Category: Investment Philosophy

Beware of Anecdotal Evidence when Investing…

There’s one thing I can’t stand when I hear an argument: Anecdotal evidence.

I think humans are inherently story tellers and perhaps a good story provides some comfort. And that’s why anecdotal evidence creeps into our investment processes.

To me, though, it is no different than someone saying, “well my Dad smoked a pack of cigarettes a day and he lived to be 90!” Ok, so is that actually good evidence for me to smoke? Or should I trust the troves of actual, scientific evidence that says I should not smoke? (yes, I know I just wrote an article about “sin” stock out-performance)

Equally, when I hear a stock pitch or reason for investment, I hate to hear anecdotal evidence as a real justification. Here are some examples:

  • Media: I just cut the cord and hear all my friends are too. Cable companies like Comcast are going to face pressure
  • Transportation: I hear millennials are all about traveling compared to buying new products. I am buying airline stocks that will benefit from this.
  • Healthcare: My grandma needs a lot of medical attention. As the baby boomer wave hits retirement, the amount spent on healthcare is undeniable going up.
  • Retail: I only shop at Amazon now. All other retail / distribution is essentially un-investable.
  • New Technology: I read an article on how this [new technology] was able to do [something in a novel way]. There’s going to be a paradigm shift in the way we do things.

I think this type of investing is popular for a few reasons. For one, it is easy. You can just identify something you know and think of a company that will benefit from a trend. Second, Peter Lynch often wrote in his books that his children would talk about something they liked, he bought the stock, and it ended up being a 5-bagger or something.

I do think it is extremely important to be aware of trends, but this sort of investing has led to a lot of trouble. You also have to know “what is priced in”. For example, look at the return of Comcast since cord cutting really starting about 10 years ago — it is up 300%+ compared to the S&P return of ~170%.

Sure Netflix is up more, but do you think many people analyzed whether or not growth in other Comcast businesses would offset the traditional cable model? Or that this was a lower margin business so therefore it didn’t impact earnings as much as one would expect? Also think about how much people complain about Comcast… yet it still prints a lot of money. That is a testament to its business model!

On the flip side of that negative outlook, look at something in the technology sector like 3D printing. It used to be all the rage where people would discuss how the industry would change the world after they saw it in action. However, that would have been a disastrous long-term investment decision, as shown below:

3D Printing stocks

These types of situations often allow a contrarian investor to profit. All asset prices reflect people’s expectations of future growth. By analyzing what investor expectations are compared to the price today, we can see whether an investment makes sense and is particularly undervalues. That’s often why in my model I run a “worst case” scenario for industries in which people believe are in secular decline as well as a “what do you need to believe” in the case of booming, hot technology stocks.

I like to invest in stocks where the expectations are really low. I’m critical of using GAAP net income and the P/E ratio for valuing a business (I prefer FCF), but for simplicity, let’s look at this example.

If you value a business on 1) current steady state part of the business and 2) the future growth of the business.  For number 1, we should assign a multiple equal to the cost of equity. If that cost is 10%, that is a 10x multiple. If I buy the business for 10x and those earnings are sustainable, then any future earnings are complete upside for me. If I can pay a low multiple then for a company that has a history of value creation, then I can get the business for value + the upside for free.

I think I should also mention one other thing: a secular declining business can last a lot longer than people think, but it has to have the right capital structure.

For example, the yellow pages are still around! And the business actually throws off a lot of cash because the managers don’t need to reinvest in the business. However, YP has also been overlevered in the past, which has led to cases of bankruptcy. If someone had acquired the business for cheap, ran it with conservative leverage, then it might have been an attractive equity return.

3 (often forgotten) things to remember when investing in Emerging Markets

I wanted to take some time to discuss 3 things when investing in Emerging Markets that are not widely discussed. The impetus for this article was driven by my blog post titled, “How to invest when inflation picks up“, in which I said that because I was bullish on commodity prices, I was going long Brazil.

Brazil has a very commodity driven economy (oil, metals & mining, agriculture) and my view was that a rebound in commodity prices would result in Brazil’s economy improving and its stock market should improve as well.

That call has not come to fruition yet, as shown by the Brazil ETF EWZ being down 21% since that call. And here are 3 lessons I think are important when investing in emerging markets, of which the first will relate to why my call on Brazil has been wrong so far.

1. Changes in currency can have a big impact on results

I would say a central reason why my call on Brazil has been wrong is because of currency.

The Real (Brazil’s currency) has been very volatile and has depreciated against the dollar since the slowdown in China started to occur in 2015 along with the commodity bust, which put Brazil in a deep recession. Recently, a trucker strike derailed plans to get the economy back on the path to recovery and sent the currency tumbling again.

BRL depreciation

What this has meant for my dollar investment is also depreciation…

Let’s use an example to see why: say a stock in Brazil was trading for 100 BRL when the USD/BRL rate was at 3.00. I place an $10,000 order, exchaning my dollars for 30,000 BRL and buy 300 shares. In local currency terms, lets say the stock goes up 10%, such that the quoted price is 110 BRL. I should have made $1,000 bucks on my investment, right?

Nope. If the BRL depreciated like it did in the chart above from 3.00 to 3.85, I’d be sitting on a pretty poor return actually, as shown below.

BRL Investment Example

Alas, this would mean even though I was right on stock selection, the currency movements negatively impacted my returns. This is partially why with all the global currency volatility, currency hedged ETFs are launching all over.

When in investing in emerging markets, currency will be key.

Do I advocate for currency hedges? Sometimes. It depends on the time-horizon. A long term investor may look at the levels of the BRL to the USD and see this as a buying opportunity and therefore, you can be right on stock selection AND the currency may be in your favor which would boost returns.

However, I don’t think anyway can really tell me where a currency will be in 10 years, so I won’t opine on that. What I will say is that our return thresholds should be much higher when investing in Brazil than lets say the US or another developed economy like Germany.

I don’t know what the currency will do over the next 2-3 years, but what I do know is that the real will depreciate over time relative to the dollar. No one questions that the inflation rate in Brazil will be higher than the US over the long run and that should mean that over time, the real should depreciate relative to the USD.

In sum, you have to be aware of currency, especially volatile ones. You’re taking a risk, so we should get paid for that.

2. Just because you’re buying a company’s stock, it does not mean you are afforded the same protections as the US.

Alibaba’s stock is up 25% in the past year and has roughly doubled since IPO’ing in 2014.

But did you know that if you hold BABA which trades on the NYSE, you actually don’t own Alibaba at all?

China forbids foreign investors from owning certain types of companies. As such, you aren’t really buying Alibaba. You are buying a holding company that has a claim on Chinese subsidiaries profits, but no economic interest. The risk here is that China comes in and says that is not allowed and guess what? You own nothing.

The New York Times reported on how China has not actually weighed in on this. You may also want to check out the risk factors of Alibaba’s 10-k entitled, “If the PRC government deems that the contractual arrangements in relation to our variable interest entities do not comply with PRC governmental restrictions on foreign investment, or if these regulations or the interpretation of existing regulations changes in the future, we could be subject to penalties or be forced to relinquish our interests in those operations”. 

I don’t mean to pick on BABA here (Tencent, Baidu, JD.com each have this problem as well), but the risk here might be higher than you think. Lots of people would say, “look China is relaxing its command economy and moving more to a free market. They wouldn’t do something like that.”

Rule of law is paramount in the US, but often forgotten when investing in Emerging Markets because people just look at the low P/E ratios.

And to that I say, look at Russia. In the 1990’s, following the “end” of the Cold War, Russia issued privatization vouchers that allowed investors to actually own former State Owned Enterprises. This was a huge step for Russia and it seemed like the old communist power would be relaxing its grip on businesses. But I encourage you to study what happened when Russia deemed it needed to re-control “strategic sectors”. Yuko Oil Company is a fascinating case study.

In a very brief summary, Yuko went to the private markets and quickly adopted transparent rules and practices, became one of the world’s largest non-state owned oil companies, and even had 5 Americans on its board. The company was paying dividends and growing internationally as well.

When Putin came to power, things quickly changed. The CEO of Yukos was arrested for tax evasion and fraud and Yukos was slapped with a $27 billion fine which was higher than its total revenues for the past 2 years. Yukos was forced to break up and its shares were frozen (to prevent a foreign company like Exxon from buying them). Eventually, Yukos declared bankruptcy. Many viewed this as a direct attack on the CEO of Yukos who was gaining political power.

In sum, I think its important to remember these risk factors and not get too comfortable in international / emerging markets that are known to have limited privileges to foreign investors.

3. Active management makes sense in Emerging Markets

So much has been written on active vs. passive investing in the US, it is actually making me nauseous. But I think this is a good topic to end on for this post, because it sums up the previous points here.

An active manager can weigh the impact of currency on a potential investment. They can weigh the political changes that are happening in the base of a country. And lastly, they are paid to do work on changes in the tastes of the economy.

One area of research I always try to look for is primary work. That is, if I buy the stock of a company, particularly one oriented to consumers, I want to conduct surveys on what its consumer say about the actual product and understand if that helps or hurts the investment decision in any way.

It’s also important to remember that sometimes we take for granted the tidal shift occurring in the U.S. such as Amazon, Netflix, or Apple because we interact with those products and see them on TV everyday. But how can you tell what type of products they are using in India or China without being there? Did you know Netflix and Apple are not the primary sources of products in those countries? They have their own.

Tastes change and they change quickly, so in my view, unless you’re traveling to the country often, you are paying an active manager to do that work. Indexes are backward looking (i.e. they weight the companies that have performed the best in the past at the top in a market cap weighted index), so they do not always calculate the risks mentioned herein. Sometimes they don’t include the entire universe, which can limit returns or at least potential for higher returns.

And as a result, we can see in the chart below that it pays to pay the higher management fee for active. This chart (taken from AllianceBernstein) shows that “70% of active managers in emerging equities have beaten the benchmark over the five-year period ended March 31, 2017, while 66% have outperformed over 10 years, net of fees. On a rolling five-year basis, the percent of active managers outperforming the EM index has never fallen below 50%”.

Active managers in EM

Hope this was helpful for investing in Emerging Markets.

Ray Dalio’s All Weather Portfolio and the place for fixed income in the portfolio

After reading Principles, by Ray Dalio, this past winter (which I highly recommend as it gave me many, many things to think about) I have been reconsidering my position on being highly underweight fixed income. Perhaps you are similar to me and kept waiting for rates to move up for an attractive entry point. Ray Dalio’s All Weather portfolio is something to consider.

Now the ten year treasury is hovering around 3% and as I noted previously, is not that far off from long-term averages. Does it make sense to allocate more of our portfolios to fixed income now?

Perhaps you have heard of Ray Dalio’s “All Weather Portfolio” in which he allocates a surprising amount to fixed income, as shown below. His rationale centers on a few factors. One is that by having weighting your portfolio at 80% stocks / 20% bonds is actually heavily weighting “risk”, given the volatility of stocks vs. bonds and for someone like Ray Dalio who is trying to build wealth over the long, long term, performing well in down markets matters.

Bonds should go up when stocks go down due to “flight to quality” impact in a down market. The allocation to gold and commodities provides extra diversification, plus these assets perform well during periods of high inflation, whereas bonds will not perform well.

  • 40% long-term bonds
  • 15% intermediate-term bonds
  • 30% stocks
  • 7.5% gold
  • 7.5% commodities

“The principles behind All Weather Portfolio relate to answering a deceptively straight-forward question explored by Ray with co-Chief Investment Officer Bob Prince and other early colleagues at Bridgewater – what kind of investment portfolio would you hold
that would perform well across all environments, be it a devaluation or something completely different?”

The results are pretty surprising. Dalio says he’s back-tested the portfolio from the great depression, to the Weimar Republic when hyperinflation set into Germany. If you choose not to read Principles, then I implore you to read the white paper on Bridgewater’s website on the background of the strategy.

Using portfoliovisualizer.com, I decided to see the results for myself and ran different 3 portfolio cases from 1978-2017.

The first is based on Dalio’s All Weather Portfolio, though admittedly, I had to do a 15% allocation to gold as a general commodities fund was not available that far back. I then ran a 60% stocks / 40% intermediate treasuries portfolio and then an 80% stocks / 20% intermediate treasuries portfolio.

Let me first say that it shouldn’t be too surprising that the higher stock portfolio wins out. Stocks have been a terrific asset class over this time period. Its higher risk, so higher return makes sense.

But look at the results of portfolio 1, the All Weather Portfolio. Results over this time period are not too shabby, logging a 9.4% CAGR and growing $10K to $380K. But the really interesting thing to me is the worst year and worst drawdown. The worst year was only down ~4%! Compare that to the stock heavy portfolio of -25% and having a near 40% loss in portfolio value during the year. Makes me think of “Slow and steady wins the race”

PV All WeatherPV ALl Weather Chart

This analysis isn’t perfect for a host of reasons. Bonds have been in a bull market for 30 years and were at much higher rates during this time period and subsequently went way down. I do like a quote from the white paper though, in which it states,

“In the US after peaking above 15% in the 1980s, cash rates are now zero. Stocks and bonds price relative to and in excess of cash rates. A 10-year bond yield of 2% is low relative to history but high relative to 0% cash rates. What is unusual about the recent environment is the price of cash, not the pricing of assets relative to cash.”

For further analysis on portfolio outcomes that aren’t tied to back testing, I decided to build a monte carlo spreadsheet analyzing a 50/50 portfolio of stocks and bonds. I then ran 10 random simulations over 40 years to see where the portfolios would shake out. This was pretty simple analysis and I probably should’ve added a component that says, “if stocks are down, then bonds are flat or up”, but decided to keep it random.

Given how high the standard deviation is for bonds, it is no surprise that the highest returning situations are driven by bonds outperforming, but we should also not ignore the simulations where in year 38 out of 40, stocks fall 45%, as shown in scenario 3. Bond provide decent offset to a devastating scenario.

Monte Carlo assumptions

Monte Carlo

I think the takeaway I have is that bonds / fixed income can make sense in the portfolio, depending on what you buy. So far, all I’ve shown is buying treasuries, but think there are solid opportunities in high yield and municipal bonds which are much more stable than stocks, but provide good returns.

I’ll follow up in another article on a bond fund that I think makes a lot of sense to buy for a pretty attractive return.

-DD

Recap from Berkshire Hathaway Annual Meeting

I was fortunate enough to attend the Berkshire Hathoway annual meeting and wanted to provide a recap to readers. I’ll try to skip much of the fluff questions that were asked.

IMG_2825

But to kick it off, I think its important to recap how Buffett started the meeting. He noted that he expects to receive many “macro” questions, such as what the fed will do with interest rates, risks from an unpredictable president, and the tariffs and to put these topics into context, he brought an actual, physical NY times newspaper from March 1942. The Phillipines had just been lost to Japan. The US had been bombed by Japan in the previous December. The outcome of World War II was far from certain.

Despite all this, 11 year old Warren Buffet decided to invest. And although he did not have this much money at the time, he noted if you bought $10,000 in the S&P500, it would be $51 million today. If you had bought productive US assets, they would have compounded at a fantastic rate of return.  At the same time, if you bought gold in fear and left it, it would be worth $400,000, higher than you invested but significantly less than the amount generated by stocks. Also, the yield on bonds at the time was 2.9% and there was encouragement by the government to “support the cause” and buy war bonds. Buffett & Munger did not partake much in this by simple math -> 2.9% minus taxes less 2% inflation leads to a minuscule return.

  • Succession planning:
    • Many questions related to succession planning, which makes sense given Mr. Munger and Mr. Buffett’s age (87 and 94 respectively). However, based on their responses, their ability  to work all day from ~7:30am to ~5:00pm all while eating peanut brittle and coca-cola, made me confident that Buffett and Charlie are in solid mental health at least.
    • “I’ve been semi-retired for decades”, Buffett’s response to succession planning. Ted Weschler and Todd Combs have assumed some investment responsibilities and Ajit Jain and Greg Abel now oversee Berkshire’s operating businesses.
    • However, Ted and Todd manage ~$25BN compared to Berkshire’s $100BN in cash as well as his current investment decisions. Bottom line: Buffett is still in charge
    • That being said, it should give some confidence that Buffett is relinquishing the reins responsibly.
  • Dark clouds on the horizon
    • Buffett was asked about Amex, given there are “dark clouds on the horizon” in payments. By this, he meant changes are happening in the industry and many technologies are trying to disrupt the industry.
    • However, he reiterated that the business is terrific, global payments are increasing, and Amex is a great brand. Over time, through share buybacks, Buffett will increase his stake.
    • In response to dark clouds, Buffett said something along the lines of, we used to buy outright declines (e.g. the textile business Berkshire is named after) so they are improving.
  • Dividends & Share buybacks
    • When asked to clarify why Buffett does not pay a special dividend or conduct buybacks, yet Buffett is favorable on Apple’s massive share buyback plan.
    • For starters, Buffett thinks Apple’s stock is cheap, and recently added 75MM shares to his portfolio. It then would make sense for Apple to buyback its stock if it also thinks it is cheap.
    • Second, it is unlike that Apple can find acquisitions in size “that they can make at remotely sensible price that really become additive to them.”
    • “The reason companies are buying their stocks is that they are smart enough to know it’s better for them than anything else,” Mr. Munger said.
    • Therefore it makes sense for them to acquire shares. Buffett on the other hand, has said he is open to share repurchases if he can’t find a way to deploy it (but he think he can).
  • Cryptocurrencies
    • Much has been said about what Buffett and Charlie said on crypto, but it bears repeating.
    • First, like gold, cryptocurrencies are non-productive assets and therefore depend on a “greater fool” to buy at a higher price than you bought it.
    • Charlie called this idiotic and immoral (given the greater fool piece). However, the BEST PIECE, was when he compared it to turds.
    • “To me, it’s just dementia. It’s like somebody else is trading turds and you decide you can’t be left out.”

Are you speculating or investing?

I think when most people begin to invest in stocks, they buy companies that make a product that they really like or that they think will be beneficiaries of major trends. This seems completely reasonable, but is simple speculation until cash flow enters the equation. Before I get into how I approach investing in companies, I’ll first break down the significant differences between the two, as I think it’s an important distinction and provides a valuable backdrop before we put money to work.

Back in the 1990’s, the commercial internet had just dawned. What was clear was that it would change the way we live forever; what was not clear was how. One new service was going to offer grocery delivery ordered online. It would deliver groceries to customers during a 30-minute period of their choosing. This presumably would change the way we shop for groceries forever (sound familiar?). Their plan was simple; they would raise cash from an IPO to fund investments in warehouses and expand to new cities. Clearly, THIS was the future. The company raised $375MM in an IPO to fund expansion and the company at peak was valued at $1.2BN. Moreover, they had an uber experienced and already successful founder, Louis Borders (of Borders bookstore fame), in addition to top-of-the-line VC money and guidance.

The company was growing too. It achieved 750,000 users, had 3,500 employees, and for the 3 months ended Dec-31-2000, the company did $84MM of revenue compared to $9MM in the 3 month period in the prior year (+833%!). However, the company’s losses expanded to $173MM from $49MM (and cash flow was a similar story) as it tried to expand quickly and needed to invest back in the business. In the end, the company was running out of cash, capital dried up (the tech bubble burst, closing the public equity markets), and it declared bankruptcy in 2001. The name of this company was Webvan if you want to study it further.

Ok, so how is that different than investing? Both investing and speculation involve taking risk. As Ben Graham said, investing inevitably has “substantial possibilities of both profit and loss.” However, in speculation the risk vs. reward is often miscalculated. You believe, since the price of something has gone up in the past, you can anticipate these movements and gain profitably from them. And maybe this strategy works for a little while, but see how similar that sounds to a roulette wheel? “It hit black 3 times in a row… it must be red next time.”

Think about today’s market. Infrastructure spending, tax reform, the next tech event… nothing has actually even been laid out yet, which has allowed investors to write their own narrative. This has led to speculation and driving stocks higher.  

When investing, we must take a calculated, fundamental approach to what we are buying, while also being realistic. We are buying an asset that we want to produce cash flows in the future to grow our capital or pay us back. However, we can’t pay any price for it if we want our capital to appreciate at a fast rate – which should be our goal! That philosophy alone also eliminates some “investments” out there, such as art, popular crypto currencies, etc. – to wit, anything that is not a producer of cash.

We must understand the industry, the company’s position, management, and cash flow. Unfortunately, this is harder than speculating, but also can create more significant wealth with much less risk. There is no free lunch, so it does require challenging work, but it can be well worth it and will be the subject of future posts here.

Think about it; is something in your portfolio right now that you’d equate to Webvan? Good concept, excellent product, or immense potential, all they need to do is… make a great leap? Or you’ve seen this stock rise so much in the past, you don’t want to miss the opportunity. This is all speculation and yes, sometimes there is a place for it in our broader portfolios and yes, it can be hard to draw the line between investing and speculating.

In future posts, I will delve further into my investing approach. But for now, I want to leave you with the following; if you have a large speculative position in a company, consider taking some risk off the table in favor of a real investment.

– Diligent Dollar