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                                                                                                                                                                  Edited by the Research Team of

                                                                                                    SPECIAL EDITION
  “Confronted with the challenge to distill the secret of sound investment into three words, we venture the motto: Margin of Safety.” —Ben Graham                            February 9, 2009

                    With                                        Dear Fellow Idea Seekers,
                    John Mihaljevic, CFA
                                                                   There are many ways of becoming a better investor. You can study the
                    Managing Editor,
                    The Manual of Ideas                         experience and writings of great investors, including Ben Graham, Warren Buffett,
                                Seth Klarman, and others. You can become better at analyzing financial statements
Inside This Special Edition                                     and valuing companies. You can improve your investment mindset and discipline.
                                                                   At The Manual of Ideas, we are committed to assisting you in all of these
Investing Lesson:
Grow Your Intuition For Value … p. 2                            endeavors. Of course, the most tangible way in which we provide value is by
                                                                sharing well-researched investment ideas with you in Downside Protection Report
About Downside Protection Report
                                                                each month. Occasionally, we also try to step back from specific stocks and give
Our mission is to uncover stocks with                           you a glimpse of the thought process that leads to good investment decisions.
a large margin of safety and bring
them to you once a month.                                           In this special edition of Downside Protection Report, we discuss a quality
John Mihaljevic, editor, is a fund
manager, former banker and analyst.
                                                                crucial to successful investing—intuition for value. Intuition is almost impossible to
He is a member of Value Investors                               teach; it usually builds over many years of experience. Nonetheless, we hope to
Club, an exclusive community of top
money managers, and has won the                                 contribute to your “intuition for value” in just a dozen or so pages.
Club’s prize for best investment idea.
John is a trained capital allocator,
having studied under Yale chief
investment officer David Swensen
and served as research assistant to
Nobel laureate James Tobin. John
holds a BA in Economics, summa
cum laude, from Yale and is a CFA
charterholder. He resides in New
York City with his wife and two kids.

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                                               INVESTING LESSON
                                               Grow Your Intuition For Value

                                                    Millions of investors have read Ben Graham’s
                                               The Intelligent Investor, Warren Buffett’s annual
                                               letters to Berkshire Hathaway shareholders, and
                                               other pieces of investment wisdom. Few, however,
                                               have consistently beaten the major stock market
                                               indices. This somewhat surprising outcome
                                               conforms to the view that investing is at least as
                                               much art as it is science (presumably, science can be     Ben Graham
                                               taught, while art cannot). There is obviously no          “Father of Security Analysis”
                                                                                                         Author, The Intelligent Investor
                                               formula for investment success and each investment
                                               opportunity is slightly different. The good news,
                                               however, is that much of the art of investing can be taught and learned. To do so, we
                                               must reach deeper than financial statement analysis and P/E ratios. We must build
                                               intuition for value.

                                               No Free Lunch
                                                    The assertion that you can’t get “something for nothing” goes a long way
Statistics don’t have to be
                                               toward building economic intuition. The things we want typically exist in limited
wrong to be misleading.
                                               supply, making them valuable in exchange for other goods. (An exception is
“If you live to be one hundred, you’ve         oxygen, which is plentiful in air and therefore rarely bought or sold.) If you
got it made. Very few people die past          internalize the “no free lunch” principle, you will have already made a small step
that age.”                                     toward investment success.
                            –George Burns          In the debate over the stock option expensing a few years ago, one side—the
                                               “cons”—essentially asserted that there was such a thing as a free lunch. The cons
                                               wanted companies to record no expense for something of value given by a company
                                                                                       to its employees. Warren Buffett and others
                                                                                       intuitively dismissed the cons’ position.
                                                                                            In the immediate aftermath of
                                                                                       Hurricane Katrina in September 2005, the
                                                                                       U.S. stock market rose because investors
                                                                                       predicted that companies would benefit
                                                                                       from reconstruction work that would surely
                                                                                       follow the destruction of New Orleans and
                                                                                       the surrounding areas. The bullish reaction
                                               Warren Buffett                          contradicted the “no free lunch” principle
                                               Chairman, Berkshire Hathaway
                                                                                       and should have been viewed with
                                               suspicion. “Intuition for value” would have told investors that destruction, in the
                                               aggregate, was bad, not good for the stock market. Were this not so, we could just
                                               keep destroying and rebuilding parts of the country, and stock prices would go ever

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                                                    We see the “no free lunch” principle violated almost daily in the political arena,
                                               with politicians promising bailouts or tax cuts with little regard for how the bills
                                               will be footed. We are constantly bombarded with messages that one can get
                                               something for nothing. The truth, meanwhile, is quite different.

                                               Embrace Multidisciplinary Inquiry
                                                    We liken approaches such as Charlie Munger’s “latticework of mental models,”
                                               which infuses investing with multidisciplinary knowledge, to the curricula of the
IMPROVE YOUR INTUITION:                        nation’s best colleges, where undergraduates earn liberal arts rather than
The best investors and CEOs                    professional degrees. Yale, for instance, does not offer an undergraduate major in
are life-long learners who                     business or accounting. You study economics instead, thereby gaining a broader
don’t sacrifice long-term                      understanding of the forces that underlie the conduct of business. An accountant
development for short-term                     who understands business management is a better accountant, and a manager who
gain. Invest with people who
                                               understands accounting is a better manager.
love what they do more than
they love the money.                                The best investors are not only expert at finance, accounting and corporate
                                               strategy. They also study other disciplines, seek to understand human nature, and
“Everything that is really great and           realize that our world is uncertain and probabilistic. Multidisciplinary insight can be
inspiring is created by the individual         developed through academic study and reading but also through extreme personal
who can labor in freedom.”
                                               experiences, such as growing up in a war zone or living in a country with a hyper-
                           –Albert Einstein    inflationary economy. The first-hand experience of extreme events produces a gut-
                                               level appreciation for the aberrations that periodically occur in society. Such
                                               aberrations may be several standard deviations removed from normal experience,
                                               but they tend to recur more frequently than statisticians would expect (this
                                               phenomenon is sometimes referred to as “fat tails” or “black swans”).
                                                    You would obviously gain a huge
                                               advantage in the stock market if you had the
                                               ability to anticipate fat tails or at least avoid
                                               being caught entirely off-guard by them.
                                               Academic finance does a poor job of
                                               developing such ability, perhaps because it
                                               ignores the possibility of simultaneous
                                               irrational behavior by a large herd of market
                                               participants. George Soros points out that
                                               economics isn’t designed to predict or
                                               prevent market mania: “…imposing the
                                               standards and criteria of natural science on
                                               the human sciences gives rise to false claims
                                               and misleading results. It encourages theories
                                               such as rational expectations that do not          George Soros
                                               correspond to reality…” Soros’s comment            Founder, Soros Fund Management

                                               echoes Aristotle’s admonition in the
                                               Nicomachean Ethics that we cease looking for precision where none is to be found:
                                               “Our discussion will be adequate if it has as much clearness as the subject matter
                                               allows. Equal precision cannot be found in all discussions. Political science

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                                               investigates many things with much variety and volatility. It is the mark of an
                                               educated person to look for precision only as far as the nature of the subject allows.”
                                                    The fact that today’s investment professionals tend to be somewhat narrow-
                                               minded finance practitioners reflects a broader trend in society. Businessmen and
                                               fund managers are highly paid “stars,” while other intellectuals—doctors, scientists,
                                               and writers—rarely acquire significant wealth or win public acclaim. The question
                                               is whether the ever-greater specialization in specific financial and business
                                               disciplines has reached the point of diminishing returns. Can an investment manager
                                               focused on the data networking industry, for example, succeed in the long term
                                               thanks to his intimate knowledge of technology, products and relative market share
                                               trends, or will that manager sooner or later “blow up” because she will miss a
                                               broader trend that will significantly diminish the value of companies in the entire
                                                   Lawrence Krauss of Case Western University’s physics department adds some
                                                                  We live in a society where it’s considered okay for intelligent
                                                            people to be scientifically illiterate. Now, it wasn’t always that way. At
                                                            the beginning of the 20th century, you could not be considered an
                                                            intellectual unless you could discuss the key scientific issues of the day.
                                                            Today you can pick up an important intellectual magazine and find a
                                                            write-up of a science book with a reviewer unashamedly saying, “This
                                                            was fascinating. I didn’t understand it.” If they were reviewing a work by
                                                            John Kenneth Galbraith, they wouldn’t flaunt their ignorance of

                                                    It seems self-evident that well-rounded
                                               individuals should make the best investors.
                                               Charlie Munger devours knowledge across a
                                               wide variety of disciplines and uses such
                                               knowledge to build—and continually
                                               improve—his latticework of mental models.
                                               These models allow Munger to think
                                               strategically about the long-term prospects of
                                               industries and companies. To give you a        Charlie Munger
                                                                                              Vice Chairman, Berkshire Hathaway
                                               flavor for the breadth of Munger’s interests,
                                               consider one of his book recommendations: Gino Segre’s A Matter of Degrees:
                                               What Temperature Reveals About the Past and Future of Our Species, Planet, and

                                               Think Probabilistically
                                                    Individuals often use the words “I’m sure” to assert things of which they are
                                               not entirely sure. We know—we’ve done it many times. These days, however, we
                                               seem to be “sure” much less often. Instead, we tend to be “quite sure” about some
                                               things and “less sure” about others. Probabilistic thinking has replaced categorical
                                               or binary thinking. While the latter made us more comfortable about many things

DOWNSIDE PROTECTION REPORT — Special Edition         Edited by the Research Team of The Manual of Ideas            4

                                               (“this plane will arrive safely”), the former reflects more accurately the uncertain
                                               nature of our world (“most likely, this plane will arrive safely”).
                                                   Many famed investors will attest that they view the world through the prism of
                                               probability. Such thinking is ideally suited to dealing with an unknowable future,
                                               whether you care about tomorrow’s weather or the completion chances of a merger.
                                               Former U.S. Treasury Secretary Robert Rubin, whose reputation has been tarnished
                                               amid Citigroup’s recent woes but whose talents Warren Buffett describes as
                                               “extremely rare,” considers himself a probabilistic thinker:

                                                                                                                What has guided my career in both
                                                                                                          business and government is my
                                                                                                          fundamental view that nothing is
                                                                                                          provably certain. One corollary of this
                                                                                                          view is probabilistic decision making.
                                                                                                          Probabilistic thinking isn’t just an
                                                                                                          intellectual construct for me, but a habit
                                                                                                          and a discipline deeply rooted in my
                                                                                                          psyche. I first developed this intellectual
                                                                                                          construct in the skeptical environment of
                                                                                                          Harvard College in the late 1950s, in
                                                                                                          part because of a year-long course that
                                                                                                          almost led me to major in philosophy. I
                                                                                                          started to employ probabilistic decision
                                                                                                          making in practice at Goldman Sachs,
                                                                                                          where I spent my career before
                                               Robert Rubin
                                               Treasury Secretary, 1995-99                          As an arbitrage trader, I’d learned
                                                                                              that as good as an investment prospect
                                                            might look, nothing was ever a sure thing. Success came by evaluating
                                                            all the information available to try to judge the odds of various outcomes
                                                            and the possible gains and losses associated with each. My life on Wall
                                                            Street was based on probabilistic decisions I made on a daily basis.

                                                    Probabilistic thinking presents some obvious advantages: For example, it
IMPROVE YOUR INTUITION:                        allows you to calculate more accurately the expected return on an investment, and
Differentiate between                          then decide whether the return is worth the risk. Consider the case of an airline that
certainty and likelihood.                      is believed likely to file for bankruptcy. Many investors would say, “The airline will
“It is unbecoming for young men to             go bankrupt and shareholders will get wiped out. I don’t want to own the stock.” A
utter maxims.”                                 more enlightened investor (you!) might say, “There is a 90% chance the airline goes
                                  –Aristotle   bankrupt and the stock is worthless. If the airline doesn’t go bankrupt, though, the
                                               stock should be worth at least $10.” If the stock can be bought meaningfully below
                                               $1, it may be a good investment even though you expect the company to go
                                               bankrupt. If the company fails, it doesn’t mean investing in it was a bad decision.
                                               As Rubin points out, “even a large and painful loss didn’t mean that we [his
                                               arbitrage team at Goldman] had misjudged anything.” One outcome simply isn’t
                                               enough to judge. Tens of similar situations would need to be tallied up in order to

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                                                   decide whether the investor has a good grasp of the probabilities and payoffs
                                                   involved. Even so, evaluating probabilistic judgments can be tricky.

                                                   Distressed Investing: A Simple Exercise in Probabilistic Thinking
                                                        Consider the following scenario: Over the course of a year, we evaluate twenty
                                                   situations in which a company is in financial distress. Our goal in each case is to
                                                   estimate the probability of bankruptcy. Let’s assume we peg the likelihood at 50%
                                                   in each of the twenty cases. Let’s also assume ten of the twenty companies
                                                   subsequently bankrupt. Looks like we got it right…

  Twenty Hypothetical Distressed Situations—Our Estimates.
   Situation                             1   2   3   4   5   6   7   8   9   10  11  12  13  14  15  16  17  18  19  20
   Attribute A [-1, 0, 1]                0   0   0   0   0   0   0   0   0    0   0   0   0   0   0   0   0   0   0   0
   Estimated Probability of Yes         50% 50% 50% 50% 50% 50% 50% 50% 50% 50% 50% 50% 50% 50% 50% 50% 50% 50% 50% 50%
   Outcome: Bankruptcy?                  Y   N   Y   N   Y   N   Y   N   Y   N   Y   N   Y   N   Y   N   Y   N   Y   N

                                                        …not so fast. While it’s true we estimated the collective probability of
                                                   bankruptcy correctly, we did not succeed in developing a high-confidence opinion
                                                   in any one situation. We based our probability estimate on the value of “Attribute
                                                   A,” which, for example, could be a company’s annual revenue in each of the twenty
                                                   situations. We reasoned that small companies (those with an Attribute A of -1)
                                                   would be likely to file for bankruptcy, while large companies (those with an
                                                   Attribute A of 1) would be unlikely to do so. Since all Attribute A values in the
                                                   above scenario were zeros (all companies involved were mid-sized firms), we
                                                   estimated each probability of bankruptcy at 50%.
                                                        Unfortunately, other investors in our hypothetical scenario turned out to have
                                                   been smarter and we ended up losing money even though one-half of the twenty
                                                   companies did go bankrupt. How could it happen that others invested more
                                                   successfully? Consider the average performance of other investors, or what we’ll
                                                   call the “consensus”:

  Twenty Hypothetical Distressed Situations—Consensus Estimates.
   Situation                             1   2   3   4   5   6   7   8   9   10  11  12  13  14  15  16  17  18  19  20
   Attribute B [-1, 0, 1]                1   -1  0   -1  1   0   1   -1  1    1   0   0   1   0   1  -1   0   1   1   0
   Estimated Probability of Yes         60% 20% 40% 20% 60% 40% 60% 20% 60% 60% 40% 40% 60% 40% 60% 20% 40% 60% 60% 40%
   Outcome: Bankruptcy?                  Y   N   Y   N   Y   N   Y   N   Y   N   Y   N   Y   N   Y   N   Y   N   Y   N

                                                                                                                                       Attribute B
                                                                                                                                  -1         0     1
                                                                                                              Number of   Y        0         3     7
                                                                                                              Outcomes    N       4          4     2

                                                        As the table above indicates, most market participants focused their analysis on
                                                   a different factor or set of factors (“Attribute B”). Attribute B may have been each
                                                   company’s debt-to-equity ratio. If the ratio was low (Attribute B of -1), the
                                                   consensus pegged bankruptcy at 20%. If the ratio was high (Attribute B of 1), the
                                                   consensus estimate was 60%. Weighing those estimates based on the frequency of

DOWNSIDE PROTECTION REPORT — Special Edition             Edited by the Research Team of The Manual of Ideas          6

                                                           Attribute B values, the market’s average bankruptcy estimate was 45%. So even
                                                           though our average estimate hit the mark while the consensus estimate was a bit
                                                           low, other investors actually made money at our expense. Here is why: Assuming
                                                           that each payoff equals the respective probability estimate if bankruptcy
                                                           materializes—and a payoff equal to 100 minus the probability estimate otherwise—
                                                           here are the gross payoffs for us and the consensus:

Twenty Hypothetical Distressed Situations—Gross Payoffs.
Situation                              1        2     3     4     5     6        7       8       9      10       11     12   13     14   15    16      17   18     19     20
Our Gross Payoff                      $50      $50   $50   $50   $50   $50      $50     $50     $50     $50     $50    $50   $50   $50   $50   $50    $50   $50   $50    $50
Consensus Gross Payoff                $60      $80   $40   $80   $60   $60      $60     $80     $60     $40     $40    $60   $60   $60   $60   $80    $40   $40   $60    $60

                                                                                                                             Our Gross Payoff                       $1,000
                                                                                                                             Consensus Gross Payoff                 $1,180

                                                                Of course, since the gross payoff must come from somewhere, we subtract a
                                                           “wager” of $2,180/2 from each total gross payoff. This leaves us with a $90 loss
                                                           and the consensus with a $90 profit. The consensus beat us because others found a
                                                           better explanatory variable for bankruptcy (ignore the small sample size of our
                                                               In the real world, the market is good about estimating probabilities, but you can
                                                           be better. Perhaps there was an “Attribute C” in the scenario above that would have
                                                           mapped perfectly each bankruptcy event to an Attribute C value of 1 and each non-
                                                           bankruptcy to a value of -1.
                                                                How do you go about finding this elusive Attribute C? Sometimes extra work,
                                                           such as digging through SEC filings, makes the difference. Sometimes the
                                                           difference is rigorous asset analysis. Sometimes it is intuition refined by experience.
                                                           The search for Attribute C is never-ending, as perfect foresight is impossible. But
                                                           you can get ever-closer, and the rewards go up exponentially!

                                                           Warning: Skip This Part If You Want to Believe in Miracles
                                                               Scientific American writer Michael Shermer invokes the striking example of
                                                           death premonitions to show how probability theory can debunk seeming miracles:
Humans have a tendency to                                                     A common story is the one about having a dream or thought about
look for miracles and paint                                              the death of a friend or relative and then receiving a phone call five
ordinary people into heroes.                                             minutes later about the unexpected death of that very person.
Embrace skepticism toward                                                     […] In the case of death premonitions, suppose that you know of 10
assertions that defy logic.                                              people a year who die and that you think about each of those people once
                                                                         a year. One year contains 105,120 five-minute intervals during which
“Extraordinary claims require
                                                                         you might think about each of the 10 people, a probability of one out of
extraordinary evidence.”
                                                                         10,512—certainly an improbable event. Yet there are 295 million
                                –Carl Sagan                              Americans. Assume, for the sake of our calculation, that they think like
                                                                         you. That makes 1/10,512 x 295,000,000 = 28,063 people a year, or 77
                                                                         people a day for whom this improbable premonition becomes probable.

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                                                            With the well-known cognitive phenomenon of confirmation bias firmly
                                                            in force (where we notice the hits and ignore the misses in support of our
                                                            beliefs), if just a couple of these people recount their miraculous tales in
                                                            a public forum (next on Oprah!), the paranormal seems vindicated. In
                                                            fact, they are merely demonstrating the laws of probability writ large.

                                                   Shermer’s example shows that probability theory is powerful because it
                                               debunks events that may otherwise go unexplained or spawn fantastic claims. In
                                               investing, there is no room for an individual to say a major catastrophe was a
                                               “miracle” that could not have been anticipated. It is the job of each investor to
                                               construct a portfolio that can withstand “miracles,” including a severe credit
                                               contraction and near-meltdown of the financial system.

                                               Soros on Philosophy
                                                    George Soros, a renaissance man
                                               among today’s fund managers, believes
                                               that philosophy is a worthwhile pursuit for
                                               investment managers. Soros’s love of
                                               philosophy grew under his former mentor,
                                               philosopher Karl Popper. According to
                                               Soros, “Our knowledge is not so securely
                                               based that we can afford to stop asking the
                                                                                                 Karl Popper
                                               eternal questions about the relationship
                                                                                                 Author, The Logic of Scientific Discovery
                                               between thinking and reality, the meaning
                                               of meaning, and so on, even if we cannot find satisfactory answers to them, or, more
                                               exactly, even if the answers always raise new questions. We are fed up with
                                               philosophy because the questions never end. But the questions are inherent in the
                                               human uncertainty principle. If the principle is valid, we must never stop
                                               questioning. A critical mode of thinking is indispensable to a better understanding
                                               of the world and also for making the world a better place.” As further reading on
                                               this topic, we highly recommend Soros’s Alchemy of Finance, Popper’s The Logic
                                               of Scientific Discovery, and books on epistemology, the philosophy of knowledge.

                                               More Intuition: Real versus Monetary Property
                                                    Things such as your car, house, land, gasoline, and orange juice constitute
                                               “real” property. “Monetary” property, on the other hand, denotes dollar bills and
                                               other means of exchange, which possess value because others are willing to
                                               exchange real property for them. Internalizing this distinction is important to
                                               developing the right investment mindset. The difference between real and monetary
                                               is easily comprehended but often disregarded, as real property can be converted
                                               quite effortlessly into monetary property, and vice versa, under normal
                                               circumstances. This caveat is critical to understanding the risk implications of
                                               investing in monetary versus real property.

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                                                    Imagine the following scenario: It is the year 2050, and American retirees have
                                               saved enough money to pay for a carefree retirement. However, they wake up one
                                               day to find that most young Americans have emigrated to pursue a better future
                                               elsewhere. As a retiree, you may still find the window of the local barber shop
                                               advertising a $20 haircut, but there is no barber to provide it. You may have the
                                               same amount of money (monetary property) as before, but it would be more
                                               difficult to convert it into a haircut (real property/service). If lucky, you would have
                                               to pay a little more than $20, perhaps $25, to get a haircut. If unlucky, there simply
                                               wouldn’t be a barber around, regardless of price. Convertibility of monetary into
                                               real property would have become impaired. (This scenario is a form of “extremist”
                                               thinking, which we discuss below.)
                                                    What is the point of the foregoing example? Monetary property has no intrinsic
IMPROVE YOUR INTUITION:                        value; its value is derived solely from the willingness of owners of real property to
Differentiate between                          accept money in exchange. When the supply of real property is constrained, as
monetary and real property.                    above, monetary property becomes worth less (a $20 haircut may cost $25).
Sometimes no amount of                         Inflation alters the terms of trade.
money is enough to buy the
                                                    This intuition is sometimes lost when we talk about less easily conceptualized
things you want most. In a
world of declining productivity                issues, such as the future of social security. Ultimately, the schemes political parties
or depleting resources,                        propose to save social security involve different ways of accumulating financial
inflation is almost inevitable.                property. As the above example illustrates, however, no financial scheme, no matter
                                               how well conceived, will succeed if there isn’t enough real property around (read:
“In an ugly and unhappy world the              working-age Americans or equivalent immigrants) when the financial assets need to
richest man can purchase nothing but
                                               be converted into real goods and services. To be sure, most goods could be
ugliness and unhappiness.”
                                               purchased from overseas, but other, “non-tradable” goods and services, such as a
                 —George Bernard Shaw
                                               haircut, would have to be rationed or would become much more expensive. As a
                                               result, we can say with near certainty that a flare-up of inflation, regardless of what
                                               social security scheme is implemented, would
                                               be inevitable if America’s population pyramid
                                               became too “top heavy.” This insight may
                                               help you steer clear of long-term government
                                               bonds in countries that have bad
                                                   Economics Nobel Laureate James Tobin,
                                               summed up the good features of monetary
                                               property, while elucidating the problem of
                                               convertibility, as follows:

                                                                 By enabling individuals to hold
                                                            wealth in fluid, flexible, and
                                                            generalized forms and to consume
                                                            wealth at will, our monetary and
                                                            financial institutions create an illusion.    James Tobin
                                                            […] One individual’s wealth is both           Economics Nobel Laureate, 1981

DOWNSIDE PROTECTION REPORT — Special Edition         Edited by the Research Team of The Manual of Ideas           9

                                                            consumable in total and fluid in form without loss of value, but only so
                                                            long as most other owners refrain from exploiting these same
                                                            characteristics. […] It is quite impossible for all individuals in the nation
                                                            to consume their wealth at the same time.

                                                   Tobin’s quote succinctly explains why you could retire on $1 million
                                               tomorrow, but why not every person in the world could retire tomorrow, even if
                                               each were given $1 billion today.
                                                    This train of thought, in a slight digression, leads us to an observation regarding
                                               the superiority of the capitalist economic system: Capitalism appears to be the most
                                               workable system not only because (1) it makes people work harder thanks to the
                                               ability to build and retain wealth, but also because (2) most people who have built
                                               enough wealth to retire choose to continue working instead. We know that socialism
                                               failed because it lacked condition (1), but the real reason might be that without
                                               condition (1), socialism never came to enjoy the benefits of the human behavior
                                               described in (2). The crucial importance of condition (2) becomes evident if you
                                               consider what our capitalist system would look like if every CEO, CFO, fund
                                               manager, investment banker, and politician who can afford to retire actually chose
                                               to do so. (Well, considering recent events, perhaps that wouldn’t be such a bad thing
                                               after all!)

                                               Yet More Intuition: “Extremist” Thinking
                                                    What we call “extremist thinking” in the context of investment management
                                               has nothing to do with how the term is commonly used in society. Investment-
                                               related extremist thinking can be one of the most useful tools for analyzing complex
                                               interactions between economic variables. Often, the causal relationship between two
                                               or more variables is difficult to judge. Pushing a variable toward an extreme can
                                               help illuminate a relationship.
                                                    We have found extremist thinking as useful as the commonly accepted insight
                                               that there is “no free lunch.” The latter truism helps investors avoid schemes that
                                               promise much but in the end deliver little. Extremist thinking can have a similarly
                                               powerful effect on investment decision making.

                                               An Example: Impact of Currency Devaluation on ADR Prices
                                                    The following thought process, which explores the relationship between
                                               currency devaluation and American Depositary Receipt (ADR) prices, shows why
                                               extremist thinking can be indispensable in some circumstances.
                                                    Consider this question: What happens to the price of an ADR if the foreign
                                               company’s home currency is devalued by 20% versus the U.S. dollar? Since ADRs
                                               are quoted in dollar terms, you may conclude that the ADR price should also
                                               decline by 20%. This may indeed occur, assuming that the company’s home
                                               currency stock price remains the same. But is this assumption realistic? Since a
                                               sharp currency devaluation and investor pessimism regarding a country’s economic

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                                               prospects go hand in hand, investors are likely to sell the locally listed shares as
                                               well. The decline in the foreign stock price, coupled with 20% currency
                                               devaluation, of course, implies that the ADR price may fall by more than 20%. So
                                               far, this scenario sounds logical and, indeed, it routinely occurs in real life.
                                                   But what if we consider these questions by invoking extremist thinking? What
                                               if we push the assumed currency devaluation to an extreme, i.e., what if the local
                                               currency is devalued not by 20% but by 95%? Would the ADR price drop by 95%
                                               as well? Or, as we have seen above, could the ADR price drop by even more than
                                               95%? Might a foreign company that, for example, is the number-one media
                                               company in its country, has a strong balance sheet, and was valued at $5 billion
                                               only a few days ago suddenly be worth $250 million or less simply because its
                                               government wasn’t able to defend the currency?
                                                    If a $250 million valuation for such a company doesn’t strike you as odd, let’s
                                               take one more step in our extremist thinking. Imagine a different foreign company
                                               that owns 10% of the real estate of an entire country (let’s say Argentina), has no
                                               debt and is profitable. Also imagine that there are no calls in the country to
                                               confiscate property from investors. If the home country’s currency is devalued by
                                               99.999990%, should the company’s market value decline from $10 billion to $1
                                               thousand? (Hint: We would love to buy 10% of Argentina’s land for $1,000, no
                                               matter how worthless the local currency!)
                                                    The following must be true to prevent someone from buying 10% of Argentina
                                               for $1,000: The Argentine company’s stock price in local currency terms must soar
                                               post-devaluation rather than decline, contrary to our initial instinct above.
                                                   Extremist thinking has just helped us debunk a widespread stock market
                                               misconception—that stocks of companies in countries undergoing major currency
                                               devaluation should fall not just in dollar terms but also in local currency terms
                                               because of the deteriorating home-country economic situation.
                                                    Of course, just because investors may be wrong to sell such foreign companies
                                               in local currency terms, there is nothing to prevent them from doing so anyway.
                                               However, such behavior may create a unique buying opportunity.
                                                    Next time a currency undergoes major devaluation, we will certainly take a
                                               look at how the ADRs of affected companies respond. If the ADR prices drop by
                                               more than the currency decline, and if the companies own real assets (such as raw
                                               materials, land, or industrial equipment) and have a healthy balance sheet, we will
                                               take a close look. In late 2002, when the ADR price of Cresud (Nasdaq: CRESY),
                                               an Argentine agricultural company with large land holdings, was cut in half due to
                                               the devaluation of the Argentine peso, we found the shares a compelling value.
                                               Cresud had a solid balance sheet and was trading significantly below tangible book
                                               value, suggesting that investors had overreacted. A year later, the ADR price had
                                               increased from $5 to $15.

DOWNSIDE PROTECTION REPORT — Special Edition         Edited by the Research Team of The Manual of Ideas   11

                                               Keynes’s “Beauty Contest”
                                                   John Maynard Keynes’s “beauty contest” refers to the attempt by investors to
                                               guess what other investors will do in the future, and to “beat them to the draw.”
                                                    Extremist thinking makes it quite clear
IMPROVE YOUR INTUITION:                        that the “beauty contest” is a zero-sum
                                               game: If all investors focus solely on
Don’t get caught up in the
                                               guessing the future behavior of other
market’s mood swings. Just
because other people are                       investors, there will be no reason for anyone
crazy about a stock does not                   to allocate capital based on underlying
mean you need to own it. Use                   fundamentals. If all that mattered to each
your own criteria to decide                    participant’s investment decision was the
whether you should buy a                       perceived future behavior of others, there
piece of a business—and at                     would be nothing to stop investors from
what price.                                    making the weather, the outcome of the
“Money is what you’d get on                    Super Bowl, or the spelling of a company’s
beautifully without if only other              name (think “.com”) the criterion upon
people weren’t so crazy about it.”             which “beauty” (investment merit) is
                                                                                                John Maynard Keynes
                      –Margaret Harriman       judged. Capital won’t flow to projects           British economist, 1883-1946
                                               promising the best risk-adjusted return;
                                               instead, capital will flow to companies most in vogue.
                                                   Extremist thinking therefore shows that the self-referential guessing game in
                                               which so many investors engage does nothing to make capital allocation in the
                                               economy more efficient. Making money by engaging in a beauty contest requires
                                               one to outsmart other investors—it’s the ultimate zero-sum game.
                                                   By contrast, investing in companies based on their underlying value puts one in
                                               a position to make money because the investee companies will pay dividends or
                                               reinvest their profits into attractive projects.
                                                    While many observers contend that investing is a zero-sum game no matter
                                               what strategy investors employ, extremist thinking suggests that investing based on
                                               fundamentals is not a zero-sum game because it makes capital allocation more
                                               efficient. This increases market-wide returns. If all stock market participants
                                               focused only on fundamentals, investors might be able to earn 10% from stocks, on
                                               average, rather than perhaps only 2%, on average, if all of them engaged in a beauty
                                               contest. Market reality lies somewhere in-between.

                                               Explosion of Indexing Vehicles
                                                    The case for investing in low-cost ETFs and index funds often rests on the
                                               assertion that investing is a zero-sum game and that the only way to win is to lower
                                               costs. While it’s true that the mutual fund game is by definition a zero-sum game,
                                               extremist thinking shows that indexing is not all benefit and no cost.
                                                   There is a tradeoff between lowering costs via indexing and lowering returns
                                               due to inefficient capital allocation. Consider this extreme: Everyone invests in an

DOWNSIDE PROTECTION REPORT — Special Edition         Edited by the Research Team of The Manual of Ideas    12

                                               index fund. We know that everyone would perform the same. Everyone would incur
                                               low costs and match the market-average return. But what would the market-average
                                               return be? Extremist thinking suggests it might be as low as zero or worse.
                                                    If everyone were invested in an ETF or index fund, there would be no
                                               mechanism for pricing assets. Who would say what a company was worth? Who
                                               would determine which companies should be in the index? Who would invest in a
No financial instrument is a                   private company seeking to go public if such a company has no market value prior
panacea. New products, such
                                               to the offering and therefore has no index fund constituency?
as ETFs and leveraged ETFs,
may seem like a big                                 In other words, an index fund is a dumb investment vehicle. An index does not
improvement over index funds                   care about returns on capital or any other variable related to invest merit. An index
and mutual funds, but ETFs                     cares only about descriptive variables such as market capitalization, geography, or
have their own drawbacks.                      industry affiliation. If index funds could invest without moving market prices, they
                                               would have no effect on the efficiency of capital allocation in the economy. But
“Every generation laughs at the old
                                               since index funds do move prices, and since real capital is tied up in them, those
fashions, but follows religiously the
new.”                                          funds make worldwide capital allocation less efficient. Given the amount of capital
                                               currently invested in ETFs and index funds, the magnitude of the negative effect is
                   –Henry David Thoreau
                                               probably small but not negligible.
                                                    In this case, extremist thinking has illuminated the tradeoff investors as a group
                                               face with index funds. There is a point at which the fee-lowering benefit of index
                                               funds is outweighed by the cost of less efficient capital allocation. We can argue
                                               where that “point of indifference” lies on the continuum from 0% to 100% of index
                                               fund assets as a percentage of total stock market assets. Extremist thinking does not
                                               specify such a point, but it does make it clear that such a point exists.

DOWNSIDE PROTECTION REPORT — Special Edition         Edited by the Research Team of The Manual of Ideas    13
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