Profit from Folly

Value Investing & Academia

Abdulaziz Alnaim — Sun, 15 Jan 2012 06:10:24 +0000

I was talking to a good friend of mine yesterday about the evidence for the success of value investing strategies. I agreed with him that we cannot use the success of people like Warren Buffett to prove that value investing works because the sample size is too small to be statistically significant and because there’s significant survivorship bias in such a sample. Warren Buffett has addressed the first of these two concerned in his famous speech, The Superinvestors of Graham-and-Doddsville (see here). Another issue is that the sample size for a long-term value investing strategy (especially focus ones like Buffett’s) are naturally much smaller because the number of “trials” is very low. But there are a lot of academic studies on the subject. The Value Investing Retrospective is an ongoing project at the Heilbrunn Center for Graham & Dodd Investing at Columbia Business School and its goal is to collect and organize academic papers on the subject of value investing (see here). I have my own issues with some of this research, but without getting into that, the research shows a persistent “anomaly” (which we tend to call “value stocks”) and it seems that exploiting it works over time. The classic economists would point out the impossibility of a persistent way to outperform the market because it’s an arbitrage opportunity that enough smart people will exploit until it disappears. But that argument assumes that people/investors/traders are perfectly rational and we know from recent research in behavioral finance that they are anything but. Human beings–I’m assuming we financial types are human–seem to display frequent, persistent, and PREDICTABLE biases. The last adjective being key here. We make the same types of mental and emotional mistakes over and over again. We think we learn from our mistakes, and we do in some areas, but in others we forget very quickly. When markets start to get scary, our “System 1″ (as Daniel Kahneman calls it) kicks into high gear and start making quick survivorship-driven decision, such as “sell, sell, sell”. Value investors learn how to keep “System 2″ working and in charge in times of panic and that gives them an edge. But as long as most market participants continue to be human (I’ll admit this is not guaranteed), such biases and the resulting profit opportunities will continue to show up in the market. Here’s a great quote from Seth Klarman: “Value investing is at its core the marriage of a contrarian streak and a calculator”

Taxation and Holding Period

Abdulaziz Alnaim — Sun, 01 Jan 2012 11:02:17 +0000

We often hear that value investors should hold their investments for a very, very long time. In fact, Warren Buffett is often quoted saying that his favorite holding period is “forever”. One argument that I’ve heard from many for holding stocks even if they seem to be currently overvalued is taxation. The typical example goes something like this: say you buy shares in Company A for $100 and hold them for 20 years. If the average annual return on those shares is 12% and your tax rate is 30% then by the end of the 20-year period each share would be worth $605. If, however, you kept rotating your portfolio every year (selling A, paying taxes, and buying Company B then selling B, paying taxes and buying C, etc.) and you also managed to earn 12% a year, then your $100 investment would grow to a mere $501 and the difference between the two strategies grows as your returns become higher and the period gets longer. In fact, you would have to earn almost 2 percentage points higher for the two strategies to produce equal results (actually a little more once you factor in trading costs).

Now there are two reasons why I am willing to sell more frequently than “forever”. First, my fund is not a taxable investor, so the impact of compounding money tax-free is non-existent. Second, I think that in many cases, it is a relatively safe bet that you’ve sort of “out-earned” in a certain investment relative to your expectations. I define “out-earning” as making too much money too soon. Say you own an investment that you think will compound 12% p.a. but a few months after buying it, it goes up 60%. Now if your estimate of its intrinsic value hasn’t changed and you have relatively attractive opportunities elsewhere, I believe you should sell. If you were expecting to earn that 60% over around 4 years and (with no change in the company prospects) you make that much sooner, it’s time to move on to another opportunity (or, at a certain point even to cash).

For investors who are not as big as Warren Buffett, there’s no reason to lock yourself into a “forever” holding period. Your small size is an advantage because of your opportunity set and because of the ease of getting into and out of investments. Even if the investment is a business you truly believe in and want to hold forever, you can do what I do sometimes, which is to trim the position down and build it up again when the valuation improves in the future. Walter Schloss used to do that a lot.

There is one important caveat that I must add. Note that in the example I basically demonstrated a situation where your margin of safety has disappeared quickly because of a quick run-up in price, so the shares are probably overvalued. But you have to be relatively sure of that. If instead of a 60% increase the shares increase only 20% I would continue to hold. Remember that your estimate of your intrinsic value is nothing more than an estimate, so don’t go chancing an extra point or two of return, no one is that good! Only do it when it’s very clear that going forward, the odds are that you will earn very little going forward for several years if you continue to hold.

Buffett on Walter Schloss’s Record

Abdulaziz Alnaim — Sat, 24 Dec 2011 12:57:23 +0000

The attached document is a letter that Warren Buffett wrote about the remarkable investing record of Walter Schloss, one of the greatest (though not-so-famous) value investors of all time. One of my favorite things about it is Buffett pointing out that Schloss’s total business expenses were $11 thousand on $19 million net income (this is not a typo, the first is in thousands and the latter is in millions!). Special thanks to my friend Ali Al Daftari for digging up this letter.

BuffettonSchloss-15apr1994.pdf

Thoughts from the inaugural dinner of the Value Investors of Arabia Club

Abdulaziz Alnaim — Sat, 24 Dec 2011 12:11:59 +0000

On Thursday we had the inaugural dinner of the Value Investors of Arabia Club. It was held at Mangiamo Ristorante & Pizzeria in Al-Khobar, Saudi Arabia, and five of the founding members were in attendance. By all accounts, it was a great evening. Value investors are a rare commodity, so I believe that getting them together in a room to share ideas and discuss investments, markets, and methods is very valuable. Here are some of the things we discussed:

- The existence of moats in companies publicly-listed in Saudi Arabia and their depth and durability

- General discussion of how moats change as companies grow, enter new markets, and new businesses and how it depends on the kind of competitve advantages that a business has

- Some specific thoughts on Al-Marai and the consumer sector in Saudi Arabia

- Whether classic value investing in the Graham and Dodd tradition could be practiced successfully in small equity markets like Saudi Arabia

- Thoughts on applying classic value investing in micro- and small-cap companies globally

- Dealing with a global versus local investable universe, screening tools, and watchlists

- The investing record of Walter Schloss and how it was acheived

- The investing performance of Warren Buffett across time as his stragy changed

- The decision by Warren Buffett to shut down the Buffett Partnership in 1969 and focus on Berkshire. Why he did it and what are the implications

- The Saudi stock market bubble: how it began, progressed, and whether it could’ve been predicted

- The difference in governance between equity markets

- Why so many value investors got crushed in 2008-2009-2010 because of exposure to finacials, especially banks

- The importance (or lack of) book value in difference businesses and its implications to a modern value investor. Some specifics on US homebuilders in 2005-2006, banks in 2009-2011, and great businesses with low capital intensity and assets like Visa and Microsoft

- How people can be a successful contrarians in investing and still exhibit herd behavior when ordering food in restaurants

In attendance were Ali Al Daftari, Faisal Al Shoaibi, Mohammad Al-Alwan, Mohammed Al-Nahash and me, Abdulaziz Alnaim

Value Investing – Introduction

Abdulaziz Alnaim — Fri, 09 Dec 2011 03:53:00 +0000

Here are the slides from my presentation on Tuesday at the Clearing, Settlement, and Custody ME 2011 conference in Dubai. Exciting stuff :p

Slides: Value Investing – A Global Perspective

Conference website: http://www.iirme.com/cscme/home

Ignore the Economy

Abdulaziz Alnaim — Sat, 03 Dec 2011 10:38:25 +0000

One of the most important thing that an investor must do is realize what’s not important and ignore it. The biggest challenge that most investors face today is not the lack of information but rather its dealing with the enormous amounts of information that we get bombarded with on a daily basis. Sifting through this information to figure out what’s important and relevant to an investor’s long term success and what’s nothing but noise is key. I realized very early on in my investment career–thanks to my extensive reading of great investors experiences–that most of the information available is nothing but noise, and that quality, not quantity, is what matters. This is true on the security/company level and even more true at the “macro” market/economy level.

One stream of unending information in the form of news, reports, and data is that about the economy. There are literally hundreds of pieces of information of this kind that you could be looking at any day of the week. You can never go through all of it. You can build your own models and feed all the available data into it. Yet, despite armies of economists and investors doing exactly that, no one seems to be able to forecast any of it with any reasonable degree of accuracy. Also, when they do, it’s not always clear how to make money from such forecasts. So, is the process of following the economy futile? Here’s what one great practitioner had to say about it:

We try to price, rather than time, purchases. In our view, it is folly to forego buying shares in an outstanding business whose long-term future is predictable, because of short-term worries about an economy or a stock market that we know to be unpredictable. Why scrap an informed decision because of an uninformed guess.

…

We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen. Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%.

But, surprise – none of these blockbuster events made the slightest dent in Ben Graham’s investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist

A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results.

–Warren Buffett, 1994 Berkshire Hathaway Shareholder Letter

Buffett’s most important insight here is pointing out to the reader the importance of accurate, high quality information and how short-term uncertainty about something which is unpredictable–the economy–should not deter us from investing in attractive long-term opportunities.

But Buffett isn’t the only great investor who ignored economic forecasts. Many other great investors such as John Templeton and Peter Lynch also did that. Here’s what Peter Lynch said:

“I spend about 15 minutes a year on economic analysis. The way you lose money in the stock market is to start off with an economic picture. I also spend 15 minutes a year on where the stock market is going.”

I’m not advocating that you blindly follow their advice, I’m not trying to replace one dogma for another. What I’m trying to advocate is to start questioning the conventional wisdom of trying to use economic and market forecasts to make investment decisions. Here’s how I see things:

1- Forecasting where the economy or the market is heading in a month or a quarter or even a year is not possible, at least not with consistency. Just see the shameful forecasting record of all economists.

2- Even if possible, forecasting in the short term is not relevant to the long-term performance of companies.

3- Forecasting the long-term performance of the economy is extremely difficult, if not impossible. Therefore, I invest in companies where their long-term performance is less dependent on where the the economy is heading.

4- I will make mistakes in finding such companies. Only buy when the price is significantly below your conservative estimate of intrinsic value. This also means almost never paying for growth.

5- Finally, because “shit happens”, it’s important to have a reasonably-diversified portfolio with at least 10 investments (but no more than, say, 30) across several industries and countries. It’s important to have the number be small enough for you to be able to track those investments/businesses effectively.

6- Remember that your long-term performance as an investor has nothing to do with how your portfolio performs over a week or month or year, it’s the big moves over multiple years that count.

7- Finally, remember the oldest rule of investing: buy low and sell high. That means buy when things are NOT looking good and prices are low and sell when everything seems nice and dandy.

It’s very difficult to get yourself to act while knowing that there is a lot of uncertainty about the future of a certain company or economy. But trying to deceive yourself into a false sense of security by trying to accurately calculate the incalculable is not the solution. Uncertainty will always be with us. The rational long-term investor must train his/her mind to live with it and even embrace it at times. I will leave you with a quotes from the great John Templeton:

“An investor who has all the answers doesn’t even understand the questions.”

Investing in Uncertain Times

Abdulaziz Alnaim — Sat, 26 Nov 2011 10:34:31 +0000

“The future is never clear, and you pay a very high price in the stock market for a cheery consensus. Uncertainty is the friend of the buyer of long-term values.”
– Warren Buffett

I’ve been hearing the term “uncertainty” with increased frequency in the past few weeks and months. I’ve heard it from friends, fellow fund managers, and some of my partners and potential partners in Mayar. The general feeling, it seems, is that we are in uniquely unpredictable times. And the general reaction to this feeling is decision paralysis and inaction. Many are either “on the sideline” or “hedging their bets”. Studies show that most people react in this manner in the face of uncertainty because they become motivated predominantly by fear. But Benjamin Graham and Warren Buffett taught us that it is in times of uncertainty and fear that the value investor should be decisive and take advantage of such conditions. Current conditions are not unique. There have been many equally and more uncertain times in the past. There have been dozens of wars, recessions, crises, and panics. Yet every time, human beings acting in the form of government and economies have been able to eventually sort things out and come out in even better shape. It is the word “eventually” that is key here and where a long-term value investor has an edge. By ignoring current conditions and focusing on the long run, looking ahead 5 or 10 years in the future, the diligent investor will be able to estimate the future course of events with a decent probability. What happens between the “now” and the “then” is anybody’s guess–and I truly believe everyone is just guessing. In the end it will come down to price and value. As I search world markets today, I see many solid companies with superb business models and strong financial conditions selling for severe discounts to their intrinsic value. Because everyone is afraid, they are painting everything with a dark brush. It reminds of the beginning of the Rolling Stones’ song that goes:

I see a red door and I want it painted black
No colors anymore I want them to turn black
I see the girls walk by dressed in their summer clothes
I have to turn my head until my darkness goes

History shows that when people are pessimistic (or depressed) they usually turn pessimistic about everything. But things are rarely, if ever, black-or-white. Benjamin Graham came up with a superb metaphor for markets with the fictional character Mr. Market. It goes something like this:

Imagine you are partners in a private business with a man named Mr. Market. Each day, he comes to your office or home and offers to buy your interest in the company or sell you his [the choice is yours]. The catch is, Mr. Market is an emotional wreck. At times, he suffers from excessive highs and at others, suicidal lows. When he is on one of his manic highs, his offering price for the business is high as well, because everything in his world at the time is cheery. His outlook for the company is wonderful, so he is only willing to sell you his stake in the company at a premium. At other times, his mood goes south and all he sees is a dismal future for the company. In fact, he is so concerned, he is willing to sell you his part of the company for far less than it is worth. All the while, the underlying value of the company may not have changed – just Mr. Market’s mood. (About.com)

The lesson is not to blindly buy when others are selling, that too is stupid. It’s that when Mr. Market is depressed, you need to pay careful attention because sometimes he will be willing to sell you for a lot less than intrinsic value. In a nutshell, that’s what value investing is all about. There’s not guarantee that he will not be even more depressed tomorrow or next week, but buying below intrinsic value and insisting on buying something with a solid and growing intrinsic value, you will be in a great position years later because not only will you be able to own something with intrinsic value that is much higher than what you paid for (growth) but, with some luck, you’ll be able to sell it to Mr. Market on one of his euphoric days (valuation expansion). Let me demonstrate with an example. Say Company A is worth $20 a share today. On a particularly gloomy day (when Mr. Market is thinking about Europe, recessions, and a ugly divorce), Mr. Market might sell it to you for $15 a share. Now fast-forward 5 years in the future and Company A’s intrinsic value has growth to $32 a share (~10% per year). However, on that specific day or month, Mr. Market might be feeling especially euphoric and offer to “take it off your hands” for a premium price of $35 a share. By taking advantage of Mr. Market’s mood swings, you’ve been able to generate an annualized return of 18.5% when the underlying company growth was only 10%. But that’s not the whole story. Let us say Company A stumbles along the way and it’s growth is reduced from 10% to 3% per year. If Mr. Market buys you out at a similar premium, your annual return will be a still respectable 9%, despite making a huge error in estimate Company A’s growth rate. Of course, this strategy only works if you “take advantage” of Mr. Market’s mood swings and buy when he’s depressed and sell when he’s euphoric. That, of course, is easier said than done. It means buying today when everyone is worried about European sovereign debt, a dysfunctional US Congress, a wobbly China, and an earthquake-shattered Japan. It takes special control of one’s emotion to ignore the crowd, focus on the facts, and focus on the long run. But unless you do exactly that, you will be a slave to Mr. Market’s mood swings and, at the very best, miss out on beating him or, at worst, do the opposite of what you should be doing and lose lots of money.

Ignore the crowd. Do your homework, run the numbers, demand a fat margin of safety, and then hold on tight on the bumpy road to financial salvation.

Daniel Kahneman: The riddle of experience vs. memory

Abdulaziz Alnaim — Mon, 31 Oct 2011 07:02:19 +0000

Bias, Blindness and How We Truly Think

Abdulaziz Alnaim — Sun, 30 Oct 2011 07:20:08 +0000

Excellent series of articles by Daniel Kahneman. I believe that one of the most important things for investors to do is understand the psychology of investing, not only in others but also in themselves. History shows that most otherwise-smart investors who fail to achieve satisfactory results, fail because they don’t understand or cannot control their own psychological impulses. While value investors throughout history have known that assets sometimes get driven to extremes either upwards (greed) or downwards (fear), Kahneman in these articles and others in the field point out that fear is a much stronger emotion. That is probably why market crashes are much faster and more violent than bubbles forming. Enjoy reading…

Bias, Blindness and How We Truly Think (Part 1): Daniel Kahneman

Bias, Blindness and How We Truly Think (Part 2): Daniel Kahneman

Bias, Blindness and How We Truly Think (Part 3): Daniel Kahneman

Bias, Blindness and How We Truly Think (Pt 4): Kahneman

Jack Bogle Says Mark Cuban’s Investing Advice is Crazy Talk

Abdulaziz Alnaim — Wed, 12 Oct 2011 09:57:11 +0000

Jack Bogle Says Mark Cuban’s Investing Advice is Crazy Talk
Good advice for the individual investor who isn’t willing to work full time on his/her investments.