Neilson, 30 November 2012

Firstly, crises are not as rare as you may think. Secondly, you need to have realistic expectations from your share investments.  Thirdly, there are always opportunities - a brief case study.

This is a speech given to audience titled:

‘A short framework for investing your own money’

In the next 10 minutes or so, I shall try to provide you with a framework for investing your own money.

I will cover three topics ever so briefly:

• Firstly, crises are not as rare as you may think.
• Secondly, you need to have realistic expectations from your share investments.
• Thirdly, there are always opportunities - a brief case study.

With all the noise we get from the media, it is very easy to believe that we're facing one of the worst crises ever.  It certainly won't be a walk in the park with government’s overspending and creating money, but it is important to go back in history to realise that the system eventually sorts itself out and after five or 10 years, the game will be ‘on’ again.

In fact, the US economy is littered with a large number of financial crises starting with the railway building manias in the early 1800s as the country expanded West, to the well-known contraction of the great depression of 1929-1933.  In those 3.5 years, the economy contracted by close to 30% and prices fell by about a quarter.  The same sort of pattern has been evident elsewhere and the workout tends to follow a saw-tooth type of recovery with lots of concern throughout!

Time doesn't permit me to elaborate but it is highly likely that these damaged economies will gradually be brought back onto an even keel principally achieved by the debasement of money.  This process of sharing the burden is not attractive and if it is poorly executed, it will result in social dislocation, but this is too early to call.

A more interesting observation is that for all the turmoil, the trend in the last 110 years has been for real earnings to grow by 2% per annum.  This single figure hides huge swings and even includes periods when earnings did not grow!  More interesting still, is that even in periods were earnings have oscillated in a wide band but with no upward tendency, real returns from shares have been quite positive.  Over this 110 year period, real returns from shares have been considerably higher than real earnings growth and have averaged 6% a year; in money terms, this was 9.2% a year in the case of the US stock market.  In the first half of that period, returns were quite modest at around 3.5% real return but a full 9% real return in the second half because earnings were treated as more certain and shares were re-valued upwards.  By contrast, over this long period bonds gave one a 2.1% real return and cash about a 1% real return.

Now this is important; of the 9.2% total return from shares over this 110 year period, nearly half came from the receipt of dividends.

The message from this section is that real earnings growth is much lower than many people believe and secondly, that the dividends play a very important part in rewarding shareholders for the risks they take.

I have sped through these first two points because the most important message I wish to convey is that the market always provides us with opportunities; come inflation, deflation, economic expansion or contraction, the behaviour of the crowds invariably results in imperfect pricing.  At Platinum we try to exploit these by following two simple ideas.

Firstly, that the crowds tend to overemphasise the recent event, and

Secondly; there is a natural predisposition towards extrapolating the present situation far into the future.

Before giving examples of this, I would like to deliver a couple of key bullet points.

1.     The valuation of shares you propose to buy is critical; if you pay too much for a share you’re unlikely to make much money.

 2.    When assessing the price, it is essential to think about the sustainability of earnings and whether the earnings are being driven by temporary factors, which for example, are resulting in growth being above trend.  Ask yourself whether margins are high or low and what allows them to stay where they are.

3.     Be clear about the risks you are exposing your money to.  This can be broken down into many categories; economic, financial, political, business type etc.  For example, has your success herded you into an increasing exposure to Chinese dependent growth stories i.e. resource stocks.  We saw at the turn of this century how excess exposure to tech stocks and the Internet damaged one’s wealth.  Ask yourself about your currency sensitivities and the like.

Think carefully about the business you are buying.  We have a preference for companies that can control their destiny, set their prices independently of their competitors because of their market position and so on.  In a low growth environment this is particularly important.  One useful way of assessing management is to compare what they say, to what they do and to look for shifts in the narrative where excuses or external factors are blamed.

4.     Be patient and give your investment thesis time to work out but be decisive when the facts change.  It is essential that you change your position if the facts have changed.

5.     It is important to realise that the stock market owes you nothing.  It is simply offering you a smorgasbord of opportunities; some are cheap and some are expensive.  The cheap ones in our experience give you the best opportunities to make money so long as you can understand and see through what appear to be blemishes.  Lastly, it is not enough simply to be contrary and if the stock is cheap you must presume generally the market gets it right and an intelligent investor will start by trying to assess where he or she has got the wrong end of the stick.

Example

We have made some good money on individual stocks during this crisis period by ignoring the noise.  Into the teeth of the European crisis in the middle of last year, we bought a company that was highly sensitive to economic activity.  We were driven principally by considerations of value and the fact that this business was almost impossible to replicate without spending a great deal of money.  When DHL tried to break into the express delivery service in the US, it spent several years and a total outlay of about $8 billion and had to retreat ignominiously.  The company we bought was of this nature by the name of TNT Express.  It had around a fifth of the European market in fast delivery of parcels, was making around €400 million per year and became available in the market sell-off at under €2.5 billion.  We figured that one of the American giants, FedEx or UPS, would be unable to resist acquiring TNT as the one part of their global network that was weak, was Europe.  Within six months of buying a big position in TNT, we received a bid from UPS at over €8 per share; our entry price was around €5.  Sure we were lucky that they made a bid at that time; we could have experienced a much longer holding period but the logic of our case was strong.

There have been several other opportunities coming out of this crisis in Europe which have been very profitable for us including a company by the name of Amadeus which is listed on the Spanish exchange and again, as the country faced miserable conditions, the opportunity arose to build a large position in a company that is arguably almost a monopoly in the global air travel booking system; subsequently the shares have risen by about 60%.

These war stories are not meant to convey our proficiency but to highlight the fact that in the teeth of a gale, opportunities arise.  Hold your poise, do your work, remain independent in thoughts and action, and wealth will accrue.

How Charlie Munger Transformed the Daily Journal

http://www.fool.com/investing/general/2016/02/17/how-charlie-munger-transformed-the-daily-journal-i.aspx

With a handful of well-timed stock purchases in 2009, the chairman of the Daily Journal breathed new life into the newspaper company.

One of the most interesting financial stories from the last decade involves the incredible returns earned by the Daily Journal (NASDAQ:DJCO) on its portfolio of common stocks.

The Daily Journal isn't an investment company. It generates most of its revenue from publishing newspapers throughout California -- ones like the San Francisco Daily Journal and the San Jose Post-Record.

What makes the Daily Journal so unique is the fact that Charlie Munger, Warren Buffett's longtime confidant, is its chairman. And Munger, like Buffett, personifies the power of capital allocation.

At the beginning of 2009, the low point in the financial crisis for the stock market, Munger invested $20 million worth of the Daily Journal's cash largely into the shares of four companies: Wells Fargo (NYSE:WFC), Bank of America (NYSE:BAC), U.S. Bancorp (NYSE:USB), and Posco, a company that manufactures and sells steel rolled products and plates in South Korea.

The recovery of their stock prices has since more than quadrupled the size of the Daily Journal's balance sheet.

By the end of last year, shares of Wells Fargo were 570% higher than when the Daily Journal bought them in the first quarter of 2009. Bank of America's stock finished last year 431% higher than the Daily Journal's basis. And U.S. Bancorp was up 374%. Only Posco has seen its stock price fall, losing 31% of its value over this stretch, leading the Daily Journal to pare its position.

It would be an understatement to say that this has transformed the Daily Journal. Eight years ago, it didn't own any stocks. Today, three-quarters of its assets consist of marketable securities. Its investments in Wells Fargo, Bank of America, and U.S. Bancorp alone made up 55% of its assets at the end of last year.

You can see the impact of this on the Daily Journal's income statement as well. It earned $3.8 million in dividend and interest income in 2015. That's up from $704,000 in 2009. As a percent of revenue, its dividend and interest income went from 1.7% all the way up to 8.7% over this stretch.

This income stream is only bound to increase. Bank of America in particular has substantial room to boost its quarterly dividend, which sits at $0.05 per share after it all but eliminated distributions during the financial crisis. And even though Wells Fargo and U.S. Bancorp's dividends have recovered since then, they can both be expected to ratchet up their payments on an annual basis for the foreseeable future.

In short, the Daily Journal's transformation speaks to the impact that a single individual can have at a company. This is especially true if that person has the knowledge and ability to profitably allocate capital. Indeed, if Munger and Buffett have taught us anything, it's that capital allocation should never be an afterthought for investors or executives.