The Pleasure/Pain Principle

The financial crisis of 2008-2009 was painful, not to mention the Flash Crash of 2010; the Debt Ceiling / Credit Downgrade of 2011; and the never-ending European saga. Needless to say, these and other events have caused pain akin to burning one’s hand on the stove. This unpleasant effect has rubbed off on investors.

Admitting one has a problem is half the battle of conquering a challenge.  A key challenge for many investors is understanding the crippling effects fear can have on personal investment decisions. While there are certainly investors who constantly see financial markets through rose-colored glasses (my glasses I argue are only slightly tinted), Nobel Prize winner Daniel Kahneman and his partner Amos Tversky understand the pain of losses can be twice as painful as the pleasure experienced through gains (see diagram below).

Said a little differently, faced with sure gain, most investors are risk-averse, but faced with sure loss, investors prefer risk-taking. Don’t believe me? Well, let’s take a look at some of Kahneman and Tversky’s behavioral finance work on what they called “Prospect Theory” (1979) – the analysis of decisions made under various risk scenarios.

In one specific experiment, Kahneman and Tversky presented groups of subjects with a number of problems. One group of subjects was presented with this problem:

Problem #1: In addition to whatever you own, you have been given $1,000. You are now asked to choose between:

A. A sure gain of $500

B. A 50% change to gain $1,000 and a 50% chance to gain nothing.

Another group of subjects was presented with this problem:

Problem #2:  In addition to whatever you own, you have been given $2,000. You are now asked to choose between:

A. A sure loss of $500

B. A 50% chance to lose $1,000 and a 50% chance to lose nothing.

In the first group, 84% of the respondents chose A and in the second group, 69% of the respondents chose B. Both problems are identical in terms of the net cash outcomes ($1,500 for Answer A, and 50% chance of $1,000 or $2,000 for Answer B). Nonetheless, due the different “loss phrasing” in each question, Answer A sounds more appealing in Question #1, and Answer B sounds more appealing in Question #2. The results are irrational, but investors have been known to be illogical too.

In practical trading terms, the application of “Prospect Theory” often manifests itself via the pain principle. Due to loss aversion, investors tend to cash in gains too early and fail to allow their winning stocks to run higher for a long enough period.

The framing of the Kahneman and Tversky’s questions is no different than the framing of political and economic issues by the various media outlets (seePessimism Porn). Fear can generate advertising revenue and fear can also push investors into paralysis (see the equity fund flow data in Fund Flows Paradox).

Greed can sell in the financial markets too. The main sources of financial market greed have been primarily limited to bonds, cash, and gold. If you caught those trends early enough, you are happy as a clam, but like most things in life, nothing lasts forever. The same principle applies to financial markets, and over time, capital in today’s winners will slowly transition into today’s losers (i.e., tomorrow’s winners).

A healthy amount of fear is healthy, but correctly understanding the dynamics of the “Pleasure/Pain Principle” can turn those fearful tears into profitable pleasure.

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Buffett & Munger on Gold

This morning on CNBC, Warren Buffett offered his views on gold.

According to him, productive assets (and maybe even caves) have an advantage over the yellow metal.

As he has said on earlier occasions, Buffett believes since gold is not a productive asset that, over the long haul, it will not do as well as productive assets like farmland and stocks.*

Buffett added that gold buyers have it right to be concerned about the future value of paper money, but he thinks the strategy of buying gold to protect against that decline is the wrong one. From this CNBC article:

They have a "correct basic premise" that paper money will be worth less in coming years. 

He disagrees with them on the strategy of buying gold to avoid that decline in value. 

Buffett later added... 

"They want everybody to be so scared they run to a cave with gold. Caves might be a better investment than gold. At least they're not producing new caves all the time." 

Charlie Munger believes civilized people don't buy the yellow metal. In this separate interview on CNBC, he added:

"...I think civilized people don't buy gold, they invest in productive businesses."

It's certainly not at all wrong to expect that paper money will go down in value. In fact, paper money almost certainly will go down in value over time, much as it has been doing this past century or so.
(and, well, pretty much throughout financial history.)

It's just that the right productive assets (durable competitive advantages, capable management, conservatively financed) bought at the right price (comfortable margin of safety), at least in the long run, offer a fine way to protect against that seemingly inevitable decline in paper money, Well, at least for the investor with discipline, who can judge value well, and control emotions during market highs and lows.

Now, let's say gold does in the long run, in fact, perform better than the paper currencies (as it very well may).

To me, that's equivalent to voluntarily choosing to be the passenger of one of two sinking ships when there's a more seaworthy long-term alternative.

Best case, the satisfaction comes from having chosen the sinking ship that, under certain conditions, seems to be remaining afloat but may actually also taking on water, albeit more slowly.

The more seaworthy alternative, that being well-chosen productive assets (especially the more durable ones), not only can remain afloat but the better ones benefit from a rising tide that to some extent is their own making.
(By producing something useful and through reinvestment of the proceeds generated.)

A farm (especially one with some built in advantages, better yielding, well-located etc.) will still be a farm in a hundred years (assuming no development of it for other purposes) but its owner(s), and the world for that matter, will have benefited from everything it has produced over that time, plus what it's capable of producing from that point forward.

The value of what the farm produces each year will be sold at inflation-adjusted prices, of course, in whatever currency exists at that future time. So some inflation protection is built in. Also, technology has a good chance of continuing to enhance what that farm can yield per acre (better seeds, fertilizer, machinery etc.).  Compounded over a long period of time, the growth in value of this activity is far from inconsequential. This works with partial ownership via marketable securities of the right businesses (as, of course, does outright ownership).**

In contrast, an ounce of gold will also just still be an ounce of gold in a hundred years, but will have produced nothing of use or value in all those intervening years for the owner(s), and will continue to produce nothing of value. Since gold is a nonproductive asset, itsfaith-based price depends on how the changing attitudes of buyers/sellers impact demand for it, and whether lots of the yellow stuff happens to be discovered over time.

To me, that seems a pretty daunting thing to effectively judge.

I can certainly see why many would want to bet that gold, over the long run, will be worth more than all the paper money that is being printed.

It just seems that there are more weaknesses and limits to this approach than some admit.

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Buybacks Take a Smarter Tack

Here's a Wall Street Journal article on the recent share buyback behavior of companies in the S&P 500 index. Apparently, companies did plenty of buying when the market was low then backing off as it rallied.
Buybacks take a smarter tack
The fact is companies do not always get this right. The article also points out that buybacks were at record levels as the market was peaking back in 2007. Yet, once stock prices fell dramatically, the buyback activity dropped off quite a bit.

Substantial corrections can happen (and have happened) where shares in general never fall to an unattractive valuation. So I'd be cautious about considering a large generalized drop in market prices, in combination with aggressive buyback activity, to be a reliable indication that shares are being bought back cheap.

A big drop certainly increases the probability that shares are at bargain valuations but hardly assures it.

For too many stocks, even near the bottom of some of the corrections (including larger ones in the past decade or so), the market price relative to intrinsic value provided insufficient or no margin of safety. Having said that, this most recent time there seemed to be quite a few bargains made available by market conditions in the third quarter of last year.

So, at least in this instance, many companies seemed to be getting it more right than wrong.

Effectively executed buyback programs usually have management (and a Board of Directors) who 1) provides a clear indication, through words and past actions, that they know what their shares are likely worth and 2) a track record of buying back shares more often than not when:
- the discount to intrinsic value is substantial,
- the business itself is in a comfortable financial position, and
- other more attractive investing opportunities are not on the horizon.

For long-term investors, large corrections in market prices are always a welcome thing to see. It often creates an environment where the price of individual shares become very attractive compared to intrinsic value.

Long-term investors can naturally take the opportunity to buy more shares when they're at a discount to value, but it's nice to know that management is likely to intelligently do the same with excess cash.

It's good to see the recent buyback pattern but, at least to me, it's not sufficient to look at what companies as a group are doing with buybacks. The track record is just too mixed. Instead, I'd rather look at the buyback behavior of a specific company, especially one that I happen to know its specific strength and challenges very well.

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How US Economy Changed Since Last FOMC Mtg

Here’s a table comparing how the US economy has changed since the last FOMC meeting in March. More weakness than strength 4 sure…

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Now NZ Economy Fared Since March Mtg

Aside from the Federal Reserve, the Reserve Bank of New Zealand also has a monetary policy announcement this afternoon. The RBNZ is expected to keep rates unchanged – hard to validate a rate hike when the RBA is planning to ease. Also, the last time the RBNZ met, Governor Bollard said “sustained strength in NZD would reduce the need for further increases in the cash rate.” – So it doesn’t look like rate hikes are in the pipeline until there is more evidence of a recovery. Nonetheless, here’s a table of how the economy changed since the last meeting:

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Read Quartery & Annual Reports

Now that March has passed, companies have finished reporting annual results for last year and are busy preparing to release Q1 results in the April-June time frame.  Its a good opportunity to catch up on reading the reports that are related to your investment holdings and potential investment candidates.  Reading quarterly & annual reports help investors to gain more information & accumulate knowledge. Other benefits include insights and details that are not usually mentioned in press releases.  Such information will help investors to make better & safer investment decisions.  I consider this activity to be one of the keys to successful investing and will highlight exactly how it benefits your investments profits.

Important But Often Ignored By Individual Investors :

Reading the company reports (quarterly and annual) are one of the simplest things an investor can do that will return the greatest benefit.  Yet, many individual investors tend to skip it, opting to instead follow the stock’s price movement or read “financial pornography” related directly/indirectly to buying/selling the stock (How you can retire off it,  How it’s the perfect stock,  How the stock can make you rich,  Whether or not you should invest in it,  Its dividends,  Why it should be in your portfolio,  etc).

Investors also convince themselves that they are doing enough just by reading quick summaries & highlights posted by various news sources, rather than reading through the reports themselves. The number one excuse given is that it takes too long and they don’t have the time.  However, consider that its likely to take a much longer time to re-accumulate lost investment capital from bad investment decisions or a lack of taking necessary action, as a result of not reading crucial information contained in the report!  A few bad decisions, and the financial losses become quite large very quickly, and difficult to recover from.  Summaries & highlights are great sources of timely information, but are not substitutes for actually reading the reports.

Benefits Of Reading Quarterly & Annual Reports (Awareness & Insight – Better Decisions) :

The main purpose of reading the quarterly & annual reports is to gain information & knowledge.  Reading them helps an investor gain insight into the business itself in terms of growth, current health, direction of the business, etc..

The reports usually detail potential negative and positive issues, and other factors that may have an affect on future performance/results, as well as the industry in general.

• Current success – they are doing what you want them to do, business operating as expected, building strengths, etc. [Examples - project milestones, company milestones, market share, efficiencies, early stage successes, etc.]
• Current issues – what they are, what area of the business is being impacted, challenges, associated risks, weaknesses. [Examples - bad debts, write-downs, government regulation changes, labour strikes, material cost increases, new competition, disruptive technologies, etc.]
• Insight into upcoming quarters or year(s) – growth initiatives, direction, industry challenges & issues. [Examples- Patent cliffs, cost cutting plans, large expansion, loan losses, M&A, entry into new industry or business, etc.]

Insight Allows Investors To Determine The Impact Of Issues :

• How each aspect impacts the business.
• How long the impact may be (lasting or temporary?).
• How the intrinsic value may be affected.

Details Not Mentioned Elsewhere:

Perhaps one of the most beneficial reasons for investors to read the reports, are that significant details are found in them, that are often not mentioned elsewhere (not in regular press releases, news articles, or analyst comments):

• Certain qualitative details (ex: strategic initiatives) whose importance and significance cannot be conveyed by earnings headlines or numbers, as they simply have not yet had an effect on the numbers yet.
• Certain quantitative information (numbers, metrics, etc.) are often not stated in headlines or press releases (numbers too detailed or specific, not a main indicator), but are significant to the investor and can only be found in the reports.

Information & Insight Allows For Better Investment Decisions:

The details contained within quarterly & annual reports, whether quantitative or qualitative, are just as important as the main financial results, as they enable the investor to make informed & better decisions:  

• Capitalize on opportunities at earlier stages.
• Awareness allowing for decisions to be made in order to reduce risk of loss (risk mitigation).
• Better able to judge business/operating performance of company, as well as compare against its peers using a number of metrics.
• Being able to act on negative issues or can determine if an investment is worth investing in.  May allow you to dispose of or reduce investment exposure at a more favorable price (rather than a less favorable once issue becomes larger and makes headlines).
• Intrinsic value calculation may change in light of information – current stock price may be trading higher/closer or lower/further to updated intrinsic value, which may justify adding to or reducing/selling the investment.
• etc.

Beginners Understand Less But Gain A Lot :

Beginners have much to gain and benefit from reading reports.  It helps them become familiar with the format and regular content contained within reports, the details of the specific company’s operations, and the management team. The biggest benefit is in terms of risk mitigation. Both Benjamin Graham and Warren Buffett continually remind investors that “risk comes from not knowing what you are doing”.  Being ignorant of the business and issues related to it (that can be found in the reports) increases the risks significantly.

Recommended Approach :

Investors should get into the habit of reading quarterly & annual reports from each investment holding cover-to-cover. It is the minimum necessary ongoing due diligence.  Most are downloadable from website as a pdf found on the company’s website (Investor Relations section).  Just read it, and don’t worry if you don’t understand every single item being discussed or presented.  Rather, don’t let that be an excuse not to read it!You will still learn something and gain valuable information. Investors will gradually become more familiar the format, content, and language. You will gradually know what to look for, as well as be able to identify the tone of the report (positive/negative).

There is no set rule as to what to look for, as it is highly dependent on the specific stock/business, as well as investor preference (some may like to concentrate on a specific metric more than others for various reasons). However, many investors will choose to skip the mundane numbers & financial statements.  But they are a must read!  Reading the numbers rather than just Management Discussion & Analysis (MD&A) is important because some items may not be discussed, but tell a lot.  Numbers can give insight into what is happening and the changes in the level of risk.  Some examples include:

• Debt levels of casino/gaming companies. The debt levels showed that many gaming businesses borrowed huge amounts of money (too much) to fund casino property development.  One nay not know if it came from cash on hand, without reading the reports.
• Increasing loan loss reserves and detailed loan breakdowns.  Prior to the financial crisis in 2007, many investors could have saved themselves from heavy losses if they had taken the time to look at these numbers!
• Increasing credit costs! Increasing debt ratios!

Additional Tips:

• Many qualitative issues are in the management discussion and analysis section (MD&A).
• Quantitative data, are in tables or charts as well (you can get a quick picture of things from looking at these tables).
• Numbers that matters for specific industry. [Examples - NIM is important for banks, FFO for Real estate investment trusts, etc.]• Financial data – Look at absolute numbers, but also compare with previous year and/or previous quarter (relative).
• Be aware that results can sometimes be important, while at other times not. [Examples -  Seasonal/cyclical fluctuations, real issues or large improvements/decline?.  Disposition of some assets may temporarily increase profit, write-downs may temporarily decrease profit.  These may not be indicative of the true operations of the business.  Net operating income, sales revenue, etc.]• Have some questions in mind that you want answered before reading, so you also look for the answer in the report.
• Look for red flags, financial performance, and strategic initiatives.

A Few More Specifics (among other things) I Usually Look For :

• REITS: cap rates on new properties, refinancing rates on properties, sources of financing, tenants, same store sales per sq ft, leasing activities, etc.
• Financial Firms: loan loss reserve ratio, capital ratio, NIM, etc.
• Production capacity, production output.
• Revenue growth of specific products/services in specific geographic markets.
• New strategic initiatives/changes, marketing efforts, etc.
• Sources of financing & revolving credit lines, and corresponding rates.
• Management’s tone (positive/negative) & outlook.

These are just a few specific items to give you an idea. There are just too many to list.

Use Time Saving Tools:  Use time saving tools such as Evernote and Read-It-Later.  You can save & store the reports or read them later (without having to re-download or search for them again).

Earnings Conference Calls:  I also recommend listening to earnings conference calls, particularly the management Q&A session.

Insight Makes A Big Difference :

One small piece of information found in a quarterly or annual report, can make all the difference between significant investment profits or losses.  This information & insight, allows you to not only see where the ball was and is currently, but where it is going to be.  In investing, that is something you need to know very well, which you can accumulate from reading the reports.  It is an activity that helps to achieve consistent investment returns.

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Dow Hit a New High

I think Dow hit a new high yesterday. I'm still feeling very uncomfortable because of contradictory evidences that I have seen. I like this piece written by John Hussman. It's a long article but I will just extract the charts for you. For more details, please visit http://hussmanfunds.com/wmc/wmc120326.htm. He has done a great job to refute some of the popular beliefs.

Evidence #1: Valuation wise, we are no where near a secular bull market. His valuation model says the return of the next 10 year is only 4%. Sucks!!!!!



Evidence #2 : The stock is cheap. Yeah but profit is seems to be out of norm. Reversal to mean will make stock valuation expensive.



Evidence # 3: The consumers are doing fine. How would they are doing fine if wages disbursement have not shown any improvement?



Evidence # 4: "The Fed is creating huge amounts of money, and all of that money has to go somewhere."

My comment on evidence # 4: Probably Keynes is correct. We are all dead in the long run. Things are absolutely not making sense to me empirically but what can I do? The bloody Fed force everybody to spend and borrow. 

SPEND!!!!!! and BORROW!!!!!!

They export the similar model to the rest of the world as well. Trichet was making a comment of what he called behavioural contagion. His successor Daghi seems to prescribed the exact same medicine. (http://globaleconomicanalysis.blogspot.com/2012/03/trichet-warns-of-behavioral-contagion.html)

This kind of investment environment is absolutely disastrous. You can get caught at the wrong end very easily.

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