Category: Commentary

I have no doubt  that value investing is based on inherently sound principles and it could be a source of consistent profits over time. I am not sure if it is a style suitable for everyone. It requires an amazing patience, an iron will to overcome naturally ingrained biases and a strong stomach to get over temporary setbacks. This is the good news for those willing to devote to this investment style. If everyone was practicing it, it would not be so profitable.

On the surface value investing looks like shopping. If an $80 shirt is suddenly on sale for $40, you got yourself a deal. Capital markets are actually quite different than consumer markets. There is a big difference between shopping for a shirt and buying a financial asset. If you are an end consumer, you buy a shirt in order to wear it. You have no intention to make money out of it by re-selling it or renting it out. You purchase a financial asset with a plan to profit from it by playing one of two roles:

– a retailer, who buys with the intention to sell for a gain later or

– an investor, who buys for the income in terms of capital gain and dividends.

In capital markets price volatility is much higher than fundamentals’ volatility. Stocks that drop from $80 to $40 look like a bargain, but they may continue to look cheap all the way to $20. The fact that an asset seems attractively priced doesn’t mean that it can’t go even lower. In theory such huge discrepancy between value and price should not exist as arbitrageurs should offset the extremes. In practice such an event occurs much more often than most investors are willing to admit. The job of a value investor is to figure out: why is the price down and why the market is not seeing the existing value? Is the reason behind the sell off fundamental or emotional?

Value investors base their market approach on the assumption that the economy and  investors’ confidence are cyclical. They realize that in short-term perspective prices are heavily impacted by risk appetite, not by net asset value, cash flows or growth prospects. Occasionally emotions and biases become the main driving force of  investors’ decision making. Experienced value investors know that recessions happen often enough to offer great buying opportunities and economic recoveries always follow. When they do, risk appetite comes back and prices rise.

Essentially value investors make a  bet on the human nature – after all it hasn’t changed since the beginning of time. Market often acts irrationally as people forget all logic and become slave to their emotions. When people are in capital preservation mode, suddenly the return OF capital becomes more important than the return ON capital and investors rush for the exits at all cost. At this point there is not enough liquidity to meet the supply and prices might fall quickly. A patient value investor, who is also a good risk manager will come and will start to nimble, gradually building a position that he will sell later at much higher prices, probably to the same people who sold to him when they were scared.

I distinguish three basic approaches to value investing:

– very conservative: they don’t care about future cash flows and discount rates, because they realize that they cannot be forecasted with good enough precision. There is one important question to be asked -If I pay the current market price,  am I going to make money in case this business liquidates tomorrow? They calculate the market value of all liquid assets; give a good 50-70% discount to the current book value of the inventory and fixed assets, assume that intangible assets’ value is zero, subtract from all that the debt and if the remaining sum is still higher than the current market cap, they’ve found an investment candidate deserving further investigation. If this company survives, its fixed assets are likely to costs much more than they were accounted for. Such positive development would be considered a bonus. Now you may wonder, why would a company sells below its net liquid assets value? There are times when emotions reign supreme, when the return of capital becomes more important than the return on capital and investors want out at any price. Such times create opportunities for patient investors with deep pockets.

– pay fair price for good businesses: recessions occur frequently enough to offer favorable entries in good businesses and the stock market eventually always come back due to the cyclical nature of the economy and investors’ risk appetite. The important question here is – is the company going to survive the economic turmoil. If yes, when the economy starts to recover, the market will recognize the value and prices come back to pre-recession levels or higher.

– using reversed engineered DCF model. By taking into account the current price, a conservative (high) discount rate and current year’s operating cash flow, the projected growth is calculated. The main question here is – is the already embedded in the price growth sustainable based on historical reference? This approach provides a general estimate of that how overvalued or undervalued is a stock. It doesn’t provide a buy or a sell signal. Market can remain irrational for a long, long time.

The goal of value investors is not to beat the market benchmark every quarter or every year. There will be periods when they will underperform for 2-3 consecutive years, followed by times when they will be up 500-600%, which will more than offset any previous disappointments. To use a baseball analogy, they are looking for home runs, not doubles and triples.

Of course, value investors also make mistakes. As Warren Buffet likes to point out – “if I ever write a book about investing mistakes, it will be autobiographical”. The most often met mistakes in value investing are associated with the timing of an entry. Sometimes you have done your analysis, all the existing evidence points out that it is right, but the market may not agree with your thesis for years. In the meantime your capital is locked in a position that doesn’t produce cash flow and if you manage other people’s money – they might start to question your analysis. If you enter too early, you might experience significant losses. Are you able to tolerate them? If you manage other people’s money – are they able to tolerate them? Someone said that if you want to make 100% return you have to be willing to experience a drawdown of 20%. You can’t go down 20% with other people’s money. If you are too leveraged and start to get redemptions from scared customers, you will become a forced seller.

There is a saying that the difference between a great value investor and a good value investor is that the former knows how to time its entry properly. Timing is hard. Trying to build big position by timing the market is harder, because catching the absolute lowest point is a matter of luck. Even if by some accident you happen to catch it, the liquidity at the bottom is usually way too shallow. Correct timing  is not about catching the absolute bottom, it is about getting into a neglected stock that won’t remain neglected for too long.

Experienced value investors minimize the negative impact of timing by keeping plenty of cash and by gradually building new positions. Most of their investments could be essentially described as well in-the-money calls without an expiration date.

– ITM because there is margin of safety in the position (even if the underlying company is liquidated, what is left after debt payments will be higher than the market cap at which it was purchased);

– call options, because the potential reward could be tremendous (5-10 times the paid price  or even more);

– without expiration, because they keep plenty of cash reserves and aren’t leveraged; therefore they can’t become forced sellers before their thesis materializes.

The true value investor is a very rare bird that represents a very small part of the investors’ community; probably less than 1% of all involved in the stock markets. I have a huge respect for the people who have the mind to practice this contrarian investing approach. Their abnormal long-term profits are fully deserved. From psychological stand point everything is against them. It takes a special kind of character to overcome all biases wired in the human brain – our desire for instant gratification, our inability to feel financial pain for longer periods of time, our urge to jump from one market method to another when things are not going flawlessly. At this point of my life, I realize that I am still not patient enough, not able to stomach big drawdown in my portfolio, unwilling to go against the trend in order to be a good value investor. Maybe this will change with time.

P.S: over the weekend I will take a look at the underlying dynamics of momentum investing. I will present my view on why it works, how it works and when it works.

Lao Tzu – a 6th century BC philosopher, observed: Those who have knowledge, don’t predict. Those who predict, don’t have knowledge.Yet, most of the investment industry seems to be  obsessed with trying to guess the future.

While in school, I often wondered why would anyone assume that it is possible to forecast with precision future cash flows and interest rates. It turns out, I am not the only one. Charlie Munger points out: “Some of the worst business decisions I’ve ever seen are those with future projections and discounts back. It seems like the higher mathematics with more false precision should help you, but it doesn’t. They teach that in business schools, because well they have to do something.”

To come up with an earnings estimate, analysts need to forecast  economic growth, industry growth, interest rates, competitors’ moves, market share, sales, margins. There is so much room for mistakes. It is not surprising that analysts are often clueless about future cash flows and earnings estimates; therefore they rely on:

– perceived authority: the management of the company they follow is often regarded as the ultimate expert. After all, who else would know more about its company than management itself, right? The point is that management has monetary incentives not to be entirely honest.

-overconfidence: if an analyst has a good recent track record, many assume that it will continue forever.  Such behavior has the highest probability of failure. The scariest thing about it is that most people would follow blindly someone with a lot of confidence and little knowledge and ignore someone with little confidence and a lot of knowledge. Vanity is my favorite sin as they say in one of my favorite movies.

– follow the herd: put their estimates close to the already existing consensus. The thinking is: if I am wrong, I won’t be the only one. We will be wrong together. There is a feeling of higher security when you are moving with the herd. You tend to feel less invincible.

Taking the above sequence into account, it is understandable why so many companies beat market’s estimates so often and why a small surprise is nothing more than a well executed guidance by companies’ management. This is why, when a company misses it is a clear indication of: 1) lack of knowledge and professionalism of the management (not knowing your own company doesn’t speak too good about you) or 2) deteriorating conditions on a macro level. Both factors are hard to reverce in one quarter. The most useful information that earnings expectations provide is that they tend to exhibit trending behavior. Prices reflect changes in expectations. Expectations are impacted by interpretations of news, forecasts and emotions.

It is said that capital markets are forward looking mechanisms that constantly try to discount any available information, both public and private. The point is that market does not only try to discount objective news, but it also try to discount forecasts. We already know that forecasts are often based either on subjective opinions or on objective analysis of unknown or imprecise data. This explains why capital markets are often irrational (of course they can remain irrational longer than you can remain solvent). The beauty of capital markets is that they tend to trend and once a trend is in place it is hard to be reversed.

If forecasts are often so flawed why so many market decisions are impacted by them? Why do we still keep forecasting? One simple answer – there is a demand for forecasts. Investors are afraid of uncertainty and any look into the future makes them feel more comfortable. The point is that it also makes them less profitable. If someone believes that he knows the future, he would be more confident in his decisions, more likely to leverage and less careful in his risk management – a recipe for disaster.  A proper way to use forecasts is to treat them as cornerstones of  your conditional thinking. For example: if events A and B occur simultaneously, the historic probability of event C to occur is 80%. Based on that we prepare a plan of action.

I pay huge attention to catalysts that cause high volume, price range expansion. Earnings surprises, Earnings guidance, New contracts, New regulation are catalysts with the potential to start a major process of reprising (new trend or continuation of an existing trend). My logic is simple – when institutions buy, they leave traces. They are heavy, but slow buyers, therefore I have enough time to enter and exit as they build their position.  But I also understand that any new information should be interpreted only in the context of the current sentiment. When the return OF capital becomes more important than the return ON capital, emotions trump rationality and investors run for the shore of perceived safety (lately that shore has been UST, Gold, USD, JPY). No setup works all the time. The success rate of any setup is derivative of the current market environment. During severe market corrections earnings surprises and guidance don’t matter. Participants sell first and ask later. Correlation between stocks approximates 1.00.

I have a very simple philosophy – I want to be aggressively long when there is clear evidence that institutions are buying across the board. I want to be in cash or net short when there is evidence that institutions are selling.

Source: The little book of behavioral investing, James Montier

Black swan is regarded as a rare, unexpected event that could bring disastrous consequences for those that don’t have a contingency plan. Can you be prepared for something that by definition is unexpected? It depends on how do you look at the world. There is a difference between the impossible and the highly improbable. The latter is possible.  The  black swan is not the same for everyone. What looks like unexpected to one, could be totally predictable for another. For the turkey Thanksgiving day is a black swan, but this is not so for the butcher.

There is a natural tendency for human beings to underestimate the odds of seemingly unlikely events. Few realize that once in a 100 years event is equally likely to happen tomorrow as it is to happen after 95 years. And if there are insufficient data to calculate the probability of a very bad outcome, as is often the case, that doesn’t mean we should assume the probability is zero and look at contingency plans as a waste of time and efforts.

There is an Irish proverb, which I have always thought that relates very well to capital markets – The obvious rarely happens, the unexpected constantly occurs. The “unthinkable”, the “unimaginable” takes place much more often than most people are willing to accept. The stock market crash of 1987 was described at the time as a 27-standard-deviation event. That implies that the odds of such an event not happening were 99.99% with 159 more 9s after it. It was unheard of kind of event, but it happened. Those who weren’t prepared, those who were over-leveraged, didn’t survive.

When it comes to objectively assessing the real risk of any investment, there is one important question to ask: What is the worst thing that could happen and how it may impact your solvency. Human beings are naturally biased and tend to look for information that only confirms an already established thesis. Not much thinking is devoted to figuring out what could go wrong and to preparation of a contingency plan of action. People are often not prepared and when something unpleasantly surprising happens they don’t know how to react. They panick and let their emotions to rule decision making, which invariably leads to losses.

A good way to minimize the impact of emotions is to go long gamma. What are some of the characteristics of getting long premium:

– more precise risk control

When long or short equity, you don’t have full control of your potential losses. Stops are not very helpful when your position gaps against you or during sudden evaporation of liquidity. If you are long gamma, you know the exact amount of the potential maximum loss – the whole premium. Armed with that knowledge, position sizing becomes easy.

– more precise time management

You know exactly how much time you have  in order to be right. If your thesis happens to remain wrong until options expiration, your position is automatically wiped and you start clean all over again. Many investors realize in hindsight that they were right on their analysis, but wrong in their timing as the market was not ready to accept their  thesis. Being long premium takes away the whole aspect of having to worry about precise risk management. It is like paying for someone else to be your risk manager. You have an investment thesis and you want to go long GLD for the next 12 months. Going long gamma is the perfect way to do it. You pay a small amount to see if your thesis is right. Even if the option goes down a lot in the beginning to the point that it is worthless, you will still own it and you never know what might happen. Adverse market moves and emotions won’t shake you out of your position, because you already have a plan for the worst possible outcome – you will lose the paid premium.

– overpaying for premium, but still able to make money

You have to realize that in most of the time you will overpay for options. If you did proper due diligence that should not bother you as the move in the underlying asset will more than compensate the wasting effect of time and volatility. Especially when you move past one month options. There is a tendency to believe that people overpay for options because the research shows that IV is higher than realized volatility. That has to be the case for the seller to be willing to take the risk and to write you an option – he’s got to make some money. The difference is, he’s going to delta hedge and you’re not, so you are going to have to pay a little bit extra so that he gets compensated. You have to realize in advance, that yes you are overpaying. The seller is making his money of the delta hedge, and you are paying him a little bit by paying him more than what realized volatility is, but no one really knows in advance how big the realized volatility and the move of the underlying asset are going to be. Both the seller of the option and the buyer could make money. The profit for the seller comes from extracting the risk premia in the daily volatility and for the buyer it comes from the fact that most underlying assets tend to exhibit trending behavior.

– smaller capital allocation

Being long gamma via options allows for getting the same risk/reward with much smaller capital allocation; therefore you have less money at risk.

– smaller liquidity risk

Liquidity seems to disappear when you need it the most. If you have a huge equity position, a quick exit might be impossible. While is true that most options have wider bid/ask spread than their underlying assets, when it comes to exiting a big position options offer more alternatives – you can either exercise them if they they are ITM, roll them over to latter date or just offset them.

Despite the fact that there is substantial statistical evidence that implied volatility is less than realized volatility, (especially in shorter time frames), many experienced hedge fund managers are reluctant to go short gamma. The horrific memories from selling OTM calls against tech stocks in the late 1990s, the losses experienced due to shorting the housing sector too early have scared many for life. Being short premium via naked calls or puts exposes you for more than 100% losses. From risk management point of view, being short gamma is much harder to deal with, because as your position goes against you, it becomes larger part of your portfolio.

Insurance companies are in the business of writing premium. Those which managed to survived over time diversified properly their risk, hedged their losses by making deals with reliable counter parties and more importantly invested the received premium wisely. As Warren Buffett likes to say: “The curse of the insurance business, as well as one of the benefits of it, is that people hand you a lot of money for writing out a little piece of paper. What you put on that paper is enormously  important. The money that’s coming in, which seems so easy, can tempt you into doing very, very foolish things… Simple mistakes can wipe out a lifetime of earnings – a few cents gained when you’re right and a fortune lost when you’re wrong.”

When you are leveraged 100:1, it doesn’t take an armagedon, to wipe out your equity. A one % move in unfavorable direction and you are practically insolvent. You can’t insure against all losses, but you can make sure that you will remain solvent no matter what.