It's tough not getting depressed....

The more I read the newspaper, the more convincing the headlines seem. There are very disturbing macroeconomic signs in every country in the globe, even our own supposedly steadfast one (Canada). Unemployment rates are rising, net worth is dropping, people are walking away from their homes and there is no light at the end of the tunnel. Some very erudite essays in the Economist and those insightful pieces written by Vitaliy Katnelson paint a gloomy picture for China, India and Russia's outlook in contrast to their recent stellar view .

No place to run. No place to hide. Cheap energy and a devalued loonie is suddenly our enemy when only a year ago the opposite was true.

Believe it or not, there is another way to view the market's prospects. It's my personal belief that there's a 90% chance that the US will lead the world out of this mess just as they lead us into it the first place. I sure don't know when, though.

Consider these points, made by the Southwestern Asset Management group in a recent conference call:

• "The earnings yield of the S&P 500 relative to Treasurys has made equities the most compelling since the mid 1930s.
• "The annual 10 year return for large company stocks has turned negative – something that has occurred only two other times, in 1938 and 1939, since tracking began in 1926.
• " The VIX, an index measuring expected volatility and therefore fear, hit an all-time high in November.
• "Significant margin calls and capital calls from various types of private funds have caused widespread selling of equities.
• "Advisor sentiment measuring bulls versus bears has fallen to the lowest level in over two decades.
• "The amount of cash being held on the sidelines by individuals has grown to a sum significantly greater than the total market cap of U.S. stocks.
• "Investors have bought Treasurys with no return, an indicator of the fear of other investments.
• "Institutional managers have held high cash balances in spite of acknowledging equities’ undervaluation.
• "Warren Buffett and Prem Watsa, two of the best fundamental investors, have made significant moves into equities.
• "Insider buying at companies has been rampant."

I think the last point is debatable. In late 2007, insider buying was much higher than it is now, particularly in my holdings. The rest have merit.

The bottom line is that I agree with the bears that more pain is probably due. These problems will work themselves out over a number of years. The thing is that the stock market is forward looking (usually 6-9 months or so) and when the first sparkle of light shows through the darkness it's not unreasonable to expect a violent ramp UP from pent up demand to invest the money on the sidelines. T-bill's are in negative territory and bank accounts don't look very appealing.

Over the next 6 months I plan to find a number of small to mid cap companies with excellent management, very solid balance sheets and liquidity and preferably with a decent dividend and sock my money away there. Stay tuned.

l

Why you should ignore experts and do your own research.

Worst Predictions of 2008.

Mea culpa note: I got sucked into AIG as well. My mistakes were buying a complex company that I didn't really understand and to interpret aggressive insider buying as a buy signal in isolation. It looks like in retrospect that the AIG insiders didn't understand the company any more than I did!

PETER COY, BusinessWeek Economics Editor

Just about everybody got wrong-footed by 2008, but some people's mistakes were truly spectacular. Here are some of the worst predictions that were made about 2008. Savor them -- a crop like this doesn't come along every year.

1. "A very powerful and durable rally is in the works. But it may need another couple of days to lift off. Hold the fort and keep the faith!" -- Richard Band, editor, Profitable Investing Letter, Mar. 27, 2008

At the time of the prediction, the Dow Jones industrial average was at 12,300. By late December it was at 8,500.

2. AIG "could have huge gains in the second quarter." -- Bijan Moazami, analyst, Friedman, Billings, Ramsey, May 9, 2008

AIG wound up losing $5 billion in that quarter and $25 billion in the next. It was taken over in September by the U.S. government, which will spend or lend $150 billion to keep it afloat.

3. "I think this is a case where Freddie Mac and Fannie Mae are fundamentally sound. They're not in danger of going under…I think they are in good shape going forward." -- Barney Frank (D-Mass.), House Financial Services Committee chairman, July 14, 2008

Two months later, the government forced the mortgage giants into conservatorships and pledged to invest up to $100 billion in each.

4. "The market is in the process of correcting itself." -- President George W. Bush , in a Mar. 14, 2008 speech

For the rest of the year, the market kept correcting ... and correcting ... and correcting.

5. "No! No! No! Bear Stearns is not in trouble." -- Jim Cramer, CNBC commentator, Mar. 11, 2008

Five days later, JPMorgan Chase took over Bear Stearns with government help, nearly wiping out shareholders.

6. "Existing-Home Sales to Trend Up in 2008" -- Headline of a National Association of Realtors press release, Dec. 9, 2007

On Dec. 23, 2008, the group said November sales were running at an annual rate of 4.5 million -- down 11 percent from a year earlier -- in the worst housing slump since the Depression.

7. "I think you'll see [oil prices at] $150 a barrel by the end of the year" -- T. Boone Pickens , June 20, 2008

Oil was then around $135 a barrel. By late December it was below $40.

8. "I expect there will be some failures. … I don't anticipate any serious problems of that sort among the large internationally active banks that make up a very substantial part of our banking system." -- Ben Bernanke , Federal Reserve chairman, Feb. 28, 2008

In September, Washington Mutual became the largest financial institution in U.S. history to fail. Citigroup needed an even bigger rescue in November.

9. "In today's regulatory environment, it's virtually impossible to violate rules." -- Bernard Madoff, money manager, Oct. 20, 2007

About a year later, Madoff -- who once headed the Nasdaq Stock Market -- told investigators he had cost his investors $50 billion in an alleged Ponzi scheme.

Victoria Contrarian Investing Club Launch

Starting in January 2009, I'm putting together a email list of interested investors of all knowledge levels who have a value bent. The idea is that about once a month one of us will present an investment idea in detail to the others via email. About twice a year we can get together in person for wine, appies and either a guest speaker or a presentation from one of the members, mostly for fun.

I'm going to analyze Fortress Paper Ltd. FTP.TO as the first project. I'm trying to establish a format that will be easy to understand for members of all levels. I'm guessing that most of us will be caught up to the others within a few months. Questions about the terminology etc. will be encouraged.

There are many different approaches to value investing i.e. deep value, distressed company investing, GARP, risk arbitrage etc etc so I don't care what you like-- just teach us! Hot stocks with premium valuations and/or junior mining ventures with no earnings probably won't go over too well, though.

After you do your first one, you'll see how much work it is to do a full analysis. Nothing comes easy in this world and investing is no different.

The main point of each presented idea is to increase our level of knowledge and not necessarily as a prompt to invest with real money. That's your decision, of course. I will track all the securities presented and present their performance once a year.

I've tried to get a listserv set up but am experience "technical difficulties", so for the short term anyway, we'll just email the list by hitting "reply all". If interest grows, I'll figure something much better out.

I'll continue to blog and include gems from all over the internet here, of course.

Anybody interested in joining (even if you don't live in Victoria) please email me at lporayko@gmail.com. I'll add your name to the mailing list.

Those of you who want an invaluable resource to read about value investing (second only to "The Intelligent Investor" by Ben Graham) please open yourself a gmail account. I have a very large file to send you that will be your investing bible.

l

Sum of the parts analysis

This is a superficial but intriguing example of two opportunities at Gurufocus.com. Read about it here.

P/B

Book Value Bargains

The Cheapest Buffett stocks at Gurufocus.com

Seth Klarman speaks on the value investor's perspective

One of the most admired value investors in the world who only rarely talks to the media about his methods. Read the brief interview here.

l

Fortress Paper: a cheap, profitable microcap

As I grow older I've learned an important lesson: age (experience) and treachery will always trump youth and enthusiasm. Unfortunate but true-- and nowhere else do you see this as well demonstrated as in the investing world.

Along these lines, I'm never afraid to steal a great idea from people that may be smarter than me. Even more satisfying is the opportunity to buy a fractional ownership in a company at a considerably more favourable price than a good or even great investor has--- essentially utilizing all their expensive expertise and resources for FREE! Sounds pretty parsimonious, doesn't it? Isn't that what value investing is all about?

Of course the usual caveat applies: don't ever follow gurus (not even Warren Buffet) blindly. Their investment objectives and constraints are likely vastly different than yours. You need to understand the investment thesis in depth. If you don't want to do the research to do that, buy a few ETFs.... the couch potato's portfolio will do better than 90% of the "experts" at any rate and now is probably one of the best times to set one up.

Although I get a lot of my best ideas from the value gurus that I follow from gurufocus.com, I also search SEC sites for the smaller cap stocks that the giants pretty much need to ignore. These companies may have a lot of promise but they are simply too small to move the needle for these funds.

One company that has caught my eye for a couple of years and I'm intensifying my research efforts is Fortress Paper Ltd FTP.TO.

In my thieving and lazy fashion, I'm going to let the ABC funds guys (value investing oriented hedge fund, based in Canada) describe the compelling fundamentals, strong management and excellent prospects for this company that is trading at a fractional of its tangible book value-- providing a decent margin of safety. A sum-of-the-parts and DCF analysis conservatively indicates an intrinsic value of $10/share and FTP.TO is trading at half that today. I think that they are dead right about what the "Street" is missing: this is not a commodity play whatsoever. The market is treating the stock as if the company had a crappy balance sheet or negligible or absent earnings. This type of dislocation is where opportunity for small investors lies. I also think that investors see the wallpaper segment and run away screaming.... because it has something to do with housing and construction. We're still suffering from that hangover and probably will be for some time. Surprisingly, the wallpaper part of the company has been doing very well by selling to eastern European customers doing inexpensive renos.

The other issue is that not just anyone can open up shop and start printing security papers and currencies (lol) for obvious reasons. There are regulatory hurdles and expertise/reputation to attain first. I think this warrants FTP an economic moat albeit a narrow one. That is rare for such a small company.

The only thing I can add that isn't covered in the link above is that management owns 25% of outstanding shares and insider buying has occurred throughout 2008--- having the top people with "skin in the game" is almost mandatory for my investments, particularly these days. It firmly aligns their interests with ours, focuses their minds when market values dwindle and encourages long term thinking.

Downside risks:

• microcap and smallest in its industry
• competition coming on line for non-woven wallpaper niche
• material costs/capex high and difficult to anticipate
• really in the tech sector and in a rapidly changing industry-- we prefer slowly changing ones
• no dividend (a considerable downside when a near-term catalyst is not on the horizon)

I'm in no rush to invest in this company mostly because of downside #5. I plan to continue studying it for another quarter. A possible entry point would be <$5/share and target of >$10/share.

l

SYK v.s. IHI

I use the time spent actively ignoring the bear market rallies such as the one we're in now to study companies in depth for possible entry positions during the inevitable pullbacks.

Stryker SYK, a wide moat high quality medical device company, has caught my attention as it comes off of 52 week lows. Strong management, a bullet-proof balance sheet and great free cash flow growth certainly makes it attractive. Even in the current environment, SYK has increased its modest dividend by 20% (effortlessly sustained with a miserly 12% payout ratio). I'm still doing my due digilence on this one and fortunately, it's well within my circle of competence.

iShares Dow Jones Medical Device ETF IHI is also very interesting. It's a concentrated ETF with the top 10 out of 43 companies making up about 80% of the holdings. It's trading at about 40% discount to Morningstar's fair market value and I'm quite familiar with the most highly weighted companies 2/3rds of which are wide to narrow moat entities. Great FCF mean values, very tax efficient (no capital gains distributions since inception) and diversification of litigation risk (one of the major downsides of investing in this group) make this ETF quite compelling.

enjoy your research.... I do. :-)

from Barron's: LUK (one of my favourite long term investments now)

Leucadia's Unmined Potential

By ANDREW BARY

Leucadia has savvy management and cheap assets -- an enviable combo.

LEUCADIA NATIONAL MAY BE THE CLOSEST THING to what Berkshire Hathaway was 20 years ago, before Berkshire became so large that Warren Buffett needed investments of several billion dollars to move the needle.
AFP/Getty Images
Above, a western Australia mine run by Fortescue Metals, a company in which Leucadia has a big stake.
Run for 30 years by a secretive duo, Ian Cumming and Joseph Steinberg, Leucadia has invested in a wide variety of stocks and a diverse group of businesses. It has generated impressive returns and developed a cult-like following among value-oriented investors who like its investment style -- and results. Buffett is a fan of Leucadia, although Berkshire doesn't own the stock. Leucadia's book value, which stood at $23 a share on Sept. 30, is up from just 11 cents in 1979, an annual growth rate of more than 20%.
Leucadia (ticker: LUK), however, has fallen 60% since Sept. 30, to about 17, leaving it way below its May peak of 57 and slashing its market value to $4.3 billion. Investors fear that Cumming, 68, and Steinberg, 64, have lost their touch, owing to declines in many of Leucadia's key equity holdings, including Australian iron-ore producer Fortescue Metals Group (FMG.Australia), securities firm Jefferies (JEF), Canada's Inmet Mining (IMN.Canada) and auto-finance outfit AmeriCredit (ACF).
MANY OF THE COMPANY'S OTHER investments are suffering, including Cresud (CRESY), an Argentine agricultural and real-estate company, and Leucadia's 10% stake in a hedge fund run by William Ackman of Pershing Square that owns a single stock, retailer Target (TGT). Leucadia probably has lost half of the $200 million it put in the fund last year.
Fans argue that Leucadia is oversold, noting that it rarely has traded below book in the past decade and in recent years typically has commanded 1.5 to two times book. The stock could hit $30 in the next year if the company's equity holdings turn around and if Steinberg and Cumming take advantage of the current financial distress to display their old stock-picking magic. Says one Leucadia holder: "I don't think that they suddenly took stupid pills." Given market declines since Sept. 30, Leucadia's book value has now probably fallen closer to $20 a share.

Table: Leucadia's Key Investments


Steinberg and Cumming, who couldn't be reached for comment, focus on minimizing Leucadia's tax bill. The company now has $1.6 billion of deferred tax assets, indicating that it expects to shield some $5 billion of future profits from federal income taxes. Strip out that tax asset to reflect no future gains, and estimated book falls to around $14 a share. "That's a worst-case assumption. You're not paying much above that for the stock," says a recent Leucadia investor.
Book value also may be understated because of conservative valuations for real estate and other assets the company owns, plus a potentially lucrative agreement with Fortescue that pays Leucadia 4% of net revenues from its Australian iron-ore mine for more than a decade. The deal could produce more than $100 million of annual profits for Leucadia, assuming ore prices don't collapse.

Leucadia's operating businesses, including plastics, wood products, pre-paid phone cards, as well as a Napa Valley winery and the Hard Rock Hotel & Casino in Biloxi, Miss., don't generate much profit. Investors tend to value the company on book value, rather than earnings, because most of its worth lies in investments.

LEUCADIA ALSO HAS INVESTED about $100 million for an 87% stake in a medical start-up called Sangart, which is developing a blood substitute now in clinical trials. There have been many failures in this field, but Leucadia hopes that Sangart's product, Hemospan, is a winner.
Many holders simply view Leucadia as a play on Cumming and Steinberg's investment acumen. Both intend to stay on the job for a while; their employment contracts run into 2015. Some Leucadia watchers believe the company will be liquidated or sold when Cumming and Steinberg leave the scene.

Like Buffett, Cumming and Steinberg believe in a strong balance sheet. As of Sept. 30, Leucadia's $8.4 billion in assets significantly exceeded its $2.6 billion in debt and other liabilities. Leucadia had about $500 million of cash and equivalents on Sept. 30, down from $1.4 billion on Dec. 31. Dividends certainly aren't a drain on its cash. This year, there will be none; last year, the payout was only 25 cents a share.

Unlike Berkshire, Leucadia lacks significant operating businesses; its focus tends to be on more speculative companies. It has paid $405 million for 32 million shares -- a 28% stake -- in AmeriCredit, which provides auto loans to those with weak credit. Reflecting a tough economy and tightness in the credit markets, AmeriCredit shares are 40% below Leucadia's cost.
Cumming, Leucadia's chairman, and Steinberg, its president, may be the lowest-profile leaders of any sizable public company. Outside of their annual shareholder letter and appearance at the annual meeting, they stay out of public view. There are no earnings conference calls, no investor presentations and no financial guidance. There are no photographs of Cumming or Steinberg in the annual report. Hardly any analysts cover the company because of its complexity and minimal communications.

LEUCADIA INVESTED IN FORTESCUE in 2006, when founder and CEO Andrew Forrest needed money to build a giant mine in a remote area that would compete with Australian iron-ore titans Rio Tinto and BHP Billiton to supply the voracious Chinese steel industry. Leucadia, which initially invested $400 million, now owns 9.9% of Fortescue. The miner's shares got as high as A$13.15 in May, at the height of the commodity boom, making Leucadia's stake worth $3 billion and pushing up Leucadia stock. Since then, Fortescue has slid to A$2.50 still more than double Leucadia's cost.

The Bottom Line
Leucadia is trading near 17, versus a book value now estimated at 20. If Leucadia's two top managers haven't lost their investment touch, the stock could hit 30 in a year.
Leucadia also has a close relationship with investment firm Jefferies, reflecting in part Steinberg's friendship with CEO Rich Handler. Last year, Leucadia took a 50% stake in Jefferies junk-bond trading unit, in return for $350 million, even though securities firms rarely sell outsiders parts of their trading operations. This year, Leucadia has accumulated a 30% stake -- 48.6 million shares -- in Jefferies itself, at an average cost of $16. But the stock has dropped to around 10, less than 80% of book value.

Jefferies isn't immune to Wall Street's troubles -- it laid off about 10% of its staff last week -- but its losses have been relatively modest because it doesn't take big trading positions. Still, its high-yield trading business has lost more than $80 million this year. Jefferies, a scrappy niche firm, focuses on equity trading and junk bonds, as well as investment banking.
Leucadia now looks like an attractive play on its depressed investments and on the ability of Cumming and Steinberg to find new opportunities. Unless the pair has indeed taken "stupid pills," investors could do well taking a ride with them

Risky business

The Economist article on bond spreads and dividend yields.

l

ps I'm putting together a few presentation for investing ideas together that I'll post in the next few weeks.

A few pictures that tell an important story... click on the graphs to see the whole thing

to summarize:

• investors are sitting on a LOT of cash-- historical highs
  
• valuations are at 30 year lows while dividend yields are at their highs (albeit with more than a few US companies cutting dividends of late)
• junk bond credit spreads are also at 30 year highs

is capitulation/a market bottom looming? If I had to guess, I would it will come over the next 6 months or so.

Happy bargain hunting!

Have a look at USG

Read this article first.

Q&A with Buffet-- Part I, II and III

Part I



Part II



Part III


Disclaimer: my wife and I own shares in USG, USB and COP

David Dreman's Forbes article

read it here

More BAM: cash flow analysis

from Desjardins Securities: read it here

BAM is one of my favourite longterm investments: wide moat real estate (both residential and commercial), "green" power generation assets along with prolific management fees, keeps the cash coming in. 17% of shares are insider owned. Capital allocation is carefully and intelligently considered: read CEO Bruce Flatt's comments regarding that topic in the Q3 2008 conference call transcript.

I have a low ball bid in for $10/share (below book value of approx $11/share!).

l

A couple of opportunities to watch for...

I don't have time to fully analyze these businesses for you now but 3 amazing values have come up today:

NOK Nokia- cash rich, market share hogging, well managed with a 6%+ yield etc etc trading at $13 and change. One of the few free thinking analysts, Vitaliy Katnelson, has a brief overview of the bull case for Nokia here.

LUK Keucadia National Corp- 28% increase in book value/year since 1968! trading at 1998 values $17/share. There's an analysis of some of LUK's portfolio here.

BRK-B Berkshire Hathaway-- grazing $3000/share, also trading at 2005 levels. I don't think I need to say more than that about this one.

I'd study them all.

l

Bill Miller's Q3 letter

Whether you have respect for him as an investor or not, I think you'll benefit from reading this extremely insightful letter here.

Wait until Santa does his thing

my comment: the article below is immoderate to say the least and I don't agree with a few things he says; however, there's a few nuggets of truth in there:

• tax loss selling is likely to produce even better buying opportunities in quality companies next month
• commodities could go down even further than they have and the recovery time will be difficult or impossible to predict, even if you believe that we are in the midst of a long term secular bull market in commodities

Tax-loss selling for 2008 will be the rule the next eight weeks.
Story By Rob Cornelius

Money on the sidelines isn't coming back to the market. Don't expect the cavalry to show up and save us. Money that is out of the market either vaporized as losses, is in "safe" investments, such as U.S. government securities, or capitalizing one of these banks that is begging for deposits.

Preserving capital is critical. Nobody is feeling greedy yet.

Tax-loss selling for 2008 will be the rule the next eight weeks. Investors will sell their losers (and, boy, do we have a bunch of those) to make up for their gains. The pressure on stock prices should continue to be downward. Hedge-fund and mutual-fund redemptions will happen before year's end as well.

Carryover losses will be awesome. Investors have seemed to fear a Barack Obama presidency, and the last 1,500 points of Dow fall appear correlated to his rise in the polls. Some will sell to incur taxable losses; others who have huge assets are trying to get rid of them now to avoid changes in tax laws.

Retirement Plan Disasters

Pensions, charities and endowments will continue to hide behind terms like "unrecoverable losses." Read the daily newspapers and you see that term come up. That simply means losses they were forced to take by selling a devalued asset. There still are plenty more on the books that will have to be taken eventually. Understand that many of those organizations' stocks now need to go up 100 percent to be where they were a few months ago: If you are down 50 percent, you have to go up 100 percent to be even.

As S&P and Moody's do their jobs in coming months, more corporate bonds will be downgraded. More companies adjust earnings estimates down. When they drop below certain ratings thresholds, pension funds will be forced to sell them at market, cascading still further "unrecoverable" losses.

Pension funds were and are handicapped by being slow-moving, committee-driven animals -- late to bull markets and slow to evacuate bad ones. Not active, but reactive. And they are paying for it.

While state pensions have embarrassed all over the country, their corporate or private brethren may be worse; the former have the ability to raise shortfalls via taxes or bigger employee deductions. Ask U.S. Steel or the UMWA where their pension plans will be in a year. They are based on increasing share prices of the underlying company or adding more jobs/members. Neither is happening.

The Federal Pension Benefit Guarantee Corp. is seriously short of money, and a couple of good-sized corporate failures could deplete its kitty. It is like the FDIC for pension plans -- the insurance of last resort.

Someone will be made to take responsibility. In 2010 or 2012, this will be a political tool for un-electing state treasurers or anyone else vaguely responsible of either party.

The only upside of all this may be the fact that inflation, for the short term, is dead. Deflation is the word, as everything shrinks in value, be it homes or tons of coal or barrels of oil. But that said, I can never imagine a scenario when governments reverse cost-of-living-increases to those on the dole. They seem to have little self-interest in shrinkage.

People in many non-Roth IRAs and employee savings plans of all sorts are trapped. Some plans have no way to become un-invested other than money markets, which were shown to be potentially deadly in recent months. Worse still, you have no way to go short or bet against the markets. No sector has been safe for the last 90 days.

For those who are still mad at people who short stocks, it was pension funds that got rich as part of that process. To short a stock, some other investor must loan it to you. In most cases, it was big pensions, such as CALPERS loaning you those shares of Citibank and collecting margin interest on the loan. Like prostitution, it was a mutual agreement of two parties -- one of whom never really expected Citi to fall to $12.

Who Else Can We Blame?

Illegal immigrants and their contributions to the real estate mess will be brought to the forefront to create scapegoats. National reporting states that as many as 5 million home mortgages may have been extended to illegal aliens, many of whom are in worse financial straits than Americans. In big, round numbers, and knowing that more illegals bought more homes in western states (where they are more expensive), say banks lose an average of $100,000 on each of those transactions. You're looking at a loss just there of $500 billion. Maybe that's overstating a dollar number, but protectionism and assessing blame tend to be big in economic disasters.

I cited "losers" and "poor people" as root causes of this crisis when I first started writing about it here on Aug. 9, 2007. That said, they were rational actors empowered by government to take what they knew they couldn't afford. When government told lenders to loosen standards so that anyone who could fog a mirror got a mortgage, these folks took advantage. Having everyone equal may be fine in a co-ed game of soccer among first-graders with no one keeping score. But in real life, some of you are richer/smarter/faster and get more playing time or score more goals. The market should reward that. Not all our children can be above average.

U.S. Dollar is Strong

U.S. Bank government guarantees are bringing every dollar here to federally backed investments. This strengthens our dollar and weakens foreign markets' currencies. The eventual inflection point will be when the rest of the world loses faith in the Treasury to pay back and our rates to borrow suddenly skyrocket. That's when inflation should return. At this point, the best course of action may be to sell as much new debt as possible while rates are super low. As other nations cut interest rates to spur their own economies, the flight to U.S. dollars should intensify further.

Thank God the U.S. didn't make many loans to developing countries, whose currencies are crashing. Typical European banks may have those loans filling 20 percent of their books; the U.S. averages 4 percent. Crashing currencies make it harder to pay back your loans.

The idea of rising interest rates at the same time as deflation is pretty unique in economic history. No one is really sure how to model this crisis after anything else except maybe the American Panic of 1873.

Hard Assets Soften

Cheap energy is a terrible sign for growth and the world economy.

Oil has more room to contract in price, as demand will slow further. The only thing keeping American refiners open is the fact that they can still make money on the middle distillates they refine (heating oil, diesel and aviation gasoline). They ship a lot of those to Europe. They are losing on auto gasolines right now. Once you see the diesel price in West Virginia slim down to maybe a 50-cent premium over regular gasoline, you'll know the refiners are in real trouble.

Low energy prices will destroy whatever progress has been made on alternative energy. Well-capitalized companies will do well as steel cheapens for massive windmills, but most of the solar guys were selling at ridiculous price/earnings multiples.

Ethanol is also dead if wholesale gasoline stays under $2 a gallon. Farmers may shift from corn to soybeans next spring for the sake of profits. Short term, alternative energy will expand only as a direct result of government handouts.

Gold/silver .... paper versus reality. Go to eBay. While gold that trades in the markets is less than $700, you see one-ounce gold coins selling for a three-digit premium to that at $850 or more. The percentage gap is still greater for silver and platinum.

People are hoarding gold and extra bullets it would seem. Central banks are trying to raise U.S. dollars and appear to be dumping physical gold while they can, depressing price. Price is now dropping enough to make mining unprofitable for not just gold but also many of the non-precious metals, such as copper and nickel.

Stop Whining, Learn

Great reads/blogs to scare yourself straight on this topic: calculatedrisk.blogspot.com, globaleconomicanalysis.blogspot.com, nakedcapitalism.blogspot.com ... and pay attention anytime "Dr. Doom" Nouriel Roubini or Oppenheimer analyst Meredith Whitney show up anywhere. Billionaire genius Mark Cuban at blogmaverick.com has been smart and full of good ideas, albeit with no sense of investment timing at all. All seem pretty sure our financial system isn't done with its turn in the spanking machine.


Rob Cornelius of Parkersburg follows energy and the markets for The State Journal.

Gurus falling down

• ROI
• NOVEMBER 14, 2008, 9:34 A.M. ET

The Year of Wall Street's Fallen Idols

Chagrined, even ashamed, about your portfolio losses? Take heart: Even managers with some of the best reputations on Wall Street have seen their holdings savaged this year.

• By BRETT ARENDS

Millions of Americans are reeling from investment losses this year.

For many, the financial cost of the red ink is only part of the misery. They're also kicking themselves for the losses.

Maybe you feel you invested too much. Maybe you feel you should have invested in different assets.

This may prove scant consolation, but it is worth noting: The best of the best have done no better. So go easy on yourself.

This has been Wall Street's year of the fallen idols.

Bill Miller

Marty Whitman, the legendary septuagenarian who co-manages Third Avenue Value, has seen crises come and go. There are few you could trust more in a panic. But his fund has almost halved this year. Bill Miller, the famous manager at Legg Mason Value, has fallen by nearly 60%. And that's not even the worst of it. Miller's more flexible, go-anywhere fund, Legg Mason Opportunity Trust, is down by two-thirds since the start of the year.

Ron Muhlenkamp at Muhlenkamp, Wally Weitz at Hickory, Manu Daftary at Quaker Strategic Growth, Richie Freeman at Legg Mason Partners Aggressive Growth, Ken Heebner at CGM Focus, Christopher Davis and Kenneth Feinberg at Davis New York Venture Fund, Will Danoff at Fidelity Contrafund, Saul Pannell at Hartford Capital Appreciation: They've all lost about 40% or more. Some have nearly halved.

It is a shocking bloodbath. These are managers with some of the highest reputations on Wall Street. They have beaten the Street over many years, even decades. And even they got shellacked.

What chance did you have?

Even most of those who anticipated a crash got pummeled. Bob Rodriguez at FPA Capital has been very bearish for years, and was holding large amounts of cash in the fund. But he's still down 36%.

The picture for Warren Buffett looks somewhat better, although he swung from $3 billion investment profits to $1.4 billion losses in the first nine months of the year, while net earnings more than halved. Shares in Berkshire Hathaway have fallen about 31% since Jan. 1.

Those who look good include John Hussman at Hussman Strategic Total Return, who is down just a few percent. And Jeremy Grantham at GMO, who predicted much of the meltdown. His GMO Benchmark-Free Allocation Fund, an institutional fund that has a pretty free rein on what to hold and what to avoid, has still lost 11% so far this year.

There are three long-term lessons here for ordinary investors.

The first is that if the smartest and best fund managers can't successfully anticipate a crash with any degree of confidence, you can't either. Time spent trying is time wasted.

The smart money rarely spends much time very bearish, and with good reason. In practice it is almost impossible to predict a crash. And even if you are right about the direction, you will probably get the timing wrong. That may end up compounding your losses instead of preventing them.

John Hussman is among very few who have gotten this one right. I know at least two superstar managers who correctly anticipated a blow out, and moved heavily into cash… in the fall of 2006, a year too soon. Markets soared instead.

I also know of at least one portfolio manager who's been predicting the U.S. credit implosion for at least seven years.

Prudent Bear has been betting on falling shares (and rising gold) for a long time. It's finally getting its reward: It's up about 37% so far this year. But investors actually lost money between 2003 and the end of 2007, while the rest of Wall Street rose 70%.

And remember that investing is a long-term game. This has been the worst financial bloodbath since 1929. Yet Ken Heebner is still up more than fivefold over the past ten years, even after factoring in this year's carnage. Mr. Daftary has more than doubled investor's money. Many others are up 50% or more over that time.

The best an investor can do is to look for value, prefer unfashionable assets over fashionable ones, and avoid chasing past performance.

As previously observed here, everything has now fallen. Inflation-protected government bonds. Munis. Gold stocks. The whole shebang. Eighteen months ago, every single asset class was expensive. Today it's possible that almost every single asset class – with the possible exception of regular Treasurys - is cheap.

Write to Brett Arends at brett.arends@wsj.com

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New stock to study: Mohawk Industries MHK

Mohawk Industries is a producer and distributor of residential and commercial flooring including carpet, ceramic and porcelain tile, hardwood, laminate and home textiles including area rugs. They also distribute resilient (vinyl) and vinyl composition tile (VCT) flooring through a partnership with Congoleum.

Mohawk and Shaw (owned by Berkshire) are the 2 largest floor covering manufacturers in the world-- this represents a near duopoly: together they own 46% of market share.

MHK was founded 130 years ago. Its distribution system is much admired in the industry. It has over 30,000 regular customers (mostly specialty stores), none representing more than 5% of the total revenues. Market Cap approx. 2.5 B. Share price is down 53% from 52 week highs.

Bull Case:

• duopoly and global footprint
• boring business with a slow rate of change
• very easy business to understand
  
• Management is shareholder oriented and communicates very clearly in all reports
  
• high insider ownership 18% of the company's outstanding shares are owned by the CEO
• one director bought about $7 M worth of stock at $69/share in late Aug '08
• value gurus have large stakes: Berkowitz, Ruane Cunniff and Wallace Weitz
• meets criteria for Graham stock: P/E 4.1 P/B 0.5 Current Ratio > 2, 5y EPS Growth Rate > 3, EV/EBIDTA is only 5.
  
• generated 371 M of cash flow in the first 9 months of 2008, actively paid down 271 M of a total of 2 B of debt. D:E is 0.47 well below industry average of 0.61.
• no debt matures until 2011
  
• Q3 results distorted by a quirky accounting rule that forced the company to write down a large non-cash charge v.s. goodwill (1.2 B) and tax deferral charges (0.25 B) triggered by the rapid and steep decline in MHK's share price.
• 60% of revenue is derived from renovations and remodelling, not new builds.
• MHK has been able to raise prices recently despite lower input costs from the drop in petrochemical prices which should help boost margins in the intermediate term
• Gurufocus backtested business predictability index rates MHK's 10 year financials at 4.5/5 stars.
  

Bear Case:

• 13.5% of outstanding shares have been sold short. The short sellers are probably right-- the share price is going to drop even further
• there is a debt covenant on one of the LOCs that stipulates that the debt:equity ratio must stay below 0.6 or the company will be forced to liquidate assets at less than favourable terms
  
• nat gas/oil prices (2/3 of costs of goods sold) are likely to rise again with the economic recovery and impact margins adversely
  
• there is no end in site for the housing bubble implosion. There is at least 8 months of new home inventory to clear before builders start to significantly increase demand for MHK's products and its very possible that the slowdown could drag on longer than expected.
• no dividend despite great and predictable cash flows!

This company is definitely worth further study. It would clearly be a long term investment 18 months to 3 years+. It is fundamentally cheap now; however, it's clear that the share price has further to drop. I would be interested at <$30/share and I would buy in small increments over the next 18 months, watching the company's liquidity very carefully. Housing in NA and Europe will recover one day-- I'm not sure when. The stock will likely rocket up (if the company survives, that is) 6 months or so before the recovery is obvious just because that's how the market works. With these kind of investments you need to commit during the times of maximum uncertainty, unfortunately.

Bedtime reading for China bulls and Gold-bugs

Globe and Mail's Avner Mandelman

A little brain damage might make you a better investor...

I'm hopeful that this is true because just yesterday I got caught by a left hook in my MMA class straight in the nose.

This article describes the psychological underpinnings that hold us back from making asymmetrically rewarding bets after we have made recent losses (realized or not). Patients with traumatic brain injuries often have disordered limbic-cognitive function which prevents them from being fearful bettors, even when they probably should be.

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BAM-- Technical Knock out from the G&M

My confidence in the management and position of this company continues to grow. In an awful environment for financing and raising capital, they continue to outperform all their competitors.

I'll buy at <$20 with conviction. I'm also very interested in some of the preferred offerings.


The Canadian Press
November 7, 2008 at 9:53 AM EST
TORONTO — Brookfield Asset Management Inc., formerly known as Brascan, reported Friday a sharply higher net profit and rising revenue.
Its third-quarter net profit was $171-million (U.S.), or 27 cents a share, up from earnings of $93-million, or 13 cents for the same 2007 period.
Overall revenue jumped to just under $1.3-billion from $980-million, said the company, which reports in U.S. dollars.
In breaking down its quarterly results, Brookfield said increases in operating cash flows were offset by higher non-cash charges, including depreciation on assets bought since the 2007 second quarter.


“Our operating performance in the quarter reflected the durability of our cash flows, most of which are supported by long-term contractual arrangements with credit-worthy counterparties, the high quality of our asset base and operating platforms, and the stability of our long duration investment grade capitalization,” said Bruce Flatt, the company's senior managing partner.
“In the last few months we increased our overall cash holdings and liquidity to more than $3.5-billion, most of that at the Brookfield corporate level.”
“This is one of the highest levels of liquidity we have ever held, but given uncertainty in the markets we want to be prepared for the unknowns, and opportunities which may present themselves in this environment.”
Mr. Flatt said although Brookfield is “exercising caution during these turbulent times, and preserving a high level of liquidity, we are exploring a number of potential opportunities to expand our operating platforms and create additional shareholder value.”
Brookfield Asset Management is focused on property, power and infrastructure assets and has about $90-billion of assets under management.

Along the same lines

Since Buffett is buying up a railroad--- he now owns 18% of Burlington North-- maybe you can too.

GSH Guangshen Railway serves the Pearl River Delta in mainland China. It has miniscule debt for a railroad (Debt to capital ratio 13%) and is a predominately commuter railroad (i.e. less sensitive to economic cycles). It has a wide economic moat simply because the Chinese government will not allow competition to arise. It owns the only railway connecting HK and mainland China to boot. EV/EBIDTA is 14, comparable to NA railways. Dividend is 3% yield. P/B x P/E is 10.

I would definitely not buy GSH now. Morningstar has calculated a FMV of $28/share. I would be interested in buying shares if it dropped during a market scare to $15/share or less.

Another analysis here.

Asia rising

I've become much more interested in the Asia investment arena lately, precisely because almost everyone else is running away from it.

As I've mentioned before, I still believe that the best way to invest in overseas markets is to buy global companies based in the US. Many of the components of the DOW 30 get more than 50% of their revenue offshore. With that you get access to a lot of information and at least some accountability (yes, I know the banks and brokers have let us down, but compare it to the skulduggery that goes on in many other countries and it looks bland). My reservation about investing in these areas is that it is so difficult to do what Phil Fisher called "scuttlebutt" (getting as much information in addition to the financial reports as you can to give you an edge over other investors).

One approach to this problem is to see what the value gurus are buying and imitate them. They do have a lot more resources than you have and if you can buy the same stocks they do in these faraway places at a cheaper price than they did, you may have an edge. OTOH, I don't like blindly following gurus as their goals, time horizon and asset allocation model may be radically inappropriate for my relatively tiny portfolio.

That said, I think there are a few gems that can be got for pennies on the dollar these days.

This Forbes article gives some Japanese examples of companies that are trading at or below their net liquid asset value.

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"Net-Net" bargains

In a net-net situation, an investor estimates a liquidation value for a company, then tries to pay a fraction of that value in the market. Ben Graham loved these types of situations, defining the net-net value as:

Cash and short-term investments + (0.75 * accounts receivable) + (0.5 * inventory) - total liabilities

Graham looked for companies whose market values were less than two-thirds of that net-net value, for two reasons. First, he wasn't sure he would receive the full value for accounts receivable and inventory before paying off the creditors. Second, he wanted to make sure he had a margin of safety to fall back on, in case it didn't work out. After all, if the market valued the company this low, something was certainly wrong with it.

Graham's idea was to bet on a situation with asymmetrical odds. In such situations, the probability of losing money is fairly high, but the magnitude of any loss would be small. However, the potential payoff is large, despite having a lower probability of success. That's why these situations are special and worth looking for, even today.

For some current equities who meet this criteria read here

Contrarians hate it when the market moves up!

...particularly when there isn't a valid reason for it to do so!!! Efficient market, my #@$@.

I realize that Wall and Bay Street try to be forward looking but this is nuts. All the fears that precipitated the panicked selling have not gone away. They were overblown to an extent but they are still there. Every level headed person realizes that the "great de-leveraging" still has to play out for some time longer-- probably until mid-2009 at the very least.

In the mean time, I'm accumulating as much cash on the sideline as I can for entry into up to 4 new position and adding to some old ones:

New ones:

LUK: mentioned in the previous post, LUK came within a few dollars of my bid of $19/share and then leaped up to $27. Very frustrating. There is a cult-like following of this holding company so a lot of regular people (and gurus like Bruce Berkowitz) understand the quality of its management and the balance sheet despite the detractor: short term uncertainty of the highly assets Leucadia is so adept at acquiring (i.e. 70% of the portfolio is in JEF, a boutique investment bank!). I'm hoping that these people will go away soon and there will be some sort of macro-economic scare to knock them out of the stock so I can buy it real cheap. I'd hold this 3-10 years+.

HHULF.PK: Hamburger Hafen und Logistik reviewed several times. Knocked down to the low 20's euros. Short term outlook for this high margin, highly profitable company isn't good but long term is excellent. I think that it is very well managed. I'd buy in the high teens-- only because Europe is so out of fashion right now (like PHG) and I think I can get that price. I think the FMV of HHLA should be 50-60 Euros/share based on comparable ports EV/EBIDTA valuations. Being traded OTC makes this a thinly traded stock-- another reason it shouldn't be traded but bought for the 5 year+ horizon.

Old ones:

PHG-- because of the dividend, great balance sheet and the "green" play with the LED lighting market share. It's also very, very cheap, even after the rally. I don't think it's a GREAT company like LUK or has potential to be great like Hamburger. I think it's dirt cheap for a profitable company with 3 B of cash in the bank, trading at 0.7 book value, P/E of 5, P/S 0.5 and 15% ROE. Hard to resist at < $16/share

BBSI-- one of my favourite small caps. In a deeply cyclical business and still making money. Has no debt, high insider ownership and very strong management. The CEO has been sick lately and required some sort of major surgery-- this has me mildly concerned. The company ran well and maintained their + cash flows despite a terrible environment for staffing/PEO services with him being absent so that's reassuring. Dividend is being maintained and the share buyback proceeding as planned. They still have 50 M in the bank for acquisition etc. I'd buy at $9 or less without hesitating.


Others:

SEB

AXP

HOG

SNY

NVS

Pzena's view of value opportunities

Read it here.

Don't fight the drug dealers--- buy them!

My favourites: SNY, NVS, BMY, SGP

Invest in the Investors: LUK Leucadia National Corporation

I'm attracted to holding companies that are:

1. trading below book value
2. have management with "skin in the game" (significant insider ownership) and a long term track record
3. little or manageable debt

I've admired Leucadia for a long time but much like BAM, held off actually owning shares because of inflated valuations. This clearly is no longer the case.



Run by gifted mavericks Ian Cumming and Joseph Steinberg, Leucadia National corp is an eclectic, diversifed holding company that was founded over 150 years ago. Its investment portfolio is quite focused and includes small cap biotechs, wineries, copper mines and boutique investment banks. They are deep value investors with a penchant for the "cigar butt" approach. To quote the duo in a shareholder's letter:

“We tend to be buyers of assets and companies that are troubled or out of favor and as a result are selling substantially below the values which we believe are there. From time to time, we sell parts of these operations when prices available in the market reach what we believe to be advantageous levels.”


Bull Case for LUK

• masterful capital allocation has produced a 21.4% CAGR increase in book value/share since 1979!
• average ROE is 21% over 29 years
• being mid cap (5 B) has allowed it to outperform Berkshire Hathaway's stock over the last 20 yrs
• high insider ownership. Steinberg and Cumming each own 13% of the outstanding shares.
• high degree of guru ownership, with many recently increasing their stakes including Bruce Berkowitz, Tom Gayner and David Winters.
• Mr. Steinberg and Mr. Cumming have signed a 10 year contract to stay with the company and in the last AGM they said they would work there as long as they physically could. Apparently they are both in excellent health.
• historically trades at 2 x book value, currently trading at 0.7
• plenty of liquidity current ratio> 3
• mostly long term debt with a low D:E ratio v.s. peers of 0.29 and leverage ratio of 1.38.
• currently P/E ratio 10 x P/B 0.7 = 7 (far below Ben Graham's 22 criteria)
• using an aggregate sum-of-the-parts, P/B value analysis and DCF analysis, they came up with a FMV of about $40/share roughly double what the shares are currently trading at.
  

Bear Case for LUK

• shareholders need to rely on the expertise of only 2 aging individuals as the company is a specialist in picking unprofitable and troubled investments and fixing them up as opposed to Buffett's strategy of picking wonderful businesses that essentially run themselves, with or without him
• heavy exposure to commodities and overseas ones to boot. These will suffer in the global slowdown and may well not survive
• a concentrated portfolio magnifies bad investment decisions as well as good ones
  
• recent heavy investment in JEF, a small investment bank they bailed out of trouble. It may have a rough run before the credit squeeze runs its course.
• LUK's assets under management has shrunk by almost half (9 B-->5.3B) since Jan 2008 due to dwindling valuations
• as the company grows, it will likely grow more slowly due to more competition for distressed potential investments and the law of large numbers
• dividend yield is very modest at 1%; however, the managers are considering increasing this
  

IMHO, this is an excellent long term opportunity to own a company with a superb track record at an affordable price. It would be appropriate for a 3+ year time horizon in an RRSP.

I've put in a low ball bid at $19/share and hope it gets filled on a really nasty day in the stockmarket!

when a dollar goes for $0.60

Stocks trading for less than the company's cash in the bank

More comments and stocks ideas to exploit the panicked selling

Unwinding hedge funds, mutual funds and some silly retail investors with margin accounts have been forced to sell their favourite holdings of late. Those of us who have some cash on the sidelines may well have the opportunity of a lifetime.

Read First Eagle's view on this matter.

I've been concentrating on accumulating shares in companies with an established history of creating shareholder value (i.e. ROE >20% over 5 years), strong balance sheets, dividend yield over 2.5% and compelling valuations. The Grahamian simple valuation measure of focusing on companies that have a price-to-book ratio multiplied by the price-to-earnings ratio of less than or equal to 22 is helpful. I also prefer companies that have hard assets so I can focus on tangible book value that exclude such nebulous items as goodwill.

If you can ignore the macro-economic view for a moment (and I agree that it is hard to), you can choose wide economic moat companies with household names trading at amazing discounts to FMV. Most of them are in the DOW: AXP, MMM, GE, JNJ just to mention a few. DIA (the DOW Diamond ETF) is yielding about 3% now which isn't too shabby.

If you haven't read it already

Warren Buffett's New York Times Opinion Piece

Grumpy old man = brilliant investor

Marty Whitman's Value Picks


I'm intrigued by the ADR Henderson Land Development. It has extensive commercial and residential properties in HK and mainland China. It is trading at a deep discount to NAV (as Whitman suggests....> 50% discount on shares as they currently trade) and only has a D:E ratio of 0.15. Read the latest annual report presentation here.

I need to delve into this company's financial reports much more extensively before taking the plunge; however, if the LONG term growth story for China is intact and one believes in investing in hard assets then buying a company like this at bargain basement prices is compelling.

Note dividend yield is 2.7%. IMHO this would be a very long term investment >3 years +. Real estate is illiquid and one needs to be patient to allow the market to recognize hidden value.

Also: you may be confused by the currency denominations. 1 US dollar = about 8 HK dollars (7.7 today)

The greatest challenge now: Allocation of Capital

The short and intermediate term outlook for both the domestic and global economy has probably never been more uncertain in my lifetime.

Companies with superb track records, strong management, excellent liquidity and minimal debt are available at valuation ratios not seen for many years. Benjamin Graham criteria for stock selection is so rigorous that most years since I started investing either no stocks in North America qualified or only a couple. Today there are 270 stocks that meet his criteria on the US exchanges alone! Interesting times, eh? BTW, to review those criteria:

Benjamin Graham's Criteria for the Defensive Investor

1. P/E Ratio less than 15
2. P/Book Ratio less than 1.5
3. Book Value over 0
4. Current Ratio over 2
5. Earnings growth of 33% over 10 years
6. Uninterrupted dividends over 20 years
7. Some earnings in each of the past 10 years
8. Annual revenue of more than $100 Million (1950).
   Source: The Intelligent Investor, 4th Revised Edition (pages 184-185).

I belong the school of thought that the macro economic picture is inherently unpredictable. Those few who successfully perceive the future are really only guessing and statistically some of them are going to be right, sometimes even several times in a row. It's similar to slot machines. The danger is that after going on a statistically inevitable winning streak you start to believe that you have a special skill or insight that others do not. Of course, you don't and the casino walks away with all your winnings (eventually) and more. The stock market is really no different.

The vast majority of successful investors with a long term track record of profitable investment decisions (i.e. Buffett, Klarman, Berkowitz, Schwartz) take only a faint and detached interest in the macro economic picture and/or what the stock market is "doing". He/she is doing that for one reason only-- to find high quality companies on sale for pennies on the dollar.

I've been spending a lot of time reading through SEC filings and conference call transcripts, trying to find companies that have at least a narrow moat and the financial health to survive a downturn in the global economy, even a protracted one. I have quite a few prospects, many of which I already own and have analyzed on this blog and intend to buy more of. A few new ones I'm intently interested in and will review when I have time:

ISCA
FSTR
NTRI
POW.to


Vitaliy Katnelson is an offkey but insightful value analyst/money manager. He comments on his favourite stocks here.

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Time to buy the survivors

I'm buying businesses today with the following "safe and cheap" characteristics:

• ample liquidity
• wide moat
• manageable or no debt
• trading at or less than tangible book value P/E <8
  
• high insider ownership (15% or higher)

Wow-- never in my life has there been so many opportunities. Rather than reel with the sheer number of them I've chosen to concentrate on a few:

BAM-- on sale like it never has been. I don't use conventional metrics to value this company.
SEB-- same
MKL
BBSI
PHG

I'm spending hours pouring over financial reports so I can decide the best way to allocate my limited capital. I may sell BPOP as its share price has been propped up by an improbable upgrade. I would love to own more CX, LYG, AXP and CKI.TO; however, these companies are being conspicuously quiet (well, other than Cemex) and there is a palpable opacity to their current liquidity situation that makes me nervous. All four have potential to be great investments and I'm monitoring them closely.



I'm putting in bids for some or all of them today and adding slowly over the next year to my stake in DIA, the diamonds of the DOW. I think the DOW has potential to drop into the 7000's and that would be great.

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Seth Klarman's comments about today's opportunities and risks

Posted by: sabonis (IP Logged)
Date: October 9, 2008 01:52PM

I called my boy Seth at Baupost and he gave me some details of what he talked about:

Seth Klarman at CIMA Conference 10/2/08


1. Biggest fear was buying too soon and on way down, from up in over-valued levels. Knew market collapse was possible and sometimes imagined I was back in 1930. Surely there were tempting bargains and just as surely would have been crushed after decline of next 3 years. A fall from 70 to 20 and fall from 100 to 20, would feel almost exactly the same. At some point being too early becomes indistinguishable from being wrong.

2. Getting in too soon brings risk to all investors. After a stock market has dropped 20% – 30% there is no way to tell when the tides will change. It would be silly to expect that every bear market will turn into a great depression. Yet fair value from under-valued can’t be predicted, and would be equally wrong.

3. As market descends you are tempted with purchasing companies. You will be bombarded with tempting opportunities. You never know how low things will go. When credit contracts and tide goes out on liquidity. At these times recall the wisdom of Graham and Dodd. At this time, you should not market time, but stick to your value convictions. You will see tempting bargains and value imposters. Ignore macro and look to buy cheap.

4. In a market like we have been experiencing. Most investors lose their rudders. They become unwilling to part with cash. They start working on macro economic level. Investors look to pull out of market and wait for a clear signal of change. Value investors should be able to keep their focus and remember Graham and Dodd of 1934.

5. If you can maintain your focus, resist business pressures and have a multifaceted tool kit, you can expect to prosper, even in difficult times.

A. Always recall road map of Graham and Dodd. Revisit this road map when times get difficult. Maintain discipline and value with a margin of safety. This doesn’t mean you won’t lose money. It means if there are drops in price, you have even more of a bargain.

B. Avoid highly leveraged stocks, junk bonds and shaky financials.

C. Look for bargains in various industries and nations.

D. Look at value, not great companies and great management.

E. Listen to Warren Buffett when he states you should buy a stock as if the market would close for a long period of time after you bought the stock.

6. Remain focused on the long run. Graham and Dodd motivate our diligence. They are like silent sentinels. Navigate the best you can and Graham and Dodd are the North Star for value investors.

7. Stand against the prevailing winds, selectively and resolutely. Yet for a while a value investor will under-perform. Interim price declines allow you to average down. Do not suffer the interim losses, relish and appreciate them.

8. Value investing at its core is the marriage between a contrarian streak and a calculator. Buying what is in favor is ensuring long-term under-performance.

9. It is critical to remind your clients, investment team and as often as necessary yourself, that you can only control your process and approach. Understand that you cannot control or forecast the vagaries of the market. Then you should invest in what you believe and what your research dictates. Be indifferent if you lose your short-term oriented clients, remembering that they are their own worst enemies.

10. Controlling your process is essential.

A. Be focused on process, not outcome.

B. Do not judge a decision based on its outcome.

C. During periods of under-performance it is easy to change your process.

D. When a firm is worried about tempers, second-guessing and fear, the process will fail. Look for long-term results; anything else will corrupt the process.

11. Value investing is an art and not a precise science. It is dealing with the fact that we do not work with perfect information.

12. Mechanical rules are dangerous. Graham and Dodd principles should serve as a screen.


Q&A


1. How do you see current investment climate?

A. James Grant - Look at some MBS and beaten down bonds. Some are priced to yield teens. They are priced for a further 25% decline. Also unsecured debentures of nations top retailers. These are priced at 5% to 7%. Hence, short the retailers at 6% and go long the beaten down mortgages.

B. Seth Klarman - Unusual amount of forced sellers, via margin calls. This could breed opportunity. Sees a lot of money managers staying on the sideline. He finds this as an opportunity to buy. Buy when others react to news or false news. His experience is when people give away stocks out of need, due to fear or margin calls, that sounds like a great buying opportunity. In this environment you are playing against very smart people.

C. Bruce Greenwald - Take a deep breath. All the doomsday talking is not being reflected in stock prices. Stocks are basically down 25%, but unemployment is not great like early 1940’s. You need to put this into perspective like 1991 or 1982.

2. Klarman discussed buying one security at a time. Not everything is a bargain out there. Be selective. Many of us have seen opportunities now, and history says to buy them. We bought knowing that banks are going to fail, that real estate would drop, but that certain mortgage backed securities were under-valued. Never leverage, where you can have an opportunity to buy and not be able to take advantage of it because of leverage.

3. James Grant - Treasuries are yielding less than expected future CPI. Treasuries are now being priced as a macro-economic play. Treasuries are not intrinsically safe. They are not safe based on valuation.

4. What factors do you look at in sizing a position?

Seth Klarman - He thinks this has been missed over the last 15 years. Most of the diversified risk is done via 20 to 25th position. We have had a 10% or so concentrated position about a dozen times over the last 20 years. Most of the time we have 3,5 and 6% position. We will take it higher if we see a catalyst for increased value. We would not own 10% position in a common stock, only because it seemed under-valued. We would have a greater than 10% position if there was a margin of safety. I see managers make mistakes with concentrated positions in similar industries. Small positions of say 1% are nonsensical. We do not use macro views, yet when we hedge, we will use a macro view. We think inflation could become out of control in 3 to 5 years. Yet, we might not wait for that position. Hence, perhaps early, we have a large inflation hedge. We don't own gold as a commodity. We won't disclose our inflation hedge, yet with enough work, you can find true inflation hedges.

insane P/E ratios from Bespoke

The average 2009 estimated P/E ratio for stocks in the S&P 500 is 11.9. Currently, 48% of stocks in the index have an estimated P/E of less than ten. Below we highlight stocks with the lowest estimated P/E ratios in the S&P 500. Either earnings estimates are still way too high, or many of these stocks are trading at values of a lifetime. Just looking at the top three stocks on the list (GNW,X, CF), even if their '09 earnings come in at half of current estimates, at current prices their P/Es would still be less than five.

Tips for bargain hunting from Morningstar

Value in Healthcare as well as safety

read the brief review here.

My favourites: NVS, SNY, WLP and UNH for reasons detailed in previous posts.

UNH and WLP are cheaper (per PEG ratio) than the others because of real or perceived political risk they face from the incoming US administration's promised reforms. These reforms may well not be in the HMOs best interest.

If you believe that the more things change the more they stay the same, either company is a pretty good bet. Healthcare is on the back burner in the US as it is eclipsed by the economy, Iraq and Afghanistan.

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Ponzio's view of today's situation

Now What? The Great Market Meltdown.
October-7-2008

The US Government passes a $700 billion bailout (or rescue) package, and the markets continue their spiral down. Financial advisors across the country are shouting, "Stay the course!" (Usually from under their desks.)

This crisis is unlike anything we've seen in recent history (and perhaps not-so-recent history); so, what should we do now?

First, Stocks Stink. Consider Buying Bonds.

One year ago (actually, on October 11, 2007) the S&P 500 topped out at 1,576.09. Today, it hit 1,007.97 — a 36% loss. From top to bottom, the Dow lost 32% over the past year. While the news is reporting that we closed at 2004 levels, I think a much more sobering reality needs to be addressed: Over the past ten years — from October 8, 1998 through today's close —[b] the Dow has grown just 2.6% on average for ten straight years.[/b]

Add in dividends, take out some management fees and commissions, and you're lucky to have a 4% or so return for a decade.

(And I won't say anything about how irresponsible, foolish, or downright fraudulent some of Wall Street's finest were over those ten years. Remember Lucent? WorldCom? Enron? Merrill Lynch? Bear Stears? Really — I don't want to beat a dead horse.)

(Morons.)

What can Joe and Jane American learn from all this volatility? First off, remember that stocks stink! A portfolio of solid bonds would have crushed the stock markets over the past ten years; and, while I don't necessarily advocate 100% bonds for everyone, I do think that most people should own them.

Wall Street doesn't talk about bonds except to the extent that they try to get you to buy bonds funds. Individual bonds are not very profitable to Wall Street; bond funds will pay your broker the quarterly kickbacks and allow you to be put on the back burner. (What adviser wants to track all those individual maturities or have to actually do some research?)

That leads me to my first point: Beware of bond funds.

The Danger of Bond Funds

Simply put, when you invest in a bond fund, you give the manager $x to purchase bonds. The manager then takes your cash, pools it with cash from other investors, and buys bonds of varying maturities.

Sounds pretty harmless.

The problem with bond funds is not in the buying, but in the selling. When investors sell their bond funds, the manager must generally sell bonds to pay the investors. The problem is that bond prices change; so, the manager might have to sell some bonds that you personally would have held to maturity.

How does this affect you? Consider this: You want to hold bonds for income and stability; but, in bond funds, your income and stability is directly affected by the actions of other investors. If a ton of people are buying into your bond fund today, your manager will be forced to buy bonds for you in a low interest environment. Then, when those same investors want to get out of that bond fund in five years — and if interest rates are higher — your manager might have to sell those low interest, now low priced bonds at a loss.

At the end of the day, you got a raw deal.

Instead, focus on buying individual bonds with the goal of holding them until maturity. If you buy a high quality bond offering a 5.5% yield until June of 2009, you know exactly what to expect — a 5.5% return for two years, and a definite dollar amount upon maturity, regardless of how happy or scared other investors are.

In short, don't let the panic and fear of other investors determine your return if your goal is stability, income, and a defined return.

Second, Realize That Volatility Is Here To Stay.

I'll admit — 6% or 8% daily swings in the markets are out of line. Still, volatility is here to stay. If you recall from this earlier post, the average number of daily transactions in the markets have grown 562% over the past ten years. Every day, 4.4 billion transactions occur, each moving a stock price in a certain direction.

Over the past two weeks, this number has grown to more than 8 billion transactions. If you are waiting for things to calm down, you'll be waiting a long time. There is simply too much excited money floating around to ever return us to consistently small and "comfortable" movements.

If 36% losses make you sick to your stomach, it's time for a reality check and a new strategy. Diversification (ie. holding a bunch of investments) is not the key — asset allocation is what will help you sleep at night.

When you are putting money to work in stocks, you must have a completely iron constitution. If watching your portfolio drop 50% will make you nervous, you shouldn't be 100% invested in stocks. Nobody likes 50% drops and we'd love to avoid them whenever possible; but, if you're 100% invested and prices drop quickly with no fundamental change in your businesses, you'll suffer some big temporary losses in your portfolio.

Combating Volatility the Intelligent Way

Many advisors will tell you that "diversification" will help mitigate losses and maximize returns. Then, they sell you a mutual fund that holds hundreds or thousands of stocks.

It doesn't make sense.

If the key to growing and preserving wealth (as Buffett has said) is putting your money into great investments and great prices, how can it make sense to buy a basket of great, mediocre, and bad companies at great, mediocre, and bad prices?

[i]As of June 30, AllianceBernstein Holding LP; ClearBridge Advisors, a subsidiary of Legg Mason Inc.; Fidelity Management & Research LLC; Barclays PLC unit Barclays Global Investors NA; Wellington Management Co.; and State Street Global Advisors were the mutual-fund managers with the largest stakes in Lehman's stock, according to FactSet.[/i]

So said the Wall Street Journal on September 16, 2008. While most of the funds did not comment, Vanguard's Rebecca Cohen had this to say:

[i]If you look at the absolute number of shares, we end up as one of the larger holders of Lehman...but on a relative basis, it's a relatively small portion of our funds.[/i]

Oops. We lost hundreds of millions of dollars of your money; but hey, you were diversified. You only lost a little (even though you shouldn't have lost anything in Lehman).

The intelligent way to combat volatility is to realize how much volatility you can handle, and then invest the rest in bonds. If you take a step back and realize that 50% losses are possible, then you have a base for building your portfolio.

Comfortable with a 10% drop, but not a 15% drop? Invest 20% in stocks and 80% in bonds and cash. Okay with a 25% drop but not a 30% drop? Put half of your money in stocks and half in bonds.

Focus on intelligently allocating your portfolio, not on broadly diversifying into more and more mediocre and bad investments. After all, [b]those broadly diversified, armchair investor stock and index funds are down just as much — if not more — than the markets right now.[/b]

Don't Change a Darn Thing in Your Approach

It is times like these that many investors panic and change their investment strategy in stocks. The fact that the markets are down does not change the fact that:

1. stocks are pieces of businesses with intrinsic values;
2. the value is the amount of cash that can be taken out of the business during its remaining life; and,
3. price follows value, even if it takes a few years for that to occur.

Stock market volatility

When we bought Johnson & Johnson last year, we looked sheepish, as though JNJ was a boring buy at $62 or so. A few months later, we looked really smart as JNJ topped $72 a share. Today, it was down as much as 14% from its near-$73 high, and many people are kicking themselves thinking, "Boy, I wish I took my profits $10 ago."

Why did we buy Johnson & Johnson at $62? Because we saw more than $62 — and more than $72 — of value. As the company's value continues to grow, we have to sit back patiently until Mr. Market is ready to realize it.

It may take a few months; it may be years.

Finally, Realize That It Will Be Better In a Few Years

I wish the internet was around in the 1970s. From its peak on January 11, 1973, the Dow began a two year, 47% slide from 1,067 to its December 9, 1974 low of 570. With no internet or stock market channel, most people continued on saving and investing, cognizant of the losses but not completely panicked or terrified.

Today, the doomsday crowd is calling for the end of the world and a total and final financial collapse. If we were to drop 47% from our high, the Dow would be 2,300 points lower at 7,568. Possible? Absolutely. Anything is possible.

But, like we did after the Great Depression and the 47% drop in 1973 and 1974, and like after so many other times throughout history, we will get through this, great businesses will be more valuable five- and ten-years from now, and price will eventually follow value.

Believe me — there are some very attractive bargains developing in this market, and you should look for them the same way you looked for them when the Dow was at 14,000.