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On Confidence

I get a fair amount of emails both from readers of the blog and listeners to the podcast. Most of the emails come from people who listen to the podcast. The two most common varieties are: 1) “Before I listened to your podcast, I thought investing was impossibly complicated; now, I think it may be simple enough for someone like me.” 2) “Before I listened to your podcast, I though investing was simple; now, I think it may be too complicated for someone like me.”

Part of the reason for these two very different reactions is the nature of the podcast. I talk for almost half an hour about things that aren’t regularly discussed at length by the financial media. So, it’s natural for listeners to feel I’m discussing something familiar in an unfamiliar way.

That can cause listeners to question some of their beliefs, especially if those beliefs weren’t all that firmly held to begin with. Most people’s beliefs about investing are very tenuous. There are, of course, people who are very passionate about investing. They don’t view investing as some esoteric subject, but rather as a field intimately connected to the human behavior they observe in their everyday lives.

For everyone else, however, beliefs about investing come in the form of passive knowledge. The tendency is simply to accumulate an inventory of conventional dictums. Investing beliefs are formed much the way a student prepares for a test. If the subject of investing were as simple as a third grade spelling bee, this wouldn’t be a problem.

But, investing is a far more complex subject. That isn’t to say it is necessarily a difficult subject. For some, it is relatively easy. But, it is never simple. An investor can not analyze relationships with the certitude and precision a physicist can. The investor is concerned with human phenomena, which are necessarily complex phenomena.

The complexity of the subject is what makes it appear so difficult. While you can develop a set of guiding principles, it is impossible to devise rules that will lead you to the best course of action in each and every case.

If you try to build an intellectual edifice based on principles such as high returns on equity, strong consumer franchises, low price-to-earnings ratios, low enterprise value-to-EBIT ratios, high free cash flow margins, and rock solid balance sheets – you will fail.

The entire structure will collapse, leaving the architect disillusioned. Why? Because the items listed above are desirable attributes – nothing more and nothing less. They are not true principles. Even as rules of thumb, they are badly flawed. Ultimately, investment decisions are not made about general classes; they are made about special cases.

Every investment decision requires good judgment and sound reasoning. You need to start with the correct principles. But, principles alone are not enough. You aren’t being asked what the law is, you’re being told to apply the law to the …

Newsletter Problems

You may be wondering why I haven’t posted for over a week. The time I normally use to write blog entries has been spent on the newsletter instead. It’s been a terrible experience. I was very disappointed with the printer I had selected for the job. I’ve switched print shops, but production has already been delayed.

Everyone who ordered the April issue will still receive their printed copy via mail. I have also decided to send each subscriber a PDF file with the contents of the newsletter. There are a couple graphical problems with the PDF; but, they are limited to pages 11, 12, & 13 which contain statistical summaries rather than text.

I’ve sent an email with the attached PDF to each subscriber. Unfortunately, I had to use the emails from the payment receipts. If you’re anything like me, you get too much email at your main address, so you have a second email address to use for online payments, subscriptions, etc. If that’s the case, please let me know where you’d like the PDF sent.

I know a PDF is not the same thing as a printed, bound copy. However, it is the best I can do today. Subscribers who would like to see the contents of the newsletter without having to wait for the printed copy should check their email right now. There should be a PDF waiting for you. The newsletter runs 48 pages; 46 excluding the front and back covers.

Subscribers should feel free to email me about the newsletter, the PDF, etc. I will be happy to discuss any questions or concerns you have about all this.

I know some of you have probably emailed me about the newsletter within the past week. This printing problem has consumed all my time. I apologize for not responding sooner. I’ll spend tonight working my way through the backlog of emails (from least recent to most recent). Anyone who emailed me this week should hear back from me tonight.

Thank you for your patience.…

Wall Street 2.0: Marketocracy Contest

Wall Street 2.0 is an investment blog network. Marketocracy is a website that lets you create simulated mutual funds and track their performance. I recommend checking out both sites even if you don’t join this contest:

With many of our readers being Marketocracy users, the Wall Street 2.0 Network has decided to start a Marketocracy Club. Registration is already underway, and trading will begin on Monday, April 10th. The only rule is that your fund be compliant (if you are not yet a Marketocracy member, you will learn about their compliance rules after joining).

Did we mention the prize? The member with the highest returns after 3 months, will receive $200 cash, courtesy of the Wall Street 2.0 Network.

To join the club, head over to the Wall Street 2.0 Message Boards and register. Then check out the Wall Street 2.0 Marketocracy Club sub-forum for details on joining the club.

I already have several funds over at Marketocracy to test how difficult it is to successfully invest with various restrictions in place. These restrictions are meant to force a certain degree of concentration or diversification. For instance, the most diversified fund tries to keep 1% of assets in each of 100 different stocks. That’s pretty diversified.

On the other side of the spectrum, one of my Marketocracy funds only invests in companies headquartered in New Jersey. That narrows the investment universe considerably.

This is the sort of fun stuff you can do at Marketocracy.

I posted a check-up on these funds back on March 15th.

Visit Wall Street 2.0

Visit Marketocracy…

On Buffett’s Big Bet

Over the past few days, there have been several stories written about Warren Buffett’s $14 billion bet on global stock markets. I believe these stories are all in reference to this disclosure in Berkshire Hathaway’s annual report:

“Berkshire is also subject to equity price risk with respect to certain long duration equity index put contracts. Berkshire’s maximum exposure with respect to such contracts is approximately $14 billion at December 31, 2005. These contracts generally expire 15 to 20 years from inception. Outstanding contracts at December 31, 2005, have been written on four major equity indexes including three foreign. Berkshire’s potential exposure with respect to these contracts is directly correlated to the movement of the underlying stock index between contract inception date and expiration. Thus, if the overall value at December 31, 2005 of the underlying indices decline 30%, Berkshire would incur a pre-tax loss of approximately $900 million.”

It’s impossible to evaluate exactly what this means for Berkshire (or what it tells us about Buffett’s thinking) without knowing more details. But, there are a few things I’d suggest you consider when reading the news reports.

First, the $14 billion headline number makes this bet look larger than it really is. According to the above disclosure, a 30% decline in the underlying indices would only create a $900 million pre-tax loss. One article stated that a decline in the indexes to zero was highly unlikely given historical trends. It’s a lot more than highly unlikely. But, since we don’t know the details of Berkshire’s exposure, we can’t evaluate the real risk of a very large loss.

A lot of these news stories have called Berkshire’s “long duration equity index put contracts” a bet on global stock markets. A few individuals have been quoted as saying Buffett has become bullish long-term. Buffett’s always been optimistic about the very long-term insofar as he recognizes how better things are today than they have been at any other time in history, and how that is likely to remain true for some time. Despite Buffett’s concerns about nuclear war, he doesn’t see a return to the Dark Ages and those kinds of anemic returns on capital.

That’s important to keep in mind, because I’m not sure this bet is much more than that. If you assume returns on equity will be similar to those achieved in the years since industrialization began, and you assume central governments will continue to cause inflation, a long duration equity index put contract isn’t much of a stretch.

Equity will earn returns, much of those returns will be retained by the businesses, and inflation will increase (nominal) stock prices regardless of whether the underlying businesses’ assets are increasing or remaining stable.

I’m not sure this is a bullish sign. In fact, it may be a bearish sign, because it suggests Buffett can’t find individual equities to buy, three of the four indexes are foreign, and someone wants to be protected against very large losses in a …

On Asymmetric Opportunities

Most difficult investing decisions are not caused by fine distinctions. Two apparently similar stocks are usually just that. There is little difficulty in evaluating such situations. More importantly, the magnitude of whatever miscalculations are made is likely to be small. The true difficulties arise when the investor is presented with two or more asymmetric opportunities.

The intrinsic value of a business isn’t printed anywhere. To the extent that a business’ intrinsic value is similar to its earnings power, the evaluation process is simplified. In fact, this so greatly simplifies the process that many investors are tempted to calculate earnings power alone and simply assume the intrinsic value reflects the earnings power.

This is a mistake. While you will rarely lose a lot of money by focusing on earnings, you will miss some great opportunities if you rely solely on earnings.

The intrinsic value of a business is the discounted value of the cash that can be withdrawn from the business. It is not merely the discounted value of the future cash flows generated from operating activities. This may sound like I’m splitting hairs. But, it’s an important concept to understand.

Obviously, a cash flow neutral business with several hundred million dollars in cash (in excess of total liabilities) is worth more than the intrinsic value of zero that would be calculated based on the free cash flow generated from its operating activities. You could account for this by treating the excess cash as a reduction to the purchase price. That is essentially what you’re doing when you use a company’s enterprise value instead of its market cap.

Actually, you’re doing more than that, because you are adding debt in excess of cash to the purchase price. Should you do that? It’s hard to say. For some businesses, this is an unnecessarily harsh adjustment, because the debt needn’t be repaid anytime soon. The advantages of the free cash flow generated will be amplified by the debt, which needn’t be repaid until long after the cash flows are received.

But, by the same logic, one could argue that whatever excess cash a business holds needn’t be returned to shareholders via a dividend, stock buyback, etc. within the next few years. If that cash isn’t utilized relatively quickly, its intrinsic value will be diminished.

In my experience, you will seldom go wrong by valuing a company’s cash too highly. Judging by the spreads in EV/EBIT ratios among various stocks, the market doesn’t seem to overvalue cash too often.

So, my advice is to count the cash as if it were being paid out to you at the time you purchase the shares. Since the cash has already been taxed, whatever advantages you would have in generating returns on the cash greater than those the retained cash generates will be mitigated.

Counting excess cash as a reduction in the price per share isn’t a perfect solution, but it is a simple, workable solution. As I mentioned in a previous …

On Contrarianism and Negativity

This post was inspired by a piece entitled “Long Term, Short Term, and Contrarianism” written by Rick of Value Discipline

In one of my earlier podcasts (“Why Small Caps?”), I said that undervalued stocks usually suffer from either contempt or neglect. In some sense, I suppose it’s true that there are beloved bargains out there; they just aren’t beloved enough. But, I don’t think you’re going to find too many of those. Even though a stock may be a bargain when it trades at a higher than market multiple, I haven’t seen many bargain stocks that were actually better liked than both their peers and stocks in general.

I spend most of my time looking at stocks that suffer from neglect rather than contempt. That’s one of the great virtues of small cap stocks. There are so many small cap stocks that a few are always suffering from neglect. Most investors only have time for the hottest names in small caps. Otherwise, they would have to look at thousands and thousands of individual businesses.

That’s why I talk about companies like Village Supermarket (VLGEA). Today, Village has to perform to justify its P/E of 12. But, a few years ago, Village didn’t have to accomplish much of anything to justify its P/E of 6. You could have bought the stock at a P/E of 6 and a 50% discount to book value around the time of the millennium bubble.

Those were good times. It seemed every earnings report surprised investors, because no one was paying attention. Oh? Earnings are up again? Well, I don’t really like the grocery business; but, at a P/E of 5, I guess I have to buy.

While some institutions can’t put meaningful amounts of money to work in a select group of small cap stocks, there are enough reasonably sized small caps that individuals don’t have to worry about having more money than ideas. Of course, this may not be true at any given moment. But, generally, there are plenty of opportunities among stocks that suffer from neglect.

So, why should investors even consider buying stocks that suffer from contempt? Isn’t buying such stocks a lot riskier than sticking to those stocks few people care about?

I’m not sure it’s a riskier strategy to pursue. But, it is more psychologically demanding. You have to be willing to wake up each morning and have The Wall Street Journal and CNBC disagree with you – and that’s on the good days. On the bad days, it will be USA Today and the evening news.

If you can remain rational when others can’t, you should do well with your contrarian positions. But, you mustn’t take them for the sake of being contrary. You shouldn’t find pleasure in disagreeing with the consensus; you should find pleasure in being right regardless of what others think. Of course, because what others think is largely what sets the price of stocks, you’ll likely find some …

New Contributing Writer: Mike Price

In an effort to offer more content (and more variety) Gannon On Investing has taken on its first Contributing Writer. Mike Price is a fifteen year-old value investor who currently writes his own blog. Some of you may have seen his work featured at other value investing sites.

Mike’s first featured piece is a review of Jim Cramer’s Confessions of a Street Addict. He originally wrote this review for his own blog. In the future, his reviews will appear here first. But, I wanted to give you a taste of what to expect. Over the next week or two, I hope to take a little time to properly introduce Mike on this blog and in my podcast. However, I thought the best introduction would be one of Mike’s own pieces.

Read Mike’s Review of Jim Cramer’s Confessions of a Street Addict

Contributing Writers Wanted

The site is looking to take on other Contributing Writers. These aren’t full-time positions. In fact, contributing writers aren’t paid for their time; they’re paid for their contributions – hence the “contributing” part. In the future, I may consider adding an Associate Writer position, but nothing like that is currently available.

A contributing writer should have a keen interest in investing, but doesn’t have to be a particularly competent investor himself (or herself!). For the most part, I’m looking for contributions that complement the main blog. I can handle the topics you see covered on this blog; and, in fact, would prefer to do so.

The site is called “Gannon On Investing”, so you should know what you’re getting into. You’ll have to live with my edits. I will edit what you write and may do so quite heavily – some of the edits will appear arbitrary, but there are quality considerations behind all of them.

I’m more interested in finding someone who is passionate about investing and can provide compelling content than I am in finding a good writer with no real love for investing. I can work with a mediocre writer, if everything else is there.

You don’t need to be naturally gifted; you just need to be able to write clearly about a single subject for an extended period. The writing I’m looking for is longer than most of the stuff you see on the internet. It should also be better than most online writing, but it doesn’t have to sound like print writing.

I don’t pay well, but I do pay. I’ll need at least one relevant sample from you before we can talk. If you do get the Contributing Writer title, you’ll have a hyperlinked byline and resource box in every article you write in addition to the pittance you’ll be paid. Actually, the pay will increase with the quality and frequency of your output, but I can promise it will be ridiculously low for the first couple articles.

Writers that can cover a particular topic are especially welcome.

Mike will be writing book reviews for the site. This …

New Book Review: Confessions of a Street Addict

Gannon On Investing’s newest contributing writer, Mike Price, reviews Jim Cramer’s Confessions of a Street Addict:

Throwing chairs, yelling BOO-YAH and changing opinions every other day – Jim Cramer’s Mad Money has captured the attention of everyone from traders to investors. But where did Cramer’s career start? Confessions of A Street Addict, Cramer’s autobiography, chronicles how he went from a lowly newspaper reporter to a Harvard lawyer to one of the biggest and most influential hedge fund managers, before stepping down to write full-time for thestreet.com.

Read Review…

On Valuations

The first quarter of 2006 is over. Now is a good time to reflect on stock prices and the opportunities they present.

Bargains are scarce. Equities are expensive. In recent weeks, I’ve heard several fund managers say valuations are still attractive. I don’t agree. Generally speaking, valuations are unattractive. Returns on equity are higher than historical levels. A market-wide return on equity of 15% is unsustainable. Price-to-earnings ratios may not fully reflect how expensive stocks are. Price-to-book ratios are more alarming.

There are two additional concerns. Most discussions of the relative attractiveness of equities focus on the S&P; 500 and forward earnings. The S&P; 500 is not the most representative index. It may not be the best index to consider when looking at market-wide valuations.

Forward earnings are (necessarily) estimates. Where current returns on equity are unsustainable, projected earnings that use similar returns on equity may overstate the earnings power of equities in general. This can occur even where the estimates appear reasonable given current earnings. If you start with unsustainable base earnings, you are likely to overestimate future earnings even if you truly believe you are assuming very modest earnings growth.

Assets in general are pricey. Value investors have few places to turn if they continue to insist upon a true margin of safety.

Bonds are unattractive. Long-term inflation risks make U.S. treasury, corporate, and municipal bonds a fool’s bet. There is little to gain and much to lose. The know-nothing investor who buys a top-quality bond today and holds it for decades may very well find his purchasing power diminished.

There may be some select opportunities in foreign equities. But, these are difficult to evaluate. Foreign government obligations are also difficult to evaluate, but that isn’t much of a problem for value investors, because most foreign government debt is priced to perfection. You’ll have to be willing to take a lot of uncompensated risks if you want to own such bonds.

Of course, there are exceptions to every rule. There may be a few bonds out there that are attractive. There certainly are a few attractive stocks out there. But, even those stocks that look very attractive relative to their peers don’t look nearly as attractive when compared to past bargains.

Value investors face a difficult choice. They can assume stock prices will return to historical levels, and hold cash until the correction comes. Or, they can accept the reality they currently face.

There is no logical reason stock prices must necessarily return to historical levels. During the twentieth century, real after-tax returns in diversified groups of common stocks were very high relative to other investment opportunities. There have been various reasons given for why this occurred. Many have said these returns were possible, because of the higher risks involved in holding equities. Over the long-term, risks were somewhat higher than today’s investors seem to remember, but they were hardly severe enough to justify the kind of performance spreads that existed during much of the …