Mr Market - Musings of a Value Investor

Bruce Berkowitz On Berkshire Hathaway

2006-05-10T18:59:00.000-04:00

Bruce Berkowitz was recently interviewed at length by Value Investor Insight and Forbes with permisssion reproduced a segment of the interview. The article entitled "Buffet: Still The Best Jockey" concentrated on one of Fairholme's biggest position, Berkshire Hathaway.

"Berkshire is the perfect example of a company genetically engineered for adversity. The liquidity they have to take advantage of opportunities created by a crisis is really unique. I truly believe the big money in Berkshire will be made after some sort of blowup. I can sleep pretty well with that." Bruce Berkowitz

I agree with Bruce's assessment that Berkshire Hathaway is probably one of the best investment you can make if you are worried about the sustainability of current stock levels. The huge undervaluation protects you on the downside, and its huge cash holding puts it in an enviable position to capitalized on the opportunities when the market gives way. The team at Fairholme values BRK at $150,000.

Not A Lemming

Bill Miller's Perspective On Commodities

2006-05-07T21:41:00.000-04:00

Bill Miller devoted his 2006 1st Quarter commentary to the bull market in commodities. Noting the typical signs of a market top, he cites examples of johnny-come-lately pension funds including commodities in their portfolios for the first time. Prod on by investment consultants emboldened by hindsight, these funds are now convinced that including commodities in their allocation will increase returns and reduce risks. No speculative bubble is complete without the popular press giving their well argued case that we are in "a new paradigm and this time its different", in any case Bill goes on to debunk them.

Buying cyclical stocks is always hazardous, precisely because things looks most rosy at the very top. Even valuations looks deceptively benign. Looking at Bill's portfolio, he has decidedly taken a different approach to cyclical homebuilder stocks and so has Muhlenkamp and several value managers. Perhaps they know better, but to me these homebuilders look strikingly similar to commodity stocks.

Not A Lemming

Computer Associates (CA) - Cheap But Not A Compelling Buy

2006-05-03T22:14:00.000-04:00

I have been tracking Computer Associates (CA) ever since I read Gregg Power's (principal of Private Capital Management) reasoning behind his firm's investment in CA. In fact you can find the same article extracted from Peter Tanous's book Investment Visionary on their website. It is hard to fault Power's reasoning and conviction (this is PCM's 2nd biggest position in their portfolio), but the stock has seriously lagged the market during the past 3 years.

This stock really had more than its fair share of negative publicity. SEC investigation, restating of previous years earning and finally cumulating in the conviction of ex-CEO.

Beyond these controversies, the company's growth is an issue. The company's fortune is intricately tied to the mature mainframe market, where their system management software dominates. As the world moves to towards distributed computing, CA strength becomes its liability.

Despite having underperformed for several years, CA's value is not immediately apparent. Heavy amortization cost makes the stock look very expensive on a PE basis at 71x (historical). Even at 15x EV/EBITDA the stock looks stretched. Proponents of the stock values it on a Price/Free cash Flow basis, which at 10x begins to look pretty interesting. The company generated almost $1.5 billion in free cash flow last year versus Market Capitalisation of $14.6 billiion and almost similar Enterprise Value.

The latest round of selling after a profit warning caused me to take another look at the company. I have consistently made money writing puts on CA in the past 3 years but this time round I am inclined to give it a miss. Although I think the downside is somewhat limited here, the pricing on the puts are just too low. Writing the at-the-money Jan $25 puts will provide an annualized yield of just 7.5%.

Not A Lemming

USA Mobility (USMO) – Is this A Cigar Butt?

2006-04-10T04:07:00.000-04:00

"If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the "cigar butt" approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the "bargain purchase" will make that puff all profit."

- Warren Buffet

USMO is in an industry that many believe is on its way to obsolescence, but is it? Contributing to this view is a massive shift in the mass market from pagers to handphones and other mobile communication devices. I hold a contrary view, I believe that the industry is transitioning from one with mass appeal to one with a more limited audience. It will continue to be used by thousands of medical, security and emergency workers as a back up mode of telecommunication. The robustness and cost effectiveness of the paging option will ensure that this technology survive even though it will pass from popular usage.

And this is when it gets interesting. The market is probably big enough for only one player and USMO is the biggest and making sure that it is the most cost effective. Over time as other players leave the scene or gets consolidated, it will emerged as a natural monopoly in a smaller but stable market.

To ensure that USMO gets there, it has to continually cut cost and ensure that they remain the low cost provider. Over the next few years they will have to wrench out cost to stay as the low cost producer. During the last earnings webcast, it was heartening to hear management lay out plans to cut annual network costs by another $87 million over the next 5 years. This figure is significant in the context of expected revenues of only $575 million and EBITDA of $115 million. This $87 figure is not pie in the sky figure either, most of this savings will come from expiry of redundant leases just waiting to expire.

I see several catalysts that can take the stock back up. Its audited results has been held up as their new auditors had proposed accounting changes in their reported financial reports. Whilst this may result in the company restating some prior years earnings, none of the changes has any bearing on revenues or cash flow. The uncertainty pertaining to this should be lifted over the couple of weeks. Cash continues to build up as capex requirements are minimal; any decision to return money to shareholders will be welcome by the market. However, the biggest catalyst to this stock will have to come from stabilization of its subscribers base, paving the way for the market to value it as a ongoing entity rather than a stock with an expiry date.

The management is embarking on several initiatives that could materially impact future earnings. One of them is to allow utility companies to transmit meter reading from homes & buildings automatically using paging technology. Another involves putting paging functionality into cell phones. Buyers of USMO gets free options on these new business plans, but for buyers of the stock at this level, investment success is not predicated on the success of these new ventures. If any of these take off in a big way, it's pure icing on the cake.

I think many value investors are passing over USMO thinking it is just a cigar butt. USMO is no cigar butt but a miniature cigar.

Not A Lemming
(Disclosure: My family and I has a position in the stock)

2006 Trade 6 - USMO

2006-04-07T07:49:00.000-04:00

Established a new position in USA Mobility (USMO) at $24.50 yesterday. USMO is the largest paging service provider in the country. The industry has seen major contraction over the years as users migrate to handphones and blackberries. Still, current valuation is too pessimistic. At Entreprise Value/EBITDA of 3.7x, the market has put a very short "expiry date" on the company. Well I think this cigar butt may have a few more puffs left, I hope to put that into a fuller posting this weekend.

I am in good company here, Fairholme(Bruce Berkowitz) and Baupost (Seth Klarman) has taken a liking this stock as well. Ruane Cunniff is also in the shareholder list.

Have a great weekend.

Not A Lemming

Resources for Investors on the Internet

2006-04-03T04:26:00.000-04:00

The amount of resources on the internet available to investors is just incredible, and best part is that most of it is free. I have compiled a list of useful sites for the benefit of readers of this blog.

Stock Screen
Hedge fund manager and the author of "The little book that beats the market", Joel Greenblatt created this site for the benefit of his readers. The screen throws up stock picks based on 2 criteria; cheap (measured by earnings yield) and good (measured by return on capital). My only caution is that this screen throws up quite a few cyclical stocks benefiting from a boom, making them look cheap based on peak but clearly not sustainable earnings.

http://www.magicformulainvesting.com/

Tracking Fund Managers
Here I go pitching Gurufocus again, but that site has been a great help to me. All investment managers managing funds in excess of $100 million has to file Form 13 quarterly, and NASDAQ's database allows you to extract the last quarterly portfolios of the managers you specify.You can even view the portfolios of hedge funds whose actions are typically shrouded in secrecy. Value managers tend to buy too early, so the delay in reporting is not always a big disadvantage to us.
http://www.gurufocus.com/
http://www.nasdaq.com/reference/ownership.stm

Tracking Insiders

This sites consolidate Form4 filings, giving you quick summary of recent insider trades. I just started looking at them, but the listings look pretty comprehensive.
http://www.secform4.com/
http://news.moneycentral.msn.com/process/insider/top10insider.asp
http://insider-monitor.com/

Option Pricing Calculator

This site has a basic calculator is free and is quite sufficient for my use. There is a premium version on the site but I have not tried it.
http://www.ivolatility.com/calc/

Discounted Cash Flow Calculator
Save you the trouble of creating your own excel spreadsheet. I won't take their advice to use EPS as proxy to cash flow as input, but otherwise the calculator works.

http://www.moneychimp.com/articles/valuation/dcf.htm

Hope the list is useful. Let me know if there any other sites you would recommend.

Not A Lemming

1st Quarter Portfolio Review

2006-04-02T21:34:00.000-04:00

I thought it would be a good idea to review the positions I had highlighted in my previous posts. In fact I think I will make this quarterly review a regular feature of this blog.

I remain comfortable with all my existing positions. Reliant Energy had to survive credit rating downgrades from Moody's and S&P, and reduced 2006 guidance from management. The price resilience in the face of these negative headlines is somewhat comforting. Otherwise, the other position are performing nicely.

I just managed to lay my hands on the out-of-print "Margin of Safety" by Seth Klarman. Used copies of the book is being offered on Amazon at $799. Well, let's see if the intrinic value of the book is really worth that much.

Not A Lemming

Investing Maxims To Live By

2006-03-28T06:52:00.000-05:00

Fairholme Funds homepage comes with a set of A-Z maxims that underlies their focused approach to value investing.

Here is a pick of those I found rather interesting:

Cash counts (it's the only thing you can spend)
Don't guess (know)
Focus sharpens returns (own your best ideas)
Happy is sad (make your money during difficult times)
Keep it simple (focus on what is important)
Ignore the crowd (don't be a lemming)
Owners know best
Price matters (buy with a margin of safety)
Talking and Walking (we really eat our own cooking)
Value is all that matters
Zeroes don't grow (don't lose)

Besides the usual value principles, the other investing maxims are nothing more than good old common sense. But then again isn't value investing all about good common sense? In a world of correlations, betas & alphas and standard deviations, it is refreshing to hear an investment manager talk in a language we can all appreciate.

Not A Lemming

Bad News or Good News? You Decide

2006-03-21T19:57:00.000-05:00

GuruFocus.com is a great site to keep tabs on what value managers are doing or thinking, I highly recommend it. That site currently has a link to the letter from Seth Klarman of Baupost Limited Partnership to their clients, entitled "Today's Market Environment : The Bad News About Value Investing"

The gist of the article is a warning that whilst risks are building up in the financial markets, the markets are becoming increasingly complacent. Global structural imbalances, higher interest rates, dearth of values, record level of consumer indebtedness, increased used of leverage and derivatives, increased competition etc etc; all potent ingredients for creating the next perfect storm in the financial markets.

All these sounds familiar, except this does not come the usual top down doomsday prognosticator, but by a respected member of the value investing community. In fact he joins a chorus of value investors, including Warren Buffet & Arnold Van Den Berg, increasingly uneasy with the current environment.

It is probably bad taste to be talking of taking advantage of another's misfortune. But in essence the best opportunity accorded to value investors is when they step into a desperate market to provide liquidity. When complacency and greed gets replaced by fear, the value investor steps in and accept the bargains offered by Mr Market's great sale.

Below are excerpts from the letter:

Rather than ratchet up risk, our approach has been to hold cash in the absence of opportunity.

With valuations still universally high, once markets start dropping, even cautious investors are exposed to the significant risk of getting in too soon.

The world could well be setting up for considerable upheaval and with it an avalanche of opportunity.

While we won't hesitate to take advantage of investment bargains we uncover at any time, we are preparing our team to be well-positioned for the emergence of an expanded opportunity set.

Opportunity or doomsday? It is matter of perspective, or rather a matter of positioning. Cash will be king again!

Not A Lemming

2006 Trade 5 - Verisgn

2006-03-15T19:28:00.000-05:00

VeriSign hit jackpot when the tune Crazy Frog by its unit Jamster became a hit and took the stock to near $40. The fad might be over and Crazy Frog passe, but Verisign will survive.

At current level, Verisign's market capitalisation stands at $5.85 billion. Domain name registration, its core business provides steady growth and great cash flow to fund its other ventures. Free cash flow is rising rapidly exceeding $250 million in 2003 and 2004, and jumped to $370 million in 2005. The company spent $380 million buying back its shares in 2005.

Sold Sept $22.50 Puts, collected $1.70. Implied volitility is 32.6%. Yield is 7.55%, annualised 14.9%.

Viewers of my blog will know that I typically like to see a good value guru share the same opinion as me. In this case, Gregg Power's Private Capital Management is one of VeriSign's biggest supporters. Value investors will probably also find it interesting that Lou Simpson, Warren Buffet sidekick at GEICO sits on their board.

Not A Lemming

2006 Trade 4 -News Corp

2006-03-07T05:19:00.000-05:00

The whole range of media stocks have been significant underperformers; newspaper, cable, satellite, free to air broadcasting, content providers are all coming to terms with the new operating environment. Technological and regulatory changes have given the consumers more choices and that in turn have caused the fragmentation of the advertising dollar.

I believe the current environment represents a great opportunity for investors, but one fraught with danger as well. I narrowed down my choice of investment to News Corp (NWS), not that it is the cheapest nor the one with the biggest upside potential, but because I believe it is the least risky.

Rupert Murdoch, the Chairman and CEO who build this media has a significant part of his networth tied up in the company. Listen to any conference call and you will find a hands-on CEO who is on top of things. His vast experience and enterprenurial instincts will come in handy as the industry navigates in this unfamiliar territory.

The gearing level for this company is relatively low and allows the company to exploit the current low valuations to make acquisitions or aggressively embark on stock buybacks. Operating Cashflow has doubled over the past 3 years giving him even more ammunition to drive future growth.

Non-US earnings contributes to more than half of its turnover and is also showing much stronger growth, particularly in Asia. This is a truly global media company, its satellite broadcasting interest spans Asia(StarTV), Europe (SKY) and the US (DTV). With Warren Buffet's recent comments on the attractivenes of companies with strong foreign revenues, NWC looks even better. Their unique and diversified assets provides for unparalleled stability and synergies within the group.

You will find the usual suspects in this value stock, Oakmark, Longleaf etc, but the interesting discovery for me was that Baupost/Seth Klarman has a concentrated 53% of his fund in this stock. Wow, and all this comes from the man who wrote the classic "Margin of Safety".

Paid $16.60 for NWS-A shares.

Not A Lemming

Apollo Group Inc, Slowing Growth But Great Economics

2006-03-01T02:15:00.000-05:00

Click picture to enlarge chart

The pain of missing a trade because of price can sometimes haunt an investor for years. For me, Apollo (APOL) was the one that got away. I had missed putting on a trade because I had been too sticky with the price and had regretted ever since. Seeing the stock soar was almost too painful to bear, but maybe this an opportunity to make amends.

The stock peaked in June '04 and has been steadily trending down, but last night's profit warning brought the stock down another 15%.

For-profit schools fill the gaps left by the traditional universities and Apollo is by far the biggest and best managed in the pack.

The economics of the business is incredible, combining high profit margin and low capital requirement, the business is a cash machine. Gross Profit margin was 58%, Operating Margin 32% and even at the Net level 20%. The company made $444mil in profits supported by assets of only $1,302mil or a ROA of 34%.

Apollo's operations throws up tons of cash. The company spent $1.35 billion of its free cashflow over the past 2 financial years buying back its stock (not at the most intelligent of prices I must admit). Still the company sits on a net cash hoard of $200m and will generate free cashflows in excess of $500mil this financial year.

Valuation has compressed significantly in the past 2 years on the back of slowing growth. Having said that, growth is still expected to be in excess of 10% even after last night warning. P/FCF for this year is conservatively 17x. DCF even with moderate expectations of growth, comes in above $65 per share. Not quite 60 cents for the dollar, but do I want to risk missing it again? What about writing a put? Hmmm...

Not A Lemming

First Marblehead

2006-02-24T05:14:00.000-05:00

First Marblehead (FMD) has an interesting business model helping banks with their private education loans. Their clients outsourced the design, securitisation and underwriting to FMD. It is an interesting and growing niche, with the cost of higher education rising rapidly and federal funding diminishing. Business model is not capital intensive and does not put their capital at risk.

Hedge fund manager Tom Brown of Second Curve has staked a big part of his portfolio on this stock. He has repeatedly made the case for investing in FMD on his website Bankstocks.com. Yesterday he posted more comments following FMD's analyst day. Check out his posting :

See Article

My main issue with FMD has always been about the quality of earnings. Earnings are booked years ahead of actual cashflow (nature of the business rather than any hanky pank), therefore operating cashflow lags earnings significantly. Then there is the issue of over-concentration to 3 major clients; one of them now terribly unhappy with them because of a gifting scandal last year. Not expensive, but expect more volatility than upside at current levels.

Personal holdings : I bought the stock during the selloff in Oct05, which has now morphed into a covered call position.

Not A Lemming

Valuing Growth

2006-02-23T07:28:00.000-05:00

Value investing has almost become synonymous with buying low PE, low P/Bk and high dividend yielding stocks. Perhaps that is why Bill Miller with his rather unorthodox value stock picks is sometimes portrayed as a growth manager disguised as a value manager. Let me extract some relevant sections from the Intelligent Investor to dispel this notion.

“The margin-of- safety idea becomes much more evident when we apply it to the field of undervalued or bargain securities”

It is really much easier to identify value in stocks with no or little growth prospect, simply because there is no need to impute a value for growth. If the poor growth prospect drives the market value below its net liquid asset value, buying the stock really becomes a no-brainer. Most of the time, the value comes from a gap opening up between the price and DCF.

“Thus the growth-stock may supply as dependable a margin of safety as is found in the ordinary investment – provided it shows a satisfactory margin in relation to the price paid”

In his classic, Benjamin Graham went on to describe the dangers of over paying for growth, however he is not ambiguous that the central tenet of value investing which is the margin of safety concept, is equally applicable to growth stocks. The value investor should not necessarily shy away from growth stocks, rather he should try to profit from growth stocks that are under-priced.

Since the value of future growth is somewhat nebulous, the intelligent investor should be conservative in his projections. For such projections to be meaningful and correspond to reality, Warren Buffet focused his efforts on businesses with stable operation environment and a high level of predictability. Bill Miller’s circle of competence takes him in the other direction, finding values in emerging companies with strong growth prospects.

* pg 281 Intelligent Investor, Forth Revised Edition

Not A Lemming

Technology - Value Managers' New Playground

2006-02-19T20:45:00.000-05:00

Slowly but surely value manager's are venturing into what was predominantly the space of growth managers.

Private Capital Management, best remembered as the largest holder of Qualcomm during the TNT (tech, media & telecom) era, always had a strong technology component in their portfolio. One of its biggest holding for several years now is CA. Software is where they seem to be putting their bets on. Bill Miller is another value manager that has not been adverse to putting money in this sector, his preference is for business models that exploits the benefits of the internet.

Today "old techs" are finding its way into a wider spectrum of value managers' portfolios. During the last quarter, taking advantage of the earnings disappointment, value managers piled into DELL and LXK.

The common factor in all these tech businesses, is their ability to generate strong free cash flow. High margins are protected by intellectual property rights, asset light and at the forefront of the out-sourcing trend - these companies turn in high profits, ROEs, cash.

Still the grandmaster of value investing, Warren Buffet has stayed out of the game.(LXK looks like the work of Lou Simpson) He will never buy something outside his area of competence, neither will he buy something that cannot keep to his preferred holding period - forever. Just as he has passed up on the opportunity on the pharmaceucticals, looks like he will give this a miss too.

Not A Lemming

2006 Trade 3 - Tyco

2006-02-17T07:40:00.000-05:00

Bought Tyco yesterday @ $25.40.

With historical free cash flow of about $5 billion or $2.45 per share, P/FCF is just over 10x. A DCF based on a zero growth assumption yields a value of $22.94 (cost of equity of 10.68%). In other words I am paying only $2.46 for future growth, rather modest expectations at current prices. A more realistic assumption of 6% growth over the next 8 years and 3% thereafter puts the DCF value at $39.47.

I believe the stock at current level offers considerable margin of safety. Will continue to build up exposure through put writing if the market gives me the chance.

Not A Lemming

Reliant Energy (2006 Trade 1) Update

2006-02-16T07:52:00.000-05:00

Glenview brings shareholding up to 9.5% with purchase of another 5.3m shares.

Not A Lemming

Warren Buffet's Genius Is In The Waiting

2006-02-13T21:26:00.000-05:00

Wal Mart shares are trading at valuations not seen since 1996. Despite compounded revenue and eps growth of 11% & 13% during the past five years, its share price has basically moved sideways.

Price/sales 0.68x
Discount to DCF -42.5%
EV/EBIT 12.6x
ROE 22%

Date Price DCF
1/2000 $55; $44
1/2001 $53; $53
1/2002 $60; $57
1/2003 $48; $56
1/2004 $54; $65
1/2005 $52; $72
1/2006 $46; $80

DCF assumptions: 11% growth (from year 2000) for 15 years & 3% thereafter. Cost of equity is 8.6%. (from bloomberg) EPS is used as proxy to FCF.

Given current valuations, I am not surprised that both Warren Buffet and Lou Simpson acted in unison in picking up the shares in the 3 Qtr last year. The recent pullback in share price brings it back to the levels of their purchase.

As Warren Buffet said, there is no need to sweat the maths, no rocket science required. His genius is in the waiting; hopefully mine is in following after the wise.

Not A Lemming

2006 Trade 2 - Sears Holdings

2006-02-08T21:44:00.000-05:00

Sold puts on Sears Holdings and collected $10.90 for Sept $115 strike. Almost at the money, gives me a yield of 9.5% (15.7% annualised). Good premiums with implied volatility of 37%, a rarity in today's option pricing environment. In case you are wondering why I'm writing puts on Sears, you can read my previous post entitled Sears Holdings -A Bipolar Stock.

Looked at BUD, WMT, TYC but option pricing on these are not attractive. Any ideas readers?

Disclaimer : This is not a stock recommendation, just a public record of my own trades. Follow at your own risk. Remember Mama's advice not to listen to strangers, well it applies here!

Not A Lemming

Bill Miller Distills The Essence Of Value Investing

2006-02-07T21:57:00.000-05:00

Bill Miller's incredible track record of beating the S&P500 consecutively for the past 15 years has made him one of America’s most famous fund managers. A self-described value manager, he ventures where none other value manager threads. His forays into Internet stock like Amazon & Ebay is taboo to most other value managers. At the end of 2005, his biggest stockholding is Google.

In his recent letter to his clients, he explained the thinking behind his investment process and gives a concise explanation of what value investing is all about. Value investing is a philosophy, a whole new way of looking at investing.

Value investors buy businesses not stocks. They have a long-term orientation and are less concern with short-term price movement.

Price and value differ, and when a wide gap exists between the market price and the value, this variant perception becomes the investment opportunity to the value investor. Understanding the gap rather than fundamental analysis per se is the key to profitable investing.

Non-Action is sometimes the best action.

Read the Original Article

Embracing value investing as a philosophy gives investors a whole new set of lenses, a different perspective; it is not just a matter of buying low PE stocks or employing other methods for valuing stocks. Bill Miller has the religion, he just practices it differently.

Not A Lemming

Sears Holding - A Bipolar Stock

2006-02-01T22:00:00.000-05:00

Sears Holding is what I would term a bipolar stock. By that I mean, a stock which can move in either direction in a big way depending on how things plays out. Talking of bipolar stocks, other names come to mind. Recently 2 very opposing views on Overstock.Com appeared on investing blogs, Gannon on Investing and The New Wall Street. I enjoyed reading the 2 diametrically and mutually exclusive views, but over time one of them will prove to be right and the other will be awfully wrong. If there is any comfort, even Warren Buffet was once at the wrong end of the stick when he bought cheap into Berkshire Hathaway and wasn't successful in turning the textile operations around.

Sears Holding is currently is in a similar position. By most operating measures it doesn't look like a good candidate for investment; sales are declining, its gross margins are way below that of it competitors, the trend away from malls to stand alone mega stores, poor merchandizing etc. If I were to extrapolate these factors, I can make an extremely bearish case for SHLD.

However, to me Sears is a work-in-progress and I like what I am seeing.

1. Despite slipping sales, Sears is still profitable and is generating positive cash flow. By the end of January's quarter, the company expects to have a cash balance of $3 billion. Despite their problems, its healthy finances give them ample flexibility to maneuver and experiment.

2. Lampert has resisted the cry from investors to realize the value of some its real estate, concentrating his efforts in improving the retail operations. Although this may disappoint many short term investors, it reflects his confidence and long-term commitment to the business. Sticking by his convictions instead of pandering to Wall Street's whims, he shows he is his own man. The properties alone are worth $150 per share if a report by Deutche Securities is to be believed.

3. The company stock buyback is also matched by purchases by ESL, Lampert's hedge fund. (bot another $60milion worth in Jan06) His fund's investment in Sears is now worth close to $8 billion at current market prices. It is also comforting to see one of my favorite managers Fairholme in the shareholders list.

4. Lampert has done a very good job both at AutoNation and AutoZone and is not new to the retailing landscape.

In the final analysis, most bipolar investments involve making a qualitative judgment on the effectiveness of management. No amount of earnings or sales projections will be of any good unless they can execute their plans. Heads or tails? Winner takes all.

Not A Lemming

Book Review -A Mathematician Plays The Stock Market

2006-01-30T18:49:00.000-05:00

What prompted me to pick up a copy of "A Mathematician Plays The Market" was an interesting posting on Fundoo Professor blog, entitled "Cheaters Causes Crashes". That post had an excerpt from this delightful little book (only 200 pages) written by John Allen Paulos, Professor of Mathematics at Temple University, Philadelphia.

This book is written to entertain. Filled with interesting little stories and examples, and written in a style that is casual; it is the stuff that makes for interesting & intelligient chatter between friends at the dining table. Despite its brevity, the author managed to cover a wide range of topics related to investments and the stock market, but expect a broad brush treatment rather than an in-depth analysis. One common thread that runs through the book is the author's account of his own investment in Worldcom during the tech bubble. The self-deprecating manner in which he confessed his investing errors and the empathy he developed by sharing with readers about his Worldcom loss, takes the sting out of readers who disagrees with his views.

The author ought to be congratulated for his willingness to live with paradoxes, tensions & the acceptance of the limits to our knowledge; rather than to force a neat solution to a complex problem as academicians are often guilty of.

One word describes the book, fun.

Not A Lemming

Trading On Probabilities

2006-01-26T00:53:00.000-05:00

If I have a price prediction model that demonstrates consistent 90% odds of getting it right, I am sure you will want to lay your hands on it.

Now let us say there are 2 competing price forecasting models, one with only a 10% probability and another with a 50% probability of being right. Which model would you choose granted that you have the same level of confidence in the probabilities for the 2 models?

Well, I would choose the 10% system. If a system consistently gets it wrong 90% of the time, very soon you will learn to trade against it. In another words a system that is 90% wrong each time is as useful to a trader as a system that is 90% right, provided the results are consistent and can be relied upon.

Many of the trading system claim to give you a trading edge of 60-70%. Of course those figures are based on back testing and best fitted, but once you paper trade and that figures falls to 55% with a wide margin of error. Take it further and engage in real trade and murphy's law will kick in. Prices will gap, transaction cost are higher than anticipated (including price slippage), the broker didn't pick up the call, I was running a high fever when the the buy signal came.......I think you get the drift. It is not surprising that the hit rate for price forecasting models tends to bunch around the 50% level, where it is least useful to the trader, but this is not what the promoter of trading system will have you believe.

Give me a system with 60% odds, no thank you. But I will be interested if you can find one with 10% odds and some consistency. I once had access to a almost perfect model; whenever my ex-boss became totally convinced about something and then managed to convinced his boss to load up, bingo we have a sell signal!!

Not A Lemming

Analyzing Technical Analysis

2006-01-23T22:53:00.000-05:00

I am enjoying the ongoing debate amongst value bloggers on the value of technical analysis(TA). Somewhat belated and with the ground already well covered, I know I face an uphill task to add value to this discussion.

For the uninitiated, Shai Dardashti gives a good run down on the debate on his blog Shai Dardashti on Grahamian Value. Rick gives a good balanced view at Value Discipline.

Opposing technical analysis is Arpit Ranka and Bill/NoDoodahs take up the cause for TA.

From the onset, let me state that I agree with both sides in a qualified way. In short my stand is that Technical Analysis can be profitably used in trading even though it has no predictive value.

Charting is very useful to a trader not because it has any predictive power, but that it can be a very useful and objective vehicle for trade & risk management in any trading system. For good traders, TA allows them to choose their trade objectively, cutting losses and letting profits run. The expected return of such a system should be positive even if the odds are at 50%.

The managed futures industry by and large uses different versions of chart-based trend following systems. The performance of this group is highly volatile making good money in some years with trending markets and giving back some in trendless markets. But their continued existence as a group, makes a strong case for the viability of chart trading systems. When you are expected to trade and take losses routinely, the emotional toil can be very high. Perhaps that is why many of the system traders have progressed to black boxes trading, allowing computers to do the work and removing the human emotions from the equation.

I agree with Arpit Ranka that prices are mostly unpredictable and I try to remind myself each time I trade. We are conditioned to see patterns where none exist, construct cause and effects relationships in our minds. It is worthwhile repeating Arpit's coin tossing experiment oneself, seeing is believing.

The debate sees Bill correctly pointing out from his own trading experience that TA adds to his bottomline and Arpit eloquently making the case that prices are more random than perceived. Well they are both right, just not talking on the same plane. If Technical Analysts were more accurate in attributing their success to trade/risk management, perhaps we can come to common understanding. Where I would still disagree with Bill is that he equates price randomness with the efficient markets hypothesis, but that is a debate for another day.

Not A Lemming

Do Option Writers Have An Edge?

2006-01-21T00:27:00.000-05:00

In his book Fooled By Randomness, Taleb lambasted Jim Rogers for wrongly concluding that options writers had an edge over option buyers. Although Taleb does not dispute the findings that 95% of options eventually expire worthless, he pointed out (quite correctly in my view) that discussing probability without the payoff has no practical value. It is the expected return rather than raw probabilities that really mattered. Interestingly in the New Market Wizards, several options traders were asked the same question, and all agreed that neither option writers nor buyers had an inherent edge.

To make his point, Taleb made the comparison between Victor Niederhoffer and the fictitious hero in the book (himself). Victor made a name for himself as a hedge fund manager writing options and twice he blew up in the face of extreme market conditions. If nothing else Victor's trading history should caution any option writer against using too much leverage in options writing.

I agree with Taleb that the relevant statistic is not the probabilities but the expected returns. As a skeptic, I also must also agree with him on the folly of price forecasting and predicting the economy. But Taleb is a skeptic to a fault. As a value investor I do not claim to know how to predict markets, but I can know value when value presents itself. It is this value that provides accords me a margin of safety and prevents permanent capital loss of my investment.

In other words, as a value investor I do not rely on the statistic that 95% of options expiring worthless to get me out of trouble. It is the stock extreme low valuation that gives me the safety of margin. Writing puts blindly can be costly, with leverage it could be deadly; but with the right thinking and a safety of margin, it can also be very rewarding.

Not A Lemming