Introduction

I would like to elaborate on the blog description for the first post. Most commentators on the web focus on a narrow area (equities, or currency, or commodities) and ignore the most important of the three components of what constitutes a good trade idea - that it isn't already shared widely and hence priced into a security. It is relatively more easy to have ideas that are true (say 60-70% of the time) and affect the value of some security. What is hard is finding the ideas that a gazillion other people haven't thought of, and figuring out if a particular view has already been factored into a price already/is consistent with the price.

Our strategy for finding these good trade ideas is to focus on what is obviously missing in most published analysis (whether it be from Dealer Research or the popular press): an appreciation of (a)long time horizons (b)the big picture and common sense (c)a basic understanding of how to value cash flows on a discounted basis. Let me address each of these in turn with examples:

(a)time horizons: right now, when it comes to the US economy and equity markets, everyone seems to be focused on the Fed, liquidity, and the credit crunch. While these are important in the short-run, especially if you are looking at fairly leveraged companies close to having to roll their debt over, in selecting your long-term longs you should only use liquidity as a constraint (ie avoid those that could go under). But always the first thing you should be looking for is a good/growing moat at a reasonable value. This is also related to

(b)the big picture and common sense: the problems did not begin and do not end with the Fed. The problem is the combination of overindebtedness, low savings rate, recent drop in risk-premiums and the sudden return of common sense (at least to the bond markets if not quite the equity or commodity markets yet). As the housing bubble grew, more and more exotic types of mortgages were created which pumped house prices up further, and these were made to increasingly bad borrowers at increasingly low risk-premiums!! Meanwhile, as everyone felt richer because their house price was going up, they felt less need to save. In addition, a lot of the people who bought in 2004-2007 bought such overpriced places relative to their income that they simply had no cash flow TO SAVE after paying taxes and basic costs of living. So let's focus on that rather than the Fed when we consider the long time horizon trades (which to me means five or more years).

(c)How to value cash flows for a company/stock: pick a starting earnings level of 1.00. Project a growth rate out year by year in Excel for the first 5-10 years, then have it revert to the long-term nominal rate of GDP (call this 7% for now). Use a rate with which to discount (e.g. 10%).
Make sure the long-term rate growth reverts to and the discount rate are cells you can change (ie use links and formulas). Starting with each future year grow a column of earnings by your projected growth rates. Discount each of these in a subsequent column by your chosen discount rate. Finally sum up this discounted cash flow column out to 40 years. Also, sum up the first 5 years, the first 10 years, and the second 10 years separately. These will be useful for sensitivity analysis. The sum represents the multiple of current earnings you should be willing to pay for that company/stock if your subjective hurdle rate is the discount rate you have chosen.

Most people who write about equities ignore this basic analysis. The point is not that anyone can forecast those growth rates precisely and "get it right" - no one can do that, not even Mr. Buffett himself. The point is that without doing this, or something similar in a simpler and more heuristic way (with experience one can do this analysis mentally), you have no idea what the right PE should be. People come up with dumb rules, like "any P/E under 14 is cheap" or even worse start using things like the PEG ratio.

In addition to this basic strategy (the quantitative part ends with (c) above, we need to learn how to (a)read balance sheets and income statements (b)become poets, philosophers and historians at heart. I mention these 3 because these are discliplines which really teach you about hidden connections, non-linear thinking, being sceptical of everything you hear, and having the big and long-term picture. After you have understood balance sheets, income statements and valuation, the most important thing to do is to read a little about a lot, a modest amount about a modest number of things, and enough to become an expert on a small set of things that matter a lot at that historical moment.

Our approach is neither 'macro investing' (ie bet on housing collapse via ABX index, or collapse of US dollar via futures against Chinese currency) nor ignoring all the macro stuff like so many mutual funds promise to do while they focus on "bottom-up stock selection". The first to us seems to often be too broad (relying on understanding and forecasting rather complex systems quite well), and the second to be too much like trying to find the strongest house in LA
before the biggest earthquake of the century when you could simply buy a ticket to NY.

The next post will focus on where we feel 'the right' balance between the micro and the macro focus is and will begin with our current macro view.