Having recently re-read / re-listened to Nassim Taleb's books The Black Swan and Fooled By Randomness I began noticing some interesting points:

1. In Fooled By Randomness he talks about playing around with his Monte Carlo engine to create 'zorglubs' similar to how Richard Dawkin's describes evoluinoary methods in The Selfish Gene.

"My Monte Carlo engine took me on a few interesting adventures. While my colleagues were immersed in news stories, central bank announcements, earning reports, economic forecasts, sports results and, not least, office politics, I started toying with it in bordering fields to my home base of financial probability. A natural field of expansion for the amateur is evolutionary biology --the universality of its message and its application to markets are appealing. I started simulating populations of fast mutating animals called Zorglubs under climatic changes and witnessing the most unexpected of conclusions..."

Does anybody else think there is a relation here?

2. Taleb talks about maximising positive black swans which I took to mean an individual should look at ways to maximise one's options in life. That is, taking up options in all aspects of one's life, not just in the financial markets. For example, look out for options that you can take in negotiations that do not necessarily cost you to give up anything in return.

I've just finished listening to both of his books twice in a row and look to integrate some of his ideas into my investing life.

How have you found Taleb's works and have they benefitted you or not?

Checklist investing

Some like to believe the best investors must have the instincts for spotting a bargain amongst the thousands of shares in the market. But what discipline does a good investor possess that enables them to outperform the average over long periods of time?

A checklist approach for investing comes highly recommended if you truly wish to outperform over the long term. I admit the idea of a check list of investing may sound boring to some but having a methodical approach is likely to reward those who are disciplined enough to apply it. Charlie Munger has long advocated a checklist approach as a simple method to reduce risks of errors. “Checklist routines avoid a lot of errors. You should have all this elementary wisdom and then you should go through a mental checklist in order to use it. There is no other procedure in the world that will work as well.”

Possessing years of experience or access to multiple reports still does not stop the best investors from occasionally making errors in judgement. Formal checklists are common places in professionals such as aviation and medicine where lives are at risk Malcolm Gladwell, the author who coined the term ‘the tipping point’, describes in his book ‘Blink’ how the process of diagnosing heart attacks patients in a busy Cook County Chicago hospital emergency room was improved by the use of a simplified three question check list. Doctors were asked to collect less information and focus on three key criteria such as like blood pressure and fluid in the -while ignoring everything else like the patient's weight, age and medical history. As a result the hospital is now one of the top hospitals in the US in diagnosing chest pains.

In a world where investors are bombarded with constant information an investment checklist helps to filter out irrelevant information to allow focus on the key criteria for why a business succeeds and if it is a good buy. In fact Buffett has mentioned he has a mental checklist of four simple criteria when evaluating a business:

1. Do I understand this business?
2. Does the business possess a competitive advantage (economic moat)?
3. Is the management able and honest?
4. Is the price right? If so write the cheque.

In an investing environment with ever increasing investment options and complexity a check list will avoid many common errors of omission. We have all had the experience of finding what looks to be a sure-fire opportunity that we believe has been overlooked by crowd. Many value investors and fund managers have admitted in the past that if they had used a checklist it could have avoided costly investment mistakes during these heated moments! In a Forbes interview Mohnish Prabai the US fund manager who once bided US $650,100 for a charity lunch with Buffett confirmed that he now has implemented a formal checklist to systematically avoid repeating investment errors in the past.

Common check list areas include a mix of financial ratios (i.e. interest cover, debt to equity) and qualitative questions (do management have a stake in the business). Most of the answers should already be quite clear and going through the process should take less than an hour unless something striking appears or you lack the information which would prompt further research. One of the questions recently included in my checklist includes asking whether the sales revenue figures are based on boom-time earnings.

For example, are the current earnings estimates of Australian mining companies based on resource prices remaining stable or increasing? The revenue and profits of miners and mining services companies such as BHP and Monadelphous are linked to the prices of resources. Since resource prices have been increasing over the last several years due to booms in China and India this has led to good profits for many Australian resource companies.

However even without a prolonged slowdown in China it is likely that resource prices are unlikely to be maintained over the longer term. Note that when it comes to markets for iron ore, oil and even gold the only available tool to predict prices comes from using technical analysis which for fundamental value investors is an area we try not to rely too heavily on.

I'm interested to know what are some of the other checklist questions that people currently use and also what is your opinion on the ideal number of questions to be included on a checklist to avoid over analysis paralysis?

Risk vs Uncertainty

For those of you interested in interviews with famous value investors I would recommend the Value Investing videos on Youtube hosted by Steve Forbes. Tonight I was listening to an interview with hedge fund manager Mohnish Pabrai. If the name sounds familiar it is because Pabrai made headlines when he bid $650,100 in 2007 for a lunch with Warren Buffett.


During the interview Pabrai mentions the difference between risk and uncertainly. Often we are taught that to achieve high returns we need to have high returns - "High risk, high return." Value investors however believe that Low Risk, High Returns are possible. In fact when you purchase a stock for less than it traded yesterday, assuming future prospects have not changed then the risk has actually decreased. 


Pabrai uses his previous entrepreneurial background and a story about Microsoft's Bill Gates as an example to illustrate the point. Firstly he states that although entrepreneurs are seen as high risk takers, successful entrepreneurs actually take all steps to lower risk. 


Pabrai explains that he has founded three businesses during his career. The first was low risk and generated huge capital - a huge success. The second he invested a large amount of capital and suffered major losses. The third was founding a hedge fund which was low risk with potential for high payoffs. So far the third business has been a success.


According to his research successful billionaires such as Richard Branson and Bill Gates also followed the low risk, high return approach. He explains that Microsoft has never required more than $50,000 of initial capital to fund it's business growth and success. Microsoft founders Bill Gates and Paul Allen had low risk, but they did have high uncertainty. High uncertainly allowed for a range of possibilities from Gates and Allen going broke on one extreme to them becoming billionaires on the other extreme. 


High uncertainly does not necessarily mean high risk - a key point the investors need to remember. Although an investment may have high uncertainty as long as the risks are sufficiently low then it could still become a runaway success. Pabrai calls it the "Heads, I win; tails, I don't lose much" approach. In investing speak 'minimise the downside risk, and the upside will look after itself.' 

Would you like me to value your stocks?

Having read Roger Montgomery's book Value.able I have created an online spreadsheet using his formula to value shares. If interested to have a look at the spreadsheet then feel free to follow the link from my earlier November post 'Which of these stocks is currently attractive?'

Alternatively if you have any shares which you want me to value using their 2011 annual report then please feel free to let me know via a reply below.

With the current state of global economy such as European sovereign debt crisis and rehypothecation, I believe shares will continue to become even more attractive in coming months.

For example, JB Hi-Fi (ASX:JBH) is currently trading at $11.34 (28/12/11) after a surprise downgrade of their profit forecast for 2012. Could this be the chance to buy that value investors have been waiting for? I've updated my online calculator to include an estimated 10% drop in profit for JBH: https://docs.google.com/spreadsheet/ccc?key=0AoGU3QVjAi2tdEZxTVBEZzc3bUtxa0RCaWJnTDBTcVE#gid=7

Value investors around the world would currently be on high alert for opportunities. For example, Orbis Investment Management (Australia) has recently announced they are now a significant shareholder of Matrix Composites and Engineering (ASX:MCE) with a 5.48% share.

Those unfamiliar with Orbis will find this Forbes article an interesting read. The article explains their contrarian, Buffett-style value investing principles: http://www.forbes.com/global/2001/0820/036.html

The basic valuation formula is: ROE / ROR x Equity per share.

ROE = Return on equity
ROR = Required rate of return

However Roger improves on the basic formula by breaking the first part of the equation (ROE/ROR) into two parts: 1. Profit retained 2. Profit paid out as dividend.

By doing this the dividend payout ratio of the company is taken into account. Basically if you had a company with high sustainable ROE you would benefit from retaining the profit so it can grow to an even larger amount than paying it out in dividends.

For individual stock requests I'll discuss the further assumptions used in the formula and also the variables such as required rate of return.

Again, I'm also on the look out for good value shares at the moment and willing to value them if you want to let me know a stock you are interested in! 


Cheers
Sterling

Sovereign debt, Gold and Hypothecation

"Capitalism without bankruptcy is like Christianity without hell" Borman

Over the last two days I've been watching some videos on Youtube showing interviews by Kyle Bass the founder of Hayman Capital. Bass is probably most famous for the gains he made by betting against the US housing market by hedging his positions through the purchase credit default swaps (CDS). These CDS acted as insurance against market price falls of the collateralized debt obligations (CDO) being widely marketed at that time.

When speaking in a 15/11/2011 BBC interview Bass was questioned on the morality of investors of making gains from the US subprime mortgage crisis. Basically the interviewer asked if it was right or wrong to profit from the misfortunes of people who over-borrowed and lost their homes in the US. He quite succinctly replied that the such events would occur regardless of his involvement and that he had a fiduciary duty to protect his client's funds. He gave the following quote: "Capitalism without bankruptcy is Christianity without hell." I must admit that it was the first time I had heard that quote before!

Currently I'm reading his latest letter to Hayman Capital shareholders where he is extremely certain of a Japanese sovereign debt default following the default of EU nations. He paints the following picture of the current situation:

"Imagine a team of mountain climbers all strapped together for safety as they ascend a treacherous peak. While they are all holding on to the mountain there is no additional strain placed on each other. Now consider what happens if one climber, let’s call him Stavros, slips and loses his grip. He places added strain on the remaining climbers. One climber might no make a difference, but as Seamus, Pablo and Jose each lose their grip they not only add extra total dead weight to the team but also increase the amount each other climber has to carry, until finally Francois, Luigi and Takehiro let go and poor Jurgen, and Uncle Sam are left trying to keep the whole team on the mountain."

In particular he is speaking about the unsustainable sovereign debts positions of Greece, Italy, Ireland, Iceland, Spain, Belgium, Japan, Portugal, France and Japan. To quote Bass again: "We believe the debts of the following nations, among others, are not sustainable in the current economic environment: Greece, Italy, Japan, Ireland, Iceland, Japan, Spain, Belgium, Japan, Portugal, France, and have we mentioned Japan?"

So where to for cautious investors - Cash, guns or gold? We all know the implications of holding cash with all the money 'printing' being done by the world's central banks. As for guns well known financial commentators such as Robert Kiyosaki have been frequently talking about the possibility of social upheaval and alluding to the insurance policy offered by buying a gun to protect one's assets from upcoming unemployed and desperate masses! Although I do believe Kiyosaki is a very successful investor he has been know to make repeated alarmist comments in his most recent posts on his site www.conspiracyoftherich.com

As for gold the question I want to discuss is between physical or paper? In my personal opinion investing a portion of ones fund in gold is always going to be a smart move. Throughout history regardless of country or upbringing man has always had used the metal as a store of wealth and hedge against fiat currency manipulation. Dylan Grice of Societe Generale has written about the timing of gold purchases and sales in Popular Delusions. Those interested in reading the full article can find it within the 2010 annual report from Platinum Asset Management (PTM) which is where I read it.

Those of you with Australian self-managed super funds (SMSF) looking to invest in gold would mostly likely be looking at exchange traded funds such as Betashares Gold Bullion ETF (ASX code QAU). However with the recent issues surrounding hypothecation I became slightly wary of gold ETFs when I read the following article on Zero Hedge: http://www.zerohedge.com/news/gold-rehypotecation-unwind-begins-hsbc-sues-mf-global-over-disputed-ownership-physical-gold The article talks about HSBC suing MF Global over disputed ownership of physical gold that was re-hypothecated. The underlying worry for investors is whether MF Global used re-hypothecated client gold to satisfy liabilities and whether there are other occurrences of this occurring at other financial institutions.

Closer to home in Australia I'm wondering whether the same thing could occur if I purhased Australian listed ETF backed by gold bullion? As central bankers continue printing more money to reduce imminent volatility they are only causing the eventual consequences to be worse. Read The Black Swan of Cairo by Taleb & Blyth for details. However if I expect to protect myself from their actions by buying gold the last thing I would want is to find out my gold has been used as collateral for another parties transactions!

If you have any comments or find any errors in my post please feel free to let me know.

Are you a Cornucopian?

If we look at popular media and listen to interest groups we could easily become dismayed at the economic problems occurring especially from the European debt crisis. However after listening to Matt Ridley's audiobook The Rational Optimist I am reminded that we are living in the best times ever for the majority of the people on the planet. Short term economics issues and problems aside, the majority of people now have a better standard of living than any other time in history. His argument that this has come from the unique human trait of specialisation and trade is solidly backed up by a range of research spanning the entire span of human history.

The main theme of the Ridley's book is that trade is the driving force of human advancement by encouraging specialisation. For those unfamiliar with Matt Ridley I can tell you that he comes highly recommended by Charlie Munger. In fact Munger recommends Ridley's earlier book Genome in his list of recommended readings found within Poor Charlie's Almanac. Having seen one of Ridley's talks online at TED videos I finally decided to check out this work.

As I listened to his work I am reminded of other books I've read before along similar themes. In particular Paul Zane Pilzer's ideas come to mind. If I compare Ridley and Pilzer side by side then Ridley believes the engine of human progress has been the meeting and mating of ideas to make new ideas while Pilzer believes human progress was due to increases in the speed in which individuals could communication. Both authors are basically saying the same thing - that as a species humans have progressed beyond other forms of life because increases in speed and access of communication has allowed the sharing of ideas promoting economic advancement.

Bjørn Lomborg is the another author whose work I believe Ridley was highly influenced by. Although Lomborg's book The Skeptical Environmentalist is quite detailed with numerous graphs and charts it is well worth the effort as it powerfully dispels any notion that humans today are worse off than our ancestors. Lomborg shows with detailed research the improvements in: Life expectancy and health, Food and hunger; Prosperity; pollution, just to name a few.

I later realised why Ridley's arguments sounded so similar to Lomborg's - Ridley actually writes a recommendation for Lomborg's book which is found on the book cover! "The Skeptical Environmentalist should be read by every environmentalist, so that the appalling errors of fact the environmental movement has made in the past are not repeated. A brilliant and powerful book." Matt Ridley - Author of Genome.

So is The Rational Optimist a worthwhile read? Even if you have read the works of other rational optimists and don't wish to reread similar theories, his ideas on oils vs biofuels is compelling enough to give your time. The original founder of the Cornucopian theory Julian Simon would be proud of this work. I am still amused whenever I see in the newspapers an article about the impending end of life as we know it - global warming, peak oil approaching, and so forth. I found Ridley's work very refreshing and highly recommend it, especially those dooms day alarmist that still exist out there.

Piotroski Score

I always enjoy finding out more about Australian value investors and was recently reading the 2011 Platinum Asset Management (PTM) annual report. Those who don't usually read annual reports may find the PTM annual reports a pleasant surprise as at the end of each annual report are articles that value investors would appreciate. In the 2011 report there was an interesting article by Dylan Grice of Societe Generale titled Cheap Stocks for An Expensive World. In it he referenced the work of Joseph D. Piotroski who is a Stanford University Graduate School of Business professor who specializes in accounting and financial reporting issues.

Basically the Piotroski score is a ranking system based on nine criteria that calculates varios ratios from historical account information. The values range from 0 (lowest score) to 9 (highest score) with higher scores suggesting firms in better long-term financial health. First published in 2000, Piotroski’s scoring system (F_Score) has been found by a variety of researchers including himself to identify stocks that consistently outperform market indexes.
The nine criteria are:

1. Net Income: Bottom line. Score 1 if last year net income is positive.
2. Operating Cash Flow: A better earnings gauge. Score 1 if last year cash flow is positive.
3. Return On Assets: Measures Profitability. Score 1 if last year ROA exceeds prior-year ROA.
4. Quality of Earnings: Warns of Accounting Tricks. Score 1 if last year operating cash flow exceeds net income.
5. Long-Term Debt vs. Assets: Is Debt decreasing? Score 1 if the ratio of long-term debt to assets is down from the year-ago value. (If LTD is zero but assets are increasing, score 1 anyway.)
6. Current Ratio:  Measures increasing working capital. Score 1 if CR has increased from the prior year.
7. Shares Outstanding: A Measure of potential dilution. Score 1 if the number of shares outstanding is no greater than the year-ago figure.
8. Gross Margin: A measure of improving competitive position. Score 1 if full-year GM exceeds the prior-year GM.
9. Asset Turnover: Measures productivity. Score 1 if the percentage increase in sales exceeds the percentage increase in total assets.

A company's F_Score is determined by summing up the results of each test (one point if a stock passes each test and zero if it doesn’t). Therefore a company's score can range from 0 (worst score) to a maximum score is 9 (best score). Those interested in reading the award winning paper can follow this link or google to find it:

I have recently finished Roger Montgomery's book on value investing and was considering including it in my online valuation spreadsheet based on his book. Those interest can follow the link here: https://docs.google.com/spreadsheet/ccc?key=0AoGU3QVjAi2tdF9zcTUxbjBISWx3QzE5eDEzeW1oSUE

I'm interested to know your opinion of whether Piotroski's score has relevance for the current Australian ASX market?