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Forever Blowing Bubbles

It’s been quiet on The Blue Ridge lately, which usually means we’re busy working on new ideas.  In this case, we’ve also been busy working on a number of organizational enhancements which I look forward to sharing in the near future.  But not before I take off for the holiday weekend and a much needed escape with my beautiful bride next week.  Looking forward to recharging the batteries and enjoying some beach reading – on deck next week is Battle Cry of Freedom, Economics in One Lesson, Flash Boys, and The Complete Sherlock Holmes.  Not necessarily in that order!

Until then, keep an eye out for our next report which should be published shortly.  Here’s a sneak peak at the intro, compliments of Dean Martin – click the image below for the classic soundtrack.

Dean Martin

I’m forever blowing bubbles
Pretty bubbles in the air
They fly so high, nearly reach the sky
Then like my dreams they fade and die

Fortune’s always hiding
I’ve looked everywhere
I’m forever blowing bubbles
Pretty bubbles in the air

“I’m Forever Blowing Bubbles” was a popular American song written by John Kellette which debuted in 1918. More than a half century later, in 1973, Dean Martin released Sittin’ on Top of the World featuring Dino’s own version of Forever Blowing Bubbles.  Our extensive research on the subject has yet to uncover the link between Dean Martin, The King of Cool, and Alan Greenspan, The Maestro, but the Rat Pack’s influence on the Federal Reserve is irrefutable. Ain’t that a kick in the head?

Posted in Letters & Links, Policy.

Heads I Win, Tails You Lose

It would seem that there are risks to the macro outlook.  For the time being, equities appear content to ignore disappointing macro.

Disappointing Macro

It also appears that if the consensus turns out to be correct, bonds will begin to discount the expected tightening, at which point equities should react accordingly.

More Dovish

Posted in Macro, Portfolio Strategy.

Getting Lucky

Emerging market equities, now trading at a discount to slower growing western markets, are beginning to look attractive by some measures (blue line below).  Ceteris paribus, disciplined value investors may be inclined to increase positions as this discount widens further.  But all else is not equal.  Given the structural shift underway in emerging economies and the increasing likelihood of credit crisis in China, we believe the recent de-rating of emerging markets is more likely to represent a longer term inflection point. The EM discount is not yet extreme by historical standards.

EM Discount

The valuation of US equities, on the other hand, is quite extreme based on the same metric (green line above).  We are still finding select opportunities at home, but if you believe profit margins are susceptible to the laws of gravity (we do) than current stock prices are even more expensive.

Fortunately, there is a silver lining for value investors.  Or in the case of these charts – an orange lining.  Developed Markets Ex-US are still trading at relatively depressed multiples of relatively depressed earnings.  Note the spread between the orange and green lines in the chart above.  Valuations look fair and are supported by fundamental and technical tailwinds.  There is a strong structural case for owning high quality, multinational brands against this backdrop. Specifically, we expect a massive “trading up” in consumption in the developing world, compounded by an even greater “trading up” of capital flows into developed markets.

To be clear, Europe is far from fixed.  But disciplined capital allocators are beginning to put money to work.  European equities remain cheap.  And while US profits are back above the prior cycle peak, the rest of the developed world has far more upside (orange line in chart below).

Upside Outside US

We have spent much of the past two weeks analyzing a potential investment well positioned to capitalize on the accelerating efforts of EU banks and governments to shed distressed assets in order to strengthen their balance sheets. More to come on this in coming weeks.  In the meantime, maybe EM investors will Get Lucky.  Personally, I never realized how much I missed Soul Train until I saw this!

Posted in Emerging Markets, Portfolio Strategy, Valuation.

Buffett’s Alpha & Suspicious Minds

In a few weeks, I’ll be officially crossing Berkshire’s Annual Meeting off my bucket list.  Many thanks to our friends in the furniture business for allowing me to crash your Blumkin Family Party! And to any of our friends in the investment business that find themselves in Omaha for Buffett-a-palooza, please drop me a line.

Berkshire’s Annual Letter is closely scrutinized by the media these days, but in case you missed it, Buffett’s “certain fundamentals of investing” are worth highlighting:

  • You don’t need to be an expert in order to achieve satisfactory investment returns. But if you aren’t, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don’t swing for the fences. When promised quick profits, respond with a quick “no.”
  • Focus on the future productivity of the asset you are considering. If you don’t feel comfortable making a rough estimate of the asset’s future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility. But omniscience isn’t necessary; you only need to understand the actions you undertake.
  • If you instead focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so. Half of all coin-flippers will win their first toss; none of those winners has an expectation of profit if he continues to play the game. And the fact that a given asset has appreciated in the recent past is never a reason to buy it.
  • With my two small investments, I thought only of what the properties would produce and cared not at all about their daily valuations. Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.
  • Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle’s scathing comment: “You don’t know how easy this game is until you get into that broadcasting booth.”)
  • My two purchases were made in 1986 and 1993. What the economy, interest rates, or the stock market might do in the years immediately following – 1987 and 1994 – was of no importance to me in making those investments. I can’t remember what the headlines or pundits were saying at the time. Whatever the chatter, corn would keep growing in Nebraska and students would flock to NYU.

Over the years, many self-proclaimed value investors have rehashed Buffettisms.  But while the masses talk the talk, few walk the walk.  Buffett’s track record is in a league of its own. According to a recent NBER Working Paper, Berkshire has the highest Sharpe ratio of all US stocks from 1926 to 2011 and a higher Sharpe ratio than all US mutual funds around for more than three decades.

Buffett Alpha

These results were produced without luck or magic.  Rather, Buffett’s genius is largely a function of his conviction, wherewithal and skill to manage leverage and risk over multiple decades.  He recognized early on that applying leverage to safe, cheap, high-quality stocks would magnify returns without the risk of fire-sale, allowing him to stick to the principles outlined above over the course of multiple economic and market cycles.  The author’s estimate that Buffett’s leverage has averaged about 1.6 to 1 over time boosting both his risk and return, proportionately.  They conclude that, “If one had applied leverage to a portfolio of safe, high-quality, value stocks consistently over this time period, then one would have achieved a remarkable return, as did Buffett.”

Of course, no one has actually managed to do so. See you in Omaha.

Posted in Guru Focus, Letters & Links.

The Puzzle of Motivation

As I suspected, Sunday’s post on Incentives & Employment elicited some strong responses. So to be fair, I thought it would be useful to spend a few more minutes on what motivates us.  A good friend forwarded me this clip from RSA Animate yesterday.  Thanks Bo!  I am now a full-fledged subscriber and highly recommend taking a few minutes out of your day to give it a look.  Very well done.

The authors suggest that bonuses work as expected – the higher the pay, the better the performance – as long as the task involves only “mechanical” skill.  But once you get above rudimentary cognitive skill, rewards don’t work that way.  In these instances, they found that higher incentives resulted in worse performance.

I need to go back and examine this research more closely, as a number of the author’s points are just not intuitive to me without further inspection.  I suspect that there are other factors at work here. For example, in a recent book, Scarcity: Why Having Too Little Means So Much, Harvard economist Mullainathan and Princeton psychologist Shafir examined how the daily struggle for limited resources – time, money, food, etc. – greatly reduces mental bandwidth.

Scarcity creates “tunnel vision” which forces us to focus intensely on what we lack and imposes cognitive deficits in addressing other needs.  In some instances, mental performance for the poor and hungry was seen to be reduced by a factor as great as sleep deprivation.   This may very well explain why higher incentives resulted in worse performance for the poor in India, in RSA’s study.  In this instance, the “large carrot” may have forced the brain to focus on “the food” at the expense of mental bandwidth impairing cognitive skills. Try not to focus on “The Leprechan” after seeing this.

The Leprechaun

Leprechauns aside, there are several important points which I strongly agree with in this analysis, which is consistent with previous work done by behavioral economist Dan Ariely and Dan Pink, author of Drive: The Surprising Truth About What Motivates Us. Below are a few of the authors’ conclusions:

  • Seeing the fruits of labor makes us more productive
  • The less appreciated we feel, the more money we want
  • The more difficult a project is, the prouder we feel of it
  • Knowing that our work helps others increases our motivation
  • The promise of helping others makes us more likely to follow rules
  • Positive reinforcement about our abilities may increase performance
  • Images that trigger positive emotions may actually help us focus (see Leprechaun)

In the event you are still inclined to continue thinking about the proverbial “carrot and stick” this Monday morning, the following talks from Ariely and Pink offer further perspective.  See, What makes us feel good about our work? and The puzzle of motivation available through TED.

Now that I’ve cleared that up, it’s back to work for me.  Happy St Patty’s Day!

Posted in Policy.

Deep Thoughts on Incentives

In a recent post, we stated simply that, “Incentives matter. There is always a reason for individuals and businesses to make the decisions they have made.” From an investment perspective, this requires a deep understanding of alignment of interests. Our own internal checklist, which we have been developing and expanding for the past several years, prompts us to consider multiple vantage points. Some of the questions we consider include:

  • Have the managers/directors been buying/selling stock?
  • Do they have skin in the game?
  • Is their ownership a significant portion of their net worth?
  • How did they acquire their holdings?
  • What is their ownership relative to their cash compensation?
  • How is management compensated?
  • How does management evaluate itself?
  • How difficult are their performance hurdles to meet?
  • Do they use long-term metrics? Do they use the right metrics?

Or as Sherlock Holmes put it, “You’ll get results by always putting yourself in the other fellow’s place and thinking about what you would do yourself. It takes some imagination, but it pays.”

Switching gears a bit, let’s take a moment to put ourselves in the shoes of the long-term unemployed. Given the structural change in local labor markets (i.e. the gradual, then sudden, decline in the furniture and textile industries), we have a deep understanding of the other fellow’s place. That place used to be making an old-fashioned and honest living, working in any number of factories in the area. But those factories are now closed. And those skills are not easily transferrable to Google’s server farms in Lenoir. It takes time to retrain this workforce. A long time. Perhaps a generation.

This skills gap has important implications for labor market slack and inflationary pressures but that is a conversation for another day. Today, we just ask that you consider what you would do in the shoes of the long-term unemployed. Would you take a monthly check from Uncle Sam that is close to (or greater than) what you were earning in the factory? Or would you actively work to develop new skills and accept a lower-paying job instead? Stay home and collect a steady check or work your ass off 40 hours per week for minimum wage? Not a difficult decision for most.

This week, senate negotiators struck a bipartisan deal to extend these incentives on Thursday that would renew federal unemployment benefits for the long-term jobless and providing retroactive payments to more than 2 million Americans whose benefits expired in late December. Wonder what might happen if these benefits were allowed to expire? What would happen to the unemployment rate? What would happen to the long-term unemployed?

Coincidentally, the answer to these questions is also available in North Carolina where the federal extension of benefits, better known as the Emergency Unemployment Compensation Program (EUC), ended on June 30, 2013. Since then the rate of unemployment has plummeted from over 11% to less than 7%. In other words, when incentives changed, so did the results. Most of those sitting home collecting a check decided to go out and get a job. Granted, this is a difficult decision for politicians to make. However , we think the results speak for themselves. While the national unemployment rate has slowly declined, the unemployment rate here in North Carolina has collapsed relative to the national number.

NC Relative Unemployment

While I’m certain that this post will cause a bit of a ruckus locally, I’d ask that you consider these deep thoughts from Jack Handey before shooting the messenger. “Before you criticize someone, you should walk a mile in their shoes. That way, when you criticize them, you’re a mile away and you have their shoes.”

Enjoy the rest of your Sunday while I try on some new kicks.

Posted in Policy.

Dark Passenger

They say one out of a hundred people is a psychopath.  They also say that the he higher you go up the ladder, the greater number of psychopaths you’ll find there.  According to Psychology Today, “A successful psychopath is someone who fits the criteria of a psychopath, but is largely successful in their exploitations and so is able to avoid getting caught. Such people may be lawyers, professors, or politicians, and given the recent headlines, likely have a permanent address on Wall Street.”

In Snakes in Suits: When Psychopaths Go to Work, Canadian psychologist Robert R. Hare blames psychopaths for the brutal excesses of capitalism, as they often flourish in fast-paced, changing industries with widespread uncertainty. Someone who perhaps resembles Gordon Gekko?

In case you’re curious, there are twenty points on the Hare PCL-R Checklist, which is the assessment most commonly used to rate psychopathy:

  1. glib and superficial charm
  2. grandiosity
  3. need for stimulation
  4. pathological lying
  5. cunning and manipulating,
  6. lack of remorse
  7. callousness
  8. poor behavioral controls
  9. impulsiveness
  10. irresponsibility
  11. denial
  12. parasitic lifestyle
  13. sexual promiscuity
  14. early behavior problems
  15. lack of realistic long-term goals
  16. failure to accept responsibility for own actions
  17. many short-term marital relationships
  18. juvenile delinquency
  19. revocation of conditional release
  20. criminal versatility

Sound familiar?


Posted in Uncategorized.

Jumping Down the ZIRP Rabbit Hole

Markets are said to climb a wall of worry and investors have had plenty to worry about recently.  With China’s first domestic corporate bond default too small to create big waves and the risks in Ukraine seemingly “fixed” overnight, stocks have quickly climbed the wall back to new all-time highs.  We wonder what happens when they reach the top.

The bulls claim that today’s rich valuations are “justified” by low interest rates.  Low rates force otherwise conservative investors out on the risk curve, or over the ledge, depending on one’s perspective.  ZIRP (Zero Interest Rate Policy) also “supports” peak valuations in the form of minuscule discount rates.  This is particularly convenient for sell-side analysts who can now justify just about any price for an asset simply by discounting its future cash flows back to the present at today’s unusually low rates. The rational investor should think carefully before jumping down this rabbit hole. In 1991, Seth Klarman aptly described today’s rabbit hole in Margin of Safety:

It is essential that investors choose discount rates as conservatively as they forecast future cash flows. At times when interest rates are unusually low, investors are likely to find very high multiples being applied to share prices.  Investors who pay these high multiples are dependent on interest rates remaining low. When interest rates are unusually low, investors should be particularly reluctant to commit capital to long-term holdings unless outstanding opportunities become available.

Well put Mr. Klarman.  And with 50% of Baupost capital on the sidelines today, we think it is safe to assume that “outstanding opportunities” are less available after mounting the wall of worry.

Posted in Quotes, Valuation.

A Few Lessons from Sherlock Holmes


An investor introduced me to Peter Bevelin a few years back, recommending Seeking Wisdom: From Darwin to Munger, which I hope to reread during our next trip up the mountain.  More recently, I spotted Peter’s name lying on a desk in a new friend’s office. A Few Lessons from Sherlock Holmes is a thoughtful book, which maps out the detective’s methods for decision-making under uncertainty.  As investors, we are always making decisions with less-than-perfect information. Bevlin’s lessons, compiled from Sherlock Holmes, are incredibly useful for investors and for improving our thinking more broadly.

Looking forward to reading The Complete Sherlock Holmes.  Until then, here are a few tips from A.C. Doyle’s iconic Holmes.

“Breadth of view is one of the essentials of our profession. The interplay of ideas and the oblique uses of knowledge are often of extraordinary interest.”

For investors, this means considering a wide range of ideas to gain perspective.  It is a commitment to learning; to long and patient study.  It also appears as if Holmes was a student of memory training, by keeping facts in his “brain-attic” in “the most perfect order.”

“Now the skillful workman is very careful indeed as to what he takes into his brain-attic. He will have nothing but the tools which may help him in doing his work, but of these he has a large assortment and all in the most perfect order, it is of the highest importance, therefore, not to have useless facts elbowing out the useful ones.” 

“The greatest sign of an ill-regulated mind is to believe things because you wish them to be so.”

This is also the greatest risk for investors who hold onto existing positions long after the initial thesis has changed.  Recognize when you have made a mistake.  Learn from it.  Move on.

 ”I have steadily endeavored to keep my mind free so as to give up any hypothesis, however much beloved, as soon as facts are shown to be opposed to it.”

“When we meet a fact, which contradicts a prevailing theory, we must accept the fact and abandon the theory, even when the theory is supported by great names and generally accepted.”

Investors today have all the information they need at their fingertips.  The challenge is being able to filter it. More information is not always better information.

“The principle difference between a good and a bad diagnostician is usually a matter of thoroughness and method. Brains count, of course, but the man who has not collected his facts has but little chance to use his brains.”

A wise man sees as much as he ought, not as much as he can.”

“The value of experience is not in seeing much, but in seeing wisely.”

It often helps to work backwards from effects to causes.

“Most people, if you describe a train of events to them, will tell you what the result would be. They can put those events together in their minds and argue from them that something will come to pass. There are few people, however, who, if you told them a result, would be able to evolve from their own inner consciousness what the steps were which led up to that result. This power is what I mean when I talk of reasoning backward or analytically.”

Distance gives perspective.  Take time to step back and think things over.  I simply don’t understand how investors today can accomplish anything while staring at multiple screens at the same time CNBC reports “breaking news” every few minutes. Personally, I do my best thinking outside of the office and aim to spend at least one or two days a week alone in the mountains or at the library. Maybe I need a pipe?

 “It is quite a three-pipe problem and I beg that you won’t speak to me for fifty minutes.”

“Let us walk along the cliffs together and search for flint arrows. We are more likely to find them than clues to this problem. To let the brain work without sufficient material is like racing an engine. It racks itself to pieces. The sea air, sunshine and patience, Watson – all else will come.”

Incentives matter.  There is always a reason for individuals and businesses to make the decisions they have made.

“You’ll get results by always putting yourself in the other fellow’s place and thinking about what you would do yourself. It takes some imagination, but it pays.”

And finally . . . know your limits.  And work hard to expand your circle of competence at the old university.

“The best part of our knowledge is that which teaches us where knowledge leaves off and ignorance begins. Nothing more clearly separates a vulgar from a superior mind than the confusion in the first between the little that it truly knows, on the one hand, and what it half knows and what it thinks it knows on the other.

Posted in Guru Focus, Letters & Links, Quotes.

The Reflex

Is there a better way to start the week than with Duran Duran? Couldn’t resist . . . this one’s for you Vance!

The Reflex . . . Compliments of Dr. Hussman’s Weekly Market Comment:

To offer some perspective of how major peaks have typically evolved, the following charts present the Dow Jones Industrial Average in the final advances toward, and the few weeks after, what turned out in hindsight to be major stock market peaks. For reference, let’s examine the recent market peak. Notice several features:

1. A series of moderately spaced peaks forming a broad sideways “consolidation” over several months;
2. A breakout from that consolidation, leading to a steep and only briefly corrected speculative blowoff into the market’s peak;
3. A steep initial selloff from the market peak, and finally;
4. A “reflex” rally (classically on low volume – indicative of a short-squeeze with sellers backing off) that retraces much of the initial selloff.


One can observe that same general dynamic in the chart below – a series of moderately-spaced peaks forming a largely sideways consolidation, a breakout to a steep and only briefly corrected speculative “blowoff”, an initial retreat, and finally a reflex rally. This chart depicts the final advance to the 1929 market peak.


Largely the same dynamic was evident in the advance to the 1973 peak (after which the market lost half its value into late-1974): a series of moderately-spaced peaks comprising a broad consolidation, a breakout to a steep and only briefly corrected speculative blowoff and market peak, a steep initial decline, and a short-lived reflex rally after the peak.


Though the “separating decline” after the mid-1999 consolidation was quite deep, as was the initial decline from the January 2000 peak in the Dow Industrials, the same essential features were evident then as well. The correspondence isn’t nearly as pretty as in the present instance, or those of 1973 or 1929. It’s worth keeping in mind that despite a hard initial decline, many (though not all) historical bull market peaks include an “exhaustion rally” anywhere between 2-9 months after the market peak, which can carry prices within a few percent of the high. The problem is that there is too much variability to count on either their timing or extent.


From the standpoint of investor psychology, it seems understandable that the speculative enthusiasm and short-covering that contributes to bull market tops is fueled when the market “breaks out” after a period of consolidation (and what Lindsay called a “separating decline”). The blowoffs that followed – both recently and in the examples above – were accompanied by clear overvaluation on reliable measures, and also featured clearly defined overbought conditions and lopsided bullish sentiment.

Regardless of the patterns that have emerged in recent months, it’s important to recognize that the implications of extremely overvalued, overbought, overbullish conditions are not necessarily immediate. In 2000, the March high was followed by a series of retreats and recoveries, with a marginal new high in total-return terms as late as September 2000 before the market lost half of its value. In 2007, the August high was followed by an initial retreat and recovery into a very marginal final peak in October 2007 before the market lost half of its value. In 1972-73, an initial decline of nearly 20% from the market peak was followed by an advance in October 1973 that brought the S&P 500 and Dow Industrials within 7% of their highs before completing a near-50% market loss. In contrast, the reflex advances from the 1987 and 1929 peaks were rather short-lived, and were followed by steep losses within a span of weeks. Market cycles often display regularities, but investors should never conclude that they follow precise rules.

Posted in Portfolio Strategy.

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