Three Legs to Finding an Investment

From the December edition of 2011 Value Investor Insight (Issue2011DEC), Chuck Ayre’s “3 Legs” to finding a business to invest in:

• Leg One is the Business Model
  • High return businesses have something special which allows them to earn above average rates on employed capital
  • That may be intellectual property, scale economies, a regulatory advantage, high customer switching costs, or some sort of network effect
  • We want to see evidence the business produces unusual returns, to understand why and to believe that’s likely to continue
  • Part of that is the function of the opportunity to be realised – we’re always asking “how wide and how long is the runway”)?
• Leg Two is the People
  • We’re looking for managers who have demonstrated they are “killers” at business execution, and who have a history of always acting in the best interests of all shareholders
  • The closer [managers] get to saying they measure success by growth in the company’s real economic value per share – the more interested I am
• Leg Three is Reinvestment
  • Does the company have the capital allocation skills necessary and the market potential to invest all the excess cash generated by the business in projects that can earn above-average returns?
  • This is perhaps the single most important issue facing any CEO, and is also the area in which management can create or destroy value most quickly and permanently

Bond Mechanics 101

Here’s a good post on how bonds are calculated: Bond Mechanics 101

Here’s an excerpt:
Bonds generally use a “30/360” convention to determine how interest accrues over time.  This means that interest will be computed on the basis of a 360-day year comprised of twelve 30-day months.  Said a different way, 8.33333% of the annual interest payments on the bonds will accrue during each full month that the bonds remain outstanding (without regard to the actual number of days in the month).  Note that this methodology differs from the “actual/365” convention used in the bank loan market.

When calculating the accrual period, it’s important to know that interest only accrues overnight.  This means, in bondland, you don’t include the end date (i.e., the payment date) when calculating the period within a range of dates, since it is the start date of, and is included in, the next interest accrual period.  For example, during the period “from July 1 to July 24,” a total of 23 nights of interest will accrue.  July 1 counts and July 24 does not.

In bondland, for each calendar month (from the 1st of a month to the 1st of the next month), 30 nights of interest will be deemed to accrue, regardless of the actual number of nights in the month.  Thirty is the magic number.  Note that this produces some interesting results.  For example, the amount of interest accruing during the first 30 nights of a 31-night month is the same as the amount of interest accruing for the entire month (so, no interest accrues on that 31st night).  And the last night of February is a particularly good night for bondholders; during a leap year, two nights of interest accrue during the night of the 29th and, during a normal year, three nights of interest accrue during the night of the 28th.

An example:

• For bonds with interest payment dates on February 15 and August 15, as of noon on March 3, 2013, even though 16 nights have passed since the last interest payment date, 18/360ths (or 5%) of the annual coupon will have accrued.  This is the math: 16 nights from February 15 to March 1 (14 actual nights, increased by two extra nights on the night of February 28th, to produce a 30-night calendar month), plus 2 nights for the nights of March 1 and 2 = 18.

 

Repost: Best way to start investing

Fantastic post by Lee Musser on Quora

First, don’t count on a finance major or MBA to teach you how to be an intelligent investor.  Most finance curriculum is overly academic and has very little real world application. Most schools base their curriculum on Modern Portfolio Theory and The Efficient Market Hypothesis – two theories that are deeply flawed and have very little real world application.

In essence, a finance major / MBA is not going to make you a good investor.   They will arm you with beautifully complex excel and model building skills, but won’t tech you the first thing about producing alpha or proper business valuation.

A few suggestions on helping you learn and become a better investor:

(1) Read, Read, Read One of the best ways to become good at investing is to learn about companies and different business models. Read SEC filings, Annual Reports, books, hedge fund letters Etc.

Some good investing, finance, and business books for your age and skill level –
(1) The Little Book That Beats The Market by Joel Greenblatt (Greenblatt is a legendary value investor, hedge fund manager, and Columbia University B school prof)
(2) F Wall Street by Joe Ponzio (prolific value investing blogger. Visit his site, which he doesn’t update anymore and read all of the archives. This will teach you 100x more than any finance prof. Link – http://www.fwallstreet.com/)
(3) The Intelligent Investor by Ben Graham (Warren Buffett’s mentor)
(4) One Up On Wall Street and Beating The Street by Peter Lynch (one of the top performing mutual fund manager’s of all time)
(5) Value Investing: From Graham to Buffett And Beyond by Bruce Greenwald, Paul Sonkin, et la (all Columbia B school profs)
(6) The Dhando Investor by Mohnish Pabrai (famous hedge fund manager)
(7) The Essays of Warren Buffett compiled by Lawrence Cunningham
(8) The Checklist Manifesto by Atul Gawande (not really an investing book, but an excellent read on the process of dealing with complexity and limiting mistakes. Highly recommended by Charlie Munger)
(9) Liar’s Poker by Michael Lewis (classic profile of 80’s wall street that somehow inspired a generation)
(10) When Genius Failed by Roger Lowenstein (Fantastic profile of the rise and fall of infamous hedge fund Long Term Capital Management)
(11) Money Masters of Our Times by John Train (Solid profiles of famous investors through history)
(12) Fooling Some Of The People All Of The Time by David Einhorn (Einhorn is my favorite investor and this book is excellent. Might be a bit above your skill level, but still a captivating read)
(13) You Can Be A Stock Market Genius by Joel Greenblatt (another book by super investor Joel Greenblatt. This one is a bit more complex than the one mentioned above, and is all about ‘special situation investing’)
(14) Both Warren Buffett biographies are solid, and will show you how hard Buffett worked and sacrificed to become what he is today. (a) Buffett: The making of an American Capitalist is shorter, but still fasinating (b) Snowball is much longer and detailed, but a very good read.

Note the the above books are anti-market trends / trading / speculating and all espouse some form of value investing. I believe this form of investing to be far superior to all of the rest. If you read all of the above next year you will be well on your way to becoming a very solid investor, and well ahead of your peers.

Once you have the ethos of value investing down then it is time to dig in and get to work on research. Investing is not day trading, it should be viewed as an intellectual pursuit requiring years of fine tuning.

After you have read a couple dozen annual reports and other assorted articles, books, etc it would be a good idea to start a blog. The blog is a good idea for an assortment of reasons, among them:

(1) A score card that tracks all of your hard work
(2) A way to develop and hone your writing and communication skills
(3) A way to network
(4) A portfolio for future jobs

So start researching and write out a thesis for why you think people should buy the stock. A good resource to see some wall street level investment thesis’s is by registering as a guest at http://www.valueinvestorsclub.co…. This site is basically a ultra selective online investment club for hedge fund manager’s and analysts. It is truly an amazing resource and will show you the important things that need to be included in your write ups, and perhaps give you a few good stock ideas.

Above all you need to remember that a stock is more that just a ticker symbol or piece of paper. It represents partial ownership in an enterprise. The price of a stock does not equal the true value of the company, and this price will surely fluctuate. This is hard to stomach for most, but it is essential to be unemotional when investing. Greed and fear are your biggest enemies.

Never invest money that you think you will need to use in the next year. True investing is long – term, and should always be looked at with a 2-5 year time horizon unless it’s a special situation investment.

Forgot to mention something. You should definitely subscribe via email to Howard Marks (chairman of Oaktree Capital) Memo’s to investors. Mark’s is prolific in his analysis and his ability to understand history and how it will affect the future. He has become a sort of legend on Wall Street through these memo’s and he is certainly someone who should be listened to.

Per Warren Buffett, “When I see memos from Howard Marks in my mail, they’re the first thing I open and read. I always learn something”

Go to the Oaktree site and sign up for the email blast to alert when a new one comes out. Also, the complete archive since 95 is on the site and I recommend going through all the old one’s when you have time bc they are filled with wisdom for all times.
link – http://www.oaktreecapital.com/me…

As far as what exactly to invest in –

You need to decide if you’re going to invest in individual securities or some kind of actively managed mutual fund or a low-cost index fund.   I would strongly advise against investing in the vast majority of actively managed mutual funds.  Most actively managed funds underperform the market & passive index funds over the long term.

I suggest Either learning how to invest yourself of go with vanguard. Pretty much all investment reps are worthless and will just put you into a handful of shitty mutual funds that will under perform the market over the long term. The average mutual fund holds over 100 positions, which is already about 70-80 positions too large if you want to consistently outperform the market. Add in five more of those 100 stock portfolio’s and you know have essentially payed your rep and the mutual fund manager to craft you a de facto index fund with the added kicker of high fees, which will ensure you will underperform.

If you don’t have an interest in learning about investing I strongly suggest buying a passively managed index fund with a very low expense ratio. There are other options that will give you better returns than this, but please don’t give you’re money to some hack IR rep or active mutual fund manager.

There are some good mutual fund companies out there, but doubtful that a generic Merrill rep will recommend those. For a solid equity mutual fund company check out Third Avenue Funds (http://www.thirdavenuefunds.com/ta/).

Third Avenue was founded by Marty Whitman, one of the most famous investors of all time.  They have a solid long term track record, although 3k might not be enough to invest with them.

If you want to start investing in individual companies all I can suggest is to learn everything you can about the company and start with easy to understand business models with small cap market values.  Take a class in accounting and valuation.  Read the companies last 5-10 years of of annual reports / financial statements and try to understand a few of the below points:

1) How do they make money?  Measure the company’s profitability.  Is this a good business that will be around for a long time?  Do they have high returns on invested capital?  Do they have have a long term trend in growing EBITDA, FCF, Owner Earnings, etc.  Is the industry the company operates in cyclical?  Are the current earnings depressed, normalized, or peak? If depressed do you feel comfortable modeling out normalized earnings?  Does he current market value / EV justify these earnings?  What is the “market” missing?  Is there hidden value or a future catalyst that will unlock value?  Be confident and back up that confidence with deep due diligence.

2) Does the company possess any long term competitive advantages?  A low cost producer, killer brand, high switching costs, etc.  or are the high ROIC going to revert to the mean once competitors realize there are no barriers to entry and will eventually drive down excess earnings or ROC?

3). What is managements capital allocation history?  Are they shareholder friendly with stock buybacks, dividends, making smart acquisitions, etc.  Do they act like owners?  Is management heavily invested along side shareholders?  If not, why he hell would you invest?

4) How does the company fund its operations?  Debt , equity, FCF, etc.  Ensure company is not over levered and can safely cover its financial obligations.  On average the best type of business is one that earns high returns on capital and can then in turn continually reinvest those earnings at incrementally high rates of return.  Study the companies past investments to get a sense of managements abilities.

5) what are similar companies with similar business charicteristics trading at?  Why is XYZ corp trading at 15X FCF and the business you are analyzing is trading at 5X?  What is the market missing?  Maybe you’re analyzing a retail / fashion company and they missed big during a specific season and all the analyst are focused on monthly same store sales numbers.  Your company is screwed in the Short term but management has a good track record and you believe the margins are depressed for a,b, and c reasons.  Once margins expand to normalized rates and the cash hits the bottom line then that speaks for itself.  In the short term the market is a voting machine in the long term it’s a weighing machine.  Long term FCF / cash earnings growth will eventually be recognized by the market and a proper multiple will be assigned.

There are a ton more “checklist” items that will help you eliminate mistakes when dealing with huge amounts of data but I think you get the point – learn how to value businesses and don’t get taken advantage of by the vagaries of short term market volatility.  Have deep conviction in your analysis; so much so that you want the stock to go down so you can acquire more for a discounted price.

Basically your goal with investing should be to figure out what something is worth and then pay a lot less.  You will do well for yourself if you live by that credo.

Good luck you are about to embark on a fulfilling journey.

EDIT # 1 – I have added some of my favorite value investing documents below.  

(1). Class Notes From Joel Greenblatt’s Special Situations Class @ Columbia B School.  These will change your life.

https://www.dropbox.com/s/gunkw7…

(2) Buffett Partnership Letters from 1957-1970.  These are fantastic.

https://www.dropbox.com/s/fawbas…

(3) Misc Charlie Munger Speeches / Essays.  Needless to say Munger knows how to think.

1 / On The Psychology Of Human Misjudgment

https://www.dropbox.com/s/zeku7j…

2 / Commencementaddress at USC School of Law 2007

https://www.dropbox.com/s/z0qu90…

(4) Michael Burry’s Commencement Speech: UCLA Economics 2012

http://www.marketfolly.com/2012/…

EDIT # 2 – I would like to address in detail one of the comments on my original post.  I have reprinted Patrick Keener’s comment below.  His comments on academic finance and risk management were troubling to me, and I think further discussion is warranted. 

Here is Patrick Keener’s Comment copied in full, I have added emphasis on the particular points I will be digging into and discussing:

First, this was a very well written and thoughtful comment.  Nice job on that-  I also agree with about 95% of what was said. 

What I disagree with though is the value of a finance degree.  Yes, they teach you theory, but the point of the theory is to help understand the world easier.   Note the two key words:  help, as in: they won’t do it alone; and easier, as in: it’s not going to provide perfect clarity.

Regardless, there are three things you need to know to be a good investor:  what to trade, when to trade, and how to manage risk.  Every book includes the first, many include the second, but the third is rarely talked about which to me is fascinating since return on investment is a function of risk. 

Make sure you learn all three equally-  you can have great returns but if you lose them all every time then there’s no point in doing it.

And since we’re all talking about our styles, mine is:

Long/short (minimized delta) for risk mgmt (also certain restrictions on allocation based on firm risk exposures), using fundamental investing (value and growth) for valuation, and trend following for entering & exiting trades (or expected events if they occur).

Here is my response:

Patrick I appreciate the time you took to comment, but I take issue with almost everything that you said.  In fact, I categorically disagree with all of your main points.

All I can think about after reading your comment is the famous bar scene in the movie Good Will Hunting.  In particular, Will’s quote,

“you dropped a hundred and fifty grand on a fuckin’ education you coulda’ got for a dollar fifty in late charges at the Public Library.”

“What I disagree with though is the value of a finance degree.  Yes, they teach you theory, but the point of the theory is to help understand the world easier.   Note the two key words:  help, as in: they won’t do it alone; and easier, as in: it’s not going to provide perfect clarity.”

I never said a finance degree isn’t valuable.  If you want to work at a bulge-bracket investment bank or sell-side Wall Street shop it will provide all the tools you need.  But, to say that a finance degree from most major business schools will teach you to be an intelligent investor is simply incorrect.

For everyone who isn’t aware — The basic premise of most academic theory is this: It is not possible to beat the market consistently, other than by chance or luck. 

EMT and Modern Portfolio Theory are both an integral part of the finance and investment curriculum at almost all major business schools.  The theories are highly fashionable in academic circles, yet no intelligent investor on wall street or main street currently utilizes them when making buy / sell decisions for shares of stock or whole enterprises.

The EMT / Modern Portfolio theory doctrine are anti-intelligent investing.  Instead of ignoring the vagaries of “Mr. Market” they say the market is everything.  That analyzing businesses and stocks is pointless, because all available public information about the business entities is already reflected in the stock price.  Further, the theory goes further stating that people like Buffett, or Klarman, or Einhorn, or Greenblatt are an anomaly, the beneficiaries of luck.  In their world, capital managed and allocated by the likes of Buffett, Einhorn, Munger, etc. has the same chance of outperforming the market as a random portfolio picked out by throwing darts at a stock table.

Is it pure chance that among all these investors of different backgrounds that there is one common theme?  They constantly have exploited the divergence between  the value of a business and the price at which that business is selling for on the open market.

“Regardless, there are three things you need to know to be a good investor:  what to trade, when to trade, and how to manage risk.  Every book includes the first, many include the second, but the third is rarely talked about which to me is fascinating since return on investment is a function of risk.”

This paragraph just outed you as someone who has never read any of the books I recommended.  If you had read these you would know they are constantly discussing risk in the proper sense.

Before I give you a proper definition of risk as it pertains to intelligent investing I think it will be beneficial to talk about what risk isn’t.

Academic defined risk

Your academics like to define risk as the relative volatility of a stock’s share price, i.e it’s volatility as it compares to that of a large basket of stocks.

With the aid of the previously mentioned beautiful complex excel models, statistical skills, and data bases these academics are able to compute with absolute and absurd precision the “beta” of a particular stock, with “beta” representing the stocks relative price volatility in the past.  They then build laughably complex capital-allocation theories around this calculation.

For value investors and business owners, this academic measure of risk categorically misses the mark and is laughable when viewed in the context of intelligent investing and capital allocation.

Under this view of risk a stock that has dropped very sharply compared to the market becomes “risker” at a lower price than it was at the higher price.  Would that make any sense to an actual business owner?  Would they think this lower quoted price made the enterprise more risky?  NO NO NO – they would think of it as a tremendous buying opportunity; they were now being offered an entire company at a reduced price.

In fact I will go as far as to say that the true investor encourages and welcomes volatility.

A few of the commenters on here have recommended Ben Graham’s fantastic book, “The Intelligent Investor.”  This is indeed required reading for any young investor just getting his feet wet in the markets.  In particular, Chapter 8 is especially useful to recall when thinking about investment risk defined by academics, stock price volatility, and why the enterprising business investor should welcome these huge price fluctuations.

In Chapter 8, Graham introduces the infamous allegory of “Mr. Market,” to help illustrate how a smart investor can take advantage of the market.

Graham told the reader to imagine market price quotations coming from a very emotional, and manic-depressive individual named, “Mr. Market,” who happens to be your partner in a business venture. Every day Mr. Market will offer to buy your share of the business or sell you his share of the business at a particular price.

The economic characteristics of your business enterprise are stable, but Mr. Market’s daily buy and sell offers are certainly not since this poor fellow is driven by his pesky emotions, e.g.  greed, fear, panic, euphoria.  Sometimes Mr. Market is feeling particularly euphoric about the future and can only see the positive factors affecting your enterprise.  In these times of Euphoria and greed he will quote a very high price.  At other times he is very fearful, scared, and in a HUGE PANIC about the trouble ahead for your business.  On these particular occasions he will quote a very low price.

Perhaps the best quality of Mr. Market is he doesn’t mind being ignored.  If the price he quotes to buy or sell the enterprise is of no interest to you, fear not he will be back with a new quote tomorrow.  Buy and sell decisions are solely up to you, and indeed under these circumstances the more manic-depressive Mr. market is, the more opportunities there are for the intelligent investor.  This is true because a market with wide, and erratic price fluctuations means that on occasion irrationally low prices will be attached to excellent business operations. 

Just remember – Mr. Market is there to serve you.  DO NOT LET HIM GUIDE YOU.  DO NOT FALL UNDER HIS INFLUENCE.  If you aren’t CERTAIN that you can understand and value a business better than Mr. Market then you don’t belong in the ring, and YOU ARE THE PATSY AT THE POKER TABLE.

Back to those academics and purveyors of beta and their assessment of risk.  What is it that they do assess aside from past price movement?  Do they care what a company produces?  NO.  Do they care about the company’s competition, or ability to earn high ROIC?  NO.  Or how much debt the company employs?  NO NO NO.  All they need is the PRICE HISTORY OF THE STOCK.

So let’s take a step back and see which investment operation and theory really care about risk management.

1 / The beta purists don’t care anything about the company’s economics, capital structure, future prospects, competitive position, financial results.  All they need to calculate RISK is price history of the stock.

2 / The business investor –  Does not care at all about price history or price fluctuations in a particular stock.  Will constantly seek out only the information and data which will further their understanding of the company’s business operations.  Will only buy security when price being offered by the market is well below their estimated value of the business.

Now we can discuss a more adequate definition of risk, which as I said above, is discussed at length in my reading recommendations. 

The proper definition of risk should be as follows:

The chance of permanent capital loss on an investment

Put in context, this can be understood further.  The following is summarized from one of my favorite books, “The Essays of Warren Buffett” —

“The real risk a investor must assess is wether his after tax returns from a potential investment will, over his prospective period of holding, give him at least as much purchasing power as he had to begin with, plus a modest rate of return on the initial stake.”

“And while this can’t be calculated with complete precision like beta, you can use the below factors to meaningfully evaluate the riskiness of a particular investment:

1 / The certainty with which the long-term economic characteristics of the business can be evaluated;

2 / The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cashflows;

3 / The certainty with which management can be counted on to channel the reward from the business to the shareholders rather than to itself;

4 / The purchase price of the business”

The best way I have found to ensure you won’t loose money is to always have a large MARGIN OF SAFETY.  Meaning, only buy shares in a company when the market price is well below your conservative valuation of the whole business.   Indeed, MARGIN OF SAFETY, is a cornerstone of investment success and will help to manage risk better than any greek letter a finance academic throws at you.    Learn it and live by it.

If you limit your search to company’s with easy to understand, mouth-watering, and enduring economic characteristics that are run by competent and shareholder friendly managements your time will be well spent and you will find some excellent investment opportunities.  If you limit your search and analytic endeavors to those businesses which possess these favorable long-term economic characteristics and you consistently buy those businesses at sensible prices relative to conservatively calculated business value you will have a tremendous long-term track record.

Measuring Oil & Gas Finding & Development Costs

• The true cost of finding and developing reserves is rarely adequately reflected in the financial accounting of an oil and gas company
• In this paper, Evaluate Energy has summarised 7 ways in which the oil & gas industry typically measures these costs:

1. F&D Costs (Organic)
   • Numerator: Exploration cost + cost of acquiring unproved property + development costs
   • Denominator: Extensions, discoveries, revisions, improved recovery
   • One of the most common definitions of finding and development costs. Excludes acquisition cost of proved reserves
2. F&D costs (All Sources)
   • Numerator: Exploration costs + proved and unproved property acquisition cost + Development cost
   • Denominator: Extensions, discoveries, revisions, improved recovery, acquisitions
   • Gives a fuller picture of full cycle F&D costs for an IOC because includes proved property acquisitions
3. F&D costs (Technical)
   • Numerator: Exploration costs (excluding property acquisition cost) + development cost
   • Denominator: Extensions, discoveries, revisions, improved recovery
   • Measures technical, (rather than commercial) efficiency of F&D and excludes acquisitions of any kind
4. Finding Cost (Technical)
   • Numerator: Exploration cost
   • Denominator: Extensions & discoveries
   • Measures technical efficiency of IOC to find oil and gas
5. Finding Cost (Inc Acquisitions)
   • Numerator: Exploration cost + acquisition costs of proved and unproved properties
   • Denominator: Extensions, discoveries, acquisitions
   • Takes account of cost and impact of acquisitions on IOC finding costs
6. Development Costs
   • Numerator: Development costs
   • Denominator: Extensions, discoveries, revisions, improved recovery
   • Standard industry definition. Not usually separated as appears as part of F&D cost calculation
7. Development Costs (Developed reserves & Acquisitions)
   • Numerator: Development costs current year + 2 future years
   • Denominator: Change in Developed reserves (end of year minus start of year) + Production – 60% of net acquisitions/divestitures
   • Evaluate Energy forward-looking definition designed to more accurately reflect current development costs for an IOC. Tends to be higher than standard industry definitions

• In order to iron out short term distortions caused by the nature of the data reporting, the length of the time period over which finding costs are measured can be increased: a 3 year average is suggested.
• It should be recognized however that the longer the time period over which finding costs are measured, the more out of date they become, because they include increasingly older expenditures and reserves, and costs and technology are constantly changing.
• An example of F&D Costs for the Major oil companies (BP, Chevron, ExxonMobil, Shell and Total) is below:

Thoughts on Culture in an Organisation

How Google Works: An excerpt

• Set unattainable goals, and then fail well
• Listen to the lab coats not the suits, and get the lab coats to produce prototypes, not slideware
• Ask yourself, what could be true in 5 years?
• Try to imagine the unimaginable because unimaginable things are happening a lot
• Then make a bet on the future. Remember big bets can sometimes be easier to achieve than little ones… since they attract the best people

 Valve employee handbook: An excerpt

• “You were not hired to fill a specific job description. You were hired to constantly be looking around for the most valuable work you could be doing.”
• Peer Reviews: The purpose of the feedback is to provide people with information that will help them grow.
• Stack Ranking: Stack ranking is done in order to gain insight into who’s providing the most value at the company and to thereby adjust each person’s compensation to be commensurate with his or her actual value.
  • Each project/product group is asked to rank its own members on skill/technical ability, productivity/output, group contribution and product contribution
• Everyone is a designer. Everyone can question each other’s work. Anyone can recruit someone onto his or her project.
• We believe that high-performance people are generally self-improving.
• The most successful people at Valve are both (1) highly skilled at a broad set of things and (2) world-class experts within a more narrow discipline.
• Questions we ask ourselves when evaluating candidates:
  • Would I want this person to be my boss?
  • Would I learn a significant amount from him or her?
  • What if this person went to work for our competition?
• We can always bring on temporary/contract help to get us through tough spots but we should never lower the hiring bar
• Download the Valve handbook

Outsystems: Small Book of the Few Big Rules – Excerpt

• Ask Why: You are entitled to know why you are doing something
• The Small Crisis: Deal with a crisis while it is small
• Challenge the Status Quo: Be proactive
• Be Helpful: And don’t be afraid to ask for help
• 80/20: Prioritise, always
  • Minimum Excellent Delivery: The smallest amount of complete and coherent work that provides maximum results and which you are proud of
• Communicate to be Understood: Be straightforward. Put yourself in another’s shoes.
• Excel: Whatever you do, do it well. Avoid sloppy, incomplete work.
• Download the Book

Zappos: Company Culture

• Deliver WOW Through Service
• Embrace and Drive Change
• Create Fun and A Little Weirdness
• Be Adventurous, Creative, and Open-Minded
• Pursue Growth and Learning
• Build Open and Honest Relationships With Communication
• Build a Positive Team and Family Spirit
• Do More With Less
• Be Passionate and Determined
• Be Humble
• Zappos Company Culture

Optimal stopping strategies and life decisions

Solutions to optimal stopping problems in mathematics help you maximise an expected reward, or minimise an expected cost.

One example is the “Secretary Problem”. The solution to this helps you maximise the probability of making the best choice when reviewing a number of choices in a sequential order. An example would be identifying the best car:

• Step 1: Estimate how many cars you could see in a fixed time period, n.
• Step 2: Calculate the square root of that number, √n.
• Step 3: See and reject the first √n cars; the best of them will set your benchmark.
• Step 4: Continue seeing cars and choose the first car to exceed the benchmark set by the initial √n cars.

Note  that this solution was proposed by J Neil Bearden for situations where payoff is not zero when a non “best” choice is made (ie. real life): this will maximise pay-off

The general secretary problem generally prescribes stopping with the best choice after the first n/e applicants (where e is the base of the natural logarithm). This will give a probability of making the best choice about 37% of the time (or 1/e).

A unified approach to this problem can be solved where an applicant must be selected on a time interval [0,N] from an unknown number, N of rankable applicants. The strategy is to wait and observe all applicants up to time thi, and select the first candidate after time thi which is better than all preceding ones, where thi is the time at which the cumulative probability of the arrival time distribution function = 1/e.

Links:

• New Scientist: Knowing when to stop
• Slate: The Secretary Problem
• Wikipedia: Secretary Problem

20 Successful Habits

A good set of habits to keep in mind, sourced from Paul C. Brunson under the title “20 Successful Habits I learned working for two billionaires”

1) Invest in yourself
2) Be curious… about everything
3) Surround your self with “better” people
4) Never eat alone
5) Take responsibility for your losses
6) Understand the power of “leverage”
7) Take no days off (completely)
8) Focus on experiences vs material possessions
9) Take enormous risks
10) Don’t go at it alone
11) Recognise the value of simple ideas
12) Be patiently impatient
13) Be gritty (tenacious/relentless)
14) Develop great oratory skills
15) Grow thick, armour-plated skin
16) Connect with people outside your community
17) Over-communicate your message
18) Learn to laugh at yourself
19) Be great at one thing, first
20) Know a higher power

Contango vs Backwardation

• Contango and backwardation refer to the shape of a single forward contract as we take snapshots across time
• Contango is where the forward price of a commodity is higher than the expected spot price: investors/users are willing to pay more for a commodity at some point in the future than the actual expected price of the commodity
• People may want to pay a premium to have the commodity in the future rather than paying the costs of storage and carry costs of buying the commodity today
• If we assume that the spot price in the future is roughly similar to today’s spot price, the price of a single forward contract would fall through time towards the spot price as it moves towards maturity: see example below

“Contangobackwardation” by Suicup – Own work. Licensed under CC BY-SA 3.0 via Wikimedia Commons 

• When the market is in contango, it’s the commercial users of a commodity who are happy to lock in prices at the current level, while producers aren’t willing to lock in future production at the same level. So the commercial users of the commodity essentially pay speculators a premium to entice them to sell future production at the current price.
• Contango is associated with oversupply, and rising levels of the commodity in storage
• If we plot futures prices against contract maturities, we get a futures (or forward) curve. A curve associated with contango is a “normal” curve and slopes upwards.

• An inverted market occurs can be associated with a market in backwardation, where the futures price for faraway deliveries is less than the spot price.
• Normal backwardation (also called backwardation) is where the forward price of a commodity is lower than the expected spot price: investors/users are willing to pay less for a commodity at some point in the future than the actual expected price of the commodity
• When a market like oil is in backwardation, it’s because producers want to lock in the current price for future production, while not so many commercial users want to lock in the current price. So producers sell their future production at a discount to the current price to entice speculators to buy their future production.
• Backwardation is associated with undersupply, with falls in inventory levels

Investment Outlook 2015 – David Novac

The summary below covers a presentation given by David Novac at an AIA meeting held on the 6th January.

Context: Global Macro View

• Massive bank intervention since 2008, with liquidity sitting on corporate balance sheets
• Low inflation, low interest rates and bond yields
• Falling commodity prices with a threat of deflation
• Structural impact of low Chinese/Indian wages on the world
• Slow global growth
• Sovereign debt remains high
• US Debt remains very large compared to GDP, with the largest holders of US Debt being Japan and China
• Interest rates are currently the lowest that have ever been seen (charting back to 1790)

Opportunities/Potential Issues

• We have seen the longest secular bull market in history for 30 year bonds, with interest rates falling from 14% to 2% over 20+ years. This has driven bank valuations up, as well as bond prices.
• With interest rates so low, investors are getting desperate for returns: dramatic increase in junk bond volumes over the last few years
• Currently 0.5 trillion of high yield debt with Shale companies, with recent oil price impacts likely to impact this: corporate debt defaults could significantly impact the S&P
• Divergence in spreads between government debt and junk presaged the GFC and you are getting a similar situation today.
• Margin loan volumes have risen substantially over the last few years
• Level of analyst bullish sentiment (see BofA Merrill Lynch Fund Manager survey) is high -> this is a contrarian indicator
• The chinese stock market is currently the hot market, with fund managers moving funds over due to lower earnings multiples. However, import/export data (most “trust-able source”) shows that volumes are falling.
• David’s current view is that a mania exists: examples include valuations for Facebook, Twitter etc. He is currently bearish on US equities: with a stronger US dollar, earnings are likely to go down.
• Will be good opportunities in the energy space but would not be rushing in right now
• Bullish on soft commodities: agriculture, food etc
• Longer term bull on gold but the chart is not telling us to buy at the moment

Outlook for Australian Economy in 2015

• Lower GDP Growth
• Rising unemployment
• Slow down in housing market
• Likely interest rate cut by RBA
• Further weakness in A$
• Increase in Govt deficit and debt
• Continued economic slow down of growth for China and Japan – this is the biggest unknown for Australia in 2015
• Could be opportunity in the resources sector if further stimulus in China occurs
• Not bullish on banks: any indication of a slowdown will impact the banks significantly
• Housing bubble in Australia
  • We have one of the worst affordability indices in the world, with worst household debt as % of household income
  • CBA is the 8th largest bank in the world now – bigger than all the banks in Germany put together

Deflationary Global Trends

• Money is piling into the US$ for protection so it has had a massive rally
• Gold and USD have been inversely related: USD strength is growing and hence gold is going down
• Oil is currently (and is always) driven by traders: this is likely to be overdone at the moment as all the traders are shorting

Global Outlook for 2015

• Global growth and geopolitical risks?
• US interest rates in 2015?
• Stronger USD will become a big issue for the US economy and the Fed
• Government debt is much higher than pre-GFC levels yet bond yields continue to move lower
• Central banks are likely to continue massive monetary stimulus measures to fight deflation
• Investors likely to continue taking on much higher risks for lower returns

Other Learnings from the Presentation

• Look at the front page of a newspaper as a contrarian indicator
• Look at bullish sentiment as a contrarian indicator as well
• Key Investor Objectives and Tools:
  • Know when to buy: Using Technicals
  • Know when to sell: Using exit and capital protection strategies
  • Know what to buy: Using Fundamental Analysis and Rules
• Stages of a bubble:

Market Phase Analysis

These notes are a summary of the market phase analysis discussion in Colin Nicholson’s book: Building Wealth in the Stock Market.

3 Analytical Tools to determine % capital invested in Stocks:

1. Dow Theory Phase Analysis
2. Coppock Indicator
3. Trend Analysis of the market index

1. Dow Theory Phase Analysis

There are 3 bull and 3 bear market phases. The phase indicators/checklist for each Phase is described below.

Bull Market Phase 1: Reviving Confidence

• News about the economy tends to be negative
• Market expecting recovery
• Household saving ratio still high
• Interest rates still relatively low
• Private investors out of the market
• Market may ignore bad news
• Initial rise thought to be a bear market rally
• Disbelief turns to fear of missing out
• Market fundamentally undervalued
• Very few IPOs
• Inquiries into what went wrong
• Regulation is tightened

Bull Market Phase 2: Increasing Earnings

• Many companies announce increased earnings
• Good news is announced
• Employment picks up
• Household savings ratio falls
• More IPOs
• Significant market corrections end higher
• Fundamental values return to normal
• Sector rotation

Bull Market Phase 3: Rampant Speculation

• Significant fundamental overvaluation
• Interest rates relatively high
• Increased price volatility
• Many capital raisings
• Many IPOs, many without merit
• Private investors heavily in the market
• Day traders heavily in the market
• Increased use of debt and leverage by investors
• Much commercial building construction
• Someone builds “world’s highest building”
• Increased media coverage
• New paradigm theories advanced
• Market led by relatively few stocks

Bear Market Phase 1: Abandonment of Hopes

• Fundamental valuations will still be high
• Interest rates peak
• The economy is still strong
• Public see a buying opportunity
• Volumes fall; Buying is done
• Market may ignore good news
• There may be some shock news
• The public may also panic, triggering a crash
• Floats fail and are then abandoned

Bear Market Phase 2: Decreasing Earnings

• Earnings decreases announced
• Market ignores good news
• Former market leaders may fail
• A recession begins (and much discussion exists about when it started)
• Share rallies leading to further falls
• Few new floats
• The public loses interest
• Fundamentals return to reasonable levels (ratios look attractive based on past earnings)

Bear Market Phase 3: Distress Selling

• Significant undervaluation (Low price/earnings ratios)
• Unemployment peaks (high unemployment levels, with ruling party typically voted out)
• Many bankruptcies and failures
• Bad news is discounted (already built into price)
• Market is rarely in the news
• Low public interest and participation (brokers reduce staffing)
• Stock price charts show accumulation: stocks offered by general public to professionals in desperation with broad sideways formation

2. Coppock Indicator

• Momentum oscillator designed to indicate when it is time to buy long term holdings near the bottom of a bear market. This indicator measures changes in the speed of price changes in the stock market
• To calculate this:
  • Calculate the percentage change between the index value at the end of the current month and its value 14 months earlier
  • Calculate the percentage change between the index value at the end of the current month and its value 11 months earlier
  • Total the two percentages
  • Calculate a 10-month weighted moving average of the total of the two percentages
• Buy when the indicator turns up when it has fallen below the zero line. Use it only as a buy signal, and only in conjunction with analysis using other indicators

3. Trend Analysis of the Market Index

• A bull market is in place when the market rises higher than its previous peak. One of the following occurs:
  • The market is falling. It then rallies above the peak formed on the previous rally.
  • The market is falling. It then rallies, but does not rise above the peak of the previous rally. After forming a trough which is higher than the previous trough, it then rallies again and rises above the peak formed on the rally from the lowest trough.
  • The market is falling. It then rallies and declines several times, forming a trading range. It may have given several consecutive conflicting signals, which were quite quickly negated. Eventually, the market rallies above the highest peak in the trading range.
• A bear market is in place when the market falls lower than its previous trough. One of the following occurs:
  • The market is rising. It then declines below the trough formed on the previous decline.
  • The market is rising. It then declines, but does not fall below the trough of the previous decline. After forming a peak which is lower than the previous peak, it then falls again to below the trough formed on the decline from the highest peak.
  • The market is rising. It then declines and rallies several times, forming a trading range. It may have given several consecutive conflicting signals, which were quite quickly negated. Eventually, the market declines below the lowest trough in the trading range.

The two greatest sins that investors commit in the stock market

• Beginners enter the bull market much too late
  • If beginners enter earlier then losses would not have been as catastrophic
• Beginners fail to get out when the bull market ends
  • Holding on when bear markets occur create larger and larger losses
  • Beginners then sell out at horrendous losses
• The key is to start putting money into stocks when the risk is low, and be completely invested as early in a bull market as possible
• Then start taking money out of stocks as the risk becomes high and be completely out of stocks as early in the bear market as possible

Key Charts to Analyse

• Market P/E Ratio
• Market Dividend Yield
• 90-day bank bill rate
• Simple Moving Average (SMA) of new listings