per a 2006 Bloomberg video, Tom Demark recommended using TD Aggressive Sequential and TD Aggressive Combo in order to “get in” more trades. You may not get in (or sell out) right at the bottom (or top) but it is still a low-risk entry or exit.
Description:
Normally the TD Countdown compares the Close to the Low or High (for Buy or Sell) 2 bars prior.
For TD Aggressive, compare the Low to Low, or High to High 2 bars prior. (ie. replace Close with Low or High)
DailyDeMark here… I want to make a comment that was made by Marie on the previous page. You absolutely must not trade the Setup 9 count based purely on the “perfection” setup. There is a 3rd requirement not discussed by anyone here: That requirement is that the current TD Setup must not break through the TDST line that was established by the previous TD Setup in the opposite direction.
I.E.
XYZ records a TD Sell Setup. The lowest low of that Setup period is $50/share – that puts the TDST price line at $50/share. Current price is $60 share. XYZ moves into consolidation mode and then shows weakness. A sell off occurs and a TD Buy Setup occurs. When the 9 bar closes, price is at $55 share. The new TD Setup (a Buy Setup) did not have sufficient momentum to break through to the downside of the TDST line at $50.
DeMark suggests that this is the only time you trade a Setup 9 count. He would suggest that there will be a reversal to the upside.
Remember, the TD Sequential is not only a price analyzer but a real-time momentum indicator. That is why you cannot trade a 9 count only. A TD Setup demands a high degree of momentum,an amount of momentum that rarely is followed by an immediate reversal. If you look at the NASDAQ ETF QQQQ since late May, there have been three completed setups. All of them were immediately followed by a very brief period of consolidation or weakness… followed immediately by another Setup. You would have lost money each time.
One more note… do not trade against the Sequential trend that is a factor of five above your trading time frame. If you are trading daily bars, check the trend on Weekly bars. If you are trading 15 minute bars, check the hourly bars for the trend. Do not trade against the trend. Common sense.
via Forex-Strategies-Revealed
via “IMPRESSIVE SIGNALS FROM DEMARK”
THE TECHNICAL ANALYST
September/October 2004
“I recall that a recent backtest of the Sequential signals showed them to be around 70% accurate. DeMark is essentially a risk-reward strategy and its stoploss positioning means that even when the indicators occasionally underperform, losses are cut to a minimum. In my experience, the TD Sequential Indicator is more than 70% reliable; it is closer to 90%.” – Kurt Magnus, head of foreign exchange sales at Westpac bank in London
The DeMark Sequential Indicator
Magnus uses Bloomberg charts whose software automatically recognizes and displays TD Sequential Indicators as prices change from day to day. The Sequential is perhaps the most commonly used DeMark indicator and has an impressive record of identifying and anticipating turning points across the FX, bond, equity and commodity markets. Furthermore, the indicators provide signals not only on a daily, weekly
and monthly basis but also intraday. The Sequential Indicator identifies when a trend is becoming, or has become, exhausted. On daily charts, for example, DeMark identifies precisely which day to enter into a new position or liquidate an existing one. This total absence of ambiguity with regard to market timing makes the Sequential stand out. Using the indicator does require a leap of faith however, as signals often appear prematurely. As such, a buy signal may appear before a downtrend has completed so the trader may have a nervous ride before the market finally turns. Magnus warns that it is crucial the indicator is properly understood. “Unless you understand exactly the maths behind the signals, you can make costly errors. There are only two guys in the London FX market who can explain these signals with authority. Jason Perl at UBS in London and I often talk to make sure we get it spot on.”
Setups
The TD Sequential Indicator consists of two patterns, a TD Setup and a TD Countdown. Setups are the shortest in duration, lasting for exactly nine price bars when completed. For example, a buy Setup exists when there have been nine consecutive price bars in which each bar’s close is lower than the close four price bars earlier. When a price bar closes below that of four price bars previously a ‘1’ appears below the bar. If the next price bar also closes below that of four bars earlier a ‘2’ appears and so on. These appear in Figure 2 in green, a chart of EUR/USD from February to May ’04. If before price bar 9 is reached a price bar fails to close below that of four bars previously then the Setup is abandoned and the numbers are automatically deleted. Once nine consecutive price bars have been completed the trader will be looking for a “perfected” Setup; one that is now valid for trading. A buy Setup is perfected when the low of either price bar 8 or 9 is less than the lows of both price bars 6 and 7. Perfected sell Setups look for a high of either price bar 8 or 9 that is greater than the highs of both price bars 6 and 7. Figure 2 clearly shows perfected sell Setups in February and April marked with a red arrow.
Countdowns
A TD Countdown occurs after a completed Setup. A buy Countdown consists of thirteen price bars whose close is lower than or equal to the low two bars earlier. The corresponding numbers appear below the price bar. Unlike the Setup, a Countdown doesn’t have to consist of consecutive days. The Countdown is a bigger pattern than the Setup in that it can take months for a Countdown to form and often signifies a larger market move once the trend changes. Like the Setup, the Countdown also has “perfection” criteria. For a buy Countdown this requires that the low of price bar 13 be less than or equal to the close of price bar 8. Similarly, sell perfections require that the high of price bar 13 be greater than or equal to the close of price bar 8.
Note: Mistake under ‘TD Countdown – Sell Signal’: should read: “13 price bars where each close is greater than or equal to the HIGH 2 price bars earlier”
By DeMark, Tom
Publication: Futures (Cedar Falls, Iowa)
Date: Tuesday, April 15 1997
Originally designed for daily analysis, Tom DeMark’s TD Sequential indicator also works for intraday analysis. It is effective for especially targeting high- and low-risk entry points.
When I entered the investment business more than 25 years ago, volume on the New York Stock Exchange was approximately 6 million shares a day. Stock quotations appeared on a ticker tape, and futures quotes were on a large wallboard.
I did my market timing research by poring over weekly printed charts with a magnifying glass. Analysis was limited to conclusions regarding daily price activity because intraday price data were not available until the 1980s. As such, once it became available, I was pleasantly surprised to see that the TD Sequential worked on intraday price movements as well.
My research showed price movement of most markets displayed a natural rhythmic motion that could be measured by a combination of factors that either compared closing price levels or closing prices with extreme price highs and lows. Simply put, TD Sequential consists of three distinct stages: setup, intersection and countdown.
Setup
The initial setup phase consists of a series of at least nine consecutive closes less than the close four trading bars earlier for a buy setup and at least nine consecutive closes greater than the close four trading bars earlier for a sell setup. Setup establishes the environment or the context for the market and determines whether a trader should be looking to buy or sell the market.
I have added a caveat to the phrase “The trend is your friend.” It is “…unless the trend is about to end.” At that point it is not prudent to trade with the trend. Most of my market timing indicators, as is the TD Sequential, are designed to anticipate trend reversals.
Intersection
Once the setup series has been defined, I review price activity beginning on day 8 of setup to determine whether the setup process has been perfected and countdown can begin. To accomplish this, I require a phase I refer to as intersection.
Intersection requires the high of bar 8 of a buy setup be greater than or equal to the low of bars 5, 4, 3, 2 or 1 of the buy setup. If this requirement is not met, then the high of bar 9 of the buy setup must be greater than or equal to the low of buy setup bar 6 or any other price bar back to bar 1 of the buy setup. If this is not fulfilled, then each successive price bar is compared until its high is greater than or equal to the low of the price bar three or more price bars earlier back to bar 1 of the buy setup.
For intersection to occur in a sell setup, the low of setup price bar 8, 9 or the first subsequent bar must be less than or equal to the high three or more price bars earlier all the way back to bar 1 of the sell setup.
Intersection is a required step because it assures that the rate of decline or advance is decelerating sufficiently to enter the final phase, which is countdown.
Countdown
TD Sequential buy countdown consists of a series of 13 successive closes less than or equal to the low two price bars earlier. Once that has been accomplished, the market generally is in a low-risk buy entry zone. The TD Sequential sell countdown consists of a series of 13 successive closes greater than or equal to the high two price bars earlier. This generally indicates a low-risk sell entry zone.
Whereas setup requires the price comparisons be maintained consecutively, countdown does not apply such restrictions. To prevent high-level, low-risk buy countdown 13 entries and low-level, low-risk sell countdown 13 entries, I’ve installed the requirement that day 13 of a buy countdown be postponed until it occurs below day 8 of the buy countdown and, conversely, that day 13 of a sell countdown be postponed until it occurs above day 8 of the sell countdown. “Recycling” is a concern that could arise in a strongly trending market. Generally speaking, if a subsequent setup occurs prior to completion of countdown, then a new countdown process must begin.
TD Sequential in action
The TD Sequential is versatile over various time frames. The charts of the March 1997 S&P 500 Index futures contract on Jan. 23 (“Market fall,” left) show the contract declined from approximately 800 to 773, roughly a 27-point collapse, in 1 1/2 hours.
To demonstrate the sensitivity of the TD Sequential to identify the exact high and low on the chart to the minute, I’ve applied it to this time period. The respective sell count-down 13 and buy countdown 13 are not levels of entry; rather, they accurately define levels of low-risk entry. “Market fall” provides you with a perspective of how the price top and bottom were formed.
“Closer look #1 and #2” (left) magnifies the sell setup period and the buy setup period to illustrate the simplicity in calculating the respective price setups and countdowns. Note that, in the case of the market advance, I insert both setup and countdown numbers above the price bar and, conversely, in the case of a market decline, the numbers appear beneath the respective price bars.
Furthermore, it is apparent in “Market fall” that, coincident with the completion of the ninth bar of the sell setup (a series of nine or more consecutive closes greater than the close four price bars earlier), price has a tendency to retrace. A similar occurrence is observed at 1:45 p.m. when the ninth price bar of sell setup is recorded.
Buy setups demonstrate a similar behavior only in reverse. At approximately 1:15 p.m. the ninth price bar of buy setup (a series of nine or more consecutive closes less than the close four trading bars earlier) was recorded, and prices subsequently rallied. A similar event took place at 2:10 p.m.
However, not every setup elicits such a response, as you can readily see at 2:35 p.m. when the ninth bar of a buy setup failed to generate any price movement to the upside.
To demonstrate the application of TD Sequential to other markets and time periods, I’ve included a five-minute chart of May 1997 coffee futures in “Coffee TD Sequential” (right), which identifies a TD Sequential high-risk buy countdown completion just prior to the Feb. 20 early morning price peak before a 10-point plus decline.
Also, in “Longer count” (right), the March S&P 500 Index futures chart on a 10-minute basis, I identify the TD Sequential nine-13 high-risk buy indication on Feb. 19, coincident with the price peak.
Although TD Sequential has worked effectively on a daily basis for more than two decades, only within the last five years has it become apparent that this technique can be applied to intraday price charts as well. Because it originally was designed to be applied to longer time periods, its ability to identify high- and low-risk entry zones on an intraday basis is a testimony to its adaptability and dynamic design.
Tom DeMark is president of Market Studies Inc., a provider of indicator software for most major quote vendors, a consultant to large fund managers and author of The New Science of Technical Analysis
The Bear: Richard Russell
via Prieur du Plessis
With stock markets tanking around the globe, one would be remiss not to take note of Richard Russell’s view of the selloff. The 85-year-old dean of newsletter writers and author of the Dow Theory Letters, said:
“… something dramatic lies ahead. I believe we’ve been experiencing a rally within a continuing primary bear market. Over recent months, I’ve warned that the rally shows signs of topping out. If or when a bear market rally tops out, the losses can be horrific. At this time, because of the profusion of ‘rosy’ news stories about the economy, many amateurs and ignorant fund managers have loaded up again with stocks, thinking that they can recoup some of their 2008–09 losses.
“If this entire bear market rally is fated to fall apart, the losses and troubles will be fearful and traumatic. This is true because I’ve never seen a time when so many people were unprepared to withstand a crumbling market or a sinking economy.
“From what I gather, most players believe that yesterday’s [Thursday’s] ‘sell-off’ was a direct result of the mess in Greece. Maybe so, but that seems too simple and obvious to me. The far more important question is whether the entire advance from the March, 2009 low is fated to be wiped out. At this time there’s no way of knowing, but I suggest that we play it safe. My suspicion is that the stock market is back in the grip of the bear. If so, we could be entering the Elliott C or the second major wave down. I hope I’m wrong on this, but if I’m right I don’t want to find out while holding even a few stocks.
“Hope for the best, but be prepared for the worst. If this is the bear market’s final wave down, we’re going to see one of the worst markets any of us has ever seen. Just as bad, it will be a forecast of hard times ahead, and a nasty resumption of the recession (or depression).
“The boy scouts motto – ‘Be prepared.’ Better believe it.”
Although stock markets now appear oversold as far as short-term indicators are concerned, weak markets can stay oversold for a while. Looking at longer-term (monthly) data, it is premature to argue that the end of the U.S. cyclical bull market has ended, but a worrying picture emerges when considering the Shanghai Composite Index. Not only has the Index broken below its key 10-month (200-day) moving average, but the momentum oscillator (ROC) in the bottom section of the chart below has fallen below the zero line which indicates a primary bear signal. The Chinese stock market was the first to turn the corner after the credit crisis sell-off – a full five months before the majority of indices bottomed in March 2009 – and could also now be leading global markets lower. Be careful out there.
The Bull: John Paulson
via CNBC
John Paulson, the hedge fund manager who made billions by calling the U.S. housing market plunge, now sees good times ahead for U.S. home prices and corporate profits. And he says the country is in the midst of a strong V-shaped economic recovery.
According to CNBC, Paulson has told investors he expects housing prices to rise 3% to 5% in 2010 and another 8% to 12% in 2011. He says that homes are the most affordable they’ve been in 50 years, and that residential real estate is 60% more affordable than it was at the housing bubble’s peak.
Paulson “also sees buying opportunities in U.S. and European equities, even though the consensus about Europe is generally downbeat,” CNBC reports, adding that Paulson predicts “very strong” corporate earnings growth in the months ahead. And his fears of a double-dip recession for the U.S. have sharply decreased since the start of 2010.
Banking Problems..
via John Hussman
With regard to credit issues, some remarks by Meredith Whitney from a Bloomberg hedge fund conference last week are notable (if familiar):
“If you look at what happened last year, I would say a vast majority of the banking sector’s profits and capital creation was government induced. In the first quarter, it’s highly arguable that certain companies wrote up assets. People lowered their provisions on losses.
“What has kept home prices stable – and make note that politicians and banks are eating their own cooking because they really believe home prices are stable – they’re stable because there’s been a ton of inventory kept from the market. So if you control the supply, you can control the price without controlling the demand.
“Here’s a statistic that I find fascinating. This is just for the top four banks. If you look at nonperforming assets – that’s loans that haven’t paid over 120 days – the size of that is 1.5 times all of the chargeoffs that banks have incurred since 2005. So you think credit has stabilized, mortgages have stabilized? Non-performs have ballooned so they’ve more than doubled since the beginning of 2009, and that’s just stuff that has to start going on to the market, and interestingly, this quarter you’re starting to see housing supply reach the market. That to me triggers another down leg in housing, so to me, I’m steadfast in my belief that there’s going to be another double-dip in housing
“There’s huge growth in non-performing assets. These are numbers, apples-to-apples, on the four big banks. The issue is when does that stuff that’s not paying come to market, and when do banks recognize the chargeoffs? I think you’re going to see more of that in the second quarter and the third quarter. Does the supply move in the second quarter and then you report it in the third quarter? The timing may be weighted more to the third quarter. I just don’t know. I think you see a huge leg down in asset prices when you see the supply reach the market. So no, it’s not factored into valuations. No, it’s not factored into bank guidance. And yes, I think it’s going to be a big problem for the banks.”
via John Hussman weekly commentary
On Sunday, the IMF approved its 30 billion portion of the 110 billion euro bailout package for Greece – the remaining funds to come from the European Union. The reason for all of this cooperation, of course, is that Greece has enormous debt that is owed in the euro, a currency that it cannot devalue. For many years, Greece has allowed government spending and wage agreements to grow rapidly, thanks to ability to borrow in euros as if it were little different from Germany or France. Unfortunately, the Greek economy faces a debt burden that its economy is now unable to service. If Greece were not part of the European Monetary Union and its debt was denominated in drachmas, it would be able to satisfy its debts by devaluing its currency, essentially making Greek goods, services and wages worth less in terms of foreign goods, services, wages and currencies. In other words, it could alter the relative price of Greek labor and output, imposing extreme cuts in government spending, and without inducing what amounts to an internal deflation. Since this is not possible, keeping Greece as part of the European Monetary Union requires it to impose extreme austerity toward its own citizens, which has predictably led to strikes and rioting. Greek debt problems also predictably imply problems for the European banks that have lent to the country.
The bailout package for Greece should keep it from having to tap the open market for capital for about 18 months. Yet it is hard to look at the possible trajectories of Greek output, deficits and debt without concluding that a debt restructuring will ultimately be necessary – meaning that owners of Greek debt are likely to receive only a portion of face value. What European leaders seem to be attempting is to buy Greece more time, essentially to smooth the potential amount of this restructuring and its impact on the banking system, perhaps three or four years from today when, hopefully, Greece has smaller deficits and the ability to operate without new borrowing.
While this is a hopeful scenario, backward induction is not kind to it. In Game Theory, there’s a technique called “backward induction” that is often used to identify the likely outcome of a game that is repeated again and again for multiple periods. Essentially, you evaluate what would be the best move for each player that would be optimal in the very last period, then assuming those moves, you evaluate what the optimal moves would be in the next-to-last period, and so on to the beginning of the game.
Put yourself in the position of a holder of Greek government debt a few years out, just prior to a probable default. Anticipating a default, you would liquidate the bonds to a level that reflects the likelihood of incomplete recovery. Working backward, and given the anticipated recovery projected by a variety of ratings services and economists, one would require an estimated annual coupon approaching 20% in order to accept the default risk. For European governments and the IMF to accept a yield of only 5% is to implicitly provide the remainder as a non-recourse subsidy. Even then, investors are unlikely to be willing to roll over existing debt when it matures – the May 19th roll-over is the first date Europe hopes to get past using bailout funds. In the event Greece fails to bring its budget significantly into balance, ongoing membership as one of the euro-zone countries implies ongoing subsidies from other countries, many of which are also running substantial deficits. This would eventually be intolerable. If investors are at all forward looking, the window of relief about Greece (and the euro more generally) is likely to be much shorter than 18 months.
Still, for Greece, it appears that the IMF and EU will provide the funding for the May 19th rollover of Greece’s debt, so there’s some legitimate potential for short-term relief. The larger problem is that Portugal and Spain are also running untenable deficits (think of Greece as the Bear Stearns of Euro-area countries). European officials deny the possibility of contagion that might call for additional bailouts, but my impression is that Greece is the focus because its debt is the closest to rollover. The attempt to cast Greece as unique is a bit strained – Christine LaGarde, the French finance minister suggested last week “Greece was a special case because it reported special numbers, provided funny statistics.”
In other words, Greece gets the bailout because it had the most misleading accounting?
The bottom line is that 1) aid from other European nations is the only thing that may prevent the markets from provoking an immediate default through an unwillingness to roll-over existing debt; 2) the aid to Greece is likely to turn out to be a non-recourse subsidy, throwing good money after bad and inducing higher inflationary pressures several years out than are already likely; 3) Greece appears unlikely to remain among euro-zone countries over the long-term; and 4) the backward induction of investors about these concerns may provoke weakened confidence about sovereign debt in the euro-area more generally.
Despite the potential for a short burst of relief, the broader concern about deficits in the euro-area make it unlikely that global investors will be appeased by a large bailout of Greece, or will go forward on the assumption that all is back to normal once that happens.
Lending information source: https://www.sambla.se/samla-lan/
Restructure, Restructure
Looking at the current state of the world economy, the underlying reality remains little changed: there is more debt outstanding than is capable of being properly serviced. It’s certainly possible to issue government debt in order to bail out one borrower or another (and prevent their bondholders from taking a loss). However, this means that for every dollar of bad debt that should have been wiped off the books, the world economy is left with two – the initial dollar of debt that has been bailed out and must continue to be serviced, and an additional dollar of government debt that was issued to execute the bailout.
Notice also that the capital that is used to provide the bailout goes from the hands of savers into the hands of bondholders who made bad investments. We are not only allocating global savings to governments. We are further allocating global savings precisely to those who were the worst stewards of the world’s capital. From a productivity standpoint, this is a nightmare. New investment capital, properly allocated, is almost invariably more productive than existing investment, and is undoubtedly more productive than past bad investment. By effectively re-capitalizing bad stewards of capital, at the expense of good investments that could otherwise occur, the policy of bailouts does violence to long-term prospects for growth. Looking out to a future population that will increasingly rely on the productivity of a smaller set of younger workers (and foreign labor) in order to provide for an aging demographic, this is not a luxury that our nation or the world can afford.
“Failure” and “restructuring” mean only that bondholders don’t get 100 cents on the dollar. We can continue to bail out the poor stewards of capital who voluntarily made bad, unproductive investments, and waste our future productivity in order to make those lenders whole, or we can turn the debate toward deciding the best strategies for restructuring existing debt.
Eric Janszen has gotten the big picture right on the economy/stock market since 1998. He thinks the current rally is just a Bear Market bounce, and will soon be over.
The First Bounce of the Debt Deflation Bear Market has gone on for four months longer than we expected. Will it end with a down-for-the-count crash or a correction followed by quick recovery? What will end it? Rate hikes by the Fed? The escalating sovereign debt crisis in Europe? A banking and financial crisis in China’s credit bubble economy? The next Peak Cheap Oil recession? Our answer: All of them, and pretty much all at once. If you thought the 2008 crash was bad, wait until you see the next one.
Click to Continue reading: The Next Crash – How the First Bounce of the Debt Deflation Bear Market ends
Declines in Year 2 often Precede Year 3 Gains
The next six months will be interesting to watch. With investors showing confidence in the nascent recovery and above-average valuations now priced into stocks, the market is now heading toward a part of the calendar that historically has delivered weak returns to investors.
A few years back, I noted how the most distinct election cycle returns don’t actually overlap with the calendar year. While the average return during the third calendar year of a presidential term is above average, the twelve-month period beginning with the fourth quarter of the second year of a presidential term is the true standout. Going back 60 years, the average annual total return for the S&P 500 during this period has been 28 percent.
Many causes have been offered up to explain the election cycle performance, usually focusing on fiscal or monetary policy decisions. But when you look through the economic data, strong and dependable trends don’t jump out. One of the better explanations turns out to be the price action that is frequently seen during the second year of the presidential cycle, especially during the April to September period (which is the part of the election cycle that we just entered). Frequent declines during this period often set up the strong 12-month period beginning in the fourth quarter of year two.
The graph below shows the average return during each quarter of the election cycle. For example, the average return during the 1 st quarter of the second year of the cycle – the quarter that has just ended – is little more than 2 percent. The graph shows the strong average returns that have occurred during each of the four quarters beginning in the fourth quarter of year two. The first three quarters of this period are the strongest three-month periods in the cycle when measured this way. But look at the two quarters that precede these gains. These are the two worst quarters in the cycle, on average.
When you look at the individual quarters that make up this poor six-month period, an interesting pattern emerges. Not all of the periods are negative. And some of the periods have strong double digit returns. What explains the difference between the positive and negative outcomes? Part of the explanation can be attributed to the market’s valuation at the beginning of the April-September span of year two.
The graph below shows the comparison of valuation and six-month returns. The P/E multiple is from the end of March for each 2 nd year of the election cycle. The six-month return reflects the total return of the S&P 5000 for the 6-month period ending on September 30 of each 2nd year.
In general, higher levels of valuation markets have resulted in weaker performance during this period, on average, while the market has done well from lower valuations. The data doesn’t line up perfectly. Low valuations don’t always help, as investors found in 1974, and high valuations don’t always hurt, as investors found in 1994 and 2006 (although returns were still uninspiring). But it is worth noting that all of the strong returns during the April-September period of the second year of election cycle occurred when valuations were below average (typically below a 14.5 CAPE, the cyclically adjusted P/E ratio, where the denominator is the 10-year trailing average of S&P 500 earnings).
Big declines have tended to occur from higher levels of valuations. With a CAPE of 22 currently, there are only four periods that were more expensive than the current market, heading into this generally unfavorable six-month period of year 2. The average return that followed these periods was -11 percent, and it includes 2002 where the market fell by almost 30 percent.
Calendar cycles are an interesting backdrop in which to frame the analysis of other characteristics of the market, like valuation and market internals. We don’t rely on calendar cycles in setting investment policy, because it is difficult to identify cause and effect mechanisms that would make these tendencies reliable (the links between valuations, market action, risk premiums and investment returns are clearer). Also, the average returns presented above can hide a lot of variation in the individual outcomes.
Even so, it might be worth keeping in mind over the next six months that this part of the election cycle has been mostly unkind to investors, and the more steeply valued the market, the less kind the market has tended to be.
via John Hussman http://hussman.net/rsi/buselectioncycles.htm
Tariq at StreetCapitalist has great post on learning from Dr. Michael Burry, the value investor who foresaw the mortgage meltdown and made a fortune betting on it:
If you have ever wanted to learn about Michael Burry, read this post. It is long, but if you feel like skipping what I think, just read the content in the block-quotes, those come straight from Michael Burry of Scion Capital.
What I wanted to find out is how Burry went from being a medical resident to being regarded as one of the greatest investors in recent history. Burry’s story is pretty inspirational to investment bloggers — he started out in relative obscurity, posting his ideas on message boards and eventually his own site, until he built a strong institutional following. Eventually, his amateur analyst work attracted the likes of Joel Greenblatt’s Gotham Capital and White Mountains Insurance Group (NYSE:WTM). With their money, he started Scion Capital and built a market beating track record. In recent years, Burry unwound his fund in favor of managing his own money.
We are lucky in a way that the internet archives of Burry’s posts are still readily available. These archives let us see how Burry invested and the evolution in his process from about 1996 to 2000. I am sure that his approach changed while he was running Scion as well, but I still think the information here is really insightful to young investors.
1. I’ve read way too much
The first thing that strikes you about Burry is the fact that at the time of his initial post, he has read a lot:
Ok, how about a value investing thread?
What we are looking for are value plays. Obscene value plays.
In the Graham tradition.
This week’s Barron’s lists a tech stock named Premenos, which
trades at 9 and has 5 1/2 bucks in cash. The business is
valued at 3 1/2, and it has a lot of potential. Interesting.
We want to stay away from the obscenely high PE’s and look
at net working capital models, etc. Schooling in the art
of fundamental analysis is also appropriate here.
Good luck to all. Hope this thread survives.
Mike
(Silicon Investor)
Look at the type of value investing that Burry is referring to. Remember, most people mistakenly believe value investing is just copying whatever Warren Buffett does, but value investing is actually more diverse than that. The Graham tradition refers to Benjamin Graham, Buffett’s teacher, and indicates a more quantitative approach to investing. Graham targeted net-nets, stocks trading at 2/3 their net current asset value. He sought hard assets and did not mind investing in terrible businesses as long as the liquidation value was in tact and protected.
Burry later notes that he is an MD, not an MBA. He picked up most of his knowledge by reading. I believe that if you want to be successful in investing, it is important to be willing to learn and explore new concepts on your own.
This must have been especially true for Burry because when he started posting he was just an outsider. He was no Wall Street analyst and lacked the same resources as many institutional investors. But, Burry made up for his lack of professional knowledge with his drive and determination to learn. Here are some of the books he recommended:
Re: books
To get started, I’d suggest the following four books:
The Intelligent Investor by Graham
Common Stocks and Uncommon Profits by Fisher
Why Stocks Go Up and Down By Pike
Buffettology by Buffett and Clark
If you read these books thoroughly and in that order and never touch another book, you’ll have all you need to know. Another book you might want to consider is Value Investing Made Easy by Janet Lowe – a quick read. I have a fairly extensive listing of books on my site, with my reviews of them, and links to purchase them at amazon.
http://www.sealpoint.com/
My problem is I’ve read way too much. One book stated, “If you’re not a voracious reader, you’ll probably never be a great investor.” But sometimes I wish I had a more focused knowledge base so that my investment strategy wouldn’t get all cluttered up.
Re: Security Analysis you can get a lot of the same info in a more accessible format elsewhere, but everyone says that Buffett’s favorite version is the 1951 edition. Yes there are differences, and the current version has a lot of non-Graham like stuff in it.
Good Investing,Mike
(Silicon Investor)
From the period of 1996 to 2000, Burry wrote 3,304 posts or about 2.3 posts per day. He didn’t let the criticism of more experienced investors get to him, on occasion he was lambasted for being a doctor or not a financial professional. But he kept posting anyway. Many of these posts give us a glimpse of his thought process and the kinds of questions he asked. We can see that he mostly used the site as a sounding board to gauge investment ideas and learn from more experienced investors. His constant asking of questions and stock analysis posts are demonstrative of his intellectual curiosity and how he tried to continuously improve his own abilities as an analyst.
2. There’s a way to win at everything. It just has to be found.
If you go back and read Michael Burry’s posting history, you will see that his investment style was influenced by Graham and Buffett but also had a number of unique qualities. Note his use of technical analysis:
As I’ve brought up on this thread before, I was a growth/technical analysis investor for quite a while. I studied TA pretty extensively. Hence, when I felt the market getting toppy last December and became a student of value investing, I found it hard to leave TA completely behind. Mainly I use it only to avoid falling knives and to find buy points at very solid support. I try not to use it to sell stocks
because my horizon remains long-term. With the market this toppy though, I find it hard to ignore when TA says sell after a fast rise. It’s the old take the money and run. It has helped me tremendously, and I have been hurt when I ignore it completely. The four companies I hold now I’m not even charting, though I would do so if one or more gains 40-50% in a few weeks, as WHX has done.
Mike
(Silicon Investor)
Most value investors I think would cringe at the very thought of using TA, but Burry found a way to incorporate it into his approach. Part of this has to do with the fact that he actually starting his trading not in stocks, but in coffee futures:
Jim, I guess I still watch the charts a bit. After all, I cut my teeth trading coffee futures. About 8 trading days ago it broke a significant downtrend on decent volume when it moved to the high 40s. At the point, I wished I had bought more in the low 40s. Today it just popped its 200 day, after trending along it for a few days after trendline breakout. This all occurred in a setting in which the years-long stock chart tested a years-long uptrend and the support held. Maybe TA is only useful because others use it. I don’t know. But it’s interesting to watch, and I believe in it to the degree it reflects crowd psychology. Despite SLOT’s volatility, I’d be surprised if it goes back to sub-50 now.
And yes, I’m waiting for the 80’s at least before I sell, no matter what the chart does. It’s as sure a bet as Apple at 34, Oracle at 23, American Power at 27 (presplit)…
Mike
(Silicon Investor)
Was Burry a futures trading guru? Not quite:
Re: coffee futures, let’s just say I got out with the shirt still on my back.
Mike
(Silicon Investor)
Off-topic
In futures, I learned a lot about TA. The frustrating thing was it worked. You could actually predict the moves. But slippage ate away everything. I was up big at times, never down big. I left with 98% of my original capital as soon as I realized I would have to quit my day job to do it right. The friend that got me into it did quit his day job and is doing ok. There’s a way to win at everything. It just has to be found.
Mike
(Silicon Investor)
We know that right off the bat, Burry had read a number of value investing texts. However, he chose to incorporate things he had picked up previously with his new, value oriented approach. I think that his willingness to create his own systems and methods for investing highlight his ability as an investor. He wasn’t just a mindless drone that would follow whatever he read in books.
Take this rule about new lows, it shows that Burry was able to think critically enough to come up with his own investment rules:
As you know, I have a simple philosophy: sell on new lows.
There are two reasons for this:
1) Many people do this. It’s a self-fulfilling prophecy. I try to do it quicker.
2) If I know something is a fundamental value and it breaks to new lows, the selling is irrational by definition and I don’t want to be in the way of irrational selling. Better to wait for the buyers to show where they are willing to step up and give support.
I suffered for several years trying to be stubborn in the face of irrational selling and all it got me was a lot of 50% haircuts on stocks that had already been too cheap. One of the biggest lessons I’ve learned was that PE 8 stocks can become PE 4 stocks and stay that way for a long time. AT&T’s long-distance business is getting close to trading for 1X EBITDA, yet everyone looks at it like this big albatross around T’s neck. Maybe in the future I’ll get the long-distance biz for free. All we need is another $15 billion in lost market cap.
That said, I love your rhetorical questions. Why do you think AT&T is getting hit?
Mike
(Silicon Investor)
To me, that is an important aspect of learning investing. Most people will read a book about Warren Buffett and begin to think that there is only one way to really do investing. That kid of thinking really limits you. And Burry brings this up in the context of the tech bubble:
OK, here’s where I go and offend a lot of people. Religion? Style? What’s the difference? I’m sitting here fully expecting AMZN to go to 10. Don’t expect incredulity from me just because I haven’t seen it happen before. At some point, I did give up on my tech ban. Reason being that they are businesses like any other, and I couldn’t justify not valuing them. It’s fashionable for value investors to steer clear, certainly because of Buffett’s influence. But it is possible to invest intelligently there, IMO. I can’t just stick my head in the sand and say Microsoft didn’t make a lot of really intelligent investors very wealthy. Ratios bite. That’s gotta be lesson number 1 in tech value investing. I learned it with one stock – Creative Labs. Applying a little bit of Buffett to tech isn’t heresy or impossible, IMO…
Mike
(Silicon Investor)
Burry’s willingness to analyze tech companies is more evidence of his propensity to think independently. He makes a great point, totally ignoring tech on the basis of Buffett saying “tech is too hard” is probably a bit of an over generalization. If you look at some of his other posts, he gives some insights into how he evaluates tech stocks:
I just go for what has value. To me, ignoring tech doesn’t make sense. I’ve done well with Apple, Oracle, American Power this year. IMO, applying traditional value criteria to tech is deadly, because there is usually a reason it looks like a value, and it is too technical to understand.
So in tech I look for:
1) Big, Buffett-like established companies with tremendous
cash-generating ability that are out of favor despite a franchise on something
2) Small techs trading at about cash with no debt. They usually do well in my experience.
In tech, good management is rare and when it is present limits become merely a figment. But for an outsider to somehow judge this before the Street does – I don’t know that it is possible.
(Silicon Investor)
To Burry, you don’t need to ignore all of tech. Actually, when you look at established tech businesses, they are really some of the best. They tend to have clean balance sheets and are usually almost debt free, making the capital structure very straight forward. For a new investor, a mature tech company is probably easier to analyze than a bank.
Burry breaks tech into two piles. The Buffett businesses are ones that have wide moats and earn a lot — think Microsoft or Ebay (which Scion Capital has owned). The Graham businesses are likely small cap / micro cap stocks that the market has forgotten about, you will often see some of these tech companies on the net-net list (Adaptech comes to mind).
Here is how he described Apple:
I like AAPL because it IMO is now a bona fide value stock on an enterprise value/ratio basis, and is generating tons of cash. I see loads of opportunity, an extremely strong balance sheet, and little downside. And I see a huge contrarian play because a generation of security analysts have been trained to think that whatever is wrong with this world, AAPL is a part of it.
What the price will do in the next 12 months, I don’t know. Whether day traders will ever mature, I don’t know. Whether value will even become more important over the next year, I don’t know. I just see an absolute value in AAPL at recent prices.
I do feel the greatest margin of safety was back at 34 when no one ever thought it would move, but that there remains a margin of safety for longer-term holders.
(Silicon Investor)
If you were willing to overcome your biases against tech stocks, you would have seen a no-brainer value investment with Apple. Around the time of Burry’s post, Apple had about $4.5B in cash and marketable securities, with only $300M in debt. If you had taken Apple’s market cap, added the debt, and backed out cash, you would have ended up with the operating business being valued at only 10% of sales. That is absurdly low. The thing is, I am sure many investors missed this because they chose to ignore all tech stocks.
In The Big Short, by Michael Lewis, Burry argues in favor of creating your own investment style:
Burry did not think investing could be reduced to a formula or learned from any one role model. The more he studied Buffett, the less he thought Buffett could be copied; indeed, the lesson of Buffett was: To succeed in a spectacular fashion you had to be spectacularly unusual. “If you are going to be a great investor, you have to fit the style to who you are,” Burry said. “At one point I recognized that Warren Buffett, though he had every advantage in learning from Ben Graham, did not copy Ben Graham, but rather set out on his own path, and ran money his way, by his rules… I Also immediately internalized the idea that no such school could teach someone how to be a great investor. If it were true, it’d be the most popular school in the world, with an impossibly high tuition. So it must not be true.”
The Big Short (Michael Lewis)
Basically, Burry did not reject Buffett, but he understood the limitations that came with Buffett’s teachings. He didn’t have Buffett’s resources or talent for influencing management teams. As a smaller investor, he realized that he had to create his own approach so that he could invest effectively.
3. What everybody else was doing was insane
“The late nineties almost forced me to identify myself as a value investor, because I thought what everybody else was doing was insane.”
Michael Burry (The Big Short)
I am a huge believer in having investors study historical financial crises and panics since markets naturally have a tendency to become bubbles. Investors who have never really experienced a bubble will usually relax their investment standards after having a string of homeruns. This almost always leads to disaster, which we saw it in the most recent crisis. Many fund managers lamented that they had strayed a little too far from their core competencies and their investments suffered.
I was really curious about why Burry decided to do the credit default swap trade while so many other investors had missed it. Part of the reason Burry was able to see the mortgage bubble may have been a result of having honed his investment abilities during the dot com bubble. If you look through his posts, he knew the markets were being irrational:
A very, very close friend of mine whom I work with and talk with 6 hours a day has in the last 3 weeks quintupled his net worth on a single stock. Today he crossed $500,000. He’s not an insider at a company or anything. He’s just a resident phsyician who’s buying what everyone else is buying, and he’s telling me the same thing: fundamentals don’t matter anymore; who wants to talk about fundamentals?
Paul, if doctors make lousy investors, what does it tell you when doctors are making excellent investors – in droves?
Mike
(Silicon Investor)
Here is an interest exchange that Burry had with Reginald Middleton, who at the time was selling financial models that projected Microsoft to be worth north of $500 per share:
Reginald,
You appear to be arguing that junk bonds and technology equity investments have more value because they have been yielding higher returns over the last 7-10 years, thus counterbalancing the risk to a sufficient degree to call these value plays. This is the logic of a growth investor. What if you buy junk bonds just before the next crisis? Or if you buy A junk bond and the company deteriorates or is cannibalized by the people that sold it to you? You’ll be sitting on a big fat capital loss. This risk is high, hence the name.
How about the Nifty Fifty and the 72-74 crash? Good companies that didn’t see a return to their previous levels for over 10 years. In the inflationary environment of the mid 70’s to early 80’s this was devastating for holders of these growth stocks (which had been deemed “safe” due to their previous returns during the 60’s bull and size/history).
This is why we use AAA corporate bonds and gov’t securities as benchmarks for a safe return. Hold until maturity and you are guaranteed (as best as can be expected — if you don’t trust the gov’t, check out AAA bonds oneself) at least a modicrum of insurance against inflation. I am not arguing that your model doesn’t do this implicitly.
In sum, if you buy at the top, where’s the value? This is what Margin of Safety is meant to address, and why many people distinguish value investing from growth investing.
Mike
(Silicon Investor)
Finally, there is this:
Jim, I overheard two conversations today. Both were about investing – one involved the med center librarian, the other a janitor. Moreover, the friend I describe with the half-mill is not the first overnight success story. As I might’ve mentioned before, my two best friends and my younger brother’s two best friends all became multimillionaires this year. But you know, even though I’m here in Silly Valley, I’m on the fringe – that same guy who made half a mill went on a date with an HP IS employee who said it’d take 2 mill to buy her house. When informed of his goal of 3-5 million in a few years, she scoffed and said “That should last 2-3 years.” Then she asked what doctors are making in the Valley. He said “$100 to $120k.” She actually sniffed.
Jim, I’m reversing my position on your QQQ short, although I’m not yet doing it myself. Never, ever have I heard stock discussion permeate the medical center like this. This is new to me in the last few weeks.
Mike
(Silicon Investor)
Unlike most people at the time, Burry realized that he was living in a bubble. It didn’t make sense. Hearing about janitors, librarians, and co-workers, making such outsized returns with little actual investment analysis must have been jarring. The thing is, Burry not only realized that there was a tech bubble, but he sought to profit from it.
Shorting is a somewhat debated topic among value investors. They often complain that shorting saddles investors with potentially unlimited losses and runs counter to the fact that stock markets generally rise. I thought examining Burry’s perspectives on short selling would be insightful:
I’ve brought this up before, but since there’s a new group hanging around,
Does anyone have any rules for shorting based on a value basis?
I’m currently short KO on a value basis and am looking to short G next. (My AXP and WFC shorts are not value-based).
Mike
http://siliconinvestor.advfn.com/readmsg.aspx?msgid=1213782
Even though his shorts were more based in TA, Burry gradually refined his approach to incorporate more fundamental analysis:
I mentioned that I pick stocks to short based on valuation, not ratios (I ask you to find the correct free cash flow — I bet most people don’t kow they’re working with negative net working capital, either).
But I ENTER based on technical analysis. KO could go up or down. The odds are down, technically, but that’s what buy stops are for. This isn’t a long term short by any means. Research on shorts show that profitable shorts make money with small gains, not by waiting for businesses to bankrupt. The small gains are usually there for the picking. Another indicator — if it’s mentioned in Barron’s as a buy three different times — set me onto Wells Fargo.
What’s there to understand about Coke? The business is a KISS model. This gets to my value/short strategy. When people start claiming a business deserves a special valuation above all reasonable
fundamental analysis (because of the “franchise”, because there’s so little institutional ownership for a big cap growth stock, because Buffett’s in it, because global expansion will provide endless opportunity, because ROE is so damned high, because it’s nearly a monopoly, because Buffett’s in it…), that’s a short, IMO.
I just read a bunch of Graham, and he doesn’t deal with shorts (I assume it would be “speculation”), but EMT isn’t all that its panned to be either, IMO.
Just trying to think independently,
Mike
(Silicon Investor)
With further refinement, Burry started to create screens to pick up possible shorts. Here is one:
A study came out on shorting late last year. It basically said ignore the momentum plays because they move irrationally and fast. Look for companies with immense debt, crummy balance sheets and declining sales. And then hold for a while. This is just so against my nature, if not all human nature.
I screened for negative sales growth plus LT Debt>>equity, and PSR>20. The screen works, in a sense — you get all kinds of companies trading for less than a buck, and a lot of low cap oil&gas explorers. Nothing marginable, so hence they are not shortable. If you leave out the balance sheet problems you get a bunch of development stage cos, esp. biotech. But it seems to be on the right track. I’ll keep trying.
As long as you put tight stops on the shorts, there’s no unlimited risk. Problem is, how much do you believe the stock will go down? I’m only aiming for 10% in a bull market (which usually happens either quickly or not at all given my technical entry) so I need tight stops. Got stopped out of all mine today except IBM. This is why I’m looking for a value-based alternative.
Good investing,
Mike
(Silicon Investor)
Even though he was trying, he could not totally come up with a pure value approach to shorting. In this post, Burry describes how his process is still driven by TA, but that he is closer to figuring out a value based strategy:
Re: stops and shorting
Effectively, you need to use technical analysis. My shorts, though fewer in number by far, have been more successful than my longs — what that says about me I don’t know. Alternatively, you could just use percentages, but to me that’s a shot in the dark. Or if you know the company intimately, you could just waitbecause you know it’s going down.
Using TA, you can find, say, when a company is bumping up agains some significant overhead resistance, hitting a trend channel boundary, or hitting a Fibonacci number on a retracement during a downtrend. There are lots of other examples. Then, you just set a mental stop to get out if the scenario doesn’t play out technically. My futures experience led me to study TA intensely. I can’t help but use it for position entry in stocks.
To answer someone’s question, shorts do not free up cash. They are always borrowed (you are shorting stock that your brokerage borrowed for you from another investors margin account), and hence in your margin account. But it’s not like you can keep 100% shorts and then still have 100% cash to play with.
BUT this is TA. Stops are not a part of value investing as I understand it. Hence my search for a value-based strategy.
Shorts take a lot of maintenance as I practice it.
I may have found something, and am currently researching it.
Mike
(Silicon Investor)
This is where Burry’s past experience with trading futures was probably helpful. By using frequent stops, he limited the possibility of unlimited losses from a short position. Since he is incorporating shorts into his portfolio, Burry allowed himself to actually profit from the fallout of the bubble popping. Most other investors, who chose not to short, were left putting more and more of their portfolio into cash. Cash is not necessarily bad, while it does not earn returns or compound, in the short term it doesn’t decline.
One of the books that Burry recommends for learning short selling is The Art of Short Selling by Kathryn F. Staley. Here is what he had to say:
For the last week I’ve been carrying “The Art of Short Selling” around with me just about everywhere. Every time I get a break, I just open to a chapter. Doesn’t matter if I’ve already read it. I just read it again.
If there’s one thing that keeps hitting me in the head about that book and its cases is that there’s a lot of time to short and still come out ahead. The problem with net stocks is that they appear as if they require constant capital infusions, which makes them good shorts. But they’re getting these infusions at will. That makes now now a good time. When the capital spicket is turned off, the stocks will react downward, but won’t fully account for how bad the news is then. They’ll be terminally wounded but the price won’t reflect it. That’s when IMO you’ll be able to grab a lot of the net stocks on their way to zero. But before that, a lot of smaller companies will pitch themselves to larger companies. So the wild card is that they get taken over by a bigger, stupider, more capital-rich, company, a la Yahoo of GeoCities, which stands out as the single most characteristic action of this era. The AofSS describes this risk as the thing that keeps ss’s sweaty-palmed and awake at night. I think for good reason.
For my next, more certain short, I’m taking a long, measured look at Pre-Paid Legal (PPL). I posted why over on that thread. I think I finally understand that one.
Mike
(Silicon Investor)
Increasingly, we see Burry progressing towards shorting on the basis of fundamental analysis:
Shorting stocks where I can see the bad news confirmed in the numbers. Amazon.com (short at 82 5/8 again today) is pursuing some creative financing to get the cash to keep going. Selling euro-dominated bonds follows an Australian issue follows equity-linked debt follows who knows what.
Exodus (short at 129) is in a capital-intensive business with high start-up costs and business inputs that have short half-lives. The barriers to entry are minimal in the long run. Exodus’ major shareholders have sold big-time. The company should be raising its needed additional capital by selling inflated shares but instead is borrowing $1billion plus at 10%+ rates. Intel is one of the many targeting this same market.
Pre-Paid Legal (short at 24 3/4) I’ve gone through before (I shorted it from $37ish down to 24ish last year). Cash flow continues to lag far behind reported net income, membership retention stinks, and the CEO is engaging in borderline stock promotion while he steadily sells. Many in the investor community misunderstand this stock.
(Silicon Investor)
You can see the improvement and progression in his process. You will note that the analysis is more sophisticated here. It is much more value based, akin to an approach that you might see touted by a guy like Jim Chanos or other noted short sellers. With Amazon, Burry found the overall business model to be a bit suspect and disliked the complex financing. Exodus was a weak business that required large amounts of capital investments and financing that could only be raised at 10%+. Conversely, he was able to see larger businesses like Intel pose as competitive threats with the benefit of a cheaper cost of capital. Pre-Paid Legal, which astoundingly still exists today, is often a favorite among shorts. The mis-match between cash flow and net income is found in a lot of fraud businesses and is one of the indicators for trouble that you will find in forensic accounting books.
I talked about Burry’s willingness to modify Graham’s teachings to fit his own style and the time period. I think that shorting is simply an extension of that. In one instance, after being criticized by another investor, Burry outlines his philosophy on shorts:
Craig,
I wouldn’t go far as to say shorts are not part of a value investing strategy. To each his own, but one might argue that with bonds providing a weak counterweight to stocks over the last few decades, hedging with shorts might be something Graham would have considered by now had he been alive. He definitely was into market timing, and it wouldn’t surprise me to learn that he felt that shorts had a place in a rich market as a hedge against a majority long equity position. And re: Paul’s remark about hedging and shorts never coming up, I submit that Graham’s Bonds/Equity 25/50/25 theory was meant to be the equivalent of a mild hedge strategy. As for me, I’ve come out ahead on my shorts over the years, but I much favor longs, and in a fairly priced or evem overpriced market will still overwhelming favor longs…
Good investing and keep contributing,
Mike
(Silicon Investor)
Later, he cites the Rediscovered Benjamin Graham book’s material in order to argue that going long value stocks may not be enough if we are faced with a downturn:
“I’d like to think that if I own real absolute value stocks it won’t matter if the big indexes drop 50%. But that might be wishful thinking. ”
Jim, in that Rediscovered book, Graham makes it quite clear that value stocks will be punished every bit as much and probably more in a market downturn, according to his research. He of course advocates raising cash or adjusting to bonds if one thinks the market is too high. In another area, though, he talks of the tremendous values that can be found even in a high-priced market. I find this book fascinating — lots of stuff I hadn’t read before.
Mike
(Silicon Investor)
Eventually, Burry was able to incorporate short selling as just another weapon in his arsenal for value investing. Later, you can really see how improved his level of analysis has become. Take this post on WorldCom:
To answer whether this is a good business (and not just apparently cheap based on traditional superficial measures) I coincidentally just did a new return on capital calc on WCOM today, based on its latest results. Largely, I go by Stern and Stewart’s version when doing this. In terms of earning cost of capital, Worldcom is doing a poor job.
In fact, it is not earning its cost of capital. After accounting for past pooling acquisitions, and breaking down Worldcom’s cash flows, I figure the company is going to earn, optimistically, $8 billion in cash earnings on invested cash thus far somewhat above $90 billion. Even looking ahead and taking analysts estimates into consideration, I’m seeing at best a 10% return here and hence WCOM is not earning whatever its cost of capital may be – I’m estimating at least 12%.
Right now, it trades above its capital even though it is not earning the cost of its capital. Not good. This may change as WCOM finds a way to leverage its investment into further profits down the road. The latest quarterly report provides a hint of this. But it has said it will have massive capital expenditures in the future – and current cash levels imply additional borrowings to do it. All this will dilute returns further.
I think with T and WCOM, we’d have to find a way to analyze the current levels of investment and somehow come to a conclusion that future earnings will grow quite significantly off this base alone. One wonders what degree of empire building is going on – what is motivating management? Right now, T seems to have the greatest potential because of its cable assets, but it is potential. Management has to execute. Plans to spin off or merge with BT tell me that management is responding to the wrong inputs right now. Ebbers’ Sprint plan told me he is responding to the wrong inputs as well…
Following up on my examination of Worldcom, I concluded that Worldcom would have to start showing it didn’t need more acquisitions. Its acquisitions to date seem to have been borne of empire-building rather than shareholder reward. And the market is knocking it down drastically on news of its latest acquisition. Certainly it appears that the “story” phase for the stock is over, and the proving time has begun. But Worldcom is still trying to finish the story. I’m still staying away.
Good investing,
Mike
Part I (Silicon Investor)
Part II (Silicon Investor)
As many of you already know, WorldCom had engaged in massive accounting fraud. Some of this was covered up through their clever use of accounting with acquisitions. Each deal boosted their reported earnings whereas it was obvious to Burry that they weren’t even out earning their cost of capital. Being able to pick up on small details like this must have been helpful later on when he had to analyze complex subprime-mortgage backed securities.
4. The Big Short
Burry was relentless about seeking out value. That meant buying undervalued tech stocks and shorting the ones that had shoddy fundamentals and were irrationally bid up. To me, when we read about Michael Burry netting huge from credit default swaps against mortgages, we are just seeing an extension of his process.
Value purists may disagree with using credit default swaps because they are derivatives, but Burry’s wasn’t a purist. He isn’t the first value investor to get attracted by insurance. Warren Buffett has had a long history of involvement in the reinsurance business. For Buffett, insurance is all about taking premiums for well priced policies and investing them in the market to compound returns. For Burry, it was more of the opposite. He was being presented with premiums that were so low, relative to the huge payoff, that the CDSs were actually undervalued and worth investing in. His CDS positions may have costed 5% annually but had the potential to deliver 100:1 payouts.
What is funny is that in his SI posts, you could see that Burry was already suspicious about the possibility of a housing bubble back in 1999 with a post about Washington Mutual:
…with equity/assets of under 5%, WM is not in the strongest shape should its fundamentals deteriorate, i.e. real estate deflate. Out here in Silicon Valley, everyday life feels like a bubble. People can hardly comprehend when I tell them about 90-92 and the foreclosures – not when 2br/1b’s are going for 5-600k. I just can’t help but think that it will get even uglier before it gets better.
Mike
(Silicon Investor)
Burry constantly frets about the potential downside and isn’t deluded into thinking that markets will remain stable. In his posts he brings up cases where investors are afflicted by delusional euphoria. The Nifty-Fifty days, the early 90’s real estate foreclosures, investor behavior during the tech bubble, the ever appreciating home prices in California; he comes off as almost always vigilant against the the possibility of another disastrous bubble around the corner.
In the Michael Lewis article, Betting on the Blind Side, Lewis describes how Burry learned about mortgage bonds:
In early 2004 a 32-year-old stock-market investor and hedge-fund manager, Michael Burry, immersed himself for the first time in the bond market. He learned all he could about how money got borrowed and lent in America. He didn’t talk to anyone about what became his new obsession; he just sat alone in his office, in San Jose, California, and read books and articles and financial filings. He wanted to know, especially, how subprime-mortgage bonds worked.
Betting on the Blind Side (Vanity Fair)
Going back to Burry’s past, we know he had a penchant for self-teaching. The way he learned about subprime-mortgage bonds was probably similar to how he learned about investing. Simply by self teaching. My guess is that most investors did not bother wading through subprime mortgage bond prospectuses. At most, they may have double checked the rating on the bond by calling up the people at Moody’s or S&P. For Burry though, we know that when he learned something, he sought complete understanding:
The problem is, I don’t believe anything unless I understand it inside out. And even once I understand something, it is not uncommon that I disagree with accepted view (even if it’s a Nobel laureate). So I struggle pretty mightily with my own perceptions and definitions every once in a while. That’s where I am now.
Mike
(Silicon Investor)
That drive to figure out the ins and outs of every subject must have contributed to the fact that he was willing to sit down and understand all the granular details of a subprime mortgage bond. I doubt listening to a ratings agency or the common market sentiment was enough. He had to personally understand everything. And that singular focus led him to see that subprime mortgage bonds were really a sham:
But as early as 2004, if you looked at the numbers, you could clearly see the decline in lending standards. In Burry’s view, standards had not just fallen but hit bottom. The bottom even had a name: the interest-only negative-amortizing adjustable-rate subprime mortgage. You, the homebuyer, actually were given the option of paying nothing at all, and rolling whatever interest you owed the bank into a higher principal balance. It wasn’t hard to see what sort of person might like to have such a loan: one with no income. What Burry couldn’t understand was why a person who lent money would want to extend such a loan. “What you want to watch are the lenders, not the borrowers,” he said. “The borrowers will always be willing to take a great deal for themselves. It’s up to the lenders to show restraint, and when they lose it, watch out.” By 2003 he knew that the borrowers had already lost it. By early 2005 he saw that lenders had, too…
In his quarterly letters he coined a phrase to describe what he thought was happening: “the extension of credit by instrument.” That is, a lot of people couldn’t actually afford to pay their mortgages the old-fashioned way, and so the lenders were dreaming up new financial instruments to justify handing them new money. “It was a clear sign that lenders had lost it, constantly degrading their own standards to grow loan volumes,” Burry said. He could see why they were doing this: they didn’t keep the loans but sold them to Goldman Sachs and Morgan Stanley and Wells Fargo and the rest, which packaged them into bonds and sold them off. The end buyers of subprime-mortgage bonds, he assumed, were just “dumb money.” He’d study up on them, too, but later.
Betting on the Blind Side (Vanity Fair)
My guess is that most of Wall Street did not bother to wade through the hundreds of pages that comprised a subprime MBS. Unlike Burry, who sat in an office and learned these bond deals by himself, most of Wall Street likely deferred their judgement to the ratings agencies or sell side contacts. Ultimately, those groups lacked any substantial knowledge about these securities, their models were flawed which made their opinions flawed. So when investor groups came to them to get their opinions, they were almost always given the wrong answer.
Going through all of Burry’s posts, you will see that he was constantly analyzing stocks. To the point where he was at least posting a few ideas every week, in addition to his day job. To me, that is the definition of deliberate practice for an investor. You really have to get into the habit of frequently analyzing and valuing companies. In one post, Burry mentions that he has built a watch list of over 80 companies that he would be ready to pounce on if they ever hit his target price. That level of work, with a tendency to think independently, should help improve anyone’s investing.
This quote by Michael Burry in The Big Short says it best:
I have always believed that a single talented analyst, working very hard, can cover an amazing amount of investment landscape, and this belief remains unchallenged in my mind.
Here is Buffett’s answer to a question about how to become a value investor.
Buffett: 49 colleges and universities visited Omaha this year. If I ran a business school there would be only 2 courses. How to value a business and How to think about markets. No modern portfolio theory, no beta, etc. You don’t have to be right on 4000 or 400 businesses, not even 40. Circle of competence. Start with a small circle and slowly expand. Don’t spend time on companies that don’t lend themselves to valuation. Accounting is useful, but sometimes it is not meaningful. Durability of competitive advantage is the key. And market fluctuations. The market is there to serve you, not instruct you. If you are an investor and you have a 150 IQ, sell 30 points to somebody else. Being a genius can be a bad thing in this business. You need an inner peace with your decisions, because they will be challenged. I don’t know how much of that is innate and how much is taught, but it is a very good quality to have. Simple but not easy. No higher math. It’s not complicated. But you need an emotional stability. If you have that you’ll do well over time.
Charlie: Half of future investors of the world are going to be in the bottom 50%. Skill does rise to the top in this business. There is so much that is false and nutty in modern finance, banking, academia, economics departments and business schools. Just reduce the nonsense.
Warren to Charlie: Isn’t emotional makeup more important?
Munger: Absolutely. And if you have a 150 IQ and you think it is 160, you are a complete disaster! (Laughter).
Buffett: The best question I have been asked in my meetings with students was: ‘What are we learning that is most wrong?’
Munger: How do you cover that in 1 session?? (Laughs).
Buffett: Efficient market hypothesis, it’s unbelievable that this has taken hold. It’s nutty. (German physicist) Max Planck talked about the resistance of the human mind to new ideas. Science advances one funeral at a time (quoting Max Planck).
Here’s the recap. These things should, in my opinion, be committed to memory:
1. Spend your time valuing businesses and thinking about market prices.
2. If you don’t understand a company, move on. There is no margin of safety if you don’t know what you’re doing. Would you play a game against someone when you barely knew the rules and they were an expert? How about if you were betting ten or hundreds of thousands of dollars on the outcome? As I believe Buffett said, “If you want to beat Bobby Fischer, play him in anything but chess?”
3. If you can’t value a business, move on. Most businesses, most of the time are priced in such a way that there is no glaring discrepancy between price and value. Some have questions about earnings power and assets that you cannot answer. Move on, because there are plenty of fish in the sea and forcing it or falling in love with a mediocre prospect will lead to mediocre returns.
4. Focus on finding businesses with a “moat”. If not, a business may be cheap and on its way to getting a whole lot “cheaper”.
5. The market is there to serve you, not inform you. Making this payoff requires a great deal of patience and discipline.
Gregory Speicher via GuruFocus
