The Middle Ground - Competitive Markets

I don't like the terms efficiency and inefficiency. They don't seem to quite fit. We aren't talking about an internal combustion engine and we are missing the proper measuring tool, some sort of efficiency Geiger counter. I prefer the term, as suggested by Richard Roll at UCLA, "competitive". Markets are competitive. This means that prices usually indicate their true value. When they do not, as in the case of an undervalued or overvalued stock, the market, over time corrects the discrepancy. The questions then are how easy is it to find highly undervalued stock and how long it takes to correct the discrepancy. The answers are not very and your guess is as good as mine. Roll estimates that the market misprices 2% of equities. I imagine that number goes up and down depending if we are in an harem economy or a deserted island economy. With the proliferation of information through such mediums as the Internet, the markets have recently become more competitive.

The Argument For the Efficiency Market Theory

1. The bottomline of Efficient Market Theory (EMT) is that you should invest in low cost index funds. I could never fault someone who takes that approach. My 401k is invested in indices. The world is a better place with John Bogle in it and Warren Buffett himself recommends index funds for investors who don't want the hassle of picking stocks.
2. It would be foolish to think of the market as totally irrational. Otherwise, prices would be random. All parties pretty much agree that the market is, at the very least, mostly efficient. The theory, therefore, applies to that part of the market that everyone agrees is efficient. Thus, the EMT has some value as a predictive model.
   
3. EMT says that market timing, charting and momentum investing are poor investment strategies. They are.
   
4. Pension fund and endowment managers have other concerns besides pure performance. Due to the need for steady income as well as appeasement of leadership and beneficiaries, rejection of risk, as classically defined by EMT, may not be an option.
   
5. Even if you don't believe in it, your bosses might.
   
6. Most important, the more EMT is taught in schools, the more easily it is for value investors to find mis-priced securities. =)
   

The Argument Against the Efficient Market Theory

1. Mr. Market is a moody guy. Look at any security's price over any 52-week period. It goes up and down, up and down, sometimes with huge percentage differences between highs and lows. But think about it, most likely, the underlying company possesses the same or similar assets, services the same or similar customers, and is run by the same or similar people. If you were buying the entire business through a stock purchase, would these massive multi-million dollar fluctuations make sense?
2. People do beat the market and, under the Efficient Market Theory (EMT), this shouldn't happen. Ben Graham, Warren Buffet, Bill Miller, Joel Greenblatt, Peter Lynch, Seth Klarman, Mohnish Pabrai, I could name more. They may have down years, even a string of bad years, but in the long term, their percentage points are significantly higher than would be expected under EMT. You'd have to say that they were lucky, consistently lucky, over decades for them to fit into EMT. The fact that they all belong to the same value-oriented school of thought indicates something is not right in Efficiency-ville.
3. The Great Depression, Black Monday, the Internet Bubble - How can these possibly be efficient? You'd have to be blind not to see inefficiency in these events. Did the market efficiently price Enron before it collapsed?
4. Let's attack beta as a measure of risk. First of all, if I own a stock, massive upward volatility compared to the overall market is what I want. It's a good thing. Second, before I decide to buy a stock, I would prefer massive downward volatility. The price I pay sets the return when I eventually sell. Volatility is the value investor's friend, not the enemy.
5. Human beings are emotional and imperfect. The idea that enough emotional and imperfect people buying and selling stocks will cause perfect pricing, all the time, is counter-intuitive. For that to happen, for ever person who is overly optimistic on a stock, there would need to be a counterpart who is overly pessimistic on a stock. Seems more likely one side will be more weighted then the other and it will fluctuate over time.
6. EMT strictly uses past data which may not apply in the future. It is driving using your rear view mirror.
7. The real reason we have the EMT is because it is clean and some very smart people won some Nobel Prizes writing about it. Its assumptions, whether true or not, are needed for complex mathematical models to work. People, being emotional and imperfect (see #5), don't fit well into mathematical models. The solution to assume collective perfection in pricing strikes me as a convenient shortcut, or worse, intellectual dishonesty.

Black Swan Investing

Nicholas Taleb, author of Fouled by Randomness and The Black Swan, was featured in a WSJ article. He helped launch a hedge fund, Universa, based on his ideas. He essentially buys puts and calls on securities, saddle option bets (or is it strangle?), that benefit from volatility. Apparently, from what I can tell, he makes a large number of bets and works the stats. He buys options that are way out of the current price so he gets them for a low price, relative to options closer to the current price. If there is little volatility, he loses the price of the option. His investors will therefore have to stomach small losses in flat years with big gains in years when the market gyrates. His approach acts as insurance against cataclysm and benefits from rallies. Not my cup of tea, especially since it isn't clear how the stocks are chosen (high betas?). Seems to me, most stocks in the investment universe don't move that much and the losses could add up. Insurance against huge market declines is buying with a large margin of safety and having some cash available to buy on the cheap.

Sweep Account

Brokers provide interest on your sitting cash in what's called a sweep account. The problem is that the interest is fairly low, from 0.5-4%, depending on the broker and amount in the account. One trick is to simply ask your broker to raise the number. Sometimes, in the name of customer service, they'll do it to keep you happy. Additionally, many brokers have money market accounts or savings accounts available. If you are bolder, you could use a low fee index or ETF to stash the cash. Sure, you'll pay taxes on it when you pull it out but it's better than nothing, or worse, nothing plus inflation.

Questions: Where are these brokers investing the sitting cash? Is that how discount brokers make most of their money, on the float?

Whitney Tilson on the Traits of Successful Money Managers

This article from Motley Fool is a classic. I like to read it over and over again.

Best quote: "Although humility is a trait I much admire, I don't think I quite got my full share." --Charlie Munger

Regarding IQ Scores
The discussion on 130 vs 160 is interesting. I'm no genius =) , but according to my math, a score of 124.7 is in the top 5% (see below). Apparently, the first rule of investing is to pick your parents wisely. Should the 97% of people who score below 130 index or find someone with an IQ score above 130 to manage their money? Then again, maybe Buffett just pulled the numbers out of the air for the sake of demonstration and Tilson is taking it too far. My personal view -- IQ tests measure how well someone can take IQ tests. I also believe that there are other forms of intelligence that are not measured. Naturally, those beliefs are wholly dependent on my score. =)

My conclusion is that adopting a smart strategy and sticking to it is more important than being ultra-smart.

P = 0.05
z = 1.645
z = (x - μ) / σ
1.645 = (x - 100) / 15
24.675 = x - 100
x = 124.675

Spin Off ETF

There is an ETF that only invests in spin-offs. It is run by Claymore under the symbol CSD. According to Joel Greenblatt in his book, You Can Be a Stock Market Genius, spin-offs average 20% annualized returns. The specialized indexing strategy, developed by Clear Asset Management, is a black box but it should be interesting to see how she performs. It has gone up about 24% in the last 6 months compared to around 6% for the S&P. Fees are 0.5 and I note that Goldman has a 19% stake.

Here's CSD's current holdings and weights.

Crocodiles and Competitive Advantage

My son is four and loves watching Animal Planet, especially when it shows reptiles. I was watching the other day and realized that crocodiles have the ultimate in competitive advantage.

1) They sit comfortably in water all day long, not wasting energy. Less energy expended means less food needed to stay alive.
2) They wait for prey to come to them since the other animals need the water to survive. Again, less energy expended. He sits like a patient investor waiting for the fat pitch.
3) The murky water hides their presence. The poor victims don't know what hits them until it is too late.
4) The crocs don't have to kill directly and risk injury, they just need to drag the prey underwater until the animal drowns. Talk about a killer moat!
5) There are no other top predators in the water competing for food. Hippos are mean but are vegetarians.
6) Warren Buffett talks about change as being the enemy of investors. Crocs have remained unchanged for literally hundreds of millions of years.

If crocs ran a public business selling animal hides or steaks, I would definitely buy the stock, assuming it was selling cheap enough. =)

Mohnish Pabrai Interviewed by Investor Guide

Great interview. The interview asks better questions than my friends and I did when we interviewed him on 27 June.

Best quote: "I read a study a few years back where some university professor had documented returns one would have made owning what Buffett did - buying and selling right after his trades were public knowledge. One would have trounced the S&P 500 just doing that. I don't know of any investors who religiously follow that compelling approach."

Is it time to buy JNJ, BNI, WLP, and USB? Here's Buffett's portfolio. Check out the weighting and whether the stock has dropped in price since he bought.

Warren Buffett Featured in Smart Money

In this month's Smart Money, Buffett explains he currently has too much money and too little ideas. His advice for investors? If you are a "know-nothing investor" put your money in index funds. If you have the urge and aptitude, invest in easy-to-understand companies with strong balance sheets that produce a product that people will want even if prices rise. As always, he recommends buying cheap.

Behavioral Finance and Cognitive Biases

Humans are emotional and flawed. This includes you, me and everyone. Hope, fear, greed and despair often dominate investment behavior. With some knowledge of common irrational thinking, we can inoculate ourselves and possibly recognize these flaws when they come up within ourselves. Additionally, they can be exploited if we recognize that a collective cognitive bias is causing a stock to be mispriced.

1) Loss aversion - Studies have shown that people feel twice as much pain for a loss as they do for a gain of equal amount. This tends to cause panic selling even when the fundamentals and environment remain constant.
2) Sunk cost effect - This is the belief that money spent should be considered in decision making. It shouldn't. It's gone, forget about it.
3) Outcome bias - This is the tendency to judge a decision by the outcome rather than the quality of the decision at the time it was made.
4) Recency bias - This is the tendency for people to place a greater emphasis on recent events, data and experience.
5) Anchoring - This is the tendency to use readily available information rather than hard to find information when making a decision even when the difficult information is more relevant.
6) Bandwagon effect - The Law of the Herd. Doing something because everyone else is doing it. If it's on the cover of Business Week magazine as a sure-fire winner, it may be time to sell.
7) Belief in the law of small numbers - The tendency to draw unjustified conclusions from too little information. People tend to focus to much on noise.

This list is not comprehensive but it is a good start in thinking about your investment emotions and possible flawed thinking. That's one of the great things about investing, it can teach you about yourself.

[Source - The Way of the Turtle by Curtis Faith, well written but not recommended for value investors at it deals with using a Donchian Channel trend system for commodity trading]

Essential Reading

Here's my list of essential reading for the value investor:

1) Intelligent Investor by Ben Graham.
2) Berkshire Hathaway's annual reports, available free on the corporate website.
3) The Little Book That Beats the Market by Joel Greenblatt.
4) The Dhandho Investor by Mohnish Pabrai.
5) The Interpretation of Financial Statements by Ben Graham.

There are many, many valuable books out there but, to keep things simple, these should be the touchstones.

Mohnish Pabrai Wins Lunch with Warren Buffett

With a winning bid of $650,100, Mohnish Pabrai of Pabrai Investment Funds and Guy Spier of Aquamarine won the yearly charity auction with Warren Buffett. The lunch will be held at New York's Smith & Wollensky steakhouse with proceeds benefiting the Glide Foundation.

The interesting thing is that I know what Mohnish plans on discussing with Warren. Mohnish was kind enough to meet with me and several other Anderson students for an informal question and answer session on July 27th. When asked what he planned on discussing with Warren if he won, Mohnish explained that he planned on talking about charity work and estate planning (Mohnish's fund does well enough that I don't think he needs the investment advice or publicity). Following Warren's generous lead, Mohnish plans on giving back most of his estate back to the public starting with his own nascent philanthropic organization, Dakshana. He also said that he was letting his daughters come up with their own questions for Warren to answer. I'm sure they will charm the soft-hearted Uncle Warren. Seems like it will be a memorable conversation for all parties while at the same time benefiting two great causes. By any measure, that's an excellent ROI.

Welcome

Welcome to my blog, founded July 4, 2007.

I've decided to start this blog on Value Investing based on a recent informal interview with Mohnish Pabrai of Pabrai Investment Funds. I'm currently a second-year, part-time MBA student at the Anderson School of Management at UCLA. I also work full-time for a top 5 consulting firm and am a licensed California attorney.

My investment style is shamelessly stolen from Ben Graham, Warren Buffet, Joel Greenblatt and Mohnish Pabrai. In this blog, I shall reflect on my own views of their investing philosophy and hopefully pay homage to these great investors. I also will discuss MBA school, applied statistics, economics and anything else that interests me.

I hope readers enjoy the blog and I encourage you to review the materials contain herein, and welcome comments, suggestions or other associated feedback.

Very Respectfully,
Michael Lestyk
UCLA Anderson, Class of 2009

sooper.kurgan@gmail.com