September 2015 – Page 2 – The Aleph Blog

Book Review: Charlie Munger: The Complete Investor

Posted on 5 September 20156 September 2015 by David Merkel

This book is written by an interesting man about another interesting man. ?Tren Griffin writes a respectable blog called 25iq. ?His main topics are the theory of value investing, and what he has learned from bright investors and businessmen. ?One of his favorite businessmen/investors that he likes studying is Charlie Munger, and that’s why he wrote the book.

Why is Tren Griffin interesting, aside from his writing? ?Well, he solved a practical problem of his own once using the ideas of Munger and Buffett. ?As an executive at Microsoft, he had a large block of Microsoft stock during the dot-com bubble. ?His dilemma: should he sell his stock or not? ?After reading Munger particularly, he came up with a solution that I would endorse: he sold half of his holdings. ?A lot of good investing is getting around psychological barriers so that you are?happy with your results, and be able to sleep well at night. ?Selling half is never the optimal solution, but it is a good one amid uncertainty, and allows you to stop sitting on your hands amid danger.

A lot of what goes into the thought processes of Charlie Munger involves how investors let fear or greed get the better of them, and cease to think rationally. ?Learning these foibles has two advantages: you can try to train yourself to avoid these problems, and take advantage of the irrationality of others in business and investing.

In his book, Tren Griffin takes you through Munger’s thoughts on Value Investing. ?Particularly interesting to me was how the concept of Margin of Safety changed, and what role Munger played in its development. ?The key change was noting that businesses differ in quality, especially as to how long they can maintain above average returns on their invested capital, and how much of their profits would be free to be reinvested in the business. ?An ideal business would be a natural monopoly with a high return on capital, and a need for continued capital investment somewhat less than its profits.

Tren Griffin?also introduces you to the mental models of Munger. ?Strong generalist knowledge in a wide number of areas can aid making business and investment decisions. ?One drawback is that many of the mental models are clear and adequately described — the ones on human psychology. ?The rest are more vague, and seem to be?what a true liberal arts education should be, including math and science. ?Munger is a lifelong learner, and given how much the world changes, if you want to be competitive, you have to continually update your knowledge.

For those who are familiar with the way that Munger thinks, this is old hat. ?But for those that are new to it, this book is an excellent introduction, and is systematic in?a slim 150+ small pages of information. ?On that basis, I recommend the book strongly.

But, if you’re still not sure whether you would like the book or not, or whether it would be a good book for a friend of yours, you have an easy way to help you decide. ?Just visit the author’s blog, and look at the topics page. ?Scroll down and find the topic “Charlie Munger.” ?Of the nine articles presently there, pick two of them and read them. ?If you like them, you will like the book.

Quibbles

From my past dealings with authors, I know they don’t always control the title of the book, but this book is half about Munger and half about value investing generally, particularly the version of value investing practiced at Berkshire Hathaway. ?There are ample quotations from Buffett and other value investors along with more from Munger. ?If I had been structuring the book, I would have made it entirely about Munger, and might have included a biography if the book had not been long enough.

The appendices are a good example of that, in that they are less about what Munger thinks, and more about the way Berkshire Hathaway views value investing. ?The last appendix doesn’t seem to mention Munger at all.

Summary / Who Would Benefit from this Book

If you’ve read a lot of Munger, this book will likely not benefit you. ?If you are new to the thoughts of Charlie Munger, or want aid in clarifying his thoughts into a system, this book will help do that. ?If you want to buy it, you can buy it here: Charlie Munger: The Complete Investor.

Full disclosure:?I?received a?copy from a friendly?PR flack.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

When to Double Down

Posted on 5 September 2015 by David Merkel

Here is a recent question that I got from a reader:

I have a question for you that I don?t think you?ve addressed in your blog. Do you ever double down on something that has dropped significantly beyond portfolio rule VII?s rebalancing requirements and you see no reason to doubt your original thesis? Or do you almost always stick to rule VII? Just curious.

Portfolio rule seven is:

Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.

This rule is meant to control arrogance and encourage patience. ?I learned this lesson the hard way when I was younger, and I would double down on investments that had fallen significantly in value. ?It was never in hope of getting the whole position back to even, but that the incremental money had better odds of succeeding than other potential uses of the money.

Well, that would be true if your thesis is right, against a market that genuinely does not understand. ?It also requires that you have the patience to hold the position through the decline.

When I was younger, I was less cautious, and so by doubling down in situations where I did not do my homework well enough, I lost a decent amount of money. ?If you want to read those stories, they are found in my Learning from the Past series.

Now, since I set up the eight rules, I have doubled down maybe 5-6 times over the last 15 years. ?In other words, I haven’t done it often. ?I?turn a single-weight stock into a double-weight stock if I know:

The position is utterly safe, it can’t go broke
The valuation is stupid cheap
I have a distinct edge in understanding the company, and after significant review I conclude that I can’t lose

Each of those 5-6 times I have made significant money, with no losers. ?You might ask, “Well, why not do that only, and all the time?” ?I would be in cash most of the time, then. ?I make decent money on the rest of my stocks as well on average.

The distinct edge usually falls into the bucket of the market sells off an entire industry, not realizing there are some stocks in the industry that aren’t subject to much of the risk in question. ?It could be as simple as refiners getting sold off when oil prices fall, even though they aren’t affected much by oil prices. ?Or, it could be knowing which insurance companies are safe in the midst of a crisis. ?Regardless, it has to be a big edge, and a big valuation gap, and safe.

The Sense of Rule Seven

Rule Seven has been the rule that has most protected the downside of my portfolio while enhancing the upside. ?The two major reasons for this is that a falling stock triggers a thorough review, and that if I do add to my position, I do so in a moderate and measured way, and not out of any emotion. ?It’s a business, it is not a gamble per se.

As a result I have had very few major losses since implementing the portfolio rules. ?I probably have one more article to add to the “Learning from the Past Series,” and the number of severe losses over the past 15 years is around a?half dozen out of 200+ stocks that I invested in.

Summary

Doubling down is too bold of a strategy, and too prone for abuse. ?It should only be done when the investor has a large edge, cheap valuation, and safety. ?Rule Seven allows for moderate?purchases under ordinary conditions, and leads to risk reductions when position reviews highlight errors. ?If errors are eliminated, Rule Seven will boost returns over time in a modest way, and reduce risk as well.

Plan and Act, Don’t React

Posted on 2 September 2015 by David Merkel

An investor can and should learn from the past. ?He should never react to the recent past. ?Why? ?The past can’t be changed, but it can be known. ?Reacting to the recent past leads investors into the valleys of greed and regret — good investments missed, bad investments incurred.

We’ve been in a relatively volatile environment for the last two weeks or so. ?Markets are down, with a lot of noise over China, and slowing global growth. ?Boo!

The markets were too complacent for too long, and valuations were/are higher than they should be, given current earnings, growth prospects and corporate bond yields. ?It’s not the best environment for stocks given those longer-term valuation factors, but guess what? ?The market often ignores those until a crisis hits.

The FOMC is going to tighten monetary policy soon. ?Boo!

The things that people are taking on as worries rarely produce large crises. ?They could mark stocks down 20-30% from the peak, producing a bear market, but they are unlikely of themselves to produce something similar to 2000-2 or 2008-9.

Let’s think about a few things supporting valuations and suppressing yields at present. ?The overarching demographic trend in the market leads to a fairly consistent bid for risky assets. ?It would take a lot to derail that bid, though that has happened twice in the last 15 years. ?Ask yourself, do we face some significant imbalance where the banks could be impaired??I don’t see it at present. ?Is a major sector like information technology or healthcare dramatically overvalued? ?Maybe a little overvalued, but not a lot in relative terms.

There are major elections coming up next year, and a group of politicians harmful to the market will be elected. ?This is a bad part of the Presidential Cycle. ?Boo!

Take a step back, and ask how you would want your portfolio positioned for a moderate pullback, where you can’t predict how long it will take or last. ?Also ask how you would like to be positioned for the market to return to its recent highs over the next year. ?Come up with your own estimates of likelihood for these scenarios, and others that you might imagine.

We work in a fog. ?We don’t know the future at all, but we can take actions to affect it, and our investing results. ?The trouble is, we can adjust our risk profile, but our ability to know when it is wise to take more or less risk is poor, except perhaps at market extremes. ?Even then, we don’t act, because we drink the Kool-aid in those ebullient or depressed environments. ?We often know what we should do at the extremes, but we don’t listen. ?There is a failure of the will.

This is a bad season of the year. ?September and October are particularly bad months. ?Boo!

I often say that there is always enough time to panic. ?Well, let me modify that: there’s also always enough time to plan. ?But what will you take as inputs to your plan? ?Look at your time horizon, and ask what investment factors will persistently change over that horizon. ?There are factors that will change, but can you see any that are significant enough for you to notice, and obscure enough that much of the rest of the market has missed it?

Yeah, that’s tough to do. ?So perhaps be modest in your risk positioning, and invest with a margin of safety for the intermediate-to-long-term, recognizing that in most cases, the worst case scenario does not persist. ?The Great Depression ended. ?So did the ’70s. ?Valuations are higher now than in 2007. ?(Tsst… Boo!) ?The crisis in 2008-9 did not persist.

That doesn’t mean a crisis could not persist, just that it is unlikely. ?Capitalist systems are very good at dealing with economic volatility, even amid moderate socialism. ?Go ahead and ask, “Will we become like Greece? ?Argentina? ?Venezuela? ?Russia? ?Spain? ?Etc?” ?Boo!

It would take a lot to get us to the economic conditions of any of those places. ?Thus I would say it is reasonable to take moderate risk in this environment if your time horizon and stomach/sleep allow for it. ?That doesn’t mean you won’t go through a bear market in the future, but it will be unlikely for that bear market to last beyond two years, and even less likely a decade.

The Surprise Dividend

Posted on 1 September 20152 September 2015 by David Merkel

This is just a “what if” piece. If one of my readers knows better than me, leave a comment, or email me. Thanks.

The Surprise Dividend

Imagine one day in 2019 that your favorite dividend-paying stock made the following announcement:

Dear Shareholder,

As you may know, we currently pay a dividend of $2/year to holders of our common stock for each share they hold. ?In this current climate where there is uncertainty over whether dividends will be cut at some companies, we would like to guarantee the current payout, and give you more.

We are replacing the current dividend and declaring a special payout?today — an unsecured perpetual junior subordinated bond that will pay 80?cents quarterly per current share, payable to all current shareholders as of June 1st, 2019. ?It will be eligible to trade separately under the ticker [TICKER]. ?You are free to sell this income stream for a current gain, or you can continue to receive this income in perpetuity, as will any future holder of this bond.

Why are we doing this? ?The Total Revenue And Safe Harbor Act of 2018 repealed special treatment of dividends, but interest is still tax-deductible to us as a corporation. ?Much as we like the flexibility of dividends, our cash flow is more than sufficient, and can handle a higher payout. ?This higher payout?is possible partially because this is an interest payment, and we get to deduct the payment from taxable income. ?With our current corporate tax rate of 35%, the effective cost of the new dividend to the corporation is $2.08 per current share.

Many of our shareholders are not taxable, or have taxes deferred. ?Still others are retirees who are in lower personal tax brackets. ?We expect that some current shareholders in higher tax brackets will choose to sell their bonds. ?We would not be surprised to find life insurance companies as willing buyers, given our high credit rating, and their need for long bonds as investments.

Though in the near-term, we will not pay a dividend, that does not mean we will never pay a dividend again. ?We will review our payout?policy regularly, and make changes as we see best. ?It is also possible that future shareholders could see further issuance of these securities if?our reliable excess cash flow grows.

As always, we welcome your inquiries to our Investor Relations Department. ?Please be aware that this does not constitute tax advice, nor will we provide that to you. ?Please give your tax questions to your own personal tax adviser.

Many thanks for being one of our shareholders. ?We hope you prosper in 2019 and beyond.

I left aside the argument that now shareholders could choose their own income preference, and also that the income from a junior subordinated bond could survive bankruptcy (though unlikely), and could control the company post-bankruptcy (also unlikely). ?Mentions of bankruptcy don’t travel well, even in vague terms.

I also did not mention that the package of the junior bond and the post-dividend stock would likely trade at a higher price post-event. ?Might some activist investors try some more severe proposals of?this sort?

Your thoughts on this proposal are welcome. ?I can’t think of any firm that has done something like this in the past. ?Might they do it in the future?