Financial Markets

[roger]

The Atheist, Scrut seems to be playing with you a bit.

We (Scrut and I) come from a Benjamin Graham background. His theories beget people like Fisher, Buffet, Munger, Ruane, et. al. All people (and really, the only people) who have consistantly beat the markets for decades. An extraordinarily difficult and impressive record.

The central thesis is we ignore markets. We buy value - or in the words of Graham, we buy dollars for 50cents. This valuation has nothing to do with the markets. You can find those deals in bull, bear, and sideways markets, though obviously the'll occur more often in a bear, and be more difficult to find in a bull market.

But no one has ever demonstrated the ability to predict the future movement of the market, despite looking at interest rates, housing data, etc., etc., etc. So, we ignore the behavior of the market. Can't predict it, not gonna try. We just look for people offering to sell us a dollar for 50 cents.

So, to take your MSFT example, we try to place a value on MSFT based on future cash flows. That's the only rational reason to buy MSFT. Sure, the price will bob up and down with the market, but we can't predict that bobbing, so we don't try. We try to estimate the future free cash flow of MSFT, and do a dicounted cash flow (DCF) analysis to figure out what the present value of those future cash flows (FCF) are. If the current stock price is significantly below that price, and we are confident in our valuation of the company, we buy it, ignoring the market.

In the short term the market is gambling, as you have pointed out. But in the long term, stocks follow value. I.e. if you look at short term movements of stock prices, we can show they are a random walk. There's a lot of conditions behind that statement which is too much to go into in a single post; I refer you to Malkiel's "A Random Walk Down Wall Street". However, in the long term, stocks always trend towards the value given by a DCF of the FCF. I refer you again to Malkiel for this analysis.

So, investors like Scrut and I, shameless cloners of Graham, Fisher, Buffet, et. al, ignore markets. We look at individual stocks, value them, and buy or sell based on that valuation. We don't look at if the market is up or down, what the "support level" is, or anything like that. If a man offers you to buy a dollar for 50 cents, you take him up on it. If he offers to buy a dollar from you for 2 dollars, you sell. Sooner or later rationality will prevail.

I believe that is what scrut meant when he said he does not follow the market (I base this on several threads where we discussed these topics before).

 

[The Central Scrutinizer]

The Atheist, Scrut seems to be playing with you a bit.

We (Scrut and I) come from a Benjamin Graham background. His theories beget people like Fisher, Buffet, Munger, Ruane, et. al. All people (and really, the only people) who have consistantly beat the markets for decades. An extraordinarily difficult and impressive record.

The central thesis is we ignore markets. We buy value - or in the words of Graham, we buy dollars for 50cents. This valuation has nothing to do with the markets. You can find those deals in bull, bear, and sideways markets, though obviously the'll occur more often in a bear, and be more difficult to find in a bull market.

But no one has ever demonstrated the ability to predict the future movement of the market, despite looking at interest rates, housing data, etc., etc., etc. So, we ignore the behavior of the market. Can't predict it, not gonna try. We just look for people offering to sell us a dollar for 50 cents.

So, to take your MSFT example, we try to place a value on MSFT based on future cash flows. That's the only rational reason to buy MSFT. Sure, the price will bob up and down with the market, but we can't predict that bobbing, so we don't try. We try to estimate the future free cash flow of MSFT, and do a dicounted cash flow (DCF) analysis to figure out what the present value of those future cash flows (FCF) are. If the current stock price is significantly below that price, and we are confident in our valuation of the company, we buy it, ignoring the market.

In the short term the market is gambling, as you have pointed out. But in the long term, stocks follow value. I.e. if you look at short term movements of stock prices, we can show they are a random walk. There's a lot of conditions behind that statement which is too much to go into in a single post; I refer you to Malkiel's "A Random Walk Down Wall Street". However, in the long term, stocks always trend towards the value given by a DCF of the FCF. I refer you again to Malkiel for this analysis.

So, investors like Scrut and I, shameless cloners of Graham, Fisher, Buffet, et. al, ignore markets. We look at individual stocks, value them, and buy or sell based on that valuation. We don't look at if the market is up or down, what the "support level" is, or anything like that. If a man offers you to buy a dollar for 50 cents, you take him up on it. If he offers to buy a dollar from you for 2 dollars, you sell. Sooner or later rationality will prevail.

I believe that is what scrut meant when he said he does not follow the market (I base this on several threads where we discussed these topics before).

You believe correctly. And sum it up very well, as usual.

I work with a guy similar to The Atheist. Everyday he's coming over to the desk showing me all sorts of graphs and trends and support levels and momentum and blah, blah, blah. I try to educate him, but ultimately, I just have to tell him I'm not interested.

Another word that came to mind reading your post was "beta". And my friend uses that term too when discussing which stocks he is trading. I don't even know what it means, all I remember is what Mr. Buffett said about it one year at the meeting - "If someone uses the term "beta" while discussing a stock, turn and run in the other direction". So I don't know what it means, and I don't even want to waste the time to find out.

Instead of wasting hundreds of hours on "market analysis", I find it much easier to buy a piece of a great company at a bargain price (or dollars for 50 cents, as you put it) and holding them for long periods of time. Then I can spend those hundreds of hours reading books or watching movies.

 

[drkitten]

Another word that came to mind reading your post was "beta". And my friend uses that term too when discussing which stocks he is trading. I don't even know what it means, all I remember is what Mr. Buffett said about it one year at the meeting - "If someone uses the term "beta" while discussing a stock, turn and run in the other direction". So I don't know what it means, and I don't even want to waste the time to find out.

You -- and Buffett, I'm afraid -- are wrong.

Beta is a measure of how unpredictable a stock's return is. Perhaps Buffett is in a position where preservation of capital is no longer an issue (although I doubt that); I doubt you are. Even if someone is offering to sell you a dollar for fifty cents, there's still the question of how long you'll have to wait before you get your dollar. Unless you're planning to be immortal, you need to think about the downside as well as the upside.

That doesn't make the quants any more correct, of course. But the idea of figuring out the time horizon over which a stock is likely to have a positive return is hardly a waste of time.

 

[The Central Scrutinizer]

You -- and Buffett, I'm afraid -- are wrong.

Sorry, but Mr. Buffett is right in about 40 billion ways.

Beta is a measure of how unpredictable a stock's return is.

Ummmm....sorry, but every stock's return is equally unpredicatble. So how come they all have different betas?

Perhaps Buffett is in a position where preservation of capital is no longer an issue (although I doubt that); I doubt you are.

"Preservation of capital" = poor returns. I'm out to increase my capital, not preserve it. If I wanted to preserve it, I would stick it in the bank and earn 3%.

But the idea of figuring out the time horizon over which a stock is likely to have a positive return is hardly a waste of time.

Again, unknowable.

"If you don't plan on holding a stock for 10 years, don't spend 10 minutes thinking about buying it" - Warren Buffet

 

[roger]

Some have argued that Buffett got that one wrong. Beta measures how much a stock price bounces around relative to another asset. Buffett repeatedly puts down beta by bringing up his Washington Post purchase. he bought at a market cap of 80 million, whereas he valued it at 400 million. Time has proven him correct in that valuation. His dismissal of beta runs along the lines of 'would it have been more risky to have bought at 40 million than 80 million.'

Well, as the linked article points out, the Post's beta did not increase when the share prices fell in 73. However, I find it to be a bit of a fine point - short term flucuations can provide us with long term value opportunites, or margin of safeties, to put it another way. But of course you buy because of the margin of safety, not the beta. And I think that was Warren's point, he does not invest by looking at beta; if he see's value, and a reason to believe the truth will out (some catalyst to cause the stock price to eventually match his valuation), then he buys.

I believe Dr. Kitten to know something about Modern Portfolio Theory based on previous conversation. I know little except how to spell it. I believe that Beta plays quite a role in it. I'm not really aware of anyone using it to produce the kinds of returns Buffett and similar investors get. OTOH, I'm aware of groups like LTCM failing spectacularly when the sigmas didn't go their way.

So, I guess I would be presumptious to say that Buffett has it right; however, his investing methods only require a normal IQ, a pencil, and access to company reports. It's the one I'll stick with.

 

[The Central Scrutinizer]

Some have argued that Buffett got that one wrong. Beta measures how much a stock price bounces around relative to another asset. Buffett repeatedly puts down beta by bringing up his Washington Post purchase. he bought at a market cap of 80 million, whereas he valued it at 400 million. Time has proven him correct in that valuation. His dismissal of beta runs along the lines of 'would it have been more risky to have bought at 40 million than 80 million.'

Well, as the linked article points out, the Post's beta did not increase when the share prices fell in 73. However, I find it to be a bit of a fine point - short term flucuations can provide us with long term value opportunites, or margin of safeties, to put it another way. But of course you buy because of the margin of safety, not the beta. And I think that was Warren's point, he does not invest by looking at beta; if he see's value, and a reason to believe the truth will out (some catalyst to cause the stock price to eventually match his valuation), then he buys.

That part is worth underlining.

I believe Dr. Kitten to know something about Modern Portfolio Theory based on previous conversation. I know little except how to spell it. I believe that Beta plays quite a role in it. I'm not really aware of anyone using it to produce the kinds of returns Buffett and similar investors get. OTOH, I'm aware of groups like LTCM failing spectacularly when the sigmas didn't go their way.

Reminds me of one of my favorite quotes from a recent meeting (within the last year or two):

"Modern Portfolio Theory is asinine." - Charles T. Munger

So, I guess I would be presumptious to say that Buffett has it right; however, his investing methods only require a normal IQ, a pencil, and access to company reports. It's the one I'll stick with.

Me too. As Mr. Buffett always says - "Investing is simple, but not easy."

 

[drkitten]

Ummmm....sorry, but every stock's return is equally unpredicatble. So how come they all have different betas?

That's simply not true, and one of the main reasons that diversification works as an investment strategy.

"Risk," in this sense, can be defined fairly simply as the variance in the year-to-year return. As you point out, cash and high-quality bonds are more or less risk free; they will return the advertised interest rate with clockwork regularity. Stocks, on the other hand, are riskier -- they might return substantially the than the market as a whole, or they might return substantially less. But even there, some stocks are "riskier" than others; the spread of returns is wider on the riskier ones. A stock which has returned 5% each year for the past twenty years is has less variance than one that has returned either 0% or 10% each year.

That you don't understand the math doesn't make it wrong or useless.

 

[The Atheist]

The Atheist, Scrut seems to be playing with you a bit.

Did you read my previous post to him?

 

[The Central Scrutinizer]

That's simply not true, and one of the main reasons that diversification works as an investment strategy.

Or diworsefication, to put it another way.

That you don't understand the math doesn't make it wrong or useless.

It's not that I don't understand the math, it's that I don't want to waste my time learning it.

A dowser can tell you all sorts of theories on why dowsing works. I know that it doesn't, so why should I waste my time learning those theories?

 

[drkitten]

It's not that I don't understand the math, it's that I don't want to waste my time learning it.

A dowser can tell you all sorts of theories on why dowsing works. I know that it doesn't, so why should I waste my time learning those theories?

Because diversification, unlike dowsing, works.

 

[The Central Scrutinizer]

Because diversification, unlike dowsing, works.

Smooth move, trying to move the goalposts. But you really didn't think I wouldn't notice, did you?

For those following along, I compared beta to dowsing. But drkitten responded as if I had compared diversification(diworsefication) to dowsing. Nice try, drkitten. NOT!!!!

Of course diversification works. So do annuities.

 

[drkitten]

For those following along, I compared beta to dowsing. But drkitten responded as if I had compared diversification(diworsefication) to dowsing.

Of course diversification works. So do annuities.

Good. I'm glad to see that you're not totally delusional. Now, when you consider that "beta" is simply a measure of "how well will diversification work", you see what beta does for you. A high-beta investment is one where the risk eliminable by diversification is not very large, and is therefore one that is likely to produce large swings in your portfolio value. If you like large swings in your portfolio value, buy a high-beta investment. If you don't like large swings in your portfolio value, buy low-beta ones. If you are indifferent to swings in your portfolio value, you evidently plan to have an infinite lifespan.

 

[The Atheist]

Anyway, just to get boringly back to the OP, a couple of days have made all the difference - the Dow back over 13200, the Nikkei up a whopping 2% on opening this morning.

And yet those Fed T-Bills took their biggest drop the other day since.....


1987.

Quite bizarre for the sharemarkets to be going up on the back of that - possibly a sign that the Fed may have tipped a little too much in?

 

[The Central Scrutinizer]

Good. I'm glad to see that you're not totally delusional. Now, when you consider that "beta" is simply a measure of "how well will diversification work", you see what beta does for you. A high-beta investment is one where the risk eliminable by diversification is not very large, and is therefore one that is likely to produce large swings in your portfolio value. If you like large swings in your portfolio value, buy a high-beta investment. If you don't like large swings in your portfolio value, buy low-beta ones. If you are indifferent to swings in your portfolio value, you evidently plan to have an infinite lifespan.

OK, it's time to "bottom line" this discussion. For those keeping score at home:

The guy who says "beta is baloney" has 46 billion, I repeat BILLION, dollars.

The guy who says "beta is a useful investment tool" has way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way, way less than 46 billion.

You decide who is right.

 

[roger]

Did you read my previous post to him?

Yes, why?

 

[roger]

Beta is a measure of how unpredictable a stock's return is.

Beta is defined as the historical fluxuation of a stock price relative to another stock or index. On most brokerage sites, it is the last 5 year's performance compared to the S&P 500. Alpha measures the return of a stock compared to an index like the S&P 500.

Past performance is no guarantee of future performance. This is not just a legal statement - is is borne out by many studies. Beta measures historical performance. Hence the disagreement between you and scrut.

Put simply, CAPM says something along the lines of: "if the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected market return over the period is 10%, the stock is expected to return 17% (3%+2(10%-3%))." (lifted from here).


Whereas Buffett et. al. have the crazy idea that the return of a stock is measured by DCF of FCF minus the purchase price of a stock. I.e the actual performance of the business minus your purchase price.

Emperically, I am not aware of any unleveraged CAPM portfolio coming close to the performance of Buffett, Ruane, Fisher, Templeton, Miller, Graham, Dodd, Munger, Whitman, Greenblatt, et. al. I welcome corrections to my knowledge, naturally. These are people who get returns of 15-20% on billions invested, and 30-50% on millions invested.

Finally, I'll point out Malkiel himself, a proponent of CAPM to say the least, finds value style investing intellectually defensible and appealing; his only complaint is a lack of emperical evidence. I find this somewhat surprising; he dismisses decades long records as insufficient, yet repeatedly uses much smaller sample sizes in support of various points he wishes to make. However, I cannot claim an exhaustive literature survey to back up the previous point - it was just something that stood out as I read him.

 

[The Atheist]

Yes, why?

Here