Recently, one of our readers asked this question at the forum:
So why is Warren Buffett’s net worth so much higher than Charlie Munger’s? And why Ben Graham, the founder of the idea, never really make it? It seems like value investing only works extraordinarily well with Buffett. I was hoping someone like Ed could give some insight.
We see that this is an excellent discussion topic. So, what do you think? Join in the forum discussion now!
We will continue our silver series today from our previous silver article. The full guide in our silver series can be found here. This article will assume that you have already read all the previous articles in our silver series.
As you know by now, we believe that silver prices are severely undervalued.
In fact, it is likely that it is manipulated. It seems that certain entities are using the New York Commodities and Mercantile Exchange (COMEX) to use it to offload a lot of paper silver into the silver market. To do that, it sold a lot of silver futures into the COMEX market (that is, it sold a lot of promises to deliver physical silver in the future). As we explained in How futures price affect market price, the futures price have an effect on the spot prices (market prices). By manipulating the futures prices, the spot prices of silver can be manipulated.
The problem is, the paper silver that is being sold through the futures market is unlikely to exist. Why? Commodities traders on COMEX have made bets in which they promise to deliver more than twice the amount of silver known to exists! If the traders who bought the promises to deliver silver in the future demand the physical silver, the rest of the world have to be starved of silver for more than a year. That means all production of iPhones, Blackberrys, netbooks, notebooks, etc has to be ceased for a year. No other commodity has such a large short position. In contrast, the amount of gold sold through the futures market amounts to only 2.5 percent of known inventory.
Even more suspicious, of all the commodites, silver have the largest proportion of futures contracts held by the smallest number of traders. Only 4 traders hold the vast majority of the silver short (sell) positions, of which just one or two hold more than 50 percent of all of them. This means only couple of entities are controlling the price of silver for the rest of the world. These 4 traders have sold, for future delivery, more than 4 months of worldwide silver production.
The market for paper silver is far larger than the market for physical silver, with the prices of physical silver determined by the prices of paper silver. That means that the prices of physical silver are artificially set far too low. This means that with such artificially low price, the consumption of physical silver is much higher than what it should be had market prices been allowed to find its price level. Couple that with the declining supply and constrained production of silver, it will only be a matter of time before the paper silver market will fail (i.e. all these ‘promises’ to deliver physical silver fails), sending prices of physical market soaring. As this Time magazine article reported (in 2001),
Still, the jump in price spread chaos across the market as Buffett called for delivery of more than 42 million oz. of the silver he had bought–after already having some 87 million oz. in tow. Panicky short sellers, who had borrowed silver and sold it in the expectation that the price would fall, had to swallow huge losses to complete the deals. Major buyers of silver like Eastman Kodak, which processes millions of ounces a year into film, faced big increases in raw-material costs. And everywhere families began eyeing grandma’s precious flatware as a possible source of cash. “We think we may see the spike reach double digits–maybe $10 an ounce–but one doesn’t really know in this rarefied territory,” says Nick Moore, director of Flemings Global Mining Group in London.
In 2001, Warren Buffet reported buying up 129.7 million ounces of silver. His demand for physical delivery caused chaos in the market.
This silver price fuse is a Black Swan event
In our previous article, we asked our readers to spot the flaw in Warren Buffett’s logic. Today, we will reveal the answers. Before you read on, please take the time to understand our guide, Value investing for dummies.
As Buffett said, staying in cash and cash equivalent (e.g. government bonds) is a bad move because price inflation is likely to be very high in the future. This, we agree. But does it mean one should switch from cash to stocks today? If the answer is “yes,” then there’s an error in logic.
First, by that very statement, Buffett was implying that the yields of government bonds are far too low. Essentially, this means that those who buy and hold those bonds will have their wealth frittered away by price inflation.
Next, as we explained in Value investing for dummies, value is a relative concept. Stocks are valued relative to risk-free government bonds, which in turn is suppose to reflect future price inflation. If the yields in government bonds are wrong by a long shot, then stock valuation will be wrong.
To explain this point better, let’s use an example. Let’s suppose the following conditions:
If we apply a 5% discount rate on 10 years of that business’s earnings, we get a present value of $2358.76. That 5% is arbitrary chosen from the fact that it is a little above the Treasury bond yield.
As long as the long-run average price inflation is around the vicinity of the 30-year Treasury bond yield, buying the stock at below the present value of its earnings is a bargain. But what if the bond yield is way way way wrong? Let’s say the price inflation rate turns out to be, say 25% (in other words, the business earnings grow fast enough to merely keep up with inflation). You can see that applying a discount rate of only 5% will give you a return far below price inflation (but slightly higher than Treasury bond yields). If you want a return higher than price inflation, your discount rate will have to be north of 25%.
If we apply a 30% discount rate on 10 years of that business’s earnings, we get a present value of only $648.87! That 30% is arbitrary chosen from the fact that it is a little above the price inflation rate.
So, if you believe that government bonds are severely under-pricing future price inflation and you have no idea how the ravages of price inflation will look like, then how can you value stocks correctly? If the price inflation turns out to be Zimbabwean-style hyperinflation, then you will lose big money (in real terms) investing at today’s stock price.
In Warren Buffett’s latest shareholder letter, he said that,
Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long. Holders of these instruments, of course, have felt increasingly comfortable – in fact, almost smug – in following this policy as financial turmoil has mounted. They regard their judgement confirmed when they hear commentators proclaim ?cash is king,? even though that wonderful cash is earning close to nothing and will surely find its purchasing power eroded over time.
Currently, as we said before in Why are nothing-yielding US Treasuries so popular?,
One of the thing that confounds us is the fact that short-term US government bonds are yielding almost nothing. A 10-year US Treasury bonds yields a measly 2.79% while a 30-year bond yields 3.57%.
Therefore, on that paragraph alone, we agree with Warren Buffett. That’s the main idea of our earlier article, If you save, government will wage economic war on you. But assuming that this is true, what is the implication for investors? Did Warren Buffett mean that investors should shift from cash to stocks?
If the answer to the second question is “Yes,” we can’t help but notice a flaw in his logic here. We will turn over to our readers to spot the flaw at our discussion forum. The first person who spot it will be given a pat on his/her back and be quoted! 🙂
Warren Buffett’s latest dismal performance had many fans of value-investing taken note (see this Bloomberg article). In his latest shareholder letter, he confessed that
During 2008 I did some dumb things in investments. I made at least one major mistake of commission and several lesser ones that also hurt. I will tell you more about these later. Furthermore, I made some errors of omission, sucking my thumb when new facts came in that should have caused me to re-examine my thinking and promptly take action.
Some of his fans are even questioning the whole philosophy of value investing. One of Australia’s value-investing tip-sheet (which we will not name here) confessed that
Ben Graham began his seminal piece on value investing with that quote, and several of his disciples built impressive records over many decades using it as their guiding principal. Buy established businesses when their share prices have fallen substantially and are out of favour, the theory goes, and sell them when the world comes to its senses. It worked for the best part of 70 years. Then, in 2008, it stopped working.
…
I wouldn?t go that far but it?s clear this financial and economic crisis is different to anything Warren Buffett has experienced. Unless you?re an octogenarian, that makes it different to anything you or I have seen either. It?s time to tread extremely carefully.
Today’s Global Financial Crisis (GFC) is something that we warned our readers. As recent as last month, we wrote in Should you follow Buffett and be greedy now? that
Finally, take note of this: Warren Buffett has never experienced the Great Depression for himself. Neither has he experienced hyperinflation of Weimar Germany. All his life, he lives in America as an American. Today?s America is at a turning point and there?s no guarantee that it will return to the America that Buffett experienced all his life.
In December last year, we reported in Is the Warren Buffett way dead? that Marc Faber said that
I think The Warren Buffett approach is dead, and it?s been dead for ten years, and it?s going to be dead for another ten years.
In July last year, we wrote in Should value investors be ?bullish? in a bear market?,
Here, we see a potential trap for the unwary value investor.
…
But this is where the Achilles? heel of value-oriented stock research lies. Because they hold a neutral view on the macroeconomic big picture and business cycle, they can severely underestimate the effects of a protracted downturn in the earnings of businesses.
If the global economy falls into a Greater Depression, many of today’s ‘bargain’ stocks will still turn out to be value-traps. For us, we are not buying stocks yet.
One of our readers, in response to yesterday’s article (Future is bleak for conventional investing), said
Mr Contrarian, you?re stating to sound like mainstream press.
It may soon be time to turn contrarian on the Contrarian Investor.As Warren Buffet pointed out: ?Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful.?
Today, we cannot resist poking another fun at this Buffett cliché (“Be fearful when others are greedy and greedy when others are fearful”). Two years ago, we were very fearful when others are greedy. Today, others are fearful and we have not yet turned greedy. So, are we turning mainstream?
First, for those extreme Buffett devotees (we do not know whether this particular reader is one) who like to quote this cliché religiously, there are something they fail to understand about being contrarian- there is a difference between a contrarian and a reverse conformist. A reverse conformist blindly takes the opposite position of the crowd indiscriminately. The moment the crowd turns fearful, a reverse conformist immediately flips to greed. A contrarian, on the other hand, is someone who is prepared to take an opposite position at the right time. As we said in What is this publication all about?,
… if you want to achieve excellence in your investment endeavours, you have to be prepared, from time to time, to go against the prevailing market trend with strong convictions.
Second, being contrarian does not merely mean taking an opposite direction from the crowd on the same road. Sometimes it means taking a different road. Some Buffett devotees who adhere to this cliché religiously can only think in terms of investing in stocks (listed securities) of public businesses. In other words, they can only think of investments in the context of a financial market. In reality, stocks is only one road of the many roads available to the investor. That’s why we said in yesterday’s article that
For others, it may mean investing outside the financial system. For some people, they may no longer see it appropriate to call it ?investing.?
Our point in yesterday’s article is that to be a successful investor, one has to look beyond the conventional realm of the financial markets in today’s economic climate.
Third, some of these extreme Buffett devotees fail to see there is one major difference between them and Warren Buffett- he has the big money and influence to cut deals in order to acquire entire businesses outright. Many of these businesses are private ones and inaccessible from the stock market. Most investors, on the other hand, can only access publicly listed businesses from the financial markets. That in itself puts most investors at a severe disadvantage. Think about this: If you own a fantastic private business that fulfils the Buffett criteria, would you want to turn it public (especially in today’s economic climate) and subject your business under legal and institutional straits jacket and put it under the watchful public eye? If you are to turn your private business into a public business, will you ensure that you will get the better deal than the public? This is something that the Chinese Sovereign Wealth Fund had to learn the hard way when it purchased Blackstone.
Next, we may trust that Buffett to be a better businessman than us. But does that automatically mean that he has a good understanding of the macroeconomic environment? In fact, Buffett is a lousy economist. The biggest mistake a Buffett devotee can make is to believe that Buffett is good at everything and believes that his circle of competency is greater than it actually is.
Next, some Buffett devotees fail to see that he has a blind spot- Warren Buffett is an American patriot who has a biased view in favour of America.
Finally, take note of this: Warren Buffett has never experienced the Great Depression for himself. Neither has he experienced hyperinflation of Weimar Germany. All his life, he lives in America as an American. Today’s America is at a turning point and there’s no guarantee that it will return to the America that Buffett experienced all his life. As we said before in Listening to ?wise? heads can be dangerous,
The point is, no matter how experienced a ?wise? head is, his experience is still confined to either (1) a specific market or (2) a slice of time in history. That is, all the experience that a ?wise? head has is still limited in the bigger scheme of things. Therefore, to stop thinking and extrapolate blindly from this limited perspective into the general is a dangerous trap to base one?s investment decisions on.
For all you know, the panic of 2008 may be the event that becomes the undoing of Warren Buffett’s reputation as an investor.
In our previous article (Are government interventions the first steps towards corruption & inefficiencies?), one of our readers asked,
… I have been wondering what the impact on government interventions will be for investing… What if one was to invest in Blue Chips, with the idea that they are ?too big to fail? (gov. intervention likely) and are therefore very safe?
He had brought a very good point.
Let’s say you have very strong reservations regarding investing in Australian banks (see How safe are Australian banks?). Based on your own assessment of the fundamentals, you make the decision not to invest in banks (if you are a trader, you may decide to short the banks). But then, you receive some tips from banking ‘insiders’ that the recent flight out of bank stocks is a fantastic buying opportunity. You are told that bank shares are so cheap that you will make a lot of money in a few years time if you buy them today. Naturally, you laughed at those ‘insiders.’
But they were right.
A few years later, they end up laughing at you instead. Let’s suppose that your fundamental analyses of the banks are correct. So, what went wrong?
Government intervention.
As we said before in Are government interventions the first steps towards corruption & inefficiencies?,
They [bailouts and rescues] are inherently unfair because the government will have to act as the judge and decide which businesses/industries should live and which ones should die. Unfairness, by its very nature, implies preferential treatment. What is the government?s basis for favouring one business/industry over the other?
So, in your case, the government bailed out the banks (which is happening right now in the US and UK) in such a way that shareholders are protected. If you are a trader, shorting the banks will lead to heavy losses.
From this example, you can see that when government intervenes, the market is no longer completely free. When the market is no longer completely free, it means that the rules change abruptly in the middle of the game. When that happens, those who ought to lose become winners and vice versa. Incompetency is rewarded and competency is punished (indirectly through taxes).
Imagine, what will happen if there’s a soccer match whereby the umpire is allowed to change the rules abruptly any time he wants? In such a world, it’s either that bribery will abound or no one wants to play the game. The same goes for the economy. A half-free market will discourage the capitalists and entrepreneurs and encourage cronyism, corruption and speculation.
That’s one of the reason why in such an environment, the Warren Buffett way is dead. That’s why Marc Faber said this is a traders’ market. It’s possible that we will see Warren Buffet’s long-term track record flounder in the years ahead.
Very often, you may hear the more experienced investors saying things like this
I’ve been investing for the past x number of years. In my experience,
- … it is such a time of maximum fear and panic that an investor makes a killing.
OR
- … markets eventually recover soon.
OR
- … investments in stocks/property/whatever has never disappoint in the long term.
OR
- … blah blah blah
Therefore, accept what I just told you because I have more experience then you.
Today, we will not be arguing over the correctness of the points (1) to (4) that follow the phrase “In my experience.” These points in themselves may or may not be true. But this phrase (that precedes the points) is a very dangerous one. Why? This is because it has the potential to cause you to fall into a mental pitfall. It is often invoked to stop the less experienced investors from thinking and to bulldoze their arguments.
Other variations of this phrase may include:
- According to research, over the past x number of years,
- Warren Buffett has been investing successfully for the past 4 decades,
What is wrong with this phrase? It is a form of mental pitfall called Lazy Induction. As we wrote in Mental pitfall: Lazy Induction,
The trouble starts when the sample that we used for our observations is drawn from our own personal bias. Then, from the observations of the biased sample, we make generalisations based on our flawed observations.
For example, if you invest in the Australian stock market over the last 20 years, you will do very well despite the recession of the early 1990s. Some ‘wise’ heads will use this experience as a basis to extrapolate into stock investments in general. Will the next 20 years yield the same result? We wouldn’t go into that for this article.
But consider this: what if you invest in the Japanese stock market over the last 20 years? Well, in that case, your investment performance will be a disaster.
The point is, no matter how experienced a ‘wise’ head is, his experience is still confined to either (1) a specific market or (2) a slice of time in history. That is, all the experience that a ‘wise’ head has is still limited in the bigger scheme of things. Therefore, to stop thinking and extrapolate blindly from this limited perspective into the general is a dangerous trap to base one’s investment decisions on.
In a recent interview with Marc Faber, he said that
I think The Warren Buffett approach is dead, and it?s been dead for ten years, and it?s going to be dead for another ten years.
This statement lies in the context of extreme market volatility described in our earlier article, Real economy suffers while financial markets stuff around with prices,
Right now, deflationary forces are acting on the economy while at the same time, central bankers and governments are attempting to inflate. Consequently, the result is extreme volatility in prices.
In Marc Faber’s latest Gloom, Boom & Doom report, he wrote
In the next few years I expect asset markets to favor aggressive traders and not long term investors…
In my life I experienced two major trading markets (1968 – 1982) and Japan post 1992 (see Figure 9). I can assure my readers that during these trading market conditions (no net gain for the indices and in the case of Japan new lows) hardly anyone except very smart (lucky) traders made any money.
Above I tried to show the existing connectivity between global liquidity (coming from the US current account deficit), asset markets, and currency movements. To navigate successfully between all these volatile and often unpredictable market movements you need to be a genius. And whereas I am sure that my readers are all above average investors (80% of investors think they are above average investors), I am not and, therefore, in very volatile periods I try to avoid losses and look for a safe heaven such as physical gold…
In the global stock, commodity, forex, bonds and credit markets, prices are very volatile and unstable. The sudden price deflation of commodities over the past few months caught many by surprise. What’s surprising is not just the fact that prices declined. The speed of price collapse is the phenomena that shocked many investors (even Jimmy Rogers admitted to not expecting that). It was only not long ago that oil was US$147 and the Aussie dollar close to parity with the US dollar. A 70% fall in oil prices in just a few months was something that we did not anticipate too.
In the real economy, many businesses, especially the resource companies, will fail because of this unexpected surprise. Therefore, the effects of such price volatility are still yet to be permeated to the rest of the economy.
Coming back to value investing, one of its root activity is business calculation. But if prices are unstable and unpredictable due to monetary deflation/inflation, this root activity cannot be performed reliably. As we said before in How is inflation sabotaging our ability to measure the value of things?,
If you want to measure the length of a box, you may use the ruler to do it. The reason why a ruler can do such a job is because its length is reasonably consistent for the foreseeable future. Now, imagine that ruler is as elastic as a rubber band. Do you think it is still a useful tool to measure the length of the box? An elastic ruler is useless because you can always make up the measurement of the box to whatever you please just by stretching the ruler such that the edge of the box is aligned to any intended measurement markings in the ruler.
Now, let come back to measuring the value of oil. Since oil is priced in US dollars and if the supply of US dollars can be expanded and contracted, how useful do you think it is as a calibration for measuring the value of oil?
If business calculations cannot be performed reliably, then business valuation cannot be ascertained reliably too. Without a reliable business valuation, long-term buy-and-hold value investors are investing in the dark.
That’s the dilemma facing value investors right now.
Let’s say you are a long-term investor who is not into timing the bottom of the stock market. After having seen the market falling into intense panic and fear over the past few weeks, you may wonder whether it is now time to buy stocks for their long-term value. No doubt, in this climate of intense volatility and fear in the market, stocks of good businesses along with the bad ones are indiscriminately sold. Even if a depression is coming, not all businesses will be affected equally. Some of the better quality ones will fare better (and even thrive) in such a harsh environment. For example, during the Great Depression, some businesses’ profit even grew (see Which industry?s profitability grew as the Great Depression progressed?)!
Surely, some of these stocks are undervalued by now right? Should you buy now? Even Warren Buffett is buying.
Well, the answer will depend on your personal circumstances. More specifically, it depends on your current level of leverage. In other words, the right answer to this question for two different people can be different. In the coming articles, we will explain how to go about answering this question based on probability, reward and loss. Keep in tune!
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