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Book presentation: Excess Returns: a comparative study of the methods of the world's greatest investors

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This is a pdf presentation of the book Excess Returns: a comparative study of the methods of the world's greatest investors. The presentation explains the various topics that are discussed in the book and show plenty of practical examples to understand the main points. It challenges the Efficient Market Hypothesis by showing some extraordinary track records in the investment world. It explains where top investors look for bargains. It shows how they perform a due diligence and how they value stocks. A separate section is devoted to the way top investors buy and sell various types of stocks, and how they buy and sell over stock market cycles. It also explains the various psychological aspects that top investors deem essential to beat the market.

Book presentation: Excess Returns: a comparative study of the methods of the world's greatest investors

  1. 1. Book Presentation: Excess returns – A comparative study of the methods of the world’s greatest investors Frederik Vanhaverbeke
  2. 2. Business literature (best practices) Behavioral finance Topics: The investment philosophy; Finding bargains; Fundamental business analysis; Valuation; Common process mistakes; How to buy and sell intelligently; Risk versus return; The intelligent investor Books/articles/ interviews about/by top investors Books stock market behavior Book Excess Returns
  3. 3. Overview • Challenge to the Efficent Market Hypothesis • The Investment Philosophy • Effectiveness of sound investing • The Investment Process (*) Finding Bargains (*) Due Diligence (*) Common mistakes • Buying and selling (*) Stock types (*) Market cycles (*) Common mistakes • Risk versus return • The intelligent investor
  4. 4. The Efficient Market Hypothesis – are markets efficient ? EMH claim: Market cannot be beaten as pricing is always and totally efficient  1. Market beaters are random subjects who owe their “success” to luck 2. There is no systematic method to beat the market The extreme efficient market theory is "bonkers". It was an intellectually consistent theory that enabled them to do pretty mathematics. So I understand its seductiveness to people with large mathematical gifts. It just had a difficulty in that the fundamental assumption did not tie properly to reality. The efficient market theory is obviously roughly right meaning that markets are quite efficient and it’s quite hard for anybody to beat the market by significant margins as a stock picker by just being intelligent and working in a disciplined way. The answer is that it’s pretty efficient and partly inefficient. ‐‐‐ Charlie Munger The common view of top investors on EMH:
  5. 5. The Efficient Market Hypothesis – Challenge 1: Momentum trading Jesse Livermore (first decades of 1900s): spiritual father of momentum trading Turtle traders Richard Dennis: Other 1) 15 years (70s, 80s): $400 → $200 million 2) 1994 → 1998: 63% annually William Eckhardt: 1978→ 1991: 60% annually Turtle experiment Annual compound return Number of years (track record) Tom Shanks 29.7% 22 Paul Rabar 25.5% 23 Liz Cheval 23.1% 21 H. Seidler 22.8% 23 Jerry Parker 22.2% 23 S. Abraham 21.7% 19 William O’Neil (CANSLIM): 40% annually over 25 years
  6. 6. The Efficient Market Hypothesis – Challenge 2: Macro investing with George Soros and co. George Soros: 1969 → 2009: 26.3% annually George Soros + Jim Rogers: 1969 → 1980: Soros Fund x34 ↔ S&P 500: 47% George Soros solo: Outperformance continues George Soros + Stanley Druckenmiller: • Outperformance continues • Druckenmiller = person who “broke the Bank of England” (not Soros) • Druckenmiller (Duquesne Fund): 37% annually over 12 years George Soros solo (with son): Outperformance continues (e.g., return in 2008: +7%) If markets are efficient, how can this string of outperformance be explained?
  7. 7. The Efficient Market Hypothesis – Challenge 3 Edward Thorp, Mathematics professor: • Derived the Black‐and‐Scholes option pricing model a few years before Black and Scholes but decided to keep it secret (to make money) • 1969 → 1988: return Princeton Newton Partners: 19.1% annually • Princeton Newton Partners: positive performance in 227 out of 230 months !!! → probability of this kind of consistency or beƩer  6.1E‐46 (number of atoms on earth  1E50) Can this be explained by luck?
  8. 8. The Efficient Market Hypothesis – Challenge 4: The Superinvestors of Graham‐and‐Doddsville and like minded Annual compound return Number of years (track record) Benjamin Graham 21% 20 Walter Schloss 20% 49 Tom Knapp 20% 16 Bill Ruane 18% 14 Warren Buffet 22% 57 Pupils of Benjamin Graham Annual compound return Number of years (track record) Joel Greenblatt 40% 20 Rick Guerin 33% 19 Eddie Lampert 29% 16 Charles Munger 20% 14 Prem Watsa 22% 28 Warren Buffet adepts “Superinvestors of Graham‐and‐Doddsville”: Walter Schloss, Tom Knapp, Rick Guerin, Bill Ruane, StanPerlmeter, Charles Munger: identified as exceptional investors by Buffett when they had no track record!!!
  9. 9. The Efficient Market Hypothesis – Excess returns (over S&P 500) of top investors
  10. 10. The Efficient Market Hypothesis – Excess returns and the power of compounding Warren Buffet, Jan 1957 – Jan 2013 (57 years): annual compound return = 22.29% (= 12.4% annually above return of S&P 500 including dividends)
  11. 11. Overview • Challenge to the Efficent Market Hypothesis • The Investment Philosophy • Effectiveness of sound investing • The Investment Process (*) Finding Bargains (*) Due Diligence (*) Common mistakes • Buying and selling (*) Stock types (*) Market cycles (*) Common mistakes • Risk versus return • The intelligent investor
  12. 12. The Investment Philosophy –Market Philosophy Success in the market starts with a sound market philosophy… Effective market philosophy • Explains drivers behind the market • Explains how these drivers create inefficiencies • Shows how one can take advantage of pricing inefficiencies Effective market method Practical and proprietary implementation of the philosophy Common for all market operators of same “school” Different for each market operator, dependent on: • Personal preferences • Fit with personality There is nothing new on Wall Street or in stock speculation. What has happened in the past will happen again and again and again. This is because human nature does not change, and it is human emotion that always gets in the way of human intelligence. ‐‐‐ Jesse Livermore Market philosophies are timeless:
  13. 13. The Investment Philosophy – Examples Investing versus momentum trading INVESTING MOMENTUM TRADING Drivers of stock prices • Cognitive biases: herding, extrapolation, asymmetric loss aversion, etc… • Different market styles: investing, trading, speculating, etc… • Different objectives among market operators (e.g., quick win vs. long term) Basic premise Over long term stock prices revert to their (true) intrinsic value There is price momentum in stocks that tends to persist over some time Basic approach • Determine intrinsic value of stocks • Buy at discount to intrinsic value • Sell when price reaches intrinsic value • Closely track price action • Buy (sell short) stocks with strong (weak) price action • Get out when trend reverses Investing methods Find stocks below intrinsic value + Buy/ sell intelligently → take cues from most success-ful investors in the world Focus of the book
  14. 14. The Investment Philosophy BUY Sell close to or above intrinsic value SELL Stock price (value) Time Intrinsic value Stock price: quasi‐random walk around intrinsic value Buy when stock trades at significant discount
  15. 15. The Investment Philosophy – remarks It is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately to people or it doesn’t take at all. It’s like an inoculation. If it doesn’t grab a person right away, I find that you can talk to him for years and show him records, and it doesn’t make any difference. They just don’t seem able to grasp the concept, as simple as it is. ‐‐‐ Warren Buffet Fully endorse investment philosophy (“fit with personal beliefs”) Apply a method that fits their personality and preferences Have the right psychological mindset (e.g., patience, independence, emotional detachment, etc.) Successful investors
  16. 16. Overview • Challenge to the Efficent Market Hypothesis • The Investment Philosophy • Effectiveness of sound investing • The Investment Process (*) Finding Bargains (*) Due Diligence (*) Common mistakes • Buying and selling (*) Stock types (*) Market cycles (*) Common mistakes • Risk versus return • The intelligent investor
  17. 17. The Investment Philosophy – consistency of outperformance, 1 Let’s first get a myth out of the world: outperformance in every single year is not of this world !!!
  18. 18. The Investment Philosophy – consistency of outperformance, 2 Joel Greenblatt: one of the most impressive track records in the hedge fund industry!!! 1995‐2005, Joel Greenblatt on his own: 30% a year (20% better than the market)!!! 1985‐2005 Greenblatt: $1,000 → $840,000 S&P 500: $1,000 → $12,000
  19. 19. The Investment Philosophy – consistency of outperformance, 3 Even over multi‐year periods many top investors regularly underperform versus the market… Their goal = outperformance over an entire (bull‐bear) cycle
  20. 20. The Investment Philosophy – consistency of outperformance, 4 Let’s look at Seth Klarman, one of the few hedge fund managers that Buffett would entrust his money to… In spite of long period of under‐performance, track record over 26 years is exceptional !!!
  21. 21. The Investment Philosophy – common sense on track records, 1 Investing = statistical process because stocks move along a quasi‐random walk over which the investor has no control !!!! Hence, for all those who are still not convinced, answer the following question: In a game where two dice throwers must throw a green surface, does someone who throws a dice with 4 green and 2 red surfaces always win from someone with a dice that has 3 green and 3 red surfaces ?
  22. 22. The Investment Philosophy – common sense on track records, 2 → Although the odds are stacked in favor of the first dice thrower (i.e., he competes with an edge versus the other player), statistics says that only over the long run (i.e., a sufficient number of games) the first dice thrower is (very likely) to come out ahead.
  23. 23. The Investment Philosophy – common sense on track records, 3 So, ditch a top investor who temporarily underperforms at your own peril!! Common sense on track records Investing = statistical process: (*) Investor performance = quasi‐random walk versus market return (with other expected return); (*) Every year is like one throw of the dice; investor with edge will not win every year but is very likely to come out ahead over sufficient number of years; (*) Track records not easy to interpret, not even over multi‐year periods; those looking exclusively at track records don’t count the number of green surfaces of the dice.  Evaluation investment method indispensable in evaluation track record (Buffet downplays importance of track records in his search for portfolio managers of his investment float; focuses on personality, philosophy and process instead)
  24. 24. The Investment Philosophy – common sense on track records, 4 Why should the time required for a planet to circle the sun synchronize precisely with the time required for business actions to pay off? While I much prefer a five‐year test, I feel three years is an absolute minimum for judging performance. It is a certainty that we will have years when the partnership performance is poorer, perhaps substantially so, than the Dow. If any three‐year or longer period produces poor results, we all should start looking around for other places to have our money. An exception to the latter statement would be three years covering a speculative explosion in a bull market. ‐‐‐ Warren Buffet
  25. 25. Overview • Challenge to the Efficent Market Hypothesis • The Investment Philosophy • Effectiveness of sound investing • The Investment Process (*) Finding Bargains (*) Due Diligence (*) Common mistakes • Buying and selling (*) Stock types (*) Market cycles (*) Common mistakes • Risk versus return • The intelligent investor
  26. 26. The Investment Chain ‐ Overview Finding potential bargains BIASES “Investment Process” Due Diligence Qualitative analysis Quantitative analysis Valuation Focus: stocks with above‐average probability of being undervalued Ignore: stocks that are unlikely to be bargains Continuous follow‐up of existing positions Buy/stay away/ hold/ sell/sell short Preference for wrong types of stocks Biased analysis Irrational trades Succesfully coping with biases THE INTELLIGENT INVESTOR Superior process & execution PSYCHOLOGICAL
  27. 27. The Investment Process ‐ Finding Bargains ‐ 1 Huge stock universe + due diligence of single idea very time‐consuming Top investors focus efforts on most promising ideas What stocks tend to be undervalued? What stocks tend to be overvalued? Drivers of over/under valuation Sentiment Cognitive biases Information among investors about company Number of investors looking at idea Incentives to buy/sell Select for further scrutiny Deselect Tip‐offs Well‐informed buyers/sellers Well‐informed admirers Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot. ‐‐‐ Joel Greenblatt
  28. 28. The Investment Process – Finding bargains ‐ 2 Stocks in the spotlight Ignored stocks (dull, unfashionable, complex, small) Positive sentiment stocks (hot, widely admired, high‐growth) Negative sentiment stocks (despised, troubled, lousy industry) People are always asking me where the outlook is good, but that’s the wrong question. The right question is: Where is the outlook most miserable? ‐‐‐ John Templeton
  29. 29. The Investment Process – Finding bargains – Jeffries’ Finest Moment Jeffries, global investment bank; several nominations of "Best place to work“; Excellent track record in its industry up until 2011 Leucadia merges with Jeffries
  30. 30. The Investment Process – Finding bargains ‐ 2 ‐ examples Companies with “buzz” around them are seldom good investments !!! – Belgium
  31. 31. The Investment Process – Finding bargains IPOs Spin‐offs Example, Belgian spin‐off out of Omega Pharma: The new issue market is ruled by controlling stockholders and corporations who can usually select the timing of offerings. Understandably, these sellers are not going to offer any bargains. ‐‐‐ Warren Buffet Any time you read about a spinoff being accomplished through a rights offering, stop whatever you’re doing and take a look. ‐‐‐ Joel Greenblatt
  32. 32. The Investment Process – Finding bargains ‐ Summary Odds stacked against undervaluation  Don’t waste your time on these!!! (does not exclude that there can be an ocassional winner here) Above‐average probability of undervaluation  Take a closer look (don’t buy blindly!!) Hot stocks Ignored stocks IPOs Special situation stocks Stocks hitting new lows Hated stocks Greenblatt’s magic formula stocks Stocks added to an index Stocks removed from index Underappreciated beneficiaries of new trends Post‐bankruptcy stocks Stocks of pioneering businesses Businesses without earnings track record Insider buying Not necessarily good short ideas (see next slide)!!!
  33. 33. The Investment Process –What do top investors short? Shorting is not for the faint of heart + stock selection requires a very specific approach… Poor fundamentals  Management issues: dishonesty, greed, exuberance, rubberstamping of boards  Poor financials: weak balance sheet, low ROE and low ROIC, poor cash flow generation  Flawed business model  Growth saturation  Weak industry Good stock characteristics  Overinflated price  High float  Popular among professionals  Middle-sized short interest Triggers  Insider sales  Resignation key people  Change in auditors  Late filings  Rumors that something is wrong Do not short stocks with good stock characteristics that are fundamentally OK Avoid technology stocks Avoid beaten-down stocks Good Short candidates
  34. 34. The Investment Process – Finding bargains in emerging markets Compelling valuations + + Attractive country Primary beneficiaries of emergence of the country Economic reforms, hands‐off government, infrastructure, savings mentality, etc. Successful investing in emerging markets Financials, consumer products, media, excellently‐run players, etc.
  35. 35. The Investment Process – How Top Investors analyze businesses In evaluating people you look for three qualities: integrity, intelligence, and energy. If you don’t have the first, the other two will kill you. ‐‐‐ Warren Buffet Quantitative analysis Income statement  Earnings track record  Dividend history  Profit margins  ROIC, ROE Cash flows  Operating cash flow  Free cash flow Balance sheet  Liquidity  Solvency  Z-score, H-score Qualitative business analysis Industry  Barriers to entry  Competitive pressure  Threat substitutes  Capital intensity  Rate of change Business model  Simplicity ↔ complexity  Track record: scalability, profitability, market share Competitive position  Power versus customers, suppliers, internal competitors  Pillars: culture, HR, structure, processes, marketing, R&D, innovation, operations Control over destiny  Government interference  Dependence on R&D, fashion or critical decisions  Operational/financial leverage  Diversification of customer base and geography  Impact weather or economy Growth  Decent growth prospects  Track record  Growth management  Risk of growth saturation? Management Personality  Integrity  Modesty  Non-complacency  Independence Experience & skill  Track record  Capital allocation: tight ship, focus on opportunities, little leverage, no empire building  Strategy: unique + based on core competencies Values  Promotion values  Consistently enforced  Management = example Ownership & allegiance  Insider holdings  Long tenures  Fair compensation  Long-term thinking  Focus on company not on personal cult Energy and passion  Love for the job  Fascination for industry  Motivated by challenge and contents Board of directors  Skills, savvy, experience  Skin in the game  Devotion to their duties  Independence: willingness to challenge CEO, small board, low compensation, no family ties,… Insider sales? Earnings management? Late filings? Resignation key people? Auditor turnover? Footnotes? Due diligence characterized by: • Independence •Thoroughness (“going the extra mile”) • Scuttlebutt • Looking at subtle things that other investors overlook • Skipping businesses that are too complex • Critical view on leverage • Focus on one’s circle of competence
  36. 36. The Investment Process – How Top Investors value businesses Multiples –balance sheet:  P/BV: capital-intensive, no economic goodwill  P/Liquidation value: decline/near bankrupt  P/Replacement value: stable, low-growth DCF Multiples –income statement+balance Multiples –income statement:  P/E (trailing + normalized)  P/FCF: for mature companies  P/S: companies without or with unstable earnings sheet:EV/EBIT(DA), EV/S, EV/FCF Sum-of-the-parts Value on a deal basis (with discount) Graham and Dodd  EPV: business with moat  Full growth value: franchise with substantial growth Conservatism (margin of safety) KISS (simple models) Comparison with Triangulation peers/historical valuation Quality at fair price Skepticism Restrict number of parameters Preference for balance sheet multiples Normalize + use trailing values Be skeptical of moats and growth Avoid DCF when possible As long as you are consistent in how you value businesses, your degree of inaccuracy, if it is replicated through consistency, will lead to a great model for relative valuations. So if your valuation model is not sophisticated, does not take into account six dozens variables, well, as long as you are applying it the same way to every company and you are looking at a lot of different companies, you will have a useful model for relative valuation which can lead to very superior investment returns. ‐‐‐ Charlie Munger
  37. 37. The Investment Process – Common Process mistakes ‐1 1. Incoherent investment approach • Investing  trading (e.g., Buffet: “stop losses is like buying a house for $1 million and telling your broker to sell when he/she gets a bid for $800,000.”) • Investing  speculation based on hunches/rumours 2. Lack of independence: markets are quite efficient so one must do one’s own thorough due diligence (what most others know is already in the stock price) What is already known and published by others has already been acted upon. 3. Biased analysis: Assume you are always the last to know. • Mindless extrapolation of stock price performance/financial results • Cherry‐picking of information about companies • Sympathy and home bias: e.g., Kirk Kerkorian invested in GM right before its bankruptcy due to his passion for cars. • Illusion of familiarity: e.g., people invest substantial amounts in stock of employer even though they don’t know its financials well. ‐‐‐ Charles Kirk
  38. 38. The Investment Process – Common Process mistakes ‐2 4. Focus on wrong factors: economy (too challenging for most investors), short‐term “catalysts” (or lack thereof), etc. Charlie and I continue to believe that short‐term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown‐ups who behave in the market like children. ‐‐‐ Warren Buffet 5. Price instead of value: • Anchoring to purchase price as measure of cheap/expensive • Price action as element in fair value analysis 6. No attention to quality‐price tradeoff: buying cheap “crap” & overpaying for quality
  39. 39. Overview • Challenge to the Efficent Market Hypothesis • The Investment Philosophy • Effectiveness of sound investing • The Investment Process (*) Finding Bargains (*) Due Diligence (*) Common mistakes • Buying and selling (*) Stock types (*) Market cycles (*) Common mistakes • Risk versus return • The intelligent investor
  40. 40. Buying/Holding/Selling – Advice of top investors on how to trade different stock types AVOID TRADE ACTIVELY BUY‐AND‐HOLD BUY‐AND‐WAIT Emerging businesses X ‐ ‐ ‐ Fast growers Undisciplined with leverage ‐ Buy late and sell early ‐ Stalwarts ‐ Buy cheap and sell after 50% return Decent market‐beating returns ‐ Slow growers X ‐ ‐ Special situations & turnarounds Cyclicals Most investors X ‐ ‐ Turnarounds ‐ ‐ After turnaround if business great X Asset plays ‐ ‐ After asset realization if business great X Special situations ‐ ‐ After special situation priced in if business great X Most top investors focus on limited number of stock types and avoid others (determined by personality and style)
  41. 41. Buying/Holding/Selling – Advice of top investors on how to trade different stock types Textbook case of a turnaround – Thomas Cook Distress, high uncertainty Hopeful signs Peter Lynch: • Wait when uncertainty too high • Pounce when “hopeful signs” line up Source share prices: Yahoo finance
  42. 42. Buying/Holding/Selling – Advice of top investors on how to trade different stock types Will Blackberry be Prem Watsa’s turnaround story of then next few years?
  43. 43. Buying/Holding/Selling – General approach of top investors Buying • High selectivity • Patience • Gradual buying • Average down Selling • Thesis invalidated • Business not well understood • Price reaches fair value • Replace with better bargain (dangerous!) • Gradual selling Short selling • Are you up to the task? • Proper risk management: stop losses & limit sizes • High selectivity
  44. 44. Buying/Holding/Selling – General approach of top investors Example, International Coal (Prem Watsa)
  45. 45. Buying/Holding/Selling – Market cycles ‐Depression Brutal market action of the Dow Jones between 1929 and 1932:
  46. 46. Buying/Holding/Selling – Market cycles ‐Depression Only one in hundred survived the debacle of 1929‐1932 if one was not bearish in 1925. ‐‐‐Benjamin Graham
  47. 47. Buying/Holding/Selling – Market cycles ‐2008‐2009 Portrait of a smart and disciplined investor – PremWatsa Watsa – not a a one hit wonder: (*) Annual compound growth in book value per share 1986‐2005: 28% (*) Successfully navigated market bubbles (Japan, technology crisis) prior to 2005
  48. 48. In 2007, a major U.S. bank CEO famously said ‘as long as the music is playing you have to get up and dance.’ After the Lehman bankruptcy in 2008, this same bank needed $45 billion from the U.S. government to continue in business. Expensive dance! We prefer to wait for the music to stop and not depend on the kindness of strangers to be in business. ‐‐‐PremWatsa Buying/Holding/Selling – Market cycles ‐2008‐2009 Portrait of a smart and disciplined investor – PremWatsa – a detailed look
  49. 49. Buying/Holding/Selling – Market cycles ‐2008‐2009 As an aside: Does this look like “déjà vu all over again” ? – PremWatsa As they say, it is better to be wrong, wrong, wrong and then right than the other way around! ‐‐Prem Watsa Observations: • Economic growth since 2009 far below historical average in USA and Europe • Inflation steadily came down over past few years in Europe and USA; Europe close to deflation • Stock prices in USA at historically high valuations (in Shiller PE terms)
  50. 50. Buying/Holding/Selling – Market cycles – 1970s Stocks go nowhere; sentiment drifts down; inflation high (so real returns even negative); valuations move from expensive to extremely cheap
  51. 51. Buying/Holding/Selling – Market cycles – 1970s How did the Superinvestors of Graham‐and‐Doddsville fare over the period ?
  52. 52. Buying/Holding/Selling – Market cycles – 1970s Ignore the sentiment of the moment How did they do it? Focus on bargains (cheap stocks) Stay away from hot Nifty‐Fifty stocks Build cash in frothy markets Get cash to work in bear markets An investor should put money to work amidst the throes of a bear market, appreciating that things will likely get worse before they get better. ‐‐Seth Klarman Example, Warren Buffet: • 1969: could find no bargains in the market and therefore wound down his investment partnership (kept only one deep‐value stock: textile company Berkshire Hathaway) • 1974: around market bottom: “I feel like an oversexed man in a whorehouse”
  53. 53. Buying/Holding/Selling – Market cycles – bubbly 90s
  54. 54. Buying/Holding/Selling – Market cycles – bubbly 90s Would you entrust your money to these underperformers ??? Top investors refuse to participate in market folly and actually protect themselves against collapse: • Buffet: refuses to invest in technology stocks • Seth Klarman: hedges portfolio + moves into cheap small caps
  55. 55. Buying/Holding/Selling – Market cycles – bubbly 90s Seth Klarman, one of the most respected hedge fund managers of our time… Seth Klarman, Dec. 1999: Occasionally we are asked whether it would make sense to modify our investment strategy to perform better in today's financial climate. Our answer, as you might guess, is: No! It would be easy for us to capitulate to the runaway bull market in growth and technology stocks. And foolhardy. And irresponsible. And unconscionable. It is always easiest to run with the herd; at times, it can take a deep reservoir of courage and conviction to stand apart from it. Yet distancing yourself from the crowd is an essential component of long‐term investment success.
  56. 56. Buying/Holding/Selling – Market cycles – bubbly 90s Well, you better would… Top investors roar back with a vengeance and actually have positive performance throughout the collapse of the Nasdaq and S&P 500 !!!
  57. 57. Buying/Holding/Selling – Dealing with market cycles → They are NOT afraid to underperform a few years and reap the profits aŌerwards Top investors don’t try to time the market, often anticipate market turns years in advance… Indicators for market turns: market sentiment + valuations
  58. 58. Common Buying and Selling mistakes‐ some examples Common practices among investors Top Investors Constantly trying to anticipate the moves of the market Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in the corrections themselves. ‐‐‐Peter Lynch Constantly trading in an attempt to take advantage of the market’s movements Inactivity strikes us as intelligent behavior. ‐‐‐Warren Buffet Nobody has gone broke taking a profit. Can you imagine a CEO using this phrase to urge his board to sell a star subsidiary? ‐‐‐Warren Buffet Selling winners and hanging on to losing stocks Selling winning stocks and hanging on to losing stocks is like cutting the flowers and watering the weeds. ‐‐‐Peter Lynch Buying and selling based on emotion. While enthusiasm may be necessary for great accomplishments elsewhere on Wall Street it almost invariably leads to disaster. ‐Benjamin Graham The economy as a first consideration The way you lose money in the stock market is to start off with an economic picture. All these great heavy‐thinking deals kill you. ‐‐‐Peter Lynch
  59. 59. Overview • Challenge to the Efficent Market Hypothesis • The Investment Philosophy • Effectiveness of sound investing • The Investment Process (*) Finding Bargains (*) Due Diligence (*) Common mistakes • Buying and selling (*) Stock types (*) Market cycles (*) Common mistakes • Risk versus return • The intelligent investor
  60. 60. Risk versus return Top investors deride academic view on risk, have unconventional view on risk: (*) volatility = opportunity to buy cheap (*) diversification = protection against ignorance (*) risk = lack of knowledge To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. Graham & Dodd investors, needless to say, do not discuss beta, the capital asset pricing model, or covariance in returns among securities. These are not subjects of any interest to them. In fact, most of them would have difficulty defining those terms. The investors simply focus on two variables: price and value. ‐‐‐Warren Buffet Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science. ‐‐‐Seth Klarman
  61. 61. Risk versus return – Basic tenets of top investors The ten commandments of intelligent risk management 1) Do not participate in market folly – not even under the pressure of clients 2) Be patient and tolerant of temporary underperformance 3) Have the courage to accumulate cash when you can’t find bargains 4) Have the courage to get cash to work when the market is in a tailspin 5) Always insist on a margin of safety (i.e., buy cheap and sell when something is dear) 6) Know what you hold (very) well 7) First look at a stock’s downside (e.g., balance sheet); the upside will take care of itself 8) Always be prepared for the unexpected (e.g., black swans) 9) Use leverage sparingly (if at all) 10) Always remember “If something is too good to be true, it probably isn’t.” For people who do not adhere to these tenets: (*) diversification makes sense (*) volatility = risk (*) don’t ever think that you are investing !!!!
  62. 62. Risk versus return Top investors exhibit excellent risk‐return ratios
  63. 63. Risk versus return – top investors protect against the downside Limited number of down years + usually outperform when S&P 500 negative
  64. 64. Risk versus return – deviations from benchmark Although they use the S&P 500 as a yardstick, they only compare themselves with that benchmark over several years (and take large annual deviations in their stride)
  65. 65. Risk versus return – deviations from benchmark Let’s see how Buffett did versus the S&P 500 over his career: Definitely no benchmark hugging here …
  66. 66. Risk versus return ‐ concentration Example: Warren Buffet said in 2009 that if he would have been allowed by regulators he would have seriously considered to go “all in” on Wells Fargo (a company he knows extremely well) in the depth of the credit crisis… We agree with Mae West: “Too much of good thing can be wonderful.” ‐‐‐ Warren Buffet It is unwise to spread one’s funds over too many different securities. Time and energy are required to come to a sound judgment of an investment and to keep abreast of the forces that may change the value of a security. ‐‐‐Bernard Baruch Not the first time: • 1951: bulk of Buffet’s portfolio in GEICO • 1964: 40% of Buffet’s portfolio in American Express
  67. 67. Overview • Challenge to the Efficent Market Hypothesis • The Investment Philosophy • Effectiveness of sound investing • The Investment Process (*) Finding Bargains (*) Due Diligence (*) Common mistakes • Buying and selling (*) Stock types (*) Market cycles (*) Common mistakes • Risk versus return • The intelligent investor
  68. 68. The intelligent investor Are smart people automatically intelligent investors ? Newton: probably the greatest genius that ever lived… Newton lost a time‐adjusted $3 million in the South Sea bubble; After this traumatizing experience, he forbade anyone to speak the words “South Sea” in his presence…
  69. 69. The Intelligent Investor What does it take to be a successful investor ? Investor Intelligence Passion + Right Attitude + Hard work + Right mental setup Intellectual Intelligence A winning combination: Warren Buffet Without Investor Intelligence Newton (IQ) Let me emphasize that it does not take a genius or even superior talent to be successful as a value analyst. What it needs first is, reasonable intelligence; second, sound principles of operation; third, and most important, firmness of character. ‐‐‐ Benjamin Graham I have heard many men talk intelligently, even brilliantly, about something – only to see them proven powerless when it comes to acting on what they believe. Investors must act in time. ‐‐‐ Bernard Baruch
  70. 70. The intelligent investor ‐ Example Edward Thorpe, 1991: review of the Maddoff hedge fund for client His findings: • Returns inconsistent with trading strategy • Suspicious: (*) Trade confirmation statements: friend of Madoff (*) Information technology: brother of Madoff; Edward not alllowed to visit premises • Ghost option trades: (*) Many options didn’t trade on transaction dates (*) Option prices on statements impossible (different from actual trade prices) • Madoff’s organization could not be identified as counterparty to purported trades Edward Thorpe exposed the Ponzi scheme 18 years before its self‐destruction by going the extra mile… → Advises client to get out (doesn’t bother to inform the SEC as they showed little interest in fraud cases at that time)

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