Diversification

Before moving on, let me clarify one thing; there is nothing wrong with diversification. I have had a diversified portfolio ( 15+ stocks in my book) for a while now as my time for researching stocks was limited. There are plenty of value investors who diversify and outperform the market by a good margin. Walter Schloss comes to mind.

Some well known concentrators

• Warren Buffett/Charlie Munger – While Berkshire holds a great number of stocks, the majority of the stock portfolio is invested in big bets such as Coca Cola (KO), American Express (AXP), Washington Post (WPO) and prior to that  GEICO just to name a few. It was Buffett’s sidekick Charlie Munger who turned Buffett into a more concentrated portfolio.
• Peter Lynch- The worlds greatest mutual fund manager held hundreds and sometimes thousands of stocks at a time. But as he confesses in his book(s), Peter Lynch had a couple of big bets and a ton of small bets so he could keep up with a company’s “story”
• Eddie Lampert- Once considered the next Warren Buffett as the price of Sears Holdings approached $200, Lampert made the majority of his wealth by betting big on the merger of k-Mart/Sears. I believe his cost basis is $1(I might be wrong on this) as he merged the two companies when K-Mart filed for bankruptcy.
• Joel Greenblatt- Probably never believed in diversification. Reading both of his books, Greenblatt constantly advocates making few but big bets. Before I get bombarded with e-mails about the magic formula strategy and diversification, Greenblatt does make seveal points as to hold 5-8 well researched stocks for greater returns. For those individuals who want to put their portfolio on auto pilot, follow the magic formula as layed out in the book.
• David Dreman- Also advocates a diversified portfolio in his books. But, he made good money by placing big bets in Fannie Mae (prior to its recent  drop he bought below $5) and Altria

Pitfalls of concentration

• A more volatile portfolio.
• A blowup in the portfolio will be a major setback against the market
• You have to be VERY patient

Tools for concentrarion

• Time
• Time
• Time
• Knowledge
• oh yeah, patience

Quotes

I don’t look to jump over 7-foot bars: I look around for 1-foot bars that I can step over. – Warren Buffett

Put all your eggs in the one basket and — WATCH THAT BASKET.
Pudd’nhead Wilson, Pudd’nhead Wilson’s Calendar, Chap. 15

Definition of shorting according to Investopedia.com

The selling of a security that the seller does not own, or any sale that is completed by the delivery of a security borrowed by the seller. Short sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short.

Yes, some individuals are successful

Bill Ackman comes to mind as a successful short. Im pretty sure there are other individuals who have successfully shorted stocks for a living and will continue to do so.

Logic

I might not be the smartest men alive, but logic is the main reason I avoid shorting. Here it goes:

If I short a stock, my biggest gain will be 100%  and my biggest loss could be limitless (assuming I do not get a margin call). On the other hand, if I buy a stock, my gain could be infinity, while my downside is limited to losing my intial investment or 100%. Now that’s what I call controlling my risk/reward.

An example:

On January 2007, David Dreman wrote an article for Forbes properly titled “Short The Exchanges“, in which David Dreman considered the stock exchanges (CME,ICE,NYX). At the time of writing, Chicago Mercantile Exchange Holdings (CME) traded at $530. The stock continued its unprecedented run up to $714. The stock is well off its highs, but an individual would have had to stomach a 35% increase in CME’s stock price.

Without a doubt Warren Buffett and Charlie Munger have provided some of the most memorable quotes in the investing arena. Not too far behind the dynamic duo are the late John Templeton and the contrarian maestro himself David Dreman. Below are four memorable quotes David Dreman has enlightened the world with.

1. “Psychology is probably the most important factor in the market – and one that is least understood.”
2. “I paraphrase Lord Rothschild: ‘The time to buy is when there’s blood on the streets.’”
3. “One of the big problems with growth investing is that we can’t estimate earnings very well. I really want to buy growth at value prices. I always look at trailing earnings when I judge stocks.”
4. “If you have good stocks and you really know them, you’ll make money if you’re patient over three years or more.”

It’s pretty hard to argue with any of the above quotes. All four quotes are only part of the solution in outperforming the market. Number four in particular is something most investors (including myself) lack, patience.  In a world where everything moves at a fast pace, its tough waiting for value stocks to rebound. Ultimately, its the patient investor who is able to wait out the storm who benefits the most when contrarian stocks rebound.

A particular Warren Buffett quote reminds me that doing nothing is good:

“”I call investing the greatest business in the world because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! and nobody calls a strike on you. There’s no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it.”-Warren Buffett

With 14% cash on hand, its tempting to get into some positions. Especially Microsoft which has been climbing the magic formula list this past week as it hits new lows. I continue to tell everyone I know that the magic formula has to be among the most undervalued books/sites/investing system around. Where else can I find a screen that looks for great businesses at a discount. Its only a matter of being patient and sticking with the system. For many years studies have proven that low P/E’s outperform the market, but investors/speculators continue to invest in companies that are trading at sometimes catastrophic P/E’s. Companies with high P/E’s are usually dangerous in this type of market as analysts expect companies to deliver outstanding numbers. What happens next? The company delivers great numbers (usually double digit growth ) but the stock gets pummeled (i.e. AAPL, GOOG,MSFT). How do low P/E’s fare during earnings season? Good. David Dreman highlights this in the book. Expectations for these companies are so low, no matter what kind of numbers the company reports, chances are a) a positive earnings surprise will make the stock soar (WFC)  or b) the news has been priced in already.

One part of the big loses, which the article highlights, comes from being to early in sectors where macroeconomic forces were against them. I know Bill Miller invested in housing related stocks just as the bubble was bursting. Pzena made a couple presentations on Fannie-Mae and Freddie Mac. Whitman has been in the middle of the thunderstorm as he continues to invest bond insurers. Even the contrarian maestro himself David Dreman has been burned by Washington Mutual. Now, Jeremy DeGroot, chief investment officer at Litman/Gregory made brings up an interesting point which I had not thought of:

“There’s a fine line between stubbornness and discipline”

Could it be that these so called “gurus” are to stubborn to admit they were wrong in the first place and have lost millions of dollars in assets?

Did Martin Whitman continue to invest in MBIA due to his much publicized war against Bill Ackman?

I have no clue what goes on in their minds, but some of their bets are questionable. Personally, I have been burned by investing in financials. American Insurance Group (AIG) appeared like the ultimate bargain as it traded at low valuation ratios. Ultimately, the stocks price lagged as management continued to announce more capital would be needed (after it said everything is fine) due to write offs,etc.. Stubbornly, I held on as I convinced myself the numbers do not lie. Finally, I sold and have not regretted that decision.

Richard Pzena aknowledges there are “not the best of times” but continue to be optimistic about the future

“But this is a once-in-a-lifetime opportunity for valuations, for all financials. When we look back historically, we will be writing about the irrational panic of 2007 and 2008.”

It may be a once in a lifetime opportunity, but at the same time Pzena has lost a ton of money in one year. Its tempting to jump into financials but it appears there is are more write offs/downs to come. I am in the Bruze Burkowitz camp in which he continues to say ” I have no idea what is on their (finiancials) balance sheet, and I am not sure the CEO/CFO’s know what they hold.” If I had to invest in financials, USB and WFC appear to be the only one’s that have avoided the mess.

The past couple of weeks David Dreman gave me an idea of what he likes. First, David Dreman appeared on Consuelo Mack’s Wealthtrack on April 11, 2008. In this episode of Wealthtrack, in which he discusses the credit crisis and stock. Next, David Dreman was interviewed by Market Watch. In this interview, David Dreman talks about the skyrocketing prices and briefly touches on financials in which he states ” we are probably half way through this crisis” and “we should see higher earnings ahead (in a couple of years).” Stocks mentioned in the interview are Bank of America (BAC), Connocco Phillips (COP),Lowes (LOW) and long time holding Altria (MO).

Next, David Dreman’s monthly Fortune article was made available online. The article is set to be published on 5 de Mayo but online readers get a head start. In the article, Dreman gives his thoughts on the fed bailout of Bear Stearns (BSC). As has been a tradition of Dreman, he gives stock tips; in this case financials. Marshall & Ilsley Corp and Fifth Third Bancorp (22, FITB). And for the investor who can take greater volatility r Comerica (35, CMA).In addittion, David Dreman hints at this being a good time to purchase a first home or “movng up”. Not only does Dreman mention what to look at, but also what to avoid. In this case, avoid bonds (inflationary reasons).

In summary:

• Avoid bonds
• Cherry pick high quality banks for a couple years down the road (Wachovia)
• Take a look at lowe’s
• Demands outstrips supply in oil ; look at COP

But today was different. The Fast Money crew did a show on “Finding your style”, something that every investor has to go through at one point. Basically, each trader presented different ways or styles that one could make money in the market. Each trader presented what works for them. For example, Guy Adami relies on trading volume and market sentiment (whatever that means).

In a perfect world, it would be great to invest like Warren Buffett. Truth is, Warren Buffett is truly a unique individual that somehow finds a way to be a couple of steps in front of everybody. Although one can buy what Warren Buffett buys, there are drawbacks. In one quarter, Target (TGT) appeared as one of his holdings. In the next quarter, it was reduced. Even Warren Buffett had to find his style. Before becoming a value investor, Buffett tried everything, including charting. It wasn’t until he read The Intelligent Investor that “it clicked”.

Personally, I tried many different value investing styles before settling on my current style. The first contrarian investing book I read was David Dreman’s Contrarian Investment Strategies: The Next Generation. After I read that book, I bought all his other books. Next, I bought Pat Dorsey’s book and tried the almighty discounted cash flow model (DCF). While I read these books, I used Investopedia’s simulator to track my performance. I did OK but I knew I could do better. Instead of trying to be like Dreman, I started to be like Alex Garcia. The whole contrarian is in me, but I sprinkled in Greenblatt’s Magic Formula and Professor Greenwald’s emphasis on assets.

You will see this in the value investing community, where no one value investor is identical to another. Bill Miller invests in companies Warren Buffett would never touch (i.e. Amazon). Warren Buffett invests in companies Walter Schloss would never touch. Of course, I am assuming Walter would never touch a company like American Express. Why? Amex does not have the hard assets Walter Schloss likes.

How does one find an investing style?

In one word, experiment. Sites like investopedia.com and marketocracy.com allow one to experiment as much as possible without risking any money.

• Value Investing: From Graham to Buffett and Beyond- Bruce Greenwald
• The Little Book Of Value Investing-Christopher Browne
• The Intelligent Investor- Benjamin Graham

Lost in the pile are some great books that often get overshadowed by the “well known”. Below is a list of unknowns that should be considered on every value investor’s library.

1. The Rediscovered Benjamin Graham: Selected Writings of the Wall Street Legend- One of many value investing books by Janet Lowe,this gem provides plenty of unknown material by the dean of value investing. As every Benjamin Graham book out there, there is plenty of valuable information to digest.
   
2. Poor Charlie’s Almanack Expanded Second Edition. The Wit and Wisdom of Charles T. Munger- By the man who said he didn’t set out in life to become the assistant leader of a cult, “Poor Charlie’s” allows the world to see how one of the greatest financial minds of our day views the world. Upon reading this masterpiece, one will truly acknowledge the wit and wisdom of Charles T. Munger
3. Psychology and the Stock Market: Investment Strategy Beyond Random Walk by David Dreman- One of the earliest books on behavior finance, David Dreman gives the reader a great primer on bubbles and low P/E investing. If you are looking for a book on fear and greed, look no further.
4. The Five Rules for Successful Stock Investing: Morningstar’s Guide to Building Wealth and Winning in the Market by Pat Dorsey. Christopher Davis of Davis Advisors summed up the book as, “His (Pat Dorsey) methodology is sound, his examples clear, and his approach timeless.” I highly reccommend this book to anyone who is interested in value investing. The book provides a great introduction into modern day security analysis, valuation, industry analysis, moats, etc..

1. Avoid the market while it is open.

As mentioned in my article The Secret To Value Investing, avoiding the market while it is open will rid of any temptation one might get while watching CNBC.

2. Read, Read,and Read More

Warren Buffett is a perfect example of a reading machine. According to CNBC.com, while on the way to China, Becky Quick was amazed by how much Warren Buffett reads and how quick he reads. Warren Buffett usually reads six newspapers a day.

• The Wall Street Journal
• USA Today
• The Financial Times
• The New York Times
• Omaha-World Herald
• American Banker

3. Employ a low P/E approach to stock selection and avoid potential bankruptcies and “hot” stocks.

I am a big believer in applying a low P/E strategy. Every study that I have read has showed a low P/E portfolio will outperform the market indexes in the long run. According to Dreman.com, the website for Dreman Value Managemtn,LLC, their investing philosophy is based on a low P/E approach, short term market overreactions, and having a disciplined and consistent investing style. Their contrarian philosophy is summarized below:

Low P/E approach – we look for stocks where the price to earnings ratio is low and the company exhibits strong fundamentals, as well as a history of earnings growth that we through extensive research, believe will persist into the future.

Market overreactions – Years of proprietary research in behavioral finance help us distinguish between short term changes in the market and long term trends. We are able to take advantage of short term swings in order to buy fundamentally strong stocks at bargain prices.

Discipline and consistency in style – we have applied our investment strategy without wavering since inception and have avoided getting caught up in the rush of market.

Each item on the list can and should be expanded. The internet is changing the world’s information landscape. One is able to access millions of news sources ranging from personal blogs to community driven stock market news (i.e. valueinvestingnews.com). In addition, individuals can now join forums that pertain to a certain hobby. I am active in a value investing forum that is full of high quality posts by real value investors.

One can learn value investing by picking up a couple of books, attending a couple of seminars,etc. but all that is useless if you let emotions interfere with your decision making process. In the preface to the 4th edition of Benjamin Graham’s The Intelligent Investor, Warren Buffett had this to say about successful investing:

To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.

The ability to do this is simple but not easy. Below is a list of investor mistakes Whitney Tilson listed in a 1999 Motley Fool column.
1) Herding behavior, driven by a desire to be part of the crowd or an assumption that the crowd is omniscient;
2) Using mental accounting to treat some money (such as gambling winnings or an unexpected bonus) differently than other money;
3) Excessive aversion to loss;
4) Fear of change, resulting in an excessive bias for the status quo;
5) Fear of making an incorrect decision and feeling stupid;
6) Failing to act due to an abundance of attractive options;
7) Ignoring important data points and focusing excessively on less important ones;
8} “Anchoring” on irrelevant data;
9) Overestimating the likelihood of certain events based on very memorable data or experiences;
10) After finding out whether or not an event occurred, overestimating the degree to which they would have predicted the correct outcome;
11) Allowing an overabundance of short-term information to cloud long-term judgments;
12) Drawing conclusions from a limited sample size;
13) Reluctance to admit mistakes;
14) Believing that their investment success is due to their wisdom rather than a rising market;
15) Failing to accurately assess their investment time horizon;
16) A tendency to seek only information that confirms their opinions or decisions;
17) Failing to recognize the large cumulative impact of small amounts over time;
18) Forgetting the powerful tendency of regression to the mean;
19) Confusing familiarity with knowledge;
20) Overconfidence

Investor Psychology is a huge subject and countless of books have been written on it so I will concentrate on market noise and how to avoid it.

What is market noise?

I consider market noise to be anything that is not associated with the underlying fundamentals of a business. Earnings estimates, interest rates, macroeconomic issues, are just a few on the list.

How to block market noise?

I am not going to sit here and act like I have not been a victim of one of Whitney Tilson’s investor mistakes. But lately I have developed a good modus operandi that has allowed me to avoid most if not all of the mistakes. I will start with avoiding the stock market while it is open. If you are on the West Coast like I am, this is an easy task to do as when the opening bell is rung you are either A) asleep or B) eating breakfast. When the market closes you are likely to be at work. This of course assumes you have a 9-5 job. This tip alone will block the majority of the market noise. When the new semester begins I take this a step further. I rely on the business section of my local newspaper. The business section is at best 4 pages long. One page is devoted to the top business headlines from the previous day. Page two is a continuation of those headlines. Page three provides a one paragraph summary of the markets. Page four usually features a local business and some classifieds. On times when I am real busy, I rely solely on Barrons. Barrons gives me the best of both worlds. First, it allows me to ignore the market during the week. Second, I still get in depth market analysis with insights on companies, industries, sectors, etc.

The ultimate example of avoiding market noise has to be Walter Schloss. Adam Smith wrote the following quote in Supermoney (1972) after Warren Buffett told him about Walter Schloss:

He has no connections or access to useful information. Practically no one in Wall Street knows him and he is not fed any ideas. He looks up the numbers in the manuals and sends for the annual reports, and that’s about it.

In The Superinvestors of Graham and Doddsville, Warren Buffett had the following to say about Walter Schloss:

I don’t seem to have very much influence on Walter. That’s one of his strengths; no one has much influence on him.

Finally, I would like to direct you the reader to page 22 of the Berkshire Hathaway 2006 Annual Letter in which Warren Buffett devotes a section to Walter Schloss. The words speak for themselves.

Let me end this section by telling you about one of the good guys of Wall Street, my long-time
friend Walter Schloss, who last year turned 90. From 1956 to 2002, Walter managed a remarkably successful investment partnership, from which he took not a dime unless his investors made money. My admiration for Walter, it should be noted, is not based on hindsight. A full fifty years ago, Walter was my sole recommendation to a St. Louis family who wanted an honest and able investment manager.
Walter did not go to business school, or for that matter, college. His office contained one file
cabinet in 1956; the number mushroomed to four by 2002. Walter worked without a secretary, clerk or bookkeeper, his only associate being his son, Edwin, a graduate of the North Carolina School of the Arts.Walter and Edwin never came within a mile of inside information. Indeed, they used “outside” information only sparingly, generally selecting securities by certain simple statistical methods Walter learned while working for Ben Graham. When Walter and Edwin were asked in 1989 by Outstanding Investors Digest, “How would you summarize your approach?” Edwin replied, “We try to buy stocks cheap.” So much for Modern Portfolio Theory, technical analysis, macroeconomic thoughts and complex algorithms.
Following a strategy that involved no real risk – defined as permanent loss of capital – Walter produced results over his 47 partnership years that dramatically surpassed those of the S&P 500. It’s particularly noteworthy that he built this record by investing in about 1,000 securities, mostly of a lackluster type. A few big winners did not account for his success. It’s safe to say that had millions of investment managers made trades by a) drawing stock names from a hat; b) purchasing these stocks in comparable amounts when Walter made a purchase; and then c) selling when Walter sold his pick, the luckiest of them would not have come close to equaling his record. There is simply no possibility that what Walter achieved over 47 years was due to chance.
I first publicly discussed Walter’s remarkable record in 1984. At that time “efficient market theory” (EMT) was the centerpiece of investment instruction at most major business schools. This theory, as then most commonly taught, held that the price of any stock at any moment is not demonstrably mispriced, which means that no investor can be expected to overperform the stock market averages using only publicly-available information (though some will do so by luck). When I talked about Walter 23 years ago, his record forcefully contradicted this dogma.
And what did members of the academic community do when they were exposed to this new and important evidence? Unfortunately, they reacted in all-too-human fashion: Rather than opening their minds, they closed their eyes. To my knowledge no business school teaching EMT made any attempt to study Walter’s performance and what it meant for the school’s cherished theory.
Instead, the faculties of the schools went merrily on their way presenting EMT as having the certainty of scripture. Typically, a finance instructor who had the nerve to question EMT had about as much chance of major promotion as Galileo had of being named Pope.
Tens of thousands of students were therefore sent out into life believing that on every day the price of every stock was “right” (or, more accurately, not demonstrably wrong) and that attempts to evaluate businesses – that is, stocks – were useless. Walter meanwhile went on overperforming, his job made easier by the misguided instructions that had been given to those young minds. After all, if you are in the shipping business, it’s helpful to have all of your potential competitors be taught that the earth is flat.

Maybe it was a good thing for his investors that Walter didn’t go to college.