3. is the lowest probability in my mind as it may take a long time to reached undervalued. If you are going to do this you may as well invest in bubbles that have burst and gone nowhere for a while ie. significantly undervalued sectors/countries. No point in catching a falling knife, looking for yesterdays bubble, as it’s gone. 1 in my opinion is the highest probability and 2 is the highest reward but highest risk.

In terms of current bubbles, there are 3 that I can see as potentials:
1. Commodities: I’ve made more on this than anything else this year. It seems bubbly, but it could go a lot higher. Where would I sell out completely? Roughly Allords above 10000 before the end of 2014.
2. Housing in Australia: this has to be a bubble. Where would I sell out? When the commodity cycle looks to be peaking/ unemployment troughing or a 50% rise from here before 2014. Transaction costs (stamp duty, real estate agent etc) make it important that it has be quite overpriced to make it worthwhile to sell an investment property, even if things revert back to the long term mean over a 5 year period.
3. AUD: Also commodity bubble dependent. I’d factor it having the potential to exceed 1.2-1.4 in considering attempting 2. on this. It maybe a lower risk short than short commodities (because the upside maybe more limited). I haven’t thought this through enough, at the moment my inclination is to get a 10% internation exposure in my portfoilio above AUD/USD=1.

Grantham’s idea that quality stocks give a sustained (risk adjusted) edge is interesting, although there maybe situations of overpricing that would render this untrue.

I think Buffett is not as straightforward as is made out. If you followed what are thought to be Buffett principles I don’t think you would acheive anywhere near the outperformance. For instance he is thought to eschew market timing. Yet in one of his biographies (Snowball) he laments the fact that he didn’t participate more in the LTCM bailout (he was on a trip to somewhere remote with Bill Gates and his wife and the mobile reception cut out) when things became obviously mispriced due to fear. Market timing is essentially betting on mean reversion. He has done this with selling long term derivatives on the S&P and indexes.

At other stages he has not sold when it was obvious there was a bubble (late 90′s Coca Cola on PE in the 60′s). He has still made a good return on Coca Cola but it could have been so much more! Discerning what he does versus what he says he does versus what people think he has said or done is difficult. He often speaks in quotable quotes and the analysis is not as clear as Grantham. Buffett also has some serious eccentricities- are these part of his investing style or do these make his investing better ? Perhaps they make his investing style not replicable. Although his newsletters are informative, I get the impression he doesn’t say everything he thinks in there. That is probably the nature of managing a large corporation and maybe he doesn’t want to be replicable.

At different times he has said I don’t market time, but he bets on mean reversion. He says I don’t sell great stocks even if they are massively overpriced (eg Coke). He says I don’t invest in technology so missed out on Microsoft even though he was good friends with Bill Gates. The man is a contradiction (which is human). You have to wonder why not market time, why not sell massively overpriced great businesses (taking into account CGT considerations), why not buy tech stocks if you understand them and they are cheap, why not participate in bubbles whilst leaning against them ? Buffett is undoubtedly a great investor and must be studied but the man is human and not everything he says is gospel.

My own interpretation of his investments is that he was early to see that Coke was/ is a good company: it produces an addictive drink (with 1/3 equivalent cup of caffeine in each can) and has a good franchise. He was early to see that Insurance float is a free lunch. He has a good manager (Ajit) to price unique situations. He manages the insurance side of the business well.

On mean reverting investments, this is not as easy as it sounds. The highest probability investments happen when you bet against the bubble at near the peak (hard to do as it can keep going) or when there is too much fear and valuations are silly.

In terms of my own style I still think it is lower risk to bet on mean reversion in sectors, indexes of countries or asset classes. Recently I’ve tried to learn more about individual stocks because there is probably something I’m missing there. I’ve devoted 15% of my prtfolio to individual stock picks. I still predominately invest in indexes. Currently I’m 85% Australian equities, 15% individual stocks (10% Telstra, 4% WOW and 1% speculative). I think the resources boom has further to run but no longer have an overweight position in resources. Things could have further to run with that but I’m happy to just have a market weighting in resources at the current time.

I found the Grantham analsysis very interesting and more sophistocated than anything I could manage. It’s a shame the minimum investment amount for individuals is 500k otherwise I would plonk some in his fund.