Value Investing: A Balance Approach by Martin Whitman

Here are couple bulleted lists that I drew from Mr. Whitman's book. The book did not grab my attention as some of other value investing based book, but I think the following lists are full of wisdom.

Value Investing: A Balance Approach Martin Whitman

• Value Investing (VI) uses a balanced approach to analysis so that there is no a priori primacy given to any one factor in an appraisal.
  
• In VI, the essential goal is to value a business or the workout potential for credits issued by trouble companies.
  
• In VI, equity holdings are viewed as permanent or semipermanent commitments, subject only to a risk arbitrage exception.
  
• In VI, macrofactors such as the level of stock averages (e.g., the DJIA), forecasts of interest rates, or the GDP are ignored.
  
• In VI, as part of a balanced approach, businesses are viewed as both going concerns and as resource converters, deploying and redeploying their asset bases and liabilities into new areas including mergers and acquisitions, changes in control, massive refinancing, IPOs, and LBOs.

What has worked in investing

Tweedy, Browne Company LCC, a well established value based investment firm and worked as the broker for Warren Buffett with the acquisition of Berkshire Hathaway in the early 1960's

The firm has published a very insightful booklet for prospect investors called :

"WHAT HAS WORKED IN INVESTING - Studies of Investment Approaches and Characteristics Associated with Exceptional Returns"

There are 5 specific points:

1. Low Price in Relation to Asset Value
2. Low Price in Relation to Earnings
3. A Significant Pattern of Purchases by One or More Insiders (Officers and Directors)
4. A Significant Decline in a Stock's Price
5. Small Market Capitalization
   

Buffett Is Less Bullish on U.S. Than You Think: Alice Schroeder

Bloomberg has an interesting article by Alice Schroeder, the author of "The Snowball". Ms. Schroeder presented a different case on the "Buy America" bullish calls from Mr. Buffett.

If you have not had a chance to read "The Snowball", which is about the size of a brick, I would recommend it because it is probably one of the most intimate book about Mr. Buffett's life. The book is more about Mr. Buffett's life and his family and friends. It is not a typical "how to invest like Buffett" book, and I found the book quite entertaining yet very educational at the same time.

Fed Sees Up to $599 Billion in Bank Losses

For those who are interested with the banking stress test result, WSJ got a nifty interactive chart

The purpose of stress test is to test and forecast that if worse case scenarios do occur, how much capital lifeline will the banks needed in order operate at a regulatory requirement level.

Meanwhile, Taleb and Roubini tagged up again saying we are in the most difficult period of humanity because governments no long have the control they once did

Both are entertaining stories that one must read with a grain of salt.

Happy weekend! comparing all the key metrics between the different financial institutions.

Biggest Event This Weekend for the Market

Berkshire Hathaway held its annual meeting this weekend in Omaha, NB. Qwest Center arena, the location of the event, was jam packed with 35,000 anxious investors, which I believe is a new record attendance.

CNBC as usual for the last couple years, has a complete coverage about the event you can access here.

Also, Everythingwarrenbuffett, another blogspot site that is dedicated to news on Mr.Buffett, has a nice summary of the event which I will burrow from, and you can access it here.

In addition, I finally get a chance to watch the I.O.U.S.A movie this weekend, and it is an excellent piece of documentary that I recommend everyone to watch it. It is just a little bit over one hour, and you will have a better understanding about the seriousness of all these multi-trillion and billion of leverage could do to our future generations.

We are in a globalized world, and everyone will have to face the problem together. The system is so interconnected that we can no longer categorize serious issues as someone else's problems.

Warren Buffett on Wells Fargo

I have this anchoring bias with experts that I admire the most, especially Mr. Buffett, so here is an interview by Fortune with Mr.Buffett on why Berkshire owns Wells Fargo. The ideas are presented in very simplistic terms, perhaps too simplified. Nevertheless, Mr. Buffett still offers some great insights and reasoning with their investment in Wells Fargo (WFC).

Mr. Nassim Taleb argued that financial companies in general are prone to the black-swan negative events. If a project went really successful, the bankers wouldn't get additional compensation for their loan. But, if catastrophe happens, the bankers could lose a substantial amount of money. I think this makes a lot of logical sense, but then again not all financial businesses are created equal, perhaps WFC is one of those old, dirty, unpolished traders who have a long and successful trading career as Mr. Taleb witnessed in his life.

Perhaps WFC is the one that understand this risk phenomenon better than its rivals? History is hindsight 20/20, but WFC does seem to have the track record to back it up. Here Mr.Buffett mentioned:

Those guys have gone their own way. That doesn't mean that everything they've done has been right. But they've never felt compelled to do anything because other banks were doing it, and that's how banks get in trouble, when they say, "Everybody else is doing it, why shouldn't I?"

Another issue is the general sentiment that all financial companies are all screwed and not to be trusted. I don't know the probability and when the economy will recover, but WFC seems like one of the top candidates to earn sound return for its shareholders. The reason is its substantial earning power as Mr.Buffett noted:

You don't have to be a rocket scientist when your raw material cost is less than 1-1/2%. So I know that you can have a model that works fine and Wells has come closer to doing that right than any other big bank by some margin. They get their money cheaper than anybody else. We're the low-cost producer at Geico in auto insurance among big companies. And when you're the low-cost producer - whether it's copper, or in banking - it's huge.

Then on top of that, they're smart on the asset size. They stayed out of most of the big trouble areas. Now, even if you're getting 20% down payments on houses, if the other guy did enough dumb things, the house prices can fall to where you get hurt some. But they were not out there doing option ARMs and all these crazy things. They're going to have plenty of credit losses. But they will have, after a couple of quarters of getting Wachovia the way want it, $40 billion of pre-provision income.

And they do not have all kinds of time bombs around. Wells will lose some money. There's no question about that. And they'll lose more than the normal amount of money. Now, if they were getting their money at a percentage point higher, that would be $10 billion of difference there. But they've got the secret to both growth, low-cost deposits and a lot of ancillary income coming in from their customer base.

The recent changes of market to market accounting rules are worrisome. We can only hope the WFC management along with Mr. Buffett will keep acting as ethnically sound as they claim to be.

(Disclaimer: I have personal position in WFC)

Nassim Taleb and the Ten principles for a Black Swan-proof world

After reading Nassim Taleb's book The Black Swan: The Impact of the Highly Improbable. He has topped my most admired person list (Yeah, even the Great Oracle of Omaha!).

We are living in an increasing complicated and interconnected world. Many issues in today's world cannot be explained simply by some key metrics, formulas, and/or models.

Yet, we as human beings are in search for more and more explanations to every events. Why did the S&P 500 go up X amount of points today? What will be the unemployment rate for the next quarter? What will gold price be at in three years? The financial experts are as clueless as we are when it comes to prediction, even if they seems to give us a compiling story in the media.

Some professions need skills, ie. brain surgeon doctors, and some simply involves luck, ie. stock brokers. Nassim want to cautious us on the predictions made from any of the economic and financial professions because the error rate has been vastly incorrect on a single event or time-series basis.

One key I learn from the book is how to position yourself from the eventual black swans in your life, by being proactive, open minded, and acknowledge the improbable as part of life. You just have to know that the black swans may come in a bunch, or it may never come.

Thanks to my friends (the power of connection), I came across Nassim's article about his ten principles in dealing with a black swan world on the Financial Times website.

1. What is fragile should break early while it is still small. Nothing should ever become too big to fail. Evolution in economic life helps those with the maximum amount of hidden risks – and hence the most fragile – become the biggest.

2. No socialisation of losses and privatisation of gains. Whatever may need to be bailed out should be nationalised; whatever does not need a bail-out should be free, small and risk-bearing. We have managed to combine the worst of capitalism and socialism. In France in the 1980s, the socialists took over the banks. In the US in the 2000s, the banks took over the government. This is surreal.

3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus. The economics establishment (universities, regulators, central bankers, government officials, various organisations staffed with economists) lost its legitimacy with the failure of the system. It is irresponsible and foolish to put our trust in the ability of such experts to get us out of this mess. Instead, find the smart people whose hands are clean.

4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks. Odds are he would cut every corner on safety to show “profits” while claiming to be “conservative”. Bonuses do not accommodate the hidden risks of blow-ups. It is the asymmetry of the bonus system that got us here. No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.

5. Counter-balance complexity with simplicity. Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products. The complex economy is already a form of leverage: the leverage of efficiency. Such systems survive thanks to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no room for error. Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious.

6. Do not give children sticks of dynamite, even if they come with a warning . Complex derivatives need to be banned because nobody understands them and few are rational enough to know it. Citizens must be protected from themselves, from bankers selling them “hedging” products, and from gullible regulators who listen to economic theorists.

7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence”. Cascading rumours are a product of complex systems. Governments cannot stop the rumours. Simply, we need to be in a position to shrug off rumours, be robust in the face of them.

8. Do not give an addict more drugs if he has withdrawal pains. Using leverage to cure the problems of too much leverage is not homeopathy, it is denial. The debt crisis is not a temporary problem, it is a structural one. We need rehab.

9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement. Economic life should be definancialised. We should learn not to use markets as storehouses of value: they do not harbour the certainties that normal citizens require. Citizens should experience anxiety about their own businesses (which they control), not their investments (which they do not control).

10. Make an omelette with the broken eggs. Finally, this crisis cannot be fixed with makeshift repairs, no more than a boat with a rotten hull can be fixed with ad-hoc patches. We need to rebuild the hull with new (stronger) materials; we will have to remake the system before it does so itself. Let us move voluntarily into Capitalism 2.0 by helping what needs to be broken break on its own, converting debt into equity, marginalising the economics and business school establishments, shutting down the “Nobel” in economics, banning leveraged buyouts, putting bankers where they belong, clawing back the bonuses of those who got us here, and teaching people to navigate a world with fewer certainties.

Then we will see an economic life closer to our biological environment: smaller companies, richer ecology, no leverage. A world in which entrepreneurs, not bankers, take the risks and companies are born and die every day without making the news.

In other words, a place more resistant to black swans.

U.S. SEC to consider about 4 short sale proposals

U.S. SEC is reconsidering about rules for short-selling, after many blamed short-selling as the cause for accelerating severe downturn of the US financial stocks.

What exactly is short selling?

Short selling is the selling of a stock that the seller doesn't own. More specifically, a short sale is the sale of a security that isn't owned by the seller, but that is promised to be delivered.

The removal of "Up-tick" rule and the ignorance from the regulators towards "Naked Short Sales" in the last couple years have made short selling quite vicious. As soon as the vultures (specialized institutional investors) spot weakness in troubled companies, these companies could go completely bust in a matter of days. Even if some companies have a good chance of surviving, investors were too panicked to buy shares at discounted price. Meanwhile, vultures could technically take advantage of the market condition and sell the stock down to the ground, since they can continue to short the stock without promise to ever physically own the stock.

Short-selling is an important mechanism in the capital market. If we are only allowed to purchase stocks, the market may be inflated with expensive stocks and creates even greater bubble bursts. We definitely need such mechanism in place, but the current system seems to be broken. A few people getting all the pie just by being reckless and with no benefit to society.

An article from Bloomgberg illustrated how Lehman Brothers gone bust in a matter of days might have something to do more with the vultures, instead of its broken business model.

Here are some key points I find interesting:

As Lehman Brothers Holdings Inc. struggled to survive last year, as many as 32.8 million shares in the company were sold and not delivered to buyers on time as of Sept. 11, according to data compiled by the Securities and Exchange Commission and Bloomberg. That was a more than 57-fold increase over the prior year’s peak of 567,518 failed trades on July 30. The SEC has linked such so-called fails-to-deliver to naked short selling, a strategy that can be used to manipulate markets. A fail-to-deliver is a trade that doesn’t settle within three days.

“Suffice it to say that in a readily available stock that is traded frequently, there has to be an explanation to the appropriate regulator as to the circumstances surrounding the fail-to-deliver,” said Baker, who served in the U.S. House of Representatives as a Republican from Louisiana from 1986 to February 2008.

Lehman Brothers had 687.5 million shares in its float, the amount available for public trading. In float size, the investment bank ranked 131 out of 6,873 public companies -- or in the top 1.9 percent, according to data compiled by Bloomberg.

And

Short sellers arrange to borrow shares, then dispose of them in anticipation that they will fall. They later buy shares to replace those they borrowed, profiting if the price has dropped. Naked short sellers don’t borrow before trading -- a practice that becomes evident once the stock isn’t delivered. Such trades can generate unlimited sell orders, overwhelming buyers and driving down prices, said Susanne Trimbath, a trade- settlement expert and president of STP Advisory Services, an Omaha, Nebraska-based consulting firm.

On at least two occasions in 2008, fails-to-deliver for Lehman Brothers shares spiked just before speculation about the bank began circulating among traders, according to SEC data that Bloomberg analyzed.

Botox Earnings Put Crooked E in Stock Market P/E

March was quite a rally and made my utterly battered portfolio looked, very battered.

From a historical view on past modern financial crises, one might argue we are close to getting out of a bottom. S&P's P/E ratio is now around 12, rallying from the lows of single digits early in March. Earning yield, which is the reverse of P/E, is about 8.33%.

One of Benjamin Graham's criteria is to invest in companies that has at least twice as large as the average yield on long-term AAA corporate bonds. The 20 yr AAA corporate bond yield, according to Yahoo! Finance, is about 6.5%. Only companies that has an earning yield higher than 13% or P/E lower than 7.7 would Mr. Graham find attractive.

I am an optimist and believe better future is ahead, but I don't believe we have truly experienced desperate market environment as most experts claimed. Maybe we will, maybe we won't, and no one will really know. In the meantime, I am going to continue to ignore what the general market is going to do and focus on smaller cap companies with disgusted share price but strong financial balance sheet and business prospect. And, at the same time, caution people who think the market will rebound in a swift moment.

Meanwhile, there is an interesting article offering the other side of the story about earnings on the overall US market.

Joel Greenblatt, the lesser known Buffett

It is very interesting to see how the seeds have spread out from Benjamin Graham's Net Current Asset Value (NCAV) Strategy. There have been over dozens of very successful and well known investors that reside in the Graham and Doddsville. Joel Greenblatt, a stronger believer in value investing, published a nice and simple book called "The Little Book that Beats the Market". Very similar to Chris Browne's little book of value investing (earlier post) in terms of simplicity, yet filled with amazing insights.

Value Investing Encyclopedia prepared a very nice profile on Joel Greenblatt, and I just want to share the following quotes that both men would agree on what exactly are "value" and "attractive"

The following is from Buffet's letter to shareholders in 1992:

“But how, you will ask, does one decide what's "attractive"? In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition: "value" and "growth." Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross- dressing.”

“We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”

“In addition, we think the very term "value investing" is redundant. What is "investing" if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labeled speculation (which is neither illegal, immoral nor - in our view - financially fattening).”

Finally, I want to share a link I found for another amazing value based blogger David on Joel Greenblatt talks about his magic formula investing at 2006 Columbia Reunion. Click here.