Saturday, December 19, 2009

Daily Journal Corp. - A Goog Buy?

Daily Journal Corp (Stock code DJCO) seems to be selling very cheaply whether valued by itself or compared to other print businesses. What I find that really interests me is not the core print business but rather the equity portfolio which is on the books.

DJCO is an obscure and extremely small-cap stock. But behind it lies a one of the best investment managers as its largest owner and director - Mr. Charlie T. Munger. DJCO's core business is news prints and publications and are sold to more niche markets, like targeting in the area of law.

Some numbers at a glance. Market cap is $85 to $86 million. Earnings was about $8 million for the year ended Sep 2009. Free cash flow is about the same as reported earnings. Current assets = $72.5m, total liabilities = $31.1m. Of the $72.5m in current assets, $62.1m is cash, treasuries and marketable securities. And out of $62.1m, $54.1 is marketable securities ($47.9m is stock and rest is bonds).

The company, after deducting all liabilities and assuming all noncurrent assets of $10.15m is worthless, the net assets is still worth $41.4m ($72.5m - $31.1m). In other words, at the current market cap, the core business of the company is valued at less than 6 times its earnings ($85m - $41.4m / $8m profit).

As mentioned, what is interesting is the stock portfolio worth $47.9m as at end Sep 2009. The whole of 2008, DJCO actually did not own any stocks, most were invested in Treasuries worth of about $20m. During the period Jan 2009 to Mar 2009, DJCO sold the treasuries and bought mostly into stocks and some into bonds. The cost of stocks were $15.5m and bonds $4.9m. In a period of 6 months, the value has more than doubled from $20.4m to $54.1m. I don't think they achieved this due to luck but rather most likely due to the foresight of Mr. Munger that he recognized that the market is totally irrational at the time. For example, banks, even Wells Fargo, were selling for ONE time its pretax preprovision for credit losses income. That is how ridiculous it was in early Mar 2009.

However, DJCO does not disclose the stock they hold. But whatever they hold, I am highly certain it will be worth many times more the longer they hold to it. On top, investors get a rather cheap print business that is still holding out fine, though maybe a slowing and dying business in time to come.

Saturday, December 05, 2009

Buffett Personal Wealth and Wells Fargo

Too Big To Fail is surely the best investigative business book since Barbarian at the Gates or The Smartest Guy in the Room. Andrew Sorkin gave many new details and juicy insights into the events leading up to and during the crisis last Fall. One of which was the implied personal fortune of Warren Buffett.

On page 508, Buffett quoted, "I will be willing to personally buy $100 million of stock in this public offering (a Buffett's idea which subsequently led to the eventual PPIP)," which, he explained, "constitutes about 20 percent of my net worth outside of my Berkshire holdings." We can infer that he has a personal fortune of $500 million outside of his fortune in Berkshire.

And during last fall, his by-now famous co-op, Buy America: I am, revealed Buffett bought stocks for his personal account. One of which is Wells Fargo. He owns a personal stake of 2,240,000 shares which he most likely accumulated at a cost of about $56 to $60 million last fall. This constitutes about 12% of his personal fortune.

Disclosure: I own Wells Fargo.

Saturday, November 14, 2009

A review of my current and past holdings

This is the first time I'm reviewing the decisions I made for my investments - both current and past holdings. There're mistakes I made (like I should have sat rather than to jump) and things I learnt (eg., investments are like gardening, some flowers take a longer time to bloom than others).
  • Wells Fargo (current holding)
Banking sector, generally, in the States were selling at historical lows early this March. Wells Fargo hit a low of $7.8 - in effect, the whole company was available for $33 billion (based on the outstanding shares at that time). Wells potentially earns $40 billion in pre-tax pre-provision earnings. That priced the whole company at less than 1 time its earnings before tax and provision for credit losses.

Now, banking stocks have recovered somewhat - about 3 times from the sector's lows in March 09. Wells is selling at over $27. Even with the recovery, the sector is still selling at a low valuation historically. Wells, for one, is valued among the lowest of the banking stocks available. At $27, it is priced at no more than 3.2 times of pretax preprovision income. With every passing week, it's another week towards hitting the bottom, which means recovery. When the economy turns and earnings normalize, assuming Wells earns $40 billion in pretax preprovision, and 30% of it is catered for credit losses, and after a tax of 35%, it leaves roughly $18 billion available to shareholders. That translates to about $3.8 per share and if a multiple of 12 is applied, the stock can sell for $45.

Why is Wells priced so low? Probably because of the uncertainty on the extent of credit losses from the Wachovia's loan portfolio. The other worry is the rising rate of Wells Fargo's nonperforming loans. At this time, the market is likely to be a couple of quarters away from seeing a peak in nonperforming loans. Once nonperforming loans peak, banks, including Wells Fargo, will need to provide less for credit losses. If we look at Wells Fargo earnings before tax and credit losses - $40 billion - this equates to 5% of its loan portfolio. In order for Wells Fargo to sustain a loss, its nonperforming loan would have to hit 5% of its total loan portfolio. End of 3Q09, nonperforming loans stand at $21B (2.63% of the loan portfolio). So nonperforming loans would have to about double before eating into shareholder's equity.

What are the risks? If nonperforming loans continue to grow at a faster pace than in the past for the next few quarters, then Wells may have to raise capital which in turns dilute shareholders. However, if nonperforming loans grow at a much slower pace than in the last few quarters before peaking, the likelihood is the share price would shoot up quite dramatically.
  • American Express (current holding)
A much misunderstood stock early this year when it was priced at less than $20, bottoming out at about $9. Amex, unlike Visa or Mastercard, offers credit to its customer rather than just offering a system for payment. However, interest income from its lending operation only accounts for less than 15% of total revenue. Majority of Amex's revenue comes from discount revenue - slightly more than 50%.

In recent years, Amex may have over-expanded credit businesses to less than desired customers, leading to an increase in loans. When the economy tanked last year, so did Amex share price because investors became worried of the credit losses Amex may face.

All told, Amex pretax preprovision earnings is about $8.5 to $9.5 billion, which means it covers more than 10% of its total loans and accounts receivable ($78 billion at end of 2008).

At the low sub-$10 a share, the company was priced at less than $12 billion (1.36 times its pretax prevision earnings). Amex is now $40 a share or $47.5B (5.57 times its pretax prevision earnings).

In normal times, Amex is priced 7 to 8 times its pretax preprovision earnings. So if this holds in the future, the upside is another 34% or more.
  • Kraft Food (current holding)
This is a simpler investment to analyze. At $27, Kraft is selling for less than 14 times its earning power (EPS of estimated $1.97 for Y2009). Moreover, Kraft aims for a 7 to 9% growth in EPS yearly, and for a 15% operating income margin (compared to 12% in the past).

Kraft pays a dividend of $1.16 (4.4% yield). With operating cash flow of over $4 billion a year, and after lessing out dividend of $1.7 billion and capital expenditure of $1.2 billion, it leaves net cash of over $1 billion in the company's coffer.

Moreover, Kraft has lagged the stock market in 2009. With the Dow Jones gaining 17% so far this year, Kraft is about flat. Chances are Kraft would outperform the general index some time in the future, especially with the potential positives that the management has set Kraft up for.
  • Berkshire Hathaway (current holding)
Berkshire has been a laggard this year. But all good deals are happening to Berkshire. Many people believed that Berkshire always get better deals because of who they are. But the truth is many couldn't get deals like Berkshire because they did not have the lending capacity or cash like Berkshire had during the time of crisis. When all others are pulling back, Berkshire was the only one that was willing to lend to credit-worthy companies and then of course, with lesser lenders, Berkshire was able to dictate for better terms.

The past year alone, Berkshire had extended over $22 billion in various types of investment securities to 10 different companies - Goldman Sachs, Wrigley, Dow Chemical, GE, USG, Swiss Reinsurance, Harley Davidson, Sealed Air, Tiffany, and Vulcan Materials. All securities came with a basic 8.5% to 15% yield. Some of the securities come with warrants, like Goldman Sachs, which is now in the money by over $2.5B just for the warrants alone. Swiss Reinsurance is another which can be converted some time in the future, which if it is today, it is in the money by over $2B (for a principal of $3.3B).

This month, Berkshire did their biggest investment to date, acquiring Burlington Northern Santa Fe at a valuation of $34B. However, it is by no means cheap. It was bought at an earnings multiple of 17 to 18 based on 2008 earnings. But Buffett called it an "all-in" bet on the future of America's economy. If America does well in the future, Burlington will do likewise. It is invested with a very long term view of 10, 20 or 50 years. By then, Warren wouldn't be around but he is positioning Berkshire for the future which he has been building Berkshire towards this end both in terms of culture, and the mix of businesses.

That is a very brief overview of Berkshire. Now to the details of Berkshire's value. Based on Berkshire's 3Q09 shareholder's equity, the share price is valued at less than 1.3 times its book value. A ratio that has not been seen since probably for a decade or more. But simply to base an investment decision on this ratio is an easy way out, probably not sufficient for an investor to understand the value of Berkshire.

Berkshire, primarily, can be broken down into 4 major categories of business - insurance; manufacturing, services & retailing; utilities & energy and; financial & financial products.

The headline net earning on the income statement can swing wildly from year to year or quarter to quarter because of the impact of the put option derivatives underwritten on 4 major global indexes (S&P 500, FTSE 100, Euro Stoxx 50 & Nikkei 225). So in order to understand the normal earnings, the gain/loss from such derivatives should be excluded.

The ultimate gains or losses on these contracts will not be known for many years but it is important to understand the mechanics of it because derivatives that are written without discipline are "weapons of mass destruction." The notional value of these equity put options is $37.1 billion. The first contract comes due Jun 2018. Any losses will only be paid on the due date. Meanwhile the value of these contracts are mark to market and any losses will be recorded as a liability. As of 3Q09, the liability recorded for these contracts was $8.1B. Meanwhile, Berkshire received a premium of $4.9B, which they have invested. These two items - the liability and the premium - means Berkshire had so far reported a mark-to-market loss of $3.2B (compared to a mark-to-market loss of $5.1B at end 2008, showing how volatile marking to market gain or losses can be).
To illustrate how Berkshire can lose on these contracts, say, Berkshire had sold a $37.1B (the notional value) 15 year put option on the S&P 500 index when that index is at 1300. If the value of S&P 500 is at 1170 - down 10% - on the day of the maturity (15 years later), Berkshire would pay $3.71B. For Berkshire to lose $37.1B, S&P 500 would have to go to zero. In the meantime, Berkshire had been paid $4.9B as premium to write the put contract and free for Berkshire to invest. As you can see, even if the index is 10% less than the day the contract was written (which is 15 years later), Berkshire would still not have lost a dime, in fact, a gain of $1.19B, not including any other gain Berkshire had realized from the $4.9B they had put to work.

The derivatives subject is a bit of a diversion. Now, let's get back to valuing the 4 different categories of Berkshire's main business, excluding impact of derivatives.

Insurance operations:
In Y2008, insurance earned $5.3B, of which $1.8B comes for underwriting gain and $3.5B from investment income. Valuing the insurance business would depends on which approach you use. There're a few.
  • If you apply a straight 15 times multiple to its earnings, you get a valuation of about $80 billion.
  • If you based it on its net worth (or book value), the insurance book value is probably about $75 billion and applying a 1.5 times book value, you get a valuation of about $113B.
  • Another way is to value underwriting and investment income separately. Underwriting gain does not really gets its earnings from the book value or investment assets, though the capacity or amount that can be underwritten depends on the net worth or equity in the business. So if you apply a multiple of 12 to the $1.8B in underwriting gain, you get a value of $22B. Then since investment income is derived directly from investment assets, we can simply just based the value of the investment income side on the net book value which is roughly about $75B and if you apply a 1.5 times to the book value, it is worth $113B. In total, the insurance business is worth about $135B.
Depending on which valuation method, the insurance business is worth between $80B to $135B.

Manufacturing, Service & retailing:
This motley collection of businesses earned $2.3B in 2008. The various businesses in this group can be as different as night and day from each other. For simplicity sake, we will apply a multiple of 15 to its earnings which give a value of $34B.

Utilities & energy:
In 2008, this sector earned about $1.2B after one-off items. By applying a multiple of 15, it is worth up to $18B, of which Berkshire owns 87.4% (diluted) interest. So Berkshire's interest in MidAmerican is about $15.7B.

Financial & financial products
This sector earned roughly about half a billion in 2008. By applying a factor of 10 to the earnings, it is worth in the range of $5B, more or less.

Conclusion: Berkshire, when we add up the individual valuations, it is worth between $135B to $190B (difference lies in how you value the insurance business).

This is getting too long. I will try to write more on some other investments that I still hold or had held in the past.

Saturday, November 07, 2009

Food for thoughts on investing in undervalued companies

Again, I had a rather long break. And I'm back. One of the cornerstone to successful investing is to buy undervalued businesses. But is it enough? I'd argue it ain't. One other aspect is to have good management that really thinks and acts in the right manner on the behalf of the shareholders, whom the management ultimately have a fiduciary responsibility to.

Sometime in July 09, IMS Health was selling at $12 - click here for more details in a previous post. At $12, the whole company was selling for $2.2 billion. A value that substantially undervalues the company in relation to its future earnings potential. This week, a consortium led by TPG offered $4 billion (or $22 a share) to buy out IMS. The offer was accepted by IMS management. David Carlucci, IMS Chairman and CEO, said: "This transaction enables our shareholders to realize substantial value from their investment in IMS with an immediate cash premium." But is it really so?

Yes, it is but with a caveat. It only offer substantial immediate value for those shareholders who had bought at $12 or so during the period in July but not for the other shareholders. In effect, the management had sold out on the majority of its shareholders. During the period between Oct 08 to before the offer, its share was traded in the range of about $10 to $18 (mostly at $12). Only shareholders who had invested during this period had benefitted but not fully - substantial value is left on the table.

Prior to Oct 08, its share traded at above $22. At that price, it too was undervalued in relation to what a full price would be. At $22, the whole company sells for $4B, with a free cash flow of over $350 million. The company is holding up well through the crisis and business prospects appear sound, though revenue had declined. Expanding global pharmaceuticals market, as expected by IMS, to grow at a compound rate of 4 to 7% to about $1 trillion in 2013. So what value, if any, does TPG and its partner bring to the table. Indeed, much value is left behind.

In my view, the management had failed in its fiduciary responsibility to its shareholders. Even for investor who bought at $12, they may have less cause for celebration because the management failed to do their best to get a full value of what the company is really worth. One reason the management is eager to sell could be because of the generous slice of equity in the deal they can get.

So in essence, even if an investor manage to find an undervalued company (imagine you had bought IMS at $22 which is an undervalued price), they may not get rewarded because of a mediocre management.

On the other hand, it is always better to invest in a company that is not only undervalued, but comes with a decent management (think of Berkshire, YUM Brands, Amex, Wells Fargo) who takes care and thinks for their shareholders whom they represent. However, if an opportunity comes where a company is undervalued but its management is mediocre, it's best to buy only at a substantially undervalued price, for IMS case, it did be at $12 or so, not $22 - though both prices are undervalued. Any value investor who had bought before Oct 08 at $22 would perhaps rethink about the whole concept of buying into a company that is run by people who do not think for the people they represent.

Tuesday, September 08, 2009

NYT: Closely Watched Buffett Recalculating His Bets

Published September 8, 2009

Warren E. Buffett has two cardinal rules of investing. Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1.

Well, a lot of old rules got trashed when the financial crisis struck — even for the Oracle of Omaha.

At 79, Mr. Buffett is coming off the worst year of his long, storied career. On paper, he personally lost an estimated $25 billion in the financial panic of 2008, enough to cost him his title as the world’s richest man. (His friend and sometime bridge partner, Bill Gates, now holds that honor, according to Forbes.)

And yet few people on or off Wall Street have capitalized on this crisis as deftly as Mr. Buffett. After counseling Washington to rescue the nation’s financial industry and publicly urging Americans to buy stocks as the markets reeled, in he swooped. Mr. Buffett positioned himself to profit from the market mayhem — as well as all those taxpayer-financed bailouts — and thus secure his legacy as one of the greatest investors of all time.

When so many others were running scared last autumn, Mr. Buffett invested billions inGoldman Sachs — and got a far better deal than Washington. He then staked billions more on General Electric. While taxpayers never bailed out Mr. Buffett, they did bail out some of his stock picks. Goldman, American Express, Bank of America, Wells Fargo, U.S. Bancorp — all of them got public bailouts that ultimately benefited private shareholders like Mr. Buffett.

If Mr. Buffett picked well — and, so far, it looks as if he did — his payoff could be enormous. But now, only a year after the crisis struck, he seems to be worrying that the broader stock market might falter again. After boldly buying when so many were selling assets, his conglomerate, Berkshire Hathaway, is pulling back, buying fewer stocks while investing in corporate and government debt. And Mr. Buffett is warning that the economy, though on the mend, remains deeply troubled.

“We are not out of problems yet,” Mr. Buffett said last week in an interview, in which he reflected on the lessons of the last 12 months. “We have got to get the sputtering economy back so it is functioning as it should be.”

Still, Mr. Buffett hardly sounded shellshocked in the wake of what he once called the financial equivalent of Pearl Harbor. (An estimated net worth of $37 billion would be a balm to anyone’s psyche.)

“It has been an incredibly interesting period in the last year and a half. Just the drama,” Mr. Buffett said. “Watching the movie has been fun, and occasionally participating has been fun too, though not in what it has done to people’s lives.”

Investors big and small hang on Mr. Buffett’s pronouncements, and with good reason: if you had invested $1,000 in the stock of Berkshire in 1965, you would have amassed millions of dollars by 2007.

Despite that formidable record, the financial crisis dealt him a stinging blow. While he has not changed his value-oriented approach to investing — he says he likes to buy quality merchandise, whether socks or stocks, at bargain prices — Buffettologists wonder what will define the final chapters of his celebrated career.

In doubt, too, is the future of a post-Buffett Berkshire. The sprawling company, whose primary business is insurance, lost about a fifth of its market value during the last year, roughly as much as the broader stock market. While Berkshire remains a corporate bastion, it lost $1.53 billion during the first quarter, then its top-flight credit rating. It returned to profit during the second quarter.

Time is short. While he has no immediate plans to retire, Mr. Buffett is believed to be grooming several possible successors, notably David L. Sokol, chairman of MidAmerican Energy Holdings at Berkshire and also chairman of NetJets, the private jet company owned by Berkshire.

After searching in vain for good investments during the bull market years, Mr. Buffett used last year’s rout to make investments that could sow the seeds of future profits.

Justin Fuller, author of the blog Buffettologist and a partner at Midway Capital Research and Management, said the events of the last year, while painful for many, provided Mr. Buffett with the opportunity he had been waiting for.

“He put a ton of capital to work,” Mr. Fuller said. “The crisis gave him the ability to put one last and lasting impression on Berkshire Hathaway.”

For the moment, however, Mr. Buffett seems to be retrenching a bit. Like so many people, he was blindsided by the blowup in the housing market and the recession that followed, which hammered his holdings of financial and consumer-related companies. He readily concedes he made his share of mistakes. Among his blunders: investing in an energy company around the time oil prices peaked, and in two Irish banks even as that country’s financial system trembled.

Mr. Buffett declined to predict the short-run course of the stock market. But corporate data from Berkshire shows his company was selling more stocks than it was buying by the end of the second quarter, according to Bloomberg News. Its spending on stocks fell to the lowest level in more than five years, although the company is still deftly picking up shares in some companies and buying corporate and government debt.

Among the stocks Mr. Buffett has been selling lately is Moody’s, the granddaddy of the much-maligned credit ratings industry. Berkshire, Moody’s largest shareholder, said last week that it had reduced its stake by 2 percent.

The shift in Berkshire’s investments suggests Mr. Buffett is starting to worry, said Alice Schroeder, the author of “The Snowball,” a biography of Mr. Buffett.

But Ms. Schroeder said Mr. Buffett was also growing anxious about how he would be remembered. He wants to remain relevant in the twilight of his career, she said, and is taking a more prominent role on the public stage. That shift means ordinary investors are getting a chance to hear more of his sage advice, but it also carries some risk.

“Before, he always made sure to dole out the wisdom with an eyedropper,” Ms. Schroeder said. In the past, Mr. Buffett “said it was a mistake to believe that if you are an expert in one area that people will listen to you in others,” she said.

Whatever his recent missteps, many people, from President Obama down, listen to what Mr. Buffett has to say. He is important in his own right as a billionaire businessman but also because millions of ordinary investors follow his homespun aphorisms, copy his investing strategies and await his pronouncements on the markets.

Mr. Buffett refused to be drawn out on where stocks are headed, but he warned about the dangers of investing with borrowed money, or leverage, which proved disastrous when the crisis hit.

As for regrets, he has a few. His timing was bad, he concedes. He should have sold stocks sooner, before the markets tumbled. Then he served up a Buffettism that any investor might heed:

Asked if anything was keeping him awake at night, he said there was not. “If it’s going to keep me awake at night,” Mr. Buffett said, “I am not going to go there.”

Monday, September 07, 2009

Vanity Fair: Henry Paulson’s Longest Night

Excerpts from article:

In 2006, Goldman Sachs C.E.O. Henry Paulson reluctantly became Treasury secretary for an unpopular, lame-duck president. History will score his decisions, but the former Dartmouth offensive lineman definitely left everything on the field. In private conversations throughout his term, as crisis followed crisis—Bear Stearns, Fannie Mae and Freddie Mac, Lehman Brothers, A.I.G., and so forth—Paulson gave the author the inside track, from the political lunacy and bailout plans to the sleepless nights and flat-out fear, as he battled the greatest economic disruption in 80 years.

As he noted, “There’s a great lack of financial literacy and understanding in this nation, even among college-educated people.” But Paulson did figure out how to behave on the Hill. “There’s a way, keeping full integrity, of answering the questions you want to answer,” Paulson told me in one of our conversations, reflecting on what he had learned about committee hearings. “The thing that scared me was not a question I didn’t know the answer to. Just say, ‘I don’t know.’ The thing that scared me was some question that I knew, and answered correctly, and I’d be in deep doo-doo!” As his tenure wore on, Paulson confessed, “I amuse myself a lot by sitting there sometimes and thinking what would happen if I said, ‘Do you realize what an idiotic question that is?’ "

Wednesday, September 02, 2009

Bill Gross September 09 Investment Outlook Notes

Here are notes from Bill Gross's Sep 09 Investment Outlook article:
  • When it comes to whacking golf ball, the possibilities of explanation are endless: For relaxation, for socialization, to get close to mother nature, etc.
  • The "new" vs. "old" normal dichotomy was perhaps best contrasted by Barton Biggs when he said he was a "child of the bull market."
  • Biggs' point was for as long as he's been in the market, it has paid to buy the dips because markets, economies, profits and assets always rebounded and went to higher level.
  • Economies grow, profits grow, just like children do.
  • However, the surprise is that there's been a significant break in that growth pattern because of delevering, deglobalization, and reregulation (DDR).
  • DDR in combination means that it's time to recognize that things have changed and that they will continue to change for the next decade or even two.
  • We are heading towards the new normal which is a period of time in which economies grow very slowly as opposed to growing like weeds, the way children do; in which profits are relatively static; in which government plays a significant role in terms of deficits and reregulation and control of the economy; in which consumers stops shopping until he drops and begins.
  • American-style capitalism and the making of paper instead of things. America would consume, then print paper assets and debt in order to pay for it. Developing countries would make things and accept America's securities in return. This game is over and unless developing countries step up and generate a consumer ethic of their own, the world will grow at a slower pace.
  • The invisible hand of free enterprise is being replaced by the visible fist of government. The once-successful "shadow banking system" is being reregulated and delevered.
  • Global economic leadership. China has spent three times the amount of money (relative to GDP) to revive its economy and managed to grow at a "near normal" 8% pace vs. U.S. "big R" recessionary numbers.
  • Old normal housing models encouraged home ownership, eventually peaking at 69% (sometime in 2004). Subsidized and tax-deductible mortgage interest rates promoted a long-term housing boom and now a significant housing bust.
  • Housing alone can't lead U.S. out of this big R recession no matter what the recent Case-Shiller home price numbers may suggest. Home ownership may sink perhaps to a new normal level of 65%, as opposed to 69% of American households.
  • The shadow banking system has fueled an American era of consumerism because debt was available, interest rates were low and the living became easy.
  • Saving rates plunged from 10% to -1%. Now things have perhaps changed and saving rates are headed up, consumer spending growth rates moving down. A new normal is taking place.
  • Increased health care may be GDP positive but it's only a plus from a "broken window" point of view. It's far better to have a younger, healthier society than to spend trillions fixing up an aging, increasingly overweight and diabetic one.
  • Same thing goes for energy. Better and more profitable to pump oil than to spend trillions on a new "green" society.
  • The investment implications of this new normal evolution cannot easily be modeled econometrically, quantitatively, or statistically. The successful investor during this transition will be one with common sense and importantly the powers of intuition, observation, and the willingness to accept uncertain outcomes.
  • PIMCO observes that the highest probabilities favor the following strategic conclusions: 1) Global policy rates will remain low for extended periods of time; 2) The extent and duration of quantitative easing and fiscal stimulation efforts are keys to future investment returns across a multitude of asset categories: 3) Investors should continue to anticipate and shake hands with government policies, utilizing leverage and guarantees to their benefit; 4) Asia and Asian-connected economies (Brazil, Australia) will dominate future global growth; 5) The dollar is vulnerable on a long-term basis.
  • Investors need to play conservatively and avoid critical mistakes. An "even par" scorecard may be enough to hoist the trophy in a New Normal world.

Tuesday, August 25, 2009

WSJ: The Mistakes We Make—and Why We Make Them

By Meir Statman
Published: August 23, 2009

The Mistakes We Make—and Why We Make Them

How investors think often gets in the way of their results. Meir Statman looks into our heads and tells us what we're doing wrong.

What was I thinking?

If there's one question that investors have asked themselves over the past year and a half, it's that one. If only I had acted differently, they say. If only, if only, if only.

Yet here's the problem: While we know that we made investment mistakes, and vow not to repeat them, most people have only the vaguest sense of what those mistakes were, or, more important, why they made them. Why did we think and feel and behave as we did? Why did we act in a way that today, in hindsight, seems so obviously stupid? Only by understanding the answer to these questions can we begin to improve our financial future.

This is where behavioral finance comes in. Most investors are intelligent people, neither irrational nor insane. But behavioral finance tells us we are also normal, with brains that are often full and emotions that are often overflowing. And that means we are normal smart at times, and normal stupid at others.

The trick, therefore, is to learn to increase our ratio of smart behavior to stupid. And since we cannot (thank goodness) turn ourselves into computer-like people, we need to find tools to help us act smart even when our thinking and feelings tempt us to be stupid.

Let me give you one example. Investors tend to think about each stock we purchase in a vacuum, distinct from other stocks in our portfolio. We are happy to realize "paper" gains in each stock quickly, but procrastinate when it comes to realizing losses. Why? Because while regret over a paper loss stings, we can console ourselves in the hope that, in time, the stock will roar back into a gain. By contrast, all hope would be extinguished if we sold the stock and realized our loss. We would feel the searing pain of regret. So we do pretty much anything to avoid that pain—including holding on to the stock long after we should have sold it. Indeed, I've recently encountered an investor who procrastinated in realizing his losses on WorldCom stock until a letter from his broker informed him that the stock was worthless.

Successful professional traders are subject to the same emotions as the rest of us. But they counter it in two ways. First, they know their weakness, placing them on guard against it. Second, they establish "sell disciplines" that force them to realize losses even when they know that the pain of regret is sure to follow.

So in what other ways do our misguided thoughts and feelings get in the way of successful investing—not to mention increasing our stress levels? And what are the lessons we should learn, once we recognize those cognitive and emotional errors? Here are eight of them.

No. 1
Goldman Sachs is faster than you.

There is an old story about two hikers who encounter a tiger. One says: There is no point in running because the tiger is faster than either of us. The other says: It is not about whether the tiger is faster than either of us. It is about whether I'm faster than you. And with that he runs away. The speed of the Goldman Sachses of the world has been boosted most recently by computerized high-frequency trading. Can you really outrun them?

It is normal for us, the individual investors, to frame the market race as a race against the market. We hope to win by buying and selling investments at the right time. That doesn't seem so hard. But we are much too slow in our race with the Goldman Sachses.

So what does this mean in practical terms? The most obvious lesson is that individual investors should never enter a race against faster runners by trading frequently on every little bit of news (or rumors).

Instead, simply buy and hold a diversified portfolio. Banal? Yes. Obvious? Yes. Typically followed? Sadly, no. Too often cognitive errors and emotions get in our way.

No. 2
The future is not the past, and hindsight is not foresight.

Wasn't it obvious in 2007 that financial institutions and financial markets were about to collapse? Well, it was not obvious to me, and it was probably not obvious to you, either. Hindsight error leads us to think that we could have seen in foresight what we see only in hindsight. And it makes us overconfident in our certainty about what's going to happen.

Want to check the quality of your foresight? Write down in permanent ink your forecast of tomorrow's stock prices. Do that each day for a year and check the accuracy of your predictions. You are likely to find that your foresight is not nearly as good as your hindsight.

Some prognosticators say that we are now in a new bull market and others say that this is only a bull bounce in a bear market. We will know in hindsight which prognostication was right, but we don't know it in foresight.

When I hear in my mind's ear a voice that says that the stock market is sure to zoom or plunge, I activate my "noise-canceling" device rather than go online and trade. You might wish to install this device in your mind as well.

No. 3
Take the pain of regret today and feel the joy of pride tomorrow.

Emotions are useful, even when they sting. The pain of regret over stupid comments teaches presidents and the rest of us to calibrate our words more carefully. But sometimes emotions mislead us into stupid behavior. We feel the pain of regret when we find, in hindsight, that our portfolios would have been overflowing if only we had sold all the stocks in 2007. The pain of regret is especially searing when we bear responsibility for the decision not to sell our stocks in 2007. We are tempted to alleviate our pain by shifting responsibility to our financial advisers. "I am not stupid," we say. "My financial adviser is stupid." Financial advisers are sorely tempted to reciprocate, as the adviser in the cartoon who says: "If we're being honest, it was your decision to follow my recommendation that cost you money."

In truth, responsibility belongs to bad luck. Follow your mother's good advice, "Don't cry over spilled milk."

Where am I leading you? Stop focusing on blame and regret and yesterday and start thinking about today and tomorrow. Don't let regret lead you to hold on to stocks you should be selling. Instead, consider getting rid of your 2007 losing stocks and using the money immediately to buy similar stocks. You'll feel the pain of regret today. But you'll feel the joy of pride next April when the realized losses turn into tax deductions.

No. 4 Investment success stories are as misleading as lottery success stories.

Have you ever seen a lottery commercial showing a man muttering "lost again" as he tears his ticket in disgust? Of course not. What you see instead are smiling winners holding giant checks.

Lottery promoters tilt the scales by making the handful of winners available to our memory while obscuring the many millions of losers. Then, once we have settled on a belief, such as "I'm going to win the lottery," we tend to look for evidence that confirms our belief rather than evidence that might refute it. So we figure our favorite lottery number is due for a win because it has not won in years. Or we try to divine—through dreams, horoscopes, fortune cookies—the next winning numbers. But we neglect to note evidence that hardly anybody ever wins the lottery, and that lottery numbers can go for decades without winning. This is the work of the "confirmation" error.

What is true for lottery tickets is true for investments as well. Investment companies tilt the scales by touting how well they have done over a pre-selected period. Then, confirmation error misleads us into focusing on investments that have done well in 2008.

Lottery players who overcome the confirmation error conclude that winning lottery numbers are random. Investors who overcome the confirmation error conclude that winning investments are almost as random. Don't chase last year's investment winners. Your ability to predict next year's investment winner is no better than your ability to predict next week's lottery winner. A diversified portfolio of many investments might make you a loser during a year or even a decade, but a concentrated portfolio of few investments might ruin you forever.

No. 5 Neither fear nor exuberance are good investment guides.

A Gallup Poll asked: "Do you think that now is a good time to invest in the financial markets?" February 2000 was a time of exuberance, and 78% of investors agreed that "now is a good time to invest." It turned out to be a bad time to invest. March 2003 was a time of fear, and only 41% agreed that "now is a good time to invest." It turned out to be a good time to invest. I would guess that few investors thought that March 2009, another time of great fear, was a good time to invest. So far, so wrong. It is good to learn the lesson of fear and exuberance, and use reason to resist their pull.

No. 6 Wealth makes us happy, but wealth increases make us even happier.

John found out today that his wealth fell from $5 million to $3 million. Jane found out that her wealth increased from $1 million to $2 million. John has more wealth than Jane, but Jane is likely to be happier. This simple insight underlies Prospect Theory, developed by Daniel Kahneman and Amos Tversky. Happiness from wealth comes from gains of wealth more than it comes from levels of wealth. While gains of wealth bring happiness, losses of wealth bring misery. This is misery we feel today, whether our wealth declined from $5 million to $3 million or from $50,000 to $30,000.

We'll have to wait a while before we recoup our recent investment losses, but we can recoup our loss of happiness much faster, simply by framing things differently. John thinks he's a loser now that he has only $3 million of his original $5 million. But John is likely a winner if he compares his $3 million to the mountain of debt he had when he left college. And he is a winner if he compares himself to his poor neighbor, the one with only $2 million.

In other words, it's all relative, and it doesn't hurt to keep that in mind, for the sake of your mental well-being. Standing next to people who have lost more than you and counting your blessings would not add a penny to your portfolio, but it would remind you that you are not a loser.

No. 7 I’ve only lost my children’s inheritance.

Another lesson here in happiness. Mental accounting—the adding and subtracting you do in your head about your gains and losses—is a cognitive operation that regularly misleads us. But you can also use your mental accounting in a way that steers you right.

Say your portfolio is down 30% from its 2007 high, even after the recent stock-market bounce. You feel like a loser. But money is worth nothing when it is not attached to a goal, whether buying a new TV, funding retirement, or leaving an inheritance to your children or favorite charity.

A stock-market crash is akin to an automobile crash. We check ourselves. Is anyone bleeding? Can we drive the car to a garage, or do we need a tow truck? We must check ourselves after a market crash as well. Suppose that you divide your portfolio into mental accounts: one for your retirement income, one for college education of your grandchildren, and one for bequests to your children. Now you can see that the terrible market has wrecked your bequest mental account and dented your education mental account, but left your retirement mental account without a scratch. You still have all the money you need for food and shelter, and you even have the money for a trip around the country in a new RV. You might want to affix to it a new version of the old bumper sticker: "I've only lost my children's inheritance."

So here's my advice: Ask yourself whether the market damaged your retirement prospects or only deflated your ego. If the market has damaged your retirement prospects, then you'll have to save more, spend less or retire later. But don't worry about your ego. In time it will inflate to its former size.

No. 8 Dollar-cost averaging is not rational, but it is pretty smart.

Suppose that you were wise or lucky enough to sell all your stocks at the top of the market in October 2007. Now what? Today it seems so clear that you should not have missed the opportunity to get back into the market in mid-March, but you missed that opportunity. Hindsight messes with your mind and regret adds its sting. Perhaps you should get back in. But what if the market falls below its March lows as soon as you get back in? Won't the sting of regret be even more painful?

Dollar-cost averaging is a good way to reduce regret—and make your head clearer for smart investing. Say you have $100,000 that you want to put back into stocks. Divide it into 10 pieces of $10,000 each and invest each on the first Monday of each of the next 10 months. You'll minimize regret. If the stock market declined as soon as you have invested the first $10,000 you'll take comfort in the $90,000 you have not invested yet. If the market increases you'll take comfort in the $10,000 you have invested. Moreover, the strict "first Monday" rule removes responsibility, mitigating further the pain of regret. You did not make the decision to invest $10,000 in the sixth month, just before the big crash. You only followed a rule. The money is lost, but your mind is almost intact.

Things could be a lot worse.

--Mr. Statman is a professor of finance at Santa Clara University in Santa Clara, Calif.

World Safest Banks

As published by Global Finance Magazine, the world's safest banks for midyear 2009 are as follows:



Caisse des Dépots et Consignations (CDC)
Bank Nederlands Gemeenten (BNG)
Landwirtschaftliche Rentenbank
Landeskreditbank Baden-Wuerttemberg-Foerderbank
NRW. Bank
BNP Paribas
Banco Santander
Royal Bank of Canada
National Australia Bank
Commonwealth Bank of Australia
Banco Bilbao Vizcaya Argentaria (BBVA)
Toronto-Dominion Bank
Australia & New Zealand Banking Group
Westpac Banking Corporation
Banco Espanol de Credito S.A. (Banesto)
ASB Bank
New Zealand
HSBC Holdings
United Kingdom
Crédit Agricole
Wells Fargo
United States
Nordea Bank
La CaixaSpain
Svenska HandelsbankenSweden
U.S. BankcorpUnited States
DBS BankSingapore
Pohjola BankFinland
Deutsche BankGermany
Société GénéraleFrance
Intesa SanpaoloItaly
Bank of MontrealCanada
DnB NOR BankNorway
The Bank of New York MellonUnited States
Banco Popular Español
Caixa Geral de Depositos
37 =
United Overseas Bank
37 =
OCBC (Oversea-Chinese Banking Corp.)
Axa Bank Europe
Landesbank Baden-WuerttembergGermany
Nationwide Building SocietyUnited Kingdom
43National Bank of KuwaitKuwait
45JPMorgan ChaseUnited States
46Bank of Tokyo-Mitsubishi UFJJapan
47Credit Suisse Group
48Banque Fédérative du Crédit Mutuel (BFCM)France
49Crédit Industriel et Commercial (CIC)France
BB&T Corporation
United States