Friday, April 7, 2017

JP Morgan 2016 Annual Report (JPM)

I haven't posted much about JPM recently as it's still basically the same story. Great CEO building an awesome company performing really well etc.  After even a couple of posts, they are basically the same.

But since I haven't been too active here recently, I figured why not? Let's take a look at this. There is a lot to learn here, not just about banking and the economy, but about markets and investing too.

So first of all, let's look at how well JPM has done in recent years. And it's not just because of the huge bull market since 2008. If you look at the performance figures below, they go back to 2004, and the performance chart in the proxy is from 2007, which is the benchmark I use to get 'through-the-cycle' returns.

Anyway, Dimon's Letter to Shareholders is really good so go read it if you haven't done so already. I sort of look forward to this one even more than Buffett's lately.

Check out the total return of JPM stock over various time periods:



This is really crazy given what has happened since 2000 and particularly after 2007. Back in 2000, I don't think anyone would have guessed JPM stock would outperform the S&P 500 index over the next 16 years. People were bearish the financials after the collapse of the 1999/2000 internet bubble, especially JPM which had a large investment bank attached to it with trillions in notional derivatives outstanding. For years, JPM has been considered the first domino in the coming financial collapse.

And yet, look at that! Yes, bears will argue that JPM got bailed out during the crisis etc. I've talked about that a lot here so won't go into it too much, but I disagree. I agree that the government bailed out the whole system, which is what it should do (that's what the Fed is for, and that's what the government has the power to do in extraordinary situations).  But I don't think JPM was in any danger unless the whole system itself collapsed, in which case nothing would matter anyway. 

So let's look at the performance of the company itself:


This is just totally insane. TBPS has increased even more than the stock (total return).

Here's a chart from the proxy that is indexed to 2007:


That's a 10.5%/year return since 2007.  That's crazy. Let's say you knew that the worst financial crisis would come and almost destroy the country. People would have called you an idiot if you said, "Fine. I don't care. My stock will return 10.5%/year over the next 9 years!".  In fact, I did own JPM and didn't sell in front of it, even when cracks appeared. I didn't sell any during or immediately after either. 



Investment Lessons
And here's sort of the lesson on investing. It was widely known that Dimon was a super-competent manager when he took over Bank One. I think he was already considered at the time one of the best managers in finance. When he left Citigroup, many thought C would collapse because Dimon was the detail guy that made sure everything was OK.  Sandy was a big picture guy while Dimon chased after the details. No Dimon == noone looking at the details => eventual blowup. (I heard this from someone that was there at the time and watched how they worked up close too.)

But a lot of people didn't invest in JPM because it was a large money-center bank and banking cycles tended to be severe. Everyone remembers the banking crisis of the 1970's and the late 80's/early 90's.
So the thought was 'thanks, but no thanks'.  I confess I was one of those. I've owned Bank One since forever and JPM too, but never allowed it to become a huge position because of that. (On the other hand, I would not mind being 100% in Berkshire Hathaway, even though BRK has gone down 50% on a number of occasions).

In 2007, bank stocks were expensive and we were at the tail end of a very long credit cycle. Contrary to the claims of some best-selling books, the leverage built upon shrinking credit spreads was pretty well-known within the industry. It would have been wise to not be too exposed to financials at this point.

But, when you own a great business run by great people, it is often better off to ride out the cycles than to try to time them.  And that's another lesson here with JPM stock. This is not really hindsight trading either, as I would have told you back in 2007 (and I think I did even though this blog was not in existence back then) that JPM and GS would be the survivors in any crisis, and they would come out the other end bigger and stronger (as Charlie Munger says about how great companies grow; they grow in bad times, just like Rockefeller, Carnegie and everyone else did).

The argument back in 2007 really focused a lot on the notional derivatives outstanding at JPM. This was one of the major red flags that kept some investors away. I have managed derivatives before so understood that notional amounts outstanding is not a measure of risk. When you are a big banker and dealer, you end up with huge amounts of notionals outstanding because, for example, if you issue bonds for an issuer, you sometimes do interest rate swaps to accommodate the client's cash flow needs. Same with FX. As a major FX dealer, you often use swaps as a tool to help risk-manage clients' risk exposure.  Those 'straight' swaps often have very little risk.

Cyclical or Secular?
The other lesson is that markets have cycles. After the financial crisis and after JPM has shown its resilience and management competence, it traded cheaply for a long time. Even the most prominent bank analysts would say things like, "Yes, it's cheap, but there is no reason to own it as regulations make it hard for them to make money...". I've heard that argument over and over again post-crisis.

But these folks held a linear, static model in their heads. They didn't realize, or underestimated how the industry would adjust to new regulations and requirements. If the regulatory capital burden got too heavy in a line of business, they would drop it. They can cut expenses. They can reprice products as new regulations apply across the industry.  Sure, they may not get back to bubble-era returns, but banks don't need to to be good investments.

Maybe this was due to the short-term nature of Wall Street; with regulatory headwinds and low interest rates, bank stocks were simply not recommendable.

Either way, long term value investors look to invest in great businesses at reasonable (or cheap if available) prices.

And interestingly, now, hedge funds and others seem to be piling into banks.  Nobody wanted JPM at $20 or even $40, and now they are piling in at over $80!  And people say the market is efficient, picked over etc.?

I think all of this sort of just illustrates the cyclical nature of markets. The key in successful investing is being able to see the difference between cyclical and secular. It's true that this is very hard a lot of the time. But I never thought banking itself was in secular decline. Every year, Dimon has shown how much business needed to be done over the long term in banking.

Regulations tend to be cyclical too as the pendulum can swing wildly from one extreme to the other. We are now seeing the pendulum start to swing back the other way. As Dimon says, a lot of this can be done (simplify regulations) without congressional action.

By the way, I have a lot to say about this, maybe in future posts, but I do believe that this max exodus out of hedge funds too is cyclical, as is the move towards machines (vs. people) / indexing. I do believe that most hedge funds probably don't deserve to exist, and machines will more and more take over money management, but I think it will still be very cyclical.  We have seen this before in the past; move to quantitative money management, indexing vs. active, hedge funds vs. index etc...

Buffett and WFC
And this sort of thing explains why Buffett has been buying WFC for all these years, even right before the crisis. I always heard comments like, "doesn't Buffett see this big trouble brewing? This huge storm?  Doesn't he understand that the era of big banks is over?". He has been buying before, during and after the crisis at 'high' prices.

He focuses on what a business can earn on a normalized basis over time, so he doesn't care about the short term outlook. He doesn't care about what other people say. He doesn't worry about downturns as strong institutions should be managed to survive and grow in such situations. Trading in and out to avoid such dips is a loser's game.





2x Tangible Book
Dimon says it was a no-brainer to buy back stock at 1x tangible book, but says this year that it still makes sense to buy back stock at 2x TBPS. That would be over $100/share!

That sounds insane. Who would have even guessed JPM would be closing in on $100 just a couple of year ago? 

Assuming a 50% payout ratio on $6.00 or so in EPS, that would be $3.00/share in dividends.  Using a $100/share price, that's a 3% dividend yield.  Assuming JPM grows along with the economy (4% nominal), that's an expected total return of 7%/year against what I would assume a normalized long term rate of 4% (actual is 2.3%).  As a sanity check, EPS grew around 4%/year from 2007 to 2016. 

OK, students will immediately jump on me and argue that earnings growth should be 6.5%/year for a 9.5%/year return (50% retention at 13%). Well, JPM is a big bank so it may not be able to grow that much more than GDP over time, so let's just say earnings grow at nominal GDP.  That would just mean that payouts would be higher as capital can't be invested at a 6.5% growth rate.  

In that case, payouts may be 70%.  On a $6/share EPS, a 70% payout is a $4.20/share dividend for a yield of 4.2% (again, at a $100 stock price).  4.2% dividend yield plus 4% growth is 8.2% expected return. 

This reminds me of Buffett talking about how he bought a stock yielding more than the financial products the company was selling. 

Of course, as we wait for things to normalize, bad debt may normalize too; JPM is sort of over-earning in the sense that credit trends are really good now. This has probably bottomed out and should head higher. I don't think there are any time bombs at JPM, but it will sort of be a race on the economy picking up steam and interest rates normalizing versus credit trends bottoming out. 

But of course, stocks never trade at what they are supposed to trade at. Which leads to my next digression.

Models and Odds: Ed Thorp Book
I was actually going to make this a whole separate post; maybe I still will.  But writing the above got me back to thinking about models, odds and things like that.

This goes back to the argument about stocks being expensive or not, wondering about being short because the market is overpriced and losing money for years on end etc.

I just finished this book by Ed Thorp:  A Man for All Markets

And I have to say it's one of the best books I've read in a long time. It's not a manual like Securities Analysis or the Greenblatt books, but an autobiography.  But it is a fascinating read. Some may be disappointed by the lack of mathematical details, but this is not meant to be that sort of book. In any case, the math involved in what he talks about is widely available now anyway. But the thinking that went behind figuring all this out is fascinating.

Other than his adventures in Las Vegas, I've been involved in just about every area he talks about in the book, from options, warrants, convertible bonds, closed-end funds, even the Palm stub trade, statistical arbitrage etc. (One thing he fails to mention about the Palm trade is that even though it looks like the market is inefficient, in some cases, there is no stock to borrow to implement the trade; rebates go through the roof and reduces or takes away potential profit etc... The stock lending side is often not as visible).

For Buffett fans, there is a whole chapter on Warren Buffett, which is fun to read. They knew each other and Buffett even checked him out over dinner long ago.  Thorp also invested in Berkshire Hathaway but moved his money elsewhere as returns went down as BRK got larger.

One interesting fact that Thorp mentions is that the Buffett partnership returned 29.5%/year, gross, in the 12 years from 1956-1968 versus 19%/year for small caps stocks and 10% for large caps. I knew Buffett made his money buying small/microcaps back then, but it was surprising that a good half of the outperformance came from the small cap bias.  Maybe I should not have been surprised.  But anyway, I did take note of that as I read the book.

OK. Back to models. Early in my career, I spent a lot of time creating models; economic models, stock market valuation models, statistical models, single stock valuation models, technical trading systems, mean-reversion trading models (early stat-arb) etc...

And what struck me while reading the Thorp book was the difference between the typical economist who creates models and the traders that write models.

Economists plug in all these numbers and tell you that the economy should do this or that, and that the market should be valued here or there. And sometimes, they get all caught up in their models and think they are absolutely right and get their head handed to them.  I've seen this happen time and again. One benefit of working at a large firm was that I sat through many presentations (people pitching big banks to fund their proprietary trading models/ideas).  And a lot of the ideas lacked real world common sense.

And then you read what Thorp did. For example, he created the option model before or at the same time as Black-Scholes etc. This model told you what an option or warrant was theoretically worth. But the model would have been useless if there wasn't a way to capture the price difference. You can hedge the option by trading the stock and capture any mispricing.

All of the strategies that Thorp was involved in had very specific odds attached to them, including the possibility of adverse outcomes. What are the odds of this or that? What happens when you are on an expected, normal losing streak? You have to have enough capital to be able to stay in the game. Traders' models usually have a "what if this happens, or what if that happens? what are the odds of this or that happening?".  Economist models are like, "This is what will happen and all the back-testing proves it will happen... we have calculated to the seventh decimal places using 30 models and they all confirm we are right". If you ask them, but what if reality deviates from the model? They say, "it won't because we are right".

Even some investors I respect had a huge hedge on their equity book that lost them tons of money. It made sense on the surface; stocks are expensive so we must hedge our equity exposure. The problem is that, as I have shown in previous posts, overvaluation is a very poor reason to go short the market or put on hedges (well, it might make sense to do some hedging).

I've seen the bubble in Japan in 1989 and the U.S. bubble in 1999 and I would guess that most people who correctly identified those as bubbles didn't make money when the markets collapsed. It was stunning how many funds were hurt during the late stages of the bubble and weren't around to capitalize when they were proven correct.

The problem with overvalued markets is that the odds of a blow-off are pretty high, and when things blow off, the more expensive things are, the higher they go. So, if you own a bunch of value stocks and hedge using the S&P 500 index or some other market cap-weighted index, you will probably be destroyed as the expensive large caps will go up the most.  (This reminds me of something I did long ago; I owned some value stocks that went up 20-30% so was proud of myself, but was short Starbucks against it and that doubled... Oops.  So much for hedging a value portfolio with a growth/mo-mo stock).

There was an interesting article recently that said that a bubble isn't a bubble unless the market has gone up 100% over a period of two or three years or something like that.

This is why people like Thorp would not make directional bets on the market. One can easily observe that markets are expensive, but what is the edge that that specific observation brings to you?  I remember Buffett telling someone, when shown a chart of how overvalued the stock market is, that it's just a squiggly line and it can go this way or that way, who knows which way it would go? That seemingly 'clueless' response is much wiser than it seems on the surface.

If you hedge using market-cap weighted indices or go net short, can you survive a real bubble-like blow-off? What are the odds of such an event occuring?  Is it really zero? I bet that this is not even incorporated in most models or the thinking of most investors. Of course, most of the quant funds would have this worked out (or hedged out); quants don't like to take risks that they can't hedge.

On the other hand, if you are a long manager, do you need to care about the odds of a correction? No, because if you own solid stocks that won't go bust (like owning JPM from 2007-2016), then corrections don't really matter. You just ride it out. The only way the market can break you is if the companies you own actually go out of business.  Otherwise, you may just have to wait longer to realize value. But otherwise, there is not that much risk.  This is not true when you are short, of course; it is much easier and probability of survival higher for a long to live through a bear market than the other way around.

Cheap Labor
Back to JPM. The great thing about JPM is that we get all of this for so cheap. OK, 'cheap' may be offensive to average folks out there earning normal salaries. So I shouldn't say that too much. But still, cheap is cheap. We paid Dimon 0.1% of profits. Compare that to other financials! (from the proxy).  Let's not get into hedge fund fees here.



...also from the proxy:



And for the Berk-heads here, a familiar new face on the board:



OK, this is getting way too long.  There is a lot more in Dimon's Letter to Shareholders so go read it. I may post more about it later (but maybe not), but let me just get this post out before more time goes by without a post!


Thursday, March 2, 2017

Buffett on Valuation

Buffett was on CNBC the other day and it was very interesting as usual. Well, most of what he says is not new.

Not in Bubble Territory
Anyway, he was asked about the stock market and since so many people keep saying that the stock market is overvalued or that it's in a bubble, I found it interesting that he says that, "we are not in a bubble territory or anything of the sort now."

He said that:
  • it's a "terrible mistake if you stay out of a game because you think you can pick a better time to enter it...", or something like that. He's been saying the same thing for years. 
  • if interest rates were 7 or 8%, prices will look "exceptionally high", but that measured against interest rates, stocks actually are on the cheap side.
  • if interest rates stayed at 2.30% over the next ten years, "you would regret not owning stocks".
  • we have to measure against interest rates.  Interest rates acts as gravity for valuations.
  • compared the long bond to an entity trading at 40x earnings with no growth and said stocks are attractive compared to that. 

This agrees with the charts/analysis I've been posting here relating P/E ratios with interest rates.

I know  there are quants who say this is wrong, that P/E ratios can't be compared to interest rates (we discussed this in the comments section of one of my posts about P/E's). I understand that argument, but history shows that the market does in fact use interest rates to value the stock market however theoretically wrong it may be, and the greatest investor of all time does so too.

What if?
OK, many commentators and pundits are baffled at this huge rally in the stock market thinking it's insane and taking the market to extreme valuations.  I have been posting here for a while that the valuations aren't all that extreme given the interest rate environment, even if you assume interest rates go up a lot from here.

Well, Buffett says if rates get up to 7-8%, then stocks are really expensive. But will rates get up that high? Even though I'm not an economist and have no idea what interest rates will do (actually there is no relationship between the two), I tend to believe that interests rates will get to 4-5% at most, on average.

So, let's play a simple what if game. This is not a prediction or anything, just a scenario that sounds plausible and is not at all a stretch.

What if GDP growth is stuck, more or less, at the 2% level?  Maybe Trump gets it up to 3%, but a lot of people don't think that is possible (except Jamie Dimon who thinks we can go much higher in terms of growth). And let's say that inflation does tend towards the 2% level.  That gets us to a nominal GDP growth of 4% or so over time.

Let's also assume that long term rates do revert to the level of nominal GDP growth.  Then long term rates would get to 4%. Of course, there will be overshoots in both inflation, GDP growth and interest rates. But over time, it's not hard to imagine interest rates averaging 4%. Total debt levels, demographics etc. make it hard to imagine higher nominal GDP growth.

So using the earnings yield-bond yield model, let's assume that the earnings yield tracks closely to the long term interest rate of 4%.  That means, over time, that the P/E ratio can average 25x in this environment.

Right now, 25x P/E ratio just seems super-expensive to many people because they look at the past 100 years and the stock market hasn't stayed at the 25x level for very long and has more often signaled a major market top than anything else.

But given the above scenario, it's not really inconceivable that the market P/E gets up to this level for an extended period of time. Some will argue that Japan has had lower interest rates and has been unable to sustain a high P/E ratio, but Japan has a lot of problems at the micro level too (companies not allowed to cut costs in their system of "corporate socialism" where large corporations are expected by the government to carry the burden of unproductive, unnecessary workers).


S&P 500 at 3250, DJIA at 29,000
The consensus EPS estimate for the S&P 500 index is $130. OK, I know that this will come down throughout the year, but that's what we have now so let's just use it. I'm not making a prediction or anything, just conducting a simple thought experiment.

Using the above, future average P/E of 25x, that would put the S&P 500 index at 3250!.  Using the same percentage increase, that would take the DJIA to 29,000!

Believe me, that sounds just as stupid to me as it does to you. I'm just making simple assumptions and plugging in numbers. My own personal experience (anchoring?), however, makes these figures hard to swallow.

But you see, it doesn't take much for the market to get up so high, and I am using a 4% interest rate, not 2.3%! So a large increase in interest rates is already built in.

Sure, inflation can get out of control and rates can go higher. I am just trying to figure out a long term, stable-state, through-the-cycle sort of scenario, and 4% rates and 25x P/E ratio just seems normal in that sense.  OK, so we can expand that to 5% rates and 20x PE; so let's just say rates can get to 4-5% and P/E ratios to 20-25x without it being stretched in any way.

Again, this sounds crazy and sort of feels like 'new era' thinking and Irving Fisher's "permanently high plateau". I know. Every time I make a post like this, I feel like I am putting in the top. But this doesn't feel like justifying anything new. In fact, I am insisting that things will go back to the way they always were; P/E ratios will be driven by interest rates, interest rates will be determined by nominal GDP growth rate etc.

I'm not making any outrageous assumptions like real GDP growing 4%/year or earnings growing 15%/year into perpetuity or anything like that.

And keep in mind that in this scenario, this is just the future 'average'. The markets can get much higher than 25x P/E in a manic phase and much lower in times of panic.

In fact, this has already been happening. The stock market has been overvalued in the eyes of many since the 1990's and hasn't reverted back to 'normal' levels in a long time. I think the error is that many look at raw P/E's and don't account for interest rates.

Not to be Bullish
And by the way, I have been saying this sort of thing over the past few years not because I am bullish; I am actually an agnostic (but bullish over the long term). I say this stuff to counter a lot of the "market is overvalued so it must go down!" argument and to caution people (and myself) to stay the course and act rationally.

Some funds claim to use a lot of sophisticated models and they write great reports, but at the end of the day, they are just net short the market (and have been for years!). That's just gambling; betting all their client's money on a single trade. Crazy.

Trust me, I get the same queasy feeling you do when I type 25x P/E. I honestly don't know what I would do with the S&P 500 index at 3000.  I know I would be very uncomfortable (if it happened within the next year or two).

So I'm not really being a Pollyanna.

When considering this stuff, it becomes less of a mystery why Buffett would spend $20 billion buying stocks since the election (or including some buys just before). And it becomes a big mystery why anyone would want to be net short this market (unless you are a short term trader who will be in and out as markets rally, like some hedge funds do etc...).

Sanity Check
And by the way, when all this talk of high P/E's make you nervous, just go check out my valuation sanity check page at the Brooklyn Investor website. This is updated after the close every day.

    Sanity Check

I often look here to make sure I am not seeing the trees looking like the Nifty Fifty.  When I see 20x or 30x P/E ratios on the S&P 500 index, I look at individual stocks to see if I see the same thing. If I do, maybe I worry. If I don't, I don't worry at all and assume the high market P/E is due to large cap, speculative names trading at high P/E's and/or hard-hit industries dragging down the 'E', or some of both.

Speaking of the Nifty Fifty, in the Bogle book I mentioned here the other day (Bogle book), he mentions a Jeremy Siegel study that showed that 50 nifty stocks bought at the start of 1971, near the peak, marginally outperformed the market over the subsequent 25 years.  Nifty Fifty returned 12.4%/year versus 11.7%/year for the stock market.

That's kind of crazy.  Even if you bought the Nifty Fifty at near the top, you would've beaten the market over the next 25 years, returning an above average 12.4%/year. By average, I mean the market returned 10%/year in the past 100 years or so.

Pzena Q4 Commentary
Pzena Investments posted their Q4 commentary and it follows up on their theme of the value cycle, and it is very interesting.

Check it out here.

Anyway, it shows that value has started to outperform again but that we are still early in the value cycle. Check out the tables and charts below.






I thought that was really interesting and I tend to agree with it. As much as I agree with Bogle and Buffett about indexing, there does seem to be a big, extended move in that direction which would have impact on valuations of individual securities, so it seems to make sense that maybe individual stock pickers can start beating indexes again (but don't bet on many being able to do so).

I still have a lot to say (or at least think about) in terms of fund managers, but that will have to be in a future post.




Tuesday, February 14, 2017

Six Sigma Buffett, Taxes, Fund Returns etc.

Whenever I read about Buffett and other great managers, what I tend to see all the time are things like, "xx has beaten the market y out of z years; the odds of that happening are 1 in 5,000!" or some such thing. Not too long ago, there was an article about managers with outstanding performance and the screen was based on who beat the market five years in a row, ten years in a row or something like that.

But for me, I tend not to care about that at all. In fact, I would rather invest with someone who only beat the market seven out of the last ten years but with a wider and more consistent margin than someone that beat the market ten years in a row, and only with a small margin.

So that got me thinking about what I should look at. Well, when I say that, I don't mean that I would use this stuff to choose investment managers since I don't really invest in funds at all. What I mean, I guess, is that if I don't like the above 'beat the market x out of y years', what is a better indicator?

Tax Digression
But before that, I just happened to be reading the 1986 Berkshire Hathaway letter to shareholders and came across this comment about taxes.  Trump is expected to do something about taxes and I heard Buffett or Dimon mention somewhere recently that any tax cut will be competed away by the market implying that it won't make a difference to investors.  Anyway, this is what he wrote about it back in 1986 after the last big tax change:

Taxation

     The Tax Reform Act of 1986 affects our various businesses in 
important and divergent ways.  Although we find much to praise in 
the Act, the net financial effect for Berkshire is negative: our 
rate of increase in business value is likely to be at least 
moderately slower under the new law than under the old.  The net 
effect for our shareholders is even more negative: every dollar 
of increase in per-share business value, assuming the increase is 
accompanied by an equivalent dollar gain in the market value of 
Berkshire stock, will produce 72 cents of after-tax gain for our 
shareholders rather than the 80 cents produced under the old law.  
This result, of course, reflects the rise in the maximum tax rate 
on personal capital gains from 20% to 28%.

     Here are the main tax changes that affect Berkshire:

   o The tax rate on corporate ordinary income is scheduled to 
decrease from 46% in 1986 to 34% in 1988.  This change obviously 
affects us positively - and it also has a significant positive 
effect on two of our three major investees, Capital Cities/ABC 
and The Washington Post Company.

     I say this knowing that over the years there has been a lot 
of fuzzy and often partisan commentary about who really pays 
corporate taxes - businesses or their customers.  The argument, 
of course, has usually turned around tax increases, not 
decreases.  Those people resisting increases in corporate rates 
frequently argue that corporations in reality pay none of the 
taxes levied on them but, instead, act as a sort of economic 
pipeline, passing all taxes through to consumers.  According to 
these advocates, any corporate-tax increase will simply lead to 
higher prices that, for the corporation, offset the increase.  
Having taken this position, proponents of the "pipeline" theory 
must also conclude that a tax decrease for corporations will not 
help profits but will instead flow through, leading to 
correspondingly lower prices for consumers.

     Conversely, others argue that corporations not only pay the 
taxes levied upon them, but absorb them also.  Consumers, this 
school says, will be unaffected by changes in corporate rates.

     What really happens?  When the corporate rate is cut, do 
Berkshire, The Washington Post, Cap Cities, etc., themselves soak 
up the benefits, or do these companies pass the benefits along to 
their customers in the form of lower prices?  This is an 
important question for investors and managers, as well as for 
policymakers.

     Our conclusion is that in some cases the benefits of lower 
corporate taxes fall exclusively, or almost exclusively, upon the 
corporation and its shareholders, and that in other cases the 
benefits are entirely, or almost entirely, passed through to the 
customer.  What determines the outcome is the strength of the 
corporation’s business franchise and whether the profitability of 
that franchise is regulated.

     For example, when the franchise is strong and after-tax 
profits are regulated in a relatively precise manner, as is the 
case with electric utilities, changes in corporate tax rates are 
largely reflected in prices, not in profits.  When taxes are cut, 
prices will usually be reduced in short order.  When taxes are 
increased, prices will rise, though often not as promptly.

     A similar result occurs in a second arena - in the price-
competitive industry, whose companies typically operate with very 
weak business franchises.  In such industries, the free market 
"regulates" after-tax profits in a delayed and irregular, but 
generally effective, manner.  The marketplace, in effect, 
performs much the same function in dealing with the price-
competitive industry as the Public Utilities Commission does in 
dealing with electric utilities.  In these industries, therefore, 
tax changes eventually affect prices more than profits.

     In the case of unregulated businesses blessed with strong 
franchises, however, it’s a different story:  the corporation 
and its shareholders are then the major beneficiaries of tax 
cuts.  These companies benefit from a tax cut much as the 
electric company would if it lacked a regulator to force down 
prices.

     Many of our businesses, both those we own in whole and in 
part, possess such franchises.  Consequently, reductions in their 
taxes largely end up in our pockets rather than the pockets of 
our customers.  While this may be impolitic to state, it is 
impossible to deny.  If you are tempted to believe otherwise, 
think for a moment of the most able brain surgeon or lawyer in 
your area.  Do you really expect the fees of this expert (the 
local "franchise-holder" in his or her specialty) to be reduced 
now that the top personal tax rate is being cut from 50% to 28%?

     Your joy at our conclusion that lower rates benefit a number 
of our operating businesses and investees should be severely 
tempered, however, by another of our convictions: scheduled 1988 
tax rates, both individual and corporate, seem totally 
unrealistic to us.  These rates will very likely bestow a fiscal 
problem on Washington that will prove incompatible with price 
stability.  We believe, therefore, that ultimately - within, say, 
five years - either higher tax rates or higher inflation rates 
are almost certain to materialize.  And it would not surprise us 
to see both.

OK, the last paragraph is kind of interesting too. Buffett said he bought $12 billion in stocks after the election so I guess he is not so worried about the fiscal position of the U.S.

Back to fund performance stuff...

Comparing Two Distributions
I said that I don't care for the 'beat the market x out of  y years' idea. So that got me thinking about the simple high school statistics problem of comparing two normal distributions. I am aware of the argument against using normal distributions in finance, but I don't really care about that here. I am just looking for some simple descriptive statistics. I'm not creating a derivatives pricing model to price an exotic option for a multi-billion dollar book where modeling errors can cause huge losses. So in that sense, who cares. Normal distribution is fine for this purpose.

Plus, I am not so interested in factor models that try to assess fund manager skill. Some people use factor models and whatever is left over is what they define as 'skill'.  Well, say the model cancels out 'quality' as a factor and doesn't give the manager credit for it; what if the manager intentionally focused on quality investments? Should he not get credit for it? Having said that, I don't know much about these models so whatever...  I don't get into that here. Whatever factor exposures these managers have, I assume the manager intentionally assumed those risk factors to gain those returns.

Basically I just want to compare two distributions and see how far apart they are. It's basically the question, is distribution A, with 99% confidence, the same as distribution B? In other words, are the two distributions different with any degree of statistical significance? Or are we just looking at a bunch of noise resulting from totally random chance?

The simple comparison of two distributions is:

standard deviation of the difference between two means (Std_spd) =

   Sqrt[(Vol_A^2/n) + (Vol_B^2/n)]

   where: Vol_A = standard deviation of distribution A and
               n = number of samples

So the z-score would be:
  (mean_A - mean_B) / Std_spd

And then you can just calculate or look up the probability from this z-score.

Looks good.  This would tell me how significantly different a manager's return is versus the market.

But the problem is that these two distributions are not independent. In your old high school statistics text book, the example is probably something like number of defective parts in factory A versus factory B.  Obviously, those distributions would be independent.

This is not so in the stock market. A fund manager's returns and the stock market's return are not independent. Hmm... Must account for that.

The answer to that goes back to my derivative days; calculating tracking error. Sometimes fund managers or futures traders wanted to use one index to hedge against another. An example might be (in the old days!) an S&P 100 index option trader wanting to hedge their delta using the S&P 500 index futures.  Does this make sense? What is the tracking error between the two indices? Does it matter? Is the tracking error too big for it to be an effective delta hedge? How about using the S&P 500 futures to hedge a Dow 30 total return swap? TOPIX index swap with the Nikkei 225 futures?

Anyway, the calculation for tracking error simply makes an adjustment by making a deduction for correlation (getting square root of the covariance).

So, the above formula becomes:

    Sqrt[(Vol_A^2/n) + (Vol_B^2/n) - ((2 * Vol_A * Vol_B * correlation(A,B)) / n)]

Using this formula, I calculated all this stuff for the superinvestors, just for fun.

I just wanted to know simple things like, is it harder to outperform an index by 10% per year over 10 years, or by 3% per year over 20?  Or something like that.  The Buffett partnership was only 13 years, and Greenblatt's Gotham returns in the Genius book is only 10 years. But the spread is so wide that it is yugely anomalous to achieve, or is it? This is sort of what I wanted to know. It normalizes the outperformance spread versus the length of time the outperformance lasted.

Few Standouts
A few of the standouts looking at it this way, not surprisingly:

  • Buffett Partnership 1957-1969:  a 6.0 sigma event, 1 in 1 billion chance of occurring (yes, that b is not a typo!) 
  • Walter J. Schloss 1956-1984:  5.2 std, 1 in 9.4 million 
  • BRK 1965-2015:  4.8 std, 1 in 1.3 million
  • Greenblatt (Gotham 1984-1994): 3.8 std, 1 in 14,000
  • Tweedy Brown 1968-1983: 3.7 std, 1 in 9,300

For the Graham and Doddsville superinvestors, I looked first at the "beat the market x out of y years" to see the probability of that happening assuming a 50% chance of beating the market in any given year. And then I'll compare the two distributions as described above. At the end, I also added Lou Simpson's returns from the 2004 Berkshire letter.

Keep in mind that just because a manager is not in the 4-5 sigma range, that doesn't make them bad managers. Some of these numbers are just insanely off-the-charts and can't be expected to happen often.

Anyway, take a look!

Buffett Partnership (1957-1969)
Beat the market 13 out of 13 times: Chance of occuring: 0.012% or 1 in 8,192.

Given that Buffett partnership gained 29.5%/year with a 15.7% standard deviation while the DJIA returned 7.4%/year with a 16.7% standard deviation and the Partnership had a 0.67 correlation, the partnership returns is 6.0 standard deviations away from the DJIA.  6 standard deviations make the partnership returns a 1 in 1 billion event.

What's astounding is that the standard deviation of Buffett's returns is actually lower than the DJIA.


BRK 1965-2015
Beat market 40 out of 51 years:  0.003% chance or 1 in 35,000

                     BRK        S&P500
Return          19.3%        9.7%
std                14.3%      17.2%
correl             0.61

4.8 std, 1 in 1.3 million

This uses book value, which may not be fair as not everything in BPS is marked to market (over 51 years). Using BRK stock price, it would be a 3.2 std event, or 1 in 1,455. But this too may not be fair as the volatility of the price of BRK is more a function of Mr. Market than Mr. Buffett.  This may be true of all superinvestor portfolios, but in the case of BRK, there is a penalty in that we are looking at the volatility of a single stock (BRK), and not the underlying portfolio.  Single stock volatility is usually going to be much higher than that of a portfolio.

Munger 1962-1975
Beat the market 9 out of 14 years: 21% chance or 1 in 5

                    Munger     DJIA
return           19.8%       5.0%
std                33.0%      18.5%
correl:            0.73
#years: 14

2.4 std, 1 in 122.

Sequoia 1970-1983
Beat the market 8 out of 14 years: 40% chance or 1 in 2.5

                Sequoia        S&P 500
return       17.2%        10.0%
std            25.0%        18.1%
correl         0.65

1.4 std or 1 in 12.

This is the in-sample period; the period included in the Superinvestors essay.

Sequoia 1970-2016
Beat the market 26 out of 47 years, 28% chance or 1 in 3.6


                  Sequoia       S&P500
return        +13.7%        +10.9%
std               19.3%          17.1%
corr 0.67

1.3 std or 1 in 10

Sequoia 1984-2016
This is the out of sample period; the period after the essay.

Beat the market 18 out of 33 years, 36% chance or 1 in 3

                  Sequoia      S&P500
return          11.9%         10.9%
std               16.0%         16.6%
corr               0.73

0.5 std or 1 in 3

Sequoia 2000-2016
And just for fun, a recent through-cycle period starting in 2000. They have been underperforming the market since 2007, though.

Beat 9 out of 17 years, 50% chance or 1 in 2.

                   Sequoia     S&P500
return           7.3%          4.5%
std              13.7%        18.1%
correl           0.69

0.9 std or 1 in 5

Walter J. Schloss 1956-1983
Beat the market 22 out of 28 years, 0.2% chance, or 1 in 540

                   WJS      S&P500
return         21.3%     8.4%
std              19.6%   17.2%
corr:             0.75

5.2 std or 1 in 9.4 million


Tweedy, Browne Inc. 1968-1983
Beat the market 13 of 16, 1.1% chance or 1 in 94

                   Tweedy   S&P500
return           20.0%       7.0%
std                12.6%     19.8%
corr:               0.71

3.7 std or 1 in 9,300


Pacific Partners Ltd. 1965-1983
Beat the market 13 of 19 years, 8% chance or 1 in 12

              Pacific       S&P500
returns    32.9%         7.8%
std          60.2%       17.2%
corr:         0.37

1.9 std or 1 in 35


Gotham 1985-1994
Beat the market 9 out of 10 times: 1.1% or 1 in 93 chance

3.8 std, 1 in 14,000

Lou Simpson (GEICO: 1980-2004)
18 out of 25 years. 2.2% chance or 1 in 46.

               GEICO   S&P
return      20.3%    13.5%
std           18.2%   16.3%
corr:         0.74

2.7 std, 0.4%, 1 in 288


Conclusion
So that was kind of interesting. It just reaffirms how much of an outlier Buffett really is. There is a lot to nitpick here too, so don't take these numbers too seriously. I used standard deviation of annual returns, for example. I suspect some of these correlations may be higher if monthly or quarterly returns were used.

This sort of thing may be useful in picking/tracking fund managers. At least it can be one input.  For example, it gives you more information than the Sharpe ratio; whereas the Sharpe ratio doesn't care how long the fund has been performing, the above analysis takes into account how long someone has been performing as well as by how much. But yeah, Sharpe ratio is trying to measure something else (return per unit of risk taken).

Anyway, as meaningless as it may be, it's one way of seeing if it's harder to create a long term record like Buffett (1965-2015) or a shorter super-outperformance like Greenblatt (1984-1994). This analysis says that Buffett's 1965-2015 performance is a lot more unlikely to be repeated (well, at least on a BPS basis; using BRK stock price, Greenblatt's performance is more unlikely!).

I sliced up Sequoia Fund's return into various periods for fun as it is the only continuous data (other than BRK) out of the Graham and Doddsville Superinvestors. I was going to look into their performance since 1984 a little more deeply, but this took a little more time than planned (despite the automation of a lot of it; well, debugging and fixing takes time, lol...).

So maybe I will revisit the Sequoia Fund issue in a later post. My hunch is that the Superinvestor returns were achieved on a much lower capital base so the universe of potential investments were much larger than what Sequoia (and others) are looking at now despite their efforts to keep AUM manageable.

Also, you will notice that comparing the two distributions gives a more nuanced or accurate picture of the performance than just looking at how many years someone has outperformed; it incorporates the spread, correlation, volatility etc...

Anyway, I guess that's enough for now...






Wednesday, February 1, 2017

Bogle Book, Indexing etc.

I have watched and listened to John Bogle for years and always thought he was great, but I never read any of his books. I understand his message and agree with him for the most part. But the other day while I was browsing the library, I came across this book and just grabbed it and decided to read it even though I have a big stack of books that I started and have yet to finish.




There is nothing new in here in terms of message (active managers don't outperform, costs is primary determinant of performance over time; low cost beats high cost in every category, every time period etc...), but it is still amazing to read with all the tables and facts laid out.

Every time non-industry people ask me about stocks and how to learn about them, I go through the usual books that we've all read. I noticed, though, that if they are not in the industry, or not a true market fanatic, people don't ever read the books you recommend.

I understand telling someone to read all of the Berkshire Hathaway letter to shareholders going back to 1977 (available for free, I tell them, at the BRK website) seems like such a tedious thing that no normal, non-financial person would actually do it.

From now on, I think, I will just direct them to this book. It's that good, and it would answer most questions I typically get in the usual 'cocktail party' conversation about markets.

As for stock picking, from now on, I will tell them to just pick stocks based on what you like and believe to be truly good businesses at reasonable valuations.  Even overpriced is OK as long as it is kept small and it's not bubble-like; compensate for the assumption of price risk by keeping dollar exposure low. But keep most of the equity exposure indexed (OK, BRK is fine too, but most people won't know what to do when something happens to Buffett, and may not want to deal with the volatility/uncertainty related to the headlines).

Expensive Stocks
Every once in a while, you just come across businesses that you think are just really, really great, as a customer and as a business analyst. For me, that was Chipotle Mexican Grill (CMG). I bought some a while ago and did very well with it, even selling out at the top once and buying back in at a low and then selling out again (most recently in late 2014).  I know others who have owned Starbucks (SBUX) forever, and I kick myself for not owning that one too. I go there way more often than I'd like to admit, and when you travel, there is never a SBUX anywhere that doesn't have a long line in the morning. And often, it's the only place to get a bagel and coffee.

(By the way, this section has nothing to do with the Bogle book!)

So, on those occasions where you actually see and verify for yourself a great business in action, and the price is reasonable, or even a little on the high side, I say go for it. Own it and hold it for as long as it's good. We value investors are usually afraid of high P/E stocks because we remember 1999/2000 and many high P/E disasters.

Value investors who run value funds might get into trouble owning such growth stocks, but for individuals managing their own money, why not?

I know this goes against the idea of having discipline, but if most of someone's equity exposure is indexed and they 'play' with a small portion of their portfolio on their own picks, it's probably not a bad idea.  Plus, those opportunities don't come up all that often. That's all the more reason to go for it.

Worse is actually going out and trying to find stocks that will go up; buying stuff that you have no idea about etc.  At least with some businesses, you have a strong idea about their competitive position etc. What you absolutely don't want to do is to bend that rule and overpay for things just because everyone says it's the next Chipotle,  Starbucks, Facebook or whatever.  Forget about those "this is the next..." stocks.  Only go for the ones that you really understand.  The "this is the next..." argument is a shortcut; it allows people to pump stocks with minimal bandwidth.  Who's adrenaline doesn't start to flow when you hear about the next CMG, or next Buffett?  (Well, I do some of that here...).

Market Timing
Bogle is also anti-market timing, and that's been a constant theme on this blog too. Market timing is a waste of time unless you are a Druckenmiller-type active trader. But market timing when you are supposed to be allocating assets / investing doesn't make much sense.

I was thinking of this the other day, seeing a lot of market-timers doing horribly in recent years. A lot of people have horrible performance because they were short the market for the past few years.

Gambler's Fallacy
And I realized that this "the market is expensive so it must go down. Therefore, I am short"-type manager is falling for the gambler's fallacy.  OK, well, not exactly.  With the gambler's fallacy, for example, if a coin toss results in heads ten times in a row, people tend to believe the next one must be tails. But the fact that the coin landed on heads ten times in a row doesn't affect the probability of the next coin toss.  Each coin toss is independent. Regardless of how many times you had heads in a row, the odds on the next flip is still 50/50.

In the stock market, this is not true. The higher the market goes, the more expensive it gets, and the lower the prospective returns will be.  So the probability distribution of going forward returns actually shifts lower; the probability of a loss increases as the market gets more expensive.

So this is not an accurate analogy. But for me, it still is interesting because when the stock market is expensive, my temptation is to ask, when the market is this expensive, what tends to happen in the following year?  Greenblatt does this and mentions it just about every time he is interviewed. And even in the past few years, using 30 years of data, I think, his prospective returns one year out from the then current valuation has always been positive.

Even many of the bears have long term expected returns that are positive, but just low. Yet they are short. Even more recently with negative long term expected returns, it is usually low negative. So maybe -2%/year or some such.  In that case, it's still better to invest in corporate bonds or other fixed income at something higher than that to earn a positive return than shorting the market.  What if the market went into a bubble like in 1999/2000? The stock market valuation is nowhere near that silliness. If the market did rally like that, it would put a lot of those bearish funds out of business.

Now, what are the odds of some sort of blow-off like that? Versus what are the chances of an imminent collapse/bear market? These are things that you usually don't hear about, and to me, are the more relevant statistics to look at if you insist on timing the market.  And I suspect those are some things that the more successful quant funds are good at evaluating (and therefore don't lose money being net short for multiple consecutive years!).

Hasty Generalization?
The other related and more precise fallacy is the fallacy of hasty generalization or maybe faulty causality. Actually, I'm not sure this is the right one, but let's use it. Initially I was thinking it was fallacy of composition, but my understanding is a little bit different there. I'm referring to the fallacy of assuming that since all bank-robbers had guns, that all gun-owners must be bank robbers.

We all look at these long term valuation charts and go, hey look!,  the market P/E was over 20x before 1929, 1987 and 1999! So, the thinking goes, the market is now over 20x P/E so a crash must be imminent! But then we tend not to look at all the people who own guns that are not bank robbers.

Also, when someone says that the stock market is 90% percentile to the expensive side, there is a tendency to want to believe that there is a 90% chance that the market will go down in the future. Well, if the market is 90% percentile to the expensive side over the past 100 years, then it means that the market will be valued at a lower level 90% of the time in the next 100 years if the same conditions occur.

Anyway, since I was so curious about the year-forward returns and was worried about the declining interest rate bias of Greenblatt's sample (as he uses the past 30 years), I decided to look at this data for myself.

First let's look at Greenblatt's time span. That would be starting around 1985 or 1986.

Just so we can actually see the data, I will use annual figures.  I will look at the P/E ratio (as reported) of the stock market at the beginning of the year and compare it to how the market did during that year (actually, the P/E ratio of the end of the previous year is used).

Using Greenblatt's time period and looking at years when the stock market started with a P/E ratio of over 20x, here are the results:

P/E level of over: 20
Number of up years: 11
Total # years: 15
Percent up years: 73.33%
Average change: 5.5%

DateP/Ereturn
1991.1224.3315.32%
1992.1222.829.85%
1993.1221.290.52%
1997.1224.2325.34%
1998.1231.5621.45%
1999.1229.66-5.70%
2000.1226.62-12.79%
2001.1246.37-20.06%
2002.1232.5922.11%
2003.1222.1712.77%
2004.1220.487.09%
2007.1222.35-38.75%
2008.1258.9829.08%
2009.1221.7813.86%
2014.1220.082.10%
2015.1223.74


The data excludes total return for 2016, but we know it was more than 11%, so the results would be even stronger.  From the above, when the market started the year with a P/E ratio of over 20x, the market was still up more than 70% of the time, for an average gain of 5.5%.  Sure, 5.5% is lower than the 10% or so long term average.

But if you own a fund that is short and is losing money with the market going up, it makes no sense. Actuarially speaking, it makes no sense to short the market just because the P/E ratio is over 20x.  Any middle schooler would know this is a bad bet to make.

Oh, and this only looks at the period since 1985. Interest rates have been declining so there has been a huge tailwind.  So let's look at the same table over a longer time period.

Here is the analysis using data since 1871:

P/E level of over: 20
Number of up years: 14
Total # years: 20
Percent up years: 70.0%
Average change: 5.9%

DateP/Ereturn
1894.1226.884.88%
1896.1220.1016.82%
1921.1225.2127.09%
1933.1222.66-2.61%
1961.1222.49-9.72%
1991.1224.3315.32%
1992.1222.829.85%
1993.1221.290.52%
1997.1224.2325.34%
1998.1231.5621.45%
1999.1229.66-5.70%
2000.1226.62-12.79%
2001.1246.37-20.06%
2002.1232.5922.11%
2003.1222.1712.77%
2004.1220.487.09%
2007.1222.35-38.75%
2008.1258.9829.08%
2009.1221.7813.86%
2014.1220.082.10%
2015.1223.74

And I was sort of surprised that using data that goes all the way back, the results aren't all that different. This includes periods of increasing and decreasing interest rates, so you can't say the data is biased due to a bond bull market tailwind. You can still argue that it is biased by a U.S. bull market tailwind, though.

So yes, my gambler's fallacy analogy is not accurate, but check it out. If someone says that the coin landed heads ten times in a row so the next flip must be tails, you'd think he is an idiot. But if you are short the market because the market is overvalued at 20+x P/E ratio, you are even more of an idiot because at least the coin flipper and real fallacious gambler has a 50% chance of being right whereas if you are short a 20x P/E market, you only have a 30% chance of being right!

That's kind of surprising.

What happens if we do the above with a 25x P/E threshold?

Since 1871:

P/E level of over: 25
Number of up years: 5
Total # years: 8
Percent up years: 62.5%
Average change: 8.3%

Since 1985:

P/E level of over: 25
Number of up years: 3
Total # years: 6
Percent up years: 50.0%
Average change: 5.7%

The average change is still up. Since 1985, the market was up only 50% of the time in years the market started at a 25x or higher P/E ratio. But these figures are questionable as there isn't enough data points to be significant.

Even the earlier figures are questionable with only 15 or 20 years in the sample size.

All Months, not just year-end
Just to be thorough, I reran all of the above using all months, not just year-end.  I looked at all months where the P/E ratio was over 20x or 25x and what the total return was 12 months later.

PE >= 20

Since 1871:
P/E level of over: 20
Number of up years: 139
Total # years: 223
Percent up years: 62.3%
Average change: 3.5%


Since 1985:
P/E level of over: 20
Number of up years: 111
Total # years: 162
Percent up years: 68.5%
Average change: 4.8%


PE >= 25

Since 1871:
P/E level of over: 25
Number of up years: 58
Total # years: 96
Percent up years: 60.4%
Average change: 5.1%

Since 1985:
P/E level of over: 25
Number of up years: 54
Total # years: 90
Percent up years: 60.0%
Average change: 5.2%

Using all months, you still get positive expected return with P/E's over 20x and 25x over the next 12 months, with the market rising 60%-70% of the time. I think markets are usually up 70% of the time, 12 months after any given month.

This sort of shows you why it doesn't make too much sense to point to an 'overvalued' stock market, go short and stay short. There are people who have been net short for years and it's amazing to think anyone would do so given the above statistics.

It also explains why Buffett and others can keep buying stocks even as many 'experts' claim the market is way overvalued and due for a correction. Buffett is a numbers and odds guy so I'm sure all of the above figures, at least intuitively, are in his head.

Anyway, the next time someone tells you that they are short because the market is expensive, run away! If they have your money, get it back.

But as usual, this is not to say that the market won't correct at some point. It will correct, as it always does.

Indexing
So, why am I advocating indexing here on a value investing, stock-pickers blog? I don't know. That's a good question. I do believe that most funds over time will not outperform the market so I do believe that indexing is probably right for most people. But do I believe that the market is totally efficient? Well, no. I am a big fan of Buffett, Greenblatt and many others who have outperformed over time.

The stats in Bogle's book are amazing. He shows how top performing funds almost always revert to the mean, even in the long term.

I was going to post more about this here, but this is already getting long and I would like to get this out, so my next post will be about funds, indexing and things like that. Just my random thoughts on the subject.

I was thinking about the above analysis and was playing around with Python and ended up writing a script to calculate all of that. I loved how Greenblatt always said the market is valued at so-and-so percentile and the going forward expected return from these levels is x%.  And he uses 30 years as his history and it always sort of nagged at me that the entire sample period was during a huge decline in interest rates. The above work sort of comforts me.

Trump
Oh yeah, and on Trump. Hmm.  What can I say. We live in interesting times. I binged House of Cards last year and loved it, but nowadays, it seems like truth is stranger than fiction (fiction has to make sense!).

Am I worried? Well, I am worried about all sorts of things, but although I may be wrong, I am not that worried about economic issues. I am not expecting some huge infrastructure binge or anything like that. All that was needed is just a leaning in the other direction from over-regulation. Just the lifting of some of that pressure, and not even a lot of deregulation, I think, is enough to lift business sentiment.

I am comforted by the fact that Trump is surrounding himself with people I respect (business world people, not the alt-right), and I hope they will be listened to.

As for the tweeting and big pronouncements, I do think a lot of that is posturing. He is a negotiator so it's to his advantage to start at the extreme and then work his way down.

At least that's my hope. That' what I hope he's doing. But we can't be sure.

We shall see.