- Don't use many financial ratios or formulas, and when you've picked the few that will actually tell you what you want to know, don't believe them very much (Prof. James T.S. Porterfield);
- Remember that any damn fool can compute an IRR or DCF. The trick is to find a business that can return 20% after tax, understand its critical indigenous and exogenous variables, and then run it so it meets its return target. (Prof. Alexander Robichek.)
- Always ask what can go wrong (Porterfield);
- Never extrapolate beyond the observed points of a distribution, you have absolutely no information outside the observed range (Prof. J. Michael Harrison);
- Remember that you can always break the bank at Monte Carlo by doubling your bet on red at the roulette table every time you lose. The problem is it will break you first; It's called "the takeout." Therefore, always manage your financial structure so that takeout is not an issue. (Porterfield.)
- Big M (today Nassim Taleb's Black Swan) is never a part of the optimal solution. If it shows up in the answer with any coefficient greater than zero, you have the wrong answer and have to continue to do program iterations. (Harrison.)
- There is never any excuse for looking through the substance of an economic transaction, whatever the accounting, and if the accounting permits you to do so, it's wrong (Prof. Charles T. Horngren.)
Monday, March 30, 2009
Sunday, March 29, 2009
I often don’t agree with columnists in the Sunday NYT Business section, but today three unrelated articles came together for me. I thought that they contained some good investment lessons. I’ll address the first two here, and leave the last for a subsequent article.
I may tend to run on here, so let me give you the conclusions first and you can decide whether to read more or save time and go about your business.
1) Everyone tries to use correlations and statistical analysis to predict the future, but it’s a very difficult if not useless endeavor.
2) Analysts focus on the things that they can analyze, but many other factors are more important but unanalyzable.
3) Times of extreme stress bring big changes. That’s the natural order of things, and while it can be painful, it’s usually necessary and good. (See next post).
Mark Hulbert writes about a recent study by two finance professors who challenge the conventional notion that long-term equity investments always produce superior returns Strategies - Now the Long Run Looks Riskier, Too, for Investors. Essentially, they endorse the old saw that past performance is no guarantee of future performance. Although we all nod our heads in agreement, most of what passes for equity investment research is based on the premise that past performance does indeed predict future performance.
The professors note that uncertainty increases with the holding period, and that the reason for the good historical equity record in the
Robert Schiller, another finance professor (wouldn’t all of our problems be solved if the world was run by finance professors?) addresses the field of social psychology in the investment world It Pays to Understand The Mind-Set. Professor Schiller explains social psychology as “a theory of mind—defined by cognitive scientists as humans’ innate ability… to judge others’ changing thinking… It is a judgment faculty, quite different from our quantitative faculties.”
“Of course, forecasts based on a theory of mind are subject to egregious error. They cannot accurately predict the future. But the uncomfortable truth has to be that such forecasts need to be respected alongside econometric forecasts, which cannot reliably predict the future, either.”
This is a very important point. Stock investments are like icebergs: only a small portion of the essential information is visible. There’s a vast mass of unknown and unpredictable information, including the changing motivations of customers, competitors, and other investors, beneath the surface. Yet rather than to acknowledge the huge inherent unknowns, analysts engage in silly exercises to micro analyze the small part that is visible and extend their conclusions to the whole. For the most part, they all have access to the same data, often provided to them by the company or the government. They produce surveys, and channel checks, and sophisticated models. They issue buy and sell opinions in an effort to distinguish their particular outlook. But in the end, they all have essentially the same understanding of the investment, and it’s a limited understanding.
I’m not trying to pick on analysts (buy side or sell side). My comments apply equally to most economists. It’s not that they aren’t smart, or hard-working, or experienced. But the nature of the job requires that they make predictions, and they almost never acknowledge the extremely high degree of randomness.
So what’s the bottom line? Be skeptical of anyone who offers investment predictions. But be particularly skeptical of investment predictions that are based on extensive and rigorous statistical analysis, because they’re probably based on only an obvious and small part of the whole.
Friday, March 27, 2009
Wednesday, March 25, 2009
Monday, March 23, 2009
Monday, March 16, 2009
Thursday, March 12, 2009
Wednesday, March 11, 2009
Monday, March 9, 2009
So what if I'm wrong? Where could this go? First, it's important to understand that we'll come out of this with a new paradigm. This won't be a typical recession/recovery pattern. That's why those experts who try to identify an ever lower bottom target will be at worst completely wrong and at best completely misleading. This economic event is a game changer. It's not like anything that we've experienced in the past, so historical metrics like trough Price/Earnings and Price/Book are pretty much meaningless. Jeff Jarvis takes a good first stab at what the other side of this crisis could look like in The Great Restructuring.
Secondly, the market is constrained by some ultimate bottom that's greater than zero. It obviously wasn't S&P 800 or 700, but the stocks in the index have some real value that's supported by real assets: property, inventory, receivables, and real cash on the balance sheet, to say nothing of brand equity and goodwill. We can debate the value of those assets, but it's a real number. Maybe you'd rather have a dollar's worth of gold than a dollar's worth of Procter&Gamble stock, but would you prefer the dollar of gold to ten dollars worth of downtown
Then what are the outcomes that would prove me totally incorrect? It seems to me that there are two: Obviously the first is Financial Armegeddon-- a complete meltdown of the system. It could happen, and if it did we're all screwed. Sure, you could bring your gold coins to the supermarket to exchange for meat and bread, but what makes you think meat and bread would be available even to exchange for gold? It could happen, but it's tough to hedge and will produce an unhappy outcome even for the bears.
Second is the prolonged recession. If it lasts more than four years, I'm completely wrong. Media Star Nouriel Roubini predicts the L shaped recession: down and staying down. In that circumstance, Treasury notes might do well, but they might not. Stocks would probably exhibit basing behavior with limited further declines. Treasuries would do well initially but ultimately be decimated by oversupply and currency debasement. This one is somewhat more likely, but if it happens I think that my portfolio of high quality dividend paying stocks will hold up as well as anything.
Finally, I need to allow for the unknown and unanalyzable. Intelligent investors must make allowances for their own shortcomings. The economy is an incredibly complex mechanism, and merely to guess correctly on one or two aspects scarcely guarantees an accurate overall assessment. Peter Schiff absolutely nailed the risk in housing, but his hedge fund was a poor performer because he incorrectly extrapolated the impact on the dollar. Kyle Bass is a very smart guy and he couldn't have been more right about the worldwide economic collapse, but his fund was only up 6% in 2008-- better than most, but not the type of home run that investors probably expected given his boldly bearish predictions.
I believe that the current economic crisis will be well on its way to being resolved sometime in 2010. I don't know where the market will go in the near term. But my core belief is that good quality stocks purchased today will produce substantial returns-- doubles or more-- in three to four years.
I have a full position in Google, my largest holding, so I won't be buying more. However, I believe that under 300 it's an extremely attractive investment opportunity.