Jason Zweig of the Wall Street Journal has an interesting piece up called Could Computers Protect the Market From Computers?  I appreciate Jason, he writes a lot of intelligent stuff, and had the guts to revise one of my favorite books, “The Intelligent Investor.”

We are talking about positive feedback loops, where computers amplify the actions of humans demanding action now.  Computers, for all of their strengths, are rules based, and we the humans feed them the rules, or the information that allows them to react to data as they emerge.  The rules may be very complex, but they are rules, and do not allow for humans to modify the computer’s reaction to the market on-the-fly.

I’m skeptical that we can stop unusual things from happening resulting from computers trading rapidly by having other computers monitor it.  First, stocks are volatile, and news can break that leads to significant rallies/declines.  Second, part of the difficulty from the “flash crash” was computers getting out of sync with one another.  We can’t guarantee that the regulatory computers might not fall behind the trading computers, and what might happen if the “right” action to slow trading emerges slowly.

Third, one has to recognize that you should only have regulations that are understood easily by participants, and accepted, or else the rules will face a lot of lobbying pushback.

I think that there is little to no gain to the market as a whole from sub-second trading speeds.  I think we could slow down the market, and force a more rational market than what we currently have, by limiting the ability to cancel orders — all orders must be good for at least one second.

Markets need good rules and structure to work well.  Rather than having shadowy computer overlords, which only academics could like, craft a rule that says, “One auction per second.”  Or create a central order book and eliminate alternative venues for execution.  The cost listed in the article is cheap.  I’m agnostic on what the best solution is, but to me, the best solution involves slowing things down, so that information does not cause cascades off of short-term signals.

Even simple rules like, “Stop trading for any company that has dropped/risen by more than 5% on the day for 30 minutes,” would be preferable to any guidance from computers that is less clear.

Rather than using computers and complex reasoning, we need simple rules to slow things down, or…who cares, let errors happen.  I made money on the day of the “flash crash” by buying shares of a company that was solid but temporarily depressed.  Teach people not to use market orders or they could get harmed.

This is the market, after all, and if you are “bellying up to the bar,” you should be ready for the fact that you are outgunned.  You are likely not smarter than all of the resources being deployed against you by hedge funds, high frequency traders, etc.  Secondary markets in equities exist to provide flexibility to holders of the equities, most of whom hold their stocks every day, with only a small fraction trading.  Trading is a sideshow to value creation, which happens in the companies, not the exchanges.

Which makes me take step back and mention that Buffett wouldn’t care if the exchanges were closed for a year, because he buys solid companies.  Suppose for a moment, I had written an article called 391 Auctions, where I would suggest that the markets have one auction each minute, and that all orders must last until the end of the minute, with no cancellations.  (After I wrote, this I changed the article title, so I did do it.)

With 391 auctions per day, who couldn’t think that we were providing enough opportunity for price discovery each day?  Slow things down, and ignore those arguing for technical efficiency versus those arguing for rational markets that allow people to make reasonable decisions in real time.  One auction per minute?  Could work well — watch the bids and asks line up, once per minute.

Markets need structure to work well.  This could be one way of doing it; I am open to other ideas, but letting the computers attempt to do it opaquely seems like a loser to me.  Slowing things down seems like a winner, because secondary trading is a sideshow to the real value creation that happens inside the companies.

Dynamic hedging only has the potential of working on deep markets.

Arbitrage pricing can reveal proper prices in smaller less liquid markets if there are larger, more liquid markets to compare against.  The process cannot work in reverse, except by accident.

The recent case of JP Morgan’s hedging activities bring to light an observation that should be clear to all but isn’t.  Hedging only works when you are small relative to the markets in which you hedge.

Let’s consider tranched credit index default swaps.  We can create models where the prices of each tranche can be calculated given default frequency and severity.  But default is not a constant beast.  Defaults come in waves, and when incidence is high, so is severity of loss.  Vice-versa when incidence is low, leaving aside fraud.

We might have a good idea of where credit default should trade for a basket of corporate debtors “credits” so long as we look at the thing as a whole,  and don’t carve it up.  In general, a basket of borrowers is easier to predict than individual borrowers.

But the basket gets difficult when we split it up into first loss, second loss, third loss, etc. claims where different parties lose their capital at differing levels of total loss.  Yes, in theory, we can come up with prices.  We can even come up with hedge ratios  that show the theoretical tradeoff between tranches as losses increase or decrease, which might work, might, if you are a small player in that market.

Woe betide you, if you do anything too fancy, and you are big relative to the market.  Because you are big, you have affected the prices of the market.  Price relationships that were normal before you arrived have shifted and reflect your interests, which in the short-run makes your accounting look better.  As the bubble grows, those investing in the bubble look better.  But as the bubble expands, those that have invested in it find a wave of cash fighting against them, but it doesn’t matter, because momentum investors are still buying.

At the end, the large investor amid the bubble finds himself stranded.  The market knows his positions, and he can’t make trades to extricate himself, because the terms are onerous.

Look, I used to trade small-issue lesser-known bonds.  I only bought stuff that I knew would be money-good, i.e. pay off.  In that case, you have the option of speculating when spreads are wide, and selling when they get tight.  But if you do that with bonds that you don’t know whether they will likely pay in full, the ability to hedge is meaningless, because your hedge could break in a default.

And so it was for JP Morgan.  When you get too big relative to the market, it had better be when you are the buyer or seller of last resort, and you are catching the turn.  But in normal markets, bigs are pigs, and are likely to be slaughtered.

It doesn’t matter what your model says is the right tradeoff if you are too big relative to the market.  Your own actions have poisoned the signals that your models receive.

Amaranth fell into this same bucket, with a talented energy trader who understood how the market generally worked.  As his success grew, so did his size, and he didn’t realize that the size of the fund was distorting market prices.  At the end there was one unlikely scenario that was unhedged, and that was the scenario that occurred, and the results led to the collapse of the fund.

If Amaranth had been smaller they could have traded out of it.  At their size, they were “elephants in an elevator.”

Size matters, and for investment purposes, smaller is better.  And for the most part, less complex is better too.  Don’t demand liquidity from markets, or you will lose.  If liquidity comes to your door, and it seems to be a good deal, wave it in.

Dr. Jeff Miller wrote an interesting question the other day:

“Why does a Shiller disciple care about profit margins?“

Now, I am not a disciple of Dr. Shiller, I disagree with him on many issues, Trills for an example.  When Shiller talks, odds are 50-50 that I agree, which makes him interesting to me, unlike Bernanke and Krugman who I almost always disagree with, and James Grant and Caroline Baum, who I almost always agree with.  Someone who agrees with me and disagrees with me equally is interesting, because he makes me think harder.

And with his cyclically-adjusted price-earnings [CAPE] ratio, I was a reluctant partial convert.  Consider this piece.

There are a couple ways to answer the question:

1. Most stocks are cheap on a forward P/E basis, less so on a trailing P/E basis, and still less so on a P/B or P/S basis.  The difference between P/E and P/S is profit margin — E/S.
2. Consider the critiques from Dr. John Hussman, who awaits the reset that will come if/when profit margins get competed down.
3. My answer: we should care about it a little, for the above reasons.  But labor is no longer scarce, which leads to higher profit margins for a time while wages are depressed.

My view is that profit margins will not revert to mean for many years, until the increase in capitalist labor is absorbed.  Until then economic results will be poor those that labor on the low end — you have got a lot of new competition.

As I wrote earlier:

A reason to consider the validity of the CAPE is twofold: it has a huge similarity to Tobin’s Q-ratio, which compares market capitalization to replacement cost.  It also has a similarity to Michael Alexander’s Price-to-Resources ratio, out of which the book makes a lot (link here for an example).  It’s a Price-to-Adjusted Book value ratio as I see it.

The CAPE has value as a proxy.  It mirrors overall market value pretty well, like other fundamental ratios.

But I don’t agree, at least in part because profit margins should remain high, until readily obtainable labor is less scarce.  Getting there could be a long time.  Profit margins could remain high for a long time as a result, leaving  markets in a limbo zone, where it treads water as underlying value builds.

So profit margins should remain high for now.  Once labor is scarce globally,  and companies must pay more to get more or better quality labor, then will profit margins come under stress.

One of the problems with many politicians, journalists, financial analysts, economists, etc., is that they don’t think systematically.  Go back to late 2006, when I wrote my piece Wrecking Ball Looms for Big Housing Spec, which was regarding the coming subprime crisis.  (Note: my editor often retitled my pieces; my original title was more circumspect.)  Or read my piece in mid-2005 regarding the impending unwind of leverage and prices in residential real estate, Real Estate’s Top Looms.  Both of those are inside the wall at RealMoney.  Apologies if you can’t read them.

At the beginning of the crisis, most economists, including the present Fed Chairman, said that problems ere limited, because they only affected limited areas of the residential real estate market.  Now, part of that response reveals that the Fed and other regulators beneath them had not been doing their jobs, because it is well-known now that underwriting quality of all residential mortgage lending had deteriorated.

When an economic system is overleveraged, with leverage that is layered, such that a domino effect can occur, small failures can have disproportionate results.  It is almost like the economic system during the bull phase self-organizes for the largest possible failure.  (Note: self-organizing systems do not always optimize for the long term.  Think: what other ideas could that invalidate?)

An overlevered residential real estate system had the possibility of a self-reinforcing decline in prices, once prices started declining nationally.  Now we face a still-overlevered residential real estate sector with a lot of the market inverted, where people owe more than the house is worth, though pockets on the low end of prices show recovery in some areas of the US.

Little things are important.  Some people say, “How can Greece pose so much risk to the rest of Europe?  It’s economy is so small relative to the rest of Europe.  Well, that’s where the leverage comes in again.

Core Eurozone banks have lent to Greek entities, and those banks are not well-capitalized.  If Greece left the Eurozone, and repaid loans in depreciated New Drachma, it would lead to a crisis in confidence regarding loans made to Spain, Portugal, and Italy.  The exposure of core Eurozone banks is significant, to the point where it could cause a broader crisis.

Little things are important where the system has been optimized; where something near perfection is needed to insure the proper performance of the over-evolved system where many entities are playing for a slice of the cash flow, and most have over-borrowed, and overpaid.

The optimized scenario is akin to the dominoes being set up, and they are beautiful, but woe betide the one who knocks over a domino.  (Note: as a kid, I would build domino structures, but would leave out every tenth domino, in order to create something where if I made a mistake, only a little would fall down.  The last dominoes were added with the greatest care.)

There are some worries in the US over European exposure.  I don’t think that is likely, except with some of the biggest banks.  Maybe that could spill over, but I doubt it.  If it does spill over, it will prove that the biggest banks should be broken up.  My favored way is to regulate banks like insurers.  You can do business across state lines, but you are tightly regulated by your state.  Much better than what we have currently.

Survivable systems exist when adequate returns are earned without high leverage.  That may sound vague, but vague is often the best we can do in economics.

When debts are complex, aim for simplicity.  Complex systems tend to die.  Simple systems survive.  This is a rule of value investing, measure simplicity versus reward.  Complexity has a price; avoid it unless well compensated for it.

This book has just been released.  I got an early copy.  The book is interesting enough that I would like to do a Q&A with the author, and I have contacted the PR flack to do so.

To the review:

Would you like to understand the mindsets of a variety of successful hedge fund managers?  This book will give that to you, but there is a catch: you will also learn how these managers developed, and this is a big plus.

Most of the managers went through rigorous experiences that made them far more effective at evaluating risk and return potentials.   Have you been through anything similar to that?  If not, you might read this very interesting set of accounts, but then realize that you don’t have the personality/skills necessary to replicate what they have done.  Don’t feel bad, most people don’t have that.

A large part of what makes hedge fund managers successful is their willingness to limit their activity to areas where they have genuine expertise.  They gain insight beyond most into areas where they are experts in discerning value.

This book does not give you a formula for how to make money; instead, it gives you lessons in the characters of those that have made a lot of money for themselves and their clients.  What are they like?

Among their many attributes, they are:

• Driven/competitive — though I have known my share of failures in investing that have that attribute.
• Lifelong learners, like Buffett and Munger — though I have known some really bright people who know a lot about investing/finance who add little to an investment process.
• Opportunistic — they recognize what their best opportunities are, and pursue them to the exclusion of others.
• Focused — they develop an edge, and try to be “best in class,” whether in mathematics of the markets, understanding the legal rights of different types of securities, understanding industry dynamics, accounting nuances, etc.
• Patient — if opportunities are not promising, don’t do much.  It’s like being an intelligent underwriter — when your competitors are giving away the store, don’t write business, spend time sharpening your skills.  Study what could go wrong, and see if there is a way to take advantage of the situation.
• Team-builders — They develop talented teams/cultures and motivate them to excellence.
• Sensible — They know when to be doggedly persistent, and know when to admit defeat.

Now, no hedge fund manager has all of these, but the best have most of them.

Contents

The book covers nine managers/firms:

1. Ray Dalio — Bridgewater
2. Pierre LaGrange & Tim Wong — MAN Group / AHL
3. John Paulson — Paulson & Co.
4. Marc Lasry and Sonia Gardner — Avenue Capital Group
5. David Tepper — Appaloosa Management
6. William A. Ackman — Pershing Square Capital Management
7. Daniel Loeb — Third Point
8. James Chanos — Kynikos Associates LP
9. Boaz Weinstein, Saba Capital Management

About the Author

Her name is Maneet Ahuja, and is a producer for CNBC, specializing in covering hedge funds.  That’s how she gained the contacts in order to write the book.  Business Insider did a profile on her, and you can find it here.

Quibbles

The book needs something to tie it together and give it depth, otherwise the book is only “Meet these nine nifty hedge fund managers that I have gotten to know.”  That’s a serious deficiency; even a single chapter at the front or back would have enriched the book, making it more general and cohesive.

I also think there would have been better choices for those that wrote the foreword (Mohamed El-Erian) and the afterword (Myron Scholes).  The former is an accomplished investor, but is not an expert on hedge funds.  Myron Scholes is an accomplished academic, has worked for hedge funds, but is still not an expert on them.

Who would benefit from this book: If you want to learn about what type of people these nine hedge fund managers are, and read anecdotes about some of their best and worst trades, this would be a book you would enjoy.  If you want to, you can buy the book here: The Alpha Masters: Unlocking the Genius of the World’s Top Hedge Funds.

Full disclosure: The book was sent to me out of the blue; did not ask for it.

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.

I appreciate Eddy Elfenbein.  He comes up with ideas that make me say, “Huh. Interesting.  Let’s test that.”  His recent article, World’s Simplest Stock Valuation Measure, put forth the idea that:

Growth Rate/2 + 8 = PE Ratio

Cool, reminds me of my 1993 formula for value investing:

Price per share < Tangible Book per share + 5 * EPS

Eddy’s idea is that you can buy a company that isn’t growing or shrinking earnings at a PE of 8, or alternatively, a E/P (earnings yield) of 12.5%.  In a weird environment like this, it means an earnings yield that is more than 9% over the long bond is a good purchase.  I like that idea, it offers a good reward for taking risk.

But as the growth rate rises, you can expand the PE multiple by half of the anticipated growth rate.  So, a company anticipated to grow at a 10% rate would warrant a PE multiple of 13, a 20% rate 18, etc.  I like his formula, because it is conservative.  It seeks growth at a reasonable price.  It will not overpay for high growth rates.

But now let’s test this statistically to see what validity it presently has.  I ran a regression on Current year expected PEs versus expected 3-5 year growth rates.  I excluded all companies with fewer than two analysts putting forth growth estimates.  Here were the results:

Significant results statistically, but what a low R-squared.  Just shows us all how complex the market really is.  Look at this graph to see it as it is:

There really doesn’t seem to be much of a relationship.  But Eddy’s formula is conservative versus the estimates.  His formula invests in no-growth  companies  at an earnings yield of 12.5%, the market does so at an earnings yield of 8.4%.  His formula increases the PE multiple at a 50% rate as earnings increases, but the market does so at a 69% rate.

Good for Eddy, and any that follow him.  His method builds in a margin of safety, which is a key to all good investing.

Before I close I would like to offer the 20 most mispriced companies, both positively and negatively.  Just be aware that the markets are complex, and this valuation method is simple, and most likely wrong… but it can provide a jumping-off point for due diligence.

Potential Buys

Potential Sells

That’s all for now.

This book is written by one of the foremost stock investors in emerging markets, Mark Mobius.  This is a short book that has little to no math in it, and few graphs.  It can be read in 2-3 hours.

The edge that this book will give you is understanding the limitations of emerging market investing.  What are those limitations?

1) Emerging markets are volatile, and dependent on the overall health of the developed economies.  Companies in emerging markets often export to the developed nations.  Emerging market governments often gear their monetary policy to aid their exporters, which forces them to absorb the loose or tight monetary policy of the developed nations.

2) Emerging markets often lack legal safeguards on property rights that developed markets take for granted.  Remember that there is a difference between “rule of law” (governments are subject to a constitution), and “rule by law.” (governments make laws to enforce their will on everyone else)

3) Accounting methods may be less well-developed.  Typically this leads to valuation discounts, until the accounting is deemed as trustworthy as in the developed nations.

4) Corporate governance can be weak, with insiders getting significantly more benefits than shareholders.  Getting to know whether the board & management are honest, and acting for the good of all is critical.

5) Frontier emerging markets offer a lot of potential for profit, but they have all of the above problems, and much larger.  When there are few foreign investors in a market, safeguards are few.  Ask who registers the shares, and you may find that no one does, or the company does, so how can you prove you are the owner.

6) As a result, one must insist on a large margin of safety when investing in emerging markets.  That involves a good balance sheet, cheap valuation, and growth potential.

7) Emerging market investing is a hybrid — look at the country, the industry, and the company itself.  To buy, you have to have some confidence in most/all of them.

Opportunities are often best after a large pullback in the nation’s stock index.  Buy the strongest most liquid names after a crisis.  They will come back.

9) Privatizations are often good opportunities to buy; the company will do much better once there is a profit motive.

10) Banks are mirrors of the local economy; they lead the market down and up.  Anything affecting the economy in specific affects the banks, because usually bond markets are not active.

11) To be long emerging market stocks, you have to be an optimist.  It is similar to being a high-yield bond manager.  Investment grade bond managers are paid to be pessimists; there is little to no upside.  High yield managers have some upside that they play for; they are always more optimistic.  So it is for emerging market stock managers — there is a lot of upside to play for , so they have to be optimists.

12) As such, investing in emerging markets takes a lot of work to do it well.  And if you read the book, you might think by the end that you don’t have enough information to do it on your own, and I think you would be right.

Think for a moment about all of the scandals over Chinese reverse mergers with US shell companies — and these are listed in the US!  What hope does a US investor have of investing in emerging markets at a distance?  Accounting differences, disclosure differences, legal rights can be different… it could be a full time job.

This is why you need a manager of an open-end or closed-end mutual fund, or at least an exchange-traded fund [ETF] to invest in.  Mark Mobius explains how difficult it is to do it yourself, without saying that bluntly to you as I am doing.  Personally, I would encourage investing in a broad fund that can go anywhere, and not a country-specific fund, unless you have a very strong view of why a particular market will do well.

I recommend this book so that you can learn, but I think at the end, you won’t do much with it, except buy a mutual fund or an ETF.

Quibbles

This is a “little book.”  As such, you only get a taste.  If you want a full meal from Mr. Mobius, you might get this book: Passport to Profits: Why the Next Investment Windfalls Will be Found Abroad and How to Grab Your Share.

Who would benefit from this book:People who want an introduction to emerging market investing, including the market cycles would benefit from this book.  If you want to, you can buy the book here: The Little Book of Emerging Markets: How To Make Money in the Worlds Fastest Growing Markets (Little Books. Big Profits).

Full disclosure: This book was sent to me without my asking for it.

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.

This stretches from August 2010 to October 2010:

The Education of a Corporate Bond Manager, Part VII

On the value of credit analysts.

The Education of a Corporate Bond Manager, Part VIII

On price discovery in dealer markets, and auctions gone wrong.  I never knew that I could haggle so well.

The Education of a Corporate Bond Manager, Part IX

On the vagaries of bulge-bracket brokers, and how a good reputation helps on Wall Street.

The Education of a Corporate Bond Manager, Part X

On how we almost did a CDO, and how it fell apart.  Also, how to make money in the bond market when you reach the risk limits.

The Education of a Corporate Bond Manager, Part XI

On my biggest mistakes in managing bonds.  Also, on aggressive life insurance managements.

The Education of a Corporate Bond Manager, Part XII (The End)

On bond technical analysis, and how to deal with a rapidly growing client.   Also, the end of my time as a bond manager, and the parties that came as a result.   Oh, and putting your subordinates first.

Queasing over Quantitative Easing

Queasing over Quantitative Easing, Redux

Queasing over Quantitative Easing, Part III

Queasing over Quantitative Easing, Part IV

Queasing over Quantitative Easing, Part V

Queasing over Quantitative Easing, Part VI

The problems with the Fed’s seemingly “free lunch”strategy.  Pushes up asset prices and commodity prices, benefiting the rich versus the poor.

The Economic Geography of Publicly-Traded Companies in the United States by Sector

The Economic Geography of Publicly-Traded Companies in the United States by Sector (II)

Shows what US states have diversified vs concentrated economies by sector, and what states dominate each sector.

Portfolio Rule One

Industries are under-analyzed, relative to the market on the whole, and relative to individual companies. Spend time trying to find good companies with strong balance sheets in industries with lousy pricing power, and cheap companies in good industries, where the trends are not fully discounted.

Portfolio Rule Two

Purchase equities that are cheap relative to other names in the industry. Depending on the industry, this can mean low P/E, low P/B, low P/S, low P/CFO, low P/FCF, or low EV/EBITDA.

Portfolio Rule Three

Stick with higher quality companies for a given industry.

Portfolio Rule Four

Purchase companies appropriately sized to serve their market niches.

Portfolio Rule Five

Analyze financial statements to avoid companies that misuse generally accepted accounting principles and overstate earnings.

Portfolio Rule Six

Analyze the use of cash flow by management, to avoid companies that invest or buy back their stock when it dilutes value, and purchase those that enhance value through intelligent buybacks and investment.

Portfolio Rule Seven

Of Investment Earnings Assumptions and Century Bonds

If we could turn back the clock 65 or so years and set up a more conservative method of accounting for pension liabilities, we would be much better off today.

Who Dares Oppose a Boom?

This piece won a small prize, and in turn, I received three speaking engagements.

Fairness Versus Economics

Fairness Versus Economics (2)

People care more about fairness than improving their own economic/social position.

Earnings Estimates as a Control Mechanism, Flawed as they are

Earnings Estimates as a Control Mechanism, Flawed as they are, Redux

Earnings estimates have their problems, but they exist to give us a flawed method of estimating the future performance of companies.

-==-=-=-=-=–=-=

That’s all for now.  Never thought I would do so many long series when I started blogging.

Before I start this evening, if you like my reviews generally, please go to Amazon and tell them that my reviews are helpful.  From this link, it does not take long to do so.  Thanks.

This was one of those books that grew on me.  The author, the well-known John Mauldin, strings together a bunch of ideas originated by others.  That’s not much different than what Tadas Viskanta does at Abnormal Returns.  He brings us the best ideas that he has culled from others.  That is a significant piece of work that should not be denigrated by others.

The beginning of the the book is consumed with 12-20 year market cycles.  There are times when investing in risky assets where you face headwinds and tailwinds. The headwinds and tailwinds are driven by valuation, often expressed through Q-ratio, CAPE, or Michael Alexander’s Price-to-Resources ratio, out of which the book makes a lot (link here for an example).  It’s a Price-to-Adjusted Book value ratio as I see it.

Regardless of the method, if you buy in at high valuations, the wind is in your face, and you are not likely to earn much.  The opposite is true for low valuations, but at the valuation trough, everyone is disgusted, and few are willing to buy.

So it takes a strong stomach and mind to follow a method like this.  Strong stomach, because when it is time to buy one will fear that the money will be lost.  Strong mind, because near valuation peaks people will tell you that you are nuts to leave the party — it’s just getting started.

But what if a decent sized portion of institutional money did this?  The cycles would go away, or be muted.  That’s not likely to happen in my opinion: some men may change, but you can’t change mankind.  Emotions of fear and greed dominate over clear thinking.

The book touches on many other topics:

• Why strategies go in and out of favor
• Why to be skeptical of those who give investment advice (including Mauldin & me)
• That the growth rate of the economy eventually limits the growth rate of any company.
• The effect of demographics on the markets
• Why chasing performance doesn’t work.
• Why most newsletter writers strategies could never be as good as they state, or they manage money in tiny niches.
• How to detect value in stocks.
• How to use bonds and commodities in asset allocation.

I say “touches on” because in line with its title, it is a “little book.”  You are only getting a taste of what an intelligent investor who hires other managers to manage money for clients thinks.  This is especially true as you go through the section on value investing, which does not get much beyond dividend yield, dividend growth, and price-to-book (common equity).

As such, this book will not be a complete answer to any investor wanting to learn about the markets.  It introduces basic concepts in ways that most ordinary people could learn.  Reading time should be less than two hours.  One more thing, the book has very little in the way of math.

I appreciated the short summaries at the end of each chapter.  If someone wanted to get the gist of the book, they could read all of the short summaries in about 10 minutes, and then they would have the skeletal ideas of the book, allowing them to read all or part of the book with greater understanding.

Quibbles

The book could have used an index.

Who would benefit from this book:People who want an introduction to investing, including long-term market cycles would benefit from this book.  It would be of modest help to experienced investors who understand market cycles.  If you want to, you can buy the book here: The Little Book of Bull’s Eye Investing: Finding Value, Generating Absolute Returns, and Controlling Risk in Turbulent Markets (Little Books. Big Profits).

Full disclosure: This book was sent to me without my asking for it.

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.)

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Buffett made a few comments over the weekend that I thought were significant.

Warren Buffett, who built Berkshire Hathaway Inc. (BRK/A) with stock picks before focusing on takeovers, said he recently opted against a $22 billion acquisition because he didn’t want to sell investments in marketable securities. (Article here)

and

Berkshire Hathaway Inc is adding to its shareholdings of two U.S. companies amid a market dip, billionaire investor Warren Buffett said on Monday. (Article here)

and

Mr. Buffett said he and Mr. Munger “have nothing against” commercial insurance and pointed out that they’ve expanded in the medical malpractice field. “If we could find a quality company in commercial lines… we would buy it in an instant,” he said.

…

Another analyst question prompted Buffett to discuss how he values Berkshire’s non-insurance operations. Rubalcava was excited by the answer, in which Buffett said he’d look to buy similar businesses for nine to 10 times earnings. (Article here)

1) On the first point, he does not want to sell marketable securities is quite a statement.  It means he expects more return off of public securities than whatever the target might have been.   Given that he would only be liquidating $5 billion of securities to maintain the $20 billion buffer, it either could not have been that good of a deal, or Buffett has a high view of his current public securities portfolio.

But I sat down and thought about what Buffett might have wanted to acquire.  It could have been a private company; I have no data on that.  What if it were a public company and one with a low P/E and decent prospects, what could it be?

Well, the current market cap would have to be between $15-20 Billion, and so I came up with the following tickers:

PPG APD NOC RTN VFC BRFS PSX DFS AON ALL CME TMO BDX RCI TU PSO RUK WM ETN AEP

There are some with large moats: PPG, APD, NOC, RTN (Chemcials and Defense) AON, CME unique businesses, hard to challenge.  Other moats: VFC, TMO, BDX, RCI, TU, PSO, RUK, WM, ETN

Pipelines, which fit into other BRK subs: PSX

Free cash flow generators: PSX and DFS

Cheap providers of float: ALL  (Of course there would be issues merging Allstate and GEICO, if you merge them at all.  You could keep both systems whole, you could sell off Allstate’s Life companies, or you could merge them into existing BRK insurance subs.  Me?  I would sell the life subs,  and analyze whether having an agency force had value.  My guess would be no, and I would spread the Allstate inforce block onto the current GEICO support system after a year or two.)

Adds to the utility portfolio: AEP

I’m not saying BRK should buy any of these companies, but they seem to be reasonable possibilities for BRK to buy.

2) So BRK is buying two companies that they already own.  What could they be?  My two best guesses are General Dynamics [GD] and DirectTV [DTV].   BRK bought them in the last reported quarter and the price hasn’t moved much.  Other possibilities include: WFC, SNY BK, INTC, USB, CVS, IBM, DVA, V, VRSK, and LMCA.

3) If BRK really wants to get into commercial insurance at a cheap price there is an easy choice — ACE.  Low P/E, P/B, reasonable reserving.  Yes, it is in Bermuda, but that offers BRK other ways to lower its tax bill, which Warren Buffett aggressively pursues.  He never pays a dime more than he has to!

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These are just my musings, don’t give them more emphasis than that.  Buffett offers a few crumbs at his buffet, and I make an effort to offer ideas consistent with what little he said.  I am very likely to be wrong, but I like a lot of the ideas here.

Full disclosure: long AEP, PSX & INTC for myself and clients