Here’s the second half of my most recent interview with Erin Ade at RT Boom/Bust. [First half located here.] We discussed:

  • Stock buybacks, particularly the buyback that GM is doing
  • Valuations of the stock market and bonds
  • Effect of the strong dollar on corporate earnings in the US
  • Effect of lower crude oil prices on capital spending
  • Investing in Europe, good or bad?

Seven minutes roar by when you are on video, and though taped, there is only one shot, so you have to get it right.  On the whole, I felt the questions were good, and I was able to give reasonable answers.  One nice thing about Erin, she doesn’t interrupt you, and she allows for a few rabbit trails.

I was on RT Boom/Bust yesterday with Erin Ade, and got to talk about:

  • Apple
  • The “Tech Bubble”
  • The “Bond Bubble”
  • Different sectors of the stock market, and their prospects.

This was the first half of the interview.  If they run the second half, I will post it.  Note my modest confusion on the tech bubble as I forget the second thing and try to recall it, while vamping for time.  I don’t often glitch under pressure, but this was a bad time to have a foggy memory (on something that I wrote myself).  Sigh. :(

Full disclosure: positions in sectors mentioned, but no positions in any specific securities mentioned

Photo Credit: Kevin Trotman

Photo Credit: Kevin Trotman

Before I write this evening, I have updated the blog’s theme so that it is more readable on mobile devices.  I’ve tried to preserve most of the best of the former design.  Let me know what you think.  Also, I have tried to get commenting to work using Jetpack.  For those that want to comment, if you can’t, drop me an email, and I will try to work it out.  I prefer more interaction than less, even if I can’t always get around to responding.

On to the two warning signs: the first article is The Fuzzy, Insane Math That’s Creating So Many Billion-Dollar Tech Companies.  This is about the terms that some private equity investors are getting that help to support current valuations of companies.  Here are a few examples:

  • Guarantees that they’ll get their money back first if the company goes public or sells.
  • They can also negotiate to receive additional free shares if a subsequent round’s valuation is less favorable
  • Warrants to allow the purchase of shares at a cheap price if valuations fall.

Here’s my take.  When companies try to offer protection on credit or market capitalization, the process usually works for a while and then fails.  It works for a while, because companies look best immediately after they receive a dollop of cash, whether via debt or equity.  Things may not look so good after the cash is used, and expectations give way to reality.

In the late ’90s and early 2000s a number of companies tried doing similar machinations because they had a hard time borrowing at reasonable rates, or, they wanted to avoid clear public disclosure of their debt terms.  In the bear market of 2000-2002, most of these schemes blew up, some catastrophically, like Enron, and some doing minor damage, like Dominion Power with their fiber ventures subsidiary.

When you hear about a guarantee, think about how large it is relative to the total size of the company, and what would happen if the guarantee were ever tapped by everyone who could.  If the guarantee is fueled by some type of dilution (issuing stock now or contingently in the future), maybe the total shares to issue would be so large that the price per share would collapse further.

There’s no magic here — there is no good way in the long run to guarantee a certain market cap or creditworthiness.  That said, I agree with the article, this sort of behavior comes near the end of a cycle, as does the behavior in this article: Why Bankers Are Leaving Finance for No-Salary Tech Jobs.

We saw this behavior in the late ’90s — people jumping to work at startups.  As I often say, the lure of free money brings out the worst in people.  In this case, finance imitates baseball: those that swing for the long ball get a disproportionate amount of strikeouts.  This also tends to happen later in a speculative cycle.

So be wary with private equity focused on tech, and any collateral damage that may come from deflation of speculative valuations in technology and other hot sectors.

Photo Credit: Fortune Live Media

Photo Credit: Fortune Live Media

As I mentioned yesterday, there wasn’t anything that amazing and new in the annual letter of Berkshire Hathaway.  Lots of people found things to comment on, and there is always something true to be reminded of by Buffett, but there was little that was new.  Tonight, I want to focus on a few new things, most of which was buried in the insurance section of the annual report.

Before I get to that, I do want to point out that Buffett historically has favored businesses that don’t require a lot of capital investment.  That way the earnings are free to be reinvested as he see fit.  He also appreciates having moats, because of the added pricing power it avails his businesses.  Most of his older moats depend on intellectual property, few competitors, established brand, etc.  Burlington Northern definitely has little direct competition, but it does face national regulation, and dissatisfaction of clients if services can’t be provided in a timely and safe manner.

Thus the newer challenge of BRK: having to fund significant capital projects that don’t add a new subsidiary, may increase capacity a little, but are really just the price you have to pay to stay in the game.  From page 4 of the Annual Letter (page 6 of the Annual Report PDF):

Our bad news from 2014 comes from our group of five as well and is unrelated to earnings. During the year, BNSF disappointed many of its customers. These shippers depend on us, and service failures can badly hurt their businesses.

BNSF is, by far, Berkshire’s most important non-insurance subsidiary and, to improve its performance, we will spend $6 billion on plant and equipment in 2015. That sum is nearly 50% more than any other railroad has spent in a single year and is a truly extraordinary amount, whether compared to revenues, earnings or depreciation charges.

There’s more said about it on pages 94-95 of the annual report, but it is reflective of BRK becoming a more asset-heavy company that requires significant maintenance capital investment.  Not that Buffett is short of cash by any means, but less will be available for the “elephant gun.”

Insurance Notes

Now for more arcane stuff.  There are lots of people who write about Buffett and BRK, but I think I am one of the few that goes after the insurance issues.  I asked Alice Schroeder (no slouch on insurance) once if she thought there was a book to be written on Buffett the insurance CEO.  Her comment to me was “Maybe one good long-form article, but not a book.”  She’s probably right, though I think I have at least 10,000 words on the topic so far.

Here are two articles of mine for background on some of the issues involved here:

Here’s the main upshot: reserving is probably getting less conservative at BRK.  Incurred losses recorded during the year from prior accident years is rising.  Over the last three years it would be -$2.1B, -$1.8B, and now for 2014 -$1.4B.  (See page 69 of the annual report.)  Over the last three years, the amount of reserves from prior years deemed to be in excess of what was needed has fallen, even as gross reserves have risen.  In 2012, the amount of prior year reserves released as a proportion of gross reserves was greater than 3%.  In 2014, it was less than 2%.

In addition to that, in general, the reserves that were released were mostly shorter-tailed reserves, while longer-tailed reserves like asbestos were strengthened.  In general, when longer-tailed lines of business are strengthened in one year, there is a tendency for them to be strengthened in future years.  It is very difficult to get ahead of the curve.  Buffett and BRK could surprise me here, but delays in informing about shifts in claim exposure are a part of longer-tailed lines of insurance, and difficult to estimate.  As I have said before, reserving for these lines of business is a “dark art.”

From page 91 of the annual report:

In 2014, we increased estimated ultimate liabilities for contracts written in prior years by approximately $825 million, substantially all of which was recorded in the fourth quarter. In the fourth quarter of 2014, we increased ultimate liability estimates on remaining asbestos claims and re-estimated the timing of future payments of such liabilities as a result of actuarial analysis. The increase in ultimate liabilities, net of related deferred charge adjustments, produced incremental pre-tax underwriting losses in the fourth quarter of approximately $500 million.

This was the only significant area of reserve strengthening for BRK.  Other lines released prior year reserves, though many released less than last year.

There were a few comments on insurance profitability.  In addition to asbestos, workers’ compensation lost money.  Property-catastrophe made a lot of money because there were no significant catastrophes in 2014, but rates are presently inadequate there, and BRK is likely to write less of it in 2015.

My concern for BRK is that they are slowly running out of profitable places to write insurance, which reduces BRK’s profitability, and reduces the float that can be used to finance other businesses.

Maybe BRK can find other squishy liabilities to use to create float cheaply.  They certainly have a lot of deferred tax liabilities (page 71).  Maybe Buffett could find a clever way to fund pensions or structured settlements inexpensively.  Time to have Ajit Jain put on his thinking cap, and think outside the box.

Or maybe not.  Buffett is not quite to the end of his “low cost of informal borrowing” gambit yet, but he is getting close.  Maybe it is time to borrow at the holding company while long-term rates are low.  Oh wait, he already does that for the finance subsidiary.

Final Notes

From an earnings growth standpoint, there was nothing that amazing about the earnings in 2014.  A few new subsidiaries like NV Energy added earnings, but existing subsidiaries’ earnings were flattish.  Comprehensive income was considerably lower because of the lesser degree of unrealized appreciation on portfolio holdings.

On net, it was a subpar year for Berkshire Hathaway.  The annual letter provided a lot of flash and dazzle, but 2014 was not a lot to write home about, and limits to the BRK business model with respect to float are becoming more visible.

Full disclosure: long BRK/B for myself and clients, for now

Photo Credit: Chuck Coker

Photo Credit: Chuck Coker || Another Dynamic Duo and their secret Batcave

This piece has kind of a long personal introduction to illustrate my point.  If you don’t want to be bored with my personal history, just skip down to the next division marker after this one.

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There will always be a soft spot in my heart for people who toil in lower level areas of insurance companies, doing their work faithfully in the unsexy areas of the business.  I’ve been there, and I worked with many competent people who will forever be obscure.

One day at Provident Mutual’s Pension Division [PMPD], my friend Roy came to me and said, “You know what the big secret is of the Pension Division?”  I shook my head to say no.  He said, ” The big secret is — there is no secret,” and then he smiled and nodded his head.  I nodded my head too.

The thing was, we were ultra-profitable, growing fast, and our financials and strategies were simple.  Other areas of the company were less profitable, growing more slowly, and had accrual items that were rather complex and subject to differing interpretations.  But since the 30 of us (out of a company of 800) were located in a corner of the building, away from everyone else, we felt misunderstood.

So one day, I was invited by an industry group of actuaries leading pension lines of business to give a presentation to the group.  I decided to present on the business model of the PMPD, and give away most of our secrets.  After preparing the presentation, I went home and told my wife that I would be away in Portland, Oregon for two days, when she informed me we had an important schedule conflict.

I was stuck.  I tried to cancel, but the leader of the group was so angry at me for trying to cancel late, when I hung up the phone, I just put my head on my desk in sorrow.

Then it hit me.  What if I videotaped my presentation and sent that in my place?  I called the leader of the group back, and he loooved the idea.  I was off and running.

One afternoon of taping and $600 later, I had the taped presentation.  It detailed marketing, sales, product design, risk control, computer systems design, and more.  If you wanted to duplicate what we did, you would have had a road map.

But the presentation ended with a hook of sorts, where I explained why I was so free with what we were doing.  We were the smallest player in the sub-industry, though the fastest growing, and with one of the highest profit margins.  I said, “The reason I can share all of this with you is that if you wanted to copy us, you would have to change an incredible amount of what you do, and kill off areas where you have invested a lot already.  I know you can’t do that.  But maybe you can imitate a few of our ideas and improve your current business model.”

So my colleague took the tape to the meeting, and when he returned, he handed me a baseball cap that had the word “Portland” on it.  He said, “You did it, Dave.  You won the best presentation of the conference award.  Everyone sent their thanks.”

Sadly, that was one of the last things I did in the Pension Division, as corporate management chose me to clean up another division of the company.  That is another story, but one I got few thanks for.

Today I call that hat “the $600 hat,” and I wear it to my kids baseball and softball games as I keep score.

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The secret of Berkshire Hathaway is the same as my story above.  There is no secret. Buffett’s methods have been written about by legions; his methods are well known.  The same applies to Charlie Munger.  That’s why in my opinion, there were no significant surprises in their 50th anniversary annual letter. (There were some small surprises in the annual report, but they’re kinda obscure, and I’ll write about those tomorrow.)  All of the significant building blocks have been written about by too many people to name.

Originally, this evening, I was going to write about the annual report, but then I bumped across this piece of Jim Cramer’s on Buffett.  Let me quote the most significant part:

…Cramer couldn’t help but wonder if things in the business world could be different if we approached other CEOs the way that Buffett is approached.

Perhaps, if the good CEOs were allowed to stay on longer like Buffett has or if people treated them as if they were their companies the way that Buffett is treated in relation to Berkshire, things could be different?

“Clearly something’s gone awry in the business world if we can praise this one man for everything he does, and yet every other chief executive feels shackled into being nothing like him,” Cramer said.

Cramer is very close to the following insight: the reason why more companies don’t imitate Berkshire Hathaway is that they would have to destroy too much of their existing corporations to make it worth their while.  As such, the “secrets” of Berkshire Hathaway can be hidden in plain view of all, because the only way to create something like it would be to start from scratch.  Yes, you can imitate pieces of it, but it’s not the same thing.

Creating a very profitable diversified industrial conglomerate financed by insurance liabilities is a very unique strategy, and one that few would have the capability of replicating.  It required intelligent investing, conservative underwriting, shrewd analysis of management teams so that they would act independently and ethically, and more.

Indeed, an amazing plan in hindsight.  Kudos to Buffett and Munger for their clever business sense.  It will be difficult for anyone to pursue the same strategy as well as they did.

But in my next piece, I will explain why one element of the strategy may be weakening.  Until then.

Full disclosure: long BRK/B for myself and clients

Photo Credit: Eddy Van 3000

Photo Credit: Eddy Van 3000

This piece is an experiment.  A few readers have asked me to do explanations of simple things in the markets, and this piece is an attempt to do so.  Comments are appreciated.  This comes from a letter from a friend of mine:

I hope I don’t bother you with my questions.  I thought I understood bid/ask but now I’m not sure.

For example FCAU has a spread of 2 cents.  That I understand – 15.48 (bid) – that’s the offer to buy and 15.50 (ask) – that’s the offer to sell.

Here’s where I’m confused.  How is it possible that those numbers could more than $1 apart? EGAS 9.95 and 11.13.  I don’t understand.  Is the volume just so low?  And last price is 10.10 which is neither the ask nor bid price.  Can you please explain?

You have the basic idea of the bid and ask right.  There is almost always a spread between the bid and the ask.  There can be occasional exceptions where a special order is placed, such as an “all or none” order, where the other side of the trade would not want to transact the full amount, even though the bid and ask price are the same.  The prices might match, but the conditions/quantities don’t match.

You ask why bid/ask spreads can be wide.  I assume that when you say wide, you mean in percentage terms.  Here the main reason: many of the shares are held by investors with a long time horizon, who have little inclination to trade.  Here is a secondary reason: the value of the investment is more uncertain than many alternative investments.  I believe these reasons sum up why bid/ask spreads are wide or narrow.  Let me describe each one.

1) Few shares or bonds are available to trade

Many stocks have a group of dominant investors that own the stock for the longish haul.  The fewer the shares/bonds that are available to trade, the more uncertainty exists in where the assets should trade, because of the illiquidity.

Because few shares are available to trade, price moves can be violent, because it only takes a small order to move the price.  Woe betide the person who foolishly places a large market order, looking to buy or sell at the best price possible.  I did that once on a microcap stock (the stock of a very small company), and ended up doubling the price of the stock as my order was fully filled, only to see the price fall right back to where it was.  Painful lesson!

As a result, those that make markets, or  buy and sell stocks tend to be more cautious in setting prices to buy and sell illiquid securities because of the difficulty of trading, and the problem of moving the market away from you with a large order.

I’ve had that problem as well, both with small cap stocks, and institutionally trading illiquid bonds.  You can’t go in boldly, demanding more liquidity than the market typically offers.  If you are buying, you will scare the sellers, and the ask will rise.  If you are selling, you will scare the buyers, and the bid will fall.  There is a logical reason for this: why would someone come into a market like a madman trying to fit 10 pounds into a 5-pound bag?  Perhaps they know something that everyone else does not.  And thus the market runs away, whether they really do know something or not.

In some ways, my rookie errors with small cap stocks helped me become a very good illiquid bond trader.  For most bonds, there is no bid or ask.  Some bonds trade once a week, month, or year… indicative levels are given, maybe, but you navigate in a fog, and so you begin sounding out the likely market to get some concept of where a trade might be done.  Then negotiation starts… and you can read about more this in my “Education of a Corporate Bond Manager” series… I know most here want to read about stocks, so…

2) Uncertainty of the value of an asset

Imagine a stock that may go into default, or it may not.  Or, think of a promoted penny stock, because most of them are in danger of default or a dilutive stock offering.  Someone looking to buy or sell has little to guide them from a fundamental standpoint — it is only a betting game, with volatile prices in the short run.  Market makers, if any, and buyers and sellers will be cautious, because they have little idea of what may be coming around the corner, whether it is a big news event, or a crazy trader driving the stock price a lot higher or lower.

For ordinary stocks, large enough, with legitimate earnings and somewhat predictable prospects, the size of the bid-ask spread reflects the short-run volatility of price.  In general, lower volatility stocks have low bid-ask spreads.  Even with market makers, they set their bid-ask spreads to a level that facilitates trade, but not so tight that if the stock gets moving, they start taking significant losses.  And, as I experienced as a bond trader, if news hits in the middle of a trade, the trade is dead.  You will have to negotiate afresh when the news is digested.

As for the “Last Price”

The last price reflects the last trade, and in this era where so much trading occurs off of the exchanges, the bid and ask that you may see may not reflect the true state of the market.  Even if it does reflect the true state of the market, there are some order types that are flexible with respect to price (discretionary orders) or quantity (reserve orders).  Trades should not occur outside of the bid-ask spread, but many trades happen without a market order hitting the posted bid or lifting the posted ask.

And though this is supposed to be simple, the simple truth is that much trading is far more complex today than when I started in this business.  I disguise my trades to avoid alarming buyers or sellers, and most institutional investors do the same, breaking big trades into many small ones, and hiding the true size of what they are doing.

Thus, I encourage all to be careful in trading.  Until you know how much capacity for trading a given asset has, start small, and adjust.

All for now, until the next time when I do more “simple stuff” at Aleph Blog.

Photo Credit: Roscoe Ellis

Photo Credit: Roscoe Ellis

I was reading an occasional blast email from my friend Tom Brakke, when he mentioned a free publication from Redington, a UK asset management firm that employs actuaries, among others. I was very impressed with what I read in the 32-page publication, and highly recommend it to those who select investment managers or create asset allocations, subject to some caveats that I will list later in this article.

In the UK, actuaries are trained to a higher degree to deal with investments than they are in the US. The Society of Actuaries could learn a lot from the Institute of Actuaries in that regard. As a former Fellow in the Society of Actuaries, I was in the vanguard of those trying to apply actuarial principles to risk management, both when I managed risks for insurance companies, worked for non-insurance organizations, and manage money for upper middle class individuals and small institutions. Redington’s thoughts are very much like mine in most ways. As I see it, the best things about their investment reasoning are:

  • Risk management must be both quantitative and qualitative.
  • Risk is measured relative to client needs and thus the risk of an investment is different for clients with different needs.  Universal measures of risk like Sharpe ratios, beta and standard deviation of asset returns are generally inferior measures of risk.  (DM: But they allow the academics to publish!  That’s why they exist!  Please fire consultants that use them.)
  • Risk control methods must be implemented by clients, and not countermanded if they want the risk control to work.
  • Shorting requires greater certainty than going long (DM: or going levered long).
  • Margin of safety is paramount in investing.
  • Risk control is more important when things are going well.
  • It is better to think of alternatives in terms of the specific risks that they pose, and likely future compensation, rather than look at track records.
  • Illiquidity should be taken on with caution, and with more than enough compensation for the loss of flexibility in future asset allocation decisions and cash flow needs.
  • Don’t merely avoid risk, but take risks where there is more than fair compensation for the risks undertaken.
  • And more… read the 32-page publication from Redington if you are interested.  You will have to register for emails if you do so, but they seem to be a classy firm that would honor a future unsubscribe request.  Me?  I’m looking forward to the next missive.

Now, here are a few places where I differ with them:

Caveats

  • Aside from pacifying clients with lower volatility, selling puts and setting stop-losses will probably lower returns for investors with long liabilities to fund, who can bear the added volatility.  Better to try to educate the client that they are likely leaving money on the table.  (An aside: selling short-duration at-the-money puts makes money on average, and the opposite for buying them.  Investors with long funding needs could dedicate 1% of their assets to that when the payment to do so is high — it’s another way of profiting from offering insurance in of for a crisis.)
  • Risk parity strategies are overrated (my arguments against it here: one, two).
  • I think that reducing allocations to risky assets when volatility gets high is the wrong way to do it.  Once volatility is high, most of the time the disaster has already happened.  If risky asset valuations show that the market is offering you significant deals, take the deals, even if volatility is high.  If volatility is high and valuations indicate that your opportunities are average to poor at best, yeah, get out if you can.  But focus on valuations relative to the risk of significant loss.
  • In general, many of their asset class articles give you a good taste of the issues at hand, but I would have preferred more depth at the cost of a longer publication.

But aside from those caveats, the publication is highly recommended.  Enjoy!

At Abnormal Returns, over the weekend, Tadas Viskanta featured a free article from Credit Suisse called the Credit Suisse Global Investment Returns Yearbook 2015.  It featured articles on whether the returns on industries as a whole mean-revert or have momentum, whether there is a valuation effect on industry returns, “social responsibility” in investing, and the existence of equity discount rate for the market as a whole.

There are no surprises in the articles — it is all “dog bites man.”  They find that:

  • Industry returns exhibit momentum
  • There is a valuation component in industry returns
  • Socially responsible investing doesn’t necessarily produce or miss excess returns
  • There is an overall equity discount rate, which is levered about 20-25 times, i.e., a 1% increase in the rate lowers valuations by 20-25%.

The first two are well-known for individual stocks, so it isn’t surprising that it happens at the industry level.  The third one has been written about ad nauseam, with many conflicting opinions, so that there is little effect is no big surprise.  The last one resembles research I saw in the mid-90s, where the effect of changes in real interest rates has about that impact on stocks.  Again, nothing new — which is as it should be.

But now some more on industry returns.  They found that industry return momentum was significant.  Industries that did well one year were likely to do well in the next year.  The second finding was that industries with cheap valuations also tended to do well, but it was a smaller effect.

So, using one-year price returns as my momentum variable and book-to-market as a valuation variable (both suggested in the article), I divided industries for companies trading in the US into quintiles (also suggested in the article) for momentum and valuation.  (Each quintile has roughly 20% of the total market cap.)  Here is the result:

IMVC

 

Low valuations are at the right, high at the left.  Low momentum at the top, high momentum at the bottom.  Ideally by this method, you would look for industries in the southeast corner.

To me, Agriculture, Information Technology, Security, Waste, Some Retail, and Some Transportation look interesting.  One in the far southeast that is not so interesting for me is P&C Insurance.  Yes, it has done well, and compared to other industries, it is cheap.  But industry surplus has grown significantly, leading to more competition, and sagging premium rates.  Probably not a great time to make new commitments there.

Anyway, the above table should print out nicely on two sheets of letter-sized paper.  Not that it would be a substitute for your own due diligence, but perhaps it could start a few ideas going.  All for now.

Photo Credit: NoHoDamon

Photo Credit: NoHoDamon

Brian Lund recently put up a post called 5 Reasons You Deserve to Lose Every Penny in the Stock Market.  Though I don’t endorse everything in his article, I think it is worth a read.  I’m going to tackle the same question from a broader perspective, and write a different article.  As we often say, “It takes two to make a market,” so feel free to compare our views.

I have one dozen reasons, many of which are related.  I do them separately, because I think it reveals more than grouping them into fewer categories.  Here we go:

1) Arrive at the wrong time

When does the average person show up to invest?  Is it when assets are cheap or expensive?

The average person shows up when there has been a lot of news about how well an asset class has been doing.  It could be stocks, housing, or any well-known asset.  Typically the media trumpets the wisdom of those that previously invested, and suggests that there is more money to be made.

It can get as ridiculous as articles that suggest that everyone could be rich if they just bought the favored asset.  Think for a moment.  If holding the favored asset conferred wealth, why should anyone sell it to you?  Homebuilders would hang onto their inventories. Companies would not go public — they would hang onto their own stock and not sell it to you.

I am reminded of some of my cousins who decided to plow money into dot-com stocks in late 1999.  Did they get to the party early?  No, late.  Very late.  And so it is with most people who think there is easy money to be made in markets — they get to the party after stock prices have been bid up.  They put in the top.

2) Leave at the wrong time

This is the flip side of point 1.  If I had a dollar for every time someone said to me in 1987, 2002 or 2009 “I am never touching stocks ever again,” I could buy a very nice dinner for my wife and me.  Average people sell in disappointment thinking that they are protecting the value of their assets.  In reality, they lock in a large loss.

There’s a saying that the right trade is the one that hurts the most.  Giving into greed or fear is emotionally satisfying.  Resisting trends and losing some money in the short run is more difficult to do, even if the trade ultimately ends up being profitable.  Maintaining exposure to stocks at all times means you ride a roller coaster, but it also means that you earn the long-term returns that accrue to stocks, which market timers rarely do.

You can read some of my older pieces on how investors earn less on average than buy-and-hold investors do.  Here’s one on how investors in the S&P 500 ETF [SPY], trail buy-and-hold returns by 7%/year.  Ouch!  That comes from buying and selling at the wrong times.  ETFs may lower expenses, but they also make it easy for people to trade at the wrong times.

3) Chase the hot sector/industry

The lure of easy money brings out the worst in people.  Whether it is tech stocks in 1987, dot-coms in 1999, or housing-related assets in 2007, there will always be people who think that the current industry fad will be a one-way ticket to riches.  There is psychological satisfaction to be had by buying what is popular.  Everyone wants to be one of the “cool kids.”  It’s a pity that that is not a good way to make money.  That brings up point 4:

4) Ignore Valuations

The returns you get are a product of the difference in the entry and exit valuations, and the change in the value of the factor used to measure valuation, whether that is earnings, cash flow from operations, EBITDA, free cash flow, sales, book, etc.  Buying cheap aids overall returns if you have the correct estimate of future value.

This is more than a stock market idea — it applies to private equity, and the purchase of capital assets in a business.  The cheaper you can source an asset, the better the ultimate return.

Ignoring valuations is most common with hot sectors or industries, and with growth stocks.  The more you pay for the future, the harder it is to earn a strong return as the stock hopefully grows into the valuation.

5) Not think like a businessman, or treat it like a business

Investing should involve asking questions about whether the economic decisions are being made largely right by those that manage the company or debts in question.  This is not knowledge that everyone has immediately, but it develops with experience.  Thus you start by analyzing business situations that you do understand, while expanding your knowledge of new areas near your existing knowledge.

There is always more to learn, and a good investor is typically a lifelong learner.  You’d be surprised how concepts in one industry or market get mirrored in other industries, but with different names.  One from my experience: Asset managers, actuaries and bankers often do the same things, or close to the same things, but the terminology differs.  Or, there are different ways of enhancing credit quality in different industries.  Understanding different perspectives enriches your understanding of business.  The end goal is to be able to think like an intelligent business manager who understands investing, so that you can say along with Buffett:

I am a better investor because I am a businessman, and a better businessman because I am an investor.

(Note: this often gets misquoted because Forbes got mixed up at some point, where they think it is: I am a better investor because I am a businessman, and a better businessman because I am no investor.)  Good investment knowledge feeds on itself.  Little of it is difficult, but learn and learn until you can ask competent questions about investing.

After all, you are investing money.  Should that be easy and require no learning?  If so, any fool could do it, but my experience is that those who don’t learn in advance of investing tend to get fleeced.

6) Not diversify enough

The main objective here is that you need to only invest what you can afford to lose.  The main reason for this is that you have to be calm and rational in all the decisions you make.  If you need the money for another purpose aside from investing, you won’t be capable of making those decisions well if in a bear market you find yourself forced to sell in order to protect what you have.

But this applies to risky assets as well.  Diversification is inverse to knowledge.  The more you genuinely know about an investment, the larger your positions can be.  That said I make mistakes, as other people do.  How much of a loss can you take on an individual investment before you feel crippled, and lose confidence in your abilities.

In the 25+ years I have been investing, I have taken significant losses about ten times.  I felt really stupid after each one.  But if you take my ten best investments over that same period, they pay for all of the losses I have ever had, leaving the smaller gains as my total gains.  As a result, my losses never inhibited me from continuing in investing; they were just a part of the price of getting the gains.

Temporary Conclusion

I have six more to go, and since this article is already too long, they will have to go in part 2.  For now, remember the main points are to structure your investing affairs so that you can think rationally and analyze business opportunities without panic or greed interfering.

Media Credit: Terence Wright

Media Credit: Terence Wright

This will be a short post. If we get a significant updraft in the price of oil, and Saudi production policy has not changed, you might want to sell crude oil price-sensitive assets. The marginal cost of production for a lot of crude oil that is shale related is around $50/barrel, and that is where I think the market “equilibrium” will bounce around for a few years, until global growth picks up.

I hold my positions for longer periods of time, so I may not do much off of this, but I would expect crude oil prices to be range-bound for a few years, with all of the volatility which a global commodity can have.

That’s all folks.