Readers of my blog know that I respect Jason’s ideas, books, and columns on portfolio and wealth management, especially given his connection with the Graham/Buffet/Klarman approach to investing. Jason’s weekly column, which appears on the front page of the Business & Finance section of the WSJ every Saturday, is a must read for me and I hope you, too.

http://blogs.wsj.com/totalreturn/2014/09/06/read-em-and-reap-smart-people-for-investors-to-follow/

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If it is easy for corporations to borrow in public debt markets because high liquidity keeps interest rates low (in the near term), corporations that lack ideas for organic expansion at high ROI will issue debt and use the proceeds to buy back equity or go on M&A sprees. Those purchases raise the price of equities regardless of underlying fundamentals.

If it is easy to borrow from a bank or in public debt markets to buy a residence for occupancy or investment (see, e.g. Blackstone’s residential investment fund http://www.blackstone.com/businesses/aam/real-estate), consumers and investors will borrow and push up house prices. There is evidence from the structured finance industry that the market that has been least resistant to secondary financing has been the auto loan ABS market, especially in sub prime loans. It’s no surprise, then, that auto prices have held up better than home prices as borrowers find easier access to auto credit than mortgage loan credit.

http://www.standardandpoors.com/spf/swf/auto_abs/index.html#/54

Finally, the least resistant path for liquidity may be in the art world as wealthy investors need to “do something” with their cash that is earning next to nothing in the fixed income market. Doing nothing can be very difficult.

In the year from July 2013, sales of contemporary art at public auctions reached $2.046 billion dollars, up 40 percent on the previous year, Artprice’s annual report said.

http://news.yahoo.com/record-breaking-contemporary-art-103321463.html

Howard Marks has a great maxim for this behavior:

What the wise man does in the beginning, the fool does in the end.

We are in unchartered territory with respect to Quantitative Easing, but as Herb Stein has said, “If something cannot go on forever, it will stop.” The Fed will have to stop providing liquidity eventually. When the Fed stops, many will be caught by surprise and they will suffer. Don’t be one of those people.

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1. He’s super-smart;

Yet, as Buffett himself has said, if you have more than 130 IQ points you should sell the excess because you won’t need it to be a great investor. In fact, that extra IQ may be detrimental if it leads to behavioral flaws such as overconfidence or lack of discipline.

2. He’s guided by an overarching philosophy;

That philosophy is value investing, which can be executed in several forms.

3. He’s mentally flexible;

It may seem as if Buffett had a change in philosophy when he transitioned from Ben Graham’s “Net Net” and “Cigar Butt” approaches to investing to Charlie Munger’s “wide-moat” approach. However, all three approaches are guided by the value-investing tenet that requires a Margin of Safety.

Graham’s margin of safety was found in businesses trading at less than the net value of their assets. Munger’s approach of investing in under-appreciated companies with wide moats found a margin of safety in well-run business with pricing power and even growth. The key is in the qualifier “under-appreciated.”  Value investors love growth, but tend to be more skeptical of growth projections than glamour investors, and are usually better at maintaining discipline when pricing growth, and rightly so.

Hence, value investors usually buy fast-growing, wide-moat companies only when the market does not fully appreciate their wide moats as much as it should. One example: Buffett paid $1.02 billion for shares of Coca Cola by the end of 1989 after the 1987 crash had damaged Coke’s shares. By 1999, that investment was worth $11.6 billion according to Hagstrom.

4. He’s unemotional;

Marks: “Many of the obstacles to investment success relate to human emotion…perhaps worst of all, (most investors) have a tendency to judge how they’re doing based on how others are doing, and to let envy of others’ success force them to take additional risk… (Warren) doesn’t care whether others think he’s right or whether his investment decisions promptly (my emphasis) make him look right.”

My Take: Warren is disciplined, which can make a person appear unemotional. I would be willing to bet that on more than one occasion in his career he lost sleep over a decision, but that his discipline allowed logic to triumph.

5. He’s contrarian and iconoclastic;

As Charlie Munger likes to say, I have nothing more to add.

6. He’s counter-cyclical;

Marks: “Many of the best investors accept that they can’t predict what the macro future holds in terms of economic developments, interest rates and market fluctuations…the greatest bargains are accessed by buying when the economy and companies are suffering…how many acted as boldly (as Buffett) when fear of financial collapse was rampant (in 2009)?”

7. He has a long-term focus and is unconcerned with volatility;

One should only invest in the equity or long-term debt of businesses to cover long term liabilities such as college tuition that is due in twenty years, retirement liabilities, and bequests, so volatility is the friend of the long-term value investor. Volatility gives the long-term value investor the chance to buy low and eventually sell high, in contrast to what most investors do; that is, buying when rising prices make them feel good and selling when plummeting prices are too painful to bear.

This is where a good wealth advisor comes in for an individual investor or family office. He or she will help such investors identify their goals and estimate when the invoices for those goals need to be paid. Then, a good advisor will allocate assets to broad asset categories that “immunize” those liabilities and help make the euphoria of rising prices and pain of plummeting ones easier to ignore and bear because short-term goals are covered in cash or high-quality short-term debt, and opportunities to cover long-term goals will arise over a multi-decade run.

This is known in High Net-Worth Investor (HNWI) Wealth Management circles as Goals-Based Investing (GBI).  The underlying assumption is that all investors would be happy to simply meet their goals and avoid their nightmares so that they can focus on their careers and the things that make them happy.

In GBI, capital for near-term goals is held mostly in cash and short-term bills, and capital for long-term goals is invested in less liquid or more volatile (in the short run) investments such as equities, long-term debt, real estate, and alternatives in order to exploit the return premiums that are available there.

Within asset categories a good advisor will help clients find investment managers who understand each asset’s risks and who can manage those risks well. He will also find managers who can exploit specific premiums in those asset classes such as the value premium in equity investments.

8. He’s unafraid to bet big on his best ideas;

So many active investors have capital spread thinly, and almost all of it is allocated to S&P 500 companies. They have low “active share,” so they are essentially closet indexers who charge higher fees than indexers.

9. He’s willing to be inactive;

According to a speech that Seth Klarman delivered at a Grant’s conference in the fall of 2013, Baupost Group has about 50% in cash. Klarman is fearful of returning cash to his investors because he believes that they may go out and invest it with a hot-hand manager and will suffer during an inevitable shakeout.

PAR views cash as an investment in an option on every asset, an option that has no expiration date. That option is worth quite a lot right now.

10. Finally, he’s not worried about losing his job;

Professional portfolio managers who work for large firms lose their jobs if they underperform. That is why many make the rational decision to become closet indexers in order to hug their benchmark and avoid underperformance.

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The difference between Warren Buffett and most investors has more to do with discipline than just about any other quality. There are plenty of smart investors, and most of them failed to deliver results that compare with Buffett (I will soon write another blog post that summarizes Howard Marks’s forward to this third edition in which Marks identifies ten qualities that make Warren, Warren).

I last read TWBW around 2003 when I picked up the paperback printing of the first edition. The third edition is a worthy update. Every time I read the quote below I am reminded that it is discipline that makes the difference in investing, as in most things in life:

“In 1969, Buffett decided to end the investment partnership. He found the market highly speculative and worthwhile values increasingly scarce. By the late 1960s, the stock market was dominated by highly priced growth stocks. The Nifty Fifty were on the tip of every investor’s tongue. Stocks like Avon, Polaroid, and Xerox were trading at fifty to one hundred times earnings. Buffett mailed a letter to his partners confessing that he was out of step with the current market environment.

‘On one point, however, I am clear…I will not abandon a previous approach whose logic I understand, although I find it difficult to apply, even though it may mean foregoing large and apparently easy profits, to embrace an approach which I don’t fully understand, have not practiced successfully and which possibly could lead to substantial permanent loss of capital.’”

Warren was finding it difficult to find any businesses that were trading with a Margin of Safety. Rather than stretch his logic or his principles, he closed his hedge fund. Of course, he replaced his hedge fund with an insurance holding company in which he also had a decided funding advantage.

As a hedge fund manager, Buffett had to promise the lion’s share of returns to his limited partners in order to entice them to deliver capital for him to invest. As an insurance company, he did no such thing. Instead, he raised his capital for “free.” Buffett invested the float–the premium collected today for insurance claims that did not have to be paid for a long time.

As long as he maintained underwriting discipline (that word again), he could pay claims plus operating expenses that were equal to the premium he received. The ratio of the former to the latter is known as a “combined ratio,” and as long as that figure is 100% or less, Buffett got his investment capital for free. Investing free capital with discipline over several decades is how one becomes one of the richest people in the world.

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I do not think that Barron’s front page headline in this week’s magazine accurately reflects Howard Marks’ thinking.

Marks’ latest full-length memo (he is famous for his memos) seems to be a LOT more cautious and a LOT less sanguine about markets, especially debt markets, than the above headline. That memo, published on January 7, 2013, is titled “Ditto” to reflect that he feels the same way about exuberent behavior in credit markets today as he did right before the credit crisis unfolded.

The memo can be found in the Value Investing Resource section in the right margin, but I will quote a little of it here and leave Marks’ original emphasis:

Risk and Return Today (2013):
“…Sober attitudes on the part of investors should be a source of comfort, since in normal times we would expect them to bring down asset prices to the point where they’re attractive. The problem, however, is that while few people are thinking bullish today, many are acting bullish. Their pro-risk behavior is having its normal dangerous impact on the markets, even in the absence of pro-risk thinking. I’ve become increasingly conscious of this inconsistency in recent months, and I think it is the most important issue that today’s investors have to confront.

…People aren’t buying because they want to, but because they feel they have to.”

Marks then writes a section he titled ”Getting Rid of Money” in which he lists an alarming number of current market behaviors driven by the policies of the Federal Reserve:

“Regardless of the reason, things are happening again today–especially in the credit world–that are indicative of an elevated, risk-prone market…”

Such as:

“Total new issue leveraged-finance volume–loans and high yield bonds–reached a new high of $812 billion in 2012…surpassing by 20% the previous record set in pre-crisis 2007…”

…I find it remarkable that the average high yield bond offers only about 6% today. Daily I see my partner Sheldon Stone selling callable bonds at prices of 110 and 115 because their yields to call or yields to worst start with numbers–’handles’–of 3 or 4 percent…I’ve never seen anything like it.”

 He lists several more examples, too. Marks’ conclusion:

“In 2004, as cited above, I stated the following conclusion: ‘There are times for aggressiveness. I think this is a time for caution. Here as 2013 begins, I have only one word to add: ditto.”

“The greatest of all investment adages states that ‘what the wise man does in the beginning, the fool does in the end.’ The wise man invested aggressively in late 2008 and early 2009. I believe only the fool is doing so now. Today, in place of aggressiveness, the challenging search for return should incorporate goodly doses of risk control, caution, discipline and selectivity.”

Wow: “Things are happening again today…that are indicative of an elevated, risk-prone market” and “…only a fool is (investing aggressively) now.” Could the impression left by that statement made by Marks only two months ago be farther from the impression that the Barron’s cover leaves this week?

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…The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century. 

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future. 

The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end. 

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth – for a while. 

Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.” 

Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A. 

Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company,   one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B? 

Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices. 

A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond. 

Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B…

Howard Marks makes a slightly more nuanced gold argument in his December 17, 2010 letter, which can be found in Howard Mark’s Memos to the right. Buffett once said that he opens and reads Marks’s letters promptly whenever he gets one in the mail. Buffett even quotes an adage in this year’s letter that Marks has been fond of quoting for years: “What the wise man does in the beginning, the fool does in the end.”

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I had gone to see Germany’s deputy minister of finance, a 44-year-old career government official named Jörg Asmussen. The Germans are now in possession of the only Finance Ministry in the big-time developed world whose leaders don’t need to worry whether their economy will collapse the moment investors stop buying their bonds. As unemployment in Greece climbs to the highest on record (16.2 percent at last count), it falls in Germany to 20-year lows (6.9 percent). Germany appears to have experienced a financial crisis without economic consequences. They’d donned head condoms in the presence of their bankers, and so they had avoided being splattered by their mud. As a result, for the past year or so the financial markets have been trying and failing to get a bead on the German people: they can probably afford to pay off the debts of their fellow Europeans, but will they actually do it? Are they now Europeans, or are they still Germans? Any utterance or gesture by any German official anywhere near this decision for the past 18 months has been a market-moving headline, and there have been plenty, most of them echoing German public opinion, and expressing incomprehension and outrage that other peoples can behave so irresponsibly. Asmussen is one of the Germans now being obsessively watched. He and his boss, Wolfgang Schäuble, are the two German officials present in every conversation between the German government and the deadbeats.

The following from Lewis is a gem, especially when reading it in conjunction with Howard Marks’s latest memo (“Down to the Wire” July 2011):

 The curious thing about the eruption of cheap and indiscriminate lending of money during the past decade was the different effects it had from country to country. Every developed country was subjected to more or less the same temptation, but no two countries responded in precisely the same way. The rest of Europe, in effect, used Germany’s credit rating to indulge its material desires. They borrowed as cheaply as Germans could to buy stuff they couldn’t afford. Given the chance to take something for nothing, the German people alone simply ignored the offer. “There was no credit boom in Germany,” says Asmussen. “Real-estate prices were completely flat. There was no borrowing for consumption. Because this behavior is rather alien to Germans. Germans save whenever possible. This is deeply in German genes. Perhaps a leftover of the collective memory of the Great Depression and the hyperinflation of the 1920s.” The German government was equally prudent because, he went on, “there is a consensus among the different parties about this: if you’re not adhering to fiscal responsibility, you have no chance in elections, because the people are that way.”

Lewis: http://www.vanityfair.com/business/features/2011/09/europe-201109

Marks: http://www.oaktreecapital.com/memo.aspx

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“Since the investors of the ‘I Know’ school, described in chapter 14, feel it’s possible to know the future, they decide what it will look like, build portfolios designed to maximize returns under that one scenario, and largely disregard the other possibilities. The suboptimizers of the ‘I don’t know’ school, on the other hand, put their emphasis on constructing portfolios that will do well in the scenarios they consider likely and not too poorly in the rest. 

Investors who belong to the ‘I know’ school predict how the dice will come up, attribute their successes to their astute sense of the future, and blame bad luck when things don’t go their way. When they’re right, the question that has to be asked is ‘Could they really have seen the future or couldn’t they?’ Because their approach is probabilistic, investors of the ‘I don’t know’ school understand that the outcome is largely up to the gods, and thus that the credit or blame accorded the investors—especially in the short run—should be appropriately limited.

The ‘I know’ school quickly and confidently divides its members into winners and losers based on the first roll or two of the dice. Investors of the ‘I don’t know’ school understand that their skill should be judged over a large number of rolls, not just one (and that rolls can be few and far between). Thus they accept that their cautious, suboptimizing approach may produce undistinguished results for a while, but they’re confident that if they’re superior investors, that will be apparent in the long run.”

Marks opened his Chapter 14 with three great quotes, one of which I use all of the time:

We have two classes of forecasters: Those who don’t know–and those who don’t know they don’t know. –John Kenneth Galbraith

He closed the chapter with a quote that I will have to start using often:

It ain’t what you don’t know that gets you in trouble. It’s what you know for sure that just ain’t so.”–Mark Twain

As Marks said, “…investing as if you know what’s coming is close to nuts.”

Are you prepared to pick off bargains, or are you one of the people in the “I know” school who was fully invested on July 7 and selling indiscriminately today? Can you trust your contrarian instincts when those instincts are supported by hard, knowable data, or will you follow the herd and the prognosticators? Which way you answer often accounts for the difference between investment success and failure.

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Especially since the publication of my book, people have been asking me for the secret to risk control. “Okay, I’ll read the 180 pages. But what’s really the most important thing?”If I had to identify a single key to consistently successful investing, I’d say it’s “cheapness.” Buying at low prices relative to intrinsic value (rigorously and conservatively derived) holds the key to earning dependably high returns, limiting risk and minimizing losses. It’s not the only thing that matters – obviously – but it’s something for which there is no substitute. Without doing the above, “investing” moves closer to “speculating,” a much less dependable activity. When investors are serene or even euphoric, rather than discomforted, prices rise and we become less likely to find the bargains we want.

The book that he is referring to above is his book titled The Most Important Thing: Uncommon Sense for the Thoughtful Investor, which was published in May. It can be found in the bookstore above.

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I’ve been asked why there weren’t any memos during the twelve weeks between September 9 and December 1. Lack of ideas? Writer’s block? Carpal tunnel syndrome? CIA posting? The answer is “none of the above.” I was putting the finishing touches on a book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor. It pulls together all of the strands of my philosophy into what might be thought of as a super-memo. It will be published in late April and I hope you’ll let me know what you think.

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