What Next?

What should you do next?

If you were fully dependent on the market and lost most of your savings/capital, find a job. Try to survive until you save enough to meet other immediate needs.

If you saved part or whole of your capital from the avalanche, re-examine your situation:-
1. Make sure you have enough liquidity to meet your immediate needs. I would recommend 6-12 months of expenses in cash (under the mattress/in a safe/in a protected or insured savings account in the currency that you are going to spend). If you have a safe job, you can even consider your source of income towards this.
2. Look at your assets outside of this reserve, re-balance it. I would recommend going 80:20 into stocks:gold over the next 6 months. And, if you are young like me, a 5% on longer-term index calls in underpriced markets. Look for high-yielding stocks - either earnings yield or dividend and earnings yield. It means look for non-dividend paying stocks with high RONW and low PE or dividend-paying stocks at reasonable PE.

Maximum Pessimism yet?

It's interesting that every news report is talking gloom and doom. This would be a time to start looking for bargain buys. I'll be looking for:-
1. Stocks with businesses that are not affected by the current crises, but are treated guilty by association in the sector/name;
2. Undervalued businesses in other sectors that are getting even more beaten up; and
3. Businesses that will perform irregardless of the trend available at fair value.

I'll be looking in India, US and UK, primarily.

Sir John's Principle of Maximum Pessimism

“The right question is: Where is the outlook most miserable?” Templeton calls this
approach to investing “the principle of maximum pessimism.” Others might call it contrarianism. He explains it this way: “In almost every activity of normal life people try to go where the
outlook is best. You look for a job in an industry with a good future, or build a factory where the prospects are best. But my contention is if you’re selecting publicly traded investment, you
have to do the opposite.You’re trying to buy a share at the lowest possible price in relation to what that corporation is worth. And there’s only one reason a share goes to a bargain price: Because other people are selling. There is no other reason. To get a bargain price, you’ve got to look for where the public is most frightened and pessimistic.” - Sir John Templeton to FORBES.

Running on a treadmill to stay at the same place

Inflation is back in the news in India (Refer the shared article link). In this context, I was reading Warren Buffett's old article in Fortune from 1977. (Try this pdf for scanned version and this link). The clarity of thought is amazing and the ability to link capital deployment and social justice in one single context is a rare find for me. In the part titled "Five ways to improve earnings", he goes through the Dupont Model with impeccable clarity of thought. Here are some key extracts:-

"Stocks are quite properly thought of as riskier than bonds. While that equity coupon is more or less fixed over periods of time, it does fluctuate somewhat from year to year. Investors' attitudes about the future can be affected substantially, although frequently erroneously, by those yearly changes. Stocks are also riskier because they come equipped with infinite maturities. (Even your friendly broker wouldn't have the nerve to peddle a 100-year bond, if he had any available, as "safe.") Because of the additional risk, the natural reaction of investors is to expect an equity return that is comfortably above the bond return - and 12 percent on equity versus, say, 10 percent on bonds issued py the same corporate universe does not seem to qualify as comfortable. As the spread narrows, equity investors start looking for the exits.
But, of course, as a group they can't get out. All they can achieve is a lot of movement, substantial frictional costs, and a new, much lower level of valuation, reflecting the lessened attractiveness of the 12 percent equity coupon under inflationary conditions. Bond investors have had a succession of shocks over the past decade in the course of discovering that there is no magic attached to any given coupon level - at 6 percent, or 8 percept, or 10 percent, bonds can still collapse in price. Stock investors, who are in general not aware that they too have a "coupon", are still receiving their education on this point."
"What widows don't notice
The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital. It makes no difference to a widow with her savings in a 5 percent passbook account whether she pays 100 percent income tax on her interest income during a period of zero inflation, or pays no income taxes during years of 5 percent inflation. Either way, she is "taxed" in a manner that leaves her no real income whatsoever. Any money she spends comes right out of capital. She would find outrageous a 120 percent income tax, but doesn't seem to notice that 6 percent inflation is the economic equivalent."

"In the next ten years, the Dow would be doubled just by a combination of the 12 percent equity coupon, a 40 percent payout ratio, and the present 110 percent ratio of market to book value. And with 7 percent inflation, investors who sold at 1800 would still be considerably worse off than they are today after paying their capital-gains taxes.

I can almost hear the reaction of some investors to these downbeat thoughts. It will be to assume that, whatever the difficulties presented by the new investment era, they will somehow contrive to turn in superior results for themselves. Their success is most unlikely. And, in aggregate, of course, impossible. If you feel you can dance in and out of securities in a way that defeats the inflation tax, I Would like to be your broker - but not your partner."

Wesco - Meeting 2008

I am posting my (pdf) brief notes from the Wesco Meeting from May 7, 2008. Enjoy Charles T. Munger's "socratic solitaire". Here are some other links to posted notes as well.
Nick Henderson - How about that!
Peter Boodel through - Reflections on Value Investing

Don't forget to check out Berkshire Notes at Reflections on Value Investing

Berkshire Hathaway Meeting 2008

Posting the excerpts from the meeting (PDF). Approx. 31000 people attended this time. I missed out on some questions while I went out for food/water. Also, I haven't repeated similar answers from previous years.
Here are some more sources for meeting proceedings.
Morningstar
Omaha World Herald

Dodging a Bullet

I am posting the performance till March ending 2008 in this downloadable pdf.

If you had invested in Nifty ETFs on Mar 30th 2007 (last trading day in 2007) and stayed invested till 31 Mar 08, the Nifty portfolio would have earned 23.89%, not including dividends. As against this, my portfolio earned, 29.85% (not including dividends), an over performance of 6%. This has been achieved without the use of margin and derivatives.

A word of caution on the posted performance, though. A special situation investment involving a demerger is in the holdings. This particular investment ceased trading end of December and is expected to list soon with the subsidiaries. Until such time as it lists, it will be valued in the portfolio along with the subsidiaries at the last traded price.

The question this time for me has been, how do you measure a dodged bullet? (It would be the present value of future cashflows from the time you dodged to the time you finally meet the maker, no? - comments anybody?) For my investments, I will be attempting to plot the course of the performance as it would have appeared if I hadn't sold the ones I did early Jan. This would be a hard measure to keep track of, with the data I have, for a longer time frame. This is an attempt to compare actual performance against another simulated portfolio if I had held on to shares early Jan 08 with portfolio unchanged. I am expecting to post this graph in the coming months.




Two alternate views I had heard during the time I was coming to a compelling conclusion that market was over-valued were:-


One, in favor of buy and hold, and


Two, use of derivates (the financial weapons of mass destruction, as Buffett terms them in his 2002 letter (Page 14 in the pdf view))




The adherence to principles as against process is detrimental to investing. The comparison between the simulated portfolio and the attained actual performance disproves that adherence to buy and hold for over-performance. Something that works most of the time will not work all the time. As I had written earlier, goal number one is preservation of capital. As long as I am moving towards this goal, I am willing to question and disregard other principles where compelling evidence exists.


Arguably, in the simulated portfolio, I only lost what the market gave. This line of thinking is a slippery slope. I would have to start thinking that when I was born, I was born with no money. As a result arguably, losses of any kind should not make any difference. Even from this particular philosophical angle, I should see myself as a trustee of the wealth entrusted to me. I should measure my overall performance in what I end up with and what I transfer to others (though I am too young to consider such a transfer in the ordinary course of events). As Guy Fraser-Sampson talks about in his book "Multi Asset Class Investing", investing must be seen as a journey.

Here's another intuitive block to overcome when making such a decision. If you are going to be in cash, how is it investing? I am reminded of an old story I had heard in college. The scene is a big factory. A machine has stopped working and as a result, the whole production has stopped. All the top operations management is at the scene worried about potential loss of customers and goodwill. They call in the maintenance guy (outsourced, of course), who comes in, looks under the hood, takes a hammer and gives a gentle knock on a part. The machine comes back to life and the whole production is back on track. When the guy sends the invoice, the operations guys are appalled to see the huge bill for Rs.1 lakh (10 lakhs is one million) (this was a time when a lakh meant something). They ask him why should they pay a lakh to just hit the machine with a Rs.100 hammer. The guy explains that the Rs.100 is for the hammer, and the rest is for knowing where to hit with it. Such is the case with investing. Most of the time is spent on doing the background work, accumulating knowledge. Then you take the decision to go cash.

This interesting study published in New York Times talks about the frame of mind among decision makers also applies to investing.

The quote from 2002 letter must seem as a bias against use of derivatives to the reader. The revelation that I have used derivatives in other portfolios in this context must seem contradictory.

The problem with plain options like put or call on shares is that they have a decay factor to it. I am always against "owning" an asset that loses value by day. Anything with a decay on time should be treated as consumable. Cash Currency, by its inherent nature of inflation, has time decay to it and investing in stocks is a way to get around it. The view that you escape an 4-8% per annum decay in purchasing power (depending on your home currency) and end up with a higher decay (inflation plus risk premium) by "investing" in options doesn't seem to make sense.
Let us take the case of my view in early Jan that markets are over-valued. My alternative to selling shares was to have bought put options. So far good. The next step is trickier - what should be the term? I would go for longer term option that is deep out of the money to minimize time decay. At that point of time, there were only 3 month options available in India. If (a big if at that) I were able to time the market right, the pay-off was good, however, the risk of decay as well as the illiquidity risk due to lack of depth in the options market was high. As against this, was the alternative of selling and going in cash.

The two guidelines for me to "invest" in options, therefore are:

1. Minimize Decay by investing in longest-term and deep out of the money, and

2. Invest in markets with depth.

Investment - Key Metric

Posting an email response that I sent out recently(italicised phrase are for clarification) for a question on my previous post on TDYT:-
As an investor, I am interested in what I term "Real RONW". I define it as the Return on Net Worth (RONW) I get by investing at the current price. Let's say you have a business earning 30% RONW currently and it trades at 3 times book value, as an investor my real RONW will be 10% (30%/3). This is an indirect way of coming up with an accounting goodwill calculation. Usually I compare the real RONW to the expected yield on stocks/bonds to decide whether to do further research on the business. Let's say I am buying a significant stake in this business, the way I would pay (assume market price USD 30 per share), USD 20 as goodwill and USD 10 would be the net equity in the books on consolidation. At the end of a year, the business (assuming the business earned at the same rate) earns the same return, I would increase the net equity by USD 3 (30% of USD 10 Net Worth or 10% of USD 30, the price). As a result, even though the business earned 30% on its networth, I earn only 10% because I paid 3 times the book value.
For TDYT, I didn't have to go into this whole exercise. It was a screaming buy, just because of the P/E and the fact that management reported in 10k that their true value was somewhere close to USD 2.50. The more than 40% calculation was just the inverse of P/E (P/E was a little over 2, if I remember correctly). I also realised that the business was facing strong headwinds because of its presence in the housing market. This was one of the reasons I was looking at it as a short-term trade than a long-term buy.

Indian Markets

Mr.Market after 70 plus years of being called manic-depressive still continues to be so. What a drastic change in one week? Everything is so great one fine day. Suddenly, there is a sign put up that says discount sale - top tier IT companies going for 16 times earnings, FMCG even better, already discounted pharma - even cheaper. Earlier, in December, I had recommended a put option to a friend who was willing and able to take the risk. He was worried about the possibility that he would have to roll it over to the next month at a not so cheap time premium (interest, for the uninitiated). He was ecstatic that he sold his put at 75% profit one day and the next week, worried that he sold too early because the put was trading at what would have been a 300% profit.
I am in the Indian market for long-term. This might seem a contradiction to my sell statement from few weeks ago. Different times call for different strategies. When I see businesses selling for 30 times earnings, no matter how good it may be - it is underpricing of risk. If anything is certain, it is that this is an uncertain world. The overpricing of cash flows is a sign to me that it is time to sell. Why? Protection of Capital is my first priority. I would rather sell now and wait for another year or so to re-invest than count ephemeral book profit. Going by the larger trends prevailing, I would most probably not have to wait a full year before opportunities spring up.

The year that was 2007

As 2007 came to a close, the annualized return so far remains at 36.6% (35.7% - 2006), whereas Nifty is trying to play catch-up reaching 28.2% (2006 - 24.1%) and Sensex at 29.2% (2006- 26.3%).My return inclusive of dividends is 40.2% (2006 - 36.6%). I don't have a definite percentage target in my mind. As long as I am able to double the investment every 5 years, I should be satisfied.

In the first week of January, I have sold off majority of my holdings – most of which were trading at high PEs. It has been a good performance so far. However, it doesn’t guarantee future performance. There are companies trading at 30 times TTM earnings. At that multiple, comparing to an investment of 8% Fixed Deposit (taxable at 25%), it would take 9 years for the cumulative earnings yield of the stock to catch-up with the compound interest of the fixed deposit. So if you see the multiple re-rating downwards soon to 20, you need only wait 3 years, and 15 (anything less than 16.67, for that matter) would give instant excess returns.

Arguably, you could buy at 30 PE and sell soon at 31 PE. However, it is a game of musical chairs with liquidity replacing the handbell/music. I had a strong dislike for that game even as a kid. I haven’t found a compelling reason to like it in the last quarter century, either. Interestingly, Chuck Prince of Citi made a now infamous statement of 2007 that they are paid to dance, before booking the losses.

It doesn’t mean that my view on Indian economy has changed. I believe it will be more like the Nifty go-go era in the US Market for the high priced stocks. The economy is very strong and should continue to be strong. There are sectoral opportunities due to over-pricing of risk, on the other extreme. I will post the specifics as and when they play out with my positions, in accordance with my policy of no tips.