The Unrepentant Recalcitrant

Lessons for an accidental entrepreneur

Archive for the tag “Efficient Market Hypothesis”

Index Fund Investing has a Dirty Little Secret

Don’t get me wrong.

Its better than speculating or gambling.

If you absolutely have no other choice, it may be the way to go.

(If you must index, consider buying the index after a market crash and selling it at the market peak. I acknowledge its easier said than done.)

As always, you should know what you are getting into.

An index fund is an investment in a basket of companies (which companies and how they are chosen is a separate bugaboo of mine).

At the point of your purchase some of these companies are fully valued (i.e. P=V).

Others are undervalued (P<V).

Still others are beginning their plunge into obscurity (P>>V).

Which is which you ask?

You would have to go over each business in order to understand the answer to that question.

But it doesn’t matter.

Because you buy the whole basket.

When you buy the whole basket, you buy everything at market price.

You buy the overpriced assets at a premium and the under priced assets at a discount.

When the price (not value, since you don’t know value of several hundred companies each bought at market price) changes, what do you learn about your investment?

Nothing. Absolutely nothing.

I repeat. Because you buy the whole basket!

How do you know when you should sell and when you should buy?

If you agree that you should buy low and sell high as an investor, you must also agree that you cant do this if you cant value the basket.

You are more prone to market hysteria and the craziness of Mr Market.

You will have a hard time knowing when the market is wrong and when it is right.

The balance of fear and greed that Warren Buffet says you must keep in opposition to the market, will know lean toward the market.

There is a much higher likelihood that you will bail at the wrong time and buy in at the wrong time.

I don’t blame you for making this mistake. When the index loses 25% of its value in a plunge, how do you know what to do if you don’t know what the companies in the index are actually worth?

With an index, you don’t have an independent frame of reference like you do with an individual stock (P/V, EVA etc, remember?)

This is the single biggest reason why people investing in index funds don’t make the same return as the index does. They respond to fear and greed the wrong way.

Find a way out of this trap.

Give it some thought.

 

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Principles of Value Investing

Toto, I have a feeling we’re not in Kansas anymore.

Yes boys and girls, put away your Excel spreadsheets and gather round the fire.

As Steve Jobs liked to say, “I’m going to tell you three things. No big deal. Just three things.”

That’s it folks.

Three Principles.

1. P/V
2. EVA
3. Rain Falls Down

( Bonus: They apply universally and are equally and importantly relevant to entrepreneurship as well.)

Before you swoon in admiration of my unparalleled genius, I want to be clear that these ideas and even the phraseology are not mine.

This is what I learned from my master, my Yoda. (Thanks Tom, for changing my life!)

Yes folks, this changed my life. If you pay attention, it might do it for you.

And then again for those of you too lazy to listen, it might not. YMMV.

 

Definitions first and details later. Ok?

 

1. P/V : Price/Value

The fundamental metric of all investing. The ratio of the price you pay for the value you get. This needs to be less than one at all costs and the lower it is, the larger your margin of safety (remember margin of safety?: https://unrepentantlyrecalcitrant.wordpress.com/2013/10/10/all-investing-is-value-investing-the-rest-is-speculation/).

All of Wall Street that makes money off of you, conflates price and value. It is the fundamental thesis of those that believe the markets are efficient.

(If you believe that, what in gods name are you doing on my blog? Go visit that fool Cramer on CNBC or something!)

Price is what you pay, value is what you get.

The lower the price and the higher the value, the better the deal.

Buffet talks about buying a dollar for fifty cents.

That’s a P/V of 0.5

Awesome.

I will discuss the estimation of value in some detail in a later post.

 
2. EVA : Economic Value Added

Also known as Abnormal Earnings ( Economists always think that profit is an abnormal situation!), EVA is defined as:

Return on Invested Capital – Cost of Capital = EVA

As an example, if your capital costs you 9% ( say a bank loan for your business) and you are able to generate 9.9% return ( savvy investing or your business profits), you have an EVA of 10%

Needless to say, it should be a positive number!

Before you laugh at that, I will in the future show you why most businesses (the majority) are not getting a positive number and as a result have a zero EVA (bad!) or even a negative EVA ( yes, they are destroying capital!).

If you are an aspiring entrepreneur, you must (MUST) have plans for a positive EVA! If not, don’t even bother. More on this later.

 
3. Rain Falls Down:

A little more fuzzy than the others, this statement underlines that certain things are an inevitability.

You must prepare for them and account for them in your estimation of value and decision to invest ( or grow your business).

Your resistance to rain clouds and gravity is useless. Rain will fall down.

 
Simple so far, no?

Remember, Value investing is simple but it’s not easy! Oh No!

I will take each of these points and expand on them in future posts.

I will review the only economic principle(s) that matter ( YES, most of economics is a massive waste of your time!)

The only thing I can’t help you with is mental toughness.

(You need to review Kipling’s poem again and internalize it!:¬†https://unrepentantlyrecalcitrant.wordpress.com/2013/10/06/rudyard-kipling-was-a-value-investor/)

Oh, one last thing. You know that money you saved up to buy the latest Excel program?

Go get a great dinner instead.

You ain’t gonna need Excel anymore.

The Emperor is Naked: Eugene Fama’s Nobel Prize

I was going to write about valuation this week but the events of last week caught my attention.

Oh the irony!

In the story “The Emperor’s New Clothes”, the only person to challenge the Emperor and point out that his new fashionable outfit was nakedness, was a little boy on the side of the street.

Not that Professor Shiller of Yale University is a hapless little boy.

The irony here is that both the Emperor and the little boy were awarded the Nobel (and are having to share it!).

The buffoons here are the Nobel committee (I know..there are no Nobel prizes for economics…but its close enough).

If you are so afraid to offend (alternatively if you are too simple minded to realize that these economists disagree on fundamental issues…fundamental issues) that you take the path of awarding them BOTH the prize (helped us understand how markets work…rubbish!), the only analogy this doctor can think of would be to award both creationists and evolutionary biologists the Nobel prize in Biology together “for clarifying the origins of man!”

I gag at the thought.

Eugene Fama believes the markets are efficient.

If you question him closely, he coyly adds/edits that he believes they are “informationally” efficient.

In other words, if you invoke human psychology (as Shiller does), Fama will tell you he is thinking about the dissemination of information being efficient.

The fact that informational efficiency in and of itself is a completely useless factoid is left unsaid.

Its the market’s actions that mean something.

I give a hill of beans that all of us have access to the same stupid analysts report.

It matters how you process that information and what you decide to do with it.

It matters whether it encourages the fear in you or the greed in you.

That’s what I want to know.

There is a silver lining here though for all of us who want to live in the real world (Fama has also said..there are no such things as financial bubbles..oy vey!).

The fixed false belief in efficient markets (in psychiatry, a fixed false belief is the definition of delusion..a belief that is unchanged in the face of contradictory evidence) has created substantial inefficiencies in the market.

The more people behave as if the markets are efficient, the more there are value anomalies that a savvy investor can exploit.

As Buffet said and I paraphrase ” If the competition goes to work every day thinking its useless to even try (to beat the market), it makes my job easier!”

I can hear Buffet and Munger as they fall off their chairs laughing at this turn of events.

Short term price movements, the kind likely to be impacted by Fama’s theory are irrelevant or should be irrelevant to all investors. I plan to discuss the (non) impact of short term price movements in a future post.

In the meantime, I hope and pray(!) that the creationists are not in line for a Nobel prize as well.

Are you listening Nobel Committee?

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