Monday, July 4, 2011

Quotes The Forever Portfolio

Currently reading the forever portfolio by Jame Altucher
This book is trying to answer the following questions
What are the Tidal wave-like demographic forces taking shape around the world that we can surf on top of?

What are the methods for identifying opportunites and companies in each demographic trend that we focus on?

A simple stock system
An example of a simple system that historically has done well in both bull and bear markets and does not apply any quantum mechanics or chaos theory. It takes advantage of the fact that the so called dumb money tends to pile into (or pull out of) a stock when a trend has played out.
About five years ago a specialist on the New York Stock Exchange taught me this trick. He said if a company has bad news, wait three days, then buy. I tested the system on all the NASDAQ 100 stocks over the past ten years.

If a stock is down three straight days, buy the next morning at the open. If you own a stock and it's up two days in a row, sell it the next day at the open.
The idea behind this that the trends run out fast. after two consecutive days up, it is reasonable to expect a stock to slow down. After three down days in a row, all of the sellers are done.
This is not always true. Often a stock goes down many more days than three. When it does, in this system you buy more. But if it goes up two days in a row you sell.
Furthermore, if you want to risk management, do not use a stop-loss. An investor using a stop-loss takes a stock position and says "If I lose 10%, then I am going to sell this position and stop my losses." Instead, it's better to keep position sizes small enough so that you never have to worry while you sleep at night about any one position. You have to give it a chance to play out. If you are nervous about a stock going down 50%, keep position sizes small and make as many trades as possible.

Diaster investing
Whenever there's a disaster, remember this tatic:
WAIT A WEEK, THEN BUY QQQQ AND SPY.
Get the benefits of the resilience of the US Economy.
Don't worry about making money back in one day, but know with confidence that the markets will bounce back.

Monday, June 20, 2011

The Subprime Debacle: Act 2 by John Mauldin

Thoughts from the Frontline Weekly Newsletter
The Subprime Debacle: Act 2
by John Mauldin
October 15, 2010
Visit John's Home Page

In this issue:
The Subprime Debacle: Act 2
Where is the Housing Recovery?
The Foreclosure Mess
Some Foreclosure Takeaways
Yankees, Rangers, and The Endgame

Trouble, oh we got trouble, Right here in River City!
With a capital "T" That rhymes with "P"
And that stands for Pool, That stands for pool.

We've surely got trouble!
Right here in River City,
Right here! Gotta figger out a way
To keep the young ones moral after school!
Trouble, trouble, trouble, trouble, trouble...

- From The Music Man

(Quick last-minute note: I think this (and next week's) is/will be one of the more important letters I have written in the last ten years. Take the time to read, and if you agree send it on to friends and responsible parties. And note to new readers: this letter goes to 1.5 million of my closest friends. It is free. You can go to www.frontlinethoughts.com to subscribe. Now, let's jump in!)

There's trouble, my friends, and it is does indeed involve pool(s), but not in the pool hall. The real monster is hidden in those pools of subprime debt that have not gone away. When I first began writing and speaking about the coming subprime disaster, it was in late 2007 and early 2008. The subject was being dismissed in most polite circles. "The subprime problem," testified Ben Bernanke, "will be contained."

My early take? It would be a disaster for investors. I admit I did not see in January that it would bring down Lehman and trigger the worst banking crisis in 80 years, less than 18 months later. But it was clear that it would not be "contained." We had no idea.

I also said that it was going to create a monster legal battle down the road that would take years to develop. Well, in the fullness of time, those years have come nigh upon us. Today we briefly look at the housing market, then the mortgage foreclosure debacle, and then we go into the real problem lurking in the background. It is The Subprime Debacle, Act 2. It is NOT the mortgage foreclosure issue, as serious as that is. I seriously doubt it will be contained, as well. Could the confluence of a bank credit crisis in the US and a sovereign debt banking crisis in Europe lead to another full-blown world banking crisis? The potential is there. This situation wants some serious attention.

This letter is going to print a little longer. But I think it is important that you get a handle on this issue.
Where is the Housing Recovery?

We are going to quickly review a few charts from Gary Shilling's latest letter, where he review the housing market in depth. Bottom line, the housing market has not yet begun to recover, and it is not only going to take longer but the decline in prices may be greater than many have forecast. I wrote three years ago that it could be well into 2011 before we get to a "bottom." That may have been optimistic, given what we will cover in this letter.

First, existing and new single-family home sales continue to slide, in the wake of the tax rebate that ended earlier this year. We have declined back to the down-sloping trend line. If you are a seller, this is not a pretty picture.

image001

The homebuilding industry, which was the source of so many jobs last decade (aka the good old days), is on its back. This country needs a healthy housing construction market to get back to lower unemployment, and until the overhang in the foreclosure market is cleared out, that is unlikely to happen.

image002

Lending is tighter, as is reasonable. Banks actually expect you to have the ability to pay back the mortgage you take out (solid FICO scores) and want reasonable down payments. Only 47% of applicants have the FICO score to get the best mortgage rates.

(Sidebar: Gary writes, "Furthermore, false appraisals rose 50% in 2009 from 2008. The tax credit for first-time homebuyers cost taxpayers about $15 billion, twice the official forecast, in part due to fraud. Over 19,000 tax filers claimed the credit but didn't buy houses, while 74,000 who claimed $500 million in refunds already owned homes." Where are the regulators?)

Shilling thinks prices are likely to fall another 20%. Given what I am writing about in the next section, that is a possibility. There is certainly no demand pressure to push up housing prices.

Finally, two charts on foreclosures. Residential mortgages in foreclosure are near all-time highs, close to 1 in 21 of all mortgages, up from 1 in 100 just four years ago. That's got to be bad for your profit models.

image003

image004

Anyone who tells you the housing problem is "bottoming" either has an agenda or simply does not pay attention to the data. I really want to see housing bottom and then turn around and the home builders come back; the nation desperately needs the jobs. But my job is to be realistic. When we see 3-4 months of non-stimulus-induced housing sales growth, then we can start talking about bottoms.

But housing sales are not really the issue. Let's look at the next leg of the problem.
The Foreclosure Mess

OK, in a serendipitous moment, Maine fishing buddy David Kotok sent me this email on the mortgage foreclosure crisis just as I was getting ready to write much the same thing. It is about the best thing I have read on the topic. Saves me some time and you get a better explanation. From Kotok:

"Dear Readers, this text came to me in an email from sources that are in the financial services business and with whom I have a personal relationship. The original text was laced with expletives and I would not use it in the form I received it. Therefore the text below has had some substantial editing in order to remove that language. The intentions of the writer are undisturbed. The writer shall remain anonymous. This text echoes some of the news items we have seen and heard today; however, it can serve as a plain language description of the present foreclosure-suspension mess. There is a lot here. It takes about ten minutes to read it. - David Kotok (www.cumber.com)

"Homeowners can only be foreclosed and evicted from their homes by the person or institution who actually has the loan paper...only the note-holder has legal standing to ask a court to foreclose and evict. Not the mortgage, the note, which is the actual IOU that people sign, promising to pay back the mortgage loan

"Before mortgage-backed securities, most mortgage loans were issued by the local savings & loan. So the note usually didn't go anywhere: it stayed in the offices of the S&L down the street.

"But once mortgage loan securitization happened, things got sloppy...they got sloppy by the very nature of mortgage-backed securities.

"The whole purpose of MBSs was for different investors to have their different risk appetites satiated with different bonds. Some bond customers wanted super-safe bonds with low returns, some others wanted riskier bonds with correspondingly higher rates of return.

"Therefore, as everyone knows, the loans were 'bundled' into REMICs (Real-Estate Mortgage Investment Conduits, a special vehicle designed to hold the loans for tax purposes), and then "sliced & diced"...split up and put into tranches, according to their likelihood of default, their interest rates, and other characteristics.

"This slicing and dicing created 'senior tranches,' where the loans would likely be paid in full, if the past history of mortgage loan statistics was to be believed. And it also created 'junior tranches,' where the loans might well default, again according to past history and statistics. (A whole range of tranches was created, of course, but for the purposes of this discussion we can ignore all those countless other variations.)

"These various tranches were sold to different investors, according to their risk appetite. That's why some of the MBS bonds were rated as safe as Treasury bonds, and others were rated by the ratings agencies as risky as junk bonds.

"But here's the key issue: When an MBS was first created, all the mortgages were pristine...none had defaulted yet, because they were all brand-new loans. Statistically, some would default and some others would be paid back in full...but which ones specifically would default? No one knew, of course. If I toss a coin 1,000 times, statistically, 500 tosses the coin will land heads...but what will the result be of, say, the 723rd toss? No one knows.

"Same with mortgages.

"So in fact, it wasn't that the riskier loans were in junior tranches and the safer ones were in senior tranches: rather, all the loans were in the REMIC, and if and when a mortgage in a given bundle of mortgages defaulted, the junior tranche holders would take the losses first, and the senior tranche holder last.

"But who were the owners of the junior-tranche bond and the senior-tranche bonds? Two different people. Therefore, the mortgage note was not actually signed over to the bond holder. In fact, it couldn't be signed over. Because, again, since no one knew which mortgage would default first, it was impossible to assign a specific mortgage to a specific bond.

"Therefore, how to make sure the safe mortgage loan stayed with the safe MBS tranche, and the risky and/or defaulting mortgage went to the riskier tranche?

"Enter stage right the famed MERS...the Mortgage Electronic Registration System.

"MERS was the repository of these digitized mortgage notes that the banks originated from the actual mortgage loans signed by homebuyers. MERS was jointly owned by Fannie Mae and Freddie Mac (yes, those two again ...I know, I know: like the chlamydia and the gonorrhea of the financial world...you cure 'em, but they just keep coming back).

"The purpose of MERS was to help in the securitization process. Basically, MERS directed defaulting mortgages to the appropriate tranches of mortgage bonds. MERS was essentially where the digitized mortgage notes were sliced and diced and rearranged so as to create the mortgage-backed securities. Think of MERS as Dr. Frankenstein's operating table, where the beast got put together.

"However, legally...and this is the important part...MERS didn't hold any mortgage notes: the true owner of the mortgage notes should have been the REMICs.

"But the REMICs didn't own the notes either, because of a fluke of the ratings agencies: the REMICs had to be "bankruptcy remote," in order to get the precious ratings needed to peddle mortgage-backed Securities to institutional investors.

"So somewhere between the REMICs and MERS, the chain of title was broken.

"Now, what does 'broken chain of title' mean? Simple: when a homebuyer signs a mortgage, the key document is the note. As I said before, it's the actual IOU. In order for the mortgage note to be sold or transferred to someone else (and therefore turned into a mortgage-backed security), this document has to be physically endorsed to the next person. All of these signatures on the note are called the 'chain of title.'

"You can endorse the note as many times as you please...but you have to have a clear chain of title right on the actual note: I sold the note to Moe, who sold it to Larry, who sold it to Curly, and all our notarized signatures are actually, physically, on the note, one after the other.

"If for whatever reason any of these signatures is skipped, then the chain of title is said to be broken. Therefore, legally, the mortgage note is no longer valid. That is, the person who took out the mortgage loan to pay for the house no longer owes the loan, because he no longer knows whom to pay.

"To repeat: if the chain of title of the note is broken, then the borrower no longer owes any money on the loan.

"Read that last sentence again, please. Don't worry, I'll wait.

"You read it again? Good: Now you see the can of worms that's opening up.

"The broken chain of title might not have been an issue if there hadn't been an unusual number of foreclosures. Before the housing bubble collapse, the people who defaulted on their mortgages wouldn't have bothered to check to see that the paperwork was in order.

"But as everyone knows, following the housing collapse of 2007-'10-and-counting, there has been a boatload of foreclosures...and foreclosures on a lot of people who weren't sloppy bums who skipped out on their mortgage payments, but smart and cautious people who got squeezed by circumstances.

"These people started contesting their foreclosures and evictions, and so started looking into the chain-of-title issue, and that's when the paperwork became important. So the chain of title became crucial and the botched paperwork became a nontrivial issue.

"Now, the banks had hired 'foreclosure mills'...law firms that specialized in foreclosures...in order to handle the massive volume of foreclosures and evictions that occurred because of the housing crisis. The foreclosure mills, as one would expect, were the first to spot the broken chain of titles.

"Well, what do you know, it turns out that these foreclosure mills might have faked and falsified documentation, so as to fraudulently repair the chain-of-title issue, thereby 'proving' that the banks had judicial standing to foreclose on delinquent mortgages. These foreclosure mills might have even forged the loan note itself...

"Wait, why am I hedging? The foreclosure mills did actually, deliberately, and categorically fake and falsify documents, in order to expedite these foreclosures and evictions. Yves Smith at Naked Capitalism, who has been all over this story, put up a price list for this 'service' from a company called DocX...yes, a price list for forged documents. Talk about your one-stop shopping!

"So in other words, a massive fraud was carried out, with the inevitable innocent bystanders getting caught up in the fraud: the guy who got foreclosed and evicted from his home in Florida, even though he didn't actually have a mortgage, and in fact owned his house free -and clear. The family that was foreclosed and evicted, even though they had a perfect mortgage payment record. Et cetera, depressing et cetera.

"Now, the reason this all came to light is not because too many people were getting screwed by the banks or the government or someone with some power saw what was going on and decided to put a stop to it...that would have been nice, to see a shining knight in armor, riding on a white horse.

"But that's not how America works nowadays.

"No, alarm bells started going off when the title insurance companies started to refuse to insure the titles.

"In every sale, a title insurance company insures that the title is free -and clear ...that the prospective buyer is in fact buying a properly vetted house, with its title issues all in order. Title insurance companies stopped providing their service because...of course...they didn't want to expose themselves to the risk that the chain of title had been broken, and that the bank had illegally foreclosed on the previous owner.

"That's when things started getting interesting: that's when the attorneys general of various states started snooping around and making noises (elections are coming up, after all).

"The fact that Ally Financial (formerly GMAC), JP Morgan Chase, and now Bank of America have suspended foreclosures signals that this is a serious problem...obviously. Banks that size, with that much exposure to foreclosed properties, don't suspend foreclosures just because they're good corporate citizens who want to do the right thing, and who have all their paperwork in strict order...they're halting their foreclosures for a reason.

"The move by the United States Congress last week, to sneak by the Interstate Recognition of Notarizations Act? That was all the banking lobby. They wanted to shove down that law, so that their foreclosure mills' forged and fraudulent documents would not be scrutinized by out-of-state judges. (The spineless cowards in the Senate carried out their master's will by a voice vote...so that there would be no registry of who had voted for it, and therefore no accountability.)

"And President Obama's pocket veto of the measure? He had to veto it...if he'd signed it, there would have been political hell to pay, plus it would have been challenged almost immediately, and likely overturned as unconstitutional in short order. (But he didn't have the gumption to come right out and veto it...he pocket vetoed it.)

"As soon as the White House announced the pocket veto...the very next day!...Bank of America halted all foreclosures, nationwide.

"Why do you think that happened? Because the banks are in trouble...again. Over the same thing as last time...the damned mortgage-backed securities!

"The reason the banks are in the tank again is, if they've been foreclosing on people they didn't have the legal right to foreclose on, then those people have the right to get their houses back. And the people who bought those foreclosed houses from the bank might not actually own the houses they paid for.

"And it won't matter if a particular case...or even most cases...were on the up -and up: It won't matter if most of the foreclosures and evictions were truly due to the homeowner failing to pay his mortgage. The fraud committed by the foreclosure mills casts enough doubt that, now, all foreclosures come into question. Not only that, all mortgages come into question.

"People still haven't figured out what all this means. But I'll tell you: if enough mortgage-paying homeowners realize that they may be able to get out of their mortgage loans and keep their houses, scott-free? That's basically a license to halt payments right now, thank you. That's basically a license to tell the banks to take a hike.

"What are the banks going to do...try to foreclose and then evict you? Show me the paper, Mr. Banker, will be all you need to say.

"This is a major, major crisis. The Lehman bankruptcy could be a spring rain compared to this hurricane. And if this isn't handled right...and handled right quick, in the next couple of weeks at the outside...this crisis could also spell the end of the mortgage business altogether. Of banking altogether. Hell, of civil society. What do you think happens in a country when the citizens realize they don't need to pay their debts?"

(I am not sure who wrote this, but if you want your 15 minutes of fame, I will be glad to credit you next week. - John)
Some Foreclosure Takeaways

Let me add a few thoughts. First, I agree, this is very serious. It has the possibility of seriously hurting the housing market, which as we saw in the first section is already on the ropes. But at the end of the day, there is a cure.

Someone borrowed money for a mortgage. Some entity is cashing a check if that person is paying. That entity should have the title until it is paid off. If someone is not making their mortgage payments, they should be removed from the house and it should be sold to the benefit of the ultimately correct and what everyone thought was the proper title holder.

If you took out a mortgage and now the title is in some doubt because the investment banks and mortgage banks and all the middle guys screwed up (big-time!) because they wanted to save some bucks and make some commissions, you did not win the lottery. That is not America as I know it. You can't pay the mortgage, I am sorry. But you do not get to keep the house. The people who (thought) they bought the mortgage in a fair deal need to end up with that mortgage.

If you pay your mortgage, you get to have the American Dream.

We CANNOT allow this debacle to continue. It will bring the system down. Who will want to buy a mortgage that is in a securitized package with no clear title? Who will get title insurance? Some judge somewhere is going to make a ruling that is going to petrify every title company, and the whole thing grinds to a halt.

Let's be very clear. If we cannot securitize mortgages, there is no mortgage market. We cannot go back to where lenders warehoused the notes. It would take a decade to build that infrastructure. In the meantime, housing prices are devastated. Whatever wealth effect remains from housing gets worse, and the economy rolls over.

This is beyond my pay grade, but there have to be some adults who can make everyone play nice in the sandbox. Ideally, someone in authority at the Treasury, with bipartisan support steps in and says everyone follow these rules, whatever these rules need to be.

I had a very spirited conversation with good friend Barry Ritholtz today (of The Big Picture). Barry runs money but is also a lawyer and has a somewhat different perspective. He thinks we do not need any legislation and there is a legal cure. He says that real trained people (lawyers and paralegals) need to look at each mortgage and figure it out, and that it can get resolved. It is expensive to the banks; but I agree, if it is just dollars I don't care. Fix it.

But that is a maybe. Other people I talk to disagree. Some think we need some regulatory fixes. Some think we will need a legislative cure. But if we need to, there need be no finger pointing, no partisan BS. This needs to get solved.

Someone took out a mortgage. Some entity thinks they are owed money. Fix the damn paper trail so that happens, whether in a legal if time-consuming manner, in a regulatory fix, or with legislation.

Now, that is not to say the people who did this stuff did not commit felonies and such. We can sort that out over time. The longer we wait the worse it will get. Fix the problem and then go round up the bad guys. There are bigger issues in play here. (I know this will be somewhat controversial. Oh well.)

I get the fraud being done here. I am regulated by FINRA, the NFA, various states, the British FSA, and ultimately the SEC. If I did something in my business like the stuff described above, someone would come in and justifiably shut me down, fine me, and ban me from the securities business. Oh, wait. These guys ARE regulated by the above groups.

Finally on this topic, I shake my head when I think that the FDIC is now running several of the banks (think IndyMac) that are part of this foreclosure crisis. These are the guys who are supposed to be preventing something like this. Again, where are the adults?
The Subprime Debacle: Act 2

OK, this letter is already getting too long. I am going to finish it next week, as the next topic needs a lengthy treatment. But I will not leave you hanging. A quick preview.

All those subprime and Alt-A mortgages written in the middle of the last decade? They were packaged and sold in securities. They have had huge losses. But those securities had representations and warranties about what was in them. And guess what, the investment banks may have stretched credibility about those warranties. There is the real probability that the investment banks that sold them are going to have to buy them back. We are talking the potential for multiple hundreds of billions of dollars in losses that will have to be eaten by the large investment banks. We will get into details, but it could create the potential for some banks to have real problems.

And all this coming as European banks are going to have to sort out their own sovereign debt problems. Shades of 2008. I hope I am wrong, but it's all connected.
Yankees, Rangers, and The Endgame

I travel on Monday to New York, where good friend Barry Habib is going to take me to the Yankees-Rangers game. I will be the guy on the second row behind home plate, behind the mayor, wearing the Rangers jacket. Barry assures me I will be safe. Cliff Lee pitching. Can the Rangers hold up to the pressure against the best there is? Stay tuned.

My book, The End Game, is coming along. It is out for comments from friends, and then I will sit down with my co-author in London for four days and we will finish this the first week of November, and then Wiley will push as fast as they can to get it out.

This has been a very tumultuous week for a host of reasons. It's all good, but exhausting. I am more than ready to hit the send button. I just turned on the TV to watch the last few innings. The Rangers have gone from up 5 to zip to losing 6-5. Can we say disheartening?

Your really wanting to see a World Series analyst,

John Mauldin
John@FrontLineThoughts.com

Copyright 2010 John Mauldin. All Rights Reserved

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Tuesday, May 10, 2011

stopped out of AGQ

Stopped out at $213, actual stop was $224 but it jumped the price"WOW"
subsquently traded down to $185 but on 5/10/11 it has traded back up to $220
now looking for a re entry point will have to research that
Can complain as a 47% gain is booked for only holding it for 6 months
Offsets the loss in nova gold resources

Still have open positions in GLD with stop at $121 and currently trading at $148 for a 10% gain
and SLV is being held for a 40% gain .


on the mutual fund front
WVALX is under performing PRPFX
2.25% to 5.14%
in the same time frame

Thursday, March 17, 2011

Montier’s “Seven Rules,”

Brett Arends' ROI

March 14, 2011, 1:00 a.m. EDT
Contrarian’s trouble with new bubble
Commentary: For one investor, it’s a question of valuing the market
By Brett Arends, MarketWatch
Hold cash, lots of it. Right now an internal fund he manages at GMO is 50% in cash, and another chunk is actually short of the market. Just 25% of the fund is net long of equities.

“I think cash has a dry-powder value that people underestimate,” Montier says. “It gives you a chance to deploy capital in tomorrow’s opportunity set, rather than assuming tomorrow’s opportunity set will be the same as today’s.”

You can almost hear the outrage in your broker’s office. “You can’t time the market!” they’ll tell you.

But this isn’t a question of “timing” the market. It’s a question of valuing the market. Stocks, after all, are just a claim on future cash flows. The more you pay, the worse the deal. The higher stocks go, the worse the long-term returns. Controversial? It’s a tautology.

Montier’s “Seven Rules,” which can be downloaded from the GMO website, make for a great read. They are the following:

1.

Always insist on a margin of safety.
2.

This time is never different.
3.

Be patient and wait for the fat pitch.
4.

Be contrarian.
5.

Risk the permanent loss of capital, never a number.
6.

Be leery of leverage.
7.

Never invest in something you don’t understand.

“They’re common sense, mostly,” according to Montier. “They’re the kind of thing your grandmother could have told you.”

But holding out against a market mania is lot easier to say than to do.

The biggest challenge most contrarians face is that of going against the crowd. It hurts, literally. Montier says scientific research has found that we feel this “social” pain “in the same part of your brain as physical pain.”

So, he says, only half-joking: “Being a contrarian is like having your arm broken, again and again.



The Seven Immutable Laws of Investing


James Montier

In my previous missive I concluded that investors should stay true to the principles that have always guided (and should always guide) sensible investment, but I left readers hanging as to what I believe those principles might actually be. So, now, for the moment of truth, I present a set of principles that together form what I call The Seven Immutable Laws of Investing.

They are as follows:

Always insist on a margin of safety
This time is never different
Be patient and wait for the fat pitch
Be contrarian
Risk is the permanent loss of capital, never a number
Be leery of leverage
Never invest in something you don’t understand
So let’s briefly examine each of them, and highlight any areas where investors’ current behavior violates one (or more) of the laws.

1. Always Insist on a Margin of Safety

Valuation is the closest thing to the law of gravity that we have in finance. It is the primary determinant of long-term returns. However, the objective of investment (in general) is not to buy at fair value, but to purchase with a margin of safety. This reflects that any estimate of fair value is just that: an estimate, not a precise figure, so the margin of safety provides a much-needed cushion against errors and misfortunes.

When investors violate Law 1 by investing with no margin of safety, they risk the prospect of the permanent impairment of capital. I’ve been waiting a decade to use Exhibit 1. It shows the performance of a $100 investment split equally among a list of stocks that Fortune Magazine put together in August 2000.

For the article, they used this lead: “Admit it, you still have nightmares about the ones that got away. The Microsofts, the Ciscos, the Intels. They're the top holdings in your ultimate ‘coulda, woulda, shoulda’ portfolio. Oh, what might have been, you tell yourself, had you ignored all the naysayers back in 1990 and plopped a modest $5,000 into, say, both Dell and EMC and then closed your eyes for the next ten years. That's $8.4 million you didn't make.

“Now, hold on a minute. This is no time for mea culpas. Okay, so you didn't buy the fastest growers of the past decade. Get over it. This is a new era – a new millennium, in fact – and the time for licking old wounds has passed. Indeed, the importance of stocks like Dell and EMC is no longer their potential as investments (which, though still lofty, is unlikely to compare with the previous decade's run). It's in their ability to teach us some valuable lessons about investing from here on out.”

Rather than sticking with these “has been” stocks, Fortune put together a list of ten stocks that they described as “Ten Stocks to Last the Decade” – a buy and forget portfolio. Well, had you bought the portfolio, you almost certainly would wish that you could forget about it. The ten stocks were Nokia, Nortel, Enron, Oracle, Broadcom, Viacom, Univision, Schwab, Morgan Stanley, and Genentech. The average P/E at purchase for this basket was well into triple figures. If you had invested $100 in an equally weighted portfolio of these stocks, 10 years later you would have had just $30 left! That, dear reader, is the permanent impairment of capital, which can result when you invest with no margin of safety.

Exhibit 1: Fortune Magazine’s Ten Stocks to Last the Decade

The securities identified above represent a selection of securities identified by GMO and are for informational purposes only. These specific securities are selected for presentation by GMO based on their underlying characteristics and are not selected solely on the basis of their investment performance. These securities are not necessarily representative of the securities purchased, sold or recommended for advisory clients, and it should not be assumed that the investment in the securities identified will be profitable. Source: Bloomberg, Datastream, GMO As of 6/30/10

Today it appears that no asset class offers a margin of safety. Cast your eyes over GMO’s current 7-Year Asset Class Forecast (Exhibit 2). On our data, nothing is even at fair value, so from an absolute perspective all asset classes are expensive! U.S. large cap equities are offering you a close to zero real return for the pleasure of parking your money in them. Small cap valuations indicate an even worse return. Even emerging market and high quality stocks don’t look cheap on an absolute basis; they are simply the best relative places to hide.

These projections are reinforced for equities when we investigate the number of stocks able to pass a deep value screen designed by Ben Graham. In order to pass this screen, stocks are required to have an earnings yield of twice the AAA bond yield, a dividend yield of at least two-thirds of the AAA bond yield, and total debt less then two-thirds of the tangible book value. I’ve added one extra criterion, which is that the stocks passing must have a Graham and Dodd P/E of less than 16.5x. As a cursory glance at Exhibit 3 reveals, there are very few deep value opportunities in global markets currently.

Bonds or cash often offer reasonable opportunities when equities look expensive but, thanks to the Fed’s policy of manipulated asset prices, these look expensive too.

Exhibit 2: GMO 7-Year Asset Class Return Forecasts* as of January 31, 2011

* The chart represents real return forecasts1 for several asset classes. These forecasts are forward-looking statements based upon the reasonable beliefs of GMO and are not a guarantee of future performance. Actual results may differ materially from the forecasts above. 1 Long-term inflation assumption: 2.5% per year. Source: GMO


Exhibit 3: % of Stocks Passing Graham’s Deep Value Screen

* With additional criterion that stocks have a Graham and Dodd P/E of less than 16.5x. Source: GMO As of 3/29/10

In order to assess the margin of safety on bonds, we need a valuation framework. I’ve always thought that, in essence, bond valuation is a rather simple process (at least at one level). I generally view bonds as having three components: the real yield, expected inflation, and an inflation risk premium.

The real yield can either be measured in the market via inflation-linked bonds, or an estimate of equilibrium (or normal) real yield can be used. The TIPS market currently offers a real yield of 1% for 10-year paper. Rather than use this, I’ve chosen to impose a “normal” real yield of around 1.5%.

To gauge expected inflation we can use surveys. For instance, the First Quarter 2011 Survey of Professional Forecasters2 shows an expected inflation rate of just below 2.5% annually over the next decade. Other surveys show little variation.

The use of surveys of forecasts might seem a little at odds with my previously expressed disdain for forecasts. But because history has taught me that the economists will be wrong on their inflation estimates, I insist on including the final element of the bond valuation: the inflation (or term) risk premium. Estimates of this risk premium range, but I suggest it should be between 50-100 bps. Given the uncertainty surrounding the use and impact of quantitative easing, I would further suggest a figure closer to the upper range of that band currently.

Adding these inputs together gives a “fair value” of somewhere between 4.5-5%. The current 3.5% yield on U.S. 10- year bonds falls a long way short of offering investors even a minimal margin of safety.

Of course, the bond bulls and economic pessimists will retort that the market is just waking up to the impending reality that the U.S. is set to follow Japan’s experience and spend a decade or two mired in a deflationary swamp. They may be correct, but we can assess the probability that the market is placing on this scenario.

In constructing a simple scenario valuation, let’s assume three possible states of the world (a gross simplification, but convenient). In the “normal” state of the world, bond yields sit close to their fair value at, say, 5%. Under a “Japanese” outcome, the yield would drop to 1%, and in a situation where the Fed loses control and inflation returns, yields rise to 7.5% (roughly speaking, a 5% inflation rate).

If we adopt an agnostic approach and say that we know nothing, then we could assign a 50% probability to the normal outcome, and 25% to each of the tails. This scenario would generate an expected yield of very close to 4.5%. We can tinker around with the probabilities in order to generate something close to the market’s current pricing. In essence, this reveals that the market is implying a 50% probability that the U.S. turns into Japan.

This seems an extremely lopsided implied probability. There are certainly similarities between the U.S. and Japan (e.g., zombie banks), but there are marked differences as well (e.g., the speed and scale of policy response, demographics). A 50% probability seems excessively confident to me.

Exhibit 4: Bond Scenario Valuation

Source: GMO

Our concerns about the overvaluation of bonds have implications for both our portfolios and for relative valuation. Obviously, you won’t find much fixed income exposure in our current asset allocation portfolios given the valuation case laid out above.

One of the “arguments” for owning equities that we regularly encounter is the idea that one should hold equities because bonds are so unattractive. I’ve described this as the ugly stepsisters’ problem because it is akin to being presented with two ugly stepsisters and being forced to date one of them. Not a choice many would relish. Personally, I’d rather wait for Cinderella to come along.

Of course, the argument to buy stocks because bonds are appalling is really just a version of the so-called Fed Model. This approach is flawed at just about every turn. It fails at the level of theoretical soundness as it compares real assets with nominal assets. It fails empirically as it simply doesn’t work when attempting to predict long-run returns (never an appealing trait in a model). Moreover, proponents of the Fed Model often fail to remember that a relative valuation approach is a spread position. That is to say that if the Model says equities are cheap relative to bonds, it doesn’t imply that one should buy equities outright, but rather that one should short bonds and go long equities. So the Model could well be saying that bonds are expensive rather than that equities are cheap! The Fed Model doesn’t work and should remain on the ash heap.

Exhibit 5: What Relationship Between Bonds and Equities?

Source: GMO As of 1/12/11

Relative valuation holds little appeal to me and even less so when I consider that neither bonds nor equities are even vaguely stable assets. In general, when valuing an asset you want a stable anchor by which to assess the scale of the investment opportunities. For instance, one of the reasons that the Graham and Dodd P/E (current price over 10-year average earnings) works well as a valuation indicator is the slow, stable growth of 10-year earnings. In contrast, the bond market was happy to extrapolate the briefest peak of inflation to over 30 years in the early 1980s, and similarly was willing to extrapolate the deflationary risks of 2009 for over 10 years. Using such an unstable asset as the basis of any valuation seems foolhardy.

I’d rather consider the absolute merits of each investment independently. Unfortunately, as noted above, this currently reveals an unpleasant truth: nothing offers a good margin of safety.

In fact, if we look at the slope of the risk return line (i.e., the 7-year forecasts measured against their volatility), we can see that investors are being paid a paltry return for taking on risk. Admittedly, Mr. Market is not yet as manic as he was in 2007 when we faced an inverted risk return trade-off – investors were willing to pay for the pleasure of holding risk – but at this rate, I believe it won’t be long before we are once again facing such a perverse situation. Albeit this time it is officially-sponsored madness!

Exhibit 6: The Slope of the Risk Return Line

Source: GMO As of February 2011

This dearth of assets offering a margin of safety raises a conundrum for the asset allocation professional: what does one do in a world where nothing is cheap? Personally, I’d seek to raise cash. This is obvious not for its thoroughly uninspiring near-zero yield, but because it acts as dry powder – a store of value to deploy when the opportunity set offered by Mr. Market once again becomes more appealing. And this is likely, as long as the emotional pendulum of investors oscillates between the depths of despair and irrational exuberance as it always has done. Of course, the timing of these swings remains as nebulous as ever.

2. This Time Is Never Different

Sir John Templeton defined “this time is different” as the four most dangerous words in investment. Whenever you hear talk of a new era, you should behave as Circe instructed Ulysses to when he and his crew approached the Sirens: have a friend tie you to a mast.

Because I have discussed the latest notion of a new era in my recent “In Defense of the ‘Old Always,’” I won’t dwell on it here. I will point out, though, that when assessing the “this time is different” story, it is important to take the widest perspective possible. For instance, if one had looked at the last 30 years, one would have concluded that house prices had never fallen in the U.S. However, a wider perspective, drawing on both the long-run data for the U.S. and the experience of other markets where house prices had soared relative to income, would have revealed that the U.S. wasn’t any different from the rest of the world, and that a house price fall was a serious risk.

3. Be Patient and Wait for the Fat Pitch

Patience is integral to any value-based approach on many levels. As Ben Graham wrote, “Undervaluations caused by neglect or prejudice may persist for an inconveniently long time, and the same applies to inflated prices caused by over-enthusiasm or artificial stimulants.” (And there can be little doubt that Mr. Market’s love affair with equities is based on anything other than artificial stimulants!)

However, patience is in rare supply. As Keynes noted long ago, “Compared with their predecessors, modern investors concentrate too much on annual, quarterly, or even monthly valuations of what they hold, and on capital appreciation… and too little on immediate yield … and intrinsic worth.” If we replace Keynes’s “quarterly” and “monthly” with “daily” and “minute-by-minute,” then we have today’s world.

Patience is also required when investors are faced with an unappealing opportunity set. Many investors seem to suffer from an “action bias” – a desire to do something. However, when there is nothing to do, the best plan is usually to do nothing. Stand at the plate and wait for the fat pitch.

4. Be Contrarian

Keynes also said that “The central principle of investment is to go contrary to the general opinion, on the grounds that if everyone agreed about its merit, the investment is inevitably too dear and therefore unattractive.”

Adhering to a value approach will tend to lead you to be a contrarian naturally, as you will be buying when others are selling and assets are cheap, and selling when others are buying and assets are expensive.

Humans are prone to herd because it is always warmer and safer in the middle of the herd. Indeed, our brains are wired to make us social animals. We feel the pain of social exclusion in the same parts of the brain where we feel real physical pain. So being a contrarian is a little bit like having your arm broken on a regular basis.

Currently, there is an overwhelming consensus in favor of equities and against cash (see Exhibit 7). Perhaps this is just a “rational” response to Fed policies that actively encourage gross speculation.

William McChesney Martin, Jr. observed long ago that it is usually the central bank’s role to “take away the punch bowl just when the party starts getting interesting.” The actions of today’s Fed are surely more akin to spiking the punch and encouraging investors to view the markets through beer goggles. I can’t believe that valuation-indifferent speculation will end in anything but tears and a massive hangover for those who insist on returning again and again to the punch bowl.

5. Risk Is the Permanent Loss of Capital, Never a Number

I have written on this subject many times.4 In essence, and regrettably, the obsession with the quantification of risk (beta, standard deviation, VaR) has replaced a more fundamental, intuitive, and important approach to the subject. Risk clearly isn’t a number. It is a multifaceted concept, and it is foolhardy to try to reduce it to a single figure.

To my mind, the permanent impairment of capital can arise from three sources: 1) valuation risk – you pay too much for an asset; 2) fundamental risk – there are underlying problems with the asset that you are buying (aka value traps); and 3) financing risk – leverage.

By concentrating on these aspects of risk, I suspect that investors would be considerably better served in avoiding the permanent impairment of their capital.

6. Be Leery of Leverage

Leverage is a dangerous beast. It can’t ever turn a bad investment good, but it can turn a good investment bad. Simply piling leverage onto an investment with a small return doesn’t transform it into a good idea. Leverage has a darker side from a value perspective as well: it has the potential to turn a good investment into a bad one! Leverage can limit your staying power and transform a temporary impairment (i.e., price volatility) into a permanent impairment of capital.

Exhibit 7: BoAML Fund Manager Survey (Equities and Cash)


While on the subject of leverage, I should note the way in which so-called financial innovation is more often than not just thinly veiled leverage. As J.K. Galbraith put it, “The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version.” Anyone with familiarity of the junk bond debacle of the late 80s/early 90s couldn’t have helped but see the striking parallels with the mortgage alchemy of recent years! Whenever you see a financial product or strategy with its foundations in leverage, your first reaction should be skepticism, not delight.

7. Never Invest in Something You Don’t Understand

This seems to be just good old, plain common sense. If something seems too good to be true, it probably is. The financial industry has perfected the art of turning the simple into the complex, and in doing so managed to extract fees for itself! If you can’t see through the investment concept and get to the heart of the process, then you probably shouldn’t be investing in it.

Conclusion

I hope these seven immutable laws help you to avoid some of the worst mistakes, which, when made, tend to lead investors down the path of the permanent impairment of capital. Right now, I believe the laws argue for caution: the absence of attractively priced assets with good margins of safety should lead investors to raise cash. However, currently it appears as if investors are following Chuck Prince’s game plan that “as long as the music is playing, you’ve got to get up and dance.”

Wednesday, March 16, 2011

Japan, Inc. on Sale - At Double-Discounts/How to Play Post-Disaster Currency Moves in Japa

Big and (Mostly) Unloved

Most of these companies, which are among the biggest in Japan, have been out of favor with investors over the past five years

Recent % Change
Company/Ticker Price YTD* 5 Yrs*
Toyota/TM $82.06 4.36% -24.16%
Mitsubishi UFJ Financial/MTU 4.66 -13.86 -67.73
NTT DoCoMo/DCM 17.89 2.70 18.95
Hitachi/HIT 50.75 -4.87 -27.23
Honda Motor/HMC 38.86 -1.62 27.66
Canon/CAJ 43.85 -14.59 2.37
Nippon Telegraph & Telephone/NTT 22.69 -1.09 0.31
Sumitomo Mitsui Financial/SMFG 6.45 -9.28 -68.99
Mitsubishi/MSBHY 51.90 -3.08 16.50
Nissan Motor/NSANY 18.31 -3.43 -21.48
Tokyo Electric Power/9501.Japan ¥798 -59.76 -74.29
Takeda Pharmaceutical/4502.Japan 3725 -6.76 -45.38
Nintendo/NTDOY $33.33 -8.26 81.14
Mizuho Financial/8411.Japan ¥135 -11.76 -85.29
Sony /SNE $31.40 -12.07 -32.89
Japan Tobacco /2914.Japan ¥320500 6.66 -25.12
Mitsui & Co/8031.Japan 1340 -0.07 -14.32
Panasonic/PC $11.86 -15.89 -46.33
East Japan Railway/9020.Japan ¥4405 -16.57 -48.96
KDDI/9433.Japan 504000 7.46 -16.00
Seven & I Holdings/3382.Japan 1973 -9.08 -55.16
Tokio Marine/TKOMY $27.50 -7.09 -29.78
Shin-Etsu Chemical/4063.Japan ¥3660 -16.82 -40.58
Nippon Steel/5401.Japan 243 -16.78 -46.94
Kansai Electric Power/9503.Japan 1994 -0.50 -27.75
JFE Holdings/5411.Japan 2170 -23.27 -50.68
*Through March 17. In local currencies. Source: Bloomberg

In the short run, Japan's economy seems sure to slow down. Indeed, this year it could shrink, versus the BOJ's pre-earthquake forecast of a 1.6% increase in real economic output. Nomura Securities last week cut its forecast to 1.1% from 1.5%. Namie Koyanaka, chief of Tokyo Financial Research Co., publishes a weekly report compiled by prominent Japanese economists and former policy makers. In the immediate aftermath of the catastrophe, the group wrote that it expected 3% economic growth for the year. Later in the week, Koyanaka acknowledged, "We have to extend the period" forecast for the rebound. "Two to three quarters ahead, Japan will start recovering," she continued. "But it's difficult to say how long the panic will last."

Over the longer term, the disaster could actually add to economic growth as Japan spends money to rebuild the devastated areas, which account for 7% of Japan's economy and a large part of its land mass. Mohamed El-Erian, chief executive of Pimco, sees the catastrophe possibly causing Japan's economy to contract this year. "If we don't have a full bounce in electricity generation this year, there's a possibility they don't print a positive number," he says

View Full Image
Japan_Familyjp
EPA/Asahi Shimbun/Landov

Earthquake/tsunami aftermath.
Japan_Familyjp
Japan_Familyjp

. "But they will print a very large number in 2012, something like 5% to 8%."

Some of Japan's most attractive stocks are those of world-class export companies. Many had facilities near Sendai, but their huge international business makes them less dependent on Japan itself. Sony for example trades at 0.87 times book value. (It should be noted that many Japanese companies' return on equity is relatively low, reducing their price-to-book value.) Canon had factories that reported damage and suspended production as a result of power failures. Down 14.6% so far this year, Canon trades at 1.64 times book and 14 times earnings.

Both Toyota Motor and Nissan had facilities and suppliers in the region that will be affected by rolling blackouts. Nissan sells for 1.1 times book and 8.4 times earnings. Toyota, which has had its own problems, sells for book value and 14.3 times earnings.

Among those likely to benefit from the reconstruction are the steel giants. JFE Holdings, down 23.3% this year, trades at 0.83 times book.

View Full Image
Japan_Rescuejp
JIJI PRESS/AFP Newscom

Rescue workers
Japan_Rescuejp
Japan_Rescuejp

The slowdown will hit the top line for companies, though the picture is still blurred. Analysts tweaked forecasts lower last week. Before the disaster, earnings revisions were on the rise, suggesting companies were weathering the strong yen and had rebounded from the 2009 recession. For the four quarters ended December, Japan's Finance Ministry reported, corporate pretax profits rose 27% as sales climbed 4.1%. At the start of this week, Morgan Stanley MUFG was forecasting 18.5% corporate earnings growth for 2011 and 22.4% growth for 2012. Apply a haircut of 25%–the amount some economists are pruning from their GDP forecasts–and you get still-respectable growth of 13.9% and 16.8%.

Japan, Inc. on Sale - At Double-Discounts
11 comments | by: Joseph L. Shaefer March 15, 2011 | about: JEQ, JOF
There is no guarantee that frightened investors won’t continue to sell off Japanese companies. That's one reason not to buy Japanese firms right now. And there are two additional reasons.

First, their extraordinary expenses are unknown at this point. One company may have had insurance from various carriers that will cover 80% of their losses from lost revenue and the costs of rebuilding. Another may be 100% self-insured and will take a larger hit to their earnings.

Second, we don’t know what revenue they will lose to competitors in other nations who will now benefit from this calamity by rushing to replace Japanese suppliers in the global markets. Already we see a number of other nations’ semiconductor companies moving up as the Japanese semiconductor industry has been particularly hard hit by the earthquake, the tsunami and the environmental hazards that make customers question the quality of the product they can produce in the short term.

So – we have a potential triple whammy: investor caution, which may keep the stock prices of Japanese companies down no matter what the actual companies do; lost revenue and great expense to rebuild what has been destroyed; and the displacement effect that comes when a supplier is seen as a possibly less secure source of product.

On the other hand… Japan will rebuild. From the rubble of WWII, the country rebuilt. From previous natural calamities, Japan rebuilt. Even from the devastating Kobe earthquake of 1995, the country rebuilt. As it does, its factories will be newer, processes more technologically advanced, and even its nuclear reactors – assuming common sense and public opinion agree – will be of the newer designs that, for instance, use gravity to bring water down over the fuel rods rather than the obviously troublesome current system of using ground-level pumps to push water up.

Those who take the long view, and who understand that any of the three factors above could bring share prices below that which they pay today, are also those who may benefit from purchasing Japan, Inc. at a discount. Shares are down. But there is a greater discount at play here, as well. Two closed-end mutual funds that buy Japanese companies are selling at discounts of 9% and 4%, as well. If you were to buy these closed-ends, you would be receiving a slightly larger dividend flow than you would by buying the companies directly. You’d also be buying a dollar worth of assets for 91 cents or 96 cents.

The first of these is the Japan Equity Fund (JEQ). Its Top 10 holdings are:

Mitsubishi UFJ Financial Group (MTU)

Toyota Motor Corporation ADR (TM)

Honda Motor Company ADR (HMC)

Mitsubishi (MSBHY.PK)

Mitsui Fudosan Co. (MTSFF.PK)

Nippon Telegraph and Telephone (NTT)

Tokio Marine Holdings (TKOMY.PK)

East Japan Railway Co. (EJPRY.PK)

Asahi Glass (ASGLY.PK)

Sumitomo Electric Industries (SMTOY.PK), and

JX Holdings (JXHLY.PK)

Tokio Marine and East Japan Railway may be hit harder than many others but my guess is that they have lain off much of the risk, the former via a consortium of reinsurers, the latter with insurance. What strikes me about all 10 of these companies, and the others in JEQ’s portfolio, is that they have been hit hard – but they also form the backbone of precisely the kind of companies that will provide the capital, the expertise, the tools, the materials and the heavy machinery to rebuild a shattered nation. Short term, they are being savaged. But is short term this week? This month? My belief is that the Japanese people will roll up their sleeves and get to work, just as they did in Chile when their horrible earthquake struck, and in New Zealand when their most recent quake almost leveled the beautiful town of Christchurch.

The second possibility is the Japan Smaller Capitalization Fund (JOF). As the name implies, these are smaller cap firms that are typically market leaders in certain niches. The Top 10 Holdings are not exactly household names in the US: Otsuka Corporation, Itochu Corporation (ITOCY.PK), Hitachi Chemical, Park24 Co., Yaskawa Electric Corp. (YASKF.PK), ABC-Mart, Inc., Nihon Kohden Sekisui Chemical Co., Don Quijote Co Ltd (DQJCY.PK), and Misumi Group.

Because they are not well-known names here, allow me to provide the top categories of the sectors in which they operate, directly from the website of the fund sponsor, Nomura Asset Management:

Industry Diversification


% of
Net Assets

Services


13.0

Miscellaneous Manufacturing


10.4

Information and Software


10.2

Chemicals and Pharmaceuticals


9.9

Electronics


9.4

Retail


8.6

Automotive Equipment and Parts


6.4

Banks and Finance


6.1

Machinery and Machine Tools


5.1

Real Estate and Warehouse


5.0

I hasten to add that the idea of purchasing Japanese companies now is replete with possible risk. Please see the “triple whammy” comments above! But where there is risk, there may also be opportunity for the bold. It seems to me there will be an awful lot of automobiles replaced in the coming weeks and months, a lot of steel buildings re-built, essential services restored, electronics at both the consumer and business level replaced, chemicals needed for cleanup and sanitization, and loans from banks to finance it all. Take another look at the list immediately above.

If your due diligence leads you to the same conclusions I have reached, that the Japanese people will rebuild and that they will “Buy Japanese” as they do so, then these and other quality closed-end funds may be a great tool to allow you to invest alongside them.

Disclosure: We have recently begun to purchase JEQ and JOF. We are buying more today and will continue to do so if/as they decline to even more attractive prices.


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How to Play Post-Disaster Currency Moves in Japan
8 comments | by: Keith Fitz-Gerald March 16, 2011 | about: EWJ, UDN, UUP, YCS

According to Biriniyi Associates, investors threw more than $1 billion into Japanese ETFs last month -- second only to U.S. energy funds and more than agriculture, large-caps and mid-cap stocks combined.

They couldn't have placed their bets at a worse time.

Amidst fears of multiple nuclear meltdowns, the benchmark Nikkei 225 Index plunged 10.55% yesterday (Tuesday) after a 6.2% decline on Monday -- a two-day decline of 17% since Friday's devastating 9.0-level earthquake and tsunami. More than $650 billion in shareholder wealth has been vaporized.

As a veteran trader and longtime expert on Asia, it's a story that I've heard countless times: Japan was supposed to regain what it once had -- a vibrant economy that helped lead the world in the years following World War II, and that finally achieved global dominance in the late 1980s.

Somehow, though, that never happened. But it didn't discourage the believers.

Three Views of the Rebound That Never Came

On Thursday, the day before the Sendai earthquake and tsunami, the Nikkei closed at 10,434.38. That means the index is down 73% from its record intra-day high of 38,957.44, reached Dec. 29, 1989 -- just before Japan's so-called "Lost Decade" began in earnest. (Sadly, that term should be listed in the plural -- as in "Decades," with an "s" -- given the perpetual malaise that has defined Japan's economy ever since.)

For some strategists and traders, the expected Japanese rebound was all about currencies and exports. Members of this group believed a weakening Japanese yen and China's growth would transform Japan into an exporting giant. In this role, Japan would become the supplier of choice to the newly emerging economies of the Asia region, the key one being China.

Those subscribing to this argument believed one of two scenarios would make this happen. Either the U.S. dollar was going to strengthen against the yen, or the Bank of Japan (BOJ) was going to begin printing money, which would drive the yen lower against the dollar.

A second group of believers based their expectations of a Japanese economic renaissance on mathematical probabilities and financial valuation. Japan, this group believed, was undervalued, and in a big way. The U.S. Standard & Poor's 500 Index had shot up 91% from its March 2009 bear-market lows, while the Nikkei managed to tack on only 47% through the same period (through last Thursday, the day before the earthquake). Therefore, the odds favored a continued rebound in Japan's shares, this group reasoned.

A third group of believers subscribed to what I like to call (for lack of a better term) the "coattail theory." Somehow, this island nation that is the world's No. 3 economy would finally pull itself up by the bootstraps of the global inflation that reflates all economies. This is nothing more than a variation of the "rising-tide-lifts-all-boats" theory.

My outlook for Japan has been the same for several years now, and wasn't dramatically changed by the events of last week: The country's huge debt load -- as much as 259% of GDP, depending on which statistics you believe -- will act as an anchor on its economy, meaning there are better (and less risky) places to put your money.

Absent the earthquake tragedy, Japan's economy might have managed to sputter along at 1% per year. But now, following the unprecedented $186 billion post-quake infusion by the BOJ, the country's debt load is obviously headed much higher -- and that puts both Japan's growth and its yen at real risk.

In my mind, there's no question that Japan will rebuild and its people will recover. But we can't say the same about the country's currency.

A False Rally

Many people won't agree with my analysis, especially since the yen immediately rallied to 80.60 per dollar following the earthquake -- an exchange rate that's only a stone's throw from the yen's all-time-record high of 79.75 versus the dollar, a level reached just after the Kobe earthquake (also known as the Great Hanshin earthquake) of 1995 following that earth-shaker. So this pattern is very familiar to currency traders who are definitely feeling a sense of déjà vu.

The immediately stronger yen is due partly to the expectation that Japanese companies will repatriate assets as part of the rebuilding process. It's also due to global traders adhering to the script that they always follow in the aftermath of any natural disaster or geopolitical upheaval by dumping their riskiest holdings.

Neither catalyst will last. I say this because the last thing Japan needs right now is an abnormally strong yen. Not only does this hurt the exports upon which 14% of Japan's $3.59 trillion economy is based (because it makes them more expensive for the rest of the world), but a more-expensive yen could cripple the domestic recovery efforts that will be so critical in the months to come.

That's why many experienced traders (myself included) expect the BOJ to intervene further in a yen-selling maneuver that will help shore up the Nikkei Index and free up liquidity for the country's industrial base, which is understandably traumatized by all that's happened since Friday's earthquake.

In other words, Monday's aforementioned infusion -- a policy-level response by the BOJ that was unprecedented in its quickness -- was just the start. Indeed, my sources in Tokyo's financial district told me early yesterday that the BOJ was meeting again to consider further measures -- something the media finally confirmed later in the day.

But let me caution you: This is not a trade for nervous money, or for the faint of heart. No global event ever is. The Bank of Japan has held interest rates near zero for years in a misguided attempt to jumpstart that nation's economy, so the only weapon left in its arsenal is currency manipulation. That reality makes what's happening in Japan's markets right now especially dangerous and potentially volatile, too.

Moves to Make

I fully expect short-term momentum traders who are driven by memories of the Kobe quake to make a run at 80 yen to the dollar, which would force Japan's central bank into an additional round of massive intervention.

Longer-term, though, I expect reality to settle in as global traders -- the vast majority of whom are already circling like sharks -- are drawn into the fray by weaker earnings and by what could be crippled national industries, especially if there is a serious radiation leak. That may sound opportunistic, or even callous. But that's the reality of the global capital marketplace.

Here are three ways to play the scenarios that I've outlined here:

* Short Term: Short the yen and buy the dollar. Be careful, though. There are lots of shorts to get cleared out around 80 yen to the dollar before this trade gathers momentum -- and it will take true nerves of steel to stare down the Bank of Japan.
* Medium term: Buy ProShares UltraShort Yen Exchange-Traded Fund (YCS). The 20% run-up experienced after the Kobe quake was very quick, and it's taken 15 years for the yen to revert to these levels. But that's true with so-called "blow-off" moves, in that they frequently are event-driven. This time around we'll probably see a similar pattern play out, albeit one that unfolds at a much faster pace because global financial markets are much more closely integrated now than they were 16 years ago.
* Long term: Short Japanese stocks. To do this, use something like the iShares MSCI Japan Index ETF (EWJ), or "put" options on EWJ, as your vehicle. It will take weeks, or even months, for analysts to factor in the true economic impact of the continuing catastrophe, and there are undoubtedly going to be downgrades along the way. Anybody caught holding Japanese equities in 1995 got smacked around for a year. And this time around the damage will be much

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Published March 22, 2011 | A A A
Screens by Jack Hough (Author Archive)
3 Japanese Stocks Priced to Buy

If there's a case to be made for investing in Japanese stocks it has little to do with sympathy, the recent earthquake or the relationship between prices and earnings. Compassion is better expressed with a call to the Red Cross than to Charles Schwab ( SCH ) . A 12% decline for the Nikkei 225 since the March 11 earthquake is small edamame for an index that topped 38,000 when the first George Bush was president and trades near 9,200 today. And Japan's average price/earnings ratio of about 14 based on projected 2011 earnings puts it on par with, rather than at a discount to, the U.S.

There's a key difference between the two markets, however. Following two years of American companies slashing costs and unloading idle assets, the country's corporate profits have reached record levels relative to the size of the economy. Japan's large firms have been slow to reduce bloat, so margins there remain well below average. To say that shares are similarly priced in the two countries based on earnings is to compare America at peak corporate performance with Japan in what might be its trough.

More Stock Screens from Jack Hough:

* 3 Stocks With Big Dividend Bumps
* Bargain Stocks for Impatient Investors
* 3 Stocks Riding Crude Prices Higher

One promising sign for Japan is that measures like profit margins and returns on assets tend to revert to industry averages over long time periods, as top performers face new competition and underperformers figure out ways to improve. Today, then, a more telling measure might be the ratio of share prices to the book value of company assets, which stands at about 1.1 in Japan, versus greater than 2 in America. Assuming Japan's companies have plenty of room to boost profits and America's have little, Japan's asset discount might signal a buying opportunity, especially among companies whose returns on assets are already improving.

Below are listed three Japanese firms that trade in the U.S., sell for close to their book values, have improving returns on assets and pay dividends.

Sony
Price/book: 0.9
Return on assets (5-year average): 0.9% (0.7%)
Dividend yield: 0.9%

Sony ( SNE: 32.28, -0.14, -0.43% ) has a hand in televisions, cameras, movie and music production, video games, banking and much else. Its stock sells for about what it fetched in 1996, when DVDs were just catching on. Efforts by chief executive Howard Stringer, installed in 2005, to cut costs were eclipsed by the recent recession, which shrank sales and led to losses. Sony has returned to profitability over the past year and according to Jay Defibaugh, who covers the stock for MF Global, it's now ready to shift its focus to new products, including a new handheld gaming device and a line of tablet computers. Other possibilities for improvement, according to Defibaugh, include the unwinding of non-core businesses like insurance and banking and the launch of a new business model for the struggling television division that uses Sony's video, games and music catalog to create a hardware-and-service offering.

Kyocera
Price/book: 1.1
Return on assets (5-year average): 6.7% (3.9%)
Dividend yield: 2.1%

Kyocera ( KYO: 96.60, -3.36, -3.36% ) makes products as different from each other as kitchen knives and dental implants. Most of its income comes from industrial ceramics, electronics components and telecom and networking equipment. Sales in recent quarters have increased by one-third on strong demand for consumer electronics, industrial equipment, cars and solar panels. According to Masaru Koshita of Barclay's Capital, who lifted his opinion of the shares to "overweight" from "equal weight" in early March, margins have greatly improved in the company's core businesses with the notable exceptions of telecom equipment and MLCCs, or multi-layer ceramic capacitors. Koshita expects a return to profitability by year's end in the former business and a restructuring of the latter, both of which could give the stock a lift.

Bridgestone
Price/book: 1.2
Return on assets (5-year average): 3.8% (2.4%)
Dividend yield: 1.1%

Bridgestone ( BRDCY ) sounds American but was founded in 1931 in Japan by Shojiro Ishibashi, whose last name translates to "stone bridge." The company makes most of its money from tires but is also known for golf balls and is dabbling in electronic paper (think Kindle, but flexible and in color). Stronger sales of cars returned Bridgestone to profitability last year, despite higher materials costs and a stronger yen, which makes Japanese exports more expensive to foreign buyers. For 2011, management projects an 11% rise in sales but a 17% decline in profits due to continued increases in material costs. Its profit estimate of 82 billion yen (about $1 billion) forecasts a net margin of just 2.6%, down from 3.5% last year. Shares sell for about 17 times that meager profit but less than eight times what the company earned back in 2005, when sales were stronger and commodity prices stable.

Read more: 3 Japanese Stocks to Buy - SmartMoney.com http://www.smartmoney.com/investing/stocks/3-japanese-stocks-to-buy-1300763435529/#ixzz1HNyTM7ot

Monday, March 14, 2011

Using REITs to Generate Monthly Income With Little Downside Risk/10 REITs Trading Near Their 52-Week Low

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Using REITs to Generate Monthly Income With Little Downside Risk
4 comments | by: Matt D'Alto March 14, 2011 | about: ICF / IYR / KBWY / REK

In our current world of sub-1% interest-bearing money market accounts, I find myself increasingly looking for "creative" ways to boost the yield of my investable cash these days. The problem is, shorter-term bonds are generally of little help to this objective. You need to go out to at least 10-year paper today for the incremental yield to matter, and that kind of duration risk right now just doesn't seem palatable to me given I have trouble seeing the future one-year out, much less 10 years. Treasuries and corporate bonds, especially those with longer-term maturities, broadly seem somewhat overpriced to me in the shorter-term and make me nervous about investing new capital at current levels.

Certainly this thirst for yield has created some of the recent demand for higher-yielding equities. Many of higher-yield alternatives, such as REITs, have attracted investors and thus have seen yields come down over the past 18 months or so. Still, the yield spread on a typical REIT relative to a money fund remains meaningfully wide.

For the most part, I have been unwilling to be long REITs because of some of the risks I still foresee in the real estate market, which I believe the market has largely ignored because of the Federal Reserve's current easy-money policy. But until Helicopter Ben decides it is time to tighten policy, the downside risks will continue to be masked.

Even with the risk of rising rates sometime in the future, I believe I have devised a relatively low-risk strategy for investing in REITs that will allow investors to take advantage of their current higher-yielding cash flow characteristics, while protecting your downside investment risk in the event of a correction in REIT prices. And you do not need a lot of capital or knowledge about individual REITs to execute this strategy.

Review of PowerShares KBW Premium Yield Equity REIT Portfolio (KBWY)

In recent months, Keefe, Bruyette & Woods and Invesco PowerShares have partnered and come to market with a new ETF called the PowerShares KBW Premium Yield Equity REIT Portfolio (KBWY). What makes this particular REIT ETF unique is that it is the only REIT ETF (at least that I am aware of) that pays its dividends on a monthly rather than a quarterly or semi-annual basis. To some, this may not be that big a deal, but personally I like the idea of earning a more frequent income stream wherever possible (something about present value that I learned in business school).

According to the KBWY prospectus,

The Fund will normally invest at least 80% of its total assets in equity securities of real estate investment trusts.

Thus, while the fund currently holds a mix of 30 smaller-cap REIT names and is not forced to be a market-cap weighted REIT index, the fund should nevertheless be relatively highly correlated with the performance of most major cap-weighted REIT indexes over time.

Based on its last monthly dividend, the annualized dividend yield of KBWY is 4.96%. This yield compares favorably with those of other popular cap-weighted REIT ETFs like the Cohen & Steers Realty Majors Index Fund (ICF), whose distribution yield is currently 3.37%, or the Dow Jones U.S. Real Estate Index Fund (IYR) whose comparable yield is 4.39%. To reiterate, both of the latter ETFs pay distributions only on a quarterly basis, making KBWY a potentially more attractive alternative investment from a cash-flow standpoint.

To be fair, the potential risk to investing in KBWY (other than the risk of investing in REITs generally) is that it is still a very new and fairly illiquid ETF. Since the beginning of 2011, this ETF has traded about 4,700 shares per day. So this ETF obviously will not be a viable alternative for traders with significant capital to put to work. But smaller investors, for example, only need to buy 200 shares of KBWY to make a $5,000 investment, given its current market price over $25/share.

I would also expect the liquidity of this product to grow with time, since it has only been a public offering since late 2010. The KBW name brand and distribution muscle behind it also gives me confidence in the product's longer-term liquidity growth and viability.

Hedge KBWY with REK

As I mentioned before, my objective is to capture the monthly cash flow stream from this REIT investment, not to bet on the upside of REITs as an asset class.

To accomplish this objective, I would pair up a long of KBWY with a long of the ProShares Short Real Estate ETF (REK). This fund's objective is to seek returns inversely correlated with the Dow Jones U.S. Real Estate Index, which is a market-cap weighted REIT index. Note that REK is not a leveraged ultra-short fund – it is "only" 100% inversely correlated, which is perfect for this essentially market-neutral income strategy.

Why go long REK, and not just pair up with a short of another REIT ETF instead? Well, you could do that. The problem with shorting any REIT ETF, however, is that you have to "pay" the fund's quarterly dividend if you are short on the ex-dividend date of that ETF. You could try to time this by getting in and out of your short before the ex-dividend date, but the commission costs of doing so may defeat the objective here, which is to earn a higher and more frequent yield on your cash. By simply going long REK, you gain an inversely-correlated hedge to your KBWY position.

In addition, REK has not had any recent distribution events associated with it, so again it protects the downside of your REIT investment, but doesn't offset any of the monthly income stream associated with being long KBWY. Finally, using a "long-long" strategy allows you to execute this pair trade in an IRA, where your monthly income can be earned on a tax-deferred basis (remember, you cannot short any securities in an IRA due to regulations against borrowing in such accounts).

Another alternative to REK is to go long a traditional open-end mutual fund called The Short Real Estate ProFund (SRPIX). This fund should largely mirror the performance of REK. The benefit to choosing SRPIX over REK is that you can buy SRPIX commission-free through many broker mutual fund distribution platforms (like Schwab OneSource). REK, however, would provide you with greater control over taking advantage of intra-day price volatility, as SRPIX is priced only once a day, at the close of the market. Either way, it's really just a question of personal preference.

Ideally, this hedged income strategy would be even better if either KBWY or REK traded options. In this way, you could enhance your income stream by writing call options against your long positions (to learn more about covered call writing, see my blog entry on the basics of this option strategy). Unfortunately, neither ETF offers option trading at this point in time.

This strategy isn't for everyone, and it doesn't provide a perfect hedge against a downturn in REITs since the holdings in KBWY and REK are not identical. But the two securities should be oppositely correlated enough to be roughly REIT-market neutral; and in the meantime, you can collect a monthly cash flow stream that currently is at least 400 basis points higher than what you can earn in your money market fund.

If any of my followers or readers have feedback or alternatives to the strategies listed above (particularly related to optionable ETFs for such a strategy), please write in your comments below – I'd love to hear them!

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in KBWY, REK over the next 72 hours.


10 REITs Trading Near Their 52-Week Low by: Alex B. Gray March 16, 2011 | about: AAT, CDR, CSA, FUR, HPP, MSW, NLP, SBRA, TCI, TRNO Font Size: PrintEmail Recommend 0 Share this page
Share0 When the U.S. stock market collapsed in the spring of 2009, REITs where hit very hard as real estate prices and occupancy rates suffered. Most REITs have recovered a good portion of their losses and the REIT indexes have performed well since those dark days. However, there are some REITs that have struggled to get back on their feet. In most cases, there is a very good reason for a stock to trade at the low end of its range so a detailed analysis would be necessary before any commitment of capital. However, occasionally these stocks can be a good hunting ground for value or a place to find a stock that is in transition and poised for a turnaround. Below are ten REITs that are trading near their 52-week lows.

Winthrop Realty Trust (FUR) operates as a real estate investment trust through the ownership of real property, loans secured by real property, the debt and equity of other real estate related companies and joint venture investments. Due to the nature of the their business, the company's holdings are very diverse and do not represent a specific real estate sector or geographic location. The company recently reported that earnings for 2010 were $16.2 million versus a net loss of $84.5 million in 2009. Funds from operations for 2010 were $32.4 million versus a negative $70.4 million in 2009. The trust also declared a quarterly dividend of $0.1625 per share payable April 15, 2011.

The 52-week range is $10.10 - $14.59 and the stock is currently trading at $11.48.

American Assets Trust, Inc. (AAT) primarily owns, operates and develops retail and office properties in California and Hawaii. The trust also has interest in apartments and one 369-room hotel. The trust just went public earlier this year at $20.50 per share and declared its initial dividend on March 4 of $0.17 per share. The company has not reported operating results since becoming a publicly traded trust, but the Form S-11showed the trust returned to profitability in 2009 after losses in 2008 and 2007.

The 52-week range is $20.45 - $22.00 and the stock is currently trading at $20.95.

Terreno Realty Corporation (TRNO) is focused on acquiring, owning and operating industrial real estate in the U.S. coastal markets of Los Angeles, Northern New Jersey/New York, San Francisco, Seattle, Miami and Washington D.C./Baltimore. Terreno went public as a blind-pool and has been acquiring properties since its offering in early 2010. Since the trust started as a blind-pool just a year ago, it was difficult to measure financial performance for 2010. Numbers reported over the next couple of quarters should prove to be more relevant. The trust did initiate its quarterly dividend at $0.10 per share and it will be payable April 19, 2011 to stockholders of record on April 5.

The 52-week range is $16.56 - $20.56 and the stock is currently trading at $16.90.

Sabra Healthcare REIT, Inc. (SBRA) owns and invests in real estate serving the healthcare industry. Most of the trust's current portfolio is skilled nursing facilities and assisted living facilities. The trust was the result of a spin-off from Sun Healthcare Group, Inc. (SUNH) in late 2010. The trust did announce that funds from operations from November 15 - December 31, 2010 were $0.12 per diluted share and earnings broke even for the period. The trust anticipates paying its initial dividend in 2011.

The 52-week range is $16.18 - $31.02 and the stock is currently trading at $17.58.

Hudson Pacific Properties, Inc. (HPP) acquires, owns and operates primarily high-end office properties in Northern and Southern California. The trust also owns two entertainment studios in Hollywood, California. The company just reported that funds from operations increased to $5.1 million in the fourth quarter of 2010 compared to $4.4 million in 2009. The company also increased its 2011 guidance for funds from operations from $0.82 - $0.86 to $1.01 - $1.06. In addition the company increased its dividend 31.6% in the first quarter of 2011 to $0.125 per share.

The 52-week range is $14.06 - $17.85 and the stock is currently trading at $14.13.

Cedar Shopping Centers, Inc (CDR) owns, develops, acquires and manages supermarket-anchored shopping centers and drug store-anchored convenience centers in the states of Connecticut, Maryland, Massachusetts, Michigan, New Jersey, New York, Ohio, Pennsylvania and Virginia. The trust announced funds from operations was $38.6 million for 2010 which was $16.3 million lower than 2009. The trust paid a dividend of $0.09 per share on February 22, 2011.

The 52-week range is $4.91 - $8.39 and the stock is currently trading at $5.38.

Cogdell Spencer, Inc. (CSA) owns, develops and manages medical office facilities in twelve states throughout the United States. The trust reported earlier this month that 2010 funds from operations excluding non-recurring events and impairment charges was essentially flat year over year at $28.5 million. The trust recently declared a quarterly dividend of $0.10 per share.

The 52-week range is $5.67 - $8.52 and the stock is currently trading at $5.73.

Transcontinental Realty Investors, Inc. (TCI) acquires, finances and operates real estate properties across the United States with a focus on acquiring undervalued properties. The company owns primarily apartment communities, office building and various other commercial properties. Most of these properties are currently located in Texas with a concentration in the Dallas-Fort Worth and Houston areas. The day-to-day management of the trust has been assigned to Prime Income Asset Management, LLC. The trust has not reported full year results for 2010, but third quarter results showed a net loss from continuing operations of $11 million compared to a loss of $13 million for the same period in 2009. The trust currently does not pay a dividend.

The 52-week range is $3.26 - $13.13 and the stock is currently trading at $3.85.

NTS Realty Holdings Limited (NLP) owns and operates apartment communities, residential communities and commercial properties. The trust's residential properties are primarily located in Indiana, Kentucky, Tennessee, Florida and Virginia. The commercial properties primarily consist of office buildings and are primarily located in the Louisville, Kentucky area. The company has yet to report earnings all of 2010, but did show a net loss of nearly $3 million for the third quarter which was essentially flat compared to the same period in 2009. The company recently declared a quarterly distribution of $0.05 per unit.

The 52-week range is $3.20 - $5.52 and the stock is currently trading at $3.40.

Mission West Properties, Inc. (MSW) is engaged in the acquisition, development and management of primarily research and development related properties in the Silicon Valley of California. The trust recently announced that funds from operations for the full year of 2010 decreased to $56 million from $60.5 million in 2009. The company paid a quarterly dividend of $0.15 per share to stockholders on January 6, 2011. This equates to a yield of over 9.2%.

The 52-week range is $6.45 - $7.74 and the stock is currently trading at $6.49.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Friday, February 25, 2011

Investing Like Buffett: 5 Ways to Achieve Legendary Returns

Investing Like Buffett: 5 Ways to Achieve Legendary Returns
32 comments | by: Follow My Alpha February 22, 2011

People are always interested to hear what Warren Buffett has to say about the current state of the economy, but what everyone actually cares about is how he continues to achieve such amazing returns after all this time. Of course he’s always willing to impart pieces of his wisdom to the public, but sometimes they sound like cryptic messages from the future, while others are crystal clear to understand. Unfortunately, a conceptual understanding of what he says is very different than turning his thoughts into sound investment principles and actions. This is why we have pinpointed five easy Buffett investment principles, which build upon each other, that hopefully will help the everyday investor to achieve better returns.

1. Be a Bear Market Investor

Buffett is, in our opinion, a bear market investor; he has historically made some of his most successful investments and deployed the greatest amount of capital specifically during bear markets. Think for one moment about how well a portfolio would do if a good chunk of its assets were consistently invested only during bear market periods, and that during bull markets capital was deployed much more sparingly. It’s not hard to understand that it would probably do much better over the long term with this general mindset. This is due to the fact that investments would be made more often when stocks are trading at depressed prices. Below is an example of Buffett being a bear market investor:

Investment: PetroChina (PTR)

Investment Date: 2002-2003 (Dot.com crash/recession period)

Total Capital Invested: $488 Million

Holding Period: 6 Years (Sold in 2008)

Capital Received from Sale: $4 Billion

Total Return: 819.67%

Annualized Return on PTR: 136.66%

Most investors were obviously not looking at investing in a Chinese state-owned oil company after the dot.com crash -- or anything else, for that matter. Still, this simple investment principle is no different than if a person only bought clothes when they were on sale at a department store. He bought a great company when it was on “sale” because he realized that the intrinsic value of the company never changed; just the price tag on it. Remember, a great company generally only goes on “sale” during a bear market -- so when there is fear in the streets, it’s time to go shopping.

2. Invest in What the World Needs

During the last recession, investors hated Goldman Sachs (GS), Burlington Santa Fe Rail (BNI), and General Electric (GE) equally. Investors crushed their respective stock prices based on illogical fears, emotional hatred, and very little analysis. Putting personal opinions aside, GE, BNI, and GS are all marble pillars of the U.S. economy. Buffett always invests with objectivity, and that’s why he bought shares in each of these firms. In particular, he bought the remaining shares of Burlington Santa Fe and folded them into Berkshire Hathaway (BRK.A). One man’s “trash” was definitely Buffett’s treasure. The takeaway point here is that Buffett went into heavily distressed industries that were crucial to the U.S. economy recovering and then bought the best in breed.

3. Fundamental Analysis and Due Diligence

The Oracle of Omaha is constantly quoted for saying “I only invest in what I understand.” As simple as this sounds, it actually goes over the heads of about 80% of investors. What he means here is that he spends a good portion of time educating/doing due diligence for himself about industries that he is interested in but potentially unfamiliar with. This includes taking time to understand the industry as a whole, how it fits into the world economy, and the company itself. We doubt he was a chocolate connoisseur before or after he bought See’s Candy, but either way, he knew what he was buying because he did his due diligence.

As an investor, he is probably one of the few who still directly requests the financial statements from firms he has an interest in. Everyone can call Buffett a “value investor” till they’re blue in the face, but he is a fundamental analysis investor at the end of the day. We have little doubt he goes through every number and checks every financial statement ratio in the book to find potential “hidden value.” He is even known to go through the granular footnote details for assumptions and/or additional information about inventory classification.

Doesn’t doing all this due diligence and research take time though? Yes, of course it does. Still, this is what he does in order to beat the market. He realizes and understands that most investors won’t take the time to do this consistently. Imagine how successful anyone could be at anything if they knew exactly how much effort they needed to give in order to outperform the competition. When it comes to investing, Buffett knows exactly how much effort he has to put forward.

This may all sound boring so far, but becoming the third-richest billionaire in the world by investing in names like Coca-Cola (KO) is not. He may like the taste of a Coca-Cola soda, but we doubt he would have invested in the company if it were short on cash, up to the eyeballs in red, and leveraged to the hilt with debt and with no hope of being able to pay it back. When he invests in a company, he knows it and its industry inside out. The time involved with principle three is substantial -- but so is the potential payoff.

4. Pricing Power beats Sound Management

The pricing power of a firm generally holds more value than does sound management, plain and simple. Further, it reduces the risk that a firm will underperform longterm should key personnel leave. Do you agree? Well, Buffett certainly does; he was quoted saying the following in two separate, recent interviews:

* "The single most important decision in evaluating a business is pricing power …. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.” (For more, see here.)
* “The extraordinary business does not require good management.” (For more, see here.)

His argument here makes sense and we are happy to follow this principle without question.

5. Patience

It’s true that Rome wasn’t built in a day, but sometimes it’s tough to remember that. Buffett understands the power of patience, and that is why he remains bullish over the long term. The rules are no different for anyone else, in that if an investor follows all the other principles then all that is left for him to do is be patient enough to wait and watch hard work pay off.

Conclusion

The Oracle of Omaha will always be bullish long term because he follows these principles without fail, in our opinion. With these five simple principles he has consistently outperformed the market and continues to see the investment landscape differently than almost everyone else.