Equity Markets (in)efficiency

Value investors generally look for something that is worth more than the market price. If your analysis is proven correct the market price will converge to your estimate in time – you just don’t know when. It may take 6 months to 3 years generally. But let’s look at the average holding period in the U.S.:
What we see is that market participants are turning the portfolio way faster than they used to. But why is that? Clients generally have a shorter timeframe than portfolio managers thus yearly we see money flowing from last year’s losers to winners. Due to that managers try to perform well in a shorter timeframe. So it is a cycle – not a virtuous one though. Now it is clear the reason a client base aligned with the investment strategy is a competitive advantage – think of the Baupost Group.
So in a market with that kind of irrationality that comes from short term/momentum investing many opportunities arise for those who are able to have a longer investment horizon. The conclusion is that the managers with well defined investment processes, disciplined, with a longer timeframe and with the client base aligned with the strategy will be the last man standing or in another expression, time arbitrage will be the last strategy standing.

Quoting Jeremy Gratham from GMO:

“For the best instituional investors, their time horizon is 3.0000000 years.” (Source: Graham & Doddsville, Fall 2012)

Quoting Joel Greenblatt on why he thinks investment time horizons will not lenghten:

“I think the reason for this is that your investors – your clients – generally just don’t know what the investment manager’s logic was for each investment. What they can view is performance.(…) Clients tend to make decisions over much shorter time horizons than are necessary to judge skill and judgment and other things of that nature. So I think time horizons are getting shorter, not longer.” (Source: Graham & Doddsville, Fall 2012)

Charlie Munger, Behavioral Finance & Mental Models

The first time I had contact with mental models and decision making was during the class of Decision Analysis and Risk – one of the best I had during the engineering course, by the way. The topics and bibliography were just great: Tversky and Kahneman`s prospect theory, heristics, framing, biases, behavioral finance and so on. I still remember the first class which was just an introduction to this important topic in investing and it talked about the decision making by Kuribayashi, the japanese general responsible for the Iwo Jima island. The movie Letters from Iwo Jima depicts the the battle between Japan and U.S. during World War II, as told by the perspective of the japanese. In the movie and in real life we might notice how the human mind deviates us from the best strategies, i.e. the ones with the highest expected value.

That said, Charlie Munger is a great thinker of our world of value investing. He brings with himself his famous mental models which are basically general ideas or thesis from very different disciplines – from psychology and medicine to physics and math – that are readily available in his brain to be picked up if a situation appears. Last time I tried to put it as simple as possible for myself:

  1. a problem appears in front of you to be solved; 
  2. checklist the problem`s characteristcs and match them with your mental models;
  3. solve the problem with the correct mental model.

Ok, it sounds really tricky when we read it, although our minds do it all the time with us – unconciously. This last word is the really tricky part of this. But wait a second, what about our biases and how heuristics play us? At the same time one might argue value investors do not have much spare time to read topics ranging from psychology to physics – we are specialists after all, aren`t we?  Anyway, I found this transcription here from Whitney Tilson`s website. It is a speech of Charlie Munger at Harvard Law School in 1995 called The Psychology of Human Misjudgment. Munger lists over 20 bias our mind develop and give many examples and little stories like the man with a hammer, Fedex problem with incentives, Pavlov association and so many more insightful stories. Please do not miss the opportunity to read this paper.

East Coast 3Q 2012 Letter – Investment Process

East Coast’s last piece tangles investment process. Christopher Begg believes that one should have a differentiated investment process in order to achieve superior compounded returns over time. When analyzing outstanding track records, the best ones were produced by firms where process, skill, intelligence and control were coupled with a value philosophy. It is interesting to notice they use an “inverted checklist” in which he seeks to respond to questions like why this opportunity is NOT mispriced instead of why it is indeed mispriced since they found out this inversion helps reduce some biases.

He classifies three types of investments:

  1. Compounders: high IRRs for a long period of time;
  2. Transformation: may be interesting for time arbitrageurs;
  3. Work-out: discounted investments which will eventually close the gap between price and intrinsic value.
The summary of their framing can be translated in:
  • what is the range of expected IRRs?
  • do we have enough margin of safety?
  • do we understand the investment’s key issues?
  • do we understand why Mr. Market is mispricing this asset?
Where do they search for opportunities?
  • Sell-offs;
  • Post-barnkrupctcy reorganizations;
  • Spin-offs and demutualizations;
  • Industry transformations;
  • Political and economic cloud;
  • Other intelligent and talented investors.
Common questions asked to management:
  • Competitive landscape;
  • Strongest competitor;
  • Market share evolution;
  • Pricing power/pressure trends;
  • Capital allocation going forward.

“I don’t think a discussion on investment process would be well served without sharing what I think is the secret to any successful sustainable compounding endeavor: creating a culture of learning and improvement. As the world evolves, so must your intelligence.” (Source: East Coast Asset Management 3Q 2012 Letter) 

 Full letter can be found here.

Baupost’s Seth Klarman 3Q 2012 Quote

“The overall market environment seems increasingly risky to us, as securities prices are rising despite weak and generally deteriorating global fundamentals. U.S. corporate earnings are expected to be lower this quarter. Higher markets in the face of eroding fundamentals can be a toxic combination. A market rising for non-fundamental reasons (i.e., QE and ECB bond repurchases) is always one that demands a healthy dose of skepticism.” (Baupost’s Seth Klarman 3Q 2012 Letter)

Given all criticisms already received by Mr. Bernanke and the lousy composition of the rally seem in the small/mid cap universe, it is indeed difficult to be constructive. As the time goes by I am being the most selective as I can to preserve capital and struggling to find cheap opportunities in a market that could hurt investors’ pockets.

As now people envision equity investments as bonds while they look for yield in the so called “new normal” environment, value investors find themselves in trouble when searching for value and one might know how this is gonna end: tons of  value going forward. Thus our job description haven’t changed so far, but acting on investment cases might take a while before they present themselves at reasonable prices. As Munger says, it’s avoiding stupidity that makes you compound at a good rate.

Greenlight Capital Q3 2012 Letter and Conference Call

After the last Value Investing Congress in which Einhorn discussed his thesis on GM, Cigna, Chipotle and updated on Green Mountain, there were no major surprises in his last letter (which can be found here). At the same time it was curious to see another portfolio manager joining the chorus of “financial wise” people against the ultra easy monetary policy being implemented by the Fed. The analogy between the U.S. Central Bank and Amex was intriguing:

“This buying binge brings to mind American Express cards, which are famous for their promise of no pre-set spending limits. (…) Like American Express, the market won’t let the central bankers know what their spending limits are until they have exceeded them and get cut off. (…) We have just spent 15 years learnings that a policy of creating asset bubbles is a bad idea, so it is hard to imagine why the Fed wants to create another one.”

On GM, Einrhon stated that the government stake is no overhang – on the contrary, it presents a good opportunity to GM make a highly accretive transaction and the same effect would be achieved if GM started an open buyback program.

To make it a little funnier, Eirnhorn summarizes the bullish thesis for Chipotle including “No quiero Taco Bell!”

During the conference call (click here to listen – Einhorn starts speaking @ 10min30sec), David Einhorn made it clear he is more cautious going forward, as he diminished his net exposure from 37% 2012 average to 26%. He is concerned with several headwinds including economic slowdown, rising key commodity prices (mentioned food and energy) and deterioration in corporate earnings growth. He also mentioned his bearish  thesis on iron ore, in which he believes iron ore could go down to as much as $60 in 2014 as a big supply hits the market. Besides he is looking for assymetric macro hedges for his portfolio. (maybe Bass’ presentation on Japan?!)

His largest long positions are Gold, Apple, Seagate, Arkema and Sprint.

Bob Rodriguez – FPA Capital Q3 Letter

In the fund`s last letter, Bob Rodriguez made it clear he is cautious with stock markets valuation – over 20x  P/E (ttm) and 15x P/E (12m fwd), which compares to 1996-1998 and 2004-2007 – and the economy perspectives. There were a couple highlights in the letter:

  • How he thinks of cash: 

“We think of cash as an asset that has no duration, but provides an embedded call option  that can be exercised when quality assets are cheap on sale.”

  • Comment on career risk: 

“It is often a lonely endeavor to be a true contrarian absolute value manager. Most people feel secure in the knowledge that others like them are nearby, doing similar activities, and generally moving in the same direction. Most people do not want to be alone or feel awkward because they are the only ones dancing on the dance floor.”

  • What he looks for in companies:

“Our pipeline of companies with long histories of profitability, strong industry positions, pristine balance sheets, and solid management team (…)”

  • His view on stretched valuations and value screened paramenters:

“It is hard to intelligently deploy capital when most people are stretching for yields. We can see the reaching for return effect in our “core value screen” which looks for companies selling below 15x earnings, 7x cash flows, 2.2x book value and 1x sales, and have debt to capital of less than 40%. This screen is qualifying less than one hundred names currently, which is in the bottom third historically.”

  • Macro thoughts:

“The U6 unemployment rate, which includes part time employees who would prefer ful time jobs, is almost double the 2007 level of 8.0%, and has increased in the last six months from 14.5% to 14.7%. Total nonfarm employment is still 4.5 million below the 2008 level. As a result, the civilian employment-to-population ratio has dropped from over 63% in 2008 to 58.5%. This is almost five-point drop is the real hit to employment level, and it is substantial.” 

“The real median income for U.S. households measured in 2011 dollars has declined by nine percent since 2000 (when it hit $54,932) to $50,054 per household.”

“In our eyes, further quantitative easing is neither logical nor well thought out, since the upside does not offset the risks.”

“White concludes that the current ultra easy policy is neither likely to be effectively transmitted to the real economy, nor to lead private sector spending to respond and reduce unemployment.”

Bottom line: macro backdrop is worrisome, with unemployment at high levels, household real income falling over a ten year period and lack of investments. S&P margins should drop going forward which should give an opportunity to value investors deploy capital wisely. Cash is king (almost 1/3 of NAV is in cash). He keeps looking for high quality companies with discount to their intrinsic value and acknowledges the rally was of low quality companies.

Full letter can be found here.

FPA Crescent Fund Q3 2012 Letter

The just released letter from Steve Romick, portfolio manager of FPA Crescent Fund, discusses the disinvestment in Walmart after his thesis played out. His frame was based on buying a “infinite duration bond with a rising coupon – a bond-like equity”, in which could have a potential return between 9% to 14% per year based on three pillars: operating income growth, share repurchases and dividends paid.

Also, he mentioned why he has sold his position in Ensco, an international offshore contract drilling company. For an average business, returns should not be outstanding. Moreover, it`s a cyclical company. So basically they bought it below replacement value of its assets and sold it during high cycle earnings, where investors were paying for the “E”. In his words:

“Our goal when investing in commodity businesses is to buy assets and sell earnings. Capital intensive, cyclical businesses often trade at discounts to the value of the underlying assets when their respective industry is in distress (companies are either losing money or earning less than what`s expected in a more normal environment). When  earnings rebound, the market seems to forget that the businesses are cyclical. Investors begin to value them on earnings as if another downturn isn`t in the cards.” 

He also began shorting yen via OTC derivatives as Japan`s prospects continue to worsen. His goal is to get paid off for the “if” part of the thesis instead of the “when”.

The full letter can be found here.

Charlie Munger at Harvard (2010)

Munger is definitely one of the greatest minds in value investing history. In this link you may find a transcript of an interview with him at Harvard in 2010. He is a brilliant, arrogant (in a good way), intriguing  and funny mind. Some quotes I have highlighted may be found below:

“It`s not brilliance. It is just avoiding stupidity.”

“Believing just by buying volatile stocks you make an extra 7 percentage points per annum, I mean those people still believe in the tooth fairy and yet it is taught to the children.” 

“Financial outcomes in security markets are not plottable. It is not a law of God that outcomes in security prices will fall over time on a curve and follow reality according to Gauss` curve. Quite the contrary, the tails are way fatter.” 

“Now you think accounting is something we can trust?”

“But boy, teaching people they don`t really have to pay and a lot of the credit being given for education, a lot of it in for-profit education. This is very foolish credit given to people who are never going to learn much. (…) I think it does enormous damage to shovel out a lot of dumb credit, raising false hopes.”

I must agree with him in the quote above in which people do not have the right incentives or the proper education or college programs to really develop the skills needed – within that in mind we enter into an entirely separate topic: student loans. As the economic recovery is lackluster, how will these students find jobs? (i) Students might not have the proper skills developed (I`d argue many colleges are mainly concerned on new enrollments only) (ii) There are just no jobs with so much uncertainty lingering (iii) New enrollments represents people with no jobs that are able to get easy credit to fund its full board tuition (sounds like a good option for someone with no job). Will it be the next credit bubble looking forward? Who`s gonna pay for that anyway? Ok, let`s move on…

“In a miasma of prosperity and gambling with $100,000 bills floating around like confetti, you can`t expect people to bahave as if they were in a monastery.”

It is quite serious when you have troubles and the people who do things are proud of their ignorance”

Howards Marks backs up one of Munger`s answers saying:

“I think that the problems we`ve had have stemmed from human failings and they are never going to change. You can adjust here and there, and you can encourage and dissuade with regulation – but the ability, for example, for greed to overcome morals and prudence, will never change.”

Bottom line: we should not trust accounting nor use the past as a good proxy for the future. Moral hazard and conflicts of interest are a big issue that will linger going forward. Behavioral finance is something every single investor should be aware of and study deeply. Understanding our minds and how we frame scenarios and process information to make decisions is way more important than a discounted cash flow. Last but not least, avoiding mistakes is the most important thing.