Well it turns out that the reverse is true. Academic studies in America and Australia show that their are limited abnormal returns gained after insiders buy, yet insiders do sidestep abnormal negative returns with their sales. Further investors can also on average earn abnormal returns by following suit when the insider sales are publicly disclosed. Keep in mind we’re talking averages here. So please don’t go selling your shares the next an insider in one of your companies unloads a few shares. Though perhaps it is worth keeping this in mind the next time you see large insider sales. It may be a good trigger to dig deeper and ponder whether that company is the best place for your funds.

The following graphs are based on a study by Uylangco, Easton and Faff (2010). They concluded “imitators may earn small abnormal returns by imitating directors, especially with respect to sales.”

Lessons and Ideas from Benjamin Graham by Jason Zweig. Here are even more of Zweig’s articles on Benjamin Graham.

Baupost Group’s Seth Klarman “IT’S A GREAT TIME TO BE A VALUE INVESTOR. THE COMPETITION SEEMS TO HAVE GONE AWAY.” excerpted from our March 17, 2009 edition of Outstanding Investor Digest, OID.com

A pile of GMO quarterly letters and other articles.  via GMO.com Especially The Last Hurrah and Seven Lean Years and Reinvesting When Terrified.

Simple Maths for Safe Doubles by Seth Jayson at TMF

The New Yorker – Anatomy of a Meltdown

Investment Outlooks by Bill Gross and other archives at PIMCO.

Be Nice to the Countries That Lend You Money Atlantic Magazine.

What did we do right in 2009?

One year of good return may be just a result of high tide lifting all boats or simply mean-reversion from a terrible year. Nevertheless, my biggest take-away from 2009 was a subtle but important change to my investment philosophy – I have changed my focus from “good and cheap” to “better and cheap”. I care more about change in fundamentals – I prefer a bad company that is getting better over a good company with no change in story. This new philosophy has led to solid stock picking, which generally out-performed the market with what I believe to be lower risk (“permanent loss of capital”). Equally important, this new framework gives me better guidelines to size my bets, especially betting heavily in situations where both the story is getting better and stock is cheap.

When I started investing a few years ago, I was firmly in the value investing school – concepts like “intrinsic value” and “Mr. Market”, coined by Ben Graham and popularized by Warren Buffett, clicked for me instantly. I spent time studying company fundamentals, coming up with an estimate of the intrinsic value, and trying to buy at a cheap or discounted price. In short, I was trying to buy “good and cheap”, and results were satisfactory.

However, I have come to realize the quality of the company and absolute discount to intrinsic value are not everything – one has also to consider the time and factors it takes for the discount to narrow, which typically depend on the business cycle. Thus my new approach comes down to balancing between value and momentum. Value refers to the price paid for the business. Momentum, not to be confused with price momentum in quant and technical analysis, refers to business momentum, i.e. how well the business is doing. Improving momentum can come in the form of higher margin, accelerating topline growth, or improving ROIC. With the exception of select great companies in their growth phase, most companies’ stock price and business momentum move in cycles/curves similar to sine waves with peaks and troughs.

These two curves are closely related – when business momentum is good, stock price tends to go up, and vice versa. However, there is often a lag between the two curves, and depending on the part of the cycle, stock price will react to the change in business momentum very differently. I believe this is the crux of investing – how you identify which part of the cycle the company is in, which drivers to watch for and which valuation metrics to use. For example, earning revision is a powerful factor but completely useless at business peaks and troughs. P/E may be a good valuation metric in general, but unadjusted for margins, it is useless or even dangerous at extremes. [I stopped highlighting here as it's all so good the entire article should be highlighted!]

For example, assume a retailer’s intrinsic value is $20, and buying at $15 may give an expected return of 33%. However, the same $15 price may correspond to two points on the momentum curve – one where the curve is turning up (story getting better) and the other where the curve is trending down. In the former case, you will probably get to $20 in 6-12 months. In the latter case, you may have to wait 18-24 months before the retailer corrects excess inventory and produces positive SSS (curve turning up again) to reach the $20 intrinsic value.

There are two obvious problems with buying at the latter point. First, time adjusted return is obviously inferior. Second, the stock price may first plunge to $6 before recovering. While a pure value investor may think a lower price makes it a better buy (even more margin of safety), reality is that an adverse price movement will slowly but surely inject doubt into my mind. Have I made a mistake? Is this a value trap? Very seldom does stock price move down without some deterioration of business fundamentals and some changes to the initial investment thesis. So unless one has an iron stomach (I don’t), it is very tough to keep calm during the price downdraft and continue to average down. There is an even bigger issue – if you are prepared to average down, chances are that you will not buy a full position initially, and inevitably you will end up establishing similar-sized partial positions for all new ideas. Yet some of those ideas will have good business momentum and they are your surer bets, so you lose potential profits in positions that actually have the best risk/time adjusted return.

So doesn’t quant investing capture “better and cheap”, as preached by the noted quant investor Cliff Asness? Yes and no. I believe there are two problems with quant investing. First, it mistakes cause with effect – price momentum is the result of business momentum, and while the two will resemble each other at certain part of the cycle, they will diverge significantly at critical turning points. Second, the effectiveness of various factors differs significantly from industry to industry as well as at different parts of the business cycle. Quite simply, quant investors lack the domain knowledge of each industry and use the same factors or same weightings across sectors during different points of the cycle.

For example, quant investors will universally use factors such as earning revision, revenue/EPS surprise/breadth to capture business momentum. While this does a satisfactory job overall, it will not capture key drivers for each industry, which often cannot be retrieved from standardized financial statements, such as inventory/store for retailers, or asset inflows for asset managers. Often changes in these key drivers will long precede actual changes in earnings, so generalized quant investing could easily miss the turn. As another example, six months ago, both KIRK and ARO got the highest rating in our internal quant system, yet the two retailers could not be more different in terms of where they were in the business and margin cycle, and the subsequent divergence in stock performance illustrated the flaw in the quant investing approach.

I certainly do not want to leave the impression that other investing approaches are inferior. Indeed, there are many ways to achieve success in investing, and everyone needs to find approaches to fit his or her own traits. I believe I have found mine by balancing between value and momentum. Put simply, I aim to invest in situations where fundamentals are about to turn or have turned while valuation is reasonable. I am certainly not reinventing wheels here, as this is the approach advocated by both Peter Lynch (“catching the turn”) and Warren Buffett (“What we really like to see in situations is a condition where the company is making substantial progress in terms of improving earnings, increasing asset values, etc., but where the market price of the stock is doing very little while we continue to acquire it”).

Well, this approach may sound good on paper, but how many of these “perfect” situations exist, given how efficient market is with so many hungry and smart investors poring over every corner of the market? I believe these opportunities happen more often than one may think, especially if one can invest in small-cap or micro-cap land. For example, I monitor about 50 names closely in the retail industry (which I shamelessly consider to be my circle of competence). This year alone, I identified 4 separate names that fit the criteria. They respectively returned 50%, 70%, 100% and 900%.

One may counter that retail stocks have done very well in general this year and question whether throwing darts randomly would have generated similar if not better results. I would argue that much of the return (especially the out-sized ones) was hope-based, and rational investors could not have predicted those returns ex-ante with any confidence to place a big bet, as some of those names could easily turn out to be zeros. Yet in all four names I identified, I was reasonably certain of the business momentum and earning surprise, and could accordingly place out-sized bets (10%+), with confidence that even if it did not play out according to plan, I would suffer very small losses due to valuation. While hindsight is 20/20, I could also identify at least two retail names annually over the last few years that fit my “better and cheap” criteria. So they definitely occur, and one just needs to have the patience and courage to bet big when they do come along, usually when market is bad. Those situations can occur in large-cap stocks as well, such as FDX throughout this year. FDX had over $20B market cap, was followed by 25 analysts, yet the stock was at trough EV/sales, even though earnings had bottomed and was poised to recover through cost cuts and market share gains. Earning estimates have moved up 60% in 6 months and stock went up over 150%.

As with anything in investing, there are also drawbacks to my approach. One is depth vs. width – I need to be able to identify and evaluate key drivers for the companies and industries, and this takes significant amount of time. The rarity of these “perfect” situations forces me to turn over a lot of rocks. To date, I am reasonably comfortable with retail industry, and to a much lesser degree with software, asset managers and transport industries. I may soon reach (if not already) a point where I can not physically monitor more names. The other problem is scalability – most of my top ideas are in small to micro-cap land, so it is questionable whether my approach can really handle more than say $50-100M of assets. But that will be a nice problem to have, and I suspect I will just have to make the trade-off between absolute performance and AUM.

Remember that indices are not static beasts, they are actively managed funds of the leading companies. Failing or at least flailing companies are cut from the list while successful and growing companies are added. That’s a difficult investment strategy to best, especially when actively managed fund’s fees are going to be meaningfully higher.

• Concentration means 2-20 positions. Small business people can put all their eggs in one basket, the rest of would be foolish to do so.
• Significantly is greater than 3%. As you’ll loose around 1% in fees compared to an index fund or ETF and you want at least 2% return for taking the individual risk.

Index Funds and ETFs in Australia

There are two main choices, though others do exist:

1. Vanguard Index Australian Shares Fund charges a management fee of 0.75% p.a. for the first $50,000, then 0.50% p.a. for the next $50,000 and 0.35% p.a. for the balance over $100,000. There is also a spread of .2% on purchase and .1% on withdrawal.
2. State Street Spiders ETFs on the top 50 or top 200. Management costs are 0.286% and there will be the bid/ask spread.

Index funds and ETFs are the most suitable choice for investors who do not have the time or interest for investing, but desire exposure to a particular asset. I wrote more about investing in Australia here and its related posts.

I’m still working on reducing the number of US equities we hold. I forget the peak, maybe 46. We’re down to 30 now, with three more on the chopping block followed by five more waiting a final thumbs up or down. Pfizer is our largest position.

My son has embraced his creative powers, this image is from his Gorillaz Demon Days concept series. He drew a picture for each song on the CD.

Seven Strong Australian Dividend Payers

ANZ Banking Group Ltd

ANZ Dividend History

Is currently my largest bank holding and my favourite to bank with. They have a strong strategy for Asian expansion and a management team who appear capable of delivering that strategy.

Telstra Corporation Ltd

TLS Dividend History

Telstra is the leading Australian Telco and the best brand in Australia. The current 8.8% dividend is only just covered by earnings, but thanks to a major transformation project earnings are set to increase for the next couple years at least. I previously covered Telstra’s dividend history and valuation and called it a good buy at similar prices in June and March.

The opportunity to buy a this stalwart at discount prices has arisen due to regulatory uncertainty and now the threat of structural separation of Telstra’s wholesale and retail divisions.

Westpac Banking Corp

WBC Dividend History

Westpac has the second best 10 year and best five year dividend growth history of the group. Like all the banks I view it as fairly valued at current prices, but with greater potential upside than downside surprise over the near term.

Westpac was the strongest bank coming in to the recession we didn’t have, but I’m not sure they capitalised on that as much as they could have.

National Australia Bank Ltd

NAB Dividend History

Apart from my general sentiment on banks, I know little about NAB. Except they always seem to be throwing money away on atrocious overseas acquisitions.

Commonwealth Bank of Australia

CBA Dividend History

I don’t follow them, but they certainly appear to have taken excellent advantage of the financial crises.

Macquarie Group Ltd

MQG Dividend History

I’m sure some fellow investors mocked me for buying Macquarie, but as they say he who laughs last laughs loudest. I bought MQG on a very simple premise. “The strong often prosper at these times and with the loss of some high profile competition, MQG are selling themselves as a strong survivor. I’ve bought the story” November 2008

Macquarie Group is too complicated for me to get a good handle on, consequently I started selling down our position in the forties. Management appear to be doing an excellent job of positioning the company for future growth and I would not bet against them.

Hunter Hall International Ltd

I would have liked to buy more of HHL back in June, but I was discouraged by the wide spread due to HHL being so thinly traded. I originally compared Hunter Hall to Platinum Asset Management, the darling of the Australian funds management industry,back in June. Taking dividends into account the returns have been similar since then. I haven’t updated by figures, but am prepared to take an educated guess that HHL still trades at a large valuation discount to PTM.

I covered HHL’s dividends and AUM in June and their 2009 results in August.

HHL Dividend History

What to Buy

Yeah right, as if I’d tell you that, but I will comment on what I might do, though don’t hold me to it as I’m like a willow blowing in the wind. Telstra and Hunter Hall are the only two I would consider buying at current prices, but have no plans to buy either due to current long position in both. If this rally continue ANZ is high on my list of Australia stocks to trim back on, primarily due to my position size rather than its comparative merits.

Please keep in mind I speak of what works for me. The  most important factor in investing success is knowing what works for you. Scores of commentators are prepared to tell you how to invest, that their way is the right and perhaps only way. They speak in black and white terms of certainty. One of the few things I am certain of is that there are scores of way to make money via investing, but you never will unless you know yourself and which style best fits you.

Disclosure: Small long positions in WBC and MQG, Long TLS, HHL and ANZ.

Not only is Australia yet again officially the second the best country in the world, it’s the first to raise interest rates.

See you at parity my US friends See you real soon! This raise took AUD over 88 cents. I’ve been banging on about the short USD long AUD trade for most of this year and despite the sudden rush of people late to the party I don’t see it breaking down yet.

I love this comment “Only one of 20 economists surveyed by Bloomberg News forecast today’s move. The rest predicted no change.”

Someone better get the sheep dog out to herd that stray economist back in line. Though I imagine Stephen Walters, chief economist at JPMorgan Chase & Co. in Sydney, who forecast today’s move is having quite a celebration tonight.

Julian Robertson’s favoured currency is the local currency of the best country in the world. It would appear you don’t loose points for freezing your nuts off. Norway probably only pipped Australia by having a higher life expectancy and that’s only because they’re living in partial cryogenic suspension.

In other news I placed four orders on US markets tonight, all November covered calls, above the current offer. Let’s see if anyone living in the cough cough 13th best country bites.

There is no investment potion for this new environment other than steady income-producing bond and equity investments in companies with strong balance sheets and high dividend yields, as well as selectively chosen emerging market commitments where nominal GDP growth prospects are tilted upward as opposed to gravitating to new lower norms.

While Mr Gross didn’t actually say buy Australia can you name a country which better fits Bill’s bill?

Consider the S&P ASX 20 (top 20 companies in Australia) where the average yield is 5% and the highest is 9.6% and the balance sheets are strong.

Australia’s GDP growth prospects are tilted upward as it continues to supply the raw materials for the growing number of global consumers.

Roger Nausbaum continues to talk about doubling his Australian allocation to 6%. For a guy who invests internationally I’m surprised that he doesn’t use Interactive Brokers and restricts himself to ADRs and OTC. Though as he is managing other people’s money I am sure he has good reasons.

I continue to up our Australian allocation as I pull back from my favoured investing destination of the US. Regularly taking your Australian potion should help with some of the common side side effects of a devaluing greenback and inflation.

Want to read more of my investing in Australia cheer leading? Keep in mind I am talking long term and I am not nearly as optimistic in the short term.