The Inyx forgeries

Jay Green of Inyx submitted to Westernbank a letter of credit allegedly from Pareto Securities which provided a $300MM short-term bridge financing for a buyout of Inyx. The letter was signed H. Suain, International Operations. Green identified him as Harald Suain.

The CFO of Pareto in an affidavit claimed that 1) There has never been any H. Suain or Harald Suain. 2) The letter is not authentic and not even on authentic Pareto letterhead. 3) Pareto never offered any such letter of credit to Inyx.

In other words, the letter is a forgery. This would be the third accusation of forgey against Kachkar. Apparently he submitted similar letters of credit from Countrywide Bank and also Mellon Bank in the UK. Countrywide has also called the letter a complete forgery.

Who is Harald Suain? The only record that I can find for that name is a guy in Europe who is an agent for a Norwegian Soccer Coach, Trond Sollied. Well Kachkar is a big soccer fan as he tried to buy the Marseille Soccer with the forged Countrywide letter.

The forged Pareto document is online so we can have a look at this signature and see if it resembles the handwriting from the usual suspects, Kachkar, Green or Benkovitch.

Growth and reversion to the mean

Here is an update of the previous post on whether a high 5-year growth rate predicts the next 5-year growth rate. The answer is still No but now with more statistical significance.

I have collected more data. Now I am using every stock on the NYSE, NASDAQ and AMEX.

I require that there is 10 years of data and that in each 5-year period, there is at most one year with earnings data not available or earnings that are negative. If earnings are negative (or unavailable) that one year, I ignore it and fit the growth rate to the remaining four data points. So there is a slight bias towards higher growth rates but this bias is the same in both periods so this should not cause any correlation. Growth rates above 50% or less than -50% are discarded. The results are insensitive to increasing this number 50% to 80%.

There are 2206 stocks that meet these requirements. Here is the result. (Click for higher resolution)



The top panel just shows the last 5-year growth rate versus the growth rate 5-years previously. As before there appears to be little if any correlation. The red dashed lines show the median growth for each period which is 10.5% for the last five years and 7.1% the five years before that. This higher growth in the latest period is probably real and is expected since the period 1998 to 2002, the internet bubble, went from a boom period to a recessionary one and the last five years 2003-2008 included the recovery and housing bubble. It looks like we are now going into another recessionary period due to the housing bust. The Pearson's correlation coefficient is -0.0953. This slight negative correlation is explained below.

The lower panel is even more informative. The stocks are sorted by the growth rate in the previous period and divided into 19 percentile groups. That is, each group has equal number of stocks and has similar previous 5-year growth rate. For each group, I calculate the median of the previous 5-year growth rates and the corresponding median of the last 5-year growth rates. These two median growth rates are plotted versus one another with error bars indicating the error due to having a finite sample. Clearly, there is no indication that the median growth rate in the next period has anything to do with the median growth rate in the previous one. The blue line shows the y=x relation that would be expected if the best predictor of future growth rate was the past growth rate. Clearly this is NOT a good fit to the data. The red horizontal line just shows the median growth rate in the last 5-year period. This fits the data points quite well. This would indicate that the hypothesis that "Future growth rates are independent of past growth rates" is consistent with the data. There is one deviant point which has the lowest growth rate in the previous period and in fact the highest growth rate in the more recent period. I haven't yet looked into this in detail but these may be highly cyclical companies such as oil, energy etc. This point probably is the cause of the slightly negative Pearson's correlation coefficient.

Overall, this study points toward mean reversion. Companies that are growing at higher or lower than average rates will most likely revert to average growth rates in the future.

The application to investing also seems to support the "value investing" method rather than the "growth method" at least in their simplest incarnations. That is, stocks that have grown rapidly and (usually) sport a high valuation on earning probably will not grow any faster than the stocks that have grown only slowly or even had negative growth. So paying a higher valuation for "growth stocks" does not appear to be logical. I will investigate this in more detail in future posts.

Does past growth correlate with future growth?

I did a little test to see if the past 5-year growth rate correlates with the "future" 5-year growth rate. Since I don't have access to the future data, I will use the earnings data from the past 10 years split into two parts. I have a list of stocks whose earnings I have looked at over the past few years. This is not a random sample by any means but should not be terribly biased. If there is any bias it might be that I typically look for companies with consistent results which might bias things in the direction of positive correlation.

Here is the list of tickers. There are 157 stocks. All have been pruned to have at least 9 years of data.

aa aame abk adp aeo afl ahm aig ajg all anf apol appb axp azn ba bac bax bbby bbt bcs bdx bmy bni bpop brl bro bud c cat cc cfc chc cinf cl cle clx cors crft csco ctas ctx dd dell deo dhi dis drl e educ eth expd faf fast fbp fdc fdx fitb fnm gd ge gfr ggg gm gsk hasx hban hd hsy ibm intc intu ir jnj jpm k kbh kcli key ko ksws leco lfg liz mbi mcd mdt mer mhp mlea mmc mmm mo mrk msex msft mtb mtg mth mxim ncc nke nsec nte nwlia ofg orcl ori pep pfe pg phm plxs pmi ras rdn rf rgf ri rt ryl sbux sial snn stc sti stj strt swm syy t tbl tgic tma tmk tol tsn tss tues ug uhco unh ups usb ust utmd utx vz wat wb wdfc wfc wfmi whi wmt wwy xom

For each of these I calculate the 5-year (annualized) growth rate of earnings in the most recent five year period (years 5 to 9) and in the more distant 5-year period (years 0-5). The growth rate is calculated by using all of the points and fitting an exponential curve to these points. I throw away growth rates greater than 50% or less than -50% to avoid have large numbers skew the averages.

Here are the results:

The mean annualized growth rate in the first 5-year period is M1=11.9% and the standard deviation is S1=15.2%.
The mean annualized growth rate in the second 5-year period is M2=13.9% and the standard deviation is S2=13.9%.

The Pearson correlation coefficient R is -0.0329.

R = 1/(N-1) * Sum_i (G1_i-M1)/S1 * (G2_i-M2)/S2
with N=157

So there is a small (and probably negligible) NEGATIVE correlation. Thus, there is no evidence at all that the 5-year growth rate is useful in predicting the growth rate of the next five years.

This study does not claim to be conclusive by any means but it shows that if there is such correlation, it is not very strong.

See scatter plot below of the growth rates plotted versus one another. No correlation is apparent.

Bank profitability at WHI

My last post on banking profitability can be readily applied to W Holding (WHI).

WHI has a leverage ratio assets/equity of about 14.6. In addition it has preferred equity nearly equal to common equity. So equity/common-equity is about 2.

So to build value for common shareholders and pay a small dividend we want to have return-on-common-equity at least 5%. If we cannot reach at least ROCE=5% then we can't really claim even to be worth common book value. The borrowing cost, BC, of preferred shares originally was about 6.7%. We can use the following formula (the the last post) to figure out the ROE that is required.
ROCE = ROE * (EQ/CEQ) - BC (EQ/CEQ-1)
Using the above numbers, the required ROE is 5.85%. Lets call it 6% for simplicity. Using the above leverage ratio, this requires ROA of 0.4%.

Now 0.4% might seem like a pretty easy target for a bank. Normally a good bank can generate ROA of 1% or so. However WHI has some serious problems that are difficult to overcome. Lets try to see why. We will look at our ROA profitability formula.

ROA = (1-T) * [ (1 - ER + NII) * NIM - L]

T = Tax rate = 40% for WHI
revenue = Net Interest Income + Non-interest income = 260MM (4x the first quarter)
ER = efficiency ratio = Non-interest expense divided by revenue = 67% for WHI (last quarter)
NII = Non-interest income divided by revenue = 10% for WHI (last quarter)
NIM = Net interest margin = net interest income divided by total earning assets = 1.3% for WHI (last quarter)
L = provisions for loan losses divided by total earning assets = 0.72% for WHI (assumes 30MM provisions per quarter)

Current ROA = -0.1%
Given, these number the bank is unprofitable. The only reason it booked a profit in the first quarter was because it had a tax benefit from carrying back losses to previous years earnings. However because it has to pay out preferred dividends, it is even worse. The common equity is going to shrink if it can improve profitability.

What went wrong for WHI over the last few years when it had ROA > 1%? Basically everything that can go wrong. The tax rates went up, efficiency got worse, NIM went down and loan losses went up. WHI never was a high NIM bank but it was very efficient and had excellent underwriting and it made use of lots of leverage. This leverage was great when it was profitable but now acts like an anchor slowing their recovery.

If we go back just a couple of years we have ER=33% and L=0.005 and NIM=2% and T=30%. This gives ROA=0.73%. In 2001, NIM was 2.7% and ROA was almost 1%.

The tax rates went up when they changed the Puerto Rican laws on the taxability of the securities portfolio. This was previously tax free but is now partially taxed. They have also increased the tax rates. This may improve in the future but there is no guarantee. Effective tax rates were also lower because a higher percentage of earnings was coming from the tax-free (or at least tax-efficient) securities portfolio. Now it generates negative earnings as borrowing costs have risen against these fixed rate securities. Only loans are profitable and they are taxed at the full rate.

Their main problems are poor NIM and high loan losses. Loan losses will likely be high for the remainder of the year but should improve in 2009. The poor NIM is probably temporarily low due to loans resetting before deposits. However the deposit scenario is poor for WHI since they rely on brokered deposits and Repos. Even though the Fed has cut rates, brokered CD rates are still high. Much of their Repos are locked in for a year or more at nearly 5% rates.

NIM may get back to 2% by years end but likely will not improve beyond that for quite a while. If they keep their securities portfolio small, it will be higher than previously and they will be a more normal looking bank: less leverage, less reliance on Repos for funding. Expenses will also stay high due to legal expenses and restatement expenses. They should probably improve ER to 50% by years end and improve by a little beyond that.

So by years end, if we adopt these numbers, NIM=2%, L=0.7%, ER=50%, that would bring us to ROA=0.1%. This is still poor and will not lead to a profitable year. However there may be enough in tax benefits from charge offs to make the tax rate temporarily about zero. This would result in a temporary ROA of 0.16% which is slightly better but still might result in shrinkage of equity.

If 2009 is much better, we may see NIM=2.2%, L=0.5%, ER=42% and that would be ROA=0.6% which would be good enough to build value and send the stock back above book value. However it is unlikely to result in rapid growth. Their days of 25%+ growth rates are probably over.

Banking profitability and leverage

There is a fairly simple formula for banking profitability. Return-on-assets, ROA, given by

ROA = (1-T) * [ (1 - ER + NII) * NIM - L]

where

T = Tax rate
revenue = Net Interest Income + Non-interest income
ER = efficiency ratio = Non-interest expense divided by revenue
NII = Non-interest income divided by revenue
NIM = Net interest margin = net interest income divided by total earning assets
L = provisions for loan losses divided by total earning assets

So the general strategy for banking is always to try to increase non-interest income if it doesn't increase non-interest expense too much. You want to keep your non-interest expenses as low as possible. Then you want to have a high NIM which usually means low deposit costs. Then you want good underwriting i.e. low loan losses. You usually can't do much about taxes. That is really about all there is to banking. The devil of course is in the details of how you actually do this better than your competitors.

Return-on-equity, ROE, is just
ROE = ROA*(assets/equity)
where (assets/equity) is the leverage factor. This leverage factor is limited by banking regulators. It must be less than 25 and is usually required to be less than 20 to be consider "Well capitalized". Most banks try to get it around 12-15. If a bank is profitable, i.e. ROA > 0, then they usually benefit from more leverage. However this can be more dangerous because if things turn bad, the bank may become unprofitable and this leverage will magnify losses to equity. If the bank pays no dividend and retains earnings it can grow at a growth rate equal to ROE, if all of these ratios above stay fixed. It is pays out a fraction PR of earnings as a dividend, then it can grow at (1-PR)*ROE while continuing to pay the dividend at the same payout ratio.

It is also possible to leverage up the shareholders equity by raising other forms of equity such as preferred shares. This requires a fixed dividend payout to preferred shareholders which comes after tax. This involved another leverage factor
EQ/CEQ = (equity/common-equity).
The preferred equity, PE, is the difference between equity and common-equity, PE =EQ-CEQ. If the bank goes bust, the preferred share holders are paid back this preferred equity before common shareholders get anything.

The return-on-common-equity ROCE is given by

ROCE = ROE * (EQ/CEQ) - BC (EQ/CEQ-1)
where BC = the borrowing cost or the dividend yield of the preferred shares.

If you set this to zero you you can solve for the condition where the bank's total equity stays the same size (before payment of any common dividend). That is
ROE = BC (PE/EQ). For example of PE/EQ is 1/2, then the bank's common equity and total equity stay the same when the ROE is half the borrowing cost. When this is true the bank stays the same every year. If you want it to stay the same size after paying a dividend, you replace ROE with (1-PR)*ROE.

When can the common shareholders grow their common-equity faster by issuing preferred shared? Just set ROCE equal to ROE and solve and you find this is equal when ROE =BC. So your ROE had better be higher than your borrowing cost or issuing preferred shares is not worthwhile.

If you want to know the growth rate of common equity, this is equal to ROCE. If there is a common dividend, just replace the ROE with (1-PR)*ROE. That tells you the growth rate of retained common equity. If you keep issuing preferred shares to keep the ratio EQ/CEQ the same, and the other ratios remain the same, you can grow the whole bank at this faster rate. Like the usual leverage ratio, banking regulators put limits on this leverage factor. Usually they want at least half the equity to be common equity.

Ok, lets do an example. Lets assume:
NIM = 3%
ER= 50%
NII=10%
T=40%
L=0.5%

This results in ROA = (1-T) * [ (1 - ER + NII) * NIM - L] = 0.78%. Now lets assume assets/equity =15. This results in ROE = 11.7%. Now lets suppose the bank pays a dividend at a payout ratio of PR=25% of earnings. Then it can grow at G=(1-0.25)*11.7 = 8.78%. Mid to high single digit growth rates are fairly typical for banks. Now, what about issuing preferred shares? Lets suppose it can sell preferred shares at a yield of 6%. Since ROE > 6%, this sounds promising. Lets say that it raises total equity to twice common equity EQ/CEQ=2

ROCE = ROE * (EQ/CEQ) - BC (EQ/CEQ-1) = 17%
The growth rate after paying preferred and common dividends will be
G = (1-PR)*ROE * (EQ/CEQ) - BC (EQ/CEQ-1) = 11.6%. So as long as they continue to issue preferred shares to keep EQ/CEQ=2, and everything else stays the same, then they can grow at this faster rate. In reality, of course, nothing stays the same but that is a different matter.

Now what if the economy goes into recession and the loss ratio, L, goes to 2%? Now ROA=-0.12%. It is now slightly unprofitable. ROE=-1.8%. Equity of the bank has contracted by -1.8% before payment of preferred and common dividends. ROCE=-9.6%. The leverage due to the preferred shares has magnified this loss. Common equity has dropped by -9.6%. That is a pretty big hit for just 2% loan losses. The bank will likely cancel the common dividend payment and if this goes on for another couple of years, it will have to raise common capital and dilute the interest of current shareholders in order to keep the leverage ratio below the regulatory limit.

W Holding - Analysis of the 1Q 2008 Call Report

Ok, I finally got some time to go over this. Here is what I see, starting with the income statement. (all numbers in millions, rounded)

Loans rates have reset lower by about 100 bps (from 2007 1Q) but deposits rates have increased by about 26 bps. This is squeezing net interest income. NIM is only 1.28% down from 1.915% 2007 1Q and down from 1.656% last quarter. Net interest income is down 20 from last quarter. This will likely improve next couple two quarters. We would like to see NIM closer to 2%. Expenses are higher by 10 due mostly to legal/FDIC/advisory expenses. I am glad this isn't higher. We lost 7.7 before the tax benefit of 47 but 39.7 after taxes benefit. Additional loss in comprehensive income (i.e. doesn't flow through income statement) of 9.6 probably due to balance sheet restructuring.

Total equity capital is 1097 versus 1072 or a gain of 25. This is $3.43/share of book value.

Securities were completely restructured. It appears that they simply sold most of them and bought some shorter term securities to match their remaining liabilities. Total is 5342 down from 6542 last Q. In addition, they now have 2135 expiring in 3 months or less and another 1025 expiring in one year or less. They also sold or retired all of their structured notes 170.

This reduces assets and combined with the gain in capital, the capital requirement ratios are much improved. The tightest one is still Tot Risk based cap = Tot_risk_based_capital/Tot_Risk_weighted_assets which is now 11.33%. This is above the 10% Well-capitalized level by 146 and 366 above minimum. If after next quarter they do not replace their retiring securities they will be 189 above Well cap. if there is no change in capital. If they make about 30 next quarter,as I expect, they will be 219 above well capitalized. If so they might actually be able to buy back shares. I think they only need a buffer of about 160-180 above Well cap.

Now, Past due and non-accrual. This is actually not looking good. Non-accruals dropped from 481 to 467 but 30 days late increased to 215 from 31. Thus total NPAs increased to 682 from 512. Now some of these will probably be cured but much of it will go into non-accrual. Part of the reduction of Non-farm non-res non-accrual was El Legado. But what about Pueblo, Syroco and others? I was hoping for a larger reduction. Are these loans still in non-accrual or have they been replaced by others? 55 of C&I loans are 30 days late. That is worrisome because they could be ABL loans and could lead to large losses. Construction loans 30 days late increased from 1 to 11. Provisions for the quarter was 30 which is close to what I expected. Overall, it looks like there could be a second wave of losses coming next few quarters as the US recession affects Puerto Rico. Is this what we are seeing in the 30 day lates?

Overall, the report is mixed. The bad news is non-accruals still being higher and 30 day lates increasing sharply. Also the poor NIM due to loans resetting faster is slowing our recovery.

The good news is that we are much better capitalized and this will only get better next quarter. We are still profitable. This is partly due to the tax benefits from our charge-offs offsetting high provisions. Allowance for loan losses is still 217 which will allow for more tax benefits as some of this is charged off. Interest income should improve as deposit costs come down as long as non-accruals do not increase by a lot. We might actually be able to buy back stock. Given that the stock price is 1/3 of book value, this can greatly increase BV/share.

So to conclude, it is a decent report and bolsters my case for holding this stock. We are on track to make 150 for the year which is what Stipes said he expects to do. That would put BV/share at $4.1 and EPS at $0.91 (or 0.7 after subtracting preferred dividends). If so and we get current with the SEC we should sell at around $5/share.

----------------UPDATE--------------

See my posts on profitability. After reviewing this further I no longer think they will make much in 2008. They are being hit on profitability on all fronts: NIM, expenses and loan losses and I don't see these improving much for a few quarters at least. The tax benefit from first quarter is likely much larger than what they will book in the quarters to come. I think it may take them until 2009 to improve substantially. I think they will probably linger around $1 until they get current with the SEC. After that, they will still probably stay around $2 until profitability improves after which they will return to book value. It may take them a few years to get back to $5. Still, this would make them a good long term investment. I think the chance of them buying back any stock is small. Still, they should consider it as long as they can foresee improvements in the future. Even 30MM of buybacks near $1 would increase shareholder value by a lot and probably not endanger capital ratios.

The New Bernanke Dollar

Houses for the banks

What will be the result of this whole housing bubble blow up? I will try to describe the whole thing is very broad terms.

Around 2000, the demand for real estate started to increase rapidly. Demand for real estate comes from three different sources. First of all, a population increase can cause this. There can also be demand from people who want to own more than one house. There can also be a change in preference between renting and buying. The first reason, population increase, has been fairly steady over US history and are not the main driver of the recent housing bubble.

The demand for second homes certainly increased. People, in recent times, think of second homes as an investment. After the stock market crash of 2000, the dot-com blowup, people looked for alternatives to stocks. They noted the wonderful returns that they or their parents may have received by buying during or before the inflationary 1970s. This current demand was aided by the very low interest rates following the stock market crash. The two sources of this were Greenspan's Federal Reserve as well as the "vendor financing" resulting from the rise of the US trade deficit. In short, China sends us products, we send them dollars and they buy US financial assets such as US mortgages and US Treasuries. This helped keep interest rates down leading to a refinancing boom and a boom in first home purchases.

This was the first stage of the housing bubble. The number of homes of course didn't change as rapidly. This change in the supply-demand balance lead to the beginning of the price appreciation bubble. This of course feeds back and enticed more people to think of housing as a good investment which led to more buying.

The next stage of the bubble came from converting more renters into buyers. Traditionally people would rent while they were young and save money for a down payment on a home. This is what I learned when I was young. Typically this would be 20% of a house price. This was demanded from banks to create an equity cushion. Mortgages are non-recourse loans that allow the buyer to simply stop paying the mortgage and giving the bank the right, in turn, to foreclose or take back the collateral. The equity cushion provides the incentive for the buyer to do whatever it takes to avoid default. It also allows the bank to suffer as much as a 20% loss on resale without suffering a net loss.

Due to this dramatic run-up in house prices, the banks relaxed their lending standards to allow for lower down-payments. In addition, since house prices were rising rapidly, they were not too concerned about suffering any loss on the value of the collateral. There was no need for a 20% down payment if the house would be worth 20% more next year. Many of these loans were resold to investors anyway. So it would not be the problem of the originating bank or mortgage originator once it was sold off, if the payments were not made.

The worst of this was the subprime lending industry. Fueled by short-term loans from Wall Street banks, these lenders would give loans to just about anybody capable of fogging a mirror. The lenders were extremely profitable because they could sell off the loans very quickly. A 1% gain on a home loan isn't that great if it takes you a year to do it but if you can turn-over 10 such transactions in a year, that is a 10% annual gain on your capital. Better yet, if you can leverage up your assets to 10 times capital, that is a 100% return on capital. What a business model? So faster turnover from the buying mania and leverage created this wonderful business opportunity. However it depended on insatiable demand for houses as well as a plentiful supply of borrowed money from Wall Street and finally demand for these securitized mortgage products in the secondary market.

All this time, the homebuilders were ramping up their building. There was more demand for homes and so this resulted in higher profit margins. These profits created more capital that could be used to buy more land and build more homes. The end result would of course be a much larger supply of houses.

Home prices rose. Economic activity was vibrant with all this building and buying and selling. There were profits all around. Builders made a killing. Banks made a killing. Even the buyers made a killing if you counted the capital gains on the houses. All of these were extremely leveraged. The buyer bough with little or no money down. Putting down 5% (1/20th of the house) and getting a one-year appreciation of 20% meant a 400% return on invested capital. Who needs to work when you can get returns like that just by signing on the dotted line? Bank loans are always leveraged transactions. They are allowed to leverage their capital by about a factor of 10%. Builders were leveraged as well by borrowing from the banks.

Of course this all had to come to an end. Eventually prices got so high that most people simply could not pay the mortgage payment. They could not even pretend anymore. Monthly payments were as much as twice what it would cost to rent the same house. This was almost 50% of the average persons take home wages. The supply of people that could be converted from renters to buyers or single home owners to second home owners began to dwindle. The excess supply of new homes relieved some of the pressure on home prices.

So eventually home price appreciation stopped. Then the whole process which depended on rising home prices would come apart in dramatic fashion. Now we are in a period of falling prices. Now the total supply of houses is much larger than before. The supply of people willing to speculate on house prices has evaporated. The supply of banks willing to make low down payment loans has contracted. The fact that prices are clearly dropping removes any incentive to buy now. The deflationary mindset sets in. Why buy now when you can buy cheaper next year? The supply of houses for sale is even larger due to a massive wave of foreclosures.

What is the endgame for all of this? House prices will eventually bottom. They will do so when it becomes cheaper to buy then to rent. It will do so when a person can buy a home and rent it out for a profit. The trouble is that this break even point between buying and renting seems quite a ways off.

So who is the winner and loser from all of this? Like all bubbles, this has resulted in a miss-allocation of resources. This results in a inefficiency and so a decrease in GDP. Basically, houses will end up on the balance sheet of banks who will have to auction them off at a loss. So banks will have lost money which will easily erase all of the profits from the proceeding years. People who owned before the bubble will have seen their house value go up and down. Many of these will not be impacted. However, some of these may have borrowed against their home and now find themselves with a much higher debt/equity ratio. They may now have to work longer than they had planned in order to retire and so may spend less in the coming years. Again , this will reduce GDP.

Some people with good credit and secure jobs who bought near the peak will have to pay higher than normal mortgage payments for the rest of the life of the mortgage. Some people may have lost all of their net worth by having bought at the wrong time and now have to sell for whatever reason.

Who are the winners? For every losing speculator there is a winning speculator. Some people who bought and sold at the right time made a small fortune.

Young people and renters are winners. They will in the future be able to buy houses much cheaper. There are a lot more houses now and not that many more people.

A good Zen koan for investing

Joshu asked Nansen, “What is the Way?”
“Ordinary mind is the Way,” Nansen replied.
“Shall I try to seek after it?” Joshu asked.
“If you try for it, you will become separated from it,” responded Nansen.
“How can I know the Way unless I try for it?” persisted Joshu. Nansen said, “The Way is not a matter of knowing or not knowing. Knowing is delusion; not knowing is confusion. When you have really reached the true Way beyond doubt, you will find it vast and boundless as outer space. How can it be talked about on the level of right and wrong?”
With these words, Joshu came to a sudden realization.

—“Ordinary Mind is the Way,” translated by Katsuki Sekida

This is one of my favorite koans. It also has an investing parallel. I have rewritten it as:

Joshu asked Nansen, “What is the way the make money in stocks?”
“Don't try to make money in stocks. Just invest wisely,” Nansen replied.
“Shall I try to seek after great returns?” Joshu asked.
“If you try for it, you will become separated from it,” responded Nansen.
“How can I get rich investing unless I try for it?” persisted Joshu. Nansen said, “The Way to riches is not a matter of trying to get rich or trying to keep from losing money. If you do that you will be bound with fear watching your daily net worth fluctuate wildly. Just invest wisely keeping true to your principles. If you do that you will be rich."
With these words, Joshu came to a sudden realization.

Why people lose money on fast growing companies.

Most people pick stocks like this. First they find what looks to be a "good company". A company that qualifies as a "good company" usually has a high growth rate.

For example people who call themselves "growth investors" will look for a company growing at 40% or so. Maybe it has only been around for two years but grew earnings at 40% both years. They say to themselves. "If it keeps growing at 40% for two more years (and why shouldn't it?) and retains the same valuation, then I will have doubled my money in two years."

Other people who would call themselves value investors or Warren Buffett inspired investors have read all the Buffett books. They take a variation on this. First of all, they look for high and stable return-on-equity, low debt, and a fairly high growth rate, say 20%. Then they look at valuation. They might be willing to pay P/E = 18 for a company growing at 20% and ROE=20% and no dividend. They might use DCF to get the "right" valuation.

Most of these "growth investors" and "value investors" don't beat the market.

The growth investor gets it wrong because they never really trust these growth predictions. They need to diversify into 25 growth companies because they have little faith in each one. Because of this, they do not know the companies very well. Sometimes there is not much to know. They may be speculative at best to begin with. Some do very well and keep growing quickly. Some slow down and lose their high valuation and some simply go bust. They get an average return over long time periods.

The "Buffett investor" gets it wrong as well. They also do not beat the market by much if anything. They may not get big losses because they avoid the speculative bubbles but may have some real dogs. Many of their "good companies" stop being good, drop in value and are sold. What went wrong? They read all the Buffett books. They made sure all had high ROE and therefore probably an economic moat.

What is wrong with the intrepid value investor? I first discovered it by reading this article over at Tweedy Brown, called "Great 10-year record = Great Future, Right?
(You might need to click around for it under research reports). It is a great article, a real eye opener for me. Many of these Tweedy Brown articles are great reads.

The gist of the story is that the earnings growth of companies over the proceeding 5-year period is uncorrelated with the earnings growth the preceeding 10 years. Similarly, the ROE is also uncorrelated. Companies with high ROEs over the 10-year period do not grow faster than the average company. And stock returns are not better for these high ROE companies.

What??!! You mean you can't turn Warren Buffett's performance into a simple formula based on high ROE? Sorry but no. Maybe that isn't surprising to you. After all, there are not many Warren Buffetts around despite everyone reading the books on how to emulate him.

Of course Warren never said it was that simple. He talks about many things including mangement, strong brands or economic moats. He talks a lot about fully understanding the business and being able to predict earnings. He talks about buying only cheap companies which he defines as companies selling below their intrinsic value.

I don't really think there is any great mystery to how Buffett does it. It is simply that he does it better than everyone else. When he says "really understand a business", he sets a higher threshold than most people. That is, he understands their competitors. He understands, whether their costs will likely rise or fall. He only buys companies for which he thinks he can undertstand what the demand for their products/services will be. He looks for companies that have little risk of underperforming his goals. It is these rare companies that he fully understands for which he can predict where they are going to be in 10 years. Once he knows this, he knows the value of the company and if it sells well below this value, it is a buy.

The bottom line is that Warren is hard to emulate because he does a lot of hard work that most people do not or will not do. It takes a long time to analyse an entire industry. Also, he has that rare constitution for investing. He doesn't get spooked out. He has confidence in what he is doing because he knows everything he needs to know. He doesn't get distracted. He doesn't violate his principles. He is of course the complete package, as Michael Jordan was the complete package in basketball. You can read books on how to be like Mike but that won't get you that far without talent.

One last thing about Buffett that I should point out. A rare quality he has is incredible patience. I see dozens of companies that I like and would invest in (and have invested in). Buffett aparently sees none. He has been sitting on $40B for several years and has invested very little of it. Clearly, his standards are much higher than most people. That kind of patience is incredibly rare among investors.