Lessons learned from the 2008 market turmoil

The financial market turmoil of late 2008 has made a large amount of headlines and wiped out a lot of wealth (paper or otherwise). Being involved in the market during this last year has taught me a lot of lessons about investing, markets, and more importantly, myself. These series of blog entries are my attempt to share my positive and negative experiences. I try not to have regrets, and if I do, I try to learn from them. I hope that my readers find these interesting and useful for their own investing ventures.

Why "Circle of Competence" Matters
I have been lucky (I believe) to have started to study the discipline of Value Investing last couple years, but didn't really take much action because valuations were too high. Consequently, this meant that I had a large percentage of my savings in liquid or semi-liquid form.

I decided to follow the value investing strategy for my personal portfolio starting January, 1 2008. I created valuation models for myself and screened various stocks for typical signs of value. With Graham and Buffett as my guides, I went through a lot of companies' annual reports and balance sheets.

At the beginning of 2008, it was believed that we were well within the credit crisis, and the banks were selling for major discounts to what they traded at before the U.S. subprime housing bubble burst.

Since my screens kept on revealing mostly financial companies, and they were selling at historically attractive valuations; I was greatly tempted by them. I recalled Buffett's famous maxim, "Be fearful when others are greedy; and be greedy when others are fearful". It was obvious that the fear of financial institutions' solvency was rampant in the market, and I held firm the belief that well managed banks would get out of subprime mess and the market sell off is discounting more than it needs to.

In all my greediness, I forgot one of the most important criteria that Buffett sets out for his investment choices. The criterion of Circle of Competence; he does not recommend investing into businesses that he does not understand. If it is too complicated to understand, then he suggests, that one should look elsewhere.

I ventured out of my "circle of competence" and invested in an international bank, namely Deutsche Bank (DB). From my research, the bank appeared to have intelligent and responsible management, had called for greater transparency from their peers, increased their dividend in spite of being in the crisis, and didn't have much writedowns at all during 2007.

I still hold this stock, but I have a paper loss of over 70%! When I look at that, it does bother me, but that loss reminds me that I ventured outside my circle of competence. I still think that this a sensible investment (but not at the price I bought it at), but it is very hard to know where that bottom is. For this particular stock, due to my lack of understanding of their business, I obviously couldn't set a decent fair value. Even after applying a large margin of safety, my concluded valuation numbers were way off.

Lesson learned: Circle of Competence matters-- it matters a whole lot.

Mr. Market

On a brutally bearish day like today, here is something more light hearted-- and yet, enlightening.

Why Foreigners Can't Ditch Their (US) Dollars

It is no secret that I greatly admire and respect Warren Buffett as an investor. I would like to share the following write up from Buffett in Fortune Magazine, on why it is not almost impossible for Foreigners to get rid of U.S. Dollars. So, next time you encounter some sort of media scare about foreigners stepping away from the de facto standard of the U.S. dollar, you can quote the following from Buffett:

HOW OFTEN HAVE YOU SEEN A COMMENT LIKE THIS IN ARTICLES ABOUT the
U.S. dollar? “Analysts say that what really worries them is that
foreigners will start moving out of the dollar.”

Next time you see something like that, dismiss it. The fact is
that foreigners— as a whole—cannot ditch their dollars. Indeed,
because our trade deficit is constantly putting new dollars into
the hands of foreigners, they have to just as constantly increase
their U.S. investments.

It’s true, of course, that the rest of the world can choose which
U.S. assets to hold. They can decide, for example, to sell
U.S. bonds to buy U.S. stocks. Or they can make a move into real
estate, as the Japanese did in the 1980s. Moreover, any of those
moves, particularly if they are carried out by anxious sellers or
buyers, can influence the price of the dollar.

But imagine that the Japanese both want to get out of their
U.S. real estate and entirely away from dollar assets. They can’t
accomplish that by selling their real estate to Americans,
because they will get paid in dollars. And if they sell their
real estate to non-Americans—say, the French, for euros—the
property will remain in the hands of foreigners. With either kind
of sale, the dollar assets held by the rest of the world will
not (except for any concurrent shift in the price of the dollar)
have changed.

The bottom line is that other nations simply can’t disinvest in
the U.S. unless they, as a universe, buy more goods and services
from us than we buy from them. That state of affairs would be
called an American trade surplus, and we don’t have one.

You can dream up some radical plots for changing the
situation. For example, the rest of the world could send the
U.S. massive foreign aid that would serve to offset our trade
deficit. But under any realistic view of things, our huge trade
deficit guarantees that the rest of the world must not only hold
the American assets it owns but consistently add to them. And
that’s why, of course, our national net worth is gradually
shifting away from our shores.

Complete Article: http://www.berkshirehathaway.com/letters/growing.pdf

September: Monthly Commentary

I am regular listener/reader of the monthly commentary by Irwin A. Michael from ABC Funds. Here is the commentary on the very volatile and emotionally charged September that just wrapped up today.

The fears, price volatility and uncertain financial direction of the market place continue to wear on investors. Overhanging the macro landscape is the $700 billion U.S. government rescue package for the American banking system and whether acceptance of this bailout would be sufficient to extricate the financial system from continued uncertainty. Moreover with a string of financial institution insolvencies and near bankruptcies such as Bear Stearns, Lehman Brothers, AIG, Merrill Lynch, etc. investors are primed for the worst.

Negative newspaper headlines along with spreading financial fears and the expectation as who might be next to fail has produced securities trading which has become increasingly volatile, emotional and inconsistent. Amidst the overall investor insecurity, indecision and lack of confidence frenetic stock trading is producing numerous market anomalies and irrationality. In a number of cases investors, due to the perceived ascending risks, are literally throwing the baby out with the bath water. For many investors reading the bleak front-page newspaper headlines or listening to dour TV and radio commentaries on the effusive negativity is overshadowing investment clarity and is producing a “Chicken Little – the sky is falling” investment outlook.

On a micro level, investors faced with extreme emotion are demanding investment liquidity at the expense of intrinsic valuations. In consequence in a rush toward cash the market is experiencing sell-offs/redemptions of hedge funds and equity mutual funds. Unfortunately, as this motivated selling continues it breeds more selling and is exacerbated by investor margin calls. Simplistically, this situation is akin to a dog “chasing his tail.”

As long term value investors we believe, as difficult as it may be, one must be unemotional, consistent and patient. Value will eventually be recognized. However, this is not to belittle the seriousness of the present circumstances. The fact is that worldwide governments, central banks and lending institutions are working 24/7 to cobble an international financial rescue package. This will take time and considerable patience. As a result, securities prices are and will become inconceivably volatile both on the upside and downside. Not unexpectedly we have gone through extraordinary periods like this before such as the September 11, 2001 events, the late 1980s US savings and loan failures, the high tech implosion of 2000/2001 etc. Clearly, these are extremely volatile and emotional times. Investors must be on guard for opportunities. A perfect example is Warren Buffet’s opportunistic purchase of a $5 billion 10% preferred investment in Goldman Sachs and an option on its stock at $115.

Amidst all this uncertainty we were very impressed by a full page Fidelity Investments advertisement in the Wednesday, September 24, 2008 edition of the Globe and Mail newspaper. This excellent ad highlighted Fidelity’s views on the present market environment. It was well-crafted and extremely credible. In this ad Fidelity states:

“The extraordinary events of the past week are testing the portfolios and the confidence of investors worldwide…Volatility is part of investing. Markets go up and down. The past five years have seen strong equity market growth but as we’ve seen before with dot-com stocks, the Asian financial crisis and Black Monday, corrections occur. They can be extreme but they are also temporary. It is better to be invested. Markets recover. The stock market had a positive return in nearly 3 out of every 4 years since 1957. And some of the sharpest declines have been followed by the strongest rebounds. Missing out on just a few of the markets best-performing days can mean missing out on significant gains…In the current environment, careful analysis of credit and equity markets, along with prudent portfolio management may be more important than ever…”

In summary we acknowledge that the present frenetic period is most difficult for all investors. Patience is necessary. Our ABC Funds are currently holding over $135 million of short-term cash reserves. We are adhering to our deep-value disciplines and are patiently awaiting investment opportunities.

Thank you,

Irwin A. Michael, CFA

The same commentary is available in audio format from ABC funds web site.

Story of Squanderville and Thriftville

While browsing the web, I was doing my usual round of picking up investment related stories. I stumbled upon the Berkshire Hathaway site. Anyone who isn't immediately thrown off by the almost lifeless simplicity of this site, would know that this site is a treasure chest of incredible amount of wisdom.

There is an article posted on the web site that I seem to have missed previously. I would like to highlight the following: a Fortune article from Buffett regarding the U.S. Trade Deficit. This article is a must read for anyone interested in macroeconomics, business and investing. In fact, if you have any relation to U.S., then you may find this article interesting.

Buffett describes a story of two islands called Squanderville and Thriftville. As you may have guessed from the names, the people in Squanderville prefer to squander their earnings (food, in this simple scenario) and live beyond their means. People of Thriftville, on the other hand, live well within their means, and do not mind having a surplus of food production. They eventually start trading; and in a matter of years, people of Squanderville realize that they could just offer Squanderbonds to the nation of Thriftville in exchange for food -- and Squandervillites never have to toil in the fields again. The story goes an and morphs into something very intersting.

Buffett, in his usual charming way, completes this story and talks about a way to fix the alarming U.S. trade deficit problem. He describes something called Import Certificates (ICs) that are issued to U.S. exporters.

Complete article: http://www.berkshirehathaway.com/letters/growing.pdf

Intrinsic Value Realized

Mr. Market has been incredibly excitable last week (Sept 15-19, 2008)... near the last couple of days of the week, the Mr. Market has been incredibly exuberant.

One thing I have noticed is that in the wild swings of the market, Mr. Market realized the value of Berkshire Hathaway. It closed the week at $147,000 per share. Notice that the intrinsic value that I calculated was $145,517. Frankly, I never thought that the equity would trade above my intrinsic value calculation so soon. This goes to show the positive side of the wild mood swings of Mr. Market.

Question is, should one sell their Berkshire Hathaway unit(s) to the enthusiastic market? I for one will not, since I will stick to my motto that Berkshire is for life. If I could find an appropriately priced business that can have level of consistent cash flows like Berkshire, or sane management as Berkshire, then I would gladly sell [most of] my Berkshire units (but never all) and buy that business. Alas, there is no such business I know of at this current time. That being said, I am in the long haul with Berkshire -- perhaps one of the finest businesses around.

I expect the price to fluctuate and perhaps go back down to the levels from a week ago. An intelligent investor must not be concerned with the daily fluctuations of equity prices.