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Most influential and/or educational investment related piece
Investment Strategy | 8 Comments | Thu 05 Sep 2013
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Since before the days of Graham and Dodd’s contribution to the field of security analysis, and certainly afterward, there have been thousands of investment articles written by economists, would-be investors and professional investors alike.  Some of them have stood the test of time.  The purpose of this blog is to encourage the exchange of such pieces and ignite healthy debate about which should top the poll of Most Influential and / or Educational.

We are starting the ball rolling with a particular favourite: Warren Buffett’s “How Inflation Swindles the Equity Investor” (link below).  This is a herculean work in reducing much investment know-how to simple fundamentals – it is often said that should you be unable to explain a concept to a kinder-gardener, you do not fully understand it.  Whilst this article is unlikely to ever be pre nap-time reading for youngsters, it’s a Master in Finance during afternoon tea for students of sensible investing.

This particular article might even spark a to-and-fro on recent monetary manoeuvres.  Particularly interesting is Seth Klarman's 'doubling-down' on gold, presumably as protection from what is, in his view, inevitable severe currency depreciation relative to real / scarce assets.  If you are on Seth's side, why?  In addition, what are examples of companies at reasonable valuations you would be happy to own should that scenario play out – and again, why?  If, on the contrary, you take the opposing view that there is no need to fret over impending severe currency depreciation / inflation please explain your thinking.

Note: severe currency depreciation is very different from the mild currency depreciation relative to, at an aggregate level, real goods and services we should all expect in a fiat monetary system, where the money supply monopolists (i.e. Central Banks) typically have a stated nominal inflation target. 

 

Please post, in the comments section, links to your favourite articles and letters and reference important chapters in books etc.

 

http://features.blogs.fortune.cnn.com/2011/06/12/warren-buffett-how-inflation-swindles-the-equity-investor-fortune-1977/



Comments

1.
On 01/11/2013 13:53:44, Conor Maguire wrote:
http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Seth%20Klarman/Seth%2520Klarman%2520on%2520Cash.pdf

In the 2004 Baupost investor letter, Seth Klarman’s description of investors facing a “crisis of low returns” resonates strongly with the current market climate. He describes the dilemma of choosing to either hold securities at the historically high prices prevailing at that time and the prospect of lower returns, versus the “painful” decision to remain liquid by holding cash and refrain from equities or bonds as the market climbs higher . The pain in this instance would stem from missing out on the prospect of higher returns should the market continue to rise.
His dissecting of this dilemma serves as an extremely helpful aid for investors in appraising the current market climate and the decision to deploy or conserve investment capital.
Klarman elucidates that betting that the markets never revert to historical norms, and the expectation of a new era of higher stock prices exposes the investor to genuine or “true” risk, – the potential for significant, permanent capital impairment. He contrasts that with the risk attaching to the alternative of holding cash in an expensive market – the opportunity cost of not being invested, which is of course unquantifiable ( to be able to quantify would imply having some certainty about future security prices, which is absurd). Weighing the two alternatives up then produces a very logical conclusion that speaks to prudent risk management, based on the true definition of risk (the potential for permanent loss of capital). By investing in a continuously rising market, the probability of earning satisfactory returns decreases, while the probability of loss of capital increases. In contrast, by remaining in cash, the probability of loss of capital is almost negligible (excluding an extremely inflationary environment of course), while the only downside is the negligible returns available on cash. This fear or “risk” of negligible returns that should always be of secondary concern however, as all value investors will know that rule number 1 is “never lose money” in Buffett parlance.
It therefore follows that to invest in an expensive market, such as the one at present, actually and knowingly involves running the risk of both capital impairment and lower prospective returns; in essence, prudent risk management is at best inverted (by putting the quest for returns ahead of safety of principal), and at worst ignored.
Klarman’s reminder that “One doesn’t need the entire market to become inexpensive to put significant money to work, just a limited number of securities” is reassuring to those of us frustrated by lack of value in today’s market generally. Investors much be patient, with an appreciation of what Howard Mark’s calls the “temperature” of the market, and adhere to Graham and Dodd’s over-arching principle of always seeking safety of principal first, and an adequate return second.

2.
On 03/11/2013 22:07:38, Patrick wrote:
Conor, I read your comment with interest and agreed with much of it.
However, I think there is an over-arching need to dis-aggregate 'investors' in this instance. That is, is one referring to a hedge fund manager, a mutual fund manager, a pension fund manager, an endowment manager or Mr. Smith (a retail investor) who invests his own excess income in order to prepare better for retirement?
If your game is beating market returns, of course the optionality value in holding cash today should make it an important part of your portfolio holdings - you are much more likely to compound at higher rates than the major indices if you have the flexibility and discipline to hold elevated cash levels when they (the indices) trade on relatively expensive valuation metrics. However, if you are managing a university endowment, for example, the problem is more complicated. The endowment must make a payout every year - and thus current income is a necessity and their needs are being thwarted by Bernanke et al.
If you are Mr. Smith, and are an average (typically unsophisticated) investor I believe it wouldn't be very sensible not to invest your excess income this year in an index fund, or a basket of securities fairly representative of the index but perhaps with slightly less business risk / higher business quality (all other things, like price, being equal), just because it trades on 16x earnings - or whatever the figure is.
I am afraid, much like Seth Klarman's motivation for writing MOS, that the Mr. Smith's of this world are the ones who will lose out most as a result of the current environment. Will they be attracted to the potential for higher gains by partaking in IPOs like that of the recent and ridiculous Potbelly, or buying Tesla at 100x earnings? I fear that the investment media dis-serves these people by creating so much noise in relation to the valuation of the stock market and in hyping the securities that perform 'hotly' over a short period of time.
Having said all that - of course, you are exactly right in that portfolio managers who are charged with preserving capital, first and foremost, should hold elevated levels of cash; and that should in fact, in my opinion, only be a result of the lack of individual opportunities / new ideas rather than a tactical decision.
There is one proviso, about which I have not the slightest inkling on the truth or reality going forward - that is, does quantitative easing reduce the returns on real assets (as well as obviously have done so on financial assets). If I am an entrepreneur and want to buy and employ a piece of capital equipment today - does quantitative easing have any impact on the returns I should expect from it? I suspect the answer is no - but if it is yes, then valuations of stocks today in general are by no means expensive (excepting biotechs, Potbelly, Tesla etc).

3.
On 06/11/2013 21:51:35, Conor Maguire wrote:
Patrick, thanks for reading and for your comments. A couple of points I would like to respond to:
I accept your point that different investor types may have different requirements in allocating the capital they are charged with investing. In my initial comment, I was writing from the perspective of an investor that is simply free to invest as and when he/she sees fit, whether they be a private individual, a hedge fund portfolio manager or other investor type that is afforded such flexibility by their mandate. Certain entities such as endowments do of course have less flexibility in some respects, but that should not pressure their managers to knowingly investing in expensive investments with likely poor future returns where possible. To invest on this basis would veer into the illusory realm of relative performance and ultimately underperformance.
When you stated that “If you….. are an average (typically unsophisticated) investor I believe it wouldn't be very sensible not to invest your excess income this year in an index fund…. just because it trades on 16x,” are you saying that the average investor should still invest in an index fund (or similar representative product) in an environment such as the present, which is c. 16x non-normal (artificially elevated) earnings? Why do you believe this to be sensible? Surely the advantage of the “little guy” is that he/she has the optionality to abstain from overheated markets, not being subject to the relative-performance oriented mindset of the conventional fund management game? Surely cash-optionality offers an advantage to the small investor in this regard?
I also quite agree with you in relation to the current crop of IPO’s – I am very much reminded by Benjamin Graham’s views on the dangers of IPO’s, as history has shown that IPO’s have often tended to the mechanism by which formerly private owners cash-out of companies that are of questionable quality, resulting in the average investor being burned, should he/she opt to invest. The current raft of IPO’s to my mind is one of those classic warning signs, along with markets reaching new all-time highs (check), increased issuance of covenant-lite loans (check), record low yields on junk debt (check) and extrapolation of peak profit margins into the future (check).
With regard to your final point on whether QE has an impact from a piece of capital equipment you might buy today, I would argue it does, and I would point to Warren Buffett’s recently capital allocation patterns to support this: during 2012, Berkshire invested heavily in capex-heavy businesses such as BNSF, Iscar and others. Why do this? Firstly, the likely result of QE is eventually massive inflationary pressure, but how does this impact corporate capex spend, and why is this relevant to an investor? Essentially, corporates can invest now in expensive capital equipment at a historically lost cost of funds, before any potential rise in inflation causes the prices of such equipment to rise significantly once inflation again takes hold. As corporate borrowing has never been done on better terms, and with corporate cash balances at record levels, companies have the means and opportunity now to bolster their operations by investing intelligently in plant machinery, equipment etc., at abnormally advantageous prices. If capex programmes are deferred until the economy begins to re-inflate, capex will be more costly and the cost advantage will have been lost. It is these businesses who will be better placed to maintain and grow their market share in future at the expense of competitors who defer capex now due to economic uncertainty. The businesses that hesitate and sit on cash piles that earn little or no return may find their competitive position weakened while being forced to investment in maintenance capex at comparatively higher costs in future. In my view, Buffett is effectively saying that this failure to recognise such favourable conditions for bolstering competitive position by shunning the current capex opportunity may well prove to be an unintelligent and costly mis-allocation of capital.

4.
On 11/11/2013 12:02:53, Patrick wrote:
Conor – again I would like to respond as best I can to some of your points. This to-and-froing may not get us anywhere in the end; but I enjoy reading your thoughts and it’s fun to think about these things.

Yes - I firmly believe that for a typical retail investor, who has a steady and modest income and who knows little about investment matters, and who – sensibly – wants to allocate a portion of their disposable income to financial assets which will leave them better prepared for retirement, it would be more sensible for them to buy the same real dollar amount of stocks this year as last. I say this, not in abandonment of the principles of investing, but in recognition of the practicalities of many people’s heuristics and tendencies which will, unfortunately, inevitably force upon them returns worse than the average stock fund’s returns. I refer you to an article on the iCubed website (http://www.icubed.ie/docsrepository/Investing%20is%20simple%20but%20not%20easy.pdf). I admit that this is mainly a result of excitement when in the recent past stocks have performed well, and extrapolation into the future leads to increased buying of stocks when valuations look less attractive which in turn leads to poorer returns. I think it is simply not natural for many people to buy more stocks when they get cheaper and buy less when they get more expensive – so I suggest that they avoid any strategy except the simplest one. I am thinking about someone who has perhaps $5,000 to $10,000 (in today’s money) per year in ‘save-able / investible’ income. I contend that these people will serve their long-term interests much better if they buy a fixed real (nominally adjusted and perhaps additionally for real salary increases above cost of living increases) amount in a basket of stocks fairly representative of the world economy every year without regard to short-term fluctuations in valuations. Over a life-time of investing, say perhaps from 25 years of age until 65 years of age – returns will be much more dependent on business performance than on multiple expansion or contractions. I think that equity market returns over the very long term should be something like 6%-8% (some companies will turn out to be infinite duration fixed (real) income securities - today with ROEs of 15% and selling for 2 x Book Value and distributing all or almost all of their earnings, whilst others will grow and reinvest some earnings at 15% ROE, whilst others will cease to exist over the long run. Returns will of course depend on what long term sustainable profit margins are, productivity growth, population growth inter alia. If Mr. Smith can compound at something like those rates over the very long term and is able to put enough of his income aside every year in order to compound ever greater amounts of capital he will find himself very nicely prepared for retirement.

On whether QE will affect the returns on assets going forward, I was of course referring to real returns. Buffett has himself said that in an inflationary environment the worst businesses to own are capital intensive ones, where continual maintenance of equipment means inevitably decreasing real profits – since most companies can’t raise prices enough to offset the increases in capital costs – so real returns are affected. If Buffett is in fact investing in capital intensive industries in order to ‘time inflation’ as you suggest, which may in fact be an accurate interpretation of those purchases, it will only be the capital outlay on which he saves (which will be less meaningful over time). That may in fact allow those businesses to take market share etc. but again, I don’t know enough about them or their respective to industries to really make a comment.

I post here a link to a letter written by Buffett to Katherine Graham about pension costs and inflation written decades ago. It is another on my all time favorites list.

http://www.cookandbynum.com/wp-content/uploads/2013/08/Warren-Buffett-to-Katharine-Graham.pdf


5.
On 13/12/2013 12:26:01, David Horgan wrote:
Hi Connor & Patrick,
Great exchange from you both, informative and relevant. I would agree with most of what you have said above and would particularly echo Connor's concerns on market valuations, and symptoms of a highly over valued stock market in the US, about fair value in the UK, and similar in many developed markets in Europe. All the signs are there for a significant correction in the short to medium term, or else the prospect of lousy returns over the next 10 to 15 years.

There is a great chapter in William Bernsteins 'The Intelligent Asset Allocator' which fully illustrates the relative advantage that a well informed and disciplined (i.e. have a plan & stick to it) private investor has over all institutional investors who make up approximately 80+% of the market.

From memory these advantages were as follows:
being able to invest with a longer time frame than 1 year
Not being assessed quarterly and not having to track an industry benchmark
Having the discretionary ability to invest more in risk assets when they are relatively cheap (like Europe was 2 years ago say) and less in risk assets when they are expensive e.g. bonds or the S&P currently for instance.
Being able to invest in small caps
Being able to invest in alternative asset classes
Being able to invest counter cyclically on a systematic basis

I would highly recommend this book and this chapter in particular but would advise would be readers that it is not an easy read. There's a fair bit of thought and engagement required to digest it.

Finally, I'll finish with a question and request for discussion if you don't mind: assuming one accepts that the US & many other developed markets are now heavily over valued versus long term norms, and since many Asian & Other EM currencies and markets have dropped significantly from their peaks and relative to their measurable medium term norms, are emerging markets now a value buy???

I.e. can a value index investor ignore the turmoil that a likely revaluation of developed markets will probably have on EM equity indices over the coming 12 to 18 months say?????


P.s. stonking value buys for retail investors over past 3 years:
Irish goverment bonds
Euro equities
Berkshire Hathaway when it fell below book value

P.s. more on Bernstein's work


http://www.economist.com/blogs/buttonwood/2013/11/economics-and-markets-0


6.
On 06/01/2014 11:55:26, Conor Maguire wrote:
David,

Thanks for your comments and for posing an interesting question with regard to EM vs. developed equity markets.

Personally, I feel my circle of competence is limited to US, UK and Western European economies and businesses, rather than those further afield. While this may seem like I am limiting my potential investment universe significantly by avoiding Asian or South American companies for example, I simply feel I don’t know or understand their markets, their consumers or economic drivers enough to enable me to make sufficiently informed investment decisions. By contrast, I have travelled extensively around the US and Europe, and regularly read up on current affairs and economics in these markets and so I can feel much more comfortable in appraising these businesses.

Additionally, from a governance and financial reporting perspective, I feel that standards remain higher or at least more reliable in the US and Europe versus, for example Indonesia or Mexico. Additionally, much of the large-cap companies in the US and Europe are active in EMs and so I can always gain exposure that way, with less business or political risk.

Perhaps in time I will be able to widen my circle to understand EM’s but in the meantime, there are approx. 5000 publicly listed companies trading on the major US exchanges alone, and I only wish to hold approx. 10 in my portfolio at any given time! (Due to time and resource constraints, I cannot reasonably expect to know and understand any more than this number of businesses in sufficient detail for me to comfortably own).

So what do I do when developed equity markets are at or near all-time highs, such as at present? I sit and wait for the “fat pitch” to use Buffett’s expression.

I will read up on Bernstein’s book – thanks for sharing.

Regards,

Conor.

7.
On 24/02/2014 16:49:44, Paul wrote:
Why try to be smart about it? Each and every one of the Berkshire Hathaway shareholder letters contains so much wisdom. This may not be an earth shattering post.. but these letters are all 'diamonds'

http://www.berkshirehathaway.com/letters/letters.html

Here is a preview of this year's from Fortune:

http://finance.fortune.cnn.com/2014/02/24/warren-buffett-berkshire-letter/

This is a fantastic excerpt:

After all, if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his -- and those prices varied widely over short periods of time depending on his mental state -- how in the world could I be other than benefited by his erratic behavior? If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.


8.
On 15/03/2014 12:13:21, Conor Maguire wrote:
Paul, I agree – The Berkshire Hathaway letters are a complete repository of investing wisdom that I read and re-read without ever getting bored.

I think the following excerpt from the 2013 letter is extremely helpful in the context of current stock prices:

"When Charlie and I buy stocks – which we think of as small portions of businesses – our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out, or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings – which is usually the case – we simply move on to other prospects. In the 54 years we have worked together, we have never foregone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions."

In just six sentences, Buffett provides us with the essential framework on how to value a business.

I’ve just posted my own thoughts on the 2013 letter at the following link – would welcome comments, feedback etc.

http://independentvalue.wordpress.com/2014/03/15/buffetts-2013-letter-to-shareholders-investment-strategy-outlook-and-the-valuation-of-businesses-2/

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