03/30/2013 The Buffett Ratio

Sector Model	XLB	0.00%
Large Portfolio	Date	Return	Days
BBRY	7/16/2012	99.31%	257
SEAC	9/25/2012	45.53%	186
CAJ	9/25/2012	6.66%	186
CFI	10/31/2012	34.72%	150
RE	11/26/2012	24.59%	124
BOKF	2/4/2013	11.13%	54
SWM	2/12/2013	7.70%	46
GMCR	2/19/2013	27.87%	39
OKE	2/25/2013	0.55%	33
TAC	3/25/2013	-0.07%	5
S&P	Annualized	8.77%
Sector Model	Annualized	27.51%
Large Portfolio	Annualized	34.18%

 

Rotation: selling CFI; buying TTM (again).

TTM has dropped over 10% since I sold it a few weeks ago, and it’s now back in the buy zone.

CFI has reached an inflection point, outside of the parameters of my model.  I’ll take profits for now.

Also, as I posted on the real-time note on Friday, the sector model flipped to XLB before the close.

 

Now, where were we on the Buffett series?

Ah, yes, fundamentals.

Fundamentals are invisible things people appeal to when everything else is going the other way.  In 2008 McCain was lambasted for saying “the fundamentals of our economy are strong.”

Most of us could barely hear McCain above the chorus of screaming terror as we stared over the edge of the abyss.

For what it’s worth, I was rolling my eyes at McCain too, but our friend Warren Buffett was screaming “BUY!!!!!” at the same time:

http://www.nytimes.com/2008/10/17/opinion/17buffett.html?_r=0

We can discount McCain, but Buffett?

Anyone who looked at the news saw that we were doomed (hint, NEVER- EVER-EVER-EVER TRADE THE NEWS).

The news was right… for a few months.  The market continued to collapse until it hit that ominous 666 in March 2009.  But the news was wrong… for a few years.  It all depends on your time frame.  Buffett was looking through a different hour glass than most of us.  I remember pointing out to my family in late 2008 that the total market bullish percent index had fallen below 10 the day before Buffett was screaming to buy.  For most traditionalists, that’s about as clear an over-sold buy opportunity as you can get.

Those kinds of broad market opportunities don’t happen very often, but on any given day we can look for value in individual stocks.  Each stock is its own market – we don’t have to wait thousands of days for a market opportunity, because on any given day we can search thousands of stocks for a value opportunity.

A few weeks ago I did a fundamental screen of all the stocks in the market – and AAPL came up in first place.  First, among thousands!  And then it immediately went down another five percent.  Go figure.

The truth is that fundamentals have a bad rap because they get better looking the more the price of a stock tanks.  In other words, fundamentals are like some crazy carnival mirror image of price: the more “wrong” they appear to be, the more “right” they really are.  That’s not always true, of course.  There are indeed value traps out there.  And we can never screen them all out.  But ON AVERAGE a stock is a better buy the cheaper it becomes.

But that begs the question, “cheaper than what?”  If all you looked at is price, then a penny stock would be “cheaper” than APPL.  But a ten dollar banana is NOT cheaper than a hundred dollar house (or at least, we HOPE not).  “Cheap” has to be measured against… against…

Earnings?  P/E should be the trick, right?

WHICH P/E?  Current?  12 month trailing?  Forward?  Cyclically adjusted?

Let’s say you have a stock that normally earns 3 dollars a share and sells at a price of 45.  That’s a P/E of 15, which is about average for most decades.  But what if they have an earnings hit this quarter and only earn 1 dollar a share?  Suddenly that current P/E shoots up from 15 to 45!  Folks panic and dump the stock.  Now it’s selling at 30 dollars.  The current P/E falls from 45 to 30 – still nosebleed expensive.  Even worse, the “forward earnings” estimates are lowered (because they are really a lagging indicator as the people making the estimates try to make the “future” look like the most recent past).  So, the forward earnings are lowered from 3 to 2.

The current P/E is 30.

The forward P/E is 15.

But 12 month trailing earnings are for the past 4 quarters: 3, 3, 3, 1 averages to 2.5.

So, for 12 month trailing P/E we have: 30/2.5 = 12.

People looking at (expensive 30) current P/E will be selling to people looking at (cheap 12) trailing P/E, while people looking at (average 15) forward P/E start to get nervous.

And that’s just P/E.

There are hundreds of different fundamental features out there, with thousands of possible ratios.

How on earth to parse them?

Well, there are two ways.  The first is trial and error (preferably someone else’s).  The second is to study correlation.

http://bigthink.com/e-pur-si-muove/friscos-for-scientists-i-correlation-does-not-imply-causation

Ah, yes, “correlation does not imply causation.”

In a pig’s eye.  Of course correlation implies causation.  How else did Warren Buffett get so rich? 

Buffett is bright, but he isn’t some super genius with inhuman insight – and that’s a good thing for the rest of us, because it means that (other than buying whole companies outright)… Buffett isn’t doing anything that the rest of us can’t do. 

He’s value investing and compounding his returns through the tax avoidance that long term holding provides.  He isn’t looking at charts.  He’s looking at debt, profits, cash flow – or in McCain’s terms “fundamentals.”

And for all his baloney of “please tax me more” for the front page, he tells the investors in Berkshire Hathaway that he accomplishes just the opposite.  He holds for as long as possible to pay as little taxes as possible.

As we have seen, Buffett is using his “please tax me more” as an inside joke… with short term traders as the punch line.

Okay – we get the joke.  Buy and hold has merit.  But you have to know WHAT to buy and HOW LONG to hold.  You could just buy anything at random and hold forever – and odds are you’ll beat the DOW index by about a percent a year because small caps outperform large caps over the long term.  But that won’t get you to a billion, or even help you retire at 80.  No, you have to look at those fundamentals like a businessman.

As I said last week – you aren’t buying a piece of paper; you’re buying a piece of a company.

But most of us aren’t businessmen.  How do we know WHICH of the hundreds of fundamentals to look at?

Any of them.

No, seriously – ANY of them, as long as you look at their time ratio.

A company has a track record, a reputation, a brand, a business model.  Value is created when the short term prospects are worse than the long term ones. 

It’s really that simple.

Did you miss it?  Here it is again.  Read it ten times through, then read it again:

Value is created when the short term prospects are worse than the long term ones. 

No, I’m serious, DRILL THIS INTO YOUR HEAD:

Value is created when the short term prospects are worse than the long term ones. 

THAT is the only ratio that matters, and ALL of the fundamental parameters you look at should serve that one theme.  Book value growth – better long term or short term?  Cash flow growth – better long term or short term?  Earnings – better long term or short term?

Value is created when the short term prospects are worse than the long term ones. 

Notice I didn’t even mention P/E there.

The ratio is not “P/E” or “Book / Price” or “Current ratio”.  It’s long term / short term.  That’s long term earnings over short term earnings, or long term Book Value over short term Book Value.

We live in a flash-mob investment world, where everyone is trying to outpace the next; and all the while those high frequency trading algorithms are running circles around us all like wolves driving a herd of sheep.

If you really want to compete with HFTs, figure out how to get them to work FOR you instead of AGAINST you.  Figure out what kinds of havoc they are creating and then figure out how to pick up the pieces afterward.

Sometimes you’ll be early and you’ll see the price continue to collapse.  Don’t look at the bloody chart.  Look at long term fundamentals / short term fundamentals.

Heck, even TECHNICAL traders do that.  They’ll determine a long term trend and then wait for a pullback to enter.

You do the same thing with fundamentals.

That’s what Buffett does.

That’s ALL Buffett does.

And the longer term the better, because it means that you’ll be able to trade less often and get taxed less dramatically.

We profit when we do what other people won’t do, and what high frequency trading algorithms can’t do.

A reader guessed the theme a few posts ago: it’s simple, but not easy.

The problem is that it goes against human nature.

It’s not “easy” at all to watch your favorite stock tank in price, with horrible news and competition eating its lunch.  It’s not “easy” to invest in such a company in the first place.  My best stock to date is the one I was most convinced would go completely bankrupt: BBRY (formerly RIMM).

When I first decided to invest in it, I was convinced it was a horrible mistake:

http://market-mousetrap.blogspot.com/2012/07/07152012-going-off-deep-end.html

Just a few days later I was hoping the model would dump it before I lost my investment:

http://market-mousetrap.blogspot.com/2012/07/07212012-waiting-out-stupidity.html

I only calmed down a bit after it was up 50%:

http://market-mousetrap.blogspot.com/2012/12/12232012-rimm-and-other-mysteries.html

Now, BBRY could STILL tank.  But it was a lesson to me – my gut instincts really were as bad as I thought they were when I made the model.  We are geared to follow the herd and make Buffett richer in the process:

http://www.wired.com/wiredscience/2013/03/powers-of-swarms/all/

Investors like to look at charts, but the only thing that charts tell you is what other investors have been doing.  If humans really are programmed to just follow other humans, as that wired article on swarms indicates, then we need to follow something OTHER than other humans.

And that means we need to be looking at timeframes OTHER than the ones human instincts operate in.

I’ll talk more on timeframes… next week.

Tim

03/28/2013 realtime note

The sector model is selling the XLI shares and buying XLB instead -- before the close.

03/24/2013 Be[ating] Buffett

Sector Model	XLI	1.86%
Large Portfolio	Date	Return	Days
BBRY	7/16/2012	105.66%	250
SEAC	9/25/2012	46.02%	179
CAJ	9/25/2012	8.17%	179
CFI	10/31/2012	33.73%	143
RE	11/26/2012	25.34%	117
BOKF	2/4/2013	11.27%	47
SWM	2/12/2013	7.15%	39
GMCR	2/19/2013	24.87%	32
OKE	2/25/2013	-2.51%	26
CASH	3/14/2013	0.00%	9
S&P	Annualized	8.40%
Sector Model	Annualized	25.73%
Large Portfolio	Annualized	34.70%

 

Replacing the CASH position with TA.TO (TransAlta Corp.) in the POWER industry.

When I sold TTM last week I was up just shy of 4%.  It dropped 10% this past week, so CASH didn’t do so bad.

The technical configuration of the market has improved, with the model showing a 70% net long recommendation. 

BBRY took another hit.  Two steps forward, one step back.  What a crazy ride this one has been so far.

Okay, back to Buffett (and the subject of this post): “Be[ating] Buffett”:

FIRST, WHAT WE CANNOT DO…

Some folks had questions about how Buffett avoids dividend taxes, so I’ll have to quote his explanation from his book of Essays.

http://www.amazon.com/Essays-Warren-Buffett-Lessons-Corporate/dp/1611634091/ref=sr_1_1?s=books&ie=UTF8&qid=1364095016&sr=1-1&keywords=the+essays+of+warren+buffett

That link is to the 2013 edition.  I’ll be quoting from the 2001 edition, page 269:

“There’s a powerful financial reason behind Berkshire’s preference [to acquire 100% of a business rather than a small fraction], and that has to do with taxes.  The tax code makes Berkshire’s owning 80% or more of a business far more profitable for us, proportionally, than our owning a smaller share.  When a company we own all of earns $1 million after tax, the entire amount inures to our benefit.  If the $1 million is upstreamed to Berkshire, we owe no tax on the dividend.  And, if the earnings are retained and we were to sell the subsidiary – not likely at Berkshire! – for $1 million more than we paid for it, we would own no capital gains tax.  That’s because our ‘tax cost’ upon sale would include both what we paid for the business and all earnings it subsequently retained.

“Contrast that situation to what happens when we own an investment in a marketable security.  There, if we own a 10% stake in a business earning $10 million after tax, our $1 million share of earnings is subject to additional state and federal taxes of (1) about $140,000 if it is distributed to us (our tax rate on most dividends is 14%); or (2) no less than $350,000 if the $1 million is retained and subsequently captured by us in the form of a capital gain (on which our tax rate is usually about 35%, though it sometimes approaches 40%).  We may defer paying the $350,000 by not immediately realizing our gain, but eventually we must pay the tax.  In effect, the government is our ‘partner’ twice when we own part of a business through a stock investment, but only once when we own at least 80%.”

I cannot stress enough how important it is to read the entire book cover to cover – twice.  It gives an entirely new light on the balderdash of “please tax me more” he keeps shouting for the news cameras.

Imagine you were playing a game, where your back is to the sun and it cannot affect you – but it can blind your competition.  The sun, which does nothing DIRECTLY to you, still works in your favor by suppressing the competition.

Warren Buffett has his back to the blinding rays of the tax man.  And those rays are aimed straight at us.  It is entirely in his interest to have that light ramped up as bright as possible.

Warren Buffett should be read, studied, and emulated.  He should not be dismissed, and he should not be worshipped.

He should not be “whale watched” either.  Whale watching is that bad habit of buying stocks just because some successful guy owns them.  You’ll just pump up his stocks without necessarily doing anything for yourself.

So, let’s take a look at higher taxes to see how they HELP Warren Buffett:

1) They suppress his competition (pretty much anyone who is not big enough to buy entire companies as he describes above).

2) They suppress volatility.  Volatility is exacerbated by the short term flipping of stocks.  If short term traders have a 43.8% hit on capital gains, they will VERY QUICKLY lose their firepower, and will have a diminishing effect on the market.

3) They suppress momentum trading (typically short term and pro-volatility as well).

So, what does that leave?

It leaves long term value investing with a greater competitive edge than it used to have.

Therefore, taxes HELP Warren Buffett.

And this leads me to the next part of this post:

WHAT WE CAN DO

We can observe Buffett’s so-called fourth law of motion, which I’ve paraphrased to “the more you trade, the less you have.”

We have to consider the effect of taxes as obsessively and as skillfully as Warren Buffett.  We have to IGNORE what he says in the news about taxes not being an issue, and instead read his essays to see just how important tax avoidance is to successful investing.

We have to look for long term value and short term cheapness.

We have to think in terms of years, and not weeks or months.

We have to get a sense of what a company is worth, and see investment as owning a piece of a COMPANY instead of owning a piece of PAPER.  We aren’t buying a “stock”; we are buying as much of a “company” as is reasonable for our own net worth.

In other words, the first step in “Beating Buffett” is learning how to “Be Buffett.”

The greatest lesson I ever learned about investing came from my grandfather.  Ever since 1996, my grandfather has beaten the pants off of the market.

What did he do?

Nothing.

And I mean, ABSOLUTELY nothing.

My grandfather passed away in 1996.  I’d give anything for another game of Uno with him.

I can’t play Uno with him, but I can let him hold my hand when I invest.

When he bought companies, he bought companies that would still be around when he was gone, and year after year my grandmother was “advised” to flip her stocks, but she refused, and let my grandfather’s long term stock picking keep her steady.  She even had to sign wavers because her “advisors” didn’t want to be responsible for holding companies for so long!  Years run into decades, but some companies and industries are set to outlast even the youngest of us.

Invest as if you won’t be around to “flip” the stock if the company or industry turns sour.

It takes homework and fundamental thinking.

In short, it takes a different perspective.  A simple switch, but not an easy one.

The homework of learning fundamentals is not as complex as the plethora of technical tricks out there.  The key is that it takes more time BEFORE you buy a stock than technical tricks do.  But it takes less time AFTER you buy the stock, because you aren’t obsessing over every tick of the price 18 times a day.

Simple – but not easy: because people are not geared to work BEFORE they get something.  We’d rather buy something on credit than save for it.

Another switch is to focus on the value of the company instead of the price of a stock.  If the price is plummeting, but the long term value of the company is not greatly affected, the stock has gone on sale.  You may buy it and watch the price plummet ANOTHER 50%.  But if you look at the value of the company instead of the price of the stock, you’ll be able to do another thing that’s “simple, but not easy.”

We aren’t geared to work BEFORE we buy, and we aren’t geared to be punished AFTER we buy.

And if we do these things – if we try to “Be Buffett”, then we can “Beat Buffett” – not by winning any money from him (he doesn’t sell, remember?), but rather by NOT losing any more money to him than we already have, and by NOT falling prey to Buffett’s “business partner” (the tax man) who wants to suppress our ability to compete.

In the next few posts, I’ll talk a bit more about some specific fundamentals, and the only real ratio we need to focus on.

But this is enough for now…

Tim

 

 

 

 

03/20/2013 The Buffett conundrum

I’ve written about the Buffett conundrum before, but it’s time to revisit it.

Buffett has a puzzling stance regarding the relationship between government and industry.  He keeps crying out for the government to tax him more, and mocking those who are afraid of taxes and regulation.  At the same time, he is the master of the art of avoiding capital gains taxes by long term holding, and even avoiding dividend taxes by simply buying the entire company outright.  To add to our befuddlement, he is buying “green energy” companies on the hopes that government regulation will force profits his way.

When faced with such contradictions, there are three possible responses.

First, admirers will assume he is speaking so profoundly that when he doesn’t seem to make sense, we must be at fault for our pitiful intellects.

Second, former admirers will look at the obvious contradictions and conclude that he’s completely lost it.

I used to be in the first camp, upgraded to the second, and am dipping my toe in a third way of looking at the man:

Third – he has a hidden agenda.

Let’s assume that Buffett is BOTH a shrewd businessman and investor, AND STILL crying out for business and investment destroying policies.  Let’s also assume that he’s not playing some kind of “nyah nyah you can’t tax me” joke on the government.  He would know that the joke would be on us instead of the government.

Keep in mind that, unlike Mitt Romney who pays a ton of taxes and gives a ton more to charity, Buffett is holding everything in a death grip that will only be pried loose by the grim reaper himself.  He doesn’t sell, so he doesn’t pay capital gains.  He buys whole companies, so he doesn’t pay dividend taxes.  And he’s holding his charitable contributions for his will to avoid even the death tax.

So, these taxes he’s calling for do NOT affect him – at least not directly.

But what about indirectly?

http://reason.com/archives/2013/03/04/warren-buffetts-economic-confusion

A close read of that article has a telling quote from Buffett about his motives: “Let us unburden you.”

The statement is made both about CEOs who are afraid of government policies and also potential investors in Berkshire.

In other words, the destructive intrusion of government only affects us little folk who are collectively Buffett’s competition.  Once you reach his size, you no longer win by competition, but instead by the suppression of competition.  This is effectively the modus operandi of a monopoly.

And maybe his most recent years are revealing that monopoly is all he can still play:

http://www.nypost.com/p/news/opinion/opedcolumnists/warren_buffett_falls_to_earth_ynH4Xw9Gb2PFpOIbU1UpcK

As Bugs Bunny is fond of saying, “Of course, you know this means war.”

Higher taxes and regulations ON HIS COMPETITION, does indeed benefit Buffett, and that is precisely why he is crying out for them and getting medals from ideologues who don’t understand how they are being manipulated by Buffett.

So then, in the following posts I will show how to compete with Warren Buffett.  The goal isn’t to follow his TRADES, but instead to follow the METHODS that made him rich in years past.

If you follow his trades you’ll just make him richer by pumping up the value of the shares he already owns.  What you want to do instead is to anticipate his trades and the trades of other billionaires.  As small as we are, we can get into these value companies faster than he can – so instead of pushing up the value of shares he already owns, we can have him push up the value of shares WE already own.

Ready?

This should be fun.

 

03/17/2013 Double, double toil and trouble

Sector Model	XLI	2.71%
Large Portfolio	Date	Return	Days
BBRY	7/16/2012	106.62%	243
SEAC	9/25/2012	44.31%	172
CAJ	9/25/2012	5.61%	172
CFI	10/31/2012	42.10%	136
RE	11/26/2012	23.67%	110
BOKF	2/4/2013	10.83%	40
SWM	2/12/2013	7.15%	32
GMCR	2/19/2013	22.14%	25
OKE	2/25/2013	-5.15%	19
CASH	3/14/2013	0.00%	2
S&P	Annualized	8.64%
Sector Model	Annualized	26.62%
Large Portfolio	Annualized	34.98%

 

No rotation for Monday.

The market maintains a long bias, but it continues to weaken technically.  Right now the cash version of the Mousetrap is 90% long.

That empty 10% is like a nag on my screen, screaming “opportunity cost!”

Yes, it is an opportunity cost.

But the goal of a model is to end the day with the most money, and not always to be statically invested.  The market is in a feeding frenzy, and money is beginning to paint a picture.

Of the best long industries we have:

ENTTECH

FURNITUR

ELECFGN

BANKMID

OILGAS

TOBACCO

WIRELESS

REINSUR

POWER

AUTO

GROCERY

GOLDSILV

 

Of the best short industries we have:

OFFICE

ENTRTAIN

RETAIL

CABLETV

RETAUTO

BIOTECH

DIVERSIF

PIPEMLP

 

Notice that both Retail and Retail Auto are shorts.

More intriguing is that Auto remains a long (notwithstanding the sale of TTM last week).  The theme is clear from Furniture, Oil & gas, Tobacco, Power, Auto, Grocery, Gold & Silver mining.  Things.  Invest in things.  Don’t invest in demand from consumers (retail).  Invest in inflation instead.

Yes, yes, I know that the whole “Gold & Inflation” idea has become out of favor – but that’s how investment opportunities are made.  We appear to be in the latter phases of a pre-inflationary surge.  Breadth in the broad market should continue to tighten as investors pile into index funds and large caps.  Commodities should pick up.  Bonds should soften.  And the market should have an annoying acceleration that will give pain to the hedges I have in my (unlisted) discretionary short positions.

I say, “should” a lot in that last paragraph.  Truth is, no one KNOWS any of this for sure.  You can’t invest in “should” very well, can you?

The problem is that the Fed has promised QE infinity, and has tried to talk it back a bit, without slowing down the money printing.  At the same time, end consumers have had their take home pay cut by a few critical percentage points.

But, but, but, hasn’t the dollar stopped falling?  Indeed it has, but the dollar isn’t measured against commodities.  The dollar is measured against other currencies.  If EVERYONE is printing money, then the dollar could rise AND commodities could rise too.

This kind of absurd environment is what separates theory from reality.  Can we say it together?  Ready?

“Bubble.”

Or rather:

Double, double toil and trouble
Fire burn, and cauldron bubble.

Macbeth Act 4, scene 1, 10–11, etc

 

My own model should (there’s that word again) have some trouble navigating this, while mindless momentum chasing should (and again) take the lead.  This is where Buffett exits stage left, while Sauron, er Soros, comes out of the shadows and says, “Boo!”

People don’t trust Soros because they don’t understand him.  But he explained himself quite clearly in an interview a few years back when he said that he chases bubbles.

He’s a bit of a mutant, so he can do that.

I’m not a mutant, so I’ll have to defer to Soros here.  All I can do is go for the boring trade.

And my boring trade is about to get REAL boring for a while.

Watch for a weird market.

Although I plan to avoid the excitement, I WILL get some popcorn and 3D glasses to watch the fun.

No doubt Soros will get richer right now – hopefully not off of MY money…

Tim