"Welcome to another lost decade"

Vitaliy Katsenelson recapitulates his secular range-bound market thesis on GuruFocus today ("Welcome to another Lost Decade"), this time with a slight twist: he thinks a 1990-? Japan-style bear market is also a possibility going forward. As I noted in the comments there, Katsenelson's diagnosis makes sense, but his prescription ("active value investing") seems limited:

why rely on any form of long-only investing -- even his active value investing -- if we are in for possibly another decade like the last one? How did long-only value investing fare in 2000-2002 or 2007-2008? How will it fare when the current cyclical bull rally inevitably leads to another cyclical bear correction?

Buying a lottery ticket to bet against gold

I've mentioned the pseudonymous GuruFocus commenter Buffetteer17 before, noting that he is probably the savviest and most numerate of the commenters on that site. There's a lot more chaff than wheat on GuruFocus, but I usually read Buffetteer's posts with interest. He wrote this in a GuruFocus comment thread today:

According to the Sornette bubble detector formula, the gold price bubble is nearing a critical point, meaning there's likely to be a large correction in the next few weeks. I applied the formula to GLD price history going back to March and got several high quality fits, with an R-squared in the range of 92-94%. You can clearly see the faster-than-exponential price rise on a log price plot. The critical dates range from 11/27 to 12/4. I bought a few Dec 09 and Jan 10 put options on GLD as a lottery ticket.

At this point, a commenter mentioned the devaluation of the dollar as the cause of the spike in gold prices. Buffetteer's response:

Gold prices in dollars are going up super-exponentially, way too much to be explained by dollar devaluation. Maybe dollar weakness is an underlying cause, but the gold price is now disconnected from that. We're seeing herding behavior. The motivation seems to be buy gold because other people are buying it and the price is increasing.

As I noted in my own comment on that thread,

I had a related exchange with Aaron Edelheit, after he wrote a post saying people should get out of cash because of dollar weakness. My guess is that when we get the inevitable stock market correction, the dollar will rise as it did last time, and gold will drop. The longer term trends might be different, but that seems like the most likely near term scenario.

I piggybacked on Buffetteer17's idea here and picked up a handful of Jan 10 puts on GLD today.

Talent: Not Everyone Has It...

...And those who do have it often don't seem to realize that. That thought came to mind twice recently, first when skimming a recent post on GuruFocus about Joel Greenblatt's book about special situations investing, You Can Be a Stock Market Genius. Clicking on the Amazon link, I found this comment by a reviewer from Orange County, CA named Mike Ferry:

Look before you LEAP

I get up in the morning and walk my dog on the walking path just off the beach (Pacific Ocean adjacent). On my walk I always say hello to Mrs. Rothchild who is reading the Investor's Business Daily while sitting on her polished teakwood patio set. I jibe her that she should switch to the Wall Street Journal and get a real job investing like I do. After a quick but nutritious breakfast, I settle down to my state of the art computer where I E-trade my way to this lavish lifestyle I currently enjoy (takes no more than an hour!). After my "investing", I'll cruise PCH in my new convertible BMW and work on that driving tan. Thanks Joel Greenblatt!

What the heck? Oh drat, the alarm went off. I was having that dream again; now I must get ready for the drive to Pomona in my '98 Daewoo. So kick me, I am not yet a stock market genius. Can I be if I apply the lessons of this book? Maybe... but I have neither the time nor the money. For the person with both it might still be a great idea to have a stock market genius walk them through the paces for a few months.

On the merits of readability, Greenblatt dishes out the drudgery in a well presented and entertaining style. You get case studies, nifty chapter summaries, advice not to run through dynamite factories with lit matches, and a Gilligan's Island hit in the glossary (not bad for fourteen Yankee Dollars).

P.S. All you reviewers and review readers out there, have any of you struck pay dirt following the advice in this book?

I didn't read all the other comments, but, in the ones I did read, I don't recall anyone mentioning that he had struck it big implementing Greenblatt's advice. Has Joel Greenblatt considered that maybe we can't all be him? Maybe he has, and that's why he came up with the Magic Formula, so retail investors could lose invest their money in an automated fashion.

The second time the thought in the title of this post came to mind was a few minutes ago, when I read this post by the Atlantic's Ta-Nehisi Coates, "Taking Myself Way Too Seriously". From his post:

I went to the Met yesterday, the boy likes to draw, so we've put him in a class there. I've been several times before, indeed we have a family membership. And yet somehow, I'm never prepared for the raw power of the place. Samori [Ta-Nehisi's son] went up with the kids to sketch in the modern art gallery.

[...]

I found my way down to the sculpture garden and circled The Burghers Of Calais a few times. It's funny to know something is beautiful, and not know why.

[...]

I sat for a minute, insecure, because everyone else sitting was sketching and I can't draw a lick, and for some reason, I think I should be able to.

[...]

I stopped in front of a color pencil drawing of two women smiling over a small cake. According to the description, the women were strangers. Some guy stopped next to me and took me for an artist. I think it was my gutter style--hoodie and Air Force ones, but perhaps not, since he introduced himself as an artist too. He was wearing a three-piece suit. I told him I did not have the gift, and he shook his head. "Just get some pencils and put some stuff down man."

This struck me.

It's exactly what I tell people when they say things like, "I wish I could write." or "I wish I had the gift to write." In my mind there is no gift--there is a considerable amount of labor, but I don't have much interest in talking about talent. There are a lot of talented niggers on the corner, in jail, under early tombstones. That's what my mother used to say.

I probably disagree with what Ta-Nehisi writes more often than not, and as an autodidact, he'll make a grammar mistake occasionally (as he readily admits), but the man can write. He's got talent, but, like many talented people, he doesn't seem to realize that not everyone does. That doesn't make what his mother used to tell him wrong: there are plenty of talented people who never achieve much -- that's true. But that's not the same as saying that everyone has talent. It just means that some measure of talent is often a necessary, but not sufficient, requirement for success.

"Beating Buffett"

Occasional commenter Stockdoxc/Dr. Paul Price has his own blog now, BeatingBuffett.com, with an apparently soon-to-be launched subscription-based service. From his "about" page:

Like Warren Buffett, we believe in ‘Value Investing’. Unlike Mr. Buffett, who is so rich that money has ceased to matter for him, we’re still looking to make better than market returns while limiting risk.

Over 31 years of investing we’ve been refining our techniques to allow for achieving outstanding results without incurring margin interest costs. The strategic use of option sales combined with solid fundamental analysis leads to wide statistical bands of high profitability while incurring below average risk.

Our service attempts to identify stocks with well defined upside and limited risk. We then typically add the options component and clearly spell out the best-case and static returns. Break even points are identified and calculated for every suggested trade.

We constantly update company news on our featured selections. We also report on the actual net profit or loss on all closed-out positions. All short and long stock and options positions (held by the authors) are fully disclosed at the time of publication.

Best of luck on the new site, Paul.

Answers from Joel Greenblatt

In a previous post ("My Questions for Joel Greenblatt"), I wrote,

GuruFocus announced it will be hosting a question and answer session with Joel Greenblatt and solicited questions from readers. Below are the questions I submitted for Greenblatt. For others' questions, click the link above.

Why did you set the minimum market cap to $50 million on your new Magic Formula screener, when users used to be able to enter a market cap as low as $1 million on your original screener? Did you find that the Magic Formula does not work as well for stocks with market caps below $50 million? If so, would you mind reimbursing me for the money I've lost buying Magic Formula stocks with market caps below $50 million¹?

In your book The Little Book that Beats the Market, you alluded to the dramatic under-performance of a certain investor's² strategies in the few years after he published a book on those strategies. Do you think it's a coincidence that the few years following the publishing of your book have been difficult times for adherents of the Magic Formula as well? Is it possible that, by the time someone decides to write a book on an investment strategy, that strategy is typically due for a period of under-performance?

¹A joke, Prof. Greenblatt. I find that having a sense of humor helps in handling market losses.

²You didn't mention this investor by name, but I believe you were alluding to James O'Shaughnessy.

Yesterday, GuruFocus posted the answers to the questions to which Greenblatt deigned to respond. Greenblatt ignored my first question above, about why he added a minimum market cap to his Magic Formula screener, and offered this semi-answer to my second question,

A new updated study [of the Magic Formula's recent returns] should be published at FormulaInvesting.com soon.

Another GuruFocus poster asked an interesting question, about the merits of using a long-only equity strategy such as the Magic Formula if we are in a secular bear market. Here was Greenblatt's response:

A new updated study should be posted on FormulaInvesting.com in the near future and the results appear to be quite good relative to a flattish market over the last 10 years or so. Also, since the market has not performed well over the last decade or so, that may turn out to be a good time to invest, not a bad time.

It's worth remembering, when reading that answer, that Greenblatt started working on Wall Street "at the end of 1981" (as he noted in response to another question. So he became a professional investor right before the beginning of an unprecedented 18-year secular bull market. It's not surprising, given that experience, that Greenblatt would recommend a long-only equity strategy to the masses, but I wonder whether that makes sense at this point, since, as Vitaliy Katsenelson has pointed out, secular bear markets (or range-bound markets, as he calls them) tend to last about as long as the secular bull markets that preceded them. That means we could be in for another decade or so of more of the same. Perhaps a more opportunistic approach would be better.

My Questions for Joel Greenblatt

GuruFocus announced it will be hosting a question and answer session with Joel Greenblatt and solicited questions from readers. Below are the questions I submitted for Greenblatt. For others' questions, click the link above.

Why did you set the minimum market cap to $50 million on your new Magic Formula screener, when users used to be able to enter a market cap as low as $1 million on your original screener? Did you find that the Magic Formula does not work as well for stocks with market caps below $50 million? If so, would you mind reimbursing me for the money I've lost buying Magic Formula stocks with market caps below $50 million¹?

In your book The Little Book that Beats the Market, you alluded to the dramatic under-performance of a certain investor's² strategies in the few years after he published a book on those strategies. Do you think it's a coincidence that the few years following the publishing of your book have been difficult times for adherents of the Magic Formula as well? Is it possible that, by the time someone decides to write a book on an investment strategy, that strategy is typically due for a period of under-performance?

¹A joke, Prof. Greenblatt. I find that having a sense of humor helps in handling market losses.

²You didn't mention this investor by name, but I believe you were alluding to James O'Shaughnessy.

The photo above of Joel Greenblatt is from GuruFocus.

Joel Greenblatt Makes Some Changes

Joel Greenblatt made a few changes to his Magic Formula Investing site last month. He notes one of them in his recent column:

[W]e’ve added something new. The site now has description and link to a new website FormulaTrading.com that I helped create with Blake Darcy. Blake is the founder and former CEO of DLJdirect, a pioneer in the internet brokerage field. Formula Trading is designed to make it easy for people to invest using my system. You can invest in one of two ways: either in a self directed manner (you’ll have the tools to easily select, purchase, track and sell stocks chosen by the Magic Formula system) or in a fully managed account (Formula Trading will invest it for you using the Magic Formula system). I am a significant investor in this new venture and have worked with FormulaTrading.com to ensure that it will adhere to the principles of the Magic Formula. (Either way, though, I plan to keep MagicFormulaInvesting.com a free site so that you can follow the Magic Formula system in any manner that works best for you.) This new firm hopes to open in the late spring of 2009.

It's nice to see entrepreneurship is alive and well during these difficult times.

Although he didn't mention it in that column, Greenblatt also made a few changes to the stock screener on his site: it now only lists 30 or 50 stocks for a given minimum market cap (instead of listing up to 100 stocks); it no longer lists the earnings yields and returns on invested capital for each stock; and it no longer allows you to screen for stocks with minimum market caps below $50 million. I sent a message to the site asking whether that last change was made because Greenblatt determined that his system didn't work for stocks below that market cap. If I get a response, I'll post it; if not, I'll try e-mailing Greenblatt directly, which I have had mixed success with in the past.

The photo above, of Greenblatt on his book tour, was borrowed from GuruFocus.

"Mohnish, How Are You Feeling?"

According to Mohnish Pabrai, this is what most of his investors were asking him after he lost 60% of their money last year. For his answer, see the excerpt below from his annual letter to his investors, dated January 16^th:

I did hear from a few of you in the last few weeks. While some calls and emails expressed concern over our performance numbers, the surprising thing for me was that the overwhelming majority of you were focused on asking, “Mohnish, how are you feeling?”

Well, I am actually feeling pretty good. And as Q408 unfolded, my spirits remained elevated – mainly because I remained focused on intrinsic value and was drooling over the incredible opportunity set and valuations. I was in turbo mode trying to read huge piles of 10Ks, 10Qs, annual reports, industry reports, listening to conference calls etc. – so I could pull the trigger while the prices were still incredible. And several triggers were pulled in November and December. We bought into an incredible array of assets at remarkable prices.

While it was indeed tough to watch the severe drops many of our holdings took in Q408, keeping my focus on intrinsic value, rather than fixating on the quoted market value of various positions was fundamental to staying level headed.

Pabrai isn't the only professional investor who's expressed similar sentiments when asked about his outlook recently, but I don't get this, for a couple of reasons. First, if someone asked me how I felt about the money I lost last year, "pretty good" wouldn't be my answer; "nauseous" would be -- and I just lost my own money. If I had lost 60% of the money entrusted to me by hundreds of other investors, in addition to nausea, I'd feel some remorse.

Second, it's one thing to tout the great opportunities you see in a beaten-down market, but it raises an obvious question: did you have any dry powder to take advantage of them, or have you been forced to sell your beaten-down positions to buy stocks you think are even cheaper? At least Bruce Berkowitz was candid enough to acknowledge (on a recent conference call) that that's what he's been doing, for the most part (selling cheap to buy cheaper). If that's been the case with Pabrai too (and I assume it is, considering that Pabrai has allegedly used Berkshire Hathaway stock as a "placeholder" for cash), then his zeal for current bargains ought to be tempered by some regret for not keeping more cash on hand to take advantage of them.

About the image above:

In his book The Dhando Investor: The Low Risk Value Method to High Returns, Pabrai offers the story of the end of Abhimanyu, a hero of the Hindu epic The Mahabharata, as metaphor for the difficulty of selling a stock. In an nutshell: Abhimanyu uses a technique he overheard¹ from Krishna to penetrate the spiral chakravyuh battle formation of his enemies, the Kauravas. Unfortunately, he never learned how to break out of the chakravyuh, so he has no exit strategy. He fights valiantly, one against many, and kills a number of Kauravas, but ultimately gets killed. I believe the image above², from a Geo Cities site, depicts this.


¹Please see the second comment by Ravinsu for elaboration.

²Replaced as per Ravinsu.

Daniel Wahl Breaks Radio Silence

Former commenter Daniel Wahl, after going dark for a few months, published a post on his eponymous blog last weekend, prompted by a Lucy Kellaway column in the Financial Times: "Bad Thinking".

John Hussman Becomes a Guru

Dr. Hussman takes his place among the diverse group of value investors designated as gurus at GuruFocus.com.

Here is Dr. Hussman's latest market commentary: "The Cornerstone of Capitalism". Below are a few excerpts.

On the government's response to the financial crisis:

The two most important actions that government can take to address this crisis are: 1) continue to provide capital directly to the banks, rather than purchasing troubled assets, and 2) reduce the mortgage principal of distressed homeowners in return for a claim on future price appreciation.

[...]

...Treasury was absolutely correct to abandon the awful idea of buying up distressed assets directly from the banks. As I noted in September (9/29/08 – You Can't Rescue the Financial System if You Can't Read a Balance Sheet), if you buy the bad assets off the balance sheet at their market value, nothing changes on the liability side. The only way buying questionable assets would increase capital (particularly “Tier 1” capital, which is what gives depositors confidence) would be for the Treasury to overpay for those assets.

Secretary Paulson has repeatedly said that the Treasury abandoned the plan to buy distressed assets because “the facts changed.” The only fact that changed is that the Treasury realized that this was a really bad idea.

[...]

I don't believe that the U.S. economy needs any massive “stimulus” targeted toward consumers. The force of this economic downturn is coming from mortgage losses, and the interventions we require must be targeted at 1) bank capital and 2) mortgage principal reductions in return for property appreciation rights.

[...]

Boost bank capital and restructure the payment obligations of distressed mortgages, and credit, confidence and consumption will quickly be restored.

On investment returns:

Investment returns aren't “free money.” Over the long-term, they are compensation for providing scarce, useful resources – liquidity, information, and risk-bearing – to other market participants. No useful services are provided to the market by a speculator who follows the crowd and chases glamour stocks higher late in an extended bull market run.

[...]

In contrast, the market compensates investors – not over the short-term, but predictably over the long-term – for the willingness to bear risk when other investors are unwilling; for the willingness to provide liquidity by holding out bids (gradually and at depressed prices) to panicked holders stampeding to get out; and for improving the information content of market prices by reducing the pressure for undervalued stocks to become even more distorted in relation to their probable cash slows. Long-term returns in a market economy are always compensation for providing scarce, useful resources to other participants in that market. If the activity is not scarce, and is not useful to others, there is no reason to expect it to to be profitable.

Notes from an Investor Who Avoided Large Losses This Year, Part II

Below is the continuation of Buffetteer17's notes on his hedging strategy (click here for Part I):

A few words about those S&P 500 index put options. I bought them at market highs last year. I was concerned that The Portfolio was doing too well. In Oct. 2007, it was yielding a CAGR of 39%. And that was return on assets. The return on equity was higher, about 50%, since I was about 20% on margin. While I might dream that I was the second coming of young Warren Buffett, when I woke up, I knew it wasn't so. It was largely luck, leverage, and a 3 year bull market, and---perhaps---a little bit of skill. I did not predict the bottom would fall out of the market, but I did consider what would happen to a leveraged portfolio if it did. So I decided to sacrifice a few percentage points of returns in exchange for market crash insurance. I bought S&P 500 index puts with a face value (sum of strike prices) of about 2x the size of The Portfolio. Average strike price was around 1250 and average time to expiration around 18 months. The two key objectives were to put in a floor below which The Portfolio is very unlikely to fall, and to provide funds to meet margin calls if they come. Most of my put buying was around S&P 500 level of 1500-1550, so the options would not protect much against moderate drops, say 20%. But they would become extremely valuable on a drop of 40-50%. The cost of the puts was about 6% of The Portfolio. Given that the lifetime of the options is about 18 months, and that the cost is deductable (assuming they expire worthless), this would hurt my total return by about 3%/year. As it happened, the damage is already reduced to about 1%/year, since I sold a few the puts on 1/22/08 and 3/7/08 for incredible percentage gains. Without the puts, my loss this quarter would have been 22% instead of 16%. The puts don't really fully kick in until S&P 500 level of about 1250.

Q2-08 (hedge 13.2%) The hedge comprises a number of S&P 500 index put options, with a face value (sum of strike prices) of about 2x the stock portfolio, with strike prices varying from 1350 to 800, and expirations of 12-18 months. The hedge is doing its job fairly well. That job is to insure against margin calls and put a floor under my net worth. The floor turned out to be a little lower than I planned, because my stock portfolio declined faster than the S&P 500 index. During the market dip in late June, I sold down a little. This reduced my basis cost for the options to 2.5% of my portfolio and the remaining options are up 186%. I'm in no danger of being forced to sell undervalued stocks due to a margin call. If the S&P 500 drops further and my stocks drop proportionally, I'll actually gain quite a bit, since the options are now sufficiently close to the strike prices that they have quite high deltas. I estimate that the existence of the hedge has added 3.7% to my returns since inception.

Q3-08 (hedge 10.8%) The hedge comprises a number of S&P 500 index put options, with a face value (sum of strike prices) of about 1.5x the stock portfolio, with strike prices varying from 1250 to 800, and expirations of 12-18 months. I bought the hedge a little over a year ago, at a cost of about 4% of the portfolio value. I had no idea that the stock market would crash and the economy would enter recession. But I was concerned about the collapsing housing market and early hints of a credit freeze. I figured I would take out some cheap insurance, just in case. The hedge is doing its job fairly well. That job is to insure against margin calls and put a floor under my net worth. The floor turned out to be a little lower than I planned, because my stock portfolio declined faster than the S&P 500 index. This quarter I sold about 1/4 of the options. By now, the profit from the hedge is so much that even if the remaining options expire out of the money, the hedge has more than paid for itself. This has been by far my best investment of the year, with returns north of 300%/year. Too bad I didn't put more money into it.

Notes From an Investor Who Avoided Large Losses This Year, Part I

An individual investor who goes by the name "Buffetteer17" on GuruFocus avoided large losses this year by hedging his portfolio. Below are his notes explaining what he did on a quarterly basis. This is long, so I've broken it up into two posts.

History of the Hedge. Every quarter, I do a writeup on my portfolio, so I can recall what I was thinking and review previous mistakes. Here are excerpts from the quarterly reports, starting with the Q2-2007 one. Apologies for the repetition, but I wanted each quarterly writeup to stand alone.

Q2-07: (hedge 1.0%) I started a small hedge position, comprising S&P 500 index puts with various dates going out about a year, and various strike prices around 1200-1300. The purpose of the hedge is to make it safer for me to use debt and margin to buy stocks. The portfolio yield has stayed in a band from 20% to 30%/year, after tax, for a couple of years now. I can borrow money at an after-tax rate of under 6%. Why not borrow at 6%, earn at 25%, and pocket the difference? The answer of course is risk; a serious bear market could easily reverse that 25% to minus 25%. There is also the risk of a margin call, disrupting the portfolio by forcing me to sell great companies at depressed prices. But if there is a serious correction or bear market, those S&P index puts will become extremely valuable, giving me something besides good stocks to sell to meet margin requirements. It may sound like I'm going way out on a limb, but I'm not. I'm limiting my margin debt to about 20% of capital. The hedge, incidently, is actually currently making a profit, since I bought the puts at market peaks. However, my fervent hope is that hedge expires worthless. It is strictly insurance against severe market corrections.

Q3-07 (hedge 2.8%) I slightly increased my hedge position in S&P 500 index puts with strike prices around 1250, and I will keep it going as long as I'm using margin debt. Currently margin debt is around 30%. Oddly, I've actually made a small profit on the hedge, since the S&P 500 has gone down a little since I started it. With the present combinination of high returns (32%) and high margin debt (30%), I feel quite comfortable paying the 2%/year or so that the hedge is likely to cost me for insurance. At some point, I will pay off the debt, and rethink whether the hedge is a good idea.

Q4-07 (hedge 6.8%) The Portfolio is fairly highly leveraged right now, at about 35% margin loan. This leverage was mostly taken after the big Nov. drop in the market, to pick up bargains. Hopefully, the 6.8% of S&P 500 index puts will give sufficient protection against margin calls if the market tanks in 2008.

Q1-08 (hedge 13.1%) I entered the quarter more than fully invested, about 130%, and ended it about 150% invested. I wasn't very active...Actually my S&P 500 index put options were up more than anything else on a percentage basis this quarter, 48%, but I consider them insurance rather than a for-profit investment.

Click here for Part II

M&Ms for Investing

Morbidity and Mortality conferences ("M&Ms") are regular meetings where hospital physicians discuss, without fear of punishment, their cases that had bad outcomes. The point of the exercise is to catch and correct errors and improve the way physicians diagnose and treat their patients. What prompted me to think of this was a recent discussion on the GuruFocus website, particularly this comment by prolific poster, former dentist, and stockbroker Dr. Paul Price (aka "Stockdoxc99") to Daniel Wahl,

Defending your methods regarding your highly touted pick of SRA Corp. after its 96% drop is akin to saying...

"The patient died... but the operation was a success".

Daniel Wahl had already reexamined his investment process on the zinc miner SRA Corp (TSX: SRZ.TO) on a post on his blog, and after noting that in the comment thread and making the M&M analogy, I wrote,

As in investing, there is the process and there is the outcome; sometimes a poor outcome is due to a poor process, in which case the process can and should be improved, and sometimes regardless of the process the outcome would still have been poor.

I went on to suggest that it might be useful for GuruFocus to create its own version of an M&M forum for bad investment outcomes. There's no shortage of commenters eager to point out others' losses, but usually this is done in a spirit of schadenfreude, and not in an attempt to learn from any mistakes that might have been made. I thought an M&M approach might make more sense, where investors could discuss what went wrong without insult.

A quick Google search of M&Ms brought me to an essay by Vincent A. Gaudiani, MD on the Cardiothoracic Surgery Network (CTSNet) that suggests that physicians' M&Ms have their own issues. Dr. Gaudiani writes of the M&Ms he participated in during his residency,

The huge disparity in experience level and the residency hierarchy often led to one-upmanship and a focus on affixing blame for failure as if adverse outcomes implied inadequate performance or lax intent. In other words, it was misused to create winners and losers. As we will see in a moment this is an entirely foolish and juvenile misuse of M&M.

Dr. Gaudiani also notes that problems with M&Ms continue post-residency,

Second and equally foolish is the deafening silence and acceptance of adverse outcomes that often accompanies M&M in the private setting. Experienced practitioners know that they too will have adverse outcomes and therefore choose to judge not.

[...]

To the extent that these misapplications of M&M conference prevail, they subvert the value of meeting in the first place.

It's a little disheartening, though not entirely surprising, to see the same sort of bad faith at work among physicians that you find among commenters on investing websites. Dr. Gaudiani offers some ideas to improve M&Ms. Some of this could apply to investing M&Ms as well:

For its part the community must value learning and desire to improve above all else and abandon invidious judgment. Practitioners must have the honesty and humility to recognize their contribution to an adverse outcome [...]. A few ideas may facilitate this process:

- Ask at which point critical decisions were taken that increased the likelihood of the adverse outcome.
- Ask what information or analyses might have led to a better outcome.
- Avoid defending or attacking a bad outcome. Neither helps.

Food for thought. Worth reading the rest of Dr. Gaudini's short essay.

From Joel Greenblatt to Jim Rogers, Part III: The Importance of Macro Trends

The intent of this series of posts is to put my later posts about specific investment ideas in context, by describing the evolution of my thinking on investing over the last year and a half, as I've made mistakes and tried to learn from them. I'm going to break this up into a few posts, just to keep each post from being too long.

The Importance of Paying Attention to the Relevant Macro Trends

Another lesson I picked up over the last year and a half was the importance of paying attention to the relevant macro trends when evaluating potential investments. It's important to remember here that the Magic Formula is a backward-looking screening system: it uses trailing 12-month data to calculate earnings yield and return on invested capital, on the theory that, more often than not, trailing data are predictive of future performance. The impact of relevant macro trends can determine to what extent this will be true. For example, a wallboard company might have had impressive trailing twelve month earnings at the beginning of 2006, due to the residential construction boom that peaked during the previous year, but those trailing earnings wouldn't have been a good guide to its earnings during the construction bust to come. Below is an example of a mistake I made last year by not paying attention to the relevant macro trend.


Anatomy of a Mistake

I originally wrote the following postmortem on the GuruFocus website on April 24th. Since then, the stock is down a little bit more (it closed at $11.78 today), but otherwise nothing has changed materially.

Recently, I've written about the importance of acknowledging and addressing relevant macro-trends when evaluating investment opportunities. This doesn't mean that I think one should only invest in a company when the relevant macro-trends or macro-environment are in its favor; I would consider investing in a company facing negative macro-trends or a negative macro-environment if I thought those negative macro-trends were fully priced-in, or if I thought those negative macro-trends were nearing an end.


One example of an investing mistake I made by not paying attention to the relevant macro-trend was my investment in Barrett Business Services Inc. (BBSI) at $24.28 per share last year in my Magic Formula portfolio. Today BBSI closed at $12.50 per share.


Barrett is a staffing/PEO firm serving small and mid-sized businesses primarily. When I bought the stock last year, Barrett Business Services was fundamentally a solid company: no debt, lots of cash, a no-nonsense CEO who had steadily built the company up over 27 years and owned 25% of the company's stock, etc. That's all still true today, but nevertheless, it was a mistake to buy the company when I did, because I didn't consider the relevant macro-trend.


The relevant macro-trend in Barrett's case was the real estate bust in California. Although Barrett has operations in several regions of the country, and clients in different industries, most of its business comes from California. Because California experienced one of the biggest real estate booms in the country, it also is experiencing one of the biggest real estate busts, and the effects on California's economy have been worse than on the national economy so far (on today's conference call, Barrett's CEO estimated that California's unemployment rate is now about 7.5%). Also, during economic downturns, outsourced/temporary workers are often the first to get laid off, so Barrett was quick to feel the consequences of this (conversely, as Barrett's CEO pointed out on today's call, outsourced/temporary workers are also the first to get hired during an economic upturn).


Ideally, the best time to invest in a company like BBSI would be just as the negative macro-trend was ending, but of course there is no way to time that exactly. That doesn't mean, however, that I can let myself off the hook for buying BBSI when I did. The magnitude of the real estate bust in California was obvious at the time, and I should have connected the dots and realized how this would lead to a deterioration in California's labor market.


On today's conference call, Barrett's CEO discussed how he would be using this economic downturn (as he had used previous downturns) to increase market share and position Barrett to do well during the next economic upturn. I have no reason to doubt that. I would consider investing more in BBSI within the next few months, assuming it's still on the Magic Formula list. It was still a mistake for me to buy BBSI when I did though, at the beginning of the current downturn.

A counter example of a stock I bought last June that was facing a positive macro trend is the oil royalty trust BPT that I posted about here earlier today and last Friday. Not surprisingly, I am up 50%+ on BPT over the same time frame that I am down 50%+ on BBSI.