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What I learned losing (almost) all my money

Well, my portfolio has almost completed its life cycle. It started strong, hit a high and then fell off a cliff. So what did I learn losing all my money?

Lesson 1: Don’t trade too much.

When I initially began trading in my account I traded too frequently. Whenever I get access to new capital (if I ever do) I will certainly refrain from trading too much. I was so enamored with my access to capital markets that I would constantly check my portfolio value. This is not something I would recommend.

Lesson 2: Write down the reason for purchasing a security.

Before any decision that is made write down the rationale for the purchase. I believe this lesson is critical to investing. Why a purchase is made should always be written down because the criteria for selling an issue can be decided when the security no longer follows the rationale for the purchase. I think one of the reasons I traded too much was because I failed in explicitly delineating my reasons.

Lesson 3: Don’t buy low liquidity highly speculative equity issues no matter what their balance sheet says.

This lesson might seem highly specific and that’s because it is. I purchased equity in Nova Lifestyle with a majority of my portfolio. I bought Nova because they were extremely well-capitalized. With more cash than market value plus total liabilities, I assumed they were going to initiate a large share buy-back program. However, they did not. Instead they somehow managed to buy inventory at a loss. How a company could be so ineptly managed is beyond me. When I emailed their investor relations they responded by saying “the company sees a turnaround in their business, this said, it would be best to utilize their capital for inventory”. Yet they still managed to buy inventory for less than they paid for it. I am almost certain that they are either lying on their balance sheet now or are incredibly corrupt. To avoid this mistake in the future, it would probably be in my interest to check with their management to ensure their statements are accurate.

Lesson 4: Don’t fall for the narrative fallacy

Just because there’s a good story for a security doesn’t mean you should buy it. Unless… actually there is no caveat.

Lesson 5: Write down the reason for selling the security.

It is only with a record that improvements can be made. While on any particular bet it is possible to be lucky and unlucky the logic behind the bet is important. It is in this way, through maintaining a history, that writing can help improve future decisions.

Lesson 6: Don’t assume there is only one way but stick to one anyways

John Maynard Keynes traded securities and made millions by accurately predicting crowd behavior before the crowd. Warren Buffett and Benjamin Graham are on the opposite side by ignoring what Mr.Market thought of securities and focusing solely on the underlying business. Both approaches are successful, in making money, but don’t switch approaches in the middle of an investment.

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Just Bet on Oil

I am sure everyone has seen the markets lately. It’s an American tradition to stare at our portfolios watching them go (gleefully) up and (painfully) down. I’m sure today most of us were pleasantly surprised when the markets finished up 6% today. My portfolio returns however were dismal, why? Because of oil. Sure the broader market was up but oil fell around 8% today. I believe these depressed oil prices are temporary. Saudi Arabia is undercutting all other producers and is ramping up production from 9 million barrels to their maximum capacity of 13 million barrels a day. The increased supply from both Saudi Arabia and Russia amidst lower global demand -because of the Coronavirus – are pushing oil prices to impossible low prices. Oil is trading at below $30 a barrel. Saudi Aramco can profitably sell oil above $9 a barrel, however, to fund their government without dipping into their cash reserves they must sell oil at $80 a barrel. These two price points offer us some clue as to how far oil prices can drop. Also, Russia is producing around 11 million barrels per day at an average cost of around $20 a barrel. Thus, while both nations are still profitable at these depressed prices Russia is unlikely to continue producing at these massive quantities if oil drops below $20 a barrel. So I believe it is safe to assume that $20 is a floor for the price of oil.

What about the companies that produce oil? I believe that the large globally integrated oil and gas players like Chevron, Royal Dutch Shell, and Exxon are very well positioned to weather this crisis. All of these companies are well-capitalized and can easily handle a depression in oil prices. If anything the sell-off of all energy stocks probably represents a good buying opportunity for these securities. Additionally, refiners such as Valero will probably do better. Considering the high volumes of crude oil being produced, Valero will probably experience more business than usual. Donald Trump has also spoken about continued American energy dominance. His affinity for the industry is probably indicative of fiscal support if American companies have to deal with depressed oil prices for a prolonged period.

In all honesty, I am not well versed in the oil industry. It would probably behoove me to educate myself on its workings and I probably will over the coming weeks. However, given how unprecedented these low oil prices are, I believe it is still prudent to bet on oil.

In other news. There is a rumor of an $800 billion fiscal package coming soon. Supposedly this package will include, among other things, direct cash payments to American Adults. I believe this fiscal stimulus will probably be more beneficial to economic growth than purchasing distressed financial instruments like in ’08. Most of the cash is supposed to be given to low-income Americans. This sort of cash injection will lead to more discretionary spending as low-income Americans tend to spend more as a proportion of their income than higher-income Americans. Considering that consumer spending has driven American GDP growth for the past decade, this policy will more likely increase economic activity than the asset inflation that resulted from the fiscal stimulus package distributed during the great recession.

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So the market happened…

Today, the market dropped 13%, just in case you were unaware. What does this mean for you? Well, it means you’re much poorer than you were a few days ago. Okay. That’s probably not what you wanted to hear. However, the exogenous threat of the Coronavirus is most likely a temporary threat to equity prices. The market is already predicting this depression in equity prices is temporary. Long term future contracts are still trading at a premium implying the market is predicting a quick recovery from the economic slowdown. However, considering the slow response by the U.S. government and other European nations, to the Coronavirus, there is a nontrivial chance this crisis becomes an extended crisis.

You might be asking: “What is the Federal Reserve doing?” Well, the Fed is over here printing money. They announced an emergency rate cut to zero percent, joining other major central banks, and have said they will purchase $500 billion in treasuries and $200 billion in mortgage-backed securities. All of this will help later… maybe… only when the Coronavirus and the pandemic of fear are contained.

So what are my ill-fated projections for the future? I believe the markets will continue their slide. Economic activity in the United States is coming to a standstill and there seems to be no shortage of bad news. I also believe that global economic activity will decline for a couple of quarters. While the speculators among us are freaking out, the investors are probably considering the long term ramifications of the crisis and might see these pull-backs as a buying opportunity. However, even with a 13% decline in equity prices, the market is still overpriced from a historical perspective. Although in the era of low-interest rates these higher Price-to-Earnings ratios are the new norm and therefore these huge dips warrant a buying opportunity for many securities. Also, I believe the heightened volatility the markets are displaying is symptomatic of the increase in algorithmic traders. These computer algorithms account for a huge proportion of daily trading volumes and seem to all be pushing downwards.

The “Black Swan” by Nassim Nicholas Taleb, suggests that most algorithms use a gaussian or standard distribution in their calculations for risk. Considering this exogenous shock if probably too many standard deviations from the mean to even be included in their measurement of risk, these volatile trading days are probably reflective of those poor models. I believe that these little dips are minor over the next decade and probably do not warrant any cognitive capacity on your part. Therefore if you don’t need money for the next decade just do not look at your 401(k) and you should be fine.

On a side note it seems clear who’s going to win the 2020 election now. With the economy being the only positive thing for Trump, it seems inevitable that Joe Biden will become our next president. Perhaps this is a little too early for such declarations, but if I’m right, you heard it here first.

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The new Era

Who knew it would take a pandemic to take down the bull market? I had an inkling that the Corona Virus would take down equity prices a little but not like this. When I read Sequoia Capital’s letter to their startups warning that the Coronavirus was the “Black Swan” of 2020, I immediately thought of Nassim Nicholas Taleb’s book of the same name. So what did his nearly two decade old book have to say about the crisis at hand? Before I share his advice, there must be a universal understanding of the environment at hand.

The first and principal condition that investors must consider is the novel (new) Coronavirus and it’s potential ramifications, which we’ll discuss below. The second condition that must be considered, albeit to a lesser degree, is the oil price war. However, the oil war is only an idiosyncratic concern with regards to some very specific equities.

The ramifications of Covid-19 (the disease caused by the new Coronavirus) have both social, political, and economic consequences. The numbers coming out of South Korea and Italy, both democratically elected governments, indicate two different worlds. South Korea, with more than eight thousand cases as of March 15, has a case fatality rate of about 1%. While this mortality rate is 10x deadlier than the flu, and still very concerning, it would not decimate economies as markets are predicting. Italy’s story however is extremely concerning and warrants the reaction that has been taking place across Europe and the United States. With more than twenty-four thousand cases and eighteen hundred deaths, Italy’s mortality rate with Covid-19 is 7.5%, as of the same date. With a mortality rate 75x the flu, the markets are underreacting to the possible damage of Covid-19. So if this virus is between severely damaging or just a severe flu season what does this mean to the investor?

The investor buys when the value of a security is prejudice-ly sold below its true value. However, with regards to the broader market, this has not happened. Price-to-Earnings multiples are still at all time highs and the market is not correctly reflecting the true risk posed by Covid-19. A 7.5% mortality rate is on par with the Spanish Flu of 1918-20, which killed more than 70 million people. If the conditions Italy has been subjected to becomes pervasive, the World will experience a global recession worse than the financial crisis. This disease will stifle consumer demand and prevent production to continue. Both of these factors will invariably depress economic growth until a vaccine is found. Because this exogenous threat is not purely anthropomorphic, like the financial crisis, it will NOT be resolved quickly. The investor should prepare for a prolonged period of declining economic activity and have cash on hand to purchase securities when markets drop further.

But what did Nassim Nicholas Taleb have to say about this scenario nearly twenty years ago? He said maximize the NUMBER of bets that have the possibility of a positive black swan. What does this mean in practice? Consider the current black swan of a novel virus. Companies that produce disinfectants have more business then they can handle. Teleworking companies like Zoom have exploded in market value. These opportunities could have been realized by purchasing call options with a very high strike price. In this way, the possibility of realizing a very large positive payoff could be gleaned without risking too much capital. This same consideration could be applied to the second economic condition markets are operating in: artificially low oil prices. The positive black swan in this scenario is a large rebound in oil prices. Exposure to this considerably high probability black swan could occur through purchasing call options on an oil ETF with a high strike price. This way we are risking minimal capital with a potentially huge payoff.

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My take on the current Economic Environment

The S&P 500 keeps going up and the Dow is about to hit 30,000. Equity prices have been on a tear. Last year the S&P was up 22% but profits remained steady. Why is this? I believe that the low interest environment created by the European Central Bank (ECB), Federal Reserve (Fed), and Bank of Japan has forced investors to reach for yield. Additionally, because of low global economic growth these central banks have an incentive to keep interest rates low, even negative. These low interest rates lead to an increase of liquidity. With so much liquidity in the marketplace just sloshing around, investors keep bidding up the prices of equities.

There are many problems with these levels of liquidity. First, their are clearly very limited opportunities to deploy this capital in effective ways. Venture Capitalists used money to seed new ideas, but these ideas are still largely unprofitable (Uber, WeWork). The implication is investors are so desperate for yield they are willing to set cash on fire. Because investors are no longer naive about futuristic ideas, they are buying what they’ve always bought: Common stocks.

The use of this capital to purchase equities is problematic. The capital does not improve productivity, yet people assume there is strong economic growth because of the rise in equity prices. This creates a cyclical effect of people continuing to bid up the prices of common stocks because of the recent rises. But the premiums placed on common stocks looks permanent. With so much capital unable to be deployed in improving productivity, it is forced into the stock market. Until a credit crunch, asset inflation and general market returns look inevitable.

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Nothing Like Experience

It’s really easy to read and understand the theory behind the market and various phenomena with regards to equities. But you know what’s really difficult? Actually investing. I’m sure this is well known, but there is a big disconnect between your own capital and reading about others. I wrote a blog post in 2018 about three equities: Amazon, Snapchat, and Berkshire. Snapchat tumbled but recovered. Amazon, went berserk and crushed everyone. And well, I still own Berkshire. The point is capital should stick in one place. Continuing to change asset allocation is dumb and difficult not to do. However, I’ve left most of my capital in one spot for my own detriment. See I no longer think past methodologies of finding cheap companies are valid. Mega-cap companies keep becoming more richly valued even as their profits stay the same. Asset Inflation anyone??? But some of these really cheap (current working assets: liabilities) micro-cap companies continue to underperform. Maybe the market in the long run really is a weighing machine, but when do I know if I really am a hundred pounds and not a thousand?? Wow waiting is difficult, very difficult. People might underestimate Buffet but they are wrong. I mean seriously, it is amazing the type of conviction you must maintain to hold a position for forever. Maybe I just lack the same belief in my accuracy that Buffett had. Who knows??

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Nova Lifestyle is a cigar-butt investment

As I was reading the Little Book of Behavioral Investing by James Montier (which I highly recommend) I came across a passage that described my investment in Nova Lifestyle NVFY: (%) perfectly.

Warren Buffett has described Ben Graham’s (his mentor) investment style as cigar-butt investing – that is, buying really cheap stocks almost regardless of the underlying industry economics, and then selling them when they get close to intrinsic value.

Montier 2010

Nova lifestyle is a clear example of a cigar butt company and both my initiation and planned future exit were dependent on the market realizing their intrinsic value not any growth on their part.  The company has a cash balance of close to $50 million and market capitalization plus total liabilities is a little over $28 million. This implies that if the company were to shut down operations tomorrow, equity holders would receive a 52% premium on their holdings.  Management announced last Tuesday that they would begin using their cash to repurchase shares. I believe management will continue to allocate cash to increase their share price bringing it more in line with intrinsic value.

Yes, the company is undervalued.  Yes, the upside is not trivial (>52%).  Yes, management is correctly allocating capital to improve the share price.  However, there are some risks inherent with an investment into Nova Lifestyle.  Firstly the company is a nano-cap corporation (market cap under $50 million). This confers a large amount of volatility and uncertainty regarding their share price and accuracy of their books.  Secondly, the allegations of fraud by Andri capital on Seeking Alpha was disquieting. Although Nova hired an independent auditor to look at the books and the actions taken by Andri were diametrically opposite of their stated position it is still difficult to look past.

Conclusion: The potential to almost certainly double your money when the market becomes rational far outweighs the (probably false) allegations of fraud and its extreme volatility. The only major foreseeable risk to an investment in Nova Lifestyle is ourselves. In order for an investment in such a volatile security to be successful you cannot react to its volatility and must stick to your understanding of its underlying fundamental.

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Why I liquidated SPY

Recently I liquidated my holding in SPY realizing a decent return. Why did I choose do this? Well, my investment philosophy, which is closely aligned with Buffett’s (hopefully), is rooted in investing for value. Purchasing companies that are trading at a substantial discount to intrinsic value, book value, or earnings is central to this philosophy.  In my opinion, SPY has become overvalued and other opportunities warrant the capital originally allocated to it.  For example, Mazda Motor corp is trading at a discount to book value by nearly 30% and has a stellar balance sheet.  Another great opportunity is Intel, which is trading at 12x earnings and 3.2x book value compared to 23x earnings and 3.35x book value to SPY.   

You might be asking how do I reconcile my decision to liquidate my position in SPY while I continue to own equity in Alibaba and Tencent.  These holding do not represent value in the traditional sense, but their competitive “moat” makes up for these shortcomings.  Alibaba and Tencent dominate the Chinese domestic market, the second largest in the world.  While, both companies trade at a premium to earnings their competitive advantages compensate for this premium.  However, their shares are hovering close to a value that represents too large a premium and may have to be liquidated soon. 

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Why Mazda Motor Corporation is a good investment

When buying a company as an investor you take a risk.  As a value investor, we try to mitigate these risks by understanding the underlying value of a company.  If a company were to liquidate, their value in liquidation would be determined by their net tangible assets or their net asset value. By understanding the net tangible asset value, we can determine what our margin of safety is.  If a company’s market capitalization is lower, then it’s net asset value it is trading at a discount.  If a company’s net tangible assets are double the market capitalization of the company that means for every dollar of equity you buy you get $1.5 in assets.  That represents a 50% return on capital.  Therefore, Mazda MZDAY: (%) represents an attractive investment at its current price. I will liquidate my position in this company after its market capitalization reaches its net asset value.  At a 50% discount on tangible assets, I would be hard pressed to find a more attractive use of my capital.