Wednesday, May 23, 2012

My naive and fishy view on deleveraging

I'm writing this in response to a Barron's piece about Ray Dalio. I'm writing this because I'm puzzled about the 3 strategies for deleveraging that I heard about over the years. To me, there is only one strategy. (I'm not sure if the Barron's article is behind their paywall. If so, you can also find a snipplet quoted at Frank Voisin's blog.)

* * *

In the distant land of Asgard, the currency unit was "cans of sardines". And sardine hunting was Asgard's major economical activity.

One day, an entrepreneur called Loki visited the Central Bank of Sardines. He wanted to borrow 1/2 of the nation's sardine reserve, which had been accumulated as a preparation for the next ice age. He had this grand vision. He wanted to use the proceeding to employ many engineers and scientists to create an automatic sardine harvesting machine.

Loki eventually got his loan. But on his way back to his office, he bumped into a gigantic green monster and all the sardines were lost.

Now, after this incidence, Asgard didn't have enough sardines for the nation to go through the ice age. What could they do? What were the options?

Could they "inflat" their way out? They could repackage each can with only 70% of original volume of sardines, and they could repeat doing this every year. That inflated the number of cans. But, it didn't address Asgardians' hunger... 30% less sardines was 30% stomach unfilled.

Could they go on austerity?

Well, I think austerity = hunger.

It's apparent that the only sensible option was to ramp up their sardine hunting or improve the yield (by really inventing a harvest machine!) to make up for the lost.

This means they had to grow, to improve their productivity.

Did inflation have a place? Probably. If Asgard labour and goods were cheaper, they could probably sell more stuff to other nations and thus accelerated the build up of their sardine reserve.

Did austerity have a place?  Probably. For one thing, sardines (i.e. money) should not flow through Loki's hands anymore. In other words, austerity should be applied selective at the places where waste would occur.

But, without growth, austerity and inflation were useless.

* * *

I don't have any rigorous economic theory to back up my story. I am pretty sure you can poke holes in this "analysis". I am looking forward to comments on the fallacies of my reasoning.

(Don't ask me why "Asgard" and "sardine". I just had these random thoughts in my head while I was writing this.)

Saturday, May 19, 2012

Next leg of the crisis

It's instrumental to learn the financial history. Technologies advance, companies come and go, but human psychology doesn't change. While the boom and bust cycles don't unfold in the same way each time, studying the past gives us two important insights:
  • a sense of the time scales
  • the severity and magntiude of the events
The next leg

One thing that I learned is a financial crisis unfolds over more years, at different pace in different countries and can have many many legs downwards.

It looks like we are now entering the next leg of GFC originated in 2007.

At the moment, France and Greece are throwing tantrums. On one hand we have France threatening to disintegrate the Euro core when its new president Fran├žois Hollande, rightly so, wants to reset the fiscal and monetary agendas of the Euro zone. On the other hand, we have Greece on the brink of leaving Euro.

I wrote in February this year in my private blog:
...I just can't help thinking the financial world now has some kind of "Euro zone fatigue", sick of hearing bad news from the region and has basically switched off, not to pay any attention anymore for a while. I still reckon there is a good chance Greece will default [disorderly] this year. On the top of that, we have also the possibility Isarel may attack Iran and the mess in Syria. Not to mention the China bubble is looming behind the scene. We know from high school math, to calculate the probability of "at least one bad thing will happen" is to add the probabilities up. (And this hasn't taken into account this kind of stuff is not mutually independent.)
Greece did default but in an orderly fashion. Since then, the market sentiment has been calm until 2 weeks ago. Now we have another real possibility that Greece will "default again" and send another shockwave throughout our financial systems.

What is it for value investors?

What does this mean for value investors?

How bad the situation will get? When will be the market bottom? No one knows. The key is not to time the market. The key is to price individual companies.

At a minimum, we should all be prepared. The volatility is on the rise. When Mr Market presents us with opportunities, we need to act swiftly and decisively, deploying meaningful amount of money to buy mispriced companies -- companies with wonderful prospects for the next 15 years but priced only for the outlook of the next quarter.

Learning the history

Back to the issue of studying the financial history.

There are classic like Devil Take the Hindmost, Manias, Panics, and Crashes and  Extraordinary Popular Delusions and The Madness of Crowds.

However, these two are my favourites:
  •  In an Uncertain World - This is Robert Rubin's memoir of his life as the Secretary of the Treasury in the Clinton era. You will see how the Asian Crisis, the Mexican Crisis andthe Russian Crisis unfolded through the eyes of a policy maker. Besides, this also touches on Rubin's probabilistic thinking style, which is vital for decision making under uncertainty. (Isn't that what investing is all about?!) This is quite a page turner. I've actually read it twice. This book is particularly relevant in the context of the current Euro crisis.
  • Anatomy of the Bear - Russell Napier documented four greatest bear periods in this book. This book is relatively dry and the analyses get a bit repetitive. However, it gives you a lot of charts, statistics and newspaper vignettes, showing you how different asset classes performed, what the central banks were doing and the how market sentiments turned around those four market bottoms. It uses Tobin's Q-ratio has a barometer of the market valuation and it draws the conclusion that the return of price stability of commodities is a key indictator of the bottom of the market. They are interesting perspectives. But being a bottom-up investor, I personally won't use these indicators to time the market. To me, the real value of this book is in the historical facts Russell has compiled.
Hedge fund manager Hugh Hendry reckons "we are single-digit years away from the most profound market clearing moment". Will the final leg in the next couple of years be a China fallout or a Japan collapse or something else? There is no way of knowing. But we better be prepared.

Friday, May 4, 2012

Dolby: Half time post-mortem

I bought a stake in Dolby (DLB) a year ago at ~$50. That was before Dolby revealed its Dolby Digital Plus technology was not included in the initial Windows 8 builds. When that news was eventually announced in Aug 2011, DLB free fell to around $29. Since then, it has crawled back some of the lost and was close at $37.63 yesterday.

After market close, DLB announced its 2nd quarter result with this paragraph in the press release:
"Microsoft(R) will incorporate Dolby Digital Plus in all versions of its Windows(R) 8 operating system for PCs and tablets for online and file-based content, and leading providers of cloud-encoding solutions, such as Microsoft's Azure,, Zencoder(TM), Digital Rapids(R), Nativ, and LinkoTec will also adopt Dolby Digital Plus in their platforms."
DLB jumped 23% to $46 in after-hours trade session. In this post, I'd like to reflect on this short journey, explore what mistakes and right choices I've made. At the time of writing, I'm still holding onto my stake.
Key points:
  • The key to succeed in investing is more about avoiding costly mistakes.
  • An investment case with the reasonings right but not the facts is a weak investment case.
  • Without the conviction, you won't be able to take advantage of cheaper price to average down.
  • Anchoring rears its ugly head anytime, anywhere without warning.
  • When the downside has protection, but uncertainty is high and visibility is low, the best course of action is to wait, not to sell.
What's gone wrong?

Here is an excerpt of  what I wrote in my private blog that I shared with a couple of close friends in Aug 2011 shortly after the big fall:
Since I bought DLB, it has lost a mighty 42% of its value. This makes my original thesis looks foolish. Two things contribute to the horrible performance: (1) they lowered the earning estimation the 2nd time in a row 6 months. (2) But biggest blow was they announced last week Dolby technologies was not included in current build of Windows 8. (Current build? pre-alpha?)

It's really painful looking at it. But I better make the lost worthwhile by taking an honest look to see what I can learn from it:

  • [It's a huge drag on my portfolio performance.] This confirms the widsom: the key to be successful in investing is not that much about making big wins; it's more about avoiding costly mistakes. 
  • My original thesis was: (1) [Downside protection:] Windows 7 commercial editions include DLB technologies. OS upgrade cycle at corporations is a long-tail process. I was expecting increasing revenues throughout the next 2 years to compensate for the lost of revenues from DVD players. (2) [Upside:] DLB is well positioned to cover the mobile market and online streaming market. [However,] the issue here is, I thought through it qualitatively, not quantitatively. Meaning, I didn't have the hard figures to back up my claims. Now at a much lower price, I don't have the conviction to add to the position.
  • My initial purchase was a knee jerk reaction of the 25% fall from Jan to March.
  • The thought that DLB won't be included in Win has never come across my mind. This is pretty much a black swan event to me. That means my edge (that I understand/know something the market doesn't) is either not here or not that big as I thought. Thinking in terms of [position sizing], in the light of this, my initial position was too big. Now I wouldn't want to add more to it even if I had the conviction.
All that said, it's still too early to tell if DLB is a write-off. Its potential in the mobile and streaming market is still huge. The problem I have now is I don't have the conviction to add more to my position. 
That has pretty much summed up my mistakes. My original thesis was weak on quantitative front. I fooled myself my downside protection was solid. But it was not, because I didn't have the needed data to backup my thesis. I have only worked out the big picture and competition dynamics. I didn't have the cash flow calculation.

Now when I look back, this was not that different from the dot-com mania! The 3,000 feet birdeye view that internet would change the world was and is still correct. But no one took an honest look at the numbers. Same here with DLB. While the big picture is still valid, I didn't have the access to the essential data. Yet I fooled myself I had a strong investment case. Besides, anchoring was also to blame for initial knee-jerk reaction to buy DLB. Meaning, I have mistaken a fall of market price as an indication of value.

Without a really solid valuation, I didn't have the conviction to average down. Thus, I missed the opportunity to make money back.

Anything's gone right? 

Has anything gone right? In my view, yes: I didn't panic under uncertainty. I held onto my position.

At time, I reexamined my initial thesis: While my downside protection was not as solid as I believe, DLB indeed had reliable toll-booth-like streams of revenues at literally 100% gross margin and without any need of capex. After the big fall, DLB was trading at ex-cash P/E multiples priced as if it were a definite declining business. The increase of revenue from continuous Windows 7 rollout at corporations was not priced in. The opportunity (or the option value) that it could expand into the streaming market and mobile market was also not priced in at all. The market was at its greatest pessimism because of the uncertainty with the Windows 8 platform plus the fear of the losing the DVD revenue stream.

I concluded DLB was mispriced. But as I said before, my conviction wasn't high.

When the downside has protection -- in this case, some protection -- but uncertainty is high and visibility is low, the best course of action is to do nothing.

What now?

First, I have to admit DLB's recovery because of the latest Windows 8 news was blind luck. (It's better to be luck than skillful!) I didn't expect that at all. As such, DLB is actually now stronger that what I expected. It has also advanced on the online streaming front. That's also not expected. I originally thought it had better chance to make Dolby omnipresence on all mobile phones just like what it did to Walkmans in the old days.This is still early days to tell if it can or cannot.

All in all, I'll hold onto my stake. Well, not with very strong conviction. But less action is better than more.

(Disclosure: Long DLB, without too high a conviction.)