Getting Warren Buffett sized returns by avoiding investing like Buffett
Posted on | August 22, 2010 | No Comments
The title of this post may seem paradoxical. But it is not. There is a qualifier to the statement. The title should actually be “if you want to earn the amazing returns that Warren Buffett earned in the 1950′s you can’t invest like Buffett does today.” The reason is simple: he is a victim of his own success. He simply has too much capital to deploy to have very many great investing opportunities.
Buffett has famously said that he could make 50% returns per year on investments, but with one catch. He would have to have less than a million dollars to invest. I have written around this topic before. The advantage that small investors have over large investors and mutual funds is more opportunity. Our investing universe is much larger than Buffett has today. We can invest in microcaps and other less liquid stocks that wouldn’t move the needle for one of Berkshire Hathaway’s subsidiaries even if they could invest in sufficient quantities.
Before any one jumps in to defend Warren, as though the man needs a defense, I will state that because you have a larger investing universe does not mean you will have outsized returns, just that you have more opportunity to realize them.
Many of the advantages of a small investor are overlapping or intertwined. It is not always clear why a certain investment criteria yields better results over time. For example do small caps stocks perform better because of the liquidity premium or because they are not covered as widely by analysts. Both seem to have evidence supporting them.
Information disparity- Plenty of analysts cover most large and mid cap stocks. For you to compete in the large cap investing universe you have to assume that either your analysis is better that professional analysts or that you see something they don’t see. Both are possible, but probably not enough to get extraordinary returns.
Liquidity premium- Many investors avoid stock because they have low volume. But that is not always a problem, and in the case of a small investor, an advantage. For example, if you discover a stock that is $2.00 per share but only trades 1000 shares a day on average. If you need to buy 100,000 shares for it to effect your portfolio, there is a problem. It could take you a while to accumulate a position in the company without effecting the stock price in a way that undermines your investment. But for a small investor, a $1000 investment may be a significant portion of your portfolio so you you are not as effected by the low volume. The limited liquidity then becomes an advantage since there will likely be a liquidity premium for owning a low volume stock.
Small Cap advantage- Studies have shown that investing in small caps over time can yield larger returns than large caps.
Pareto’s Principle – A Name for an Old Rule
Posted on | August 4, 2010 | No Comments
I have often referred to what I called the 80-20 principle, the common idea that 80% of the results come from 20% of the work. I have set up a portfolio to test the theory called the 80-20 portfolio. Who knew this was an actual economic concept and not just an old wives tale. It turns out this rule was actually developed by an Italian economist named Vilfredo Pareto. Around 1906 Pareto discovered that roughly 80% of the wealth in Italy was owned by 20% of the people. When he turned to other countries, he found that the percentage was roughly the same. The real result is actually a range. Sometimes 90% to 10% in others 70%-30%. But the principle is still valid. There is an important concentration of results to inputs. Most interesting to me is that the Pareto Principle is an example of a power law. I won’t get into Power laws now, but they have appeal in appreacing the concepts of Long tail events. Perhaps I need to rename my 80-20 portfolio to Pareto’s Peanuts.
Worse Case Scenario Investing
Posted on | July 30, 2010 | 1 Comment
I have just finished reading a book that has forced me to reconsider how I evaluate risk , because it discuss investing in a worse case scenario.
Evaluating risk has been an ongoing interest of mine because I assert that understanding risk is crucial to making sound investments. If you overlook an element of risk then you may be exposing your capital to loss that you have not foreseen. Or, if your investment is successful, you may be underweighting the contribution of luck to your success. I have been a fan of people like Nassim Taleb the author of the Black Swan and Fooled by Randomness and James Montier because they helped we reshape my ideas about risk.
The book I have referred to in my opening is Wealth War & Wisdom by Barton Biggs. In essence it discusses the idea of maintaining wealth in one of the big black swan occurrences of the last hundred years, World War II. The book spends a lot of time on the history of World War II and weaves the ups and downs of financial markets into his tale. Biggs also spends considerable time attempting to prove, but not quite succeeding, that the wisdom of markets is smarter than experts and world leaders. While I enjoyed the history and history of the markets during this apocalyptic time, I was most impressed with how he details that preserving wealth in time of war and upheaval is difficult at best. There are very few ways to preserve wealth let alone grow it.
How do we look at the potential of a great upheaval and its effects on our investments. Most people simply do not take into account.. Before you say that it is unlikely we will face such difficult circumstances, remember that apart from a few very smart people, most investors did not anticipate nor profit from the Great Recession we have just experienced. It seems to be our nature to under prepare for extreme events.
Biggs offers a few important ideas in his conclusion, some of which I subscribe to and some I do not. He asserts that the long term track record of equities favors a larger investment in them than other asset classes. In fact, he suggests that you invest 75% of your assets in equities, favoring index funds. He discusses the value of real estate and in particular farm land or ranch land as place that holds value but can also become a worse case scenario place to survive if the apocalypse hits your neighborhood. This farm should not be more than 5% of your wealth. He also suggest that you have to diversify your assets outside of your home country. That when the shit hits the fan, things turn quickly and we can often not get out of the way of the shit storm.
I don’t have many answers just questions that you need to consider. After all, the markets can be irrational longer than we can remain solvent. So being fully prepared for all contingencies is simply not possible. What will you prepare for and how is something worth considering. Below I have listed a few of the ideas that intrigue me as distinct possibilities, however remote. I am stating them with as a question. Perhaps, I will return with some answers later, perhaps you have some ideas to contribute. It is difficult to anticipate what the next Black Swan will be and what the unexpected consequences will be from that event.
What would you do to hedge against hyper inflation?
How about deflation?
What if we had an incidence of nuclear terrorism, that shut down a major country?
What if there is a double dip recession?
What if there is another financial panic?
What would happen if a major trading partner, say China, suffered a crippling natural disaster?
What if a sovereign debt crisis destroyed a major currency?
What if the price of real estate dropped another 50% from here?
What if headline unemployment rises to 15%, or higher?
What if a cataclysmic event shut down much of the internet?
What if there really is a worldwide pandemic?
What if there is a major war that destabilizes a part of the world?
What if there is a major disruption in oil supplies in the middle east?
What if the Mayans were right and 2012 is an apocalyptic year? O.k. maybe not this one.
Extra Investing returns by Investing Like Warren Buffett
Posted on | July 27, 2010 | No Comments
Overconfidence, Underreaction to Warren Buffett’s Investments is an interesting paper I saw at Simoleon Sense. To understand the all the details I suggest you read it yourself. You may derive different conclusions than I did. I had a few take aways.
First, that despite all logic to the contrary, if you had followed Warren Buffett’s investments in public companies from 1980 to 2006, once the trades were announced you still would have had real, significant returns. Approximately 6% returns (pg.13) The authors postulate that there was overconfidence by other traders as the root cause.
Second, more interesting to me is that Mr. Buy and Hold forever’s average holding time of an investment during this time was only one year (pg.10) with only 20% of the stocks being held more than two years. While nearly a third (30%) were sold in less than six months. This seems a case of do as I say and not as I do. I have often said that if you want to make money like Buffet you need to invest like Buffett did in the days of his investment partnerships. These funds were more like hedge funds and were more Graham oriented in style than Buffett has become. They also involved more buying and selling. I know this is not fashionable for value investors, but it worked for Buffett when his returns were often 50% a year. A small investor’s competitive advantage over large investors is that he or she can put money in less liquid investments without moving the needle very much.
Third, Buffett does run a relatively concentrated or focused portfolio. His average holdings in the 1980′s was 22, 12 in the 1990′s and 33 beyo0nd 2000 (pg.11)
Fourth, the study says that, “it appears that Buffett avoids firms with high asset growth that under-perform the market and invests in large firms with low book-to-market ratios and large accounting accruals, characteristics generally associated with low returns.”
Tags: Beginning Investor > Small TIme Investor
Morningstar gives up the Ghost
Posted on | July 10, 2010 | 4 Comments
Morningstar.com recently changed its years old policy of providing free ten year financials. It still offers free five year financials but has shifted the ten year data to an expensive premium service. Now that it is costs, I would suggest not using Morningstar anymore. Their data has been dicey at best. That is I was constantly finding data errors, but at the cost of zero it was a useful value investing tool, that required verification. But now that you must pay to get a long term view of a company with Morningstar, I will be looking at other services. Even if I settle on a pay service it will definitely not be Morningstar.
How does One Invest in a Company whose Price will Decline? Part 1
Posted on | June 2, 2010 | 4 Comments
This is not the same question as “Does shorting belong in the value investors’ toolbox,” because shorting is only one way to invest in a company that is expected to decline in share price. But it expresses the idea in an understandable way.
I think the normal response for most value investors to the shorting question is “No.” But is that really true? And if this question is not true then the title question becomes more important to answer in a value investing context. Whitney Tilson of T2 partners and co-founder of the Value Investing Congress uses shorting as a part of his investment tool set. I don’t think anyone would call Tilson a “speculator,” which is the usual label associated with shorting. He uses the value investing techniques of examining the financial statements of companies and setting a value on the company. He currently is shorting a basket of homebuilders. And in his latest letter to investors he discusses his best short position, recently, which is Inter Oil (IOC). The excellent blog Valuehuntr has also taken a short position in the same company. Valuehuntr’s position is based on the premise that IOC may be engaging in fraudulent behavior. If this is true then this could be another company that drops to the floor. Both Tilson and Valuehuntr’s logic and analysis seem sound. But I am still not going to short. Why?
Because I am risk averse. There are aspects of shorting that concern me. First, what is shorting? The idea of shorting is that sometimes it makes sense to take a negative position in a company. Shorting is where you “borrow” the shares of a company from someone else, say your broker, and then you sell the shares in the market. The proceeds are deposited to your account. A profit is made when you buy back the same shares at a lower price and return the shares to the entity that lent them to you.
So what are the risks of Short selling?
The first is the potential for extreme losses. The ordinary potential loss when buying the stock of a company is the amount you invested. If you invest $1000 buying 100 shares of XYZ company. All you can lose is $1000 plus commissions. But when you short a company and the stock price goes up you can keep losing money until you exit the position. It is often referred to as the potential for unlimited losses. It isn’t of course. No company’s stock price continues to rise forever. But the losses can be extreme.
A risk related to this is the risk of margin call. That is when the stock price rises you will be asked to post additional collateral in your account to cover the loses. I never want to be a position for someone else to decide when it is a good time for me to invest more capital into a position. If the price move up is swift you may not have any choice.
The counter argument, of course, is that you can use stops to help prevent just such a scenario. This is true, sort of, but my experience is that stops work poorly in volatile markets like now. If there is an extreme price movement your stop may be triggered but the next price up could we much worse price for you than you would like. Moreover, the stop could be triggered and then the share price retreats, but you have already covered your short and thus you have baked in your loss.
It is clear to me that short selling can play a role in a value investing strategy. After all no one expects every company to always go up. But is shorting the only way? Or are there better alternatives? In the next installment of this I will explore the world of options. While I have not yet fully developed a shorting strategy using options I will discuss some of the possibilities in the second part of this article.
Back from an Unplanned Hiatus
Posted on | May 28, 2010 | 4 Comments
My apologies to my readers.
I took an unexpected hiatus from writing my blog. If you emailed me in the last few weeks, my apologies for not responding, I will strive to resume my prompt reponses in the future.
First, the most important reason I have been absent: my wife gave birth to our first son on May 16th. The time that I would usually spend on my blog has been in part spent with my new child.
The second reason is that after six seasons “Lost” has finally come to an end. As some of you may know, I have had the great pleasure of working as a Producer on the show. The second reason I dropped off the face of the earth is that I was completing the finale. Until now, I did not feel it was appropriate to discuss what exactly my day job was, now that it is over I feel that I can. This will not be a forum for discussing “Lost,” it remains a place to explore investment ideas.
And we are living in interesting times for investors.
Two Reasons I love Volatility
Posted on | May 8, 2010 | No Comments
This past week was a reminder for some who have already forgotten the lessons of late 2008 to early 2009. Markets can turn south, and quickly. This volatility can be gut wrenching as you watch the value of your portfolio drop.
But for people like me, it brought a smile to my face.
Uh, What?
In the sea of red, I thought, wow, there are almost certainly some stocks that have dipped into the value terroritory again. Many small caps got punished way out of proportion to the overall market. That is one of the great things about investing in small cap stocks. Opportunity number 1 is the pool of possible investments just went up.
If you are scared about the long term prospect of a stock you own, don’t blame the market, perhaps you shouldn’t own it. Opportunity number 2 is re-evaluating your portfolio. We all make mistakes. The question is whether you would buy more of stocks that you own at a lower price. If not, again, it is a time to reexamine the choices you have made. Perhaps you have been too hasty in making stock selections. I have certainly done that. I am reviewing all my positions. If I don’t think they are still great opportunities, and if they are below the price I purchased them, then I probably made a mistake. If I confirm that I like the investment, perhaps I should add to my position.
Market Drops are opportunities for finding value and reevaluating your positions. If you look you will find value. Happy hunting.
I will be posting irregularly for the next couple of weeks. I am working on the series finale of a television series of I have been working on for years. Think of it as tax season for an accountant. I am slammed, but still looking for value.
Portfolio Updates
Posted on | May 3, 2010 | No Comments
This is a quick update on the status of both portfolio’s for their first month. From here on, I will only update quarterly, because a shorter time frame than that seems silly.
Small Investor Portfolio
Current Positions
DUCK up 27.2%
IFON down 13.2 %
Closed Positions
ORXE up 31.% including commissions.
This is all well and good, but I did not completely deploy capital so where is this portfolio really?
Started with $2000. Value of account before additions and other amounts, including commissions paid is $2204.88 for a total of 10.2% gain in approximately one month. Also made one monthly deposit of $200. Also received Choice Trade promo offer of $50 as discussed in my posts about choosing an online broker. Total account value today is $2454.88
80-20 Portfolio
Closed positions
HAST up 57%
Opened account with $5000 Account is worth $5285.75 including commissions paid but not additions. That is 5.7% up on the portfolio for the month. I have added my monthly amount of $300, so the actual current total is $5585.75. There are no current positions in this account.
The S & P 500 gain in the same period is 3.06% although given my investments perhaps a better comparison is the Russell Small Cap index was about 6.9% A one month result and the subsequent comparison to an index is really very silly, since it is too early to compare anything to anything else.
Tags: Beginning Investor > Small TIme Investor
Avoiding Confirmation Bias
Posted on | April 29, 2010 | 1 Comment
As I have mentioned previously, one of the points of the 80-20 Portfolio is to incorporate some of the research of Behavioral Finance into an Investing Strategy. One of the behavioral traps we go through is something called Confirmation Bias. In short, this is when you look at facts that agree with your investing thesis as confirmation of that strategy. This is a slippery slope and one that we all fall into even if we are aware of it.
I first learned about this concept when reading Nassim Taleb’s book The Black Swan. He called confirmation bias “naive empiricism”. He said, “You take past instances that corroborate your theories and you treat them as evidence.” Further he writes, “I am saying that a series of corroborative facts is not necessarily evidence. Seeing white swans does not confirm the nonexistence of black swans.” He cites a study by P.C. Wason. In the experiment subjects were given a three number sequence of 2,4,6 and asked what rule would generate this sequence. “Their method of guessing was to produce other three-number sequences, to which the experimenter would respond “yes” or “no” depending on whether the new sequences were consistent with the rule. Once confident with their answers, the subjects would formulate the rule.” The problem is that most people will say something like 8,10,12. And the answer would be yes. After a couple of confirming examples you would announce that the rule was add 2 to the number before it, in succession. But the correct answer is actually any ascending numbers. I failed this example when I read it one of James Montier’s writings when he posed the question to the reader. I was reading about the problem and still fell for it.
How to prevent confirmation bias in our approach to investing? Taleb directs us back to Karl Popper and his concept of “falsification.” We should attempt to prove false the ideas we are using. Again Taleb, “We can get closer to the truth by negative instances, not by verification!“ Popper, Taleb says leads the way out of our darkness, he “…introduced the mechanism of conjectures and refutations, which works as follows: you formulate a (bold) conjecture and you start looking for the observation that would prove you wrong. This is the alternative to our search for confirmatory instances. If you think the task is easy, you will be disappointed—few humans have a natural ability to do this.” In the Wason study, the way to figure out the proper rule would have been to submit numbers that declined, alternated, etc. To prove what the actual rule was by ruling out as many of the opposites as possible. It is only by figuring out what doesn’t work that you figure out what does.
The interesting idea to ponder is that if you are naturally a contrarian, like I am, you will be instinctively drawn to contrarian investing ideas, like value investing. These ideas make more sense to me, than say momentum investing. But, am I really just looking for investing ideas that confirm my pre-existing biases? Perhaps.
It may also be why, even though I consider myself a value investor, I have not felt compelled to be bound by some rules that seem to appear in the blogsphere. Investing is ultimately a path, not a destination, this is just another pot hole to avoid.