Thursday, May 30, 2013

The Greatest Investment Book Ever Written

No, I'm not talking about Security Analysis or Intelligent Investor by Benjamin Graham or even Greenblatt's You Can Be a Stock Market Genius.  I'm talking about Doyle Brunson's Super System: A Course in Power Poker

OK, so the title of this post is a bit of an exaggeration and yes, there are probably tons of better poker books out there now post-extended-poker-boom.  The first edition of this book was published in 1978.  The connection between poker and trading is nothing new.  Just google "poker and trading" and there's a lot of stuff out there; how poker guys started hedge funds, how a hedge fund guy became a poker guy, how they are similar/different, what can be learned from one or the other etc.   And the connection between gambling and trading was well documented in Fortune's Formula.

But I just wanted to make a post about this book because I'm starting to reread it again (don't ask).  I am not a poker player, but I remember reading this book a few years ago having borrowed it from a poker-playing friend.  Knowing that many traders and investors are very good poker players, I wanted to see what I can learn from reading about poker.

I remember falling out of my chair at the similiarites between poker and investing.  I come from more of a trading background than an investing one and what was written in this book, particularly the early chapter "General Poker Strategy",  has great advice that applies to traders and investors too.   I would make that chapter required reading along with the other investment "must reads".

Anyway, here are some comments about what Brunson talks about in this chapter by sections.  I only comment on some of the stuff so this isn't a summary of the chapter by any means.

Pay Attention... and it will pay you
Here Brunson talks about paying attention to other players during a poker game.  Watch and listen carefully even if you are not playing for the pot and you will pick things up. 

He also suggests bluffing to see what someone does to learn more about him.  We might think we can't do that in the markets, but bigger hedge fund managers actually do test the market.  They can try to buy a big lot of bonds or sell it to get a sense of where the weakness might be; they are probing the path of least resistance.  But most of us can't do that, and long term investors would have no interest in such market operations.

But the advice, to pay attention, is applicable to all of us in the markets.  We have to pay attention to what's going on in the market.  We always like to say, ignore Mr. Market, or ignore the macro, but we have to pay attention to what's going on.  Maybe if I paid more attention, I would have bought some Liberty Media in late 2008.   OK, enough of that.  Get over it.

But it's true.  We have to pay attention.  There might be a tendency, when we own positions we are happy with to get lazy and ride it out.  But then what do you do when things get to fair value or above?   Or there might be better things out there even if we are happy with what we own.

So we must pay attention.

Brunson also says, "A man's true feelings come out in a Poker game".   He says you'll learn a lot about a person's temperament by watching a ballgame he has bet a lot of money on; how well he can take disappointment etc.  He says it's the same in poker, and it's the same in trading and investing too. 

Talk to people at the height of a bull market or at the lows of a bear market and you will really know what kind of temperament the person has.   I'm sure all of us with professional experience have anecdotes about traders and investors on their big up and down days.    I tend to trust the guys where you talk to them on any given day and you have no idea if they are up or down on the day.  The ones you can tell from across the room are the ones I would tend not to trust... (well, there are overly emotional, screaming/yelling, phone-breaking-monitor-throwing great traders, and then the quiet people who just blow up with no early signs, I suppose but...)

You can really learn a lot about yourself, too.  You can't really observe other people in the investing world, so you can just observe yourself and learn a lot about yourself and who you really are and what you might or might not be cut out for.

Play Aggressively It's the Winning Way
Here he talks about the difference between a "tight" player and a "solid" player and how many people seem to be confused about it.  In poker, a tight player is a conservative one and won't play too many hands.  A "loose" player is the opposite; like a drunk player that plays every hand, calls every bet.  But a "solid" player is not the same as a "tight" player.   A "tight" player is a conservative player that will play tight all the time, but a solid player will play tight, but when he plays, he will play aggressively.

There is "tight" and "loose" in investing too.  We've all met someone who will buy almost any stock on any tip (loose), and others who won't buy anything, or will rarely buy anything.  When I first started investing for myself, I was very tight too.  I read a few Buffett books and figured, OK, I'll just by Coke in the next bear market at 8x P/E.  It's a great idea, but the only problem is, Coke doesn't get to 8x P/E, ever (and when it does, you may not want to own it!).

I just figured if I had a Buffett-like stock (high ROE, high-moat business) and bought it for really cheap, I can't lose.  Well, this is correct in theory, but that's like wanting to wait for a royal flush before ever betting.  It didn't take me long to realize that this approach won't work.

Now I like to see myself as a "solid" investor.

I would put people like Buffett, Greenblatt, and any of the great traders/investors as "solid".  They will pick their shots and not play too many hands, but when a good hand comes along, they will go in big.

Brunson says, "Timid players don't win in high-stakes Poker".  This is true in the markets too.  But that doesn't mean you have to be "loose" or that you should ignore risk.

I think there are a lot of smart and competent investors and traders that don't do well because they don't have this sort of killer instinct.  They are way too timid.   They love a stock and they have 2% of their AUM in that stock, for example.  I read a decent book on investing not too long ago and was impressed, but when I looked at the author's portfolio (no names!), it looked more or less like an index.  There is no way this portfolio is going to outperform the index by more than a percent or two with that sort of diversification in the largest cap stocks. (Yes, Peter Lynch and others have been known to have a large number of names in their portfolios but my impression is that those portfolios contained smaller and midcap names, not the largest companies.  This is why they were able to outperform despite the high degree of diversification).

We know how focused Buffett is (and was during the partnership years), and many of the other great investors/traders.

I remember talking about Soros once and someone who was close to him said something to the effect that Soros is not that different in terms of analyzing markets and finding trade ideas than others, but he had the ability to put on huge size.  In other words, he was no smarter than anyone else, but he had the biggest balls (more on courage later).

And the great thing about the markets is that the markets can't fold on you.  If you go "all in" in a poker game, you might scare people away.  But not in the markets.

Art and Science: Playing Great Poker Takes Both
Brunson says poker is more art than science, and that's why it's difficult.  Knowing what to do, the science, he says is 10% of the game, and the art (knowing how to do it) is 90%.  He says in the introduction that a computer can be programmed to play blackjack well, but not poker (even though I hear that bots win a lot of money playing poker online these days).

It's similar to the world of investing/trading.  People have used computers for years to create trading models, and many of them do make money.  But the models are programmed by humans, reprogrammed, recalibrated, adjusted etc. according to market conditions.  I don't think there is a self-learning/improving computer trader/investor out there (yet).

Money Management
In this section, there's an interesting comment:
"Any time you extend your bankroll so far that if you lost, it would really distress you, you probably will lose.  It's tough to play your best under that much pressure."

This is exactly what Joel Greenblatt said in an essay soon after the financial crisis.  He was talking about how many people thought the error in their investment was that they didn't foresee the crisis and so didn't sell stocks before the collapse.  Greenblatt insisted that this couldn't be done anyway and that the real error was that these people simply owned too much stocks.  If you own so much stock that a 50% decline is going to scare you and make you sell out at precisely the wrong moment (and as Greenblatt says, and Brunson says in this book, you are almost guaranteed to sell out at the bottom), then you owned too much stock to begin with.  Greenblatt said the mistake wasn't that they didn't sell before the crisis, but that they sold in panic at the bottom.  This was the error.

So the key defense against inevitable (and unpredictable) bear markets is to not extend yourself so much that it will distress you when the markets do fall (and they will).  Buffett says that if it would upset you if a stock you bought declined by 50%, then you simply shouldn't be investing in stocks.  As I like to say all the time, more money is probably lost every year in trying to avoid losing money in the stock market than actual losses in the stock market!

Brunson also suggests thinking about chips as units and not as money.  This is so very true in trading and investing too.  If you think about money as money, then it may impact the way you invest.  If you think of a loss as real money, it might upset you.  For example, if a stock tanked and you lost money on it, it's easy to think, "gee, I could've bought a Porsche with that money...".  Or if a loss is thought of as next month's rent, you won't be able to focus on the process; you will be distracted by the reality of the money.

Courage: The Heart of the Matter
Brunson says, "I'm asking you to walk a very thin line between wisdom and courage, and keep a tight rein on both".  He says that courage is "one of the outstanding characteristics of a really top player".  He points out that some people play really badly after losing a big pot while others play much harder.

He says that one of the elements of courage is realizing that money you already bet is no longer yours regardless of how much you put in.  This is similar to investing where people do tend to get caught up in their cost (I'll get out when it gets back to break even, etc...).  If it doesn't make sense to call, then one shouldn't call.  People probably tend to look at what they put in the pot and they might call not wanting to lose what they already bet.  Similarly in a stock, if you buy something and it's no longer a good idea, it's not good to wait for break even or even buy more just to get the average cost down so you can break even sooner.

As I said in the above about being aggressive, I think that one of the big differences between OK investors/traders and great ones is courage, or balls (is this appropriate blog language? I don't know).

But Brunson, in the section on being aggressive, distinguishes between being aggressive and being stupid.  He sites an example of a player trying to bluff someone out of his money with a losing hand, and he calls that stupid, not aggressive.

There is sometimes a fine line, maybe, between stupid and aggressive in the investing world too.  I'm sure to insurance company executives (in charge of investments), Buffett's backing up the truck on American Express during the salad oil scandal might have looked stupid or reckless at best.

There is a tendency to assume that "diversified" equals "safe" and "focused" equals "risky", just as there is a misconception that "beta" (or stock price volatility) equals "risk".  This is not true at all.  As Howard Marks says in his great book, The Most Important Thing, risk is not a function of these things.  Overpaying for high quality companies can sometimes be riskier than paying a very low price for a mediocre company etc.

The Important Twins of Poker - Patience and Staying Power
This is very obvious too in the world of trading and investing.  You have to have patience.  Ian Cummings at the last LUK annual meeting (in 2012) put it like this:   You should sit on a porch, watch the world go by and then if you see something succulent, jump on it.

Buffett talks about his 10-hole punch card, or waiting for the perfect pitch (there are no strikes in investing. There are no antes either so it doesn't cost you anything to fold right away).

Brunson talks about not drinking here; hopefully nobody reading this makes investment decisions while drinking.

There are a few other pieces of good advice (look for weaknesses in your play and fix them etc...) but an interesting point here he says,

"Maintaining confidence is your strongest defense against 'going bad'. When you start to go bad or just start to think you're going bad, you become hesitant...  Allowing your confidence to be shaken can turn a simple losing streak into a terrible case of going bad". 
He reminds us that we still have to be open to the idea that something may be wrong with our play. 

This is very interesting because watching value investors during the crisis, it feels like a lot of people lost confidence.  One investor who was a focused investor decided to diversify more after taking big losses only to go back to a focused approach after the markets recovered.

Many other value investors seemed to question the idea of value investing itself and sound these days more like macro investors.  Many seem to have lost their faith in the stock market overall.

Controlling Your Emotions
Brunson advises, "never play when you're upset".  We all know that the biggest detriment to successful investing is our own emotions.  But I saw it over and over again during the crisis; people throwing in the towel at the worst possible moment because they lose faith.  Too many 'bad' bankers and corrupt politicians etc.  It sounded like people were selling stock not only out of fear, but out of anger.  Brunson would tell these people, "don't make investment decisions when you're upset!".

The Other Similarity
There are many similarities and I don't intend to list them all up, but the other thing that struck me about poker and investing (and this is not from the Brunson book) is that in both, there are two types of participants;
  • perpetual loser
  • improving / studying winner
That's kind of a sloppy way to put it, but I notice that in the stock market, many participants (particularly individual investors) often don't put too much effort in trying to learn about how to become a good investor or trader; they just punt / speculate.  When they make money, they are smart and brilliant and when they lose, the Fed screwed them.  Or the greedy banks caused a great recession and that's why they lost money.  They were unlucky.  In other words, it's not their fault.

This is similar to what people say about poker players.  Many of them do no work to improve, but they take pride in their wins, and when they lose, it was just bad luck. 

Both poker and investing have enough of an element of luck for people to keep fooling themselves in this way (nobody would lose a chess game and say it was bad luck, for example).  And there is enough element of luck such that people will tend to win every now and then with no preparation, and this gives them enough to sustain their 'hope'.  And this is what they lean on, not any serious work.

And there's enough luck involved that many believe that it's all luck (efficient market folks thinks it's impossible to beat the market etc...).  So therefore there is no attempt by these folks to work on their game. 

And this is why it's possible to win; this is why the pros constantly walk away with the money, whether at the poker table or the stock market.

Anyway, none of this stuff is new to experienced traders and investors (and of course poker-playing traders/investors).

But I wanted to highlight some of the things that really struck me (actually, it struck me the first time I read it a few years ago, but...).  Also, it's interesting to look at what we do through sort of a different lense.  Am I playing too tight?  Too loose?  Am I being aggressive enough?  Am I really a solid player or just tight?  Or am I being timid?

Looking at your portfolio this way may tell you a lot about yourself and may even suggest ways to improve your investment performance.

Friday, May 24, 2013

Charter Communications (CHTR)

During the financial crisis I did pretty well.  I bought up some financials and other things and did pretty well coming out (having done well going into it too), but one of my biggest misses was Liberty Media.  I have no excuse for missing that as I did own it in the past and did very well with it and so was very familiar with John Malone and his various assets.  I sold out when I thought media assets were overpriced with deals being done at 15, 20, 30x EV/EBITDA (or something like that).

But during the crisis I was so focused on the financials and was so convinced that the biggest gainers coming out would be the financials that survive (and the financials seemed to be the scariest sector to even look at, which I liked) so it didn't even occur to me to look at Liberty.  I did buy CBS and other stocks in other sectors and did very well with them too, so I guess it's not so much that I was only looking at financials.  I don't know why, I just totally missed it.   I think the Yacktman fund nailed this one.

Here is a description of Liberty Media's stock price performance from the LMC 2012 annual report (it's interesting to note that Berkshire Hathaway recently took a stake in Liberty Media.  Weschler (One of BRK's new fund managers) has owned it in the past in his own fund, I think)):

So if you invested in Liberty back in May 2006, you would have earned 33%/year through March 2013.  That's an astounding rate of return no matter how you look at it.   And this stock was down a ton during the crisis and I didn't buy it, knowing that it was run by one of the greatest operators of all time! That's pretty shameful.
To rub it in, let's look at a chart. This chart is from the Liberty 2012 10K:

...and this is the actual chart of Liberty Media (which spun off LMC and changed into Starz):

If you bought some stock back in early 2009, you would have had a 25-fold gain.  Makes buying Bank of America look stupid in comparison; even the LEAPs.
If you even put just 10% into Liberty and 90% was held in cash (or investments that did nothing), you would have gained 36%/year since then.
Sure, there's no point in shoulda, woulda, coulda's.  There are tons of those.  We can't ever always get everything.  I know.  But this one was sitting right under my nose.  I've owned it before, I've owned Discovery Communications, I've always been a fan of content and never had any doubt that content would have value (and would increase value over time as more and more people would need it), knew who John Malone was etc.  There is no excuse for that.
Anyway, this would have been a career making investment (and surely it was for some; it's just that we don't hear all the stories!); kind of like Ted Weschler's W.R. Grace trade (or maybe Weschler bought a bunch in 2009!).
Next time you sit around and people are talking about finding the next subprime trade (black swan), next great bubble to short or people whining that markets are too efficient now to make the old Buffett partnership or Greenblatt-type returns, go back and look at this chart and say to yourself, "where was I and what was I doing?!"
OK, enough of that.
I may come back and take a look at Liberty and some of the other pieces of the Malone Media Complex later on.
Charter Communications (CHTR) / Malone Inteview on CNBC
But for now, what I actually wanted to do was to just post a summary of Malone's interview on CNBC not too long ago.  It was an extended interview and it was fascinating for many reasons.  It's not often that we get to hear a great investor talk about what he did and why he did it.  In this case, David Faber of CNBC asked Malone why he invested so much in Charter Communications (CHTR). 
We all know Malone built his wealth in the cable industry so it's not surprising that he is going back to it.  But it is sort of surprising in that for a long time, I have looked at the content providers as where the value was in the business and the pipe-owners as not so valuable (as competition keeps increasing).
Anyway, here are some notes from that interview.
  • Malone feels that 7-8x post-synergy EV/EBITDA multiple is very cheap if you can borrow at 3%.  Given super-cheap capital, sustainable cash flow businesses look very attractive to be bought on leverage.
  • You can't leverage a manufacturing company.  Maybe you can do 2x (debt / EBITDA).  But cable companies can go up to 5x leverage.  CHTR will operate at 5x leverage. Malone says that's where his other companies are, Discovery, QVC etc...
  • Malone believes that 80% of subscribers will reject sports programming at wholesale prices.  If that is the case, the current bundling of cable channels is an unsustainable model.  Cable is getting too expensive for too many households.  He thinks the old model will be gone in five years.
And specifically on CHTR:
  • CHTR has great management.  Rutledge, by all accounts, is the best operator/manager in the business.
  • Has been an undermanaged, underinvested asset for a number of years (implies potential for improvement).
  • Has been a victim of a lot of market share stealing by the satellite guys.
  • Faces the weakest competition terrestially.  Majority of systems not in Verizon or ATT universe/areas.
  • We are at a point in history where high speed connectivity is important.  There is a big appetite for speed.   Cable technology is the most cost-effective way to increase speed.  Cable will go to gigabyte-type connectivity speed in a couple of years.
  • Key is doing it cost-effectively at scale.  Malone says FIOS didn't work (losing money).  Overbuilding just broadband won't work.
  • Malone is personally convinced that cable can get to gigabyte speed with very little incremental capital.
The other way to look at CHTR (as Malone put it):
  • Great management team
  • Very large tax position
  • Unique position to be consolidator in the space
  • debt is very cheap
  • credibility of cash flow stream in cable has been growing so leverage is available

On TCI sale to ATT:
  • Malone didn't want to sell; it broke his heart to sell.
  • When someone offers a 40% premium you can't turn it down; responsibility to shareholders.
  • In retrospect, he wishes he hadn't done it.

Back to CHTR:
  • Unique opportunity to take a vehicle and grow it.
  • Through both superior marketing and promotion, internal/organic growth can be exceptionally strong for a number of years.
  • Particularly, the rate of growth of free cash flow can be very, very strong.
  • Allows it to access leverage market in order to do rollups/transactions, particularly when there are horizontal synergies.  Kind of like the old TCI model.
  • Horizontal acquisitions, synergies, growth scale, opportunities to work with other cable companies to form consortia (like the old "cable mafia" as Faber said).
  • Malone said he wants to bring back the old days of @Home, Ted Turner etc.  Back then they were able to create national scale.  Now he thinks they can create global scale.

Interesting Situation
So this is an interesting situation.  Malone just bought in and is just beginning to do something here.  Tom Rutledge just joined a little over a year ago.  This is also a post-bankruptcy play as one of the stocks we talk about here (Oaktree) sold a big stake in CHTR to Malone.  I suppose it's not so much a post-bankruptcy play anymore since it's up 3x or so since reemergence.

But the fact that it is reemergent, the stock seemed to be hated and despised (due to the leverage, view that old cable is dead etc...), they got a new CEO that is "by all accounts the best operator/manager in the business" and then the greatest investor/operator in the business just bought a giant stake (and wants to do something with it), and it has big tax loss carryforwards makes it pretty interesting.

Of course, this is also risky in that it is very leveraged.  A lot of people think interest rates are going to go a lot higher and that leveraged companies will get into trouble sooner or later.  This is definitely not BRK at book value or JPM at tangible book.  I tend not to think that rates are going higher as I am a little biased to the deflationary side (Japan-style). 

It's an interesting opportunity to get on board with some amazing people in the early stages of something, but there is risk here.

I was going to do some work on the valuation but I think so much of the value here is what Rutledge and Malone can do going forward (and the deals that will come down the pike).  Otherwise, the key factor in valuation is the net operating loss, which we know Malone and Co. will figure out how to use.  For other money losing operations it's hard to think NOL's will ever be realized, but when you get Malone involved, you know it will be realized sooner or later.

More Special Situations
Anyway, the stock market has come a long way since I have been sort of pounding the table on it since starting this blog in late 2011 (I loved financials, the stock market, and hated gold.  Not to brag or anything...  well, I hated Japan and Sony too, but I did expect a hard bounce on any weakening of the currency so it was not too surprising even though the speed and magnitude were.  I'm still on the fence about Japan; every few years there is this renewed enthusiasm that seems to fade.  I remember the Koizumi boom too...  Maybe I will make a post about Japan some other time).
And I will keep covering and talking about the financials since I do feel comfortable talking about them.  But since they may be getting into more 'normal' territory than 'cheap' (well, they are still cheap, but they've come a long way), I think I should start looking at other stuff.  I do look at other stuff, but posted mostly about financials.
I always wanted to talk more about special situations here, but frankly, since late 2011, the special-est situations to me were the financials.  They were great companies with great managements trading for really cheap for irrational reasons.  That is less and less the case these days so I want to look around at other stuff. 

Since markets are no longer so unloved as I thought it was in 2011, I will have to dig around a bit more to find stuff to write about (and invest in, even though I am still long a lot of financials).

So stay tuned!

Friday, May 10, 2013

Corporate Profits-to-GDP: Why Doesn't Buffett Care?

I haven't posted in a while but that's because I was busy with all the conference calls, annual reports, and of course, keeping up with all the stuff coming out of the Berkshire Hathaway annual meeting.

Anyway, there is plenty of stuff out there on the annual meeting and I don't have much to say about it; it seems like the usual, same old stuff.   It was great that Buffett invited a short to ask questions.  People have often complained about the softball questions that Buffett has gotten, and the often non-Berkshire-related questions over the years.  So he got journalists to sort out questions ahead of time and then invited professional securities analysts to ask questions that might satisfy the more hard core Berk-heads.  That was a good idea.  And to make it even more interesting and have tougher questions asked, he invited a short this year.  Unfortunately, I don't think any of the questions the short asked were very interesting and I could've answered those questions exactly as Buffett did (this is what happens when you follow Buffett for years; you tend to know what he is going to say before he says it).

OK, this is not the topic of this post.  Let's get back on topic.

Stock Market Overvalued Due to High Margins?
People have been saying for the past few years that the stock market is overvalued despite reasonable looking p/e ratios because earnings are abnormally high now.  The usual chart shown is the corporate profits-to-GDP ratio.  This has been trending up and it is unsustainable.  Even Buffett said a while ago that to think corporate profits can stay above 6% of GDP is fantasy (it is now over 11% according to the chart below from the St. Louis Fed).  Someone asked this question at the annual meeting and Munger said that just because Buffett said something a long time ago doesn't make it carved in stone (or something like that), and he added that he thinks 6% is a little low.

Despite this record high corporate profit-to-GDP ratio showing abnormally high margins at U.S. corporations, Buffett said that the stock market is reasonably valued.  Howard Marks said that too in one of his recent memos.    Are they blind?  Don't they see that current earnings are bloated and unsustainable?

I looked at this a while back and concluded that none of the big blue chips companies have this trend in profit margin (corporate profits-to-GDP is not the same as profit margin but is used as a macro proxy...); I made a post about this a while ago (see here). 

So I comforted myself by saying that if there is a stock I own that is showing rising and unsustainably high profit margins, I should watch out and lighten up.  Having not seen that in my companies, I didn't care.  In fact, since I was mostly interested in financials, most of them showed below trend profit margins.   This big chart of profit margins was not relevant to me at all.

I still don't care too much about it as I don't look at stocks as part of a stock market, but more as a piece of a business (would you sell the restaurant you love and built over the years just because the S&P 500 index is trading at, say, 50x p/e?  Nope.  If someone offered you 50x p/e for the restaurant itself, then you would have to think about it, of course!).  If I like the business, how it's doing and it's current valuation is reasonable, who cares what some GDP ratio shows?

Having said that, I was still curious how people can keep saying (including myself) that the stock market is reasonably valued despite this fact.

Actually, the question is more why people like Buffett are not more worried about the market (we know he ignores market predictions but still) with this crazy looking chart.   Why does he keep buying Wells Fargo every month (well, I told you he will keep buying WFC all the way up to $50/share. see Wells Fargo is Cheap!)?

Anyway, let's get to the picture:

There are a lot of these charts all over the internet; people have been talking about this for a long time now.  I'll use the St. Louis Fed's chart since they probably won't come after me for copyright issues.

After-Tax Corporate Profits / GDP Ratio

The chart is certainly staggering.  I too tend to get acrophobic when I see charts like this with something shooting way out of range.  Corporate profits has been in the range of 4-6% or maybe 5-7% for a very long time but is now above 11%.  This can't continue. The argument is that if profits went back to 5-6% instead of 11%, then the stock market p/e ratio of 15x (or whatever it is currently) would actually be 30x on a 'normalized' basis.

Scary for sure.  I do agree with the fact that these things do tend to mean-revert, and I also realize that there may be factors (international business of U.S. corporations) that might make this trend up over time. 

But I don't want to get into the details of that now. The point of this post is much simpler. 

What Are We To Do?!
The question is, with this ratio at such abnormally high levels, what the heck are we investors supposed to do?  "Experts" tell us to get out of stocks or lighten up as profit margins are unsustainable and the market is expensive on an 'adjusted' basis.

As I said before, my personal reaction is to do nothing and just look at my holdings and see if I have a problem with any of them.  If I owned a company that typically earned 10% operating margins and that went up to 20% due to some supply constraint that made the product prices spike up and input costs were lower than usual and the stock price reacted and is priced as if 20% margins is 'normal', then I might lighten up or sell out completely.  If that is not the case, I would hold on.  Who cares what the 'national' level profit margins are?

If you owned Berkshire Hathaway in August 1987 and were convinced that the market would crash soon, would you sell out?  How many times would you have sold due to various reasons over the past few decades?  And out of those times you would have sold, would you have gotten back in? 

Anyway, let's get back to the above chart.  Profit margins seemed high back in the late 40s and into 1950.  Interest rates were probably below 2.5% back then, and profit margins were pretty high.  If you knew for a fact that the corporate profits-to-GDP ratio is going to head down, would it have made sense to stay out of the market and wait for it to get to a level that is more comforting?

Here is the S&P 500 index from 1950 or so onwards:

 S&P 500 Index 1950 - 2013

...and just for fun here's the Dow in the last century:

Dow Jones Industrial Average 100 Years (1900-2012)

So, check this out; from 1950 on, corporate profits as a percentage of GDP headed straight down all the way until it bottomed out in the mid-1980s.  You can draw dots in February 1950, 1955, 1960, 1970, 1980 and 1985 and except for 1980, the ratio is lower than it was the dot before.   I am eye-balling this so I may be off a little here and there.  But the basic message is the same.  Corporate profits-to-GDP went down all throughout that period.

OK, so here's the fun part.  You saw the S&P 500 and Dow charts so you already know where I'm going with this.  Let's see what happened to the stock market since February 1950.  I used February since that was the earliest datapoint on Yahoo Finance for the S&P 500 index.  I do have complete data somewhere, but I didn't bother to look for it as I think this is good enough.

Let's look at what happened from February 1950 onwards to the S&P 500 index:

                               S&P 500               annualized
                               level                      return since 1950
February 1950         17.22
February 1955         36.76                   +16.4%
February 1960         55.49                   +12.4%
February 1970         89.50                     +8.6%
February 1980       113.66                     +6.5%
February 1985       182.19                     +7.0%

Keep in mind these returns exclude dividends.  It's only the change in the index.

So if you somehow had perfect foresight and you knew that the profits-to-GDP would head down in future years (back in 1950) and waited, when would you have bought stocks?  If you waited until it bottomed out in 1985 (actually, I think it bottomed a little later, but...), you would have had to pay 11x as much as you could have paid for stocks in 1950.

If you waited five years, you would have missed out on +16.4%/year in returns.  If you waited a decade, you would have missed +12.4%/year in returns etc.

So even if you knew for certain that profits-to-GDP would head down in the future, you still would have had no idea what the stock market will do.  This is the essence (or one of many) of Buffett's approach to these macro things; even if you knew exactly what the unemployment number would be one year from now and what the GDP would be, you would still have no idea where the stock market would be.  There are just too many unpredictables, or what he calls unknowables.

Please excuse my very rough eye-balling, but let's look at what happened during the time that profits- to-GDP went down versus the time it went up.  As we saw in the above table, in the 35 years between 1950 and 1985, the ratio went down a lot, but stock prices rose 7%/year.  Since 1985 through February of this year when profits-to-GDP went straight up to the current, obscene, unsustainable level, (just to keep the Feb-to-Feb comp constant), the S&P 500 index went up 7.9%/year. 

So the market went up during the years when profits-to-GDP went down, and the market went up when this ratio went up.  Is the profits-to-GDP really such a good indicator for stock market timing?

You can also try plotting the highs and lows of the profit-to-GDP chart and match it to the stock market.   Maybe you would have gotten out in 2006 or 2007 and then gotten back in in 2009.  But then maybe you sold out in 2010 or 2011.   Not bad.  But then, over time, you might have bought in 1970 and then sold in 1978 only to get back in in 1985 or 1986.   You get my point.

Buffett has this sort of long term perspective on things and that's why he is not alarmed or overly concerned with these things.   It's not always easy to do, but sometimes you have to look at the whole picture, not just the big picture.  People, myself included, sometimes get mesmerized by certain graphs and charts and make them overly weight it and distract us from making good, rational decisions.

Interest Rates
We can make a similar argument about interest rates too.  People say correctly that the stock market had a massive wind at its back with interest rates going down from double digits in 1980-82 all the way until today.  They say that this wind at its back is now a headwind.  Combine that with the abnormally high profits-to-GDP and the stock market is dead money, at least, for a very long time.

But again, in 1950, interest rates were 2% or whatever.  That went up to double digits.  I think rates peaked out in 1982, but since we already did the work for 1980, let's look at that.  The S&P 500 index went up by 6.5%/year from 1950 to 1980 despite interest rates going from 2% to 10% or so.  And that 6.5%/year includes the stock market being flat pretty much since 1965 through 1980.   And remember, these stock market return figures exclude dividends.

So here we are today with interest rates at unsustainably low levels and profits-to-GDP at unsustainably high levels.  Putting those two together, it's hard to imagine the stock market moving higher.  At best, it seems like it will be flat for a long time to come.

But looking at the whole picture and not just at cherry-picked charts here and there that look scary, we see why Buffett says that the market will keep going up and will be substantially higher over the next few years even though he admits he has no idea what the market will do next week, next month or next year.

I am not arguing that stocks will go straight up and will always do so.  I look at these charts and do believe in mean reversion and all that, and I don't entirely disagree with the bears out there.  But I just like to take one step further and ask myself, well, what would have happened if I used this as an indicator to get in and out of the market?  Would I do better than just holding on to great businesses or buying special situations? A little digging shows that maybe not.

I don't think these charts are irrelevant either.  It's just that there are so many factors that are not knowable that we can't really predict what is going to happen based on one or two (or even five to ten) really, really convincing charts.