The Most Important Wealth Secret You'll Ever Learn

The Most Important Wealth Secret You'll Ever Learn 
By Chris Hunter,

What you are about to read flies in the face of everything your stockbroker or Wall Street adviser will tell you. 

It's about the closest thing to heresy you can get in the investing world... and the newsletter business. It's also a key insight if you want to stay wealthy over time. 

It is simply this: Stock picking alone won't help you hold on to wealth. 

Unless you are very lucky... or very, very talented... you will struggle to pick the right stocks at the right time ALL the time. You will make mistakes. You will mess things up. 

And unless you have the right discipline in place, sooner or later you will lose money. 

That discipline is called "asset allocation." That sounds technical. But it's really just about how you spread your wealth over different types of investments. 

This is backed by hard data. 

For instance, a well-known study in 2000 by Yale professor of finance Roger Ibbotson and Paul Kaplan of Morningstar showed that differences in asset allocation among mutual funds explained virtually all of the variance in their returns. 

Differences in stock picks made virtually no difference to the variance in portfolio returns. 

Common Sense Decisions
It's common sense, but you don't put 100% of your wealth in stocks in a savage bear market. 

And you don't invest 100% of your wealth in bonds in times of runaway inflation. 

This seems straightforward. But you'd be surprised how many investors skip over these fundamental decisions in the rush for the latest "hot stock." 

This is nearly always a bad idea. 

Before you even think about picking which individual stocks to own, you have three decisions to make. These are the three most important decisions you make as an investor. 

1) Which assets to hold in your portfolio 

2) In what proportions to hold them 

3) When to change those proportions 

Get these three decisions right, and long-term wealth creation and preservation will follow. Get them wrong, and you are unlikely to hold on to what you've worked hard to earn and save. 

So what makes for a good asset allocation? 

Today, I'd like to share with you what we've learned so far at Bill's family wealth advisory service, Bonner & Partners Family Office... where our goal is long-term wealth preservation. 

7 Rules of Successful Asset Allocation
1) It will have a cash buffer – Having cash on board makes it easier to deal with a major downturn and the losses that come with it. Remember, you want to make sure you are not forced into dumping your investments in times of market stress. 

The more cash you hold, the more of a buffer you have. Having cash on board also allows you to go bargain hunting when investments go on sale. In times of crisis, having enough cash to buy beaten-down assets is essential. 

2) It will be an inflation beater – Your asset allocation must allow you to stay ahead of consumer price inflation. There is little use in putting together a portfolio that gets eaten away by inflation. 

This is especially important given the sky-high deficits most advanced economies are running and the widespread money printing central banks are engaging in. We may not see a lot of inflation show up now. But that doesn't mean it won't show up in the future. 

3) It will be able to withstand currency depreciation – This is particularly important if you are internationally mobile, as many Bonner & Partners Family Office members are. 

There is no point in making big portfolio gains in a currency that is losing value. Or for that matter, leaving a portfolio vulnerable to the collapse of a currency (something that is now being talked about openly in the case of the euro). 

4) It will be properly diversified – A prudent long-term portfolio will contain a mix of asset classes that reduce risk. It will also be well diversified within asset classes. 

For example, the money you have in stocks should be diversified across sectors and geographies. Having all your stock market investments in Japanese nuclear stocks, for example, is a bad idea, even if you have only 10% of your total wealth invested in stocks. 

5) It will take advantage of the "bargain counter" – The individual assets you own should only be bought when they are selling at what we like to call the "bargain counter." 

If you buy when an asset is expensive you expose your portfolio to the risk of a large capital loss. Buying assets when they are selling at a discount to their estimated fair value increases your margin of safety. 

6) It will follow sensible "position sizing" rules – Position sizing answers the question "How much should I own?" 

The answer to this question varies. But as a general rule, never put more than 3% of your overall capital at risk on one stock position. This is one of the most effective ways of reducing the risk of a ruinous loss to your portfolio. 

7) It will contain plenty of "off market" assets – "Off market" assets are assets that don't trade on a public exchange... things such as real estate, gems and stakes in private business ventures. 

Putting all your money at risk in the financial markets (whether in stock markets, commodity markets, bond markets or currency markets) is too much of a risk. 

For instance, owning a quality house... bought at a good value and soundly financed... is an excellent way of reducing overall portfolio risk. If you go about it right, you should own the home outright by retirement. 

Owning a home debt free is one of the best protectors against financial crisis that there is. Owning a private business or investing in one is another great way to earn high returns on your capital. 

The Icing and the Cake
Asset allocation is how serious investors think about investing. 

At Bonner & Partners Family Office we call the returns you get from your asset allocation decisions "beta." 

Beta is the result you get from getting the big trend right. 

Once you've got your beta right, it's time to look at boosting those returns. We call this "alpha." Alpha is what you get by choosing the individual investments (stocks, bonds, etc.) best positioned to profit from the big trends. 

Beta is the cake. Alpha is the icing on the cake. 

The most important wealth secret you'll ever learn is understanding this relationship... and always starting with the cake first. 

Most investors get this backward. And they suffer as a result. 

Source: Early To Rise

Follow us on Twitter: @blacklioncm

The Most Valuable Investment Secret of All

The Most Valuable Investment Secret of All By Porter Stansberry Friday, November 14, 2014

Today, I'm going to show you one of the most advanced investment skills you could ever master… But I don't want to tell you upfront what today's lesson is about. I want to see if you can figure it out yourself. So don't skip ahead. Think of today's essay as a test. As I always say… there is no such thing as teaching, there is only learning. And there's a hugely valuable investment lesson – the most valuable secret of all – below… Let's start with the big secret about the father of value investing, Ben Graham. (It's not that he was a notorious philanderer… Everyone knew that.) Most people know Graham literally wrote the book (or books) on how to invest: Securities Analysis and The Intelligent Investor.  Likewise, most people know he was a successful investment manager. That's all true, of course. But most people don't know how Graham got rich. Here's a big hint: It had nothing to do with his normal method of value investing. It had everything to do with insurance.  For most of his career, Graham avoided buying insurance companies and never put more than 5% of his portfolio into any individual security. But in 1948, at the age of 54, Graham decided to allocate 25% of his portfolio into insurance firm GEICO. He bought 50% of the company for $712,000.  After the purchase, the Securities and Exchange Commission (SEC) decided investment partnerships like Graham's couldn't own a controlling interest in an insurance company. To get around the rules, Graham distributed the GEICO shares among the various investors in his partnership.  Graham never sold the shares he received from the distribution. By 1972, Graham's stake in GEICO was worth $400 million. He made more than 400 times his money in 25 years. It wasn't a lifetime of careful value investing that made Graham a wealthy man… It was an investment in GEICO. Graham made vastly more money in GEICO than he made in all of his other investments combined. About 10 years after buying GEICO, Graham had made so much money that he quit investing altogether and closed his fund.  The success Graham had with GEICO led Warren Buffett – who was Graham's student at Columbia University – to study the company intensely. In January 1951, Buffett famously visited the company's headquarters on a Saturday, knocking at the front door until a janitor let him in. After speaking with GEICO executive Lorimer Davidson for four hours, Buffett put 65% of his savings in GEICO's stock – a stake worth about $10,000.  He wrote up the stock for his clients in a report titled "The Security I Like Best." The next year, Buffett sold his position for a 50% gain or so. But the lessons Buffett learned from Davidson went on to guide Buffett's entire investing career. Buffett has said publicly many times that those four hours with Davidson changed his life.  Buffett didn't own GEICO shares again until 1976. The company stumbled badly in the early 1970s when government regulations (no-fault rules), inflation, and aggressive plaintiffs' attorneys radically transformed the risks of auto insurance.  The company lost $126 million in 1975 and looked as though it might go bankrupt. The board brought in a new CEO, Jack Byrne, who radically restructured the company. He fired 4,000 of GEICO's 7,000 employees, closed down 100 offices, and exited the Massachusetts and New Jersey markets. Byrne raised insurance rates by 40%. Incredibly, in less than a year, GEICO was back in the black. By 1977, GEICO was paying a dividend again.  In May 1976, Buffett met with Byrne. He was impressed. Buffett believed the turnaround at GEICO would be successful. It's a little ironic, because Buffett is famous for refusing to invest in turnaround situations. He says most turnarounds "don't." But in this case, he had been following the company closely for 25 years… and determined it was the best business he had ever found.  He got to know the CEO. He knew he could personally provide the financing required. That's a much different situation than you or me buying shares of a cheap stock and hoping it goes back up.  Following a dinner with Byrne, Buffett began to buy huge blocks of GEICO shares. The first order was for 500,000 shares at $2.12. He later provided a huge amount of capital to the company – $75 million – through a convertible bond. His cost basis for the stock through this instrument was $1.31 per share.  Buffett's money helped save GEICO. By 1980, he owned one-third of the company. GEICO represented 31% of Berkshire Hathaway's equity portfolio at the time. Like his mentor Ben Graham, Buffett was now poised to make tremendous profits. He had allocated a huge portion of his net worth into the best business he had ever found.  By 1985, GEICO represented 50% of Berkshire's portfolio.  By 1994, Berkshire had received $180 million in dividends from GEICO – seven times more money than Buffett spent on buying the stock. Finally, in 1995, Disney bought out ABC/Capital Cities, whose shares Berkshire held. The deal gave Buffett a huge $2 billion profit. Buffett used the cash to buy the remainder of GEICO that Berkshire didn't own for $2.3 billion. By that point, Buffett had earned 48 times his initial investment in the company.  Today, GEICO's float (the amount of insurance premiums it carries) is in excess of $16 billion – up from $3 billion in 1995. If GEICO was publicly traded, it would be worth something around $20 billion. Buffett's initial $25 million investment would now be worth at least $10 billion… 400 times his initial investment.  Now… with that in mind… let me switch gears for a minute. The chart you see below is unusual. I would wager you haven't seen a chart like this before. It's designed to show you periods of time when you should have been buying stocks. It does so in a simple way: it measures changes to the S&P 500's book value as a percentage below its 24-month high.  We have good data on the S&P 500's book-value ratio since 1978. This chart makes it clear when good opportunities to buy stocks existed. Longtime investors will surely be familiar with these years: 1981, 1987, 2002, and 2009…  During my career – from 1996 to today – I've seen several excellent buying opportunities in stocks…  The first was in August 1998 when Russia defaulted. Many high-quality emerging-market stocks were trading for less than four times earnings.  The second was the end of the tech-stock bubble in 2002. My Investment Advisory subscribers can read the October 2002 issue to see how I described conditions at the time. (On the first page, I asked, "Is it the end of the world?") During this period, many high-quality technology-related businesses were trading for less than the cash on their balance sheets.  The biggest, best-known market correction of my career was in late 2008/2009, when even the world's highest-quality businesses were trading at decade-low valuations. I recall analyzing shares of jewelry company Tiffany in February 2009 and realizing that the stock was worth $24 per share, assuming you just sold the inventory and used the proceeds to buy back all of the stock and pay off all of the debts.  The stock was trading at $22. Tiffany was trading below liquidation value, implying that you could get the brand name, the operating profits, the future growth, and all of the real estate for free. I doubt you'll ever see an investment as good as Tiffany's trading cheaper than that. (As a side note, Tiffany shares trade for around $96 today. The company has paid $6.44 per share in dividends. By simply buying shares in February 2009, you would be up more than 360%.)  Based on these experiences, I've come to expect a good opportunity to buy stocks about once every five to seven years… and a greatopportunity to come around about once every decade. Lo and behold, when I asked Steve Sjuggerud's research analyst Brett Eversole to check the historical numbers for me, he found eight different 19%-plus corrections (declines) in the S&P 500 since 1976.  Again, these dates will be familiar to longtime investors: 1977, 1981, 1987, 1990, 1998, 2002, 2008, and 2011. Investors become euphoric after a period of gains. They become depressed after losses. It's human nature that's being expressed in these charts.  What's the difference between a good opportunity to buy and a great one? Studying the corrections we've seen since the 1970s, a good opportunity is a 20% or so decline in the S&P 500's price-to-book-value ratio.  The 2011 correction saw the S&P 500 fall 19.4%, but the ratio only declined 17.5%. This was the least impressive opportunity in our study, but that's largely because stocks were coming from a super-depressed bottom two years earlier.  In contrast, a great opportunity to buy is after the S&P 500's book-value ratio declines 30% or more, like it did in 1981, 1987, 2002, and 2008. The 1990s – a roaring bull market inspired by falling interest rates – was the only decade in my lifetime that didn't offer a great opportunity to buy stocks.  Keep in mind that if the book-value ratio of America's 500 largest companies has declined by 30% or more, you will be able to find dozens (if not hundreds) of high-quality businesses where book-value ratio has declined 50% or more.  So… What do you think the underlying message of today's essay is? Remember, I was trying to teach you the most advanced skill you can possess as an investor. What's that skill? What do these stories reinforce?  The most advanced skill you can develop as an investor isn't knowledge of arcane accounting rules. It's not developing real expertise in charting. It's not even becoming an expert in position-sizing and risk management.  The most advanced skill you can develop as an investor is simply the emotional discipline to be incredibly patient.  If you want to succeed in investing, you have to be other-worldly in your ability to wait until you get the rarest of opportunities – a chance to buy the businesses you've always wanted at the right price.  Buffett knew all about GEICO. He saw exactly how it enriched his mentor beyond belief. He knew it would certainly enrich him (assuming he bought it at the right price). As a young man, Buffett had foolishly advertised the opportunity and, even more foolishly, he sold the stock rather than simply continuing to buy more.  He then spent the next 34 years waiting for the right opportunity to buy the company. He waited and waited and waited and waited. Then he made 400 times his money.  Think about that the next time you're going to buy a stock. Is it a great time to be buying stocks? Is it the best time you've seen in five or 10 years to make investments in the stock market? Is the stock you're about to buy really trading at the cheapest price you've ever seen? Is it really a chance to make 400 times your money over several decades?  The more patient you become, the better your investments will be. I guarantee it. Patience is Buffett's greatest virtue. He figured out what businesses he wanted to own when he was in his 20s. Then he waited until he got the opportunity to buy them at prices he knew would make him extremely rich.  There's no reason you can't do the same – even if you're older than 50. Don't forget: Graham bought GEICO when he was 54. And Buffett's best investment ever was in Coca-Cola. He started buying the blue-chip soda brand after the 1987 collapse. He was 57 years old when he made that investment.  My advice: Keep a list near your computer or on your desk. When you come across a truly great business – a business that has enriched investors for decades – write down the name. Read its annual reports. Follow its progress. Get to know the business like you know your siblings or your spouse. See how the company responds in good times and bad times. Then… wait for the market to give you a great opportunity to buy the stock.  Regards,  Porter Stansberry Source: Daily Wealth Follow us on Twitter: @blacklioncm

Chinese Wealth Management Products Will Cause the Next Financial Crisis

BY CHRIS MAYER
POSTED 
NOVEMBER 6, 2014

The next financial crisis will begin in China.

This will be the event in financial markets when it happens. In this letter, I’ll tell you about the trouble spots and ripple effects. More importantly, I want to steer you clear of them.

Please read on…

“Troubles in China Rattle Western Banks,” says one Wall Street Journal headline. “String of fraud cases and problem loans stings foreign lenders as Beijing investigates executives, seizes assets,” says the subhead.

A few big European banks recently were on the losing end of a $475 million loan, thanks to fraud. The best part of the story was this quote:

There is plenty of evidence of recklessness in China.

“It was a surprise to all the banks. We didn’t know,” said one executive at a Western bank with direct knowledge of the matter. [Italics added].

“We didn’t know…” Of course they didn’t know. How could anyone suspect there would be fraud in China? Let’s see, there are only about half a dozen lenders involved in a suspected fraud case at Qingdao Port. Those lenders are in for a billion dollars. There’s also the case of Nomura. It lent $60 million to a Chinese shoe company just months before the CEO disappeared… along with the money.

Sarcasm aside, there have been several cases of late. Yet the story I started with was a C4 story buried in the middle of The Wall Street Journal. I want to make the case to you that these kinds of stories will work their way to the front page in 2015 — and why it matters.

To make my case, I draw primarily on two expert witnesses. The first is Yan Liang, an associate professor at Willamette University. She gave a fascinating presentation at the Post-Keynesian Conference I attended in Kansas City in September.

The focus was on the shadow banking system. You have probably heard the term “shadow banking” tossed around and wondered what it was all about. The definition can vary, but generally, a shadow bank is a lending institution that does not have the public backstop that normal banks do. (Read: a lifeline from the central bank.) They can also use greater leverage and evade certain regulations.

In China, shadow banking has quadrupled in size since 2008. Lending is not a business that grows that fast without doing reckless things. There is plenty of evidence of recklessness in China.

Liang focuses on the so-called trusts and wealth management products (WMPs). These are vehicles you can invest in that will then pay you a higher interest rate than a bank deposit will. The problem is people tend to think these are as safe as bank deposits. In fact, owning them is about as safe as swallowing a box of nails.

Trusts, for instance, use a lot of leverage. The average is about 40 times for the largest trusts, Liang says. (See the chart above.)

To show you how fragile a 40-times leverage ratio is, let me use an analogy. Imagine you owned your house at 40 times leverage. That means for every $100 of value in your house, you have just $2.50 of your own money in it. In such a case, just a 2.5% drop in the value of the house means you suffer a 100% loss of your equity.

And it is not like the trusts are investing in super-safe stuff. They make risky loans in infrastructure, real estate and industries with excess capacity. Also, they are opaque. Liang says that “only 29 out of 66 registered trusts disclose capital, and most (except for two publicly listed trusts) failed to report returns.” I imagine the ones not reporting are not proud of the results.

The wealth management products are just as bad. To an investor, they look like time deposits. But they pay higher rates because they take your money and invest it in risky loans to small businesses. Worse, Liang says that shadow banks often issue new WMPs to pay off old ones and dodge reporting bad loans. It’s like a big Ponzi scheme.

In fact, a Chinese regulator, Xiao Gang, did call them a “Ponzi scheme” last year in public. (Amazing that he still has a job. People who say stuff like this tend to wind up behind bars.) It’s easy to hide these things in China. Banks “often act alone in originating, distributing, custodying and managing WMPs,” says Liang. There is no independent party monitoring these things.

The maturity of WMPs is also getting shorter. So in 2007, only 10% of WMPs matured in less than 90 days. More than half were at least a year out. By the end of 2010, about 40% matured in less than 90 days. And less than 20% had maturities longer than a year. “But the funds raised could be invested in long-term projects, such as real estate,” Liang says. “So again, liquidity risk is excessive.” In other words, many WMPs hold long-term assets such as real estate on 90-day financing. Crazy.

Add to all this the fact that companies in China are having a hard time making money. The nearby chart, from Liang’s presentation, shows China’s corporate sector performance. The trend is bad. More and more companies are losers (almost 18% of the sector). And the median return on assets (or ROA) has fallen to under 3%. Weak. And these data are a year old. We can only guess where the numbers are now.

At this point, to further bolster my case, I’d like to call Charlene Chu to testify. I heard her talk at Grant’s fall conference. Her title was “Crash, Boom or Muddle? Casting China’s Future.”

Charlene Chu is the head of Autonomous Research Asia, started in Hong Kong in September 2014. Before that, she was a director at Fitch in Beijing, where she worked for eight years. Chinese banks were her beat at the rating agency. And before that, she worked for the Federal Reserve Bank of New York.

“The China today is not the China of before the financial crisis,” Chu began.

If you go back to the early 2000s, China’s was a banking sector in which there were hardly any other investment alternatives. Everybody put their money in the bank, Chu said. Every bank offered the same interest rate. You had no incentive to move your money from one bank to another. And there was no property market. There was barely a stock market. Chinese banks had virtually no liabilities.

That’s all changed today. Echoing Liang, Chu showed that China has a debt problem.

In her analysis, Chu did not care much for GDP growth, which most people focus on. She said it was the “most politicized number in the economic world right now, and it is not that informative.”

Instead, she focused on the massive loan growth in China. For six years in a row, China’s banks have extended net new credit. The total is an “astonishing amount.” If put in U.S. dollar terms, “we’re talking about $5 trillion of credit being extended for six years in a row.

“Under those kinds of circumstances, I think any country in the world would be growing at a very rapid rate,” she said. “The real question we should be asking about China is why isn’t growth stronger?”

China is slowing down, despite massive credit growth. She called into question the big and wide divergence between the picture in the financial data from banks and what is happening on the ground.

“I was in Beijing a couple of weeks ago,” she continued. “Across the board, everybody is expecting a slowdown.”

To answer the question she posed in her presentation, “Crash, boom or muddle?” she quickly dispatched one scenario. “I don’t see any case for a boom.” Neither do I.

Chu says China will muddle. In the Q&A, she did allow that if it got really bad, the Chinese authorities might have to make choices about who they bail out. Foreign bank claims might, in such a case, get the old shaft.

Commodities China buys heavily… would seem to be vulnerable to disappearing demand.

Meanwhile, stupid foreigners (mostly banks) have been lending money in China as if a boom was a given. Lending rose 47% in the 12 months ending in June, says the Bank for International Settlements. China is also the largest emerging-market borrower by far.

Liang also goes for the muddle-through scenario. “State-owned banks dominate China,” she said, “and the central government has the capacity to write off bad debt and recapitalize banks. Think the late 1990s.”

I will dissent from my esteemed China watchers. Markets don’t work so neatly. Big credit problems don’t go quietly into the night. Authorities, even Chinese ones, have no magic wands to wave and make problems go away. Markets boom and bust. I think China’s bust will be nasty and shake global markets to the core.

I would treat Chinese investment ideas as if they have Ebola. Some supposedly smart investors (this means you, GMO!) are bullish on Chinese banks. They cite, among other things, a low price-to-book ratio. But I agree with Chu: “The price-to-book ratios for Chinese banks are not low when you realize that 50% of the capital could be impaired in a very short amount of time.”

Stay away from China. Stay away from firms lending money in China. Those are easy steps. More difficult is to predict the ripples a financial crisis in China would create. Commodities China buys heavily — like iron ore, oil, copper and potash — would seem to be vulnerable to disappearing demand.

I have no doubt China will be a much bigger economy in 10 years’ time. But that doesn’t mean investors have to make money, especially foreign ones.

Regards,

Chris Mayer

Source: Daily Reckoning

Follow us on Twitter: @blacklioncm

A Secret Only a Tiny Number of Investors Understand

A Secret Only a Tiny Number of Investors Understand 

by Bill Bonner, Chairman, Bonner & Partners
At 7 a.m. on Saturday morning we were in our room at the China World Hotel, looking down on eight lanes of traffic that had come to a dead stop in the Beijing traffic. 

“The last century was America’s century,” says our Chinese colleague. “This is China’s century.” 

“You know why America was such a success,” he continued. “Because it was a fairly free market with massive domestic demand. Companies could scale up in the highly competitive US market. That would make them larger and more advanced than their foreign competitors. They could then enter foreign markets and easily beat the locals. 

“Now, the US is gummed up by taxes, debt and regulation. Outside of Silicon Valley most of the companies are old. There are few new businesses and not much new technology. 

“I think you wrote something about the declining number of start-ups in the US. It’s a big deal that few people recognize. I think you said it was a result of crony capitalism. The feds subsidize and protect the big boys… and bail them out when they get into trouble. That’s why GM and Fannie Mae are still in business. But the little guys can’t even get credit. 

“China, meanwhile, is full of new companies. Everything is new. And the internal market is fairly free compared to America. Talk about scale. These companies have massive domestic growth and learning capacity before they have to compete on the world markets.
The Largest IPO Ever
“Take Alibaba, for example. It’s a huge company already. It recently introduced a new kind of bank account, where you earn interest daily… at a much higher rate than banks in the US. Within a week, it was the third biggest, in terms of deposits, in the world. 

“Alibaba is going public soon. It will be the largest IPO ever.” 

More evidence of the liberty with which Chinese firms operate comes from a dear reader: 

Bill, I probably shouldn’t bother you, but this one (about China) is right on and close to my heart. My wife has been a naturalized US citizen for 3 years, an LPR for 3 years before that. For the year before that (2007), we were waiting for the I-190 immigration processing. We were married in 2007 in Nanchang, Jiangxi province, her family hometown. She had been running a business in Guangzhou. At start-up, she went to ONE place for a license. She started to tell the guy she planned to deal in Suzhou silk embroideries, calligraphies, and paintings. He cut her off with, “You want to buy and sell things. Okay.” She paid nominal taxes. In the US there is Schedule C, state B&O tax, county property tax, city license and taxes, and aaaarrrgggghhh… We own a small “fangzi” in Nanchang and visit China every few years (her daughter is our partner and manages the property). For some time I have felt that China is MUCH more truly “free market” than we are. How tragic!

Can the Market Be Beaten?
But let us leave China and return to the subject of these last few Diary entries: how to invest intelligently in a world where real knowledge is scarce. 

This is the third in our series. We have one or two more coming. So keep an eye out for those… 

We grew up with the Efficient Market Hypothesis – which was popularized by economist Burton Malkiel in his 1973 book, A Random Walk Down Wall Street. 

The hypothesis is that stock market prices reflect the sum of all publicly available knowledge about a company. Because no one could know more than everyone could know collectively, an individual would be unable to “beat the market” over the long term. 

Of course, many investors did outperform the market. But efficient market proponents believed this to be a matter of luck, not skill. 

Academics and investors attacked EMH from several directions. Some, such as a well-known investor from Omaha, pointed out he and others schooled in Graham-and-Dodd-style value investing had been able to earn the consistent above-market gains EMH theory said was impossible. 

How did they do it? 

We recently put the question to colleague Porter Stansberry. His reply: 

I’ve nearly doubled the S&P 500 over the past 10 years, beating the market in both bull and bear markets... despite the significant handicap of having to do something on a monthly basis. How could I do that if the market was efficient...? And I’m far from the only investor who has proven able to beat the market consistently, over long periods of time. These investors aren’t lucky monkeys. They all tend to follow the same types of strategies – strategies that exploit proven anomalies in the market. The Efficient Market Hypothesis, on the other hand, is the creation of academics who have never been tasked with making a living by their investments. This is second-hand knowledge of the worst kind. The EMH logic you’re aping is precisely the kind of “phony” knowledge you’ve written books about. But let’s just give you a few simple examples that make a mockery of the EMH. Right now two of the smartest investors in America – Carl Icahn and Bill Ackerman can’t agree on whether or not Herbalife is a fraud. Herbalife, as you probably know has been a public company with audited financial statements for the past 20 years. One extremely knowledgeable investor says it’s a Ponzi scheme. The other says it’s a great business. How could all of the available information about this business be accurately priced into the stock market? The answer, of course, is that it can’t be. Nor could it ever be. Bill, as you know better than anyone else that I know, human beings aren’t driven by logic or facts. They’re driven by the delusions of their hearts. These delusions are reflected in the price of stocks. That creates frequent opportunities to buy stocks at prices that are attractive. Off the top of my head, I can list at least a dozen “delusions” that are almost always available in the stock market. For the sake of brevity here are four that I’ve used in my career to trounce the market over the past 10 years... 1. The most important quality of any insurance company is the ability to profitably underwrite across the insurance cycle. But there is zero correlation between insurance company stock prices and underwriting track record. Instead, Wall Street values all insurance stocks based on return on equity alone – even though all professional investors “know” that insurance company earnings are merely estimates that future losses will actually determine. Betting on the insurance companies with good underwriting culture is nearly a free bet that shouldn’t exist in an efficient market. This opportunity has existed for as long as there is good data on underwriting and shows no signs of disappearing due to investor “knowledge.” 2. Certain homebuilders – NVR for example – have an enormous advantage by not owning any land. Rather than tying capital up in landholding, they merely option the land they need, at the time they need it. These facts were clear for all investors to “know” and have been for at least the last 25 years. And yet... the human bias to desire land is so strong that not only do these firms rarely trade at a premium to other large homebuilders, they frequently will trade at a discount. Meanwhile, the performance of the “landless” homebuilders dwarfs all of the “landed” homebuilders, both on annual measures (like returns on assets and equity) and in terms of stock performance over the long term. No one on Wall Street has ever mentioned this advantage… and in fact, Wall Street and most professional investors continue to publish research professing a desire to own the land banks inside most homebuilders. 3. Investors favor buying puts rather than calls. Investors irrationally fear losses far more than they desire gains, leading to a permanent imbalance in the demand for put options as opposed to call options. This imbalance makes it easy for investors to invest in put options (by selling them) and immediately gain an advantage over other investors who are unwilling or unable to sell puts. We’ve used this advantage to produce market-beating average returns in stocks while taking much less risk in my Stansberry Alpha product. 4. Credit investors are far better informed and far more rational than equity investors. Frequently, credit investors will price a firm’s debt at a price that indicates bankruptcy is an inevitability. In nearly every case, these firms do in fact go bankrupt. Meanwhile, equity investors will value the attached common stock as being worth hundreds of millions of dollars, when, in fact, there is no possibility of even making the bond investors whole. Shorting these stocks is sometimes even possible after bankruptcy has been announced and after the company has publicly advised its shareholders that no recovery is possible. 5. Okay... one more... frequently there are opportunities to profit from publicly announced mergers, acquisitions, spin-offs, and special dividends. Warren Buffett claims that with relatively small amounts of capital, investors can routinely earn 50% annually exploiting these anomalies. I can recall buying shares of Anheuser Busch in the fall of 2008 for less than $56 per share within weeks of a fully funded, all-cash offer of $70 per share. Although this is, admittedly, a dramatic example, you couldn’t argue that all of the information about this deal wasn’t “known” to the market participants. 6. Just one more... The entire stock market continues to be priced according to “earnings” – which are derived from FASB accounting. These accounting methods were developed by the PA Railroad more than 100 years ago. They are nearly useless for evaluating companies that have low capital investment requirements. This continuing anomaly is largely responsible for Buffett’s success... and mine. It’s easy to build a model that will always outperform the S&P over any reasonable period of time (five years) by simply focusing on companies with good margins and low capital costs. These firms will produce higher cash returns for investors per dollar of sales. Again, this information is available to all investors... And yet most investors continue to believe what they “know” about earnings – much of which isn’t so.

How the “Smart Money” Invests
And not only are individual stocks and groups of stocks often mispriced, but also sometimes the whole stock market wanders far from the path predicted for it by EMH. 

Yale’s Robert Shiller, among others, looked back at what investors actually did, as opposed to what EMH said they should have done. This “behavioral finance” approach demonstrated a wide gulf between EMH theory and real-world investor activity. 

According to Shiller, “As tests were developed, they tended to confirm the overall hypothesis that stock market volatility was far greater than the Efficient Market Hypothesis could explain.” 

As any old-timer could tell you, investors are moved by greed and fear… often becoming too bullish… and sometimes too bearish. 

This, of course, was obvious. Shiller went on to explain what Buffett, Stansberry and other market beaters were really doing. The “smart money” takes advantage of the irrational behavior of other investors. 

When investors misprice a stock – which Shiller refers to as an “innovation” – a smart investor with a sharp pencil and a clear mind buys the stock. The stock then returns to a more reasonable price. And the smart investor makes more than the great mass of greedy and fearful investors. 

Readers will recognize our own Simplified Trading Strategy (STS) as a way to “time” the market at these extremes of greed and fear. 

According to the EMH theorists – as well as many Graham-and-Dodd value investors – timing the market is impossible. But just as a single stock is sometimes extremely mispriced, so is the entire stock market. 

Our system – of buying stocks when P/Es are 10 or below and selling when they are 20 or above – is just a blunt, and rather stupid, way to take advantage of the same anomaly. 

Shiller describes the difference between the “smart money” and other investors in a way that makes most investors seem innumerate. Rather than do the numbers, they read the paper… react to the news and opinions… and are greatly influenced by recent history. 

They are “feedback investors,” he says. 

As stocks move higher and higher, more and more people come into the market hoping for quick and easy profits. These unsophisticated investors are particularly “feedback” sensitive. 

They have not done the math. They don’t know the real value of the shares they buy. They bid them up. And seeing the stock market rise, they become convinced that it is going higher still. 

The smart money sees this as irrational behavior… 

“Find the trend whose premise is false,” says George Soros, “and bet against it.” 

As we have seen in our discussion of the asymmetry of knowledge, it is easier to know what is false than what is true. 

The STS gives us a way to profit from it. 

More tomorrow – including how much you could have made with STS had you lived as long as 108-year-old value investor Irving Kahn… 

Regards, 



Bill
Source: Bonner and Partners

Follow us on Twitter: @blacklioncm