Saturday, June 10, 2006

The Sell-Off

“Face up to two unpleasant facts: the future is never clear and you pay a very high price in the stock market for a cheery consensus. Uncertainty is the friend of the buyer of long-term values.”
Warren Buffet, Forbes, August 1979

It has been a fun ride over the past 4 or 5 weeks. The Dow, Nasdaq and S&P 500 have corrected by about 7%, 10% and 6% respectively. Ouch. The volatility stems from the market’s uncertainty over the Fed’s interest rate policy and whether or not Mr. Bernanke will follow through with the Fed’s 17th consecutive rate hike in late June. Inflation appears to have pierced Mr. Bernanke’s 1%-2% comfort zone, albeit fractionally, and that has made investors jittery. Add to that the carnage in emerging markets in recent weeks and you have yourself a real doozy of a situation.

What to do? Does it make sense to sell, sell, sell a la Jim Cramer or should you instead be taking advantage of the sell-off to add to your positions. By now you should know what my answer will be. To be fair, my brother and I have trimmed or eliminated some positions in recent weeks. In particular we liquidated our Goldcorp (TSX: G.TO) position, took some money off the table on Chaparral (Nasdaq: CHAP), and reduced our position in Vimpelcom (NYSE: VIP) by 50%. Otherwise, we have used the decline to add to some of our core holdings. We have added to Ebay (Nasdaq: EBAY), Intel (Nasdaq: INTC) and Microsoft (Nasdaq: MSFT). We also nibbled a bit more at Centex (NYSE: CTX) and may do the same with Pulte (NYSE: PHM).

The homebuilders have been beaten up badly as they continue to reduce their earnings forecasts and worries about further interest rate hikes weighs on their shares. But my thesis remains intact. Scarcity of land and demographics are still positive long-term trends that should benefit the larger players. Further pain in the sector will also provide them with the opportunity to drive consolidation through the sector by gobbling up weaker players. Meanwhile, Bill Miller continued to build his positions in these companies through Q1. When we initiated our position in the homebuilders, I told my brother there could be a 20% downside in the shares. That scenario sure has materialized. To add fuel to the fire, a slightly worrisome article in a recent issue of Barron’s questioned the nature of off-balance sheet JV’s set up by various homebuilders to boost ROA and ROIC. The article also questioned whether the companies can truly walk away from the options they have purchased to buy land. Various CEO’s have claimed the use of these options will reduce their financial exposure during a downturn. In any event, I continue to believe in the soft landing scenario for housing. These companies have been around for decades and they are certain to provide us with a reasonable rate of return in the long run.

2p - 1 = x

“We try to think like Fermat and Pascal would if they’d never head of modern financial theory.”
Charlie Munger

In his book The Warren Buffett Portfolio, Robert Hagstrom does an excellent job outlining his thoughts on the focus investment strategy and the psychology of investing. But two chapters in his book in particular caught my attention.

The sixth chapter is titled The Mathematics of Investing. Hagstrom discusses probability theory and the important role it plays in Buffett’s and Munger's decision process. In one example, Buffett takes us through his thinking when he purchased a significant stake in Well Fargo in 1990 just as the West Coast was in the midst of a recession and banks with exposure to residential and commercial mortgages were thought most vulnerable. Wells Fargo’s stock had declined from $86 to $57. An approximately 50% decline.

But this was a bank that was earning $1B pretax at the time. Even if its entire loan portfolio – not just the real estate loans – were hit severely, the bank would still break even. Buffett reasoned that " a year like that ... would not distress us". Other risks existed but Buffett assigned a low probability to those as well. In the end, Buffett figured the odds of making money on the shares were on the order of 2:1 providing him with his Margin of Safety. The shares continued their decline after he bought them and were up only 5% the next year. But in 1992 and 1993 the shares appreciated 34% and 73% respectively, followed by more gains in subsequent years. Not bad.

Another interesting tool introduced by Hagstrom is the Kelly Optimization Model, 2p – 1 = x. It suggests that if you know the probability of success (p), you bet the percentage of your capital (x) that will maximize return. So if you think the probably of buying Coca Cola (NYSE: KO) has only a 55% chance of giving you above average returns over the next decade, you should invest 10% of your portfolio in the stock. It is not clear if Buffett uses this formula in his thinking, but he certainly makes a big bet when he likes his chances. Consider that in 1988 – when he began building a position in Coca Cola – Capital Cities/ABC, GEICO, Coca Cola and the Washington Post comprised 36%, 28%, 21% and 12% of his portfolio respectively.

The eight chapter introduces the concept of the market as a complex adaptive systems. The market has many agents (people) who have their own partial views and biases. They interact with other agents, none of them in control of the market, accumulate experiences and adapt to the constantly changing environment. Such a system is impossible to predict and forecast, especially in the short-term. Buffett says, “We have long felt that the only value of stock forecasters is to make fortune tellers look good.” In other words, don’t worry about price fluctuations, just focus on the economics of the business you are investing in and be assured that in the long-run, the market will reward companies that create shareholder wealth. Of course, all of this assumes you have done your homework and you are buying stock at a reasonable Margin of Safety.

Absolute Focus

“Imagine the cost to us, if we had let a fear of unknowns cause us to defer or alter the deployment of capital.”
Warren Buffett, Berkshire Hathaway Annual Report 1994

Being a successful investor is all about patience, discipline, focus and conviction. How you measure your success is also very important. Most money managers and mutual funds have locked themselves into a relative measurement game. They better deliver returns relative to their chosen benchmark or else! The benchmark can be the S&P 500 index or the Russell 2000 index. This is exactly why these funds end up owning a large number of equities in their portfolios, sometimes in the 100s. You have to own the market to keep up with the market. This is also one reason why 90% of them end up underperforming the market. So if you want average returns, this is the path you should follow.

If you want above average returns, you must become a focus investor measured on absolute performance. Forget about the day to day and short term gyrations of the market and concentrate on the economic value of the businesses you invest in. As we have discussed in the past, holding a large number of stocks in your portfolio doesn’t reduce the risk, it just spreads the risk. You are better off building a focused portfolio which enables you to become intimately familiar with each business you own. Don’t forget, you are part owner of a business when you buy stock, even if it’s just a 100 shares.

How many holdings should a focused portfolio have? Well, Warren Buffett has said he would not consider making an investment unless he is convinced he would want to commit at least 10% of his net worth. This implies a portfolio of 10 holdings. His partner, Charlie Munger, who had started his own partnership in the 1960’s had concluded that owning as few as 3 stocks would provide him with above average returns. And he was right. From 1962 to 1975, his partnership returned an average of 24.3% annually vs. the market's 6.4% return. The one caveat was that he achieved this by enduring increased volatility. The portfolio significantly underperformed the market in some years.

Indeed, a focused portfolio is not for the faint of heart. You must have the temperament and psychological wherewithal to stand the peaks and valleys. You must be patient, avoid the temptation to buy and sell and ignore market forecasts. After all, wars and market crashes and oil shocks did nothing to deter Warren Buffett from staying the course. You may underperform the market from time to time, but in the long run you should handily meet or exceed an absolute measure of performance such as inflation plus 10%.