The Importance Of Capital Intensity And Thoughts From Einhorn

It seems as though there has been a recent debate on going within the value investing community pertaining to ROE, ROIC and net-nets. At one hand of the spectrum we have the argument that value investors are throwing in the towel and buying anything with a high ROE while using 20+ years discounted cash flows to support their thesis. The central argument is, there is no margin of safety if one pays more than NCAV or liquidation value. At the other end of the spectrum we hear that the most profitable way to invest over the long-term is continually buying and selling assets trading below NCAV, P/B or low P/E. I do agree that assets available below NCAV, low P/B or low P/E can be profitable but we must ask ourselves why is Mr. Market willing to offer us a business at a price that values the business higher dead than alive?

According to Buffett “the risk in buying poor businesses is that much of the bargain element of the initial purchase discount may well be dissipated by the time a catalyst comes along to unlock what appeared to be the initial excess value.”

This is because 1) the market has discounted the asset for a reason, likely because the expectation is for the business to continue to destroy value as it is capital intensive in a declining industry where business metrics are deteriorating 2) The economic value the business earns is not enough to cover the cost of the capital used to generate it and 3) The company has poor corporate governance, questionable management practices and bad capital allocation.

Take a textile manufacturer as an example. This is a very simplistic example ignoring depreciation tax saving among other things. The company is currently earning $1,000 while revenues are declining (or stagnant) at $10,000 and the NCAV is $10,000.

Cash: $8000

Accounts Receivable: $5000

Inventory: $2000

Long-Term Debt: $4000

Accounts Payable: $1000

The company is selling for $7,000 or a 30% discount from NCAV and a P/E of 7. Sounds like a good deal right? Not so fast.

We need to examine the capital needs of the business. What if the company requires $1,500 a year to remain competitive in terms of maintenance capital expenditures? Simply stated, the company needs new machines and equipment to remain productive and keep costs low or face losing market share to competitors who do. Now the company has negative $500 free cash flow a year and you get your equity in the form of machinery. Keeping all variables constant in 5 years the company will have NCAV of $7,500, cash will be $5500, sales will be $10,000 (or less) and income will be $1000 (or less).

Assuming the market revalued the company along the way (@ a 30% discount to NCAV), it will now be worth $5250. The company would experience cash burn and have to make the difference through a secondary offering, debt or both in the long-term. Is this adequate margin of safety?

So what is the point? Context matters and it is imprudent to invest blindly in anything.   

ROE and ROIC arguably don’t matter nearly as much if the company is not capital intensive. The most important variables are how long the competitive advantage will continue and the rate of growth on unit volumes. Here is what Einhorn had
to say about the matter.

“I believe that it is irrelevant to worry about ROE or marginal return on capital in non-capital intensive businesses. If Coke or Pfizer had twice as many manufacturing plants, the incremental sales would be minimal. If Greenlight Capital – and here I mean the management company that receives the fees, and not the funds themselves – had twice as many computers and conference room tables we wouldn’t earn twice the fees…in fact, they probably wouldn’t increase at all. When the capital doesn’t add to the returns, then ROE doesn’t matter. It follows from this that in non-capital intensive businesses the price-to-book value ratio is irrelevant. The equity of the company in the form of intellectual property, human capital or brand equity is not reflected on the balance sheet. All that matters is how long, sustainable or even improvable the company’s competitive advantage is, whether it is intellectual property, human resources or market position.”

The place to find value in non-capital intensive companies is the earnings power. Think of Microsoft or another software company. The marginal cost associated with growing revenues are minimal, as the core infrastructure (the software) only requires small adjustments and tweaks overtime and costs pennies to duplicate. Each additional customer added or sold to actually costs less overall. Think if you could develop software for $100,000 total and sell each copy for $101 at a cost of $1. Once you achieve the break-even point of 1,000 customers, each additional customer sold to will only cost $1 or a hypothetical 10,000% ROE.

There are two main risks for non-capital intensive businesses, reinvestment risk and risk the competitive advantage will be lost. Do they return cash to shareholders? Do they attempt to diversify their revenue stream? More often than not the capital is squandered by investing in capital-intensive businesses after generating more cash than they know to do with. The blessing becomes the burden.

Let us circle back to Einhorn.

I believe it is very important to analyze ROE and marginal returns on capital…but only in capital intensive businesses. It may surprise you, but I prefer at the right price capital intensive businesses with low ROEs, where I think the ROE will improve, to high-, or at least medium-ROE businesses.

The problem with high ROEs in capital intensive businesses is that it is hard to sustain the ROEs. Here, high returns attract competition both from new entrants that come with new capital and existing competitors that try to see what the better performing competitor is doing to copy it. The new capital and the copycats often succeed in driving down the superior ROEs. Really bad things happen to earnings when a 25% ROE turns into a 10% ROE.

This is why I prefer the low ROEs. Great things happen to earnings when a 10% ROE becomes a 15% ROE.”

ROE can improve three ways: 1) better asset turns, 2) better margins and 3) by adding leverage. This analysis can be performed further in depth with the Dupont method. Now is there really no margin of safety in earnings power? If you and I were to agree to a deal where you lend me money ($X) for 10-years in return for $100, how much would you lend me?

I assume it wouldn’t be $100 or even $90. It would of course depend on the opportunity cost of your $100 during the next 10-years… but is everyone’s opportunity cost the same?

If I were in your situation I wouldn’t take less than $25 representing a 15% discount rate. If you were now to offer me $80 upfront for $100 in 10-years, I would take it and think of this as a margin of safety. Here is why. First the $80 represents a 2.25% discount rate or an ability to borrow at 1% less than the current prime rate. I would then invest the money during the next 10-years and collect the difference depending on the IRR.

Discount Rate Capitalization Factor Cash Flow Net Return Break Even Borrowing
6% 1.79 $143.27 $43.27 $55.84
7% 1.97 $157.37 $57.37 $50.83
8% 2.16 $172.71 $72.71 $46.32
9% 2.37 $189.39 $89.39 $42.24
10% 2.59 $207.50 $107.50 $38.55
11% 2.84 $227.15 $127.15 $35.22
12% 3.11 $248.47 $148.47 $32.20
13% 3.39 $271.57 $171.57 $29.46
14% 3.71 $296.58 $196.58 $26.97
15% 4.05 $323.64 $223.64 $24.72

Depending on my discount rate, for every $0.01 above the breakeven borrowing rate you offer me, I will be adding to my edge or margin of safety. Because the future is uncertain, and hard to predict we demand a higher margin of safety from intrinsic value and likely blend a range of values. I would rather be approximately right instead of precisely wrong.

“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”

This brings us to the Triple play. What is a triple play? Most baseball fans will understand the sports reference but how does it relate to investing?

There are three ways to earn an investment return.

1) Revenue growth

2) Margin or inventory turn expansion leading to higher net income

3) Multiple expansion

I like to invest in companies that I think are capable of all three to maximize my overall expected return. The point of the post is there is many different ways to build wealth each with its own risks. It is up to the individual investor’s style and personality to determine which strategy (or combination of strategies) he or she pursues.

Seth Klarman 2013 Letter To Investors: The Truman Show

Below is an excerpt from the Buapost Group’s 2013 shareholder letter from Seth Klarman. Klarman has recently given back 4 billion to investors due to lack of ideas, 40% of the portfolio being cash, and a “Truman Show” style market where everything is make believe and everyone is pretending. Baupost Group “has drawn a line in the sand and also cautioned “In the face of mixed economic data and at a critical inflection point in Federal Reserve policy, the stock market, heading into 2014, resembles a Rorschach test, what investors see in the inkblots says considerably more about them than it does about the market.”




“Born Bulls”

In the face of mixed economic data and at a critical inflection point in Federal Reserve policy, the stock market, heading into 2014, resembles a Rorschach test. What investors see in the inkblots says considerably more about them than it does about the market.

If you were born bullish, if you’ve never met a market you didn’t like, if you have a consistently short memory, then stock probably look attractive, even compelling. Price-earnings ratios, while elevated, are not in the stratosphere. Deficits are shrinking at the federal and state levels. The consumer balance sheet is on the mend. U.S. housing is recovering, and in some markets, prices have surpassed the prior peak. The nation is on the road to energy independence. With bonds yielding so little, equities appear to be the only game in town. The Fed will continue to hold interest rates extremely low, leaving investors no choice but to buy stocks it doesn’t matter that the S&P has almost tripled from its spring 2009 lows, or that the Fed has begun to taper purchases and interest rates have spiked. Indeed, the stock rally on December’s taper announcement is, for this contingent, confirmation of the strength of this bull market. The picture is unmistakably favorable. QE has worked. If the economy or markets should backslide, the Fed undoubtedly stands ready to once again ride to the rescue. The Bernanke/Yellen put is intact. For now, there are no bubbles, either in sight or over the horizon.

But if you have the worry gene, if you’re more focused on downside than upside, if you’re more interested in return of capital than return on capital, if you have any sense of market history, then there’s more than enough to be concerned about. A policy of near-zero short-term interest rates continues to distort reality with unknown but worrisome long-term consequences. Even as the Fed begins to taper, the announced plan is so mild and contingent – one pundit called it “taper-lite” – that we can draw no legitimate conclusions about the Fed’s ability to end QE without severe consequences. Fiscal stimulus, in the form of sizable deficits, has propped up the consumer, thereby inflating corporate revenues and earnings. But what is the right multiple to pay on juiced corporate earnings? Pretty clearly, lower than otherwise. Yet Robert Schiller’s cyclically adjusted P/E valuation is over 25, a level exceeded only three times before – prior to the 1929, 2000 and 2007 market crashes. Indeed, on almost any metric, the U.S. equity market is historically quite expensive.

A skeptic would have to be blind not to see bubbles inflating in junk bond issuance, credit quality, and yields, not to mention the nosebleed stock market valuations of fashionable companies like Netflix and Tesla. The overall picture is one of growing risk and inadequate potential return almost everywhere one looks.

There is a growing gap between the financial markets and the real economy.

“Flash-Mob Speculation”

When it comes to stock market speculation, it’s never hard to build a “coalition of willing.” A flash mob of day traders, momentum investors, and the usual hot money crowd drove one of the best years in decades for U.S., Japanese, and European equities. Even with the ranks of the unemployed and underemployed still bloated and the economy barely improved from a year ago, the S&P 500, Dow Jones Industrial Average, and Russell 2000 regularly posted new record highs (45 for the S&P, 52 for the Dow, and 66 for the Russell) while gaining a remarkable 32.4%, 29.7%, and 38.8% including dividend reinvestment, respectively, in 2013. It was the best year for the S&P 500 since 1997… In the closing weeks of 2013, it was as if the strong gravitational pull of valuation had been temporarily suspended and stock prices had been launched by a booster rocket, allowing them to reach escape velocity. As with bull markets past, favored stocks started to become unmoored and unbounded.

“Speculative Froth” and Dot-Com 2.0

Whether you see today’s investment glass as half full or half empty depends on your age and personality type, as well as your “lifetime” of experiences in the markets and how you interpret them. Our assessment is that the Fed’s continuing stimulus and suppression of volatility has triggered a resurgence of speculative froth. Margin debt measured as a percentage of GDP recently neared an all-time high. IPO activity in 2013 was greater than it has been in years, with 230 offerings taking place, 59% more than last year and approaching 2007’s record of 288 transactions.

Twitter, for example, surged from $26 to almost $45 on day one, and closed the year around $64. It was priced, after all, at only twenty times its projected 2015 revenue. One analyst suggests the profitless company might achieve $50 million of “adjusted” cash earnings this year, giving it a P/E of over 500. Some hedge and mutual funds are again investing in late-stage, pre-IPO financing rounds for hot Internet companies at valuations that only seem reasonable if the companies go public, soon, and at astronomical prices., with a market cap of $180 billion, trades at about 15 times estimated 2013 earnings, Netflix at about 181 times. Tesla Motors’ P/E is about 279; LinkedIn’s is 145. Even though Netflix now carries some original programming, we’re pretty sure we’ve seen this movie before. Some 23-year-olds have sold their startup Internet companies for hundreds of millions of dollars, while the profitless privately held Snap chat has turned down a $3 billion buyout offer.

In Silicon Valley, it seems that business plans – a narrative of how one intends to make money – are once again far more valuable than many actual businesses engaged in real world commerce and whose revenues exceed expenses.

“Ominous Signs”

In an ominous sign, a recent survey of U.S. investment newsletters by Investors Intelligence found the lowest proportion of bears since the ill-fated year of 1987. A paucity of bears is one of the most reliable reverse indicators of market psychology. In the financial world, things are hunky dory; in the real world, not so much. Is the feel-good upward march of people’s 401(k)s, mutual fund balances, CNBC hype, and hedge fund bonuses eroding the objectivity of their assessments of the real world? We can say with some conviction that it almost always does.

Frankly, wouldn’t it be easier if the Fed would just announce the proper level for the S&P, and spare us all the policy announcements and market gyrations?

“The Continuing Problems in Europe”

Europe isn’t fixed either, but you wouldn’t be able to tell that from investor sentiment. One sell-side analyst recently declared that ‘the recovery is here,’ a sharp reversal from his view in July 2012 that Greece had a 90% chance of leaving the Euro by the end of 2013. Greek government bond prices have nearly quintupled in price from the mid-2012 lows. Yet, despite six years of painful structural adjustments, Greece’s government debt-to-GDP ratio currently stands at 157%, up from 105% in 2008. Germany’s own government debt-to-GDP ratio stands at 81%, up from 65% in 2008. That doesn’t look fixed to us. The EU credit rating was recently reduced by S&P. European unemployment remains stubbornly above 12%. Not fixed.

Various other risks lurk on the periphery: bank deposits remain frozen in Cyprus, Catalonia seems to be forging ahead with an independence referendum in 2014, and social unrest continues to escalate in Ukraine and Turkey. And all this in a region that remains saddled with deep structural imbalances. As Angela Merkel recently noted, Europe has 7% of the world’s population, 25% of its output, and 50% of its social spending. Again, not fixed.

“Bitcoin And Gold”

Only in a bull market could an online “currency” dubbed bitcoin surge 100-fold in one year, as it did in 2013. The phenomenon spurred The Wall Street Journal to call it a “cryptocurrency” craze, with dozens of entrants. Bitcoin now has an estimated market “value” in excess of $6 billion, leaving alphacoin, fastcoin, gridcoin, peercoin, and Zeuscoin in its wake. Now most sell-side firms are rushing to provide research on this latest fad, while “bitcoin funds” are being formed. Recent recruitment e-mails to staff such a platform reassure that even though experience is preferred, it is not required.

While bitcoin is yet another bandwagon we are happy to let pass us by, the thinking behind cryptocurrencies may contain a kernel of rationality.

If paper currencies – dollars and yen – can be printed in essentially unlimited volumes, and just as with all currencies are only worth what recipients on any given day will exchange in goods or services, then what makes them any better than the “crypto” kind of money? The dollars and yen are, of course, legal tender issued by governments, but in an era in which governments are neither popular nor trusted, that is not necessarily a big plus.

Gold, at least, has been regarded as “money,” for thousands of years, and it is relatively stable and widely accepted store of value and medium of exchange. It’s a well-known monetary “brand.” It doesn’t exist only (or at all) in cyberspace, and it cannot be printed on the whim of authorities. Ironically and perplexingly, while gold, the hard money alternative to the printing press kind of money, dropped 28% in 2013, the untested and highly speculative bitcoin went completely through the roof.

“The Truman Show” Market

Welcome to “The Truman Show” market. In the 1998 film by that name, actor Jim Carrey is ignorant of the fact that his life is a hugely popular reality show. His every action, unbeknownst to him, is manipulated while being broadcast to millions of TV viewers worldwide. He seemingly lives in an idyllic seaside community where the manicured lawns are always green and the citizens are always happy. These people are, of course, actors. The world Truman inhabits turns out to be phony: a gigantic sound stage created for a manufactured “reality.” As Truman starts to unravel the truth, his anger erupts and chaos ensues.

Ben Bernanke and Mario Draghi, as in the movie, are the “creators” who have manufactured a similarly idyllic, if artificial, environment for today’s investors. They were the executive producers of “The Truman Show” of 2013. A global audience sat in rapt attention before this wildly popular production. Given the U.S. stock market’s continuing upsurge, Bernanke is almost certain to snag yet another People’s Choice Award for this psychological “thriller.” Even in “The Truman Show,” life was not as good as this for investors.

But there is one fly in the ointment: in Bernanke’s production, all the Trumans – the economists, fund managers, traders, market pundits – know at some level that the environment in which they operate is not what it seems on the surface. The Fed and the Treasury openly discuss the aim of their policies: to manipulate financial markets higher and to generate reported economic “growth” and a “wealth effect.” Inside the giant Plexiglas dome of modern capital markets, just about everyone is happy, the few doubters are mocked and jeered, bad news is increasingly ignored, and markets go asymptotic. The longer QE continues, the more bloated the Fed balance sheet and the greater the risk from any unwinding. The artificiality of today’s markets is pure Truman Show. According to the Wall Street Journal (12/20/13), the Federal Reserve purchased about 90% of all the eligible mortgage bonds issued in November.

Like a few glasses of wine with dinner, the usual short-term performance pressures on most investors to keep up with the market serve to dull their senses, which makes it a bit easier to forget that they are being manipulated. But what is fake cannot be made real. As Jim Grant recently noted on CNBC, the problem is that “the Fed can change how things look, it cannot change what things are.” According to John Phelan, a fellow at the Cobden Centre in the U.K., “the Federal Reserve has become an enabler of the financial havoc it was designed (a century ago) to prevent.”

Every Truman under Bernanke’s dome knows the environment is phony. But the zeitgeist so so damn pleasant, the days so resplendent, the mood so euphoric, the returns so irresistible, that no one wants it to end, and no one wants to exit the dome until they’re sure everyone else won’t stay on forever.

A marketplace of knowing Trumans seems even more unstable than the movie sound stage character slowly awakening to reality. Can the clued-in Trumans be counted on to maintain their complicity or will they go off-script? Will Fed actions reliably be met with the desired response? Will the program remain popular? Could “The Truman Show” be running out of material? After all, even Seinfeld ended.

Someday, the Fed’s show will be off the air and new programming will take its place. And people will debate just how good it really was. When the show ends, those self-deluded Trumans will be mad as hell and probably broke as well. Hopefully there will be no sequels.


Someday, financial markets will again decline. Someday, rising stock and bond markets will no longer be government policy – maybe not today or tomorrow, but someday. Someday, QE will end and money won’t be free. Someday, corporate failure will be permitted. Someday, the economy will turn down again, and someday, somewhere, somehow, investors will lose money and once again come to favor capital preservation over speculation. Someday, interest rates will be higher, bond prices lower, and the prospective return from owning fixed-income instruments will again be roughly commensurate with the risk.

Someday, professional investors will come to work and fear will have come to the markets and that fear will spread like wildfire. The news flow will be bad, and the markets will be tumbling.

“Here We Are Again

When the markets reverse, everything investors thought they knew will be turned upside down and inside out. “Buy the dips” will be replaced with “what was I thinking?” Just when investors become convinced that it can’t get any worse, it will. They will be painfully reminded of why it’s always a good time to be risk-averse, and that the pain of investment loss is considerably more unpleasant than the pleasure from any gain. They will be reminded that it’s easier to buy than to sell, and that in bear markets, all too many investments turn into roach motels: “You can get in but you can’t get out.” Correlations of otherwise uncorrelated investments will temporarily be extremely high. Investors in bear markets are always tested and retested. Anyone who is poorly positioned and ill-prepared will find there’s a long way to fall. Few, if any, will escape unscathed.

Six years ago, many investors were way out over their skis. Giant financial institutions were brought to their knees when untested structured products that were too-clever-by-half turned toxic and collapsed. Financial institutions and institutional investors suffered grievous losses. The survivors pledged to themselves that they would forever be more careful, less greedy, less short-term oriented.

But here we are again, mired in a euphoric environment in which some securities have risen in price beyond all reason, where leverage is returning to many markets and asset classes, and where caution seems radical and risk-taking the more prudent course. Not surprisingly, lessons learned in 2008 were only learned temporarily. These are the inevitable cycles of greed and fear, of peaks and troughs. Can we say when it will end? No. Can we say that it will end? Yes. And when it ends and the trend reverses, here is what we can say for sure. Few will be ready. Few will be prepared.

Position Sizes, Kelly Criterion And Prudent Capital Allocation

Rule One: Never lose money

Rule Two: Never forget rule one

First Off, What Is the Kelly Criterion?

It’s a formula Bell Labs scientist John Kelly devised in the 1950s for maximizing the long-term growth rate of capital. It was a borrowed idea from the application of information theory (Claude Shannon) and applied to gambling. It tells you how to allocate your money among the choices available, and how much to invest as your edge increases and the risk decreases. It also avoids the over-betting that can ruin an investor who otherwise has an edge. Kelly imagined a system where you have an edge, a set of expectations that differs from those of the market. He then developed a formula, based on Shannon’s work, showing the exact amount of your bankroll you should bet in order to maximize your capital over the long term. Consistent with the theory, the maximum rate of return comes when you know something the market doesn’t.

  • The chance of ruin is small. Because the Kelly system is based on proportional bets, or relative bets and losing all of your capital is theoretically impossible. A small chance of a significant loss remains.
  • It is arguably the best system to reach a specified goal within the lowest period of time.

Assume you can participate in a coin toss game where heads pays $2 and tails costs $1. You start with a $100 bankroll and can play for 40 rounds. What betting strategy will give you the greatest probability of the most money at the end of the 40th round?

The payoff is $2 for heads and $1 for tails, giving us 2-1 odds. We know the odds of the coin to be 1-1 or a 50% chance.

How much do you bet each round?

100% ???
50% ???
40% ???
25% ???
10% ???


Kelly Criterion States

F = PW – (PL/W)


F = Percent of Proportional Capital Allocated

W = Dollars won per dollar wagered (i.e., win size divided by loss size)

PW = Probability of winning

PL = Probability of losing

Now if we plug the values into the formula we find:

F = 0.50 – (0.5/2)

F = 0.25 or 25% of capital

We can rearrange the formula to end up with

Edge/Odds = f


Odds = $2
Edge = Expected return or (0.5 x 2) + (0.5 x -1)

0.5/2 = 25%

This style of betting is rather counterintuitive at first glance but upon thinking about it for a few moments, we realize this is because of the probability distribution and chance of continual (parlay style) losses in the short-run.

Mohnish Pabrai (TradesPortfolio), PIMCO, Warren Buffett (TradesPortfolio), Legg Mason and a few others seem to utilize the Kelly system in various unique respects. Buffett has not officially stated he used the system although he had the following to say during an interview with business students:

I have two views on diversification. If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification.

If it’s your game, diversification doesn’t make sense. It’s crazy to put money in your 20th choice rather than your 1st choice. ‘LeBron James’ analogy. If you have LeBron James on your team, don’t take him out of the game just to make room for some else.

Charlie and I operated mostly with 5 positions. If I were running 50, 100, 200 million, I would have 80% in 5 positions, with 25% for the largest. In 1964 I found a position I was willing to go heavier into, up to 40%. I told investors they could pull their money out. None did. The position was American Express after the Salad Oil Scandal. In 1951 I put the bulk of my net worth into GEICO. With the spread between the on-the-run versus off-the-run 30 year Treasury bonds, I would have been willing to put 75% of my portfolio into it. There were various times I would have gone up to 75%, even in the past few years. If it’s your game and you really know your business, you can load up.”

Pabrai on the other hand talks about the Kelly formula extensively through out The Dhandho Investor and recommends using a more conservative approach of a 1one-fourth Kelly, one-third Kelly or one-half Kelly, that is dividing the recommended total capital allocation by two, three or four. This is due to an important factor of over-betting and the loss of wealth it can cause as well as to subdue the emotional effects of losses. Because probabilities are usually estimates and are not known and the effects of over betting are worse than under betting, it is best to be conservative and bet less than Kelly suggests.

You have to make sure that you don’t over-bet. Suppose you have a 5% edge over your opponent when tossing a coin. The optimal thing to do, if you want to get rich, is to bet 5% of your wealth on each toss — but never more. If you bet much more you can be ruined, even if you have a favorable situation.” — Ed Thorp

(Note: Thorp had 20% average returns over a 20-year span at Princeton-Newport Partners)

The following picture illustrates the distribution of 40 coin flips using a range of f values from the example above [borrowed from Legg Mason]. The multiple of original bankroll is a function of percent of proportionate capital allocated. 

We can see that when we over bet it leads to complete ruin while if we under bet we are potentially leaving money on the table or in the market. Kelly System is a parlay style betting system and requires an investor to maximize geometric return versus a simple arithmetic return.

A quick illustration of why to use GeoMean. Imagine we had five years of data.

2013 = 25% return

2012 = -60% return

2011 = 25% return

2010 = 18% return

2009 = 90% return

The arithmetic average would be 19.6% annually. Is this measurement truthful?

No it is actually very misleading as most of us can probably see based on the 2012 returns of a 60% loss. The Geometric mean would be roughly 7% over five years, or a difference of 12.6% in expected value.

(Side Note: It is absolutely incredible how many managers report arithmetic average returns instead of geometric average returns, this is clearly due to incentives, as the arithmetic return must always be higher or equal to geometric return. This is not surprising given the negative incentive of losing assets if returns are not expectable, leading to lower compensation due to AUM loss).

Prospect Theory and Utility Theory

Both theories suggest that an investor’s utility, (as a function of investment return) is relative to proportionate wealth. Meaning the more money we have the less likely a small gain or loss is to effect us. The less money we have the more utility the returns and losses have.

These theories introduced by Kahneman and Tversky also introduce us to the evidence that humans are hard wired to be loss averse. Imagine for a second about winning $1000 and losing $1000 tomorrow. The dollars that are lost effect us asymmetrically compared to gains, usually 2-2.5 times as much as winning the same amount, dependent on the random variable, investor wealth.

Cognitive biases aside, lets review an example that can be applied to the value-investingdomain. Both examples are borrowed from Mohnish Pabrai (TradesPortfolio), the first being a gas station and the second being Warren Buffett (TradesPortfolio)’s investment in Washington Post. He gives more detailed examples regarding American Express, the gas station (when a loss occurs) and “Papa Patel’s” motel investments.

Real World Examples

First thing is first, before capital allocation should even be considered, the investment should have passed our investment checklist. The downside is minimal, it is a business that is within our circle of competence and we understand it very well. We know how the cash flows are likely to change or what they are to be in 5-10 years time. The business is priced at a discount from intrinsic value. It is a business we would be willing to commit a large portion of capital to. The management is honest, able and sound. The business has a durable moat that is expanding.

Present Value ($) of future cash flow
Year Free Cash Flow 10% Discount Rate
2007 100,000 90,909
2008 100,000 82,645
2009 100,000 75,131
2010 100,000 68,301
2011 100,000 62,092
2012 100,000 56,447
2013 100,000 51,315
2014 100,000 46,650
2015 100,000 42,410
2016 100,000 38,554
2017 Sale Price 1,000,000 385,543
Total $1,000,000 (rounded)

We find that a gas station goes on sale at the end of 2006 for $500,000.

Should we buy? Well yes.

The intrinsic value we calculated was $1,000,000 based on cash flows it will produce over ten years and the sale price (or terminal value). Lets assume now that two years have passed and someone offers us $950,000 for the gas station. What should we do?

Well first we re-calculate and analyze the intrinsic value, assuming everything has stayed constant, a sale should be made. We have received $200,000 in dividends or cash flow on top of the $950,000 sale price.

Funds Invested: $500,000

Total proceeds: $1,150,000

Years: 2

Annualized Return: 51.66%

Although this is a great return, it is dependent upon how much we invested proportionate to what was available. If a 51% return is achieved on only 3-5% of the portfolio, a total or portfolio return of only 1.5-2.5% is achieved. If 60% of the portfolio was invested, the total return would about 30%. A difference of 27.5% excess return.

Re-Enter the Kelly System

Odds of a 2-times return in three years = 80%

Odds of breaking even in three years = 15%

Odds of total loss in three years = 5%

The Kelly system would suggest we invest 92% of our available bankroll. We can reduce this suggestion by ½, 1/3 or 1/4 to 23% to 46% of available bankroll for reasons outlined previously. (f = 0.95 – (0.05/1.55)

The return of 50% would then be translated into a total return of 11.5% – 23%.

Warren Buffett (TradesPortfolio) and Washington Post

Mr. Buffett bought his Washington Post (WPO) stake for about $6.15 per share in 1973 and had believed the business to be worth $25 per share. Let us imagine now that the business will grow intrinsic value by about 10% annually ($25 x 1.1 x 1.1 x 1.1 = $33.28). A sale of the business will be made in three years when intrinsic value reaches 90%, or roughly $30 per share. We would achieve an annualized return of just under 70%.

Odds of making 4 times of better return in three years = 80%

Odds of making 2-4 times or better return in three years = 15%

Odds of breaking even to 2 times = 4%

Odds of total loss = 1%

How much bankroll would Kelly tell us to allocate?

F = PW – (PL/W)


F = Percent of Proportional Capital Allocated

W = Dollars won per dollar wagered (i.e., win size divided by loss size)

PW = Probability of winning

PL = Probability of losing

F = 0.99 – (0.01/3.68) = 98.7%

Take 1/2 , 1/3 or ¼ Kelly and we end up with a suggested range of 24.675% to 49.35%.
As Pabrai outlines in his book “At the time, Berkshire Hathaway had a total market capitalization of about $60 million. Available cash was likely a small fraction of this number. I’d estimate that Mr. Buffett likely used well over 25% of his available bank roll.”

The keys are the psychology of losses and the emotional component of investing, the edge that the investor can identify that is different from the markets views and capitalizing by concentration when the odds present themselves.

But do not be fooled. There is no “perfect” system to avoid all loses. All we can do is minimize losses, maximize gains, and optimize bankrolls. The Kelly Formula insures that you’ll never lose everything but it doesn’t guarantee that you won’t lose sometimes. The point is not to use the stated Kelly allocation amount and mathematical models when determining investments. Spend your time reading annual reports, analyzing businesses and looking to find bargains that you believe to be in the 95%+ of Kelly recommended capital allocation.

When you find these types of bargains, buy as much as you are comfortable with. What the Kelly system tells us is that is ok to concentrate our holdings in 4-20 great businesses we deem to be undervalued. Is the point of investing and the main function of any investor, whether growth or value to outlay capital at the present in return for additional capital as well as the originally outlaid capital, in the future?

The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple. – Charlie Munger(TradesPortfolio)

Invest Like a Lemming: Technical Analysis

It is likely no surprise to most people that have studied Warren Buffett that he had used technical analysis as an investment strategy for nearly 8 years. Luckily for Warren, he met Ben Graham, studied his writings, studied under Ben at Columbia and solely committed to the road of fundamental value investing for the rest of his life. The rest is history.

After Warren came to the realization that technical analysis did not work, he explained years later, “I realized that technical analysis didn’t work when I turned the chart upside down and didn’t get a different answer.”

There are many different indicators available for use by a technician, all of which are based on various weightings and combinations of price and volume. The technician believes price and volume reveals the ability to infer what is likely to happen in the future through trends and indicators.

The price and the volume is the from the past and like the ancient saying about performance, it is not indicative of the future. There is a whole host of errors that charlatans (I mean technicians), are susceptible to when analyzing a chart. Two of the largest biases are anchoring and data mining.

Anchoring: Anchoring is a cognitive bias that causes one to become attached to a piece of data, usually the first piece received or a minimum/maximum.

Think when you view a chart showing past price action. If you are like me after viewing a 1, 5, 10 or 20-year history of the price, I immediately become anchored to the all time highs and lows of the chart. I begin to think about mean reversion and come to false conclusions about the probability of the future based on past price. This is a bias one must work very hard to overcome and a bias that one can use to exploit, always using a larger number as the first offer when selling and inversely a low number when buying.

Data Mining: Give 10 different technicians the same exact chart with the same indicators and averages. They will likely all come to different conclusions because of “top-down processing” or previous experiences, judgments, prejudices and beliefs. The chartist sees what he or she wants to see and infers a narrative that is plausible at the time. The indicators or strategies that are right or “last” are simply a product of survivorship bias and a self-fulfilling forecast. [Here is one from Credit Suisse]

Hindsight bias and the narrative fallacy also causes one to believe patterns in the past were “signs” or were easily identifiable at the time. That are other biases one can identify or ask a proclaimed technician to identify (there are lots of them), the point is the list (of biases and technicians) is endless.

These biases by no means are limited to technicians but everyone is susceptible to them, especially when dealing with data. Although a major problem arises for the technician that does not for the fundamentalist, this is confidence and a tangible value that is assigned to a business.

The fundamentalist uses revenue, margins, cash flow, earnings, capital structure, operating leverage, country of origin, assets, liabilities, customers, etc. to value a business based on intrinsic value. The value investor then differentiates themself by buying at a margin of safety from the estimated intrinsic value.

The chartist values the business on none of these operating characteristics but only the past price and past volume of the market price. This is a flawed paradox, where a TA is willing to buy an asset under the assumption he or she will receive more in the future based on a given indicator or trend. The paradox is that these past trends and indicators are based on the performance of others, there for, the crowd is the hand that is guiding your decision.

There are a few studies regarding the efficacy of technical analysis that are at best inconclusive. The point being technical analysis has no statistical or legitimate empirical evidence of adding value in the form of an excess return. Un-like Value Investing proven by multiple studies, empirical evidence and the Nobel laureate Eugene Fama.

What if it did work or there was a predicative TA strategy? 

Some technicians will tell you about which indicators work for them and how you can exploit them to make money (for a subscription fee). What they won’t tell you is, if there was a definitive indicator or trend one could identify and exploit for an excess return…

The market would discount it.

Some say when a golden cross occurs it is predictive of additional gains, a death cross infers bearish times are ahead, a shooting star reveals a short term top is in, and you get the point.

Inverting, one has to ask would the market not discount a definitive pattern, trend, or indicator that can be identified as other speculators would also be aware of the signal? But what about the argument of the self-fulfilling prophecy when most market participants believe in an indicator? Sure it can happen and does, but like Ben Graham said famously many years ago, “In the short term the market is a voting machine, in the long-term it is a weighing machine.” The problem lies in predicting the votes.

In the end, a business is worth the present value of all future cash flows discounted at an appropriate rate.

The following study reveals no value is added from technical analysis.

[Study from Massey University of Technical Analysis on 5000 TAs]

But There Are Rich Technicians…

A common dispute between fundamentalists and technicians is that if technical analysis doesn’t work, why are there rich technical analysts like Paul Tudor Jones?

Using a coin flipping contest and basic probability distribution we realize this is pure chance or luck. If 300 million people all started flipping a coin today, after the first flip we would be left with 150 million winners and 150 million losers.

After the second flip we are down to 75 million winners. We carry on the exercise for 21 flips (total) before we are left with 286 winners.

Now imagine each flip as a year in the market. Each player that flipped tails won and received a 100% return on their cumulative investment. Further imagine the initial investment of all coin flippers was $1000.

The remaining 286 winners would all have roughly 2.1 billion dollars, rich by any monetary standard today.

The question is not if there is rich proclaimed technicians but how many consistently outperform the market relative to peers using the same or other strategies.

Of those 286 winner who all flipped tails imagine 26 as being technicians, 80 from the growth category and 180 from Graham and Doddsville or identify as value investors.

Which strategy would you choose?

Unlike technical analysis, fundamental analysis has a proven track record with a disproportionate distribution of successful investors and backed by empirical evidence as well as statistical evidence.

For the still skeptical, try Chart Game and play for 20-30 minutes. Write down how well you do each time. You are likely to come to the conclusion using price/volume is a heads and tails game. You may get lucky, you may get unusually unlucky, but over a large sample the empirical evidence will appear.

The best way to make money using technical analysis is to sell it. Sell a subscription, sell a service, sell lessons, write books and collect from others. It is sold to the masses by daily commercials, endorsements, brokers, pundits, banks and entrepreneurs. Most have an incentive to do so, as your commission (or subscription fee) generates their profits.

“Never ask the barber if you need a haircut”

Graham & Doddsville from Columbia Business School (Winter 2014)

The winter 2014 edition of Graham & Doddsville from Columbia has been released. It is chalked full of goodness including an interview with Jim Grant, founder of Grant’s Interest Rate Observer. 

Geoffrey Batt also talks about Iraq, Baghdad Soft Drinks, his convictions and taking advantage of historic equity re-ratings. Other interviewees included Lee Ainslie (No holds investing), Ken Shubin (A study in investing) and Justin Muzinich (Find good businesses).

I find this quote from Jim Grant to hit home.

“See the older gent walking down the street, the one not checking a mobile device? He has money, security, position. In short, he possesses everything you don’t have and desperately want. But do you know something? The elderly gent would give his money, security and position for your bounding energy, full head of hair and limitless prospects. You should enjoy them!”