I was riding the subway in New York City one day and thinking about how efficient the system is. There are plenty of trains to get you just about anywhere in Manhattan, Brooklyn, the Bronx, Queens, and Statten Island. You can ride from way up in the Bronx to the southern end of Brooklyn or all the way from Staten Island over to Breakaway Beach in Queens, 24 hours a day, 365 days a year, all for only $2.25 per trip. And best of all there are so many trains running, you’re never left waiting for long, even in the wee hours of the night.

This system along with the various buses that traverse New York City allow for true car-free living. Amazing! But how does it achieve this convenience to its customers? Ironically, through reducing choice! What do I mean? Suppose I want to go from the gym to work, within Manhattan, among my options are to bike or take the subway. But to take the subway, I have find and walk to one of its underground entrances (which may be a little out of my way) and then get off at one of the pre-determined stops and walk from there to my final destination. You can’t stop the subway wherever you want, you can’t sidetrack to your favorite shop on a different street. Once you’re on, you can only get off at one of the stops, those are your only choices.

For giving up a little choice, we gain a lot of efficiency. Underground there is no bad weather to slow down your commute or traffic jams to cause road rage. Just smooth, dependable operation. Sounds kind of like socialism, at least in theory. Reduce choice for the benefit of improved efficiency.

How does the subway compare to driving a car or riding my bike? Well, with either of these, I can go anywhere I want, whenever I want, using whatever route I want and can travel as fast as I want. But for this freedom, I have to deal with all others making their own choices, traveling via their random routes, at random times … in other words TRAFFIC!! We all get to where we want. It may not be the smoothest journey but we choose every twist and turn that is best for us. All actors, maximizing only their own utility functions. Just like capitalism.

I’m not advocating one system, capitalism or socialism, over another. I’m only pointing out an observation (where the parallels may even be too far fetched to be relevant). But there are pros and cons to both. With freedom and choice comes chaos with the hope that more freedom means more progress in the end. While true efficiency may only be possible by giving up important freedoms. I love the subway but also my bike and wouldn’t give up either.

While Greece is a small country (<0.5% of world GDP), we live in a highly interconnected world. It would be one thing if all banks holding Greek debt had to write off those holdings entirely, that would be very bad. Even more so, if Greece defaults or leaves the Eurozone, that only sets precedent for other weak countries in the Eurozone to consider similar actions. While Portugal isn’t large, Spain, Italy, and dare I say France, are!  The domino effect of such large countries undergoing even the stress Greece is going through now could make 2008 seem like a walk in the park.

How is all this connected to China? Well, China is the world’s exporter. Anything that affects high consumption markets like Europe and the US, indirectly affects China. If Americans and Europeans consume less, China exports less and therefore can’t pay it’s workers as much which could send China into a recession.

While China is best known right now for their exceptional economic growth and resilience, what makes them special in my opinion is what appears to be the existence of a credit bubble. In fact, their situation right now reminds me of Go-Go 1920′s in the US almost a century ago. Credit standards have been weak leading to lots of low quality lending. This lending, as it always does, has found it’s way into property markets leading to highly speculative behavior and valuations in major centers like Shanghai. People talk about apartment prices rising forever and using ever increasing valuations to borrow and purchase more property. The story around their stock market appeared similar about a year ago with everyone from stay-at-home mom’s and taxi drivers talking about stocks. The stock market has already fallen a little (the iShaers China 25 Index is down ~20% from peak) and the rest of the picture has many of the ingredients for a full on deleveraging. What is different about China is that many (all?) banks are controlled by the government. And if these banks got into trouble, I bet their government and central bank would recapitalize them quickly.

A slowing in China could then have ramifications for the rest of the world. China is amongst the largest consumers of many commodities. Any slow down in consumption would lead to falling commodity prices and to downturns in such countries as Canada and Australia and many commodity producing emerging market nations.

I don’t mean to be a Dr Doom but these feel like realistic risks to worry about. If they don’t materialize then we’re all better off but maybe the Elliot wave theorists are right (half joking), the next leg down in 2013 will have the S&P 500 revisiting the 400 level (1)!! The only way to be prepared for such uncertainty is a diversified portfolio. Only the safest government bonds will protect you if anything close to the above scenario materializes.

(1) Harry S. Dent, “The Great Depression Ahead: How to Prosper in the Crash Following the Greatest Boom in History”

RIM is a financially healthy company with decent earnings and cash flow (for its price) and no debt. But, as is easy to see throughout the media, the Blackberry is losing popularity and their Playbook tablet was an utter failure. The question is how far will Blackberry sales fall (in spite of what you read in the media, the number of global subscribers is actually growing). To answer this question it is useful to revisit Soros’ theory of reflexivity.

George Soros, the hedge fund manager famous for breaking the British Pound in 1992, but also for his theory of reflexivity. What is reflexivity? Under normal conditions, financial markets reflect what is going on in the real economy. But there are times when the behavior of markets can feedback into the system and in turn influence the real economy. The deleveraging effect we all felt in late 2008, as stock markets plummeted causing businesses to cut employment and halt restocking their inventories, was a perfect example of reflexivity.

This phenomena of reflexivity no doubt affected the sale of Blackberries over the last year. As more and more negative news came out about RIM and their operational issues, this certainly influenced many businesses and individuals away from buying new Blackberries. This effect is partly what has led their stock price so low and will also affect their sales in 2012. Without this reflexive effect I would feel much more comfortable my thesis. But the future of the Blackberry has only become more uncertain because of all the negative press and falling RIM stock price.

How far Blackberry sales will fall in 2012 is anybody’s guess. Though few would argue with me when I say Blackberries are unlikely to disappear anytime soon. I know I still see Blackberries, including the newest ones, everywhere I go, whether on the subway in New York, in Buenos Aires, or being used by my cousins in India. They are not the symbol of “cool” like the iPhone but people are buying and using them. It’s anybody’s guess how Research in Motion will fare in 2012, but my research tells me there is still plenty of value in their business so I’ve put my money where my mouth is.

The S&P 500 ended 2010 at 1257.64 and closed on Friday at 1257.60. A dull result if only looking at these end points (or only +2.1% including dividends). But we all know the gyrations of the past year were anything but dull because of fears of default of the PIGS countries in Europe that brought the S&P down to its low of 1074 in early October.

S&P 500: Jan 1-Dec 31, 2011

In fact most everything you read from traders and portfolio managers about 2011 is that it was a difficult year for all. The words you hear are “big ups and downs”, “high volatility”, “difficult year”. While what’s going on in Europe is far from ordinary, but from my perspective the performance of the S&P 500 was actually quite ordinary.

From a statistical perspective (barely useful on a forward looking basis, but can be instructive when looking back), the standard deviation of the S&P 500 in 2011 was 16.0%. While in comparison, the same measure going back to January 1950 (or 62 years!!) was 14.6%.  In other words, the volatility this year was comparable to the past and nothing special.  Second, how often does a return of 0% occur?  Using the same statistics, and an average return of 10.9% (the average annual return since Jan 1950), a return of 0% or lower happens approximately once every 4 years. In the past decade, there have been 3 years around or below zero (2002, 2008, and now 2011), 4 years with above average returns (2003, 2006, 2009, and 2010), and only 3 years with returns between 0% and 11% (2004, 2005, 2007). To the long-term investor who isn’t worried about short-term gyrations, 2011 was just a run of the mill year.

In such a run of the mill year, where so many professional investors were stumped by Mr. Market, what worked? This was one of those years when it felt good to be one of those, boring, long-term investors sitting back and watching the chickens run around with their heads cut off. The properly diversified portfolio of stocks, government bonds, inflation linked bonds, and gold that I have put together for my family returned 11%. We started the year adequately prepared for whatever might unfold, whether it be deflation from troubles in Europe, inflation from money printing, or a return to normal economic growth, and the portfolio proved itself as all of these conditions ebbed and flowed over the year.

Even more interesting was the result of our portfolio of high quality stocks within the asset allocation. The portfolio of high quality, brand names, with low debts including Altria, Coca Cola, Johnson & Johnson, CN Rail, and Fastenal returned 15%. This was a similar result to that of other famed value managers like Ruane and Cuniff at the Sequoia Fund whose return of 13.2% put them in the top 1% of all equity fund managers. Simply more proof that buying good businesses at fair prices produces results when you need them most.

So with this, what is my New Years resolution for 2012? Simple, to deepen my understanding of value investing through practice and remain disciplined with selecting good investments and maintaining a balanced asset allocation regardless of what the year ahead may bring.

Happy New Year everyone!

Before I get into this post about the impact of Europe on the long-term investor, I want to plug a book that I am currently reading. Based on a recommendation from a friend, I picked up The Most Important Thing by Howard Marks. Marks is a disciple of Warren Buffett (and fellow billionaire) and founder of Oaktree Capital Management. Marks’ letters to his investors are almost as widely read as Buffett’s to his. And his book is littered with thoughts, concepts, and exerpts from years worth of these invaluable letters. While I have not yet finished the book, I can quickly tell this is a classic by one of today’s investment greats.

On to Europe. The big question on Europe for me is not whether the Euro or European union will survive, the answers to these questions are guesses at best. More importantly I wonder what the impact of the situation in Europe will be on the long-term investor. It is fact that all economies go through cycles of growth and recession and boom and bust. During these cycles, some investments perform better or worse than others. For example, during a recession, government bonds perform well as investors flee risky assets like stocks in search of safety. But this type of behavior from investors presents opportunities to the prepared long-term investor.

I think the situation in Europe is no different. In the extreme, a bad outcome in Europe can alter the course of the world economy and therefore even the long-term performance of all assets. But as long as a post-Lehman style rapid deleveraging is prevented, I think we will be able to look back on today as one of those periods where the uncertainty and fears about the future presented long-term investors with great opportunities. This has always been the case historically, whether at the depths of the Great Depression in 1932, the oil embargo in 1973, when everyone thought dot.com was Dot.Dead in 2001 or even with individual snafus like when Coca Cola introduced New Coke in 1985 or more recently after the Macondo oil well explosion for BP in April 2010. All of these events presented opportunity to the prepared, long-term investor.

I am on the lookout for attractive opportunities and will try to write about some in the New Year.

But before I go on a rant, let me explain what VIX even is. The CBOE created a measure of expected volatility for the S&P 500 in 1990, the ticker for which is VIX (see Wikipedia for a more complete definition). Since VIX is only a measure of expected volatility/risk of the stock market it usually be within a range of 15-40%, which is the range of annual standard deviation for a stock index (there are ofcourse exceptions with periods in 2006/07 when the index was around 10% and in 2008 when it reached into the 80% range after Lehman defaulted). Therefore at best VIX is an instrument for speculation and maybe hedging and at worst it is a suckers sure way to lose money.

So what is so appealing about VIX? Look at this chart courtesy of Yahoo! Inc.

1990 - 2011: S&P 500 and VIX

When stocks fall, the VIX rises (and vice versa). A very clear negative correlation. In fact, the daily correlation between the two indices over the last 22 years has been -0.70. And logically I would expect this to be the case since when markets are rising, overall conditions are stable and therefore the VIX, or expected risk, falls. And when markets are falling there tends to be panic and uncertainty (like today) which leads to increasing expectations for risk so the VIX will generally be rising.

While it is true that the VIX would diversify a portfolio of stocks, the VIX is not an asset. It will not rise over time. You can see from the chart that it tends to move within a range. While if you had invested in stocks 20 years ago, and sat tight through Mexican peso crisis (1994), Asian financial crisis (1997), collapse of Long-Term Capital Management (1998), the Dot.com bust (2000-02) and the subprime crisis (2008-09), you still would have almost quadrupled your money. So unless you can time your trades into the VIX just right (which we know that almost no one can) then you’re wasting your time and money.

There has been so much focus over the last decade on diversification that investors have forgotten that you need to first pick investments that will actually rise in value (what a novel concept) and then secondarily, construct an adequately diversified portfolio to protect against the unforeseen.

As Paul Volker said, the only good financial innovation in recent history has been the invention of the ATM. VIX futures and options clearly don’t fall into this category either.

US 10yr bond yield - 1962-2011. Courtesy: Yahoo! Finance

The most common advice I see offered is to shift money from bonds into dividend paying stocks, master limited partnerships or higher yielding bonds. But all of these options are essentially the same – take more risk to chase a higher yield.

Such advice blatantly ignores the first principle of investing – protect your capital! Most of these same investors in need of yield already suffered irreparable losses during the market collapse in 2008/09. So taking more risk is certainly not prudent. There have to be better options.

Before I offer my advice, let’s take a look at the economic backdrop as this is what largely determines bond yields. Over the very long-run, capitalist economies produce growth rates of 2-3% plus some inflation. For bonds to provide a return in line with these long-term conditions, I would expect yields around 4-6%. So over the very long term, yields should rise. BUT, in the interim, there is a huge public and private sector debt overhang that needs to be resolved. Debt reduction means spending reduction. So this debt overhang puts downward pressure on growth which is therefore a deflationary force which in turn puts downward pressure on bond yields. So if anything there is more pressure on bond yields to fall rather than start rising anytime soon. There are good arguments for bond yields to rise too, from emerging market growth and currency revaluations, to out of control money printing (which we are no where close to yet) but the debt overhang appears to the dominant force right now. I also don’t want to speculate on the short-term direction of yields (and neither should you), I will leave that to the traders at banks and hedge funds.

Prudent investing has 3 components:

1. Careful research and prudence
2. Adequate diversification
3. Control over costs (fees, transaction costs, etc…)

A properly diversified portfolio is one that includes bonds in the event of another 2008. And now more than ever, #3, low costs, is more important in this new world of low returns and yields.

If a portfolio can’t prudently generate enough income to meet your needs, then you are in no position to prudently take more risk. Therefore I think the best suggestion is to periodically withdraw principle as needed. This is better than, generating a slightly higher yield off a high risk portfolio that could lose 20%, 30% or even 50% very quickly (as history has shown us time and time again).

You can further more structure your portfolio to minimize transactions if you have to periodically withdraw principle. One way to achieve this withdrawal of principle automatically is to invest in higher coupon bonds. For example, you could buy an 8% coupon bond, for $150 (per $100 face). This will pay out a higher current income and return $100 to you at maturity. Such a bond will automatically withdraw principle without the need to incur periodic transaction costs. To me, this is much better than chasing an exra 2% yield while risking a 20% loss of capital.

Buying individual bonds has many advantages over using bond mutual funds or ETF’s as long as you plan to hold the bond to maturity. The first is that you can customize the maturity of the bond for your needs so that you get a principal repayment when you need it. The second is that buying bonds directly avoids the management fees involved with funds. In a world of 2% yields, even a very low fee of 0.20% eats away 10% of your income.

You could choose to invest in foreign government bonds paying higher yields. Australia and New Zealand bonds currently pay approximately 5% and Brazil is upwards of 10%. But there is currency risk with these investments. If the Australia dollar falls by 25% over 10 years (which is not very much), you would’ve been better off just buying US bonds.

Finally, MLP’s or master limited partnerships have become popular as of late because they are income pass-through vehicles. That is, they are not subject to double taxation like a corporation and hence offer higher dividend yields. But in the end, these are still businesses that come with risks that all business come with. Additionally, given their recent popularity, MLP’s are trading at much higher valuations than stocks (~25 compared to ~15). So again, you could gain an additional 2-5% yield but this doesn’t compensate you for the risk that you could lose half your principle.

There is no free lunch in investing. More return generally comes with more risk. In the end, prudence and adequate diversification are the only time-tested formulas to investment success.

Personally, I hate it when I get ripped off (like yesterday morning at the mechanic). And I generally know that I’ve been suckered long before anyone has to point it out to me. We all have some innate concept of value and generally know whether we have overpaid for something or have gotten a bargain. Watching my friend think through his decision of which bike to buy and then choosing the more expensive one was perfect reminder of this. But when it comes to investing, most people ignore their instincts and instead only look at the market price, which is quite possibly the most useless measure of value.

Just like when shopping, a lower absolute price (or Price/Earnings ratio for stocks) does not mean a better bargain. With cars, some are faster, more comfortable, and safer than others so drivers are willing to pay a higher price. Similarly some businesses have faster growth, higher profit margins, and more sustainable barriers against competition and rightfully command a higher price (i.e. P/E) from investors.

Sadly, even most financial advisors don’t understand (or at least apply) this principle leading to unnecessary sleepless nights and poor returns for their clients. While we can’t negotiate the price of stock like we can a bike or car, Mr. Market’s mood swings (to borrow an analogy from the father of value investing, Ben Graham) inevitably provide opportunities to the patient, disciplined, and prepared investor to buy quality investments at reasonable prices. In fact, paying fair prices (rather than dirt cheap) for quality investments may be a better formula for investment success than any other. Warren Buffett’s fame and fortune have been built on this notion so why can’t more of us do the same?

Like a well-built car, a high quality investment is rarely sidelined in the garage. It provides piece of mind, adequate returns, and requires little attention and intervention. It has always surprised me that more investors don’t take this simpler and less painful road to financial security. While my own bike was pricey, I love it and it has provided me thousands of miles of enjoyable riding and I expect many more from it. Every time I get on and head out onto the open road, I am reminded of this important principle of  investing.

1) Business model changes: Will a cloud computing world change Microsoft’s business model?

2) The growing irrelevance of the PC: Is the demise of the PC and the Windows O/S overrated?

3) Accounting shenanigans: Were Microsoft’s revenue deferral practices in the last 1990′s really “cookie jar” accounting or a political move by the SEC after the Enron blow up?

I’ll spend most of my time on the first two in this post. But before I discuss these, it’s worth repeating a quote an engineer friend of mine recently told me while we were debating technology investments:

“People overestimate the pace of change and underestimate the scale of change.”

1. Business Model Changes

Microsoft has 5 divisions and each will be affected differently by the big changes in computing that the Cloud will bring. These divisions are effectively:

1. Windows (Windows and Windows Live division)
2. Office (Business division)
3. XBox and Windows Phone (Entertainment and Devices division)
4. SQL Server (Server and Tools division)
5. Bing (Online Services division)

2. Irrelevance of the PC

As for the death of the PC, it is not breaking news that investors think the iPad/tablets and smartphones are taking over PC’s and laptops as the computing devices of choice. As a result of this belief, Apple is a market darling and Microsoft shares have been flat for about a decade. This is in spite of the fact that during the last decade, Microsoft has tripled earnings and returned over half their current value in cash to shareholders via dividends and share buybacks.

While Microsoft has been dominant in PC operating systems and business software for the last two decades, the computing world is changing and this may change their Windows business model. It’s hard to speculate on how important a Windows O/S will be on desktop computers in a cloud computing world, the O/S may not matter as much. And it’s equally difficult to speculate on whether Windows Phone will make significant in-roads into the mobile phone market. Just like with PC’s, it’s the apps that determine the popularity of an O/S and the question then becomes are there enough developers to support a third major phone O/S in addition to Android and iPhone.

Keep in mind the quote above. Investors are likely over-discounting the demise of the PC. As of today, it is still the primary tool for productivity in businesses around the world and PC use in the emerging markets is only growing.

3. Valuation

Incorporating the above thoughts into my valuation, let’s see where I come out on Microsoft.

Today, their total market value (net of net cash position) is about $175 bln. This reflects a forward earnings yield of almost 15% (P/E of <7) for a company with a history of very consistent sales and earnings growth of 7-10% over the last 10 years. And because the software licensing model offers exceptional economics, they have produced incremental ROIC’s over 40% for their entire history. Simply extrapolating this past into the future conservatively gives a valuation of closer to $270 bln. But there has to be more as to why investing greats like John Rogers at Ariel Investments and Jeremy Grantham at GMO hold Microsoft as their largest position in their focused/quality funds.

Let’s take a look at each division separately, starting with Office since it is the largest in terms of sales and profits. I believe Office is the most valuable franchise that Microsoft has. There is really nothing on the market that can compete, especially in the enterprise market. Google is trying with Google Apps and OpenOffice is an open source alternative but I have tried both and the reviews confirm they are low-end competitors at best. So as business use of computers in the emerging world continues to grow, I expect Office sales will grow with it. Therefore, for Office/Business division, my valuation comes out to $100-130 bln with the expectation that if I’m right that the software-as-a-service model is less profitable that the value is on the lower end of this range.

Assuming a wide range of outcomes based on the dynamics discussed above surrounding PC’s and Windows, I get a wide range between $25-80 bln for the Windows division.  For the sake of assessing our margin of safety though, let’s assume it’s value is zero. We know that investors are likely to over-discount the demise of the PC making this assumption absolutely wrong but adequately conservative.

The Server and Tools division is a bright spot that few ever comment on. The division, is, like Windows and Office, highly profitable, and also growing fast with the most recent quarterly numbers showing year-over-year sales growth of 10%. Here I definitely don’t understand whether the cloud will disrupt their existing business model or actually help it prosper even more. But like Office, I believe this division has a big competitive advantage and I see tools like SQL used by businesses everywhere. For this division, my valuation is conservatively around $45-65 bln.

Finally there is XBox and the Entertainment division (I’m counting Online Services as a Corporate expense because they are losing money for now). XBox has become the dominant gaming system and with XBox Live is transitioning to a full on online entertainment console. Another division with a strong brand and a lot of potential. But again, without assuming any speculative changes and market share gains, I get a valuation for this division of $10-25 bln.

When you look at each of the pieces, what you see is a group of market leading products. The market concerns appear to be primarily about the future of Windows and the future of the PC and this uncertainty is reflected in the extremely low stock price.  Even the most conservative sum of the parts valuation, ignoring Windows, comes out to $155 bln (or almost $24/share after adding net cash back), which excludes the value of the Windows division. There is a solid margin of safety here.

I still need to dig into their accounting policies (specifically revenue recognition and use of deferred income accounts) to ensure I am not missing anything major. Earnings have been extremely smooth including very little decline in 2009, which doesn’t seem realistic.

So far, Microsoft is looking like a good buy at these levels.

Netflix stock price from July 11 to Oct 25, 2011

That announcement marked the exact top of their stock price at $304. Since then the stock has done nothing but plummet including the massive sell-off yesterday that left the stock trading at $77 (or a 75% decline in under 4 months). Why do some investors get caught by surprise here and others don’t?

Ignoring Netflix’s marketing blunder, let’s look at the Netflix on July 13 compared to Netflix today.

July 13

Market Valuation: $16 bln

P/E ratio: ~80

Sales growth since 2002: 34%

Sales growth since 2006: 16.5%

Net profit margin in 2011: 8.0%

Let’s assume they can maintain sales growth somewhere between their 5- and 10-yr averages, say 20%. And let’s assume they could also maintain their current profit margins in the face of competition from Apple’s iTunes, the big television broadcasters, and other free sources of online entertainment.  If we assume these rates of growth continue into eternity, then I get a company valuation of $17 bln, or something similar to what markets were pricing only 3 months ago.

Keep in mind, if Netflix were able to grow their revenues at 20% per year for even 10 years, this would mean revenues of almost $20 billion by year 2021, compared to only the $3 billion they are on pace for his year, it’s possible but highly unlikely.

In other words, a market valuation of $16bln assumed perfect execution and continuing exceptional growth rates into eternity. No margin for error means no margin of safety for investors.

October 25

Market Valuation: $4 bln

P/E ratio: 19 (based on TTM earnings)

Now let’s consider other scenarios for the future. While the headline was that Netflix lost 800,000 subscribers, they still have 23,800,000. That means they only lost 3% of their customer base with a drastic pricing change. That’s a pretty sticky customer base. Also, revenue/customer actually increased from $10.69/mo to $11.51/mo while profit margin stayed roughly near 8% this quarter in spite of the “tumult”. So on net, the pricing changes may have actually been a good move by Netflix over the long run.

Now if we conservatively assume 10% growth going out 10 yrs (keep in mind they grew sales 50% this year) while maintaining their profit margins of 8%, I get a business valuation near $6 bln. Suddenly they are looking 33% UNDERVALUED.

Only time will tell. All I can say is that I would be much more comfortable buying Netflix today than I would have been earlier this summer.