Tuesday, July 04, 2006

The Limits To Learning

By James Montier

Everybody thinks they are experts at learning. After all, most of us have gone through years of university education and emerged on the other side with a piece of paper 'proving' our ability to assimilate information. However, I'm not concerned with book learning; I am far more interested in learning from our own errors and mistakes or, somewhat more accurately, why we often fail to learn from our own past failures.

But first I ought to present just a couple of examples of the evidence we have of people not learning from past mistakes. The first comes form the work of Max Bazerman of Harvard. He regularly asks people the following question:

You will represent Company A (the potential acquirer), which is currently considering acquiring Company T (the target) by means of a tender offer. The main complication is this: the value of Company T depends directly on the outcome of a major oil exploration project that it is current undertaking. If the project fails, the company under current management will be worth nothing ($0). But if the project succeeds, the value of the company under current management could be as high as $100 per share. All share values between $0 and $100 are considered equally likely.

By all estimates, Company T will be worth considerably more in the hands of Company A than under current management. In fact, the company will be worth 50 percent more under the management of A than under the management of Company T. If the project fails, the company will be worth zero under either management. If the exploration generates a $50 per share value, the value under Company A will be $75. Similarly, a $100 per share under Company T implies a $150 value under Company A, and so on.

It should be noted that the only possible option to be considered is paying in cash for acquiring 100 percent of Company T's shares. This means that if you acquire Company T, its current management will no longer have any shares in the company, and therefore will not benefit in any way from the increase in its value under your management.

The board of directors of Company A has asked you to determine whether or not to submit an offer for acquiring company T's shares, and if so, what price they should offer for these shares.

This offer must be made now, before the outcome of the drilling project is known. Company T will accept any offer from Company A, provided it is at a profitable price for them. It is also clear that Company T will delay its decision to accept or reject your bid until the results of the drilling project are in. Thus you (Company A) will not know the results of the exploration project when submitting your price offer, but Company T will know the results when deciding on your offer. As already explained, Company T is expected to accept any offer by Company A that is greater than the (per share) value of the company under current management, and to reject any offers that are below or equal to this value. Thus, if you offer $60 per share, for example, Company T will accept if the value under current management is anything less than $60. You are now requested to give advice to the representative of Company A who is deliberating over whether or not to submit an offer for acquiring Company T's shares, and if so, what price he/she should offer for these shares. If your advice is that he/she should not to acquire Company T's shares, advise him/her to offer $0 per share. If you think that he/she should try to acquire Company T's shares, advise him/her to offer anything between $1 to $150 per share. What is the offer that he/she should make? In other words, what is the optimal offer?

The correct answer is zero. The reasoning is as follows: Suppose the acquirer offers $60. From the above we know that all points are equally likely, so by offering $60, Company T is assumed on average to be worth $30. Given that the company is worth 50% more to the acquirer, the acquirer's expected value is 1.5*$30 = $45. So a bid of $60 has a negative expected value. Any positive offer has a negative expected value, so the acquirer is better off making no offer.

In contrast to this rational logic, the overwhelming majority of responses fall in the range $50-$75. The 'logic' behind this is that on average the company must be worth $50, thus be worth $75 to the acquirer, so any price in this range is mutually beneficial. However, this ignores the rules of the game. Most obviously, the target can await the result of the exploration before accepting or rejecting, and the target will only accept offers that provide a profit.

The first chart below shows 20 rounds of the game. Across twenty rounds, there is no obvious trend indicating that participants learned the correct response. In fact, Ball et al find that only five of the seventy-two participants (MBA students from a top university) learned over the course of the game.

The second chart shows the results over a 1000 rounds of the game from a study by Grosskopf and Bereby-Meyer. Players didn't learn from hundreds and hundreds of rounds!

The second example of a failure to learn comes from a simple investment game devised by Bechara et al. Each player was given $20. They had to make a decision on each round of the game: invest $1 or not invest. If the decision was not to invest, the task advanced to the next round. If the decision was to invest, players would hand over one dollar to the experimenter. The experimenter would then toss a coin in view of the players. If the outcome was heads, the player lost the dollar. If the outcome landed tails up then $2.50 was added to the player's account. The task would then move to the next round. Overall, 20 rounds were played.

The chart below shows there was no evidence of learning as the game went on. If players learnt over time, they would have worked out that it was optimal to invest in all rounds. However, as the game went on, so, fewer and fewer players continued: they were actually becoming worse as time went on!

I'm sure you can think back and remember many mistakes that you should have learnt from, but didn't (or perhaps I shouldn't judge everybody by my standards). The above is merely setting the scene for our discussion over why people fail to learn. It is the impediments to learning that we now turn our attention towards.

The major reason we don't learn from our mistakes (or the mistakes of others) is that we simply don't recognise them as such. We have a gamut of mental devices all set up to protect us from the terrible truth that we regularly make mistakes.

Self attribution bias: heads is skill, tails is bad luck

We have a relatively fragile sense of self-esteem; one of the key mechanisms for protecting this self image is self-attribution bias. This is the tendency for good outcomes to be attributed to skill and bad outcomes to be attributed to sheer bad luck. This is one of the key limits to learning that investors are likely to encounter. This mechanism prevents us from recognizing mistakes as mistakes, and hence often prevents us from learning from those past errors.

You can't have helped but notice that the football world cup is under way at the moment. Personally I can't stand the sport, but it might just be worth listening to the post match analysis to see how many examples of self attribution one can find.

Lau and Russell examined some 33 major sporting events during the autumn of 1977. Explanations of performance were gathered from eight daily newspapers, giving a total of 594 explanations. Each explanation was measured in terms whether it referred to an internal (something related to the team's abilities) or external factor (such as a bad referee).

Unsurprisingly, self attribution was prevalent. 75% of the time following a win, an internal attribution was made (i.e. the result of skill); whereas only 55% of the time following a loss was an internal attribution made.

The bias was even more evident when the explanations were further categorized as coming from either a player/coach or a sportswriter. Players and coaches attributed their success to an internal factor over 80% of the time. However, internal factors were blamed only 53% of the time following losses. Sportswriters attributed wins to internal factors 70% of the time when it was their home team, and 57% of the time when their home team lost.

The expected outcome of the game had no impact on the post match explanations that were offered. Even when one team was widely expected to thrash the other, the attributions of the winners referred to internal factors around 80% of the time, and the attributions of the losers referred to an internal factor 63% of the time.

To combat the pervasive problem of self attribution we really need to keep a written record of the decisions we take and the reasons behind those decisions. We then need to map those into a quadrant diagram like the one shown below. That is, was I right for the right reason? (I can claim some skill, it could still be luck, but at least I can claim skill), or was I right for some spurious reason? (In which case I will keep the result because it makes the portfolios look good, but I shouldn't fool myself into thinking that I really knew what I was doing). Was I wrong for the wrong reason? (I made a mistake and I need to learn from it), or was I wrong for the right reason? (After all, bad luck does occur). Only by cross-referencing our decisions and the reasons for those decisions with the outcomes, can we hope to understand when we are lucky and when we have used genuine skill.

Hindsight bias: I knew it all along

One of the reasons I suggest that people keep a written record of their decisions and the reasons behind their decisions, is that if they don't, they run the risk of suffering from the insidious hindsight bias. This simply refers to the idea that once we know the outcome we tend to think we knew it was so all along.

The best example of this from the investment world is probably the bubble in TMT in the late 1990s. Those who were going around telling people it was a bubble were treated as cretins. However, today there seems to have been an Orwellian re-writing of history, so everyone now thinks they knew it was a bubble (even though they were fully invested at the time).

Barach Fischhoff first noted this strong tendency in 1975. He gave students descriptions of the British occupation of India and problems of the Gurkas of Nepal. In 1814, Hastings (the governor-general) decided that he had to deal with the Gurkas once and for all. The campaign was far from glorious. The troops suffered in the extreme conditions, and the Gurkas were skilled at guerrilla style warfare and few in number, offering little chance for full-scale engagements. The British learned caution only after several defeats.

Having read a much longer version of the above, Fischhoff asked one group to assign probabilities to each of the four outcomes: (i) British victory, (ii) Gurka victory, (iii) military stalemate without a peace settlement, (iv) military stalemate with a peace settlement.

With the other four groups, Fischhoff provided the 'true' outcome, except that three of the four groups received a false 'true' outcome. Again these groups were asked to assign probabilities to each of the outcomes.

The results are shown in the chart below. The hindsight bias is clear from even a cursory glance at the chart. All the groups who were told their outcome was true assigned it a much higher probability than the group without the outcome information. In fact, there was a 17 percentage point increase in the probability assigned once the outcome was known! That is to say, none of the groups were capable of ignoring the ex post outcome in their decision making.

Hindsight is yet another bias that prevents us from recognising our mistakes. It has been repeatedly found that simply telling people about hindsight and extolling them to avoid it has very little impact on our susceptibility. Rather Slovic and Fischhoff found that the best mechanism for fighting hindsight bias was to get people to explicitly think about the counterfactuals: what didn't occur and what could have lead to an alternative outcome? In experiments, Slovic and Fischhoff found that hindsight was still present when this was done, but it was much reduced.

Skinner's pigeons

An additional problem stems from the fact that our world is probabilistic. That is to say, we live in an uncertain world where cause and effect are not always transparent. However, we often fail to accept this fundamental aspect of our existence. Way back in 1947, B.F. Skinner was exploring the behaviour of pigeons. Skinner was the leader of a school of psychology known as behaviouralism, which held that psychologists should study only observable behaviour, not concern themselves with the imponderables of the mind.

Skinner's theory was based around operant conditioning. As Skinner wrote, "The behavior is followed by a consequence, and the nature of the consequence modifies the organism's tendency to repeat the behavior in the future." A more concrete example may be useful here.

One of Skinners favourite subjects was pigeons. Skinner placed a series of hungry pigeons in a cage attached to an automatic mechanism that delivered food to the pigeon "at regular intervals with no reference whatsoever to the bird's behaviour". He discovered that the pigeons associated the delivery of the food with whatever chance actions they had been performing as it was delivered, and that they continued to perform the same actions:

One bird was conditioned to turn counter-clockwise about the cage, making two or three turns between reinforcements. Another repeatedly thrust its head into one of the upper corners of the cage. A third developed a 'tossing' response, as if placing its head beneath an invisible bar and lifting it repeatedly. Two birds developed a pendulum motion of the head and body, in which the head was extended forward and swung from right to left with a sharp movement followed by a somewhat slower return. (Superstition in the Pigeon, B.F. Skinner, Journal of Experimental Psychology 38, 1947)

Skinner suggested that the pigeons believed that they were influencing the automatic mechanism with their "rituals" and that the experiment also shed light on human behaviour:

The experiment might be said to demonstrate a sort of superstition. The bird behaves as if there were a causal relation between its behavior and the presentation of food, although such a relation is lacking. There are many analogies in human behavior. Rituals for changing one's fortune at cards are good examples. A few accidental connections between a ritual and favorable consequences suffice to set up and maintain the behavior in spite of many unreinforced instances. The bowler who has released a ball down the alley but continues to behave as if she were controlling it by twisting and turning her arm and shoulder is another case in point. These behaviors have, of course, no real effect upon one's luck or upon a ball halfway down an alley, just as in the present case the food would appear as often if the pigeon did nothing - or, more strictly speaking, did something else. (Ibid.)

Indeed, some experiments by Ono in 1987 showed that Skinner's findings were applicable to humans. He placed humans into the equivalent of Skinner boxes: rooms with a counting machine to score points, a signal light and three boxes with levers. The instructions were simple:

You may not leave the experimental booth... during the experiment. The experimenter doesn't require you to do anything specific. But if you do something, you may get points on the counter. Try to get as many points as possible.

In fact, participants would receive points on either a fixed time interval or a variable time interval. Nothing they did could have influenced the outcome in terms of points awarded. However, Ono recorded some pretty odd behaviour. Several subjects developed "persistent idiosyncratic and stereotyped superstitious behaviour". Effectively they began to try and find patterns to behaviour, such as pulling the left lever four times, and then the right lever twice, and the middle lever once.

My favourite behaviour was displayed by one young lady in Ono's study. He records, "A point was delivered just as she jumped to the floor (from the table)... after about five jumps, a point was delivered when she jumped and touched the ceiling with her slipper in her hand. Jumping to touch the ceiling continued repeatedly and was followed by more points until she stopped about 25 minutes into the session, perhaps because of fatigue."

Could it be that investors are like Skinner's pigeons, drawing lessons by observing the world's response to their actions? It is certainly possible. The basic failure with the pigeons and Ono's human experiments is that they only look at the positive concurrences, rather than looking at the percentage of the times the strategy paid off, relative to all the times they tried.

Illusion of control

We love to be in control. We generally hate the feeling of not being able to influence the outcome of an event. It is probably this control freak aspect of our nature that leads to us to behave like Skinner's pigeons. My favourite example of the illusion of control concerns lottery tickets from the classic paper by Langer8. She asked some people to choose their own lottery numbers, whilst others were just given a random assignment of numbers. Those who chose their own numbers wanted an average $9 to give the ticket up. Those who received a random assignment/lucky dip lottery ticket wanted only $2!

Another great example comes from Langer and Roth. Subjects were asked to predict the outcome of 30 coin tosses. In reality, the accuracy of the participants was rigged so that everyone guessed correctly in 15 of the trials, but roughly one-third of the subjects began by doing very well (guessing correctly on the first four tosses), one-third began very badly, and one-third met with random success. After the 30 tosses, people were asked to rate their performance. Those who started well, rated themselves as considerably better at guessing the outcomes than those who started badly.

In their analysis of a wide range of illusion of control studies, Presson and Benassi summarize that the illusion is more likely when lots of choices are available, you have early success at the task (as per above), the task you are undertaking is familiar to you, the amount of information available is high, and you have personal involvement. Large portfolios, high turnover and short time horizons all seem to be the financial equivalents of conditions that Presson and Benassi outline. Little wonder that the illusion of control bedevils our industry.

Feedback distortion

Not only are we prone to behave like Skinner's pigeons but we also know how to reach the conclusions we want to find (known as 'motivated reasoning' amongst psychologists). For instance, if we jump on the bathroom scales in the morning, and they give us a reading that we don't like, we tend to get off and have another go (just to make sure we weren't standing in an odd fashion11). However, if the scales have delivered a number under our expectations, we would have hopped off the scales into the shower, feeling very good about life.

Strangely enough, we see exactly the same sort of behaviour in other areas of life. Ditto and Lopez12 set up a clever experiment to examine just such behaviour. Participants were told that they would be tested for the presence of TAA enzyme. Some were told that the TAA enzyme was beneficial (i.e. "people who are TAA positive are 10 times less likely to experience pancreatic disease than are people whose secretory fluids don't contain TAA"), others were told TAA was harmful ("10 times more likely to suffer pancreatic disease").

Half of the subjects in the experiment were asked to fill out a set of questions before they took the test, the other half were asked to fill out the questions after the test. In particular two questions were important. The first stated that several factors (such a lack of sleep) may impact the test, and participants were asked to list any such factors that they had experienced in the week before the test. The other question asked participants to rate the accuracy of the TAA enzyme test on a scale of 0 to 10 (with 10 being a perfect test).

The charts below show the results that Ditto and Lopez uncovered. In both questions there was little difference in the answers offered by those who were told having the TAA enzyme was healthy and those who were told it was unhealthy provided they were asked before they were given the result. However, massive differences were observed once the results were given.

Those who were told the enzyme was healthy and answered the questions after they had received the test results, gave less life irregularities and thought the test was better than those who answered the questions before they knew the test result.

Similarly, those who were told the enzyme was unhealthy and answered the questions after the test results, provided considerably more life irregularities and thought the test was less reliable than those who answered before knowing the test result. Both groups behaved exactly as we do on the scales in the bathroom. Thus, we seem to be very good at accepting feedback that we want to hear while not only ignoring, but actively arguing against, feedback that we don't want to hear.

Interestingly, Westen et al found that such motivated reasoning is associated with parts of the brain that control emotion, rather than logic (the x-system, rather than the csystem, for those who have attended one of my behavioural teach-ins). Committed Democrats and Republicans were shown statements from both Bush and Kerry and a neutral person. Then a contradictory piece of behaviour was shown, illustrating a gap between the rhetoric of the candidates and their actions. Participants were asked to rate how contradictory the words and deeds were (on a scale of 1 to 4). An exculpatory statement was then provided, giving some explanation as to why the mismatch between words and deeds occurred, and finally participants were asked to rate whether the mismatch now seemed so bad in the light of the exculpatory statement.

Strangely enough, the Republicans thought that the Bush contradiction was far milder than the Democrats, and vice versa when considering the Kerry contradiction. Similar findings were reported for the question on whether the exculpatory statement mitigated the mismatched words and deeds.

Westen et al found that the neural correlates of motivated reasoning where associated with parts of the brain known to be used in the processing of emotional activity rather than logical analysis. They note "Neural information processing related to motivated reasoning appears to be qualitatively different from reasoning in the absence of a strong emotional stake in the conclusions reached."

Furthermore, Westen et al found that after the emotional conflict of the contradiction has been resolved a burst of activity in one of the brain's pleasure centres can be observed (the ventral striatum). That is to say, the brain rewards itself once an emotionally consistent outcome has been reached. Westen et al conclude "The combination of reduced negative affect... and increased positive affect or reward... once subjects had ample time to reach biased conclusions, suggests why motivated judgments may be so difficult to change (i.e. they are doubly reinforcing)."


Experience is a dear teacher - Benjamin Franklin

Experience is a good teacher, but she sends in terrific bills - Minna Antrim

Experience is the name that everyone gives their mistakes - Oscar Wilde

We have outlined four major hurdles when it comes to learning from our own mistakes. Firstly, we often fail to recognize our mistakes because we attribute them to bad luck rather than poor decision making. Secondly, when we are looking back, we often can't separate what we believed beforehand from what we now know. Thirdly, thanks to the illusion of control, we often end up assuming outcomes are the result of our actions. Finally, we are adept at distorting the feedback we do receive, so that it fits into our own view of our abilities.

Some of these behavioural problems can be countered by keeping written records of decisions and the 'logic' behind those decisions. But this requires discipline and a willingness to re-examine our past decisions. Psychologists have found that it takes far more information about mistakes than it should do, to get us to change our minds.

As Ward Edwards notes:

An abundance of research has shown that human beings are conservative processors of fallible information. Such experiments compare human behaviour with the outputs of Bayes's theorem, the formal optimal rule about how opinions... should be revised on the basis of new information. It turns out that opinion change is very orderly, and usually proportional to numbers calculated from Bayes's theorem - but it is insufficient in amount. A convenient first approximation to the data would say that it takes anywhere from two to five observations to do one observations' worth of work in inducing a subject to change his opinion.

So little wonder that learning from past mistakes is a difficult process. However, as always, being aware of the potential problems is a first step to guarding against them.

Saturday, July 01, 2006

FSM Cash account rates move

Some of you asks how come the interest rates were hiking up yet the interest on cash account still does not move. guess what it did when i checked this afternoon. the latest rates are below.

you would have noticed that the usd rate at 4.445 + 0.75 comes close to the 5.195. thats looks like the ir in US after the fed raise its interest rate

as for the singapore rate i noticed that its close to 2.46% the last time round i checked.

Wednesday, June 28, 2006

Make your Investment Returns Take Off

by Bryan Kelleher

The point of investing your hard-earned capital is to attain a lot more money in the future by giving up the enjoyment and use of your cash today.

You want your returns to soar like a jet plane.

But think about how much work goes into pre-flight planning. The ground crew maintains and inspects all mechanical systems. Air traffic controllers make certain all routes are clear. The pilot consults his checklist of procedures that must be completed before take-off. Great amounts of time and resources are spent to keep airline passengers as safe as possible.

In the same way, investors should develop a mental safety checklist before making serious investments in the stock market.

This is why Warren Buffett says that the first rule of investing is never to lose money and the second rule is never to forget rule number one.

The math is simple: if you lose 50% on an investment, you must gain 100% to reach your breakeven level. Another interesting mathematical truth is to look at the performance of two portfolios:

Portfolio A: $1,000 invested, compounding at 8% per year for 4 Years would result in an account balance of $1,360.

Portfolio B: $1,000 invested, compounding at 15% for 3 years, and then losing 15% in the fourth year would result in an account balance of $1,293.

The point is that you want to avoid losses as much as possible.

Sometimes investors tend to emphasize their anticipated returns over all other factors. They get so excited and enamored with sell side analyst opinions and company projections that they often fail to consider all of the problems that can occur with stocks. Buffett has stated that investors would be well advised to pay more attention to credit analysts than sell side analysts.

You cannot control how much your stocks make. But you can control the risks you take when making stock picks.

What are you to do?

As Charles Munger has stated on several occasions:" Invert, always invert." Instead of thinking about the upside of your investments, you should emphasize the downside that can beset your stocks. The internet bubble of the late 1990's taught us all powerful lessons about what can happen when focus is applied to promised returns as opposed to all the things that can go wrong. A lot of portfolios crashed and burned.

Just as an airline pilot, most of your efforts and preparation should be directed at avoiding mistakes.

Businesses and markets are competitive and unpredictable. Investors that have prepared for worst-case scenarios, and have not paid too much for their investments will fare the best when inevitable setbacks happen.

Successful investors have developed the skills to assess the financial strength of the companies they have invested in. How much cash does a company have? How much debt does the company carry? Is the company using strange techniques to get debts off the balance sheet?

Next, as an investor, you need to assess a floor value of an investment. You need a method of calculating a "worst case scenario". If the company were to fall on hard times, or if the stock market goes south, what would the company trade for? An adjusted book value - (tangible assets less all liabilities) would be a good place to start. By focusing on this number, you will get an idea how far a current price of a stock could fall. If you identify an investment where this number is not too far from the current market price, you might have an interesting stock investment idea.

Your final analysis should be to measure the true or intrinsic worth of the security you are considering. Remember, stocks are not just pieces of paper that float around day to day based on nothing. Stocks are actual assets that represent claims to assets that throw off real cash at some point. Companies pay dividends, buyback their shares, merge, reorganize or liquidate. Your job is to estimate the fair value of these future cash flows.

Since you can't possibly know with certainty the exact value of a company, the key to being successful is to use conservative values and compare these values with the current price of the security in question. Your aim is to find companies with upside potential that are trading near the floor level you have established, and are trading below what you believe is the real intrinsic worth of the company.

You can generate a lot of investment ideas by looking at what the investment masters are doing right here at Gurufocus.com. They are buying fallen angels like Dell and Pfizer.

Often this approach will take you to unpopular or out-of-favor companies. You just have to do more homework than the average investor, and once you arrive at logical conclusions, stick to your assessments.

These steps will not only ensure that you will not overpay for a stock, but they also have the effect of magnifying your returns if the gap between the current market price and intrinsic value narrows. If the intrinsic value of the company also grows, and the market value eventually follows - this is when investment returns soar.

Remember: Before taking off, ask yourself how safe your investments are.

Friday, June 23, 2006

Do All Banks Have Moats?

Our thoughts on the banking industry's widespread competitive advantages.
by Jim Callahan, CFA | 05-01-06 | 06:00 AM

You might be surprised to hear that nearly all banks have a sustainable competitive advantage--an economic moat. Warren Buffett and Charlie Munger were surprised, too. Buffett once remarked, "Charlie and I have been surprised at how much profitability banks have, given that it seems like a commodity business."

At Morningstar, we've long recognized the moats of banks, and it's nearly impossible to understate their importance. Without a robust analysis of a company's competitive advantage and the sustainability of that advantage over time, investors run the risk of buying one-hit wonders that burn out fast…along with shareholders' money.

At Morningstar, we begin each new analysis with the idea that a company has no economic moat until one is proven. But our financial services team believes that the banking industry offers an exception to the rule. We would argue that every bank has, at a minimum, a narrow economic moat.

To review some fundamentals, an economic moat represents a company's ability to earn returns above its cost of capital and defend its ability to do so over time. After confirming that a company's historical returns on invested capital exceed its cost of capital--the easier task--one must assess the likelihood of those surplus returns persisting in the future, and here's where mistakes can be made.

Below is a table of the most common sources of wide economic moats, a brief description of each, and their application to the banking industry. We will then get into some of the more important moat sources for banks.

Sources of Economic Moats

FactorDescriptionApplication to Banks
Intangible assets (brands, patents, government
licenses, etc.)
Unique non-physical assets that limit competition or allow a firm to charge higher prices.Regulation played a more important role historically, and
we believe that the industry will continue its long-term trend of deregulation.
Cost advantageImportant for commoditylike industries in which pricing
power is nil. This advantage
is often created through
economies of scale.
How a bank funds its loans plays
a big role in its profitability--
banks have access to lower-cost funding than most other businesses.
High customer switching costsWhen customers are willing to pay higher prices for their convenience or because they can't easily get serviced elsewhere.Banks have surprisingly high switching costs.
Network effectA rare factor most often seen in technology industries, this is the widespread adoption of a first-mover's product or service until it becomes the standard.Not applicable to nearly
all banks.

The Beauty of the Deposit-Gathering Business

We believe that the true value in the banking industry is in the deposit business. The cost of banks' deposits can vary widely, ranging from market-rate-bearing deposits to non-interest-bearing deposits. This is because deposits, unlike any other form of debt, can generate revenue. (Imagine being paid to take out a mortgage!) When factoring in the income generated from deposit service fees (think ATM charges or overdraft fees), some banks are actually getting paid to hold depositors' funds.

Consider this: Banks can borrow money more cheaply than the U.S. government. The U.S. government is known as a risk-free borrower and, therefore, should command the lowest interest rates on its borrowings in the market. Of the largest banks by asset size, we found a five-year average effective deposit cost (interest costs net of deposit service fees) of 1.14% compared to a 2.13% average short-term Treasury bill over the same time period. In fact, a full 87 of the 113 banks (77%) we analyzed boasted average effective deposit costs below that of Uncle Sam's borrowing rate since 2000, while six banks actually generated deposit fees in excess of their deposit interest costs. Some of the more attractively funded banks we cover, as measured by their average cost of deposits over the last five years, include TCF Financial TCB , Provident Bankshares PBKS , and Cullen/Frost Bankers CFR .

The Advantage of Regulation

We believe that the heavy regulation of the past provided many banks a head start toward their dominant market shares. After the Great Depression, the banking industry became highly regulated. Banks were essentially granted government licenses to operate their depository and lending operations within a specified state or even county.

Further, banks were required to pay depository insurance, allowing the government to guarantee bank customers security from bank runs. The result was that, for any given operating area, one bank dominated the market, had barriers protecting it from new entrants, and was given below-market funding due to the risk-free nature of the deposit business. As long as the bank's borrowers didn't default, it was almost guaranteed a profit based upon the spread earned between the cheap funding and the interest rate on its loans. (Further, since the industry became highly fragmented, numerous banks--each operating within their own small market--often had loan officers and customers that developed deep relationships that lasted for years.)

Over the decades, of course, things have changed. Banks can apply for a charter to operate in any state and can engage in many nonbanking businesses, such as investment banking, asset management, and insurance brokerage. But the foundation upon which the industry was formed is still present. The banks that dominated certain cities 75 years ago remain (in various forms) today. Think of Wells Fargo WFC in San Francisco, Fifth Third FITB in Cincinnati, and Washington Mutual WM in Seattle. We believe that this stems from banks' integral roles within their respective communities: In assessing risk, they must know a borrower well, and in making loans, a bank is essentially financing the growth of a community over time.

Switching Costs

On a related note, we'd highlight the surprisingly high switching costs in the industry. Now, at first glance, it would appear easy enough to switch accounts from one bank to another. However, on average, deposits have proven to be fairly "sticky."

The development of alternative distribution channels--first ATMs, then in-store branches, then Internet banking---have made banks more accessible to customers. This availability lowers the chance of a customer leaving simply because a competing bank's branch is more convenient to, say, the workplace or school. Online bill payment and automatic direct deposits further increase a deposit account's "stickiness." It can be tedious setting up payees and dollar amounts upon initiating an online bill payments, making the thought of switching to another bank and having to go through the process again somewhat of a mini-barrier to exit. (We say mini-barrier because, as we speak, various technology firms are developing software to help transfer such information from one bank to another with the simple click of a button.) The bottom line is that the average life of a deposit account is surprisingly long, offering banks more opportunities to earn the spread between its borrowing and lending activities.

A Caveat: International Banks

The U.S. market is somewhat of a special case. Our comments thus far have focused on the U.S. banking industry, and the biggest difference when looking beyond the domestic banking market is that, unlike in the U.S., many countries' banking industries are largely consolidated. In fact, the U.S. ranks as one of the most fragmented banking industries in the world. Although the moat characteristics we've described broadly apply to the international banks we follow, there are exceptions to the rule, and we'd advise thorough research prior to investing internationally. (See our two-part article from January on how we approach investing in international banks.)


Banks are good businesses because of their fundamental design. Although many believe that banking is a commodity business, we believe that the basic business of banking and the industry's average profitability tell investors something different. Simply put, the proof of the industry's narrow economic moat is in the numbers: The average bank over the last 15 years has generated a 13%-14% tangible return on equity, above our 10%-11% estimated cost of capital. Those are the kind of numbers that turned the heads of Buffett and Munger.

A quick review of Morningstar's bank coverage reveals 59 domestic banks and 29 international banks. Of the domestic banks, 49 have narrow moats and 10 have wide moats. Currently, we believe the best investment opportunities are in large-cap, wide-moat banks, and we encourage investors to take a closer look.

CommentBy Gannon:

Superficially, banking appears to be a commodity business. In fact, it appears to be a particularly poor commodity business, because capacity is not constrained by the need to invest in a substantial physical infrastructure. True, whatever investments are made in tangible assets are usually intended as a means to acquire more intangible assets; however, a branch is hardly comparable to an oil well.

A bank’s ability to lend money (and thus produce income) is not completely and inextricably linked to the size of its deposits. In other words, loans are the result of both a bank’s capacity to lend money and its willingness to lend money.

It’s hard to find a parallel in tangible commodity businesses. Theoretically, this should make little difference in the long run. However, the lack of physical supply constraints in the market for loans creates the possibility for large, industry-wide mistakes. Pricing in such an industry can get very weak at times.

There’s one catch here. The underlying assumption whenever the commodity business label is used is that both the demand for a product and the supply of that product are general in nature. They can’t be specific, because that would destroy the involuntary nature of pricing within the industry.

For example, if all pineapples were unbranded, identically tasting fruits the demand side of the business would meet the requirement for a commodity business. However, if most pineapples take eighteen months to grow, but there is one magical plantation where the fruit develops fully in just three months, the supply side of the business does not meet the requirement for a true commodity business. The magical pineapple plantation would produce six times as much fruit per acre and thus the plantation owner would be able to undercut his competitor’s prices. He would earn extraordinary profits, because the return on capital in his business would be much higher than that of the industry as a whole.

What does this fairy tale have to do with banking? It suggests extraordinary profits can come from having “sticky” customers or lower costs. The lower costs needn’t be the result of lower marginal inputs. The magical pineapple plantation turned the crop over faster; it didn’t need access to below market prices for any of its inputs.

The same is true of a grocery store. Two stores that buy and sell cans of soup at the same exact prices may have very different returns on capital, if one of the stores turns over its inventory more quickly, because the fixed costs will be spread over a larger number of sales.

How does this relate to banking? While a quick turnover (or some other form of operational efficiency) is the most common reason for one firm’s unusual profitability in a commodity type business, there are other ways to earn extraordinary profits. Some of them are conceptually quite similar to the idea of owning a magical, one of a kind pineapple plantation. In such situations, the product appears the same to the consumer; but, the producer is actually unique (or at the very least special).

All of this helps to explain why some banks are more profitable than others. However, it doesn’t address the question posed by Morningstar. So, do all banks have moats?

Before answering that question, it might be best to ask under what circumstances all banks could have moats. What could insulate an entire industry from the ravages of competition? This is the question I discussed in the podcast episode: “Nature of Competition”. Why can some industries support plenty of profitable players, while others merely support a handful, one, or none?

Switching costs are one of the most commonly cited reasons for a wide moat. I think the matter is actually a lot more complicated than that. Financially prohibitive switching costs do create moats. However, most wide-moat companies don’t have truly prohibitive switching costs. What they do have is a situation in which it makes little sense to switch to a competitor and/or a tendency for their customers to not actively seek to learn more about competing products.

Where the cost of a product is particularly small per cash outlay, consumers are usually apathetic about seeking out alternatives. The key here is that the amount has to seem very small to the buyer at the time the purchase is made.

If you buy a cup (or two) of coffee every morning, it does not occur to you that you are spending hundreds or thousands of dollars a year on that coffee and that you could save a lot of money by buying the cheaper alternative. However, if you’re buying an appliance or piece of furniture the difference is immediately obvious and thus price is a major concern.

Generally, if a product can be sold over and over again at a very low price per transaction, profits will be higher, because the buyer will not make much of an effort to compare prices. Likewise, if a customer is billed for a variety of different products or services each amounting to only a small charge, the customer’s price awareness will be lower than if the charges were combined and listed as a single item.

Where price visibility, comparability, or immediacy is reduced, extraordinary profitability becomes more likely. People are very sensitive to price differences between large, juxtaposed numbers. If tomorrow the federal government prohibited gas stations from posting their prices per gallon, drivers would begin to become less concerned about gas prices.

There would be an uproar at first. But, over the years, gas prices would receive less and less news coverage and would fall off the list of consumer concerns. Obviously, a crude oil price quoted in dollars also contributes to price awareness. But, the point remains the same. Where prices are less visible, price competition is less fierce.

Compounding is a great way to exploit a lack of price awareness. The differences between various interest rates always seem small when placed side by side. Over time, these differences become quite large. However, the fact that no large differences are clearly visible at the time a decision is made about where to bank helps to minimize price competition between banks.

It also increases the relative importance of other aspects of banking like convenience and service. Usually, the cost to make a good impression is very low compared to the size of the assets that could result from attracting more deposits.

On the other hand, the importance of making a good second and third impression is minimal. Once a depositor uses a particular bank, he is unlikely to visit competitors. When he needs to do his banking, he will go directly to his own bank (or its website).

This is very different from the environment found in most consumer businesses. Packaged goods companies have their products placed next to their competitor’s products on store shelves. Retail stores are usually clustered. Whether they are located in malls or in free standing buildings, it’s a safe bet the customer has to pass at least one competing retail outlet to shop at their favorite location. In most cases, the other location won’t compete in every category as the customer’s favorite store; but, it will offer at least some competing products. As a result, the shopper is offered the option of switching every time she makes the trip.

When someone walks into a bank, it’s usually their own bank. They don’t have any use for other banks (after all, their money isn’t there). The cost of switching banks isn’t very high. However, the amount of active effort required to make the switch is substantial.

Switching banks isn’t as easy as switching toothpaste. But, more importantly, the alternative isn’t as obvious in banking. We all know other banks exist. But, unless we have a reason to consider switching from our current bank, we don’t even bother to check out the competition.

The result is a very narrow, very real moat.

Wednesday, June 21, 2006

Martin Whitman's "Cowardly" Safe-And-Cheap Way To Invest

"We're such cowards!" said Martin Whitman, the 82-year-old legendary superinvestor, at a seminar organized by New York Society of Security Analysts (www.NYSSA.org) on February 16, 2006, "We only want to be the senior-most creditors in distressed situations. We only want to be the adequately secured lenders in Europe and overseas. We don't want to be subordinate to any of the asbestos or tobacco liabilities..." And he brilliantly calls himself the "safe and cheap" investor.

Marty Whitman's "License To Steal"

The man brave enough to call himself a "coward" is never short of shocking and jaw-opening statements though. Marty Whitman says that he started as one of the "grossly overpaid bankruptcy professionals" in the 1970's. Seeing that a mutual fund business is "a license to steal", he entered the money management business in 1990 through the backdoor via a "hostile" takeover of a close end fund and then opening it. He confesses that he "goes to bed" with competent managers who kiss minority owners. And when Whitman got upset at his investors who exited his underperforming value funds in droves during 1989 and 1999, he told a reporter with undisguised relish, "As for dealing with the public, and you may quote me, screw 'em!"

With first-hand knowledge about the mutual fund business, Marty Whitman made large investments in asset management companies like Legg Mason. To Whitman, money management is a great business, better than the toll booth on George Washington Bridge. "Fund managers are prosperous �C no credit risk, no inventory, no fixed asssets, no liabilities, you are talking to the overhead," laughed Marty Whitman.

There are occasional tough times though. Third Avenue Fund's asset under management dropped from $50 billion to $38 billion during 1998 and 1999, which prompted Whitman to echo William Vanderbilt's famous line "The public be damned!"

And that's vintage Marty Whitman, someone who's honest and forthright to the core. He arrives for work on Manhattan's Third Avenue often dressed in an open-collared plaid work shirt, baggy blue cotton pants, worn sneakers, and white socks. One reporter claimed that he observed some sizable holes on Whitman's socks when he was already a multimillionaire. This author personally saw Marty Whitman carried an old and saggy polyester school bag to his talk at NYSSA. (On my lucky day, I could perhaps pick up a similar bag from a neighbor's garbage yard, and I am not exaggerating.) You could mistake this superinvestor for a street person. But Marty Whitman is a legend at picking over the balance sheets of troubled companies in search of hidden treasures. And his track record of approximately 17% per year since 1990 speaks for itself.

Safety First

According to Marty Whitman, the "safe and cheap" investor looks for four things in an investment:

* High quality balance sheet;
* Competent and shareholder-oriented management;
* Understandable and honest disclosure documents;
* Priced at 50 to 60 cents on a dollar.

The first three is related to how safe an investment is. The fourth relates to how cheap the stock is. And "safe" is more important than "cheap".

Assets Over Earnings

The first thing Marty Whitman wants is a "safe" balance sheet featuring high-quality assets, the absence of liability and the presence of cash. Without these, he doesn't even consider the common stock.

Whitman believes that scrutinizing the balance sheet is easier than trying to forecast earnings and predict stock market gyrations. Most investors are outlook-conscious. He is price-conscious. He hones his easy way of measuring price, quantity and quality. Everything is in the balance sheet - the only way you know whether you've covered all the bases is to look at the lists of assets and liabilities.

To Marty Whitman, balance sheets are much more important than the income statement. He believes that security analysis would be simpler if one focuses on the balance sheet while placing no emphasis on the income statement and earnings estimates.

Marty Whitman thinks that earnings and earnings power are vastly overrated. In his book, Value Investing: A Balanced Approach, he advises businessmen not to treat one accounting number, such as the bottom line, as more important than another. They are all part of the whole picture. Besides, profits are may be viewed as the least desirable way to create wealth because of the income-tax disadvantage. It's a lot easier to look at the quantity and quality of the assets and resources that a company has than to forecast its earnings. Assets can appreciate in value, can be enhanced, sold, or converted into something more productive.

Quality Assets

Graham & Dodd stressed the importance of balance sheet also. But Marty Whitman feels that Graham & Dodd talked more about quantitative instead of qualitative issues about the balance sheet. To Whitman, high quality means low debt, acreage of raw land, assets under management, fully paid rent, and other assets that can be easily valued. For example, some of his companies have huge investments in real estate, which may be classified as fixed assets disliked and ignored by Graham & Dodd. But Marty knows he can sell class "A" buildings with long-term creditworthy tenants easily by picking up the phone.

Marty Whitman thinks like a LBO control buyer. He asks: "How can I finance the transaction?" It is a balance sheet question regarding what can be put up as collateral to secure lending from the bankers.

Marty also has a special eye for well-positioned assets throwing off solid cash flows and using non-recourse debt. Unlike traditional debt, non-recourse debt holders or creditors lack the legal power to bring the debtors to the court or force a reorganization. So non-recourse debt is not a threat to the safety of the stockholders' position. For example, Forest City has a lot of debt but it is nonrecourse. In other words, the debt is taken on individual properties. The lender can't force the parent company into a reorganization if there's a default on a loan taken on a particular piece of property.

In terms of appraising the intangibles, Marty Whitman sticks to the easy ones, like the asset under management of a mutual fund. The intangible media assets are too hard for him. He recently took a look at Tribune Co. (TRB) and turned it down.

Marty Whitman watches out for the so-called-earnings that create "wealth" while consuming cash. If you have earnings that consume cash, sooner or later, you've got to have access to capital markets which may not be there when you need them.

Go To Bed With Competent Management

Marty Whitman looks for reasonably competent managing or controlling groups that care about minority shareholders. Community vs. conflict of interests is always the problem facing investors. Sole proprietorship is the only place where there is no conflict of interest.

Marty Whitman thinks that Warren Buffett's greatest talent is in his ability to judge people and appraise the management. And this special area is exactly where Whitman had the most of his screw-ups. Buffett is a control buyer, too.

Marty Whitman does spend a lot of time talking to the management, but he is much more document-driven than other money managers. "Evaluating the management is the toughest thing I do. By comparison, everything else is easy," said Marty Whitman. He had been impressionable when executives of semi-conductor equipment manufacturers visited him, feeling that each guy is more impressive than the next. He saw these really great managements that have a sense of urgency - great engineers trying to do good things. He also visited Japan, where they invested in some property-and-casualty insurers, where he thought he was dealing with deadheads who are not driven to create shareholder value.

Understandable and Honest Disclosures

Marty Whitman is very document-intensive. He feels that a company's documentary disclosures must be understandable so that someone with an I.Q. of 70 should be able to interpret the disclosures. He only invests in businesses where he can appreciate the excellent documentary disclosures from the company. If he can't understand the disclosure statements, he doesn't bother to meet the management.

Whitman doesn't meet the management before he studies the proxy statement, understand the compensation arrangements, analyze past transactions of the management, and scrutinize the accounting choices.

Whitman looks for the kind of company that provides excellent disclosure that supplements required filings and provides non-GAAP measures that is often critical in assessing the true health of a business and its balance sheet.

What Is Cheap?

After scrutinizing the assets, the management, and the disclosures, Martin Whitman makes sure that he places his buy orders at a big discount to the private market values of those quality assets - that is, to the net asset value per share. For example, his second largest position is Forest City Enterprises (FCE-A). When they were buyers, in the early 1990s, its income-producing properties were appraised at $80 to $90 per share. But you could buy all the shares you wanted for $17. The net asset value that Whitman talks about is what a company could sell for in a takeover or a private market auction.

What kind of a discount to net asset value is viewed as cheap by Marty Whitman? "No more than 50 or 60 cents on the dollar for what a business would be worth to a private takeover buyer," said Martin Whitman. Over 80% of his portfolio companies were acquired at a substantial discount to "readily ascertainable net asset values". This is not rocket science. A lot of real estate, marketable securities, mutual fund management companies which can be bought at intrinsic values of 3 to 4 % of assets under management (UAM). Toyota Industries is a way of buying Toyota Motors at a meaningful discount.

"It is absolutely crazy to pay more than 60 cents on a dollar for non-controlling interests in businesses. The outsiders always face agency problems," said Marty Whitman.

Valuation Rules Of Thumb

Marty Whitman has developed his own rules of thumb for calculating his buying prices for various types of businesses:

  1. Financial-services companies and depositories: Stated book value.

  2. Small banks: 80% of book value.

  3. Mortgage portfolio: Calculate yield to maturity and perform credit analysis.

  4. Financial-guaranty insurers: Adjusted book value - a publicly disclosed number that is book value plus the equity in the present value of certain future premiums.

  5. Insurance companies: Adjusted book value.

  6. Real estate companies: Private appraisal value or market value.

  7. Real Estate (REITs): Appraisal value or discounted present value of cash flow from operations.

  8. Broker/dealer and asset managers: Tangible book value plus 2% of AUM.

  9. Operating companies: 10 times peak earnings or below "net asset value."

  10. Tech companies: 2 times book value, less than 10 times peak earnings, 2 times revenue and cash larger than the book value of all liabilities.

Marty Whitman tries not to buy property and casualty insurers. He wants an underwriting loss of zero, but even the managers themselves don't know what the loss will be. He does invest in other type of financial institutions. He is currently using a 6% discount rate to capitalize cash flow from Hong Kong rental properties whereas those properties could be readily sold at 5% capitalization rate.

"We Are Growth Investors"

ccording to Marty Whitman, traditional growth investing is essentially paying up for widely recognized growth with the hope that the growth will continue.

"We are growth investors, too," declared Martin Whitman, "We buy into the kind of growth that is not generally recognized while most other growth investors buy into generally recognized growth and they have to pay up for that." The key here is to figure out the value of future growth. "Many people on Wall Street know the price of everything but the value of nothing," said Marty Whitman.

Sunday, June 18, 2006

The Problem With Indexes

The Problem With Indexes
June 16, 2006
By John Mauldin

The Problem With Indexes
When Does Your Large Stock Outperform?
Getting 2% of Alpha
Vancouver, La Jolla, and Home

This week we look at index funds, and specifically at problems that certain types of capitalization weighted index funds have. It is intuitively obvious that capitalization-weighted indexes have a larger proportion of their assets in the larger stocks. (Capitalization-weighted means that larger stocks are given more "weight" or proportion of the index or fund.) But is this what a rational investor should actually want? I think the information we look at today will surprise many.

On my way in to Las Vegas last Wednesday, I read a very interesting op-ed piece by Professor Jeremy Siegel of Wharton Business School. Basically, he says that "Fundamentally weighted indexes are the next wave of investing." On May 13 of 2005, I highlighted new research by good friend Rob Arnott, where he laid out the intellectual and practical arguments for a new type of fundamentally weighted index. By that, I mean that he says stock indexes and the funds associated with them should be based upon the underltying fundamentals of the companies and not just the size of the company. At that time I said his work would be the basis for a revolution in investing and would become hugely successful. The last year has proven me right. And now, these ideas are becoming mainstream enough to make the Wall Street Journal.

Why should the average investor care? Because fundamental indexing (and we will go into what that means below) is going to come to a 401k or pension plan near you. As we will see, this type of index is clearly superior to your average offering in such plans, and offers 2% or more of alpha per year over regular index funds. And 2% is huge over the lifetime of a pension fund. Let's look at what Siegel said:

"This new paradigm claims that the prices of securities are not always the best estimate of the true underlying value of the firm. It argues that prices can be influenced by speculators and momentum traders, as well as by insiders and institutions that often buy and sell stocks for reasons unrelated to fundamental value, such as for diversification, liquidity and taxes. In other words, prices of securities are subject to temporary shocks that I call 'noise' that obscures their true value. These temporary shocks may last for days or for years, and their unpredictability makes it difficult to design a trading strategy that consistently produces superior returns. To distinguish this paradigm from the reigning efficient market hypothesis, I call it the 'noisy market hypothesis.'

"The noisy market hypothesis easily explains the size and value anomalies. If a stock price falls for reasons unrelated to the changes in the fundamental value, then it is likely - but not certain - that overweighting such a stock will yield better than normal returns. On the other hand, stocks that rise in price more than their fundamentals become 'large stocks' with high P/E ratios that are likely to underperform.

"These discrepancies are not easy to arbitrage away on a stock-by-stock basis. The noisy market hypothesis does not say that every stock that changes price does so by more than what is justified by fundamentals. Any particular stock may still be undervalued when it moves up in price or overvalued when it moves down. New research indicates that there is a simple way that investors can capture these mis-pricings and achieve returns superior to capitalization-weighted indexes. This is through a strategy called 'fundamental indexation.' Fundamental indexation means that each stock in a portfolio is weighted not by its market capitalization, but by some fundamental metric, such as aggregate sales or aggregate dividends. Like capitalization-weighted indexes, fundamental indexes involve no security analysis but must be rebalanced periodically by purchasing more shares of firms whose price has gone down more than a fundamental metric, such as sales, and selling shares in those firms whose price has risen more than the fundamental metric....

"With the advent of fundamental indexes, we're at the brink of a huge paradigm shift. The chinks in the armor of the efficient market hypothesis have grown too large to be ignored. No longer can advisers claim that capitalization-weighted indexes afford investors the best risk and return tradeoff. The noisy market hypothesis, which makes the simple yet convincing claim that the prices of securities often change in ways that are unrelated to fundamentals, is a much better description of reality and offers a simple explanation for why value-based investing beats the market."

Siegel gave credit to my good friend Rob Arnott for the basic research. Rob challenged the conventional thinking with an explosive new study published last year (and highlighted here) in the Financial Analyst Journal. He also summarized it in a speech at my Accredited Investor Strategic Investment Conference last year. We're going to look again at a part of that speech today.

As usual, whenever Arnott's involved you have to have your thinking cap on. You will want to pay attention to this article, as Rob is going to show us how to get an extra 2% of alpha on our stock portfolios. So put up your tray tables and put on your seatbelts.

Today's letter will be a little bit different than my usual format in that almost the entire content will be directly quoting Arnott's speech. When the word "I" is used, it is Rob. So in place of the usual quotes, readers should assume that the content and intellectual property is essentially Rob's. If I want to get in a clarifying or personal side note, I will simply put it in brackets [like this].

By way of introduction, Rob serves as Editor of the Financial Analyst Journal. He has authored over sixty articles for journals such as the Financial Analyst Journal, the Journal of Portfolio Management and the Harvard Business Review. He is Chairman of Research Associates and is sub-advisor for the Pimco All Asset Fund, which now has over $6 billion. Rob is one of those guys who by walking into any given room is one of the smartest guys in the room, if not the smartest.

Rob starts out with the point that most of the financial world revolves around the use of various economic theories [Now to Rob]:

Any given economic theory will perfectly describe the world as long as you agree with the underlying assumptions. More often than not, however, the underlying assumptions take us from the real world into a world of, well, theory.

One of the most famous theories is the capital-asset pricing model (or CAPM). It is the basis for a number of index models, especially capitalization-weighted indexes like the S&P 500.

Now, for most of us, our biggest bet is in equities. Is theory leading us astray here? Let's suppose we have a perfect crystal ball. It can't tell us the share prices of every asset a year from now, or two years from now, but it can tell us the cash flows into the future on every investment we could make. The crystal ball lets us calculate the true fair value of every asset in the market. If we know the true fair value, then the market value will match that, the capital-asset pricing model will be correct, and the index will be perfectly efficient, in the sense that there is no way to boost returns without boosting risk.

Now let's suppose our crystal ball is just a little bit cloudy and we can't see the future precisely. Then what winds up happening is that every asset is trading above or below true fair value. We can't know what true fair value is. But we can know that every stock, every asset, every bond is going to be trading above or below what its ultimate true fair value is. Even the most ardent fans of the efficient markets hypothesis would say, "That's reasonable. That's reality."

Now if every asset is trading above or below its true fair value, then any index that is capitalization-weighted (price-weighted or valuation-weighted) is automatically going to have us overexposed to every single asset that's trading above its true fair value and underexposed to every single asset that's trading below its true fair value.

[Read that again. This is one of the reasons why value investing beats indexing over the long term.]

So this is the first time we've circled back to some concrete implications for the market. It means that the capitalization-weighted indexes on which our entire industry relies are fundamentally, structurally flawed and will inherently overweight every stock that's above fair value and underweight every stock that's below fair value.

Now let's look at what that does to returns. If you put most of your money in assets that are above fair value, you have proportionately too little in assets that are below fair value, and you're getting a return drag. The cap-weighted indexes are producing returns that are below what they should be, below what would be available in a valuation-indifferent index.

If you construct an index that is valuation-indifferent, that doesn't care what the PE ratios are, that doesn't care what the market capitalization is, then return drag disappears - and you can quantify it. It's about two to four percent per year. And how many managers out there reliably add two to four percent per year in the very long run? Darn few of them.

[Other studies show that about 80% of mutual funds underperform the market.]

Now while it's a bad index, equal weighting will outperform a cap-weighted index. [Equal weighting means that you put the same amount of money in a stock, no matter what its capitalization or share price.] A lot of folks think that equal-weighted indexes outperform mainstream capitalization indexes because they have a small-stock bias. The theory being that small companies beat large because they have a value bias, and cheap stocks outperform expensive ones. That's not quite correct. What equal weighting does is underweight every stock that's large, regardless of whether it's cheap or dear, and overweight every stock that's small, regardless whether it's cheap or dear.

This means that from a valuation perspective every stock that's overvalued is overweight in the cap-weighted index, and in the equal-weighted index it's a crap shoot, 50/50. You have even odds, whether it's overvalued or undervalued, of being over- or underweight.

Let's look at this from the vantage point of a concrete example. Let's suppose we have a world with two stocks. Each has a true fair value of a hundred bucks, but the marketplace doesn't know what the true fair value is. One stock is estimated by the market to really be worth fifty bucks and the other is estimated to really be worth a hundred and fifty, but both valuations are wrong. Capitalization weighting puts 75 percent on that overvalued stock.

Now suppose over the next ten years, today's valuation errors are corrected. Both stocks move to a hundred dollars, but a new 50-percent error is reintroduced because news has come along and people have been drawn into the hype that one company looks really good and the other looks really bad. These errors are introduced into the pricing, and you have a steady state: the size of the errors stays steady, but the old errors have been corrected. In that world, the estimated cap-weighted return is zero, and the equal-weighted return is 33 percent.

[Both stocks start at $50 and $150 for a total portfolio of $200. In ten years, both stocks are worth $100. If you cap-weighted your portfolio, you would not have made anything. If you put an equal $100 into the companies, you would have made $100 on the lower priced stock and lost $33 on the higher priced stock, for a portfolio profit of $67 on your original $200. Thus Rob's 33% return.]

When Does Your Large Stock Outperform?

In the May, 2005 issue of the Financial Analyst Journal, I published a short study in which I looked back over the last 80 years and asked the question, "How often does the number-one-ranked company in market capitalization outperform the average stock over the next one year, three years, five years, and ten years?" And the simple answer seems to be that on average, over time, about 80 percent of the time, the largest-capitalization company underperforms over the next ten years.

Now the magnitude of that underperformance is in the 40 to 50 percentage-point range - it's huge. The largest-capitalization company, on average, underperforms the average stock by 40 to 50 percentage points over the next ten years. You would expect the same pattern but less reliably in the top ten companies. Some of the top ten will deserve to be there; their true fair value is higher. Some of them will not deserve to be there. This symmetric pattern of errors will push many that don't deserve to be there into that top ten, and some of the ones that do deserve to be there, out of the top ten.

What do we find? On average, over time, seven out of ten of the top-ten stocks underperform the average stock over the next ten years, and three out of ten outperform. Meaning three out of ten probably deserved to be in that top ten. The average underperformance: 26 percentage points over the next ten years. So this is huge.

Now, how do we reconcile the fact that capitalization-weighted portfolios are market clearing - that is they span the entire market, they cover everything in exactly the proportion that the market owns those assets - with a return drag that is so easy to eliminate?

Getting 2% of Alpha

This gets back to finance theory and the capital-asset pricing model. I had a discussion with the originators of the model. There were two notable originators: a fellow named Jack Treynor and a fellow named Bill Sharp. And Bill Sharp's take on this was very simple, and that's that this couldn't possibly be. Jack Treynor's take on it was just as simple: "Wow, this is neat, this is correct, let me write a paper on it documenting why it works." So a very different reaction from the two co-founders of the capital-asset pricing model.

But the simple fact is, the capital-asset pricing model works if your market portfolio spans everything: every stock, every bond, every house, every office building, everything you could invest in on the planet including human capital, including the net present value of all of your respective labors going into the future. There's no such thing as an index like that. It doesn't exist. So right off the bat you can say that the S&P 500 is not the market, and anyone who says that it's efficient because it is the market is missing the point: it's not the market.

Can we improve on cap weighting? Absolutely! Any index that is replicable, objective, and focused on large and liquid companies which are easily tradable is a potentially useful index. Any such index that is valuation-indifferent should beat the stock market. If it doesn't care what PE ratios are or what the price is when setting how large your investment in an asset should be, it should beat cap weighting.

What could you do that would do that? You could look at book values. Find the thousand largest companies by book value and create an index weighted by book value. Never mind what the price is, never mind what the market capitalization is, simply do it by book value. You could do it based on revenues: which companies have the highest revenue base or sales, and then weight them by revenues or sales. You could even do it based on head count. What are the thousand biggest employers in the United States? How many people do they employ, and weight the index by the number of employees.

You can do anything of this sort, anything that captures the scale of a company, so you have a bias towards large and liquid companies that is replicable and objective but that doesn't pay attention to valuation.

Does it work? You bet. The graph below shows that the thousand largest by capitalization over the past 43 years, the red line, would have taken every dollar you invested and turned it into 70 dollars. Well that's awesome, that's what a quarter-century bull market from '75 to '99 does -- the biggest bull market in US capital markets history.

Taking a dollar to seventy dollars is remarkable. But if you use any of these other measures, any of them, you do roughly twice as well. In fact a little better than twice as well for the average: 160 dollars for every dollar at starting value. It's a huge gap. Look also at what happened after '99. The S&P 500 is still down 10 percent in total return including income. Fundamentally weighted indexes: up 30 percent.

[Note: I am not sure if you will be able to see all the different hypothetical indexes, but that is not the point. The point is that they all beat the cap-weighted index and all do it in pretty much the same manner. In any given year, one might have been better than the other, but they ALL beat cap weighting. The pattern is what is important and not the details. Also note that the fundamental indexes are far less volatile and lose less in bear markets.]

Comparison of Indexes, 1962-2004

So fundamental indexing does appear to offer structural advantages over conventional capitalization weighting. How does it work over time? In the next chart geometric return is over on the left. The S&P 500 comes in at 10.53 percent a year over the last 43 years. The reference cap -- the thousand largest by cap without the ministrations of the committee that selects which companies make it into the S&P -- stands about 0.18 percent lower, at 10.35 percent per annum. The average of the fundamental indexes? The worst of the fundamental indexes produces a 12 percent annual return, much better than the conventional indexes. And the best produce almost 13 percent -- the average is 12.50 with excess returns of 2.15 percent.

[Reference cap is what Rob uses to mean his universe of the largest 1000 stocks.]

How Significant is the CAPM Alpha?

(For those who are familiar with statistics, when the T statistic (t-stat) is over three, it's very significant. If you risk adjust, what you find is that on a risk-adjust basis you are adding closer to 2.5 percent per annum, because not only are you adding return, you're reducing risk. You aren't committing so much to the popular high fliers, the Krispy Kremes of the world, and then watching them implode. And so the statistical significance on a risk-adjust basis is off the charts - nearly a four T statistic.)

How consistent is this approach? It's awfully consistent. During economic expansions, you add almost two percent a year. During recessions - when you most need those returns - you add three and a half percent. During bull markets you add 40 basis points. You don't really add anything in bull markets, because they are driven more by psychology than by the underlying fundamental realities of the companies.

And so during bull markets you keep pace. Which is good; it's important. During bear markets you find yourself adding 600 to 700 basis points per annum. Bear markets are when reality sets in and people say, "Show me the numbers." Bear markets are when this really comes on strong. Also, during periods of rising rates, two and a half percent added. During periods of falling rates, one and a half percent added.
Results in Expansion & Recession, Bull & Bear Markets, Rising and Falling Rates

So what we find is that in an environment of a recession or a bear market or rising rates, when people are forced to say, "Show me the numbers," it works particularly well; but it also works to a slightly lesser extent in the contrary environment. That's not the same as value investing. Value investing does not work, does not add value during expansions, bull markets, or periods of rising rates. So this winds up being a really dominant approach to equity investing, and it's brand new. The work on this was just published two weeks ago.

Is it an index? Of course it can be an index. Is it passive while it's replicable, formulaic, and objectively constructed? Yes. But is it a total market portfolio? Not in a theoretically robust capital-asset pricing model context, because it doesn't span things equivalent to their weight in the actual market.

Are the cap-weighted indexes efficient? That is to say, can you improve on them [by constructing better models and indexes] without taking on more risk? Yes, you can. The classic indexes are not the market, and no commercially viable market portfolio exists; and even if one did it wouldn't matter, because the capital-asset pricing model is predicated on so many structurally flawed assumptions that the notion that the cap-weighted indexes must be efficient is the same as the notion that the underlying assumptions must be true.

Back to John: There is a lot more, but we are running short on time. There are very real implications in this model for long-short investing. Last year I predicted large institutions and pension plans will eventually move large portions of their equity assets into models like this. What's a 2% difference worth? Let's assume that whatever portfolio you start with, in 36 years you end up with one billion dollars. If you can increase portfolio performance by just 2%, you will end up with $2 billion. A 2% alpha doubles your returns over the longer time horizons of pensions.

Rob's firm has begun to exploit this research, of that you can be sure. I have said I think this will be the fastest fund idea to grow to $100 billion in history, and in ten years I think it will capture the bulk of the long-only fund world, as investors who must have exposure to the market seek ways to enhance their returns while reducing volatility.

Rob wrote me yesterday. "The ETF is already out. PRF started trading in mid-December. It's had a 99% correlation with the S&P 500 and has added over 250 basis points already. PowerShares is rolling out a small stock ETF, and ten sector ETFs, probably in August, and International, Japan and Emerging Markets, probably in Q4."

There are groups forming funds all over the world based on Rob's work. Coincidentally, I talked with a director of PowerShares last night here in Vegas. He is more than very enthusiastic about the potential for new ETFs on a wide variety of investment themes.

Is this a magic fund idea? No, it will lose money in a bear market just like any long-only fund. So, in my opinion, the time is not quite right, as I think we still have some downside. But when it is, this will be an option you will want to heavily consider for the long-only portion of your investment portfolios.

Saturday, June 17, 2006

Martin Whitman: What's Wrong With Value Investing?

By Brian Zen, SuperinvestorDigest.com

Value investors never hesitate when they ask "What's the bad news?" and "What's wrong?" Last year, Seth Klarman talked about the bad news of value investing and complained that the field is getting too crowded. On February 16 th, 2006, Martin Whitman went further to make a list about what's wrong with value investing in his talk at NYSSA. (An earlier article on Whitman's talk can be read here: Marty Whitman's "Cowardly" Safe-and-Cheap Way to Invest.)

The Problems with Value Investing

"There are a lot of things wrong with what we do," said Marty Whitman.

1) Compared to people who stare at the charts, value investors have tons of documents to read. Marty Whitman himself hired 17 analysts reading all those documents. It's very labor-intensive.

2) In order to get quality assets on the cheap, the near term outlook often sucks.

3) "Safe and cheap" companies often have the problems of low return on equity (ROE) due to concentration in underutilized assets positioned too conservatively. Management with whom Marty Whitman go to bed are just as conservative or even more conservative than Whitman himself. The management is often non-promotional people who don't need Wall Street. They don't care. One of the things that Whitman found with having competent management is that, the strong balance sheet allows them to be opportunistic. The management's ability to opportunistically take advantage of market inefficiencies has probably accounted for Whitman's 10 baggers more than anything else. When ultra conservative balance sheets meets opportunistic and able managers, a number of low ROE stocks turned into 10 or 20 baggers for Whitman as excess cash was converted into future earnings.

4) The safe and cheap investor is often subject to leverage buy out (LBO), management buy out (MBO), "take-under", or "going private" phenomenon. Most of Marty Whitman's positions were exited via takeovers. A lot of resource conversions, spin-offs, and liquidations happen within Whitman's portfolio.

5) Cheap stocks suffer the problems of poor marketability and liquidity. They are subject to the "roach motel" problem -- easy to check in, but very hard to check out. Thus, the returns are lumpy. Marty Whitman tries to avoid investment risk, or permanent impairment of capital. He pays no attention to market risk, or short-term price fluctuations. "If I recommend something, it soon goes down 20 percent," says Marty Whitman.

6) To be safe and cheap, you have to turn down a lot of ideas also. So you would miss a lot of good stuff that is a little pricy.

The Tao of Selling

Most of Marty Whitman's sellings are a result of resource conversion activity such as mergers, acquisitions, spin-offs, restructurings, etc. He would consider selling a security in the open market if:

1) as a portfolio consideration, the security appreciates and becomes excessively over-weighted in the fund;

2) a security becomes grossly overvalued; (They won't sell if something is moderately overvalued.)

3) a company experiences, or appears to have the potential for, a permanent impairment of capital; or,

4) their analysis was flawed and they made a mistake.

Marty Whitman has no hard-and-fast rules for selling. And he doesn't sell much. Their turnover rate is 16% in an active year. In essence, he doesn't depend on the stock market to deliver profits to him. He relies on the private market. Just like Warren Buffett, if the stock market is closed for five years, Marty Whitman wouldn't care. His investing style doesn't really depend on how the public stock market does. "If I'm right, these very undervalued companies will be taken over, liquidated or refinanced, and that's where you make your money," said Whitman.

According to Whitman, the "Safe and Cheap" approach works a lot better on the buy side than on the sell side. He sold many stocks after a double and then watched them triple in a hurry. So nowadays he tends to hold on to the moderately overvalued issues.

The Art of Distress Investing

In value investing, chapter 11 is the end. In distress investing, Chapter 11 is the beginning.

Marty Whitman looks for the senior-most debt issues and tries to get at least 500 basis points more in yield versus comparable credit. He would like to buy 50% or more of the senior debt of troubled companies at 15 to 20% yield to maturity. If it has to be reorganized, he converts all the senior issues into common stock. In some cases, there are prepackaged deals. He also buys into the debt of larger companies where his ownership percentages would be a lot less. He would be very interested if GM files bankruptcy.

In distress investing, the play-it-safe Marty Whitman doesn't want to be subordinate to any liabilities ahead of his claim, including off-balance-sheet liabilities. "We never did anything with tobacco stocks. In the history of Third Avenue, we virtually had no investments in old line manufacturing companies. After being investors in John Mansville credits, there is no way we would want to be junior to asbestos liabilities. There is virtually no old line manufacturing company that does not have asbestos liabilities," said Marty Whitman. And he missed the upside in the USG stock, which makes an interesting case study about the flip side of the "safe and cheap" approach.

Marty Whitman looks for debt issues that will never miss a payment, such as those of GMAC and CIT when it was controlled by Tyco. They have made huge amount of money in distressed situations like Nabors and Public Service of New Hampshire. He also buys a lot of trade claims.

But Marty Whitman has his share of blow-ups in distress investing. It's much like venture capital. "We have a high strikeout ratio. It's not easy," said Whitman.

The Huge Cost Of Reorganization

We all know that American CEO's are overpaid. But CEO's pay is nothing compared to the pay of bankruptcy professionals, said Marty Whitman. The cost of Enron's reorganization is $1 billion. And pre-petition creditors are paying for that. The key here is to shorten the process of reorganization. Bankruptcy administrative costs are payable in cash. You pay as you go. So the bankruptcy professionals have all the incentives to prolong the process. Marty Whitman told the following joke about bankruptcy lawyers:

A prominent bankruptcy attorney died young on his way to court, and found himself before the gates of Heaven. When he arrived, a chorus of angels appeared, singing in his honor. St. Peter himself came out to shake his hand. "Mr. Jones," said St. Peter, "it is a great honor to have you here at last. You broke the world record for longevity. You are older than Methuselah!"

"But I am only 40," said the attorney, "You must have made a mistake, Sir."

"No mistake here," said St. Peter confidently. "We have been carefully adding up the hours on your time sheets. You have lived 1,028 years!"

Global Values: Cheaper but Less Safe

Since the "safe and cheap" are becoming more difficult to find in America, Marty Whitman is now shopping in places like Hong Kong, Singapore and Japan. There are real risk of investing in foreign issues even though they are local blue chips, with financials audited by the Big Four because you are investing in jurisdictions where you don't get protection from the U.S. security laws. "Foreign issues are cheaper but less safe. You have communists crawling all over Hong Kong," laughed Marty Whitman, who estimated that foreign issuers are now approaching 50 percent of his portfolio.

"Because of Sarbanes Oxley, no foreign issuer like Toyota Industries will be willing subject to our jurisdiction unless they really need our capital. I think Sarbanes Oxley is screwing up our capital markets for foreign issuers and small companies," said Marty Whitman, who is known for his capacity for critical thinking. "We used to require that they have disclosures published in English, audited by the big four, with ADR trading in the U.S. Now we are dropping the ADR requirement because of Sarbanes Oxley."

For people used to the American culture, it is a lot harder to venture overseas. You need to understand foreign accounting rules also. For example, Hong Kong public companies list their fixed assets at appraisal value.

Top-Down vs. Bottom-Up

Martin Whitman believes that most people on Wall Street are top-down and those guys are still living in the 1930's. For the 70 years after the Great Depression, virtually every industry in the U.S. has gone through some sort of depression with similar magnitude of the 1930's saga. Yet the economy of the whole country never went through a depression ever since. The last time that global events were more important to long-term investors than the company-specific valuation deals in moving the stock market was 1933. "Bottom-up company and industry analysis counts a lot more, and top-down economy analysis is less meaningful nowadays," said Marty Whitman.

When asked how he sees his firm's future 10 years from now? Marty answered: "Well, I am in my 82nd year. (Applause) I assume we would do very well, and they would get rid of me. Or I may [go ga-ga], which may happen in another two weeks."

Don't be so fast, Mr. Whitman. St. Peter told me that your time sheet is not long enough due to your career switch. How about a few more cheap ones with star potential hiding on a safe bed and a few more jaw-opening moments?


Brian Zen, CFA, PhD, is the founder of Zenway.com Inc., an investment research firm that publishes Superinvestor Digest and provides training and advisory services to investors and analysts. Complete notes of Martin Whitman's talk at NYSSA can be requested from Brian at: bzen@zenway.com

Friday, June 16, 2006

Dealing With Market Corrections: Ten Do's and Don'ts

by Steve Selengut

A correction is a beautiful thing, simply the flip side of a rally, big or small. Theoretically, even technically I'm told, corrections adjust equity prices to their actual value or "support levels". In reality, it's much easier than that. Prices go down because of speculator reactions to expectations of news, speculator reactions to actual news, and investor profit taking. The two former "becauses" are more potent than ever before because there is more "self directed" money out there than ever before. And therein lies the core of correctional beauty! Mutual Fund unit holders rarely take profits but often take losses. Opportunities abound!

Here's a list of ten things to do and/or to think about doing during corrections of any magnitude:

  1. Your present Asset Allocation should have been tuned in to your goals and objectives. Resist the urge to decrease your Equity allocation because you expect a further fall in stock prices. That would be an attempt to time the market, which is (rather obviously) impossible. Proper Asset Allocation has nothing to do with market expectations.

  2. Take a look at the past. There has never been a correction that has not proven to be a buying opportunity, so start collecting a diverse group of high quality, dividend paying, NYSE companies as they move lower in price. I start shopping at 20% below the 52-week high water mark, and the shelves are full.

  3. Don't hoard that "smart cash" you accumulated during the last rally, and don't look back and get yourself agitated because you might buy some issues too soon. There are no crystal balls, and no place for hindsight in an investment strategy.

  4. Take a look at the future. Nope, you can't tell when the rally will come or how long it will last. If you are buying quality equities now (as you certainly could be) you will be able to love the rally even more than you did the last time... as you take yet another round of profits. Smiles broaden with each new realized gain, especially when most folk are still head scratchin'.

  5. As (or if) the correction continues, buy more slowly as opposed to more quickly, and establish new positions incompletely. Hope for a short and steep decline, but prepare for a long one. There's more to Shop at The Gap than meets the eye.

  6. Your understanding and use of the Smart Cash concept has proven the wisdom of The Investor's Creed. You should be out of cash while the market is still correcting. [It gets less and less scary each time.] As long your cash flow continues unabated, the change in market value is merely a perceptual issue.

  7. Note that your Working Capital is still growing, in spite of falling prices, and examine your holdings for opportunities to average down on cost per share or to increase yield (on fixed income securities). Examine both fundamentals and price, lean hard on your experience, and don't force the issue.

  8. Identify new buying opportunities using a consistent set of rules, rally or correction. That way you will always know which of the two you are dealing with in spite of what the Wall Street propaganda mill spits out. Focus on value stocks; it's just easier, as well as being less risky, and better for your peace of mind. Just think where you would be today had you heeded this advice years ago...

  9. Examine your portfolio's performance: with your asset allocation and investment objectives clearly in focus; in terms of market and interest rate cycles as opposed to calendar Quarters (never do that) and Years; and only with the use of the Working Capital Model, because it allows for your personal asset allocation. Remember, there is really no single index number to use for comparison purposes with a properly designed value portfolio.

  10. Finally, ask your broker/advisor why your portfolio has not yet surpassed the levels it boasted five years ago. If it has, say thank you and continue with what you've been doing. This one is like golf, if you claim a better score than the reality, you'll eventually lose money.

  11. One more thought to consider. So long as everything is down, there is nothing to worry about.

Corrections (of all types) will vary in depth and duration, and both characteristics are clearly visible only in institutional grade rear view mirrors. The short and deep ones are most lovable (kind of like men, I'm told); the long and slow ones are more difficult to deal with. Most corrections are "45s" (August and September, '05), and difficult to take advantage of with Mutual Funds. But amid all of this uncertainty, there is one indisputable fact: there has never been a correction that has not succumbed to the next rally... its more popular flip side. So smile through the hum drum Everydays of the correction, you just might meet Peggy Sue tomorrow.