Notes on the Art of Investing - Lessons from history's greatest investors

Investing skill, Strategy and temperament

• Value Stocks - sell at a discount
• Growth Stocks -
• The global stock market gets most of the attention but the bond market is much bigger (3x bigger)

Benjamin Graham and Value investing

• He first looked at the value of existing assets, such as cash, inventory, and property, by examining a target company’s financial statements. Next, Graham looked at current earnings. Lastly, and only in rare circumstances, he considered future profits, but only in the core competence area of a firm with a sustainable competitive advantage.

• Graham was also early to recognize the role of market psychology in investing. Today, the field of investor psychology is known by academics and practitioners as behavioral finance.
• Net-Net: One of Graham’s favorite value-oriented strategies to pick investments was to find companies selling for less than their cash liquidation value
• Strategies for the defensive investor: Adequately size stock (600M+) Strong financial condition (Assets = 2x liabilities) Earnings stability (positive earnings for atleast 10 years) Strong record of giving dividends Organic earnings growth of 33% over the last 10 years Moderate PE ratio (~15) Price : Asset (trading for less than 1.5 times its book value)
• In his later years, Graham suggested another simple value formula: Create a portfolio that consists of at least 30 stocks with P/E ratios less than 10 and debt-to-equity ratios less than 50%. Hold each stock until it returns 50%. If it doesn’t achieve a 50% return after 2 years, sell it no matter what

Warren Buffet - Investing forever

• Buffett came to believe that a better approach to value investing would be to buy high-quality companies with a moat around their businesses. Moats and competitive advantage

Fisher and price - Growth stock investors

• A firm that grows sales at a faster rate than the industry is one sign of a good quality org.
• Rigorous fundamental analysis including talking to management and competitors
• He felt that the risk of owning a stock would increase when the industry it competes in matures.
• Price preferred hunting ground was in the stable growth phase
• Criterion when looking a companies Superior research and development. Like 3M Avoidance of cutthroat competition Low total labor costs but fair employee compensation. The costs of labor and raw material effect a firm's profitability significantly. e.g. jet fuel is the largest cost for airlines

Harry Markowitz & Willian Sharpe, Modern portfolio theory

• Assumes that variance in a stock's price is a measure of risk
• The risk of a portfolio is primarily based on interaction of the portfolio's holdings, not the individual companies themselves.
• Return depends on risk. Reduce risk by adding uncorrelated stock in a portfolio (e.g. stocks in US and Singapore)
• Optimal portfolios for a person: Risk questionnaires tell people about their risk appetite Your optimal portfolio is one that guarantees you the best returns for your tolerance of risk. Used by institutions to decide on the mix of stocks, bonds and cash. Not for individuals.

• What happens if everyone tries to maximize their returns for a given risk
• The only risk that’s worth paying for is one that cant be diversified away

• Value stocks return more than growth stocks in a long period of time.
• A firm with a lower than market average price to book ratio is considered a value stock (historical average of the S&P is 2.5) Higher is a growth stock
• Risk factors investors should get compensated on: Market risk (beta) over and above the risk-free rate Size: Market value of stock. Large vs. small cap. Large cap returns worse than small cap in the long run. Style : Growth or value Momentum: Recent trend in price Liquidity: How quickly you can sell at fair market value.
• If you want to make most return Illiquid, small cap, value stock with upward momentum
• Lowest return Most liquid, large cap growth names with downward momentum

Index mutual fund

• Ultimately, stock price is only influenced by some information. The market has already adjusted for old news/information so it's only new news that will change the stock price.
• Excess returns: Returns greater than the risk you are taking. = Beating the market
• Weak form efficiency of a market is when you can't consistently beat the market with public information.
• ….
• Most fund managers can't beat a simple index funds so the efficient market hypothesis isn't really true.
• The typical horizon-date fund looks at your planned retirement date. As you gradually approach your retirement age, the fund will increase the allocation to fixed income index funds.

Small Cap stocks (<1B). More risk, more return

• Over long period of time long time cap stocks offer more return than small cap stocks.
• Ten-bagger: a stock that increases 10 times
• Wait until they turn a profit before you invest
• Look for niche companies
• Institutional ownership should be less than 50%. They eat up the value and when they pull out, they can change price significantly)
• Information isn't readily available for smaller companies.
• Pick companies that have proved that their concept can be replicated (Starbucks)
• The return is higher because there is a higher risk (variance.. i.e. beta) Reasons for risk are those mentioned above (liquidity - trading volume, variance)
• Small cap stocks offer 2-3% extra per year than larger ones
• Invest in a basket of small, young firms, in a rapidly growing industry and then sell the laggards. Put the money in the winners
• Focus on deep-value small cap stocks Or just small companies that are profitable, niche and scalable

Global treasure hunter

Contrarian

Dreman likes to invest in companies that (bargains)

• Pay High Dividends (atleast 0.5% higher than the market average)
• Low PE ratio
• Low Price to cashflow
• Price to book value
• Strong management
• 20-30 stocks diversified amongst 15 industries
• Sell the stock when the PE ratio (or other indicators) hit the overall market benchmark

Peter lynch - invest in what you know

• Buy a single share a company's stock to attend its annual shareholder meeting
• Listen to quarterly earning calls that companies host for investors
• Prefer companies that have no debt and hence cant go bankrupt
• Bought baskets of companies from an industry. Better to invest in industry and not an individual company
• Liked companies with Penny pinching managers That avoided going into debt Rejected the corporate caste system Whose workers were well paid and had a stake in the company's future
• Liked companies that bought back their own shares Started with little or no institutional ownership Inside buying by a manager is a positive sign
• If you are nervous about the stock price rising, hold at least a portion of the business if the business is still solid.
• Invest in companies, not the stock market
• Never invest in anything that you can't explain with a crayon.

Bond kings

• Interest risk : When interest rates go up, traditional bonds fall in value because the bond is viewed as riskier and is valued less.
• Reinvestment rate risk: When rates rise, the coupons and principal can be reinvested in new bonds at higher rates drawing interest away from old instruments
• Default risk
• Liquidity risk
• International bonds have a currency risk
• The expected return on a bond over its term should be pretty close to its Yield to maturity (YTM)

Sovereign wealth funds

• If one country runs a persistent trade deficit with another the two must be balanced out. This usually takes the form of the other holding bonds or other securities held by the other..

Hedge Funds

• No clear definition of what these are exists. Usually anything that charges fee + hurdle  (e.g. 2-20)
• They are known to manipulate the markets to their interest (to remove market risk).
• They use leverage to maximize risk/return on the spreads (difference between long and short positions)

Activist investors

• Machiavellian ways to take over the board of companies to force them to pay out dividends
• Brings a strong investor perspective into the board which can save stagnating value stocks
• They help keep management on its toes and be fair to investors

Short / long

• Not halal
• Long: Getting a loan from a bank. Investing that money in a growth stock and returning the loan + pocketing the profit
• Short: You loan the shares from someone with a promise to return them in say 2 mo. You sell the stock at, say 100$. During that time, you bet that the price will fall to say 70$. Then you buy the same stock at 70$ and return it to the lender and pocket the $30 as profit.
• Momentum trading:  if a stock is moving in one direction, it will keep moving in that direction until something new changes it. Works because people show crows psychology The biggest risk with momentum trading is whipsaw: that a stock keeps going up and down with you on the wrong side.
• Enron: Chanos analyzed Enron stock to find that 80% of its profits were from energy trading but they were only earning 7% on their trades while their cost of capital was 10%. He shorted and brought the company down.
• Viewed himself as sheriff of the market, rooting out corporate misdeeds

George Soros - 10B$ currency play with the GBP

• Theory of reflexivity: There is a feedback loop between prices and fundamentals wherein the price impacts fundamentals.
• Boom-bust cycle has 7 stages Start with a trend that is not yet recognized by the public as a whole Initial phase : When the trend becomes broadly recognized, that recognition reinforces it. Acceleration: Sometimes a surge in prices peters out. Price increases don’t always result in more increases but they mostly do. Moment of truth: At some point a large gap emerges between public perception and fundamentals and the market recognizes reality Stagnation period: Stocks can stay inflated for a long time Crossover point: Eventually something triggers a broad loss of belief in the stock Selling results in more selling
• Soros believed that modern economic theory has a problem: that the market will always be in equilibrium based on the fundamentals of the stock. Sorors felt markets were rarely in equilibrium. Investors add a feedback loop to the market based on their own thinking.

Bridgewater - Ray Daleo

• Alpha funds: 13% over the S&P 500's 10%
• All weather fund: designed to withstand any market condition 4 quadrants
• Clients combine at will
• Pioneers of "risk parity" approach. Risk parity aims to level risk of each asset class. Most institutions invest 60% in equities and 40% in bonds.  But 80% of the risk is in stocks. Giving stocks a smaller weight (or hedging the equity exposure) - through short sales (or derivatives) can lower equity risk. Borrowing or taking more credit exposure could increase bond related risk.
• Two randomly selected US stocks will correlate historically about 60% since both are tied to the performance of the US economy. He invests in a combination of 15 uncorrelated strategies with reduces the risk by about 80% lower than the S&P.

Future's market

• Aarthi
• When you enter into a futures contract, the price is locked in for the life of the contract. Market prices change every day and the gap is your profit/loss
• Stop-loss agreements can limit the losses. Traders set these to get out at those levels no matter what
• Don’t trade in cases when you have no control

Quants - quantitative funds

• Use a lot of data points to model behavior
• James Simon's medalian fund returned 98% when the S&P fell by 37% in 2008
• No other fund has been able to replicate the performance.
• Trends don’t seem to last and firms constantly update models that don’t work. They never found a true anomaly or because they worked so well as to have arbitraged their value away.

Distressed asset investors

• Ch 7 bankruptcy liquidates and shuts its doors
• Ch 11 continues to work
• Highly legal understanding of who gets what first in liquidation: Debt > Preferred stock > common stock

Gold and Global commodities

• Rogers takes a big picture approach that focuses on long term trends - a macro strategy. Aka Secular analysis
• Look at insider trading levels
• Invest in what you know
• Buy depressed assets (value investing)
• Review the CRB commodity yearbook
• The fungible nature of commodities (i.e. their relative interchangeability) shows why they are a cyclical asset class. Cycles tend to last about 17-18 years. e.g. farmers keep growing corn till prices there are too low. Then they switch to wheat ..
• Rogers has 4 tests of what constitutes a good country to invest in: Its market must be doing much better than it has done previously An out of favor national market with an upside potential National currency should be convertible Must be established well enough for an investor to get in and out easily (liquidity)

Private equity - Blackstone

• 2600 PE firms in the US invest more than 300B$
• Rule of thumb is to borrow 3-4 times the amount of money you plan to put up in a leveraged buyout (LBO). In part through a bank and in part borrowing against the assets of the company. This debt is generally considered junk (below investment grade)
• An ideal buyout candidate is one with high free cashflow, a low debt-equity ratio, a strong competitive position in a stable industry,  a lot of cash on hand or assets that can be sold quickly.
• The LBO and M&A markets have grown together.
• Blackstone colleagues frequently seek buyers for the firms they acquire even before the deal is consummated.
• They charge a breakup fee on the target company if the transaction doesn’t go through to avoid having risked too much into a deal. They don’t hesitate to put pressure on management to make quick decisions.
• Swartzman will buy companies near a cyclical bottom of their earnings
• Technology firms are often considered unsuitable for LBO because of the short lifespan of their products
• Blackstone has diversified into real estate, capital etc..
• Many pension funds are tied up in private equity funds.

Becoming a great investor

• Everyone needs a strategy to deal with risk: how much you want to earn and how much you can afford to lose. You can afford to lose more when you are young. Find a level of diversification consistent with your risk tolerance
• Active vs. Passive investing (index funds or buy and hold)
• What types of financial securities (stocks and bonds etc.. ) you want to invest in and how actively you want to change weights.
• If you want to play an active role in your investment: What investment edge do you possess? What are you really good at? What businesses do you understand well? Do you want to be an investor who buys and sells (trader) or an investor that buys and holds You should ask yourself whether you are a growth or value investor or some combination Large cap, small cap or both? Fundamental or technical or both? Ask yourself what investment mistakes you are likely to make or are susceptible to making (market psychology) - 3 examples in book Ask yourself whether you have the temperament to follow the rules you have setup