Anger and frustration are the two emotions pulsing through my veins as I write this. HP, once the symbol of innovation, is being dismantled by its high-pedigreed board and the CEO of the hour (I truly hope his tenure will be measured in hours, not years). I vividly remember the early 2000s, when Carly Fiorina, then CEO of HP, engineered the HP merger with Compaq. She argued that the merger was a must for HP's future to be bright. Walter Hewlett, the son of one of the founders, was publicly opposed to it, and I remember the drama of the proxy fight, the TV interviews and arguments from both sides, and the finale -– Walter Hewlett lost and the merger went through. But it was not the finale, because nine years and two CEOs later HP has announced that the PC business, the one it so desperately wanted just a decade ago, is too hard a business and that it will look for ways to get rid of it. Almost in the same breath HP announced that it will kill WebOS devices, a business it acquired in April 2010 for $1 billion; and management, possibly missing the irony in those two announcements, went ahead and announced another acquisition, which this time will for sure transform the company.

HP will buy Autonomy, a UK software company, for $10 billion. I understand $10 billion doesn't sound like a lot of money in today's post-trillion-dollar-bailout world, but it is plenty for HP, especially considering what that money bought. There are many ways to illustrate how expensive and meaningless to HP's future this acquisition is: $10 billion is about a fifth of HP's market capitalization, while Autonomous will contribute 0.7% to HP's revenues, and 2.7% to its earnings; and HP paid 10x revenues and about 25 times earnings.

Leo Apotheker, HP's CEO, bragged about Autonomy:

"Autonomy has grown its revenues at a compound annual growth rate of approximately 55% and adjusted operating profit at a rate of approximately 83% over the last 5 years."

Keith Backman, a sell-side analyst from BMO Capital, asked a very pertinent question about Autonomy:

"… metrics that you threw out for Autonomy, particularly on top-line growth, included a lot of acquisitions for Autonomy. What's the organic growth rate that Autonomy has achieved lately?"

Leo did not have an answer, whereupon HP's stock started to drop. HP had reported an OK quarter, expectations were already low (its stock was at about 6x times 2011 estimates, which remain intact), and Dell had already lowered guidance a day before; so no one was surprised when HP lowered its revenue guidance for 2011 by a few percentage points. Management said that since it will pay for Autonomy from cash on the balance sheet, it will not be buying much of its stock in the near future, and then they mentioned that this acquisition will be accretive. Yes, accretive! Nothing to worry about. This transaction is accretive only for illiterates in economics and those short on common sense.

HP is using cash on the balance sheet to pay for this transaction, and thanks to the Federal Reserve this cash yields zero and thus brings zero income. As long as Autonomy's income is greater than zero (I am oversimplifying a little) then it will be accretive (at least on a cash basis). However, this assumes that HP's cost of capital is equal to the return it receives on its cash. Which is not the case, as that would ignore such minor details as the time value of money, inflation, the risk premium (after all, unlike the US government, HP cannot print money and doesn't have nuclear weapons) and, simply, opportunity cost.

Any investment HP makes today should be compared against an opportunity set that includes its own stock, which at 6x times earnings results in about a 16% yield (cost of capital). In fact, if HP used $10 billion to buy its own stock, its earnings per share and dividend would jump by 16%. Autonomy will not be able to match this return, by a long mile.

I don't need to have a great imagination to envision another conference call in August 2015, where a new CEO decides that the software business is too difficult, and HP needs to come back to its roots (maybe going back to making calculators) and will spin off the software business into a new company, take an enormous charge, and then maybe announce an acquisition that the same highly pedigreed board will rubber-stamp.

HP's valuation has not changed that much – the PC business only represents about 16% of operating profit, so even if HP gives it away, earnings power will not decline greatly. HP should still be able to get a decent price for it, as there has got to be a Chinese company out there swimming in US dollars that wants to put them to work before they become worthless. HP's core businesses, will be slightly impacted by the global economic weakness, but the company should maintain its earnings power largely intact. Autonomy reduced HP's value by about $3; but with my lack of confidence in management, I'd not buy HP at a P/E higher than 10, which would bring the stock to the mid to high 40s.

 HP's stock sold off not because the company disappointed Wall Street but because Wall Street grew tired of the overpriced "must-have" acquisitions. Wall Street has smartened up and assumed that this acquisition, as with many other "transformative" acquisitions, will do nothing of the sort. And so, today we are faced with a decision: buy, hold, or sell. At 4.6 times earnings HP is not a sell; but considering that the company is still trying to figure out what it wants to be when it grows up, it is hard to add to our holdings of the stock; so unfortunately this company has turned into a hold.

Stefan Jovanovich writes: 

There is another perspective. HP, like National Semi and so many of the other "original" Silicon Valley companies, was - at heart - a defense contractor. Its instruments were sold to and used by other defense contractors; and the HP Way was dependent on the steady stream of direct and indirect payments from Washington. The HP Cringely knew began to die when the Berlin Wall came down. What is interesting is that this was the same time when new generation of "tech" companies started up that had no experience with government Purchase Orders and purchasing requirements. The question to be asked is how far has Microsoft gone down the road towards being the next HP, only this time the graphics being generated come not from oscilloscopes but from Power Point, etc. One of the many reasons to admire the MRD ("mad" Russian duo) is that, given a choice between competing with MSFT and AAPL, they chose AAPL, even though "everybody knows" that was the wrong decision. Of course, you want to have governments and corporations with large headcounts as your primary customer base.



ChinaMy nine-year-old son Jonah and I have been playing chess a few hours a day. I never thought I'd enjoy playing chess as much, but I do. In fact, over the past year I’ve probably played more chess than in my whole life. I win every game! When I win, I win. When I lose I win – seeing your son (your student) beat gives you an enormous satisfaction as a teacher. In fact, I never thought I'd enjoy losing so much. Jonah has this quality that I need to nurture in him – he never gives up. Even a game that is a clear loser for him, he plays till the end. What a great quality to have in life!

I am also enjoying seeing my four-year-old daughter Hannah grow up. We have yet to find an activity we both enjoy doing together (other than hugging to death), but we'll get there. She has almost learned how to ride a bike without training wheels; maybe we'll do cycling together. They’ve been going to a summer camp that is half a mile from my work and six miles from our house. A few times a week, while I tug Hannah in a bike-stroller, Jonah and I ride our bikes 30 minutes to the summer camp, through the park.

I envy my kids; they have the pleasure of spending time with their grandparents. My grandparents lived thousands of miles away from me – I saw them once a year for a few weeks and that was it. My wife's and my own parents live just a few miles from us. My father's house is a block away from my office; I stop by a few times a week for breakfast before I go to work.

My father gave Jonah a 50-state quarter collection for his birthday. Now, every day before Jonah goes to sleep, he and his grandfather spend half an hour on Skype learning about each state; and once they are done with a state, Jonah puts the coin at the proper place in the board. They also play a game of chess on Skype chat.

I gave a presentation last week at the Value Investment Seminar in Trani, Italy (here is a link to the PDF). I strongly suggest you visit their website in a few weeks, as it will have presentations and videos. It was a terrific event; I learned a lot.I spoke about China, Japan, and our favorite stock idea: eBay. I changed the title of the China presentation to “China, the Mother of all Grey Swans” (instead of “Black Swans”). A while back, when I shared this presentation with my readers, I was corrected: China is not a black swan, because a black swan is a rare, significant, and unpredictable event. However, the consequences of what is transpiring in China and Japan are for the most part predictable (especially if I am writing about it). We don't know when they will play out, but they are predictable.

Nassim Taleb, one of my favorite thinkers, who brought the black Swan to life in his books Fooled by Randomness and The Black Swan (I like both books, but Fooled by Randomness is my favorite, plus, it is by far an easier read than Black Swan), solved my dilemma with China by creating a new swan: "grey"– a rare, significant, but predictable event (though the timing is still unknown, or perfectly known only with the benefit of hindsight.)
I spent a few days at the seminar discussing and debating China with some very smart folks, who stirred up some random thoughts.

What really amazes me is how people who would not trust the US or European governments to do their laundry, have unconditional faith in Chinese government involvement in its very complex economy.

The Chinese government brainwashes its people the same way the Russians and Soviets brainwashed theirs: by controlling and censuring media. So I understand when Chinese people who live in China speak highly of their leaders – they are brainwashed (I have experienced this first-hand). However, I am amazed that the Chinese government has been able to brainwash people who reside outside of China.

No, an economy in large part controlled by the state is not superior to ours. Greater control over their economy allows the Chinese government to pull the economy out of recession a lot faster than in the democratic countries, but there is no free lunch. Their actions will just lead to greater excesses and imbalances down the road.

It seems that as Westerners we have an inferiority complex when it comes to Asian cultures. Chinese uniqueness is praised today the same way Japanese superiority was in the 1980s. I even remember reading Russian newspapers in Russia, in 1989, praising the Japanese work ethic and their unique culture and spouting predictions of the continuance of Japanese dominance. I can only imagine how the mainstream press in the US was caressing Japanese uniqueness in the late ’80s, especially as the Japanese were invading (buying) Times Square and the State of California.

What is very interesting about it is that today all those Japanese cultural advantages are looked upon as disadvantages. For instance, “saving face” did not allow Japan to deal sufficiently with failed companies; their economy was full of semi-dead, zombie companies, which did not allow the healthy ones to prosper. Their employment-for-life system that was praised to the heavens during the Japanese golden age is now killing productivity of the economy. I recently read that 12-17 million people in Japan are employed who should not be employed (for an economy of 120 million people, these are huge numbers). In other words 12-17 million Japanese show up for work every day and receive a paycheck, but add little or no value to their employers.

Back to China. Even if the Chinese are harder-working and more entrepreneurial than Americans and Europeans, that doesn't mean the laws of economics are somehow suspended in China – they are not. The Chinese economy was geared for high global growth, while now much lower growth is in the cards. The excesses created by 14% of GDP being “stimulated” into the economy through a fire hose have led to significant overcapacity. It will take time for these excesses to be dealt with, even in a country full of super-hard-working people.

A friend asked, “But what about Singapore; its government plays a significant role in the economy, and Singapore is thriving.” The clear answer: government can only succeed in running very small and relatively simple economies. Let me give you this example. I have a game on my iPad called Flight Controller – my kids love it. The point of the game is simple: you are an air-traffic controller and your job is to land planes. Planes come in three colors, red, yellow, and blue, and each plane has to be landed on the runway matching its color. The objective is not to have mid-air collisions. I can land ten planes no problem, twenty gets more difficult, and forty I cannot handle (Okay, I played the game a few times). The same is true for economies: the more complex the economy the more difficult it is to be centrally planned.

Government is not and never will be an efficient allocator of capital. It empowers bureaucrats, which in turn leads to corruption, which further misallocates capital. The size of the bribe or strength of the personal relationship decides the flows of capital instead of the invisible hand that funnels capital from low to high uses. (A side point: Singapore is one of the most uncorrupt countries in the world; this may explain in part the government’s success. China is not Singapore; it is infested with corruption).

I often hear that you have to go to China to understand it. But tourists who go to China don't see the real China, the same way that tourists who go to Moscow don't see the real Moscow. I was in Moscow a few years ago, and I was impressed by how clean and beautiful it looked; in fact it didn’t look much different from the center of Brussels. Of course, I was only in the center of the city, where you see fancy restaurants, gift shops, museums, theaters, etc.

I went to see my college friend who lives in the real Moscow – I saw a very different picture. The second you veer off the main road, it turns into pothole hell, and the streets are anything but clean. My friend lives in a nine-story apartment building that has not been painted in decades; paint is peeling both inside and outside. Interestingly, most of the sides of the buildings that face large streets in Moscow and in Murmansk (the city where I spent all my Russian life) are usually painted, but the sides that face small streets have not been painted in generations.

My friend – a lawyer – and his wife and kid have to live with his mother, as they cannot afford to live on their own. But you won't see this Russia if you are a tourist visiting Moscow. People who visit China even multiple times harbor an illusion that they understand it – they don’t. In fact they so overwhelmed by its grandness that they stop being rational in their analysis.

I keep thinking about the possible consequences of the Chinese overcapacity bubble pop. It is relatively easy to understand what will happen in Japan: deflation will quickly turn into hyperinflation as government is forced to print money to service its debt and social obligations. They'll announce and may even execute austerity measures, but those will be a decade or two too late. The Japanese yen will likely decline, though maybe not right away, as Japan owns a lot of US dollars and may be forced to sell them.

The Chinese situation is far more complex. China has tremendous overcapacity, but overcapacity is deflationary. It will drive prices for commodities down, and prices of Chinese-made goods will likely decline as well. Demand for industrial goods will collapse, pushing their prices down. But China will also have to deal with a lot of bad debt and will likely have to print money to do so – which is inflationary.

The popping of both the Chinese and Japanese bubble economies will lead to higher US, and likely global, interest rates.

Japan, as the title of my presentation suggests, is past the point of no return. Internal consumption of its debt will likely turn negative very soon. Its post office, which includes a postal savings system that was historically one of the largest buyers of government debt) announced recently that it will be a net seller this year. The situation is out of the Japanese government’s hands. It will probably not be able to intervene in the economy for much longer, so rates will rise and there will be little they will be able to do about it.

China is different from Japan. Its government is trying to slow down lending, but at the same time we have started seeing news of possibly another multi-hundred-billion-dollar stimulus over the next few months. The Chinese government’s actions are the wild card that will determine the duration and the magnitude of the bubble pop – the longer they intervene, the more dire the consequences will be.

Jim Lackey writes:

Why is it that the Soviets lasted some decades and you think China is going to self destruct after 1 decade? Are you guys serious? So the Olympic track builder comes to Nashvegas… we are building a new track and paved the berms. He told us about Beijing and the Olympics. He built the BMX track. So a dump truck so overloaded with hot pavement wheel stands up the hill– yes, front wheels off the ground…

A chopper comes in takes the bucket off the truck flys it to location 100 meters and set sit down. 50 some 50 Chinese kids come running out shovel hot pavement in a ballet and make a perfectly paved berm. He said it was wild to see. Mean while 4 of us did it on half the time with one sub load dump truck a rented bobcat with 1-10th the labor and guess what. In the USA the labor was free! We all volunteered to do it for the love of the game.



Mr. KatsenelsonI worked for Lipper Analytics (now a unit of Thomson Reuters) for about three months in 1997. They interviewed new employees for their internal newspaper. A friend found this interview in their archives. I made an interesting mistake when I discussed Russia, which is only apparent to me now with the benefit of hindsight and an additional 13 years of experience. Russia cannot have a successful commodity industry (successful is a relative word) and a prospering software industry, despite Russia's incredibly educated workforce. Russia suffers from a Dutch disease — commodity industries suck out all the capital from other industries and don't let them develop.



 As an unbiased analyst it is hard to come to any other conclusion about Japan, and I am going to put it lightly: Japan is scre#ed! As a consequence, we believe higher interest rates globally are unavoidable, as Japan, now the largest foreign holder of the US Treasuries (together with China, the second largest holder), turns from buyer of Treasuries to net seller. So in our equity portfolio we are making sure that our companies have strong balance sheets and/or significant free cash flows to pay off debt, if (more likely when) interest rates rise.

Rocky Humbert responds:

Mr. Vitaly is a most astute observer– and while his conclusions may be correct, he is not, as he claims an "unbiased analyst." I assert that no one is capable of being an "unbiased" analyst. This is a philosophical– not financial– statement. The stories that Mr. Vitaly tell have been told before: I spent the better part of 1995 to 1999 being short JGB's, and I even have a framed screenshot of the day (9/11/98) when 3-month Yen Libor interest rates traded negative. Been there. Done that. Now, when I'm tempted to short JGB's, I look at that screenshot, slap my wrist, and put the phone receiver back down.

A long-term speculation with severe negative carry is like a pounding headache. It's debilitating and distracting, and eventually one reaches the point where simply waking up with no headache is a joy. I wish good luck to my friends who short JGB's…just make sure that you have plenty of aspirin nearby.

As for macro commentary, I'd like to share the following comments from a much less-esteemed, but more widely-read analyst about the economic funk:

The litany of economic woes at times seems endless…energy, the oxygen of industrial life, has become so costly and politically controlled that the US can no longer be certain of enough fuel to keep its factories running and homes heated. The real median income of American families jumped 64% from 1950 to 1970, but has crawled up by less than 1% a year in the past decade. Weekly real take-home pay has been declining for two years. That gauge of American economic health, the stock market, has been sharply depressed. While these travails are felt most acutely in the US, the situation is common to nearly all Western nations. The world money system that function like a Swiss watch for a quarter-century has been sending off alarms. Gold has become the refuge for a world fearful of returning to an economic jungle.

Source: Time Magazine, April 21, 1980. 



 I used to do a lot of business in Japan and I think very highly of Japanese businessmen (unfortunately they rarely include women at high levels). They have an industrious, highly intelligent population, are very interested in business, and a good base as the second largest economy in the world.

It is a great mystery to me why they (and their stock market) have not done better in recent years and I have never seen any good explanation of it. Okay, they had a bubble that burst, government policies that were not great, and they have an aging population. But so what? They had plenty of opportunity to recover on their own in spite of whatever the government has been doing. (BTW their government policies could not be any worse than our current ones, so if government policies are the test, we're in big trouble.)

Has anyone seen or can anyone give a decent explanation of why Japan has lagged?

Ken Drees writes:

1. LDP party out of power after 55 years.

2. Exports and profits slumping via USA trade like others Asian exporters.

3. Big(gest) holder of USD denominated debt.

4. Aging populaton (nothing new), but 81 billion spending package just announced, more internal stimulus to follow?

5. Need to diversify their surplus holdings like others (China, Brazil, Russia, et. al.)?

6. New party administration playing a little differently with USA — recent Obama trip no real results, prior to that some grumblings about USA debt, etc.

7. Japan equities — bottoms in 1998, 2003, 2009 — skewed symetric reverse head & shoulders – or just bumping along the bottom?

8. Will need to strengthen export markets everywhere and keep USA markets open and profitable. Japan's growth lies with its neighbors if USA doesn't fix itself.

9. Yen carry trade over, yen rising — conflicts with strategic direction that exports and export profits need to be robust.

10. Zugszwang-lite Japan — any small move doesn't change game for the better. Are there any good moves available?

How will the new party lead? If they cannot rope in the yen to improve exports can they stimulate spending via QE and weaken yen at same time? Or is this approach too slow and meandering? There seems no real strong moves available unless global imbalances happen first and allow Japan countermove possibilties. Japan seems still to be unable to escape via its own power.

Is Japan getting tired of being tired?

Charles Pennington adds:

A broad-brush explanation is that the Nikkei got way out of line with other world markets and has spent the past 20 years returning to normalcy.

The Japanese price to earnings ratio was "well over 100" in the late 80s, and now it's 33 (reported by today's Financial Times), still higher than the US at 22. Earnings for the S&P are up about 2-3 times over their level in 1989, and perhaps the Nikkei's are as well, but if the P/E fell from, say, 200 down to more normal value of 33, a value much more in-line with other world markets, well, that explains a lot.

The Chair will rightly point out that this is retrospective, descriptive, and not predictive, that Japan's interest rates are (or at least were) lower, that the accounting may be different. Also, Mr. Grossman doubtless already knows all these figures, so he is looking for a better explanation, which I don't have.

Kim Zussman adds:

Country-stock could be like "best company" studies, showing admired firms under-performing the rest. Presumably established/successful companies/economies have less upside than currently dire situations. And more downside? 

Vince Fulco replies:

To the list I would add traditional factors such as:

1. Shareholders — very far down the societal list of all stakeholders in the corporate world. The stock market is generally considered more for gambling (no jokes Dr. Z!)

2. Much heavier reliance on debt financing (too much) due to roots in maibatsu/keiretsu structure whereby a conglomerate's banking branch handles all the financing needs

3. No Carl Icahn or Guy Wyser Pratte influence to shake up entrenched mgmts and unlock under-utilized assets. The quote is 'the nail which sticks up gets pounded down'. A few have tried over the years but are usually labeled degenerates or cowboys and run out of town one way or another.

4. Years of very low ROI, white elephant projects by the government, to keep happy important constituents of the LDP (the old group in power) such as construction and the mob — i.e. the bridge to an island with 50 people on it, which we almost got in Alaska a few years back.

5. Legacy obligations which haven't been addressed but simply kicked down the road as we've emulated so well in the last 12 months.

Ken Drees responds:

Mt FujiVince, Kevin, Kim and Charles have all provided excellent observations as to Japan's inbred entrenched-ness, inabilities to move, and relative over valuations. Also, the idea that is was the once high flyer status albatross, so all these past behaviors are in the rear view mirror, yet they continue to taint the view of Japan as an old has-been power country. But change agents may now be inside this yesterday/today paradigm. So far Palindrome's reflexive reinforcement of trend is still in force. The malaise continues. Will some new change agent surface? Will the reflexive reinforcement finally be breached.

The early elements for a change exist. To bet on a new bullish Japan is a long shot. But how much money can be made betting the field? Tax policy can be repealed, monopoly/hands in hands can be abolished, small investors can be made more ownership level. All the levers to lift the old dead stump and turn it over are at the ready. Or is this a dead end due to lack of will? Is Japan a stunted growth, never ever to leave off-broadway? If a global imbalance rises up, will Japan change tack and ride out on a new wind? I am watching Japan, if only since they since they are shackled to the USD. Maybe the impetus for change is at hand. This new administration in Japan — what do they owe the US? 

Stefan Jovanovich replies:

The Japanese are certainly not hidebound where their Navy is concerned. They are the dominant sea power in their part of the world. From the folks at

"Japan is currently the second largest naval power in the Pacific (after the United States), with a total of 32 destroyers, nine guided-missile destroyers, and nine frigates. The older Tachikaze-class guided-missile destroyers are being replaced by the new Atago-class destroyers. Japan also has 16 modern diesel-electric submarines. The Chinese navy is larger in terms of ships. They have 25 destroyers and 45 frigates. However, of these 25 destroyers, 16 are the much older (than Japanese equivalent) Luda class. Most of the frigates are the obsolete Jianghu class ships. China has 60 diesel-electric submarines, but most of them are elderly Romeo and Ming class boats. China's Han class SSNs (nuclear attack subs) are old and noisy. In terms of modern vessels, China is not only outnumbered, but the Japanese ships spend more time at sea and the crews are better trained. The Chinese are also at a disadvantage when it comes to naval air power. Most of China's naval fighters are old. They have a growing number of modern J-11s (a copy of the Russian Su-27) and the Su-30MKK. Japan is almost at parity in terms of numbers (187 F-15J/DJs and 140 F-2s to 400 Chinese J-11/Su-30MKKs). Japan has better trained pilots, although China is trying to close that gap as well."

Yishen Kuik adds:

 The attention to detail and sense of duty of their workforce is amazing, and the public infrastructure in Tokyo is of a very high quality — certainly better than Boston, DC, New York or the Bay Area. Tokyo is much bigger than all these four areas. It makes New York seem small.

It's not entirely clear to me why their equity markets haven't done better, but the "obvious" explanations of long term multiple contraction and shrinking internal aggregate demand seem to be correct.

I believe GDP per capita in Japan has been rising all along at the same pace as in the US since 1989, so it isn't as if quality of living in Japan has been frozen at 1989 levels. From what I can tell walking around the streets, they still enjoy a comparable standard of living to anywhere in the OECD, and have an unemployment rate (whatever that means in Japan) of 5.0%

Henrik Andersson replies:

Some investors are expressing great fear about the debt given the large amount maturing in the coming 12 months that is held by citizens, as Yishen writes, and given it has "no foreign demand, no domestic savings, structurally declining tax receipts and savings due to demographics, etc." Any views on this?

The top line numbers for the country are stagnant, but the per capita numbers don't look so bad. Japan might have a ton of public debt, but most of it is yen denominated and some 3/4 of it is held domestically by its own citizens.

Dan Grossman writes:

 Two thoughts perhaps follow from the helpful comments of Prof. Pennington and Mr. Kuik:

1. Based on the two-decade decline in average Japanese stock PEs from 200 to 33, why shouldn't average US stock PEs decline further from the current 22 if government policies following bursting of the bubble are equally ineffective in the US as they have been in Japan?

2. If since 1990 the U.S had avoided illegal and legal immigration anywhere near the extent to which Japan has, the US unemployment rate would probably also be 5%.

Vitaliy Katsenelson adds:

Please look at slide 14. Japanese valuations at the of 1989 were incredibly high, add to that a lengthy deleveraging process on the corporate side and leveraging (debt to GDP has tripled) on the government side and you also have anemic economic growth.

Vince Fulco writes:

Here is fascinating article in the WSJ re: a foreigner helping a small japanese village manage the downside of the demographic slowdown. One wonders how much more pervasive this sclerotic 'no change' attitude really is…

Charles Pennington adds:

There's a nice column by Lisa W. Hess in the Dec. 28 Forbes about investing in Japan.

She claims that small cap companies are even more undervalued than large cap, and recommends buying the Topix rather than the Nikkei.



 Virtually unlimited access to cheap money blurs lines between what makes economic sense and what doesn’t. If it can be financed it will be built. Dubai’s plan to diversify away from petrochemicals made sense. Maybe it is even destined to become the Las Vegas of the Middle East, the Mecca of business travel and luxury. Dubai, however, is like NASA; both have proven that anything is possible when you ignore economic costs.

Many technological discoveries were made in the process of putting a man on the moon; but the project did have, and was expected to have, a negative return on capital. Dubai has followed a similar path. The absolutely impossible category may not include building an underwater hotel or the tallest building in the world, at a cost of $4.1 billion, or a covered ski resort in the middle of a desert, but these projects surely deserve a place in the category of economically impossible. Like putting men on the moon, Dubai’s projects were destined to have a negative return on capital. (At least NASA was up front about it).Dubai’s construction wonders were made possible by high oil prices and, more importantly, unlimited (at the time) global liquidity – subprime global lending on steroids. Today Dubai, a city/state that could do no wrong just a few years ago, is defaulting on the debt it issued to finance its building boom. However, what is happening in Dubai is just the most recent, most vivid example of what took place all over the world until the economic crisis.Economically impossible endeavors with negative returns on capital were everywhere and Dubai is just the latest to go bust. Though everyone is talking about Dubai’s potential default, the scope of the problem is greater. Think about how much energy (oil, coal, natural gas), materials (steel, concrete), and industrial products (cranes, tractors) – in other words, stuff – it took to build these economically impossible wonders. China, the most populous country in the world, also masked its share of economically impossible projects through the guise of “stimulus” and at times outright censorship. China is the birthplace of the largest shopping mall in the world which is empty, and a city built on spec for a million people that remains mostly vacant. These two just scratch the surface.

The rest of the world, including the US (after all, we built a lot of now-empty houses and condos) is swarming with economically impossible projects. How many houses (or in the case of Dubai, mansions), factories, hotels, skyscrapers, shopping malls, and railroads will not be built because there are too many already built? And if this is not convincing enough, funding economically impossible projects will be difficult for a while, as lack of liquidity and insurmountable losses suddenly turn bankers into … bankers. They find religion (at least for a little while) and start giving loans to folks who are expected to actually pay them back.Dubai is the exemplar of economically impossible activities that have taken place everywhere, and why one can’t be optimistic that demand for stuff will return to levels even remotely close to what they were in the days when everything was economically possible and financeable.*Epilogue* My father lives a block away from my office. I stop by his house a few times a week on the way to work. We have breakfast (my stepmother makes a killer fake-egg omelet) and stimulating conversation.

My father is a true renaissance man; he is a gifted teacher, a scientist, an inventor, he holds a PhD in electrical engineering, and to top all that he is a very accomplished artist. The bottom line; he is a very wise man. This morning we discussed this Dubai article.He asked me, “But why would people in Dubai spend billions of dollars on buildings if they have little chance of earning a return on it?” He added, “I would think they’d have rational voices at the table pointing out obvious holes in these multi-billion projects.” At first I tried to explain that if things can get financed they’ll be built. I sensed skepticism. Then I explained how groupthink works, that under crowd pressure, especially after their predictions of the bubble bursting were proven “wrong,” as real estate prices kept climbing, skeptics were either turned into believers, got quiet, or got fired for being doomsayers and not being team players. My father started to see what I saw, and then I told him a joke that I heard from Warren Buffet years back.

A very successful oilman dies. He faces Saint Peter, who says, “You’ve been a good man and normally I’d send you to heaven, but heaven is full. We only have a place in hell.” The oilman says, “Any chance I could talk to other oilmen who are in heaven? Maybe I can convince someone to switch places with me?” Saint Peter says, “It’s never happened before, but sure, I don’t see any harm in it.” The oilman goes to heaven, finds an oilmen convention and yells, “They found a huge oil discovery in hell!” Oilmen are stampeding out of heaven to hell, and our oilman is running with them. Saint Peter asks him “Why are you going to hell with them? I have a spot in heaven, you can stay.” The oilman answers – “Are you kidding, what if it’s true?”

My father got it.



[Warren Buffet] would have done a lot better if he had sold [Washington Post, Procter & Gamble, Johnson & Johnson, Coca Cola…] when they became fully valued (or slightly overvalued). In most cases, that would have been a decade ago. Vitaliy Katsenelson.

Mr. Buffett retains his shares of Coke for the same reason Mr. Gates retains his shares of Microsoft. Berkshire-Hathaway's taxable gains on any sale of that position would be so large that the stocks would have to fall by 60% for the net, after-tax return from a sale and repurchase at the lower price to exceed the return from Buy and Hold, even with the relatively poor performance. Mr. Buffett remains the sharpest knife in the drawer as far as the tax code is concerned; that is why he, like Scrooge McDuck, will literally take it with him when he goes.



1. Jon Stewart on Tim Geithner's (the Treasury Secretary) inability to sell his own house — includes funny interview with Sh_ller (video) [4:52 minutes]

2. More stories are coming out about outrageous real estate projects in China; Video of empty skyscrapers in China, reminds me of empty condo buildings in Miami [4:55 minutes]

3. Lenny Dykstra (Mets baseball player) video about his business career: my favorite line "he took a year off to master the stock market"  so he could manage his own money (but he also said "I don't read books, they give me a headache"). At the end, in his foreclosed mansion devoid of furniture he denies being broke. [11 minutes]



V KThe hardest part about being a parent is setting your own example. It is so easy to tell kids what is the right thing to do, but actually doing it is a very different.

Today I washed both cars with my kids (Jonah 8, Hannah 3). It would have been so much easier to pay $20 and take cars to carwash. Well, after two hours of hard labor, the kids feel that they accomplished something, I feel tired and proud of both them.

Nigel Davies adds:

Given my own son's dislike of being told what to do I figure the best may be to lead by example, spend as much time as possible with him and listen rather than talk. And come to think of it these are all good traits for market people.

GM Davies is the author of Play 1 e4 e5: A Complete Repertoire for Black, Everyman, 2005

Legacy Daily writes:

Children teach us by example as well. They have the ability to bring out the best in their parents — and sometimes the worst. They carefully and subconsciously set up tests to bring parents to extremes to examine the behaviors and to learn from those. Their rate of learning is far beyond our rate of feeding them information. Therefore, they are programmed to learn by observation, through play, through others. Through this process, they create many opportunities for us to learn as well.



WD 40I have to admit I've never read Rolling Stone Magazine before. I read it for the first time today. I found the absence of political correctness very amusing and refreshing. I don't remember seeing the word "a-hole" used in a financial publication, especially in the name-calling type of way. Rolling Stone called John Thain of Merrill Lynch fame (who spent million dollars to decorate his office) and Cramer by that word. Latest issue has a lengthy article bashing Goldman Sachs ("The great american bubble machine") for its role in last six bubbles. I am far removed from Wall Street but it seems to me that all investment banks (and Wall Street in general) supplied the WD-40 on the wheels of bubble creation. Goldman was not a alone. It is not much worse than others with one notable exception — a lot of alums joined top positions in government — Rubin, Paulson, et. al…

From a practical perspective one factoid really made me think: oil went from $60 to $147 while supply increased and demand declined. Oil's rise was completely driven by speculators. This is important; here is why: nobody knows what the oil price should be. Thus oil producers/consumers/investors are comparing $60-$70 prices to $100-$150 prices and in comparison they appear cheap. But once you realize that $100-$150 prices were a fluke, a speculative aberration driven by pension funds "diversifying" into commodities, a one time phenomenon, suddenly $60-70 may not be cheap. In fact in the world where demand for oil is expected to drop, these oil prices may actually be expensive. Also, think what impact high oil prices had on other commodities.


12 today has a very complimentary comment on W.J.,  who I assume was Stefan's father.

The comment is from Russell Roberts; it is dated June 11 and is a quote from Mark Helprin.

The back story is that Dad gave Helprin the equivalent of a 3-picture deal in one of Dad's vain attempts to give his Trade Department some cachet. It failed. Dad would not have agreed with Helprin's comment about his publishing contemporaries - i.e. "(u)nlike many of his shallow counterparts." Dad never thought the people in publishing were "shallow". He thought they were, if anything, too subtle to be any good at simple commerce. I can understand the reason for Helprin's back-handed compliment; nobody has ever given him anything close to the money that Dad did.

The comments on death are equally overwrought: "(it) gives to our lives, no matter how glorious, a signature in a minor key". Dad had scarlet fever when he was 6 and spent the next 2 years in bed (where he read all of Dickens). He had his first heart attack when he was 33; he died of a final infarction (his 8th cardiac episode), brought on by kidney failure, when he was almost 80. He never thought mortality was a subject worth considering.

Vitaliy Katsenelson writes:

California's push for e-text books will do the same as WMT did for RFID industry, it will legitimize it and provide scale (Caligornia governor seeks online revolution in schools).

Jeff Sasmor objects:

Probably true, but Texas is the elephant in the K-12 textbook market IIRC.

Stefan Jovanovich explains:

Texas is the elephant because the books that that state adopts can also be sold in Nebraska and South Carolina and even a blue state like Rhode Island. We in the Golden State have had so many special requirements (because of our obvious superiority) that the publishers have had to make special editions. Since the central truth of manufacturing remains the same even in such a rarified business as publishing aka printing (every extra unit sold without retooling is pure profit), CA's push for e-text books could only be compared to WMT's adoption of RFID if WMT had required that every signal include a hologram of Sam and his brother, the bomber pilot. The problem with e-texts is that customer do not feel they have any obligation to pay for anything that is purely "intellectual property". Jeff Bezos is clever enough to have figured out that customers need Kindles so they can tell themselves it is worth the money to pay for the special formatted manuscript. Eventually, he will have to price the reader the way King Gillette priced his razors.



 When I think of Microsoft stock, images of Susan Boyle in "Britain’s Got Talent" come to mind. The Scottish woman appeared — middle aged, awkwardly dressed, unsure of herself, unattractive by conventional standards — and expectations of her singing were in line with her appearance. As long as she did not fall off the stage, the audience would have concluded that her performance was a success. If Susan Boyle was a stock, I’d call her a deep value stock with very low expectations, and thus a great margin of safety, selling at a discount to its fair value. Then she opened her mouth, and to everyone’s shock, this duckling had a beautiful swan of a voice. She became an overnight sensation. The video of her performance was YouTubed more than President Obama’s inauguration.

Then here comes Microsoft (MSFT). The company’s name doesn’t have the luster it once had. It's seen as middle-aged, overweight and slow, and it is believed by many that creativity retired with Bill Gates.

The sentiment is so horrible that there is almost universal expectation that it will not come up with another good product, ever. Kodak and Polaroid are now used to describe Microsoft’s “bright” future, and Apple and Google are the ones that will retire it there.

But the ugly duckling is about to sing, and it will be a Susan Boyle-like performance.

Vista's flop will lead to Windows success:

Microsoft is releasing Windows 7 sometime in late 2009 or early 2010. It's last operating system, Vista was a flop. Consumers did not care for the product and corporations did not upgrade.

Of course failure is a relative term when it comes to Microsoft. At its release, Vista sales were double that of XP, the previous version. Vista still commands almost 24% of market share, second only to XP’s 60% plus.

Windows 7 is not just another new release. It is really Windows Vista 2.0, or Vista-fixed, if you like. Microsoft took Vista’s kernel –- the core of the operating system — fixed it, made it faster, improved the interface and added new features, Voila, you’ve got a new multibillion dollar product.

Many corporations did not upgrade to Vista: they stayed with XP. This is now eight years old, a dinosaur in software years. Microsoft will eventually discontinue support and updates for XP. Unless all hackers “pinky swear” (my 8-year-old son’s favorite phrase) that they’ll not try to figure out a way to hack into the 400 million computers that run XP worldwide, a computer running could be left exposed to new security attacks.

Corporations will not likely take hacker’s “pinky swears”, they’ll have no choice but to upgrade to Windows 7. Also, this time they won’t have to do the usual thing and wait for Service Pack 2 — the inevitable set of bug fixes to the original product. Vista’s Service Pack 2 is already out, and in many ways Windows 7 is Service Pack 3. Expectations created by Vista for Windows 7 are incredibly low for Microsoft, but 7’s success is likely to be very high.

Other reasons to go Bin:

There's more: Aside from Windows 7, there is plenty of promise in other products that are not built into Microsoft's stock. Bing, a new, improved search engine, is just out and the presentation I’ve seen of it is very impressive. Office 2010 will bring a subscription-based office onto the Web which may fix a longstanding consumer piracy issue. (I personally don’t know a single person who actually bought a copy of Office for home use. Maybe I need new friends, but people just don’t want to pay $300-400 for something that we consider our birthright. )

With Office Live, Microsoft will charge an annual fee, and you’ll get a Web product that has the same look and feel of the Office you are used to using at work.

This ugly duckling is not hanging by a thread. Microsoft still has Windows, server products and Office, holds a leading position in gaming, generates billions of dollars of free cash flow, has $23 billion of cash and its debt will likely be trading at lower yields than Treasury’s very soon.

But the best part, there is nothing positive priced into this stock, which trades at about 10 times free cash flow. It is incredibly cheap. Buying it now is like a talent agent signing Susan Boyle as a client the day before she went on stage. P.S. Though I’ve written this article last week, before Susan Boyle lost on Britain’s Got Talent, her loss did not make the point of the article any less valid. In fact, I spent several hours this week watching Britain’s Got Talent on YouTube with my wife and kids. What an incredible show. Susan Boyle did not win, but did not lose either, she’ll will likely become a big star –- she has a wonderful voice. I’d buy her CD and go to her concert in a heartbeat.



 I had a very interesting conversation with a reader about an article I wrote about China. He argued that there is something very important and intangible economists cannot measure — the will of people. That will becomes even stronger when the country’s past is ridden with political and economic misery. Think of Germany and Japan after World War II, their economies were in shambles but human capital and ingenuity played a lot larger role in their recovery than the traditional capital. In other words economic models at the time would have predicted that those economies would not recover as fast and as well as they did, as they would not have accounted for human factor, the raw (and very selfish) drive to succeed.

The reader was making the argument that because of its poverty-stricken past, like Germany and Japan did after WW2, the Chinese people’s ingenuity will put their economy on a tremendous growth trajectory. I thought it was a very interesting observation, though I never really made an argument that China is going to fail and go back to pre 80s or 90s era. My argument was that all good things need time to rest, that is why economies have normal cyclicality (periods of expansion are followed by recessions). Chinese growth was very high for a very long time, it needs a good rest which it doesn’t get because its government is afraid of civil unrest and thus is spending money at a very fast pace.

Misery alone is not enough. Japan and Germany recovered and blossomed because those were capitalistic societies, in fact their success is a triumph of capitalism. China is toying with communism (socialism) and capitalism at the same time. Unfortunately, at the time of crisis if a choice is given government will chose the path of lower resistance – the communism (socialism). (Just think of what our government is doing today.) Although the harder, the right, and more painful (at least in the short run) choice is creative destruction — capitalism.

Russia is a good example, the same Japan/Germany after WW2 argument could have been made about Russia in early 1990s. It had a very educated population, which saw plenty of misery. For a while Russia was going the right direction, but the crisis of the late 1990s shifted the country back from democracy and capitalism toward a more command and control economy. This conversation made me realize that Chinese success in the future, past the short run, will depend on the market system it chooses. Capitalism will let the human ingenuity fester where communism just going to crash it.

In investing it is important to think unconventionally, to consider not obvious risks but the ones that are hiding around the corner. For many investors it is a foregone conclusion that China will consume more stuff (energy, materials, industrial goods) in the future, thus many argue that one should buy what China needs – the stuff. But this investment thesis will only workout if China sticks with capitalism, if the current crisis will not push it towards the road of the least resistance - the communism. Thus let me issue this warning: If I were to follow the “buy what China needs” investment I’d watch political developments over next couple of years in China very closely.



V KThere is a tremendous misconception that leveraged (double, triple, long or short) ETFs are to be used as long-term investments. On the surface they make a lot of sense. You want to hedge your stock portfolio, for instance, you buy a double short ETF of the market SDS (double short of S&P 500) or QID (double short of Nasdaq 100) and for each 1% decline of the market you make 2%. It does sound like a great deal. Leveraged ETFs have been sold as panacea to this market volatility, but panacea they are not. If used as investment (not trading) vehicles they may cause a lot of harm to your portfolio even if you were “right” on their use. They should not be used as a long term investment, but only for short-term trading (i.e. days not months).

Daily compounding (recalculation) will cause their returns to deviate substantially from the underlying index. The math is too complex and too boring (an article by Morningstar explains it well), but instead let me demonstrate by this very real example (chart here).

Let's suppose that six months ago you had a great insight that financial stocks would decline. You figured to get bigger bang for the buck you’ll buy a double short of Dow Jones Financial Index (a simple plain vanilla long ETF for this index goes by symbol IYF). The index and thus IYF declined almost 20% in six months thus you’d expect your double short (SKF) would be up about 40%. However, if you look at the chart  you’ll see that it declined almost 60% instead, as much as double long ETF (UYG) of the same underlying index.

Note that over the short term (days) these ETFs seem to work. This is one of those investments where you have to make sure that you nail the timing perfectly, otherwise you are in trouble.

Marlowe Cassetti comments:

I have been both an ETF junkie as well as a mechanical trading system developer. Why not combine the two? I have found trading systems that operate on a basket of ETFs tend to suffer from the inclusion of the leveraged ETFs into the basket. This leads me to infer that the leveraged act more randomly then their cohorts. With that knowledge I was confronted with my system picking UltraUltra-Short Estate ProShares (SRS). I held my nose and bought it anyway and turned a nice 8% profit in two days, all the time watching it with high anxiety.



The chair has many times pointed out how the vix level is an indication of future moves on the SPX. The VIX seems to be under great pressure here, even with yesterday 2% fall on the SPX the VIX was down, that must be highly unusual. Just an observation.

Greg Calvin writes: 

 It seems there have been numerous unusual moves in VIX recently. Similarly, today's VIX movement thus far is interesting in contrast to the market's paint-drying picture, and the relative movement in contrast to for example, yesterday's relative moves intraday.

Vitaliy N. Katsenelson writes:

I've met a money manager yesterday who explained to me that the decrease in risk premium is driving the market up (and vice versa). He showed me a nice chart that displayed risk premium as inverse P/E (earnings yeild) less 10 year Treasury. This major problem with that concept is that E over last 3-5 years did not really represent a true earnings power of S&P, it overstated it. P/E was too low. Margins reverted towards the mean -declined, E declined and took market with it. I'd suggest to use a ten year traling P/E, at least it will cover the full economic cycle and thus margins will be normalized and P/E (or earnings yield) will be more meaninfull.



I'll not make a prediction if this latest rally in stocks is sustainable or not. I don't know. But it is self-fulfilling. Rising stock prices improve consumer confidence, and more importantly send a signal to CEOs and other executives that maybe there is a light at the end of the tunnel, and maybe that light is not another oncoming train.

CEOs, who despite the appearances, are as human as everyone else, may decide to postpone or at least reduce the speed of job cuts as they start taking cues from the stock market.

Thus this stock market rally (if not followed by a sharp decline) may actually help the economy, at least in the short run.

Nigel Davies replies:

Interesting take on things. Optimism is usually associated with the likelihood of a fall, the logic being that 'everyone has already bought'. But maybe there's a difference between new optimism and old optimism.



 One of my favorite lines in a philosophical novel (Sophie's World) is "Why is Lego one of the most ingenious toy in the world?" My thoughts are that it is timeless, creative beyond imagination, durable, ageless (adults can play too), and global. Stocks are I feel parallel in that they too have to be one of the most "ingenious speculative toys in the world". What are some of the reasons for you? Many are the same for me as for Legos. 

V. Katsenelson adds:

This is what I wrote awhile back about why I love investing: I love everything about it:

The uncertainty of every decision. The intellectual exercise of putting different pieces of the puzzle together while never having enough information at your disposal. The constant battle with one's emotions, the hardest and the most important battle of all. The never-ending pursuit of perfection despite its unattainability, how just when you think you have figured it out, the market has a new lesson in store for you. The humbling aspect of the market, arguably the most humbling mechanism ever invented by humans. The people, the debate, the search for the truth. The fact that for every trade there are two opposing sides (buyer and seller), and time is the variable that separates them from discovering who was right and who was wrong. And finally, the hidden, rarely recognized, but fascinating impact that randomness plays in many outcomes.



 Russia's economy is deteriorating at a very fast pace. The Stabilization fund — a giant $450 billion savings account — has been depleted by a quarter since September as Russia tried to defend its currency. Despite that attempt, the ruble still declined.

Russian companies are facing $170 billion of debt rollover next year. Since the rest of the world is not willing to finance companies in stable political regime, getting financing for Russian companies will be a problem. Mr. Medvedev and his boss (Mr. Putin) will have to spend another quarter of the reserve fund Russian corporations. According to the FT, as the Russian economy is starring into a deep abyss and Russians suddenly start waking up to realization that almighty Mrs. Oil and Mr. Natural Gas were responsible for (temporary) resurrection of Mother Russia, not Mr. Putin, people are already whispering for Mr. Putin's resignation.

These whispers will magnify as things get worse. But what concerns me is the likely response. I visited Russia in September for the first time since I left in 1991, and even though at the time Russia was still prospering (and economic crisis was weeks away) I still felt this broad anti-American attitude.

Now that things are getting worse every minute, Mr. Putin will likely redirect the attention and shift the blame to — you guessed it — the United of States, the mother of all evil. The United States will be responsible for the global crisis, for manipulating oil markets, and anything bad that happens in Russia, the US will be the culprit. I don't think this brings the US to war with Russia, but the relationship with Russia will likely get a lot worse.



 Here are my latest thoughts on JOSB. We don't own the stock, sold it in September. This company is truly incredible; you'll see why:

When I think of the Jos. A. Bank, I think of Yogi Berra's saying "Nobody goes there because it is too crowded."

Only in the case of JOSB, it sounds like this: "Everybody goes there because it is not crowded." As most men who shop there will attest, you are lucky to see and handful of customers shop at there at once at any given time. Nevertheless, it seems that JOSB operates in a very different economy and there is an incredible disconnect between its performance this year and the rest of the economy as well as other retailers.

JOSB reported 3rd quarter numbers couple of days ago and they were stellar even by a healthy economy's standards.

They were truly incredible considering that negative double-digit same-store sales for retailers have become the norm. JOSB reported same store sales of 7% for the quarter (the company doesn't report monthly numbers anymore). Total sales were up 13.7%. Operating profits before taxes were up 20.3%. Cash was up year-over-year, and inventory growth lagged sales. Every single metric was simply beautiful.

A great number of the company's stores were opened over the last three years which puts them in the category of "immature." New stores, almost by definition, generate lower sales than mature stores. As stores mature, same store sales rise and profit margins expand. In addition, the company is able to spread advertising dollars against a large store base, which is another reason why the margins increased.

By the year-end JOSB should have over $100 mln of cash, which is about a quarter of its market cap. The margin expansion may actually continue into next year. JOSB said that it will slow down store openings next year but it will increase offerings of big and tall merchandise. I believe this will help JOSB generate more free cash flow as well as drive (a much higher margin) same store sales. At some point the economy will catch up with this retailer, but a lot of internal positives I just mentioned should mitigate the external negatives.

I presented JOSB at Value Investing Congress in Pasadena this year (see slide 31).



I wrote this short piece for Minyanville. Also, take a look at very a interesting interview [26 minute video] with Jeremy Grantham, who heads GMO — a $100 billion shop. He is (cautiously) bullish on stocks for the first time since I can remember.

"You should buy Freeport McMoRan (FCX), Caterpillar (CAT), PACCAR (PCAR)." -that is what I hear from friends of mine, who are in the biz, all the time. They tell me how cheap these stocks are - 3, 6, 8 times earnings. "You are a value guy! How come you are not loading up on them?" they say.

Let me tell you when I'll buy "stuff" stocks (if ever do buy them because I've never really cared for the cyclicality of their business). It's when everyone stops telling me how cheap they are and that they are "buys."

These stocks are very similar to housing stocks two years ago: housing stocks were down 50% and looked cheap. Value managers bought just to see their stocks get cut in half again and again.

One needs to sub-normalize earnings in this environment for all stocks, but "stuff" stocks need to see their earnings to be "sub-sub-sub-sub normalized." I've said it before, but it is worth repeating: the global economy just started its journey of going into a recession; demand for "stuff" will drop off the cliff most likely to a lot greater degree than anyone imagines.

I hear from my friends in Russia that the construction business that was booming only in September is dead. Like deader than dead. It doesn't matter if projects were finished or not, investors took their money and ran. Russia may appear like a special case since its prosperity is directly linked to commodity prices, but the slowdown is happening in the rest of the developing world like China and India… and the list goes on.

Stuff stocks are likely to bottom when they'll look expensive - their "E's" will be low or negative. Also, consumers were not the only ones that over-consumed "stuff." Emerging markets over-consumed earthmovers, tractors and factories. They still have huge overcapacity at a time when the global economy is slowing down.



V KatsenelsonQ. What provision does the value investor make for an error in his estimation of the "true" value?

A. Investing is not a precise science, a fair value is an estimate. That estimate is as good as the assumptions that went into it. I detest the precision of many sell side analysts when they estimate the value of the company (i.e. we believe this company is worth $10.75 thus at $10.10 it is 6% undervalued). I suggest to tamper with assumptions to arrive to ranges of estimate (i.e. change discount rate, sales growth, profit margins etc., tinker with them to figure out the impact they have on the fair value. Also playing with these variables will help you to understand which ones have the most impact on the value of the firm and thus you can spend your time focusing on things that really matter).

In my analysis the required margin of safety is a function of two variables: company's quality (the higher the quality the less margin of safety I need); and fundamental return (earnings growth and dividends), the lower the fundamental return the higher margin of safety I'll require as I need to be compensated for the stock turning into dead money. In other words when you own a company that doesn't grow earnings or pay a dividends, a time is not on your side, thus you want to make sure that you are compensated for that by a larger discount to fair value.

Q. What of Keynes's warning about the tenacity of the market's irrationality outlasting one's funds or investment horizon. How do you deal with that?
A. Great question!

The point I made above answers this question somewhat, but I'll repeat. If I own companies that pay dividends and grow earnings I'm compensated for the wait. Dividends provide a real time payments, where earnings growth makes companies more and more valuable, compressing the P/E under the stock.

This is a reason why I don't use leverage. Leverage compresses the time of your bet. Even if you are right on undervaluation, leverage may kick you out of the position before your proven right. To some degree this is what happened to LTCM, they were right on the arbitrage but because of the high leverage they did not survive to see themselves being proven right.

Q. Also, at what point does the value investor exit on the upside, assuming that the market "wises up" to the "true" value of the stock and starts bidding it up? When the price reaches value, or when it overshoots it by some predetermined amount, or what?

I suggest figuring out the sell price or sell P/E (I prefer P/E) at the time of purchase. This way you have not developed the psychological attachment to the company. I discuss selling in my book in depth (Active Value Investing: Making Money in Range-Bound Markets). The sell price will be close to the fair value point.

Q. Finally, can't the stock price itself affect "the fundamentals" in a Sorosian fashion (e.g., cost of capital, certain loan provision triggers, ability to make acquisitions, attractiveness as an employer, etc)?

A. I try not to own companies that rely heavily on external financing or their P/E staying high so they can make "accretive" acquisitions. This point you touched upon is so true with banks in today's environment; they have to issue stock because their capital is destroyed, but their stock is down. But let me give you the opposite side of this: I own UNH , WLP, NOK and Microsoft , these companies have couple things in common, they have incredible balance sheets (NOK and MSFT have no net debt and billions of cash), lower stock prices will provide these companies an opportunity to buy their stock on the cheap.

Q. The bedrock premises of value investing have always left me slightly puzzled, as if I'm missing something.

A. I guess the idea behind value investing is to find companies that market misprices (often for psychological reasons) and sell them when market recognizes the error.



Just came home from Columbus, OH Airport and outside of Athens, OH on Route 33 a roadside billboard ad caught my attention. The large billboard featured a stately home covered with a red brick veneer and a steep roof (likely 12 on 12) and black dimensional shingles. The company advertising is Schumacher Homes and the home featured (my estimate) would be around 5,000 ft2. Now for their ad: They are offering to make your house payments for a full year! Now, all of us know there ain't no free lunch and somebody will have to pay for the year's worth of mortgage payments, right? Most likely scenario will be that the payments for the first year will be built into the mortgage and either will lengthen the loan or make the payments higher when they ' kick in' after the first year. It is creative advertising — flawed though the concept may be.

Vitaliy Katsenelson adds:

I saw a Jeep commercial advertising $3 per gallon gas for a year (limited to 12k miles) if you buy a new car. I guess automakers are using similar tactics to try to sell gas-guzzlers.

Jeff Watson recalls:

I remember telling my wife that the real estate market was hitting a top when I saw signs everywhere, offering mortgages for 130% value with no income verification.

Adam Nelson explains:

I think these sorts of gimmicks are a way for the builder to offer a discount without lowering the house price (which would thereby officially lower the price of the houses they sold to your neighbors as well). Because appraisals are made in part via property records or MLS sales figures which don’t include discounts structured as something given in addition to the house, the builder hopes to preserve the valuation of the other houses by giving this kind of sneaky discount.



Yesterday I was just putting my 7 year old son to sleep; he asked me to tell him about my childhood.  I told him that when I was growing up in Russia we did not have VCRs and so on.  He asked me: "Pa what is VCR?".  I was shocked.  I did not realize that his generation will not know what a VCR is.

Steve Leslie reminisces:

Here is the technology that I had in my home when I was seven years old in a middle class neighborhood in Ohio: One black and white TV with rabbit ears, three networks and a local TV channel that signed off no later than 2am. A record player (mono). Two telephones and one line (my cousins had a community line where you could hear other people's conversations. A few radios — AM dominated the airways (CKlW was out of Detroit). I think I did have a combination clock radio in my bedroom. That was pretty much it. A typical day: We got home from school around 3pm. We usually walked home, most likely a mile or two. Watched American Bandstand and the Merv Griffin show. A few years later an episode or two of Dark Shadows. Did our homework, ate our family supper, went outside to play until dark then came in cleaned up for bed. Fell asleep listening to the Cleveland Indians ballgame. On Saturday, if we were lucky we could go to the movies for a Saturday matinee. We brought our own popcorn and candy. I never thought then or believe now that I ever lacked in anything of value in my childhood.

Leon Mayeri writes:

We cancelled our cable TV subscription several years ago when our youngest son was born. We have a 13 year old who enjoys watching occasional PBS documentaries with our rabbit ears analog TV. Our six year old selectively watches sports on what amounts to only three local stations, but we also actively encourage reading in our household. There’s an alternative to the plethora of mindless commercial shows: you can rent the occasional DVD for the whole family to watch, or watch something fascinating on PBS together.

Our teenager has, predictably, become fascinated with other screens: first it was game-boy, then iPod, then a MacBook laptop. and now he has hit the grand slam with his state of the art Samsung phone. His Bar Mitzvah brought great fortune and instant distraction.

Simply stated, the best plan of attack with all this heightened technology is to have active discussions about science, technology, and worldly events with your children at the dinner table, and make frequent visits to your local library. Amazon and Barnes are most helpful as well. As long as they learn to read, they have a chance to succeed.

Jeff Watson remarks:

Having converted my entire music to digital format by the mid 90s, my large collection of LP’s has sat boxed up in a closet unused for years. My turntable died in the early 90s. Last year, my son discovered the LPs, bought a turntable on eBay, and has been playing LPs whenever he is home. He considers it retro, therefore “cool.” Those pops, clicks, and hiss from the vinyl bring back a wave of nostalgia every time I hear one played. One thing I really miss is the “album art, which was a valid art form in it’s own. Albums covers and liners in the 70s from bands such as Yes, Pink Floyd, Fleetwood Mac and the Stones provided some of the best examples. Unfortunately, album art just doesn't translate very well to a CD cover.



ColonelI attended YUM's (KFC parent) investor presentation six months ago, they spent 55 minutes out of an hour talking about their China growth strategy. it seems that with the exception of Chipotle and Qdoba, that fast food growth story will be coming from outside of the US. KFC, since it serves chicken — the universal all-religions-unite meat — should do well overseas. I hope its stock will get knoced down with the rest of the market on the fears of the US recession, it may provide a great opportunity to pick a truly global fast food chain.

David Lamb adds:

Down here in Panama there is the Multiplaza, an upscale shopping mall with a large food court. On any given day when I walk into this food court I'll see two very large lines. One is for Lenos and the other is for KFC. The Panamanians absolutely love KFC.

Steve Leslie extends:

Geographically speaking, look at what is going on in Asia and the Americas. Colombia is actually reforming itself from a banana republic steeped in corruption and drug warlords towards democracy and capitalism. Vietnam is evolving from a primal war-torn country to progressivism. Even isolated communist North Korea seems to want to partake in the benefits of free market capitalism. I heard during a most recent trip to the U.S. many members of the Cuba national soccer team asked for asylum. Bi-lingualism is a very sought after commodity. English/Spanish and English/Chinese are in great demand. The best thing a parent or grandparent can do for children is direct them toward a second language esp. at a very young age. All studies indicate that the earlier a child learns a language the faster he will grasp it and the longer he will retain it.



Humans are an adaptive bunch and despite living in times of plenty, I expect there will always be a dissatisfaction amongst us. Having a media that spends all its time emphasising the negative just only makes matters worse. I'll confess that I still watch way too much garbage on the idiot box but I tend to stay away from many news stories, realising that car crashes, murders, traffic jams, etc. are always occurring and why do I need to know all the gory details? I would be interested in looking at the bigger picture trends, but the news doesn't report anything along these lines.

Vitaliy N. Katsenelson adds:

For six months I disconnected TV service completely, but reconnected it since. I still don't watch local news. If I did not know somebody's been shot in the pizza joint that I can actually recognize, would it make a difference in my life? It seems more real and thus more depressing when something bad happens not far from where you live.
I stopped reading financial articles from websites like Motley Fool that are in the business of writing several hundred articles a day. I know many great writers at Motley Fool — some of them are my friends — but you cannot write 5 or 10 articles a day that are good. Unfortunately this applies to most financial news. Yahoo News has been junked — worthless articles.
Same applies to news, if you have to have something to report 24/7 you'll report junk.



McDonaldsJust caught on the news that Mc Donalds will add a 'coffee bar' and make more dramatic changes to their drink menu than they have in the past 30 years. I enjoy their Bravo coffee and am sure I will enjoy the drink additions when they reach my area. Mc Donalds is apparently still setting the pace in many areas as it was also announced that Starbucks now plans to make changes.

Sam Marx adds:

Although Starbucks gets a different niche of customers, this not good news for Starbucks .

A coffee bar and wi-fi at McDonalds, then Starbucks really has a problem.

Adam Robinson reflects:

I've always believed that the ethos of a corporation pervades, DNA-like, throughout all manifestations of the corporation, however small the "cell." If you want to discover the values of a company, you can look anywhere, from its choice of stationery down to the cleanliness of its floors.

Back to Starbucks. It was telling for me regarding the company's values that, living as I do five blocks from the former World Trade Center, I was shocked that in the days following, when rescue workers, many of them volunteers, flooded the area to begin cleanup, the local Starbucks was selling bottles of water. I'm as much a capitalist as anyone, but the outrage this opportunism occasioned in the local community, and subsequent bad publicity — Starbucks quickly reversed its policy and began handing out bottles for free – rankles to this day. The positive publicity it could have garnered by donating the water to relief workers would have more than paid for the negligible profits "sacrificed."

Ray Kroc was fanatic about cleaning his stores, and making everything perfect. Moreover, McDonald's franchisees are a powerful force for innovation and market research. I doubt that Starbucks has any such credo. And were I a fundamental investor, I'd bet on McDonald's in the race with Starbucks.

Ryan Carlson adds:

A worthy read about McDonald's is Ray Kroc's Grinding It Out. My favorite passage:

The key element in these individual success stories and of McDonald's itself, is not knack or education, it's determination.  This is expressed very well in my favorite homily: 'Press On: Nothing in the world can take the place of persistence. Talent will not; nothing is more common than unsuccessful men with talent. Genius will not; unrewarded genius is almost a proverb. Education will not; the world is full of educated derelicts. Persistence and determination alone are omnipotent.'

Henry Gifford dissents:

Starbucks and McDonalds offer entirely different products in terms of the cultural experience they sell.

On Broadway in Manhattan, two blocks from me, there is usually a homeless person "working the door" at the McDonald's, opening the door for customers and asking for spare change. Once McDonald's put a guy with a bow tie there to open the door for free, but that didn't last long, and the homeless guy is there every day. Also, the workers in McDonalds don't hesitate to stand around and chat and ignore customers.

At Starbucks a block away I've never seen a homeless person "working the door," (nor at any of the other stores nearby), I don't see homeless people sitting there, and the workers have a spring in their step.

Jim Rogers counters:

As someone whose first career was in the hospitality industry, I can state that McDonald's moves markets in more ways than one.

The difference in demographics, however, is a present condition and certainly not a necessary condition. McDonald's has always put its eggs in two baskets: families (especially those with small children) and value. In the past, their offerings were weighted more heavily on the family side of the spectrum. Now, thanks to a number of cultural shifts (including those driven by Starbucks), McDonald's has realized that they can capitalize on the public's perception of additional value. Before, it was all about quantity (the Super-size phenomenon). Now, it's about quality (better coffee, more aesthetically pleasing decor, fresher menu items). In the past 24 months, the majority of McDonald's top line revenue growth has been driven by menu items at the top of the price scale, especially new salad offerings. There are a couple of interesting points that McDonald's has embraced: the masses (or at least a historically large percentage of the masses) will pay for quality, and design makes a difference. It made a difference in attracting the kids thirty years ago, and now it's making a difference as it re-attracts adults (with or without children) with Wi-Fi, coffee, and more pleasing decor.

Marion Dreyfus opines:

Whatever the relative merits or demerits of the individual loci, the Starbucks habituee will not 'descend' to the perceived downmarket of McD's, which is a brand-association drummed into our consciousness by millions of ad messages over decades. The food may be better, the prices definitively so, at McD's, but the smart set will not cotton to the overbright, plastic-dominated perceived lower-ranking environment of kid-friendly McD's.

The escalation of prices for a simple beverage to unheard-of stratospheres is one thing that has, to date, ensured the rarefied perception of Starbuck's as being compatible with the upward-striving status-jumper.

So unless McD's radically alters its branding, the trendoids will find it distasteful to step lively in those swinging doors, even if their coffee tastes more acidic and sets them back more by a factor of twice or thrice the McD's coffee.

Ken Smith comments:

Ronald McDonald is five blocks east of me in Seattle, a short walk downhill a ways. Property they have is also just a short walk uphill to Childrens' Hospital. Parents can stay at Ronald's place while visiting kids, many with cancer. Ronald's facility is commendable for its architecture. One can have nothing but praise for Mr. Ronald, whose plastic body is standing out front of the facility, smiling with welcome. Kids love him.

Vitaliy N. Katsenelson analyzes:

SBUX stock is transitioning from 'growth' to 'value' investors. However, it is not cheap enough for value guys. At least not yet. Also, with current news cycle it will likely see the other extreme of its valuation. In the not so distant future it will probably have to rationalize its store base, close some underperforming stores and slow its growth expansion.

Jim Rogers notes:

Fast-food restaurants, due to their staffing policies, are much more likely to employ legal immigrants than you might think. The biggest offenders in the food world for using illegal labor: high-end restaurants, because they lack the institutional oversight and back-office support to adequately check a lot of prep cook and porter staff applications (and some are simply dishonest). If you're looking for a trade opportunity in the event of some strict anti-immigration policy, short higher ticket restaurant groups.

Scott Brooks writes:

McDonalds will have to work hard to overcome their persona. They have cultivated that image for a long time. I have often joked (with an air seriousness to it) that one of the greatest inventions/innovations of the 20th century was the McDonalds Playland!
I absolutely hate the food at McDonalds and will move heaven and earth to not eat there. But my kids like it. So when the wife needs a break and the kids want to go play, I'll take them to McDonalds, buy a few Happy Meals and let the kids play and eat.
Actually, they don't so much eat as graze. They play, come back and grab a few fries and bite or two of their burger/McNuggets and go back to playing.
As much as I don't like the food at McDonalds, they are an incredibly innovative company that I respect immensely. And with their distribution chain and the demographics of America changing, don't underestimate what McDonalds is capable of.
That clown may look stupid, but underneath there is a shrewd businessman!

Nigel Davies ponders:

I'm just wondering what the real appeal of McDonalds is and what really gets people in the doors.

I often eat at McDonalds during tournaments because there's usually one around, probably they won't poison me and if they do (and I live) I can sue them.

On the other hand my five year old son much prefers the relatively civilised atmosphere of Pizza Hut, so much so that I can use the 'Would you like to go to McDonalds for lunch?' gambit as a threat. Now it turns out he quite likes pubs that do food, but the big thing here was getting him in the door and outside his comfort zone. Now he does miss the balloons but there again he's taken a liking to turkey.

So it seems to me that a lot of this is down to parental choice, the main driver here being cost. Of course most parents are going to be struck by severe pangs of guilt should there be even a whiff of a rumour that the food served up is unhealthy. So with BSE (Mad Cow Disease)/cholesterol etc appearing on the horizon, it was inevitable that McDonalds would take a hit until it overhauled its menus and image.

In this respect I see the coffee/WiFi as being a really clever means of making them look like Starbucks and feeding off the modern, trendy and healthy image of the coffee house chains. But are they a 'competitor'? I really don't see it, and I don't see a Starbucks denizen suddenly switching to McDonalds because of the cost. To me it looks more like an image thing to get the old customers back in the doors.

Julian Rowberry submits:

Starbucks never really caught on here in Australia. Its brand name and attempt at exporting US culture is a tad brash for the local market. Plus there's already a vibrant cafe scene. The Maccas Cafe has been here for years. It's aiming at the fast and convenient 'healthy eating' market that companies such as Subway feed on. Not branded wanker latte drinkers.

Alston Mabry recounts:

Burger KingAt Burger King the other day (I'm not a big fan of fast food, but I am a Coke addict, and my dogs love the burgers on the dollar menu), I hit the drive-thru, and when I pulled up to the window, the Latina there said they needed to cook the burgers and would I mind pulling into the parking lot in front for about three minutes (they know their cooking times). No problem. I don't mind waiting in the car because I always have a good book to listen to, this time Adventure Capitalist. I'm listening away, and the pooches are quiet in the back, when I notice it's been almost ten minutes. So I go back through the drive-thru, and there is a young guy at the window this time. I start to explain, and he thinks I'm placing an order. His English is good, but he is obviously from Mexico or Central America. I show him my drink and the ticket and he gets it and starts rattling away in Spanish with the staff. I realize he is the shift manager. He comes back, apologizing profusely, and explains that they accidentally gave my food to somebody else who was also waiting, that they will cook fresh burgers for me and that he will bring them out to me personally. I think he was worried that I would be angry, but I wasn't at all. We park again, and a few minutes later he appears with the food and apologized otra vez.

The point of the story is this young guy. He was a good-looking kid, maybe twenty. He was running the show, working hard on his English, taking reponsibility for the results, apologizing for mistakes and personally delivering the goods. And here was Burger King providing the structure for him to be successful. Not a dead-end job at all, not for this guy. I was very impressed.

Scott Brooks adds:

I had an funny thing happen in fast food to me in about 1985. I was a manager of a Taco Bell, putting myself through college. We had hired a new girl who had previously worked at Burger King. It was her first day and I had her working the drive-thru.
The drive thru "dings" with her very first customer. She says into the microphone: "Welcome to Burger King, can I help you." I thought it was pretty funny, she thought it was pretty funny, but the guy in the drive-thru began laughing hilariously.
But he placed his order and pulled to the window. The reason he was laughing so hard? It turns out he was the guy who owned the Burger King where she used to work.



CFCI welcome the Bank of America (BAC) acquisition of Countrywide (CFC), as for the first time I can remember BAC acts as a contrarian investor. I really don't know what CFC is worth but I know it is worth more in BAC's hands than as a standalone company.

BAC will be able to provide CFC with liquidity and staying power to survive through the current crisis. In other words it brings continuity to the table. Customers and partners that were having second thoughts about dealing with CFC are likely to stick around now.

I applaud this deal because typically these are done at the top of the market, but BAC found the restraint to wait till things went to hell. Yes, it was early with its first purchase, but picking bottoms is not easy, even for almighty BAC.



DartboardYou can make the case that stock picking is actually market timing: There are entry and exit times for any stock which are profitable, were they knowable in advance. Another version of this is that even for a "bad stock" with lots of trading volume (eg, C, WM, CFC, SLM, AMD), there were investors who bought and sold (or — cough — sold then bought) at profitable times. It is hard to pick stocks (buy and sell points), with expectation of profits or beating some benchmark, because thousands of your betters have superior information, research, and reasoning. Timing based on cash flow? Valuation? Relative strength? Debt? Patent pipeline? They all work sometimes, but how many (including big fund managers with best resources, e.g. Bill Miller) beat the index year after year over time?

Furthermore, its hard to capture the "free lunch" of diversification (away of idiosyncratic risk) with fewer than dozens of stocks — and then how to follow them all sufficiently to time them? The meal seems to me to be use of leverage to time signatures of immutable human weakness; which winds up asking whether the fear/panic reaction is written deeper in the collective mind than it is in yours.

Tom DeBolske replies:

I saw on CNBC the other day that the best hedge fund managers on the planet are right only 58% of the time. I don't see that my "betters" with their "superior information, research, and reasoning" have that significant an advantage. We all make our stock picks using whatever method we are comfortable with. With any stock at any time it's a 50:50 proposition. The trick to stock picking is to keep your losses to a minimum while letting the winners run.

Vitaliy N. Katsenelson writes:

In my book book Active Value Investing: Making Money in Range-Bound Markets I argue the long-term (10 + years) secular trend of the market will be essentially flat.  However, it will likely comprise a lot of small bull, bear and range-bound markets.  I argue that timing the market (at least for fundamental investors) is a fruitless exercise.  Instead, time (price or value) individual stocks.  I provide a Quality, Valuation, Growth (QVG) framework.  Quality and Growth dimensions of analysis help you to identify good companies, and cheap valuation will make this good company a good stock.  Yes, time stocks.  Identify a couple hundred good companies (Q and G dimensions), buy them when they turn into good stocks (all QVG dimensions line up), sell them when them they stop being good stocks (Q and/or G dimensions deteriorate or stock reaches fair-value point — V is not there any longer).



AqualungWhen I was in the third grade, growing up in Murmansk, a city above the Polar Circle in (then) communist Russia, my buddy and I decided to start a business. We pooled our modest funds (mostly lunch money), bought photo paper and chemicals, and borrowed my older brother's photo camera and photo development machine. This was in the early 1980s, a time before scanners, laser printers and copying machines. We took pictures of music record covers from the likes of Iron Maiden, Jethro Tull and Kiss, developed those pictures and sold them in school during breaks.

The business was going well, we were onto something, there was nothing like this available. We recouped our costs, and had a small profit, until one dark day (it was always dark during long sunless winters in Murmansk). My buddy and I were taken into the principal's office. We were told a student stole money from another student, and when he was caught he said he stole money to buy our pictures. Suddenly, with this twisted logic we were at fault. Never mind that we were breaking copyright laws. There was no way in early 1980s to obtain copyright, even if we wanted to. We created the incentive to steal.

My father unapologetically told the principal that we were as much at fault as the movie industry and toy retailers — the creators of incentives. Of course, none of that mattered. To appease the school authorities I donated my profit to the World Peace Fund (still not sure where that money went, maybe ended the Cold War? Nah, I doubt it). My buddy and I received an "F" for the behavior, which was not a big downgrade for me since I rarely got a grade much above "C" for behavior.



Vitaliy N. Katsenelson, CFA wrote: "Over last two hundred years every secular bull market was followed by a range-bound market.". Test this and discuss your results. 

There are a number of ways to test this, but here is a first look:

SP500 1950-present (monthly) was used to calculate Dec-Dec returns (w/o dividends), as well as check for intra-month high and low. The intra-month high and low for Jan-Dec were used to find annual high and low, and the annual range was defined as [(max monthly high)/(min monthly low)]-1

Annual range for the series ranged from 0.10 (1993) to 0.66 (1974); 2007 is 0.16

First, what effect do last year's range and return have on this year's return?

Regression Analysis: nxt yr rt versus yr ret, yr range

The regression equation is nxt yr rt = 0.0537 - 0.069 yr ret + 0.151 yr range

Predictor    Coef   SE Coef      T      P  VIF
Constant   0.0536   0.0551    0.97  0.335
yr ret    -0.0691   0.1361   -0.51  0.614  1.0
yr range   0.1510   0.1782    0.85  0.400  1.0

S = 0.165498 R-Sq = 1.8% R-Sq(adj) = 0.0%

Durbin-Watson statistic = 1.92818

Both annual return and range have insignificant effect on the following calendar year's return (though there is positive correlation with range and negative with return).

Second. What is the effect of last year's return on this year's range? Here is regression of this year's range vs last year's return (ie, does last year's return predict whether this year has big or small range?):

Regression Analysis: this range versus last yr rt

The regression equation is this range = 0.303 - 0.292 last yr rt

Predictor     Coef  SE Coef    T      P
Constant    0.3030  0.0179  16.87  0.000
last yr rt -0.2921  0.0959  -3.04  0.004

S = 0.116678 R-Sq = 14.9% R-Sq(adj) = 13.3%

Sure seems to be predictive and in the hypothesized direction, but is the correlation due to prior years which are down or up? Ran another regression: Dependent var = this year's range, IV's are last year's return if up (otherwise zero), and last year's return if down (otherwise zero):

Regression Analysis: this range versus last up, last dn

The regression equation is this range = 0.241 + 0.023 last up - 0.982 last dn

Predictor   Coef  SE Coef      T      P  VIF
Constant  0.2411   0.0281   8.57  0.000
last up   0.0229   0.1457   0.16  0.876  1.4
last dn  -0.9822   0.2659  -3.69  0.001  1.4

S = 0.110013 R-Sq = 25.7% R-Sq(adj) = 22.9%

Durbin-Watson statistic = 1.88298

The effect stems from prior years which were down. So you can't say that this year will be range-bound if last year was up big, but you can say that if this year was down - the bigger the decline the larger next year's range will be. (Actually you can say whatever you want because Putin is not running here).

Conclusion. Since declines and high volatility tend to come together, and volatility clusters, it makes sense that big down years are followed by large range years. A more correct restatement of the original hypothesis would be: large secular bear markets are followed by wide ranging markets.

Vitaliy Katsenelson writes in:

Kim took the following phrase and tested it: Vitaliy N. Katsenelson, CFA wrote: "Over last 200 years every secular bull market was followed by a range-bound market."

I understand the desire to test things, but it is also important to test the RIGHT things. My book is written about secular markets, not minute, hourly, weekly, monthly, or even yearly (if you choose to look from a single time perspective) markets. Kim tested something that has no relevance to my book.




StolichnayaAfter 16 years of almost no contact with my Russian high school and college friends I stumbled on, a website very similar to I reconnected with a lot of childhood friends. It was a very nostalgic and quite depressing experience as I found out two of my close childhood friends and five classmates died from drinking — most were in their mid-twenties. The story is the same — drinking a couple days a week leads to drinking every day, get fired, wife leaves, no source of income, sell apartment, money doesn't last long, start drinking technical alcohol (used to clean engines), death from heart shutting down. What made this even worse: I remember most all of those friends when they were only teenagers. My sister-in-law's cousins, one is 33 another 41, drinking heavily, ditched by their wives, sold their apartment — well, you know what is coming. I don't know if living in a city where winter lasts eight months a year has anything to do with it, or just simply Russia being Russia. It is probably that latter. Life expectancy for men is 59; for women is 72. I bet drinking accounts for a very large portion of this gap between men and women. I remember vaguely when I was very young that almost all of my neighbors were drinking. One would get drunk and beat up his wife, so she would hide in our apartment to avoid the beating. Another would pay a regular weekly visit asking for money or alcohol. It always upset me when Americans, after finding out I am Russian, would start talking to me about Russian vodka. Well, I guess Russia deserves that reputation.



If we learned anything over the last couple of months it is that we don't know the second and third derivative of how badly things will play out.

We knew that the housing market was in a bubble, but what we did not know was how its deflation would play out, i.e., a commercial market freeze. We did not know that that it would resonate in Germany or that it would cause a run on the bank in England. We did not know that Russia, a country that is supposed to be swimming in cash from oil revenues, will be tinkering with financial crisis again (at least we did not expect it with oil prices at $80).

What we know now is that our economies are a lot more interconnected than we ever imagined and also that the consequences of use of leverage will be found in places we never expected.



LeschetizkyA family member recently asked for my advice on piano lessons for her 3-year-old daughter. I devoted many years to piano studies and teaching, and have performed for most of my life. Specs might find my reply of interest, for children and perhaps even in other matters:

– Right from the start, realize that the most important thing is not what she can play but what sounds are in her mind. The ears are more important than the fingers. You don't "talk down" to her in conversation; don't do it with music, either, by limiting her aural intake to kiddie songs. Let her listen to great music performed by great artists. Have her listen to orchestral music, jazz, opera, choral music -– not just piano. No need to limit the genre of music — have her listen to jazz, classical, rock. But it should be really, really good. James P. Johnson for stride piano, Martha Argerich, Wilhelm Kempf, Vladimir Ashkenazy, Sviatoslav Richter, Arthur Schnabel, Frederick Gulda for classical. Take her to concerts and have her sit close up so she doesn't feel apart from the performers.

– Start by simply letting her experiment on the keyboard. Applaud her efforts. Play with her. Don't let anybody plunk her down on a piano seat and insist that she slog through one of those dreadful kid books. The music in those books is mostly really rotten. Furthermore, it is a very complicated affair to coordinate fingers, brain and ears enough to read a piece of music and perform it.

– The problem with most kiddie books is that they impose a five-finger regimen of "C, D, E, F, G" that is unproductive in building a good technique, as well as physically and mentally constricting. Let her apply the technique outlined in the Leschetizky method. He taught all the great 19th and early 20th-century pianists, and he knew what he was doing. One of his students wrote an excellent book on his technique.
– When she starts learning the system of musical notation, don't let anybody start her off with "C, D, E." No, no, no. Do A, B, C, D, E, F, G — like the alphabet. Then teach her the ledger lines: In treble clef, "Every Good Bird Does Fly" and FACE; in bass clef, "Good Birds Do Fly Always: and "All Cows Eat Grass." Let her discover the black notes. Somewhere in this, show her "middle C" – but if you start there, it could easily end there.

– Don't get just any teacher — attend a recital of students, see if they can play, evaluate their poise and the musicality they're able to project. If you can't sit through the playing without being bored or going crazy, why would your daughter benefit?
– It's crucial to help her learn an excellent piano technique early on so that she can reach a level of accomplishment that will allow her to enjoy music and get as good as her path allows. A poor technique will lead to an inability to express herself, even serious injury.

– Once she starts learning pieces, by all means make sure that her teacher is devoted to performance. She should have an opportunity to perform once a month in a big-deal recital where she can showcase her achievements to her peers and to you. When I was a girl, my teacher had monthly recitals that would include all his students, from the tiniest to the teen-agers. There would be a little musical dictation, a little talk about the pieces, and always be a big cake afterward. Somehow the excitement of competition, the joy of showing an accomplishment, the interest in observing other kids and the sweetness of the ultimate reward combined to make an atmosphere conducive to learning.

– Obtain the best instrument possible. If she is to develop an ear for sound and a fine technique, the piano must be properly responsive. If her technique is good and yet the instrument makes an ugly sound, she'll never be able to express ideas and to find the beauty of the piano.

– Don't let her become a little circus monkey. Make sure that she gets theory and musical coaching. Make time for her to learn about the lives of the composers and the history of music. Lessons should not be run-throughs of pieces while the teacher beatifically nods.

– A good piano teacher will include sight-singing and dictation as part of the training.

– Regular practice is key. It should be in a perfectly quiet environment, without distractions. Use a timer. A good teacher will send her home with a list of things to practice, to keep her moving onward. Don't sit with her — discipline is something that must come from her, not you. The discipline of piano playing will unfold into many beautiful qualities and gifts.

– Send her to music camp. A summer sojourn at a music camp is worth years of regular lessons. The chance to be with other musicians, play music together and learn more than usual is an expansive, life-enhancing experience.

– For heaven's sake do not let her think of piano as a career. It's just not possible these days to make a comfortable living as a pianist, if indeed it ever was. Pursuing a music career will ensure decades of financial weakness that could lead to an envious, malcontented existence. If by some misfortune she actually does make a career of it, she will spend two-thirds of her time on the road. Tell her that music is to be enjoyed, that the goal is to be able to play beautiful music both alone and together with other people, that the better she gets the more people will want to hear her. If, despite everything, she wants to become a great musician, then teach her to invest and trade so that she can support herself!
The Pleasures and Perils of Raising Young Musicians: A Guide for Parents, by Michelle Siteman (Vic's college girlfriend!) Her son, Benny, is now assistant conductor of the San Francisco orchestra. Michelle is a terrific writer and a smart mom.
Leschetizky's Fundamental Principles of Piano Technique by Marie Prentner. The teacher approved this book, written by one of his students.

Laurence Glazier adds:

CzernyI concur with Laurel's recommendation to follow Leschetitsky's teaching methods. He studied under Czerny, who was a pupil of Beethoven. There are still in most major cities pupils of pupils of Leschetitsky. That makes them, musically, great-great-grandchildren of Beethoven. They are worth seeking out.

Some of the Leschetitsky exercises I saw are straight out of ki-aikido, but invented long before. He reputedly had a sign on his door stating "There is no Method." Perhaps he was very responsive to each individual pupil's needs, giving rise over the years to differing accounts of the "Leschetitsky Method."

I spent a valuable hour with one elderly pupil of the great man. We looked at how to play a simple scale in great detail. "Listen to the sound," she said.

The pleasures of music can exceed the benefits of a secure income. Van Gogh was prolific though he sold only one painting. There are different kinds of capital.

With the advent of excellent music notation and playback software, there is an argument for piano lessons to be accompanied at an appropriate age by composition lessons. At this stage there are not many pianist-composers but the new technology suggests there will be many more in the future.

Alston Mabry writes:

I'm reminded me of a favorite anecdote, from Charlotte Joko Beck's book Everyday Zen:

Many years ago I was a piano major at Oberlin Conservatory. I was a very good student; not outstanding, but very good. And I very much wanted to study with one teacher who was undoubtedly the best. He'd take ordinary students and turn them into fabulous pianists. Finally I got my chance to study with the teacher.

When I went in for my lesson I found that he taught with two pianos. He didn't even say hello. He just sat down at his piano and played five notes, and then he said, "You do it." I was supposed to play it just the way he played it. I played it - and he said, "No." He played it again, and I played it again. Again he said, "No." Well, we had an hour of that. And each time he said, "No."

In the next three months I played about three measures, perhaps half a minute of music. Now I had thought I was pretty good: I'd played soloist with little symphony orchestras. Yet we did this for three months, and I cried most of those three months. He had all the marks of a real teacher, that tremendous drive and determination to make the student see. That's why he was so good. And at the end of three months, one day, he said, "Good." What had happened? Finally, I had learned to listen. And as he said, if you can hear it, you can play it.

Vitaliy N. Katsenelson remarks:

My 6-year old son is taking piano lessons. His heart is not in it. We try not to push him very hard and encourage his progress. I listen to a lot of classical music, some Oscar Peterson and Queen. My son loves listening to Queen, but my wife is concerned that he should not listen to rock music. My argument is that this is a closest crossover from rock to classical/opera music you can find. Well, she doesn't buy it.

Nigel Davies writes:

F & CI was born into a very musical family and my parents did everything they could to encourage me to play something. They had me on the violin, piano, cornet and clarinet and at school I learned the xylophone and the recorder. They had some early progress as I played the xylophone at one school concert and won a couple of prizes on the recorder at a local music festival. But I would later turn my back on music and turn to chess, which nobody approved of. One day I remember being forced to go out into the sunshine instead of sitting over my board. Of course there was only so much they could do with one small, stubborn boy.

Thinking back, it had something to do with the social dynamics of my family. My sister, a couple of years older than I, was a very good musician, certainly better than I was. On the other hand I was soon beating family members at chess, then family friends and then schoolmates. This had everything to do with early success, this was something in which I could win. I felt special, which provided the encouragement to do it more and be even more special.

Let's fast forward some 35 years. Now I'd really like my 5-year old son to play chess, and it's not because of any frustrated ambitions of my own. There are several compelling reasons: He has the right kind of mind/personality for it, I got a lot from the game myself (education, self-worth and many friends and associates) and it's one of the few things I can teach him with much authority. There's also the thought that if he gets to play chess we can go to tournaments together.

What's my method of encouragement? Well there are lots of chess sets around (both live and on computer screens), not to mention the garden-sized one which adorns my living room floor. And he plays around with it a bit and now knows what the pieces are called. I haven't tried to teach him any moves. The next step is to interest him in a DVD produced by Chessbase called Fritz and Chesster, which is a cartoon that familiarizes kids with chess concepts and moves. I don't have any plans beyond that, my intention being to play it by ear and see if it sparks any interest.

What I would never do is set him up for early competitive failure. Based on my own experience I believe success and self-worth are inextricably linked to the enjoyment of an activity. Music is easier — it's enough to listen to your child play (no matter what level) and pretend to enjoy it. With chess I might have to team with my son against the computer. I'll cross that bridge when we come to it. But I definitely want him to win a few games in his early attempts.



 By reading the biographies of great people, I learn much about how our world has been shaped, gain insights into how they thought, and through this find avenues for self-improvement.

My favoritie biography is Memories of My Life by Francis Galton, and no matter how many times I read it, I always come away more thoughtful, amused, and creative. Above all, there is a feeling of calmness and awe that comes from knowing that a person of his genius, wisdom and versatility actually existed. Galton wrote this biography at the age of 86 and it is as fresh to me as Tom Sawyer.

In broad outline, it shows the development of his contributions in the fields of geography, medicine, meteorology, photography, electricity, anthropology, psychology, statistics, heredity, and forensics. Some of his most notable contributions include the invention of correlation and regression, weather map composite photography, fingerprinting techniques, twin studies (in eugenics and genetics), and a handheld heliostat for signalling over long distances.

Almost every page of Galton's book has an example of one of his ingenious inventions, contributions, or observations on life. His insights are so great and his interests so broad that almost anyone who reads the biography will come away wanting to follow up and re-examine some insights that Galton gave that are applicable to his or her field.

I will concentrate on some insights I gained into the markets:

1) The influence of rhythm. Galton writes about the influence of rhythmic gestures in creating mass behavior, after noting how famous preachers and politicians of his day were able to influence people by personal (vocal) ascendancy. He offers the story of a college classmate who with the mere movement of a glass was able to drive assembled students into an ecstasy of enthusiam. He concludes that:

"Human senses when rhythimically stimulated by certain exact cadences are capable of eliciting overwhelming emotions not yet sufficiently investigated."

I find that market practicioners when stimulated by certain opinion leaders can fall into similar overwhelming emotions. The stimulation is heightened by the rhythmic movement in prices that accompanies the gestures. Since there are innumerable influences on markets, and an emotional reaction to one opinion leader or another is likely to lead to excess, the job of the market practicioner is to find when the rhythmic movements have run their course, and then profit by the excess of enthusiasm.

2) Positions of stability. Galton was the first to systematize the use of finger prints, as a note in the book from Bertillon confirms. Galton writes that there are quantum differences in the patterns that fingerprints show, that are similar to the different genera in nature. He notes that these patterns could not have come from natural selection but must have come from internal conditions of the structures in the hand. He generalizes the finding as such:

"The number of positions of stability in each genus must be limited, There are limits which if they can be overpassed without disaster would require a new position of stability."

He points out the analogy of the quantum leaps in fingerprints between leaps and whorls and relates it to the question of the importance of mutations versus small improvments in the theory of evolution, and he points out that these questions also arise in the fieldd of glaciers, which are formed by a succession of refreezing and crunches… in other words by successive conditions of stability of state.

What are the levels of stability in markets that correspond to these refreezings and crunches? Laurel and I have often proposed that round numbers often are positions of stability to which markets tend to move with inordinate frequency. I beleve this holds true for the 100s in the Dow Jones, the 10s in the S&P, and the previous close in any market. By testing the paths that markets take when near these numbers, we can develop insights into when disaster or equilibrium is more likely.

3) The influence of Visionaries. Galton notes that there are always visionaries subjected to fantasies that have no place in the real world. Usually the visionaries are laughed at or subjected to reality checks that discredit them:

"When popular opinion is of a matter of fact kind, the seers keep quiet as they dont want to be thought mad. But let the tide of opinion change, and grow favorable to supernaturalism, then the seers of vision come to the fore."

Most of the market visionaries in ordinary times are subject to a similar process of reality and discredit. Those who constantly posit a big decline in stocks, are subjected to the reality of the 10% a year drift over the last 100 years, but let a month or two come along with a decline, and these visionaries come out of their lairs with all reasonable safeguards broken.

SlicerNo discussion of anything written by Galton is complete without remarks on the ingenuity and sagacity that leaps out of everything that Galton touches. On one page you can find his index of boredom, measured by counting the number of fidgets, and on another a contrivance for sending telegraphic signals through the use of needles mounted on each other. Other pages include a discussion of how to divide prizes among the top three contestants in a competition, how to cut a round cake on scientific principals, or a way of measuring how horses gallop. The appendix of the book enumerates 192 of Galton's inventions and papers and offers an overview of how he developed most of them.

Memories of My Life has a freshness and decency of spirit, and is an illustration of how amazing and creative the human mind can be. It has insights into most scholarly fields, and advice and examples of living a good life on almost every page. I highly recommend it as a source of rejuvenation and growth, and as a reminder of how far the human mind can travel.

Pitt T. Maner III adds:

The collected published works by Galton are available at Also, according to Wikipedia, Terman estimated Galton had an I.Q. near 200, or about as high as it gets. How would he have fared in today's academic environment? A free thinker such as he would be quite controversial nowadays, Victorian England's somehow being more accepting of individual genius and eccentricities. 

Vitaliy N. Katsenelson notes:

Google allows you to download the book for free. Here is why: "It has survived long enough for the copyright to expire and the book to enter the public domain. A public domain book is one that was never subject to copyright or whose legal copyright term has expired." On the top right-hand side click "Download PDF" ( 8.5mb) and you are ready to go. Thank you, Google!

Sam Humbert notices:

Nass#m Tal#b discusses Galton, The Bl#ck Sw#n, pg. 244 –

Sir Francis Galton, Charles Darwin's first cousin and Erasmus Darwin's grandson, was perhaps, along with his cousin, the one of the last independent gentlemen scientists — a category that also included Lord Cavendish, Lord Kelvin, Ludwig Wittgenstein (in his own way), and to some extent, our uberphilosopher Bertrand Russell. Although John Maynard Keynes was not quite in that category, his thinking epitomizes it. Galton lived in the Victorian era when heirs and persons of leisure could, among other choices, such as horseback riding or hunting, become thinkers, scientists, or (for those less gifted) politicians. There is much to be wistful about in that era: the authenticity of someone doing science for science's sake, without direct career motivations.

Unfortunately, doing science for the love of knowledge does not necessarily mean you will head in the right direction. Upon encountering and absorbing the "normal" distribution, Galton fell in love with it. He was said to have exclaimed that if the Greeks had known about it, they would have deified it. His enthusiasm may have contributed to the prevalence of the use of the Gaussian.

Galton was blessed with no mathematical baggage, but he had a rare obsession with measurement. He did not know about the law of large numbers, but rediscovered it from the the data itself. He built the quincunx, a pinball machine that shows the development of the bell curve. True, Galton applied the bell curve to areas like genetics and heredity, in which its use was justified. But his enthusiasm helped thrust nascent statistical methods into social issues.

Denis Vako extends:

Another confirmation of the positive linear growth rate in economic activities of civilizations can be found in the works of Fomenko, whose main conclusion was that there never was such a thing as the dark ages, lost civilizations, abrupt destruction of technological and material achievements and there never existed an age of barbarians or renaissance. The history of human civilization, Fomenko indicates, is the positive linear growth from one invention to another, with one discovery on top of another, it is an almost evolutionary process, always onwards and upwards.

Hence I propose that the 10% drift was not only for the last 200 years, but rather at least for the last 800 years as covered by Fomenko.

Steve Ellison adds:

I am not familiar with Fomenko's books, but I just started reading The Renaissance by Paul Johnson. Mr. Johnson says that much more innovation occurred in the Middle Ages than in the Roman Empire. The Romans had many slaves and resisted labor-saving advancements because they feared unemployment and social unrest would result. Conversely, medieval Europe had a shortage of manpower as Christianity phased out slavery. The Black Death made the labor shortage more acute. There was great incentive to develop and deploy labor-saving technology. Many watermills and windmills were built. Medieval mariners, lacking Roman galley slaves, greatly improved sail designs, making possible larger ships that could sail much greater distances.

"Thus in the later Middle Ages, wealth was being produced in greater quantities than ever before in history" (p. 13).

Denis Vako comments:

I have never read Mr. Johnson, but at a first glance this paragraph looks a little too smooth and ideal. Renaissance, black death, middle ages these are interesting titles … but on my second thought may be they relate to real history as much as bear or bull markets labels relate to the market?

Does one really know at the time if there is a bull or bear market?

Presumably we now have better decision making tools than throughout history — databases and computing power to process and categorize knowledge — and yet the only answer we can give to the above question is no, one does not know for sure! But we can say what it was after the fact, right? — July and August was a bear market in stocks.

but then someone may justly ask: a bear market for whom?

Isn't it strange that now, in the present, after the fact, with all those great tools, it is not easy to define what really happened in the market in July and August, yet when it comes to history it is all so clear?

Suppose the market goes up 100% over the next 5 years, then July-August will be called "a minor interruption of galloping bull market"; if the market goes sideways perhaps it will be named "the beginning of maturing top formation"; and yet if it falls 50% it will be named "the start of the vicious bear market."

Anatoliy Fomenko concentrates first on time: he shows the difficulties and limits, and the proofs by calculation, based on planetary movements, then instead of 'feel good' story telling and emotions, he goes for logistics of language, weapons, fighting methods, writing style, coinage, prices and taxes, dress, burials, transport, communications, food and food supplies, buildings and building tools, climate, terrain.

He said that essencially all history is re-written from original chronicles … many of which have vital parts missing.

On mass infectious diseases he says that

"Once it was determined that people were dying from an epidemic, they were entirely exterminated in their localities by the army — all killed to save the healthy, as medical preventive injections and quarantine as we know it now was not known back then, the decision was made simply to kill."

Why the hoax, why the fake and cuo bono of historians? He indicates that too.



New Star Trek episode: World Enough and Time, based in the original Star Trek milieu. Starring George Takei ("Sulu") and a few other originals you'll notice (like Yeoman Janice Rand). Really quite well done; consistent with the original in style. Highly recommended for those who enjoyed classic Star Trek! The ending is quite touching. Following the ending, there's a teaser for the next episode. Streaming video, 65 minutes, requires Flash player.

Rich Bubb agrees:

World Enough and Time rivals any of the original and the subsequent Star Trek spin-offs. Very well done writing, good plot weaving. Special effects and sound effects are very similar to the original Star Trek, but not exact copies. The actors are darn good too. And no commercials!

Vitaliy N. Katsenelson extends:

TV-Links contains links to every TV show and most newly-released movies. Not all the links work but a good portion do. I tried Stargate Atlantis and Star Trek: The Next Generation — both work. I even watched The Illusionist.



 It seems that Motorola (MOT) comes out with a good handset that everybody wants every five years or so. Considering that, we have a couple more years to go until the company will have another blockbuster handset again. This failure by Motorola is a big positive for Nokia (NOK) on many fronts. Or to piggyback on a well-known Motorola advertising tagline: Goodbye, Moto - and hello, Nokia.

First, it shows that Nokia's management can execute despite not having the "hottest" phone on the market (i.e. Motorola's Razr). Also, it will be further taking market share from Motorola; I estimate its margins will further improve, driving its earnings north of two dollars a share over the next couple of years. After seeing Nokia's second-quarter results, that estimate could come sooner rather than later.

The best part is Nokia doesn't have to do anything heroic to achieve that goal. Operational leverage (higher volumes spread over fixed costs) and a shift to a higher margin (more feature-rich phones) will do the work. This was the driver of the company's truly incredible operating performance in the second quarter.

The second quarter was simply spectacular: operating profit in every segment with the exception of its networks division grew in the high double digits, and sales climbed a whopping 28%.

At the current share price, you are not really paying for the network segment. In fact, since it loses money it detracts from the company's valuation. But at some point its profitability will turn positive and the division will become a contributor to Nokia's bottom line.

Samsung is a conglomerate, and although it's a good one, it still lacks Nokia's focus. Despite being located in a lower labor-cost part of the world, South Korea-based Samsung doesn't have a cost advantage against Nokia, as Finland-based Nokia manufactures its phones all over the world, including in China. Nokia has proved to be the Dell of cell phones from a cost-structure and manufacturing-efficiency perspective and Apple-like when it comes to innovation, it comes out with several dozen phones year after year.

There is still upside in Nokia's global market share because Nokia has just a small market share in the U.S., accounting for only 4% of its volume. It is only a matter of time before Nokia starts taking market share in the U.S. It has already started to design U.S.-centric phones. As Nokia regains market share in the U.S., this will drive its global market share. Despite not having the phones in the U.S. that consumers seemed to want, Nokia still has an excellent brand reputation in the U.S. so it just needs to fix relationships with U.S. carriers — AT&T (T), Verizon (VZ), and T-Mobile, and start selling phones that the rest of the world is so crazy about.

Disclosure: I own Nokia stock



Jeff Macke is it when it comes to retailers. He wrote a wonderful column on Starbucks for Minyanville. I have to admit, I belonged to the majority of value investors that could not believe five years ago that SBUX could grow at its past rates. Well, it did.

Minyanville also had a cute cartoon on SBUX.



VitaliyIn the long run, the performance of a stock in isolation (ignoring the external environment, i.e. interest rates, risk, inflation) is the product of fundamentals (i.e. earnings and cash flow growth) and valuation ( i.e. P/E, P/CF).

Google and Apple may have great fundamentals: their innovation has led and may continue to lead to high earnings and cash flow growth. But are they good stocks? They may or may not be. But, more importantly, will they be good stocks at any price? No! If I were to follow the above conclusion, that since Google and Apple are great companies they are great stocks at any price, at any valuation – at 50, 500, 5000 times earnings, then I'd walk into an overvaluation trap.

Take a look at eBay in the late 90s: it was a great company (it still is), but it was grossly overvalued. So, if you bought it in the late 90s and held it until today, despite its earnings going up 100-fold, the stock is roughly at the same level it was then. I'd argue few would have the patience and conviction to hold it through the downturn the stock took in the early '00s. Most investing in the stock in the late 90s lost money on it.

One of the biggest mistakes investors make in investing is failing to separate a good company and a good stock. A great company's (fundamental) performance is wiped out by valuation compression. This is the battle of two winds: the tailwind of earnings growth and the headwind of P/E compression.

Also, with a high growth priced appropriately (even to perfection) there is no room for even a small mistake (no margin of safety) left in the valuation - a small disappointment (it doesn't have to be much) will lead to a substantial decline in price. The latest performance of Starbucks and Whole Foods stocks is a great example of being priced for perfection and delivering slightly less-than-perfect results.

This myopia in differentiating between good companies and good stocks is not just limited to wonderful, exciting, larger-than-life (Google comes to mind here), fast-growing internet companies. The bluest of the blue chip stocks, like GE, Coca Cola, Home Depot, Amgen, Johnson and Johnson (and the list goes on) were all great companies that one "had to own" but were terrible (overvalued) stocks in the late 90s. Their earnings have doubled or tripled since but the stocks have not gone anywhere.

I think it was Benjamin Graham who said that "price is what you pay, value is what you get."

Kim Zussman adds:

What are the parameters which make a good company or stock? Here are some good stock categories from the literature:

1. Large five year decline in price (DeBondt and Thaler)
2. Large one year price gain (-large 1 year price decline.) Momentum (Jegadeesh)
3. Small cap stocks (Lakonishok and others)
4. Valuation: Low P/E, P/B, P/cash flow, high dividend yield, and
various concatenations thereof
5. High (low?) short interest
6. Put/call ratio (especially when options orders are placed by grandmas in Serbia)
7. Value line timliness (used to be more timely)
8. Double tops and wiggle bottoms above and below 10 minute panting average

The problem is that they all work sometimes; actually, just often enough to keep people interested in them.

Vitaliy Katsenelson adds:

I spent a good portion of my soon to be published book called, Active Value Investing: Making Money in Range Bound Markets, discussing what constitutes a good company and a good stock. I created the QVG framework (Quality, Valuation, and Growth).

A good company should get high scores on Quality and Growth dimensions. For instance a high quality company will have high return on capital, strong balance sheet, a sustainable competitive advantage, competent, shareholder friendly management, significant free cash flows. A Growth dimension encompasses predictable (high recurring) revenue growth, multiple sources of growth, a nice dividend, etc.

If a company received high scores on Quality and Growth dimensions, for it to be a good a good stock it should pass get a passing grade on Valuation dimension - be undervalued (have a appropriate margin of safety).

As anything in investing this analysis is very subjective, but I find this framework is very beneficial to maintaining a rational head and helps me to stick to an analytical process. 

Steve Leslie comments: 

On June 28th (post number ?p=1834) I mentioned that one year ago, when Google was $350, Vic and Laurel went all-in on the search engine provider. I also remarked that Apple and Garmin were both $50 then. Today GOOG is $550, AAPL $137, GRMN $80.

When one finds a great company with a great product line and great prospects, selling at a reasonable price, it is time to buy. Strike when the iron is hot! And eschew the short-term gain for the much larger pot o' gold that lies at the end of the rainbow.

Charles Pennington responds:

I can find nothing in the original post of Mr. Leslie stating any requirement that the stock be bought at a reasonable price (let alone any definition of what a "reasonable price" would be). The concluding quote was:

".. most importantly the speculator should be willing to hold onto the companies eschewing the quick buck in search of the really big gains that can be achieved through diligence and patience."

I'm sure it was an oversight not to have included some kind of requirement of "reasonable price" in the original message. The vehemence of the reaction is because, I think, the post's assertions were untested, apart from anecdote, and Daily Speculations is supposed to be reserved for ideas that are tested.

An example among many of the way the assertions could be tested is to go back to old issues of magazines, newspapers, etc., and find the companies that were rated at the time as highly admired, and then look at their performance afterwards. If you do this exercise, you might find that highly admired companies do well.

However, it is not at all obvious. Many companies which were once highly admired are not so highly admired now, and their stocks have not done well. Enron, for example, was once highly admired.

Barry Gitarts comments:

Haven’t many value experts said Google has been overvalued since its IPO, and Apple for several years now, however both stocks have significantly outperformed the market.

Driving looking out the rearview vs. the windshield could also be the difference between over and under valued perception.


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