Saturday, July 5, 2008 0 comments ++[ CLICK TO COMMENT ]++

Articles of Interest for the Week That Gave Birth to America and Canada

First week of July... the worst June for the stock market in quite a while--perhaps ever. My portfolio is a disaster this year (-30% so far), primarily because of my investment in Ambac.

When I first started investing a few years, I always felt that the bear markets are what separates the successful investors from the rest. That is certainly true of anyone who follows some sort of contrarian strategy. People like me end up buying beaten down stocks and will get killed if our selection is wrong. But times like these are also what makes investing interesting. Investing was quite boring for the last few years but this year has been exciting to say the least. Losing a huge amount of money (losses haven't been crystallized yet but I think there will be some permanent impairment) is never fun but at least I somehow ended up getting front row seats to some of chaotic drama Wall Street has been putting on.

As usual, here are some articles on various topics, along with my thoughts (admittedly I need to sharpen some of my writing, but my excuse is that I write some of them when I'm sleepy or tired :) )...

Couple of Jim Grant Items

Jim Grant fans should check out the following two items:

Transcript of an interview with PBS' Nightly Business Report (thanks to for the original citation)

Bloomberg video interview with Jim Grant and Brad Hintz, an analyst who was a former Lehman Brothers CFO (thanks to The Big Picture for pointing it out)

Jim Grant is superbearish but he is a bottom-up investor so it is never quite what it seems. Just like how when Warren Buffett says the economy is bad, it doesn't really mean anything (Buffett would be the first one buying up stuff in that environment.)

For instance, if you read the PBS transcript, Jim Grant is still sticking with his Third Avenue Value Fund pick even though Martin Whitman's positions puts him in the thick of a lot of uncertainty (particularly with real estate plays in Asia and North America and financial guarantors). Furthermore, he is recommending Fidelity National Finance (FNF), supposedly a title insurer, which depends on the mortgage market. Given Grant's superbearish views on the credit bust, one may have blindly assumed he would avoid anything depedent on housing, let alone mortgages. Yet you would have been mistaken... At the right price, of course.

It'll be interesting to see how his bullish call on gold holds up. A lot of people, although I can't speak for Grant's thinking, bet big on gold simply because of their skeptical views of central banks. If central banks tighten more than the gold market is expecting, I can see gold getting killed. Although one can never be sure of the direction of any future events, this is one area I'm content staying out. Similar to oil, I don't see any "fundamentals" to sustain high prices. Present gold investors better be sure that they are not investing in a situation similar to 1979.

The Bloomberg interview also has Brad Hintz, who counter-balances Grant's overly bearish views. Both expect some problems for the financial sector to linger but that's pretty much market expectation. What matters is the future and they seem to differ on the future outlook. Grant seems to be concerned about financial companies whereas Hintz thinks that they will do fine when we get a cyclical recovery in a few years.

In my observation, financials are starting to stabilize--not their stock prices, mind you, but their financial losses (stock prices probably won't stabilize until we get clarity about the economy). It looks like many of the big banks and brokers are starting to write down smaller losses (although one can still not be sure until we are 3 or 4 quarters though it--say 2Q 2009). UBS, one of the worst hit, seems to be reporting better numbers. Most of the big mortgage losses seems to have been accounted for, with the current losses coming from miscellaneous sources such as bond insurer downgrades. If you think the bond insurers aren't insolvent then these banks will write up those losses in the future. There is still a lot of 'if' and 'but'; however, the key things are the amount of writedown and the source of the writedown. The writedowns have a terrible effect of not only resulting in losses (i.e. profit destruction), but also requiring massive shareholder dilution which has killed the shares. If my optimistic scenario is correct, the financials will be out of the housing-induced problems and will simply be left with a normal cyclical downturn due to a slowing economy. This latter weakening due to the economy isn't unusual and the financial service industry can handle it as they have for many decades (even through a recession, many banks post profits, albeit smaller; but the housing mess is actually causing massive losses). We can be certain of one thing, however: financials are not going to enjoy profitability like they have in the last 10 years (deleveraging and collapse of easy credit should lower their return on equity.) I'm curious to see what happens to Canadian banks, who have only suffered minor losses due to the US housing bust but have historically had very high ROE. Will the Canadian banks also post weaker profitability in the future? It remains to be seen.

One thing I'm not certain about is commercial real estate. Some say that is going to be hard hit but others seem to imply that it was nowhere near the bubble that residential real estate was (corporations in America are also doing fine (so far) so it's not like they are going to dissapear from their buidlings). As an investor (albeit of the newbie type), I don't care about a typical slowdown or recession. What I do care about is a long-term problem that permanently changes the environment. The difference between investing in financials in Japan in 1991 and USA in 1991 is quite significant. Both were hit badly due to real estate busts and slowing economies but the former was a long-term problem while the later, although painful in the short term, was simply a temporary setback.

Some investors like Bruce Berkowitz have mentioned that it was much easier to invest in financials such as Fannie Mae or Citigroup back in the early 90's because it was easier to understand them. Now, he says, they are very opaque and no one really knows what their risk is. Nevertheless, many successful value investors seem to have a neutral-to-slightly-bullish view of financials.

Gurus Also Suffering

Paul Price summarizes the beating that some so-called "gurus" are taking this year. Check out the top 10 loser (but read my note below on a big caveat):

(NOTE: these are simple average returns and are not reflective of actual returns by any of these investors)

Manager…………………. 6-months ……………..... 12-months

Marty Whitman ……….. ( - 43.38% ) ………………( - 34.61% )
Mohnish Pabrai ………... (- 41.20% ) ………………( - 36.88% )
Bill Miller ……………… ( - 37.05% ) ……………... ( - 40.90% )
Joel Greenblatt ………… ( - 37.00% ) ……………… ( - 37.00% )
Eddie Lampert ………… ( - 28.95% ) ……………… ( -33.94% )
Robert Bruce ………….. ( - 25.00% ) ………………. ( - 19.16% )
Bruce Sherman ………… ( - 24.68% ) ……………… ( - 30.55% )
Charles Brandes ……….. ( - 24.58% ) ……………… ( - 29.51% )
Robert Rodriguez ……… ( - 22.20% ) ……………… ( - 17.75% )
Mark Hillman ………….. ( - 21.53% ) ……………… ( - 25.40% )

I saw this post early in the week and was pondering whether to say anything about it. The numbers can be completely misleading if interpreted incorrectly. The numbers above, courtesy, may not track undisclosed or foreign positions. But the biggest confusion is that the reported numbers are not a weighted average representing actual holdings by those investors.

Martin Whitman, for example, is down 40% partly due to his exposure to bond insuers and mortgage insurers, most of whom are down 70% to 99%, but they make up a small percentage of his portfolio. So, these numbers are not the real losses (or gains) posted by these investors in their managed funds.

Some may dismiss this simple average as misleading and useless, but I think there is some value in this. If you are an investor whose investments are influenced by these investors, it does make sense to consider the simple average. After all, most small investors like me do not buy/sell every single security disclosed by these investors and we likely are heavily overweight select picks. If you picked a few of the selections by these superinvestors this year, you would end up similar to the numbers mentioned above, even though the superinvestors have losses nowhere near that because the picks from this year are often just a small portion of their total portfolio.

Is Bill Miller Toast?

So asks a Kiplinger article in the Washington Post by Russel Kinnel, who is the director of mutual fund research at Morningstar. That's a question on many people's minds. I'm a fan of Bill Miller and still highly respect him, but I'm in the minority. The author makes highlights several notes, including Miller's style and how it has not really changed.

(source: Is Bill Miller Toast?, by Russel Kinnel, Washington Post (originally from Friday, July 4, 2008)

Many saw Miller as a cagey investor who was always one step ahead of other investors. They figured he could sniff out the right industry just in time to beat his peers and the market. But that's not an accurate description of how Miller operates. Rather than flitting from one industry to another, Miller invests with a five- to ten-year horizon and consistently favors the same sectors.

Miller likes financial, technology and Internet stocks. And he typically holds some retail, media and health-care stocks, too. However, he hates most commodity businesses, including oil and copper. Those sector biases were perfect for the markets of the 1990s but have hurt results since oil prices started to spike three years ago. It makes sense that Miller did well in low-inflation environments and has fared poorly in today's world, with financial stocks in crisis and natural resources very precious.

Bill Miller has largely avoided commodities (so have many other value investors) and I don't think he is going to change his mind on that. Who knows how the future will transpire on the inflation front, but if Miller were to start doing well, it will likely have to come from his technology and retail picks. I personally think he is one of the few value investors that can successfully analyze technology stocks, which are a huge chunk of the US economy, so that is one of his competitive skills.

To me, the essence of Miller's strategy is conviction. He's willing to bet more and wait longer than just about any other manager out there. In 1999, he made a poor decision to buy shares of in the $50s. He loved the franchise and saw its growth potential. You know what happened next: The dot-com bubble burst in 2000, and Amazon lost more than 80% of its value. Yet Miller dived in and bought with both fists. The stock rose 75% in 2002 and 179% in 2003, and Miller trimmed his position.

The stock slogged around a bit but came roaring back to gain 135% in 2007. So far in 2008, it has given back a slug of those gains. But Miller earned a great return on Amazon even though he got in too high. That's what separates him from the pack.

Although he probably made a lot more (percentage-wise as well as money-wise on some stocks in the late 90's), Amazon in my mind is probably one of Bill Miller's best picks. It is also what made me a big fan of Bill Miller.

Because sectors rotate in and out of favor, a reasonable scenario for the next ten years is that Miller's sector biases won't help as much as they did in the 1990s, but they won't hurt as much as they have in the past three years. Put that together with the fact that the fund's trading sizes and volatility have changed, and maybe the fund could beat the S&P three out of the next five years -- and we stop talking about streaks. If the fund didn't have such a steep expense ratio (1.69%), I might even give it five years out of the next eight.

Miller will likely end up with a poor year this year. Historically his worst years have been during corrections (roughly around 1990 and 2000). But like many contrarians or value investors, his picks are often a "set up" for the recovery. As Miller has said repeatedly in the past, the person that wins in the end is the one with the lowest cost base. The key is not to end up catching fall knives when you are trying to keep your cost basis low.

The Risk In the Canadian Market

If you love commodities, you couldn't find too many other markets better than Canada. Maybe Brazil. Maybe Russia. But Canada has none of the political risk. The Canadian market has done exceptionally well over the last few years due to the commodities boom. But all this presents a risk (source: The Globe & Mail):

The crash of 1974 is a nightmare vision of what could happen to today's Canadian stock market as a result of its domination by commodity stocks. By the end of '74, the Toronto stock market was down 29 per cent, one of its worst annual declines ever. The Toronto Stock Exchange's [TSX-I]oil and gas index lost more than half its value, metal stocks were down about 40 per cent and gold was off 40 per cent from its peak for the year.

Over the past few years, these very same sectors have come to represent just under half of the S&P/TSX composite index. So far, it's all been good. Soaring prices for oil, metals and fertilizers have made Canada's stock market one of the world's best performers over the past five years.

Still, there's reason for investors to be nervous. For one thing, markets that are tilted massively to one or two specific sectors have fallen hard in the past. For another, there's almost no way to make money in the Toronto market these days outside of commodities. "The S&P/TSX is now entirely a slave to the commodities sector," said RBC Dominion Securities strategist Myles Zyblock.

A lot of commodities investors don't realize how volatile commodities are. Jim Rogers and Marc Faber have repeatedly said that commodities investors should be prepared for a 50% drop but I really wonder how many can handle that. It's oh-so-easy for 1974 to repeat.

In fact, the year 1974 is just one example of how carnage can ensue when investors flock to a sector or class of stocks and ignore everything else. Commodities once again dragged the Canadian market down in 1981, while the collapse of the Nortel Networks-dominated tech sector debacle was a key event in the bear market that kicked off this decade. In the U.S. market, the early 1970s are remembered for an obsession with the Nifty Fifty, a group of big names like McDonald's, Polaroid, Xerox and Disney.

These companies, seen as must-own "one-decision stocks," helped drive a bull market in the early 1970s as they soared to prices that today seem absurd. Example: Polaroid's price-earnings ratio — the classic measure of how expensive a stock is — soared to 90, compared with 18.9 for the S&P 500 index. When the Nifty Fifty inevitably toppled, it took the stock market seven years to recover.

One of the mistakes--or at least what I perceive as a mistake--made by some commodities investors is their view that valuations are cheap because P/E ratios are low. If you believe that commodities are cyclical then a low P/E means nothing. If anything, P/Es will be close to the low near the top than at the bottom. The low P/Es are due to peak earnings rather than low valuations. The market presently thinks that these earnings are sustainble, not just for the next year or two but far into the future (stock price is perpetual future cash flow discounted to the present after all), so most commodity stocks are priced as quasi-growth stocks.

Art Market In A Bubble

Le Bassin aux Nymphéas, Claude Monet, 1919 (source: image from Art History at

Is that painting by Claude Monet worth $80.4 million? Well that's what the record price was. No doubt it is one of the top paintings of all time, and one of the most important by Monet but I think it is a sign of the times. Namely, a bubble in art. David Dreman, who seems to be a big fan of Impressionist paintings, has also remarked over the last year that the art market may be in a bubble. Not sure what he thinks of this painting but I suspect it wouldn't pass his contrarian filters :)

I'm just a total newbie when it comes to paintings but if I'm not mistaken with the painting, I actually got a chance check out that painting in one of my few vacations a few years ago to Seattle. In an exhibition titled Double Take: From Monet to Lichtenstein in Seattle a few years ago, it was displayed. I think if you are a total newbie and interested in art, special exhibitions like these (in this case it had diverse selections, consisting of different time periods, styles, and art forms) are the most enjoyable. I'm more partial to photography and one my favourites from the exhibit was Atom Suit: Project: Desert 1 (1998) by Kenji Yanobe:

Atom Suit: Project: Desert 1 (1998), Kenji Yanobe
(source: image from Art History at

Totally love the angle of the shot, along with the unique behaviour being captured...

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