Fundamentals of investing

Quarterly Letter

Fundamentals of investing

2011 was a good year for those who hid in longer term government bonds and gold. For nearly everyone else, it was a year to forget.

The Dow Jones Industrial Average is up 5.5% mostly due to McDonald’s and IBM. The S&P 500 was flat and the Nasdaq was down 1.8%. Most technology indices were down double digits in percentage terms as were most commodity indices, from metals to agricultural products, with the exception of crude oil, corn and gold.

Outside the US, the TSX was down over 10% for the year, the Euro zone fell 18%, Japan was down 17% while the once-hot BRICs (Brazil, Russia, India and China) saw their stock markets lose 18%, 20% ,25% and 22% respectively.

Entering 2012, the mess in Europe has not changed: the Greek government is still bankrupt (but not the Greek people), the Italians still cheat the tax system (nothing has changed) and the big European banks need more capital after having lost most of it by investing in sovereign debt. In North America, US politicians have put the government in a gridlock with partisan bickering. It reminds us of a quotation from literature Nobel Prize winner Bernard Shaw: “Politicians and diapers both need to be changed often, and for the same reason.”

Meanwhile, the American economy seems to be chugging along, unemployment seems to have edged down a bit and consumers seem to have resumed their normal spending. For those of you who fear an upcoming recession, historical evidence should give you some comfort:

  • While there is no guarantee that there won’t be a double dip recession, we have never had one after the traditional leading economic indicator (LEI) index has been high and rising for five months. That is what is happening today on an absolute and year-over-year basis.

  • Since World War II, we have not experienced a recession until corporate profits per employee declined for at least six months. Currently, just the opposite is happening and this indicator is still rising.

  • The S&P 500’s dividend yield is now roughly equal to the 10 year US Treasury yield. There has not been a recession in modern history when the difference is not at least 2% in favor of Treasuries (i.e. yield on Treasuries minus yield on S&P500 is larger than 2%).


Instead of boring you with endless forecasts, which are no more valid than whatever you read in the newspapers, we will take the opportunity here to reiterate the several rules of fundamental investing. Knowing the rules does not mean one can follow them with discipline and we are guilty as charged in some of our picks. Nevertheless, frequent reminders of the rules help us focus on trying hard to abide by them.

  1. Always insist on a margin of safety.

    Valuation is the closest thing to the law of gravity in finance. Long-term investment returns depend on it. However, the goal of investment is not to buy at fair market value but to purchase with a margin of safety. As fair value is only an estimate and contains a wide margin of errors in judgment and misfortunes, it is important for investors to make sure the purchase price is at a discount to fair market value and the bigger the discount the better.

  2. This time is never different.

    Sir John Templeton defined “this time is different” as the four most dangerous words in investment. For investors who have lived through the last 2 bubbles (the 1998-2000 tech bubble and the 2005-2007 housing bubble), no explanation is needed. We still have in our files a letter from an ex-client who, in 2000, accused Claret of “having lost touch with the reality of the new internet economy”…

  3. Be patient and think long-term.

    Patience is a virtue in investment. As Benjamin Graham wrote, “Undervaluation caused by neglect or prejudice may persist for an inconveniently long time, and the same applies to inflated prices caused by over-enthusiasm or artificial stimulants.”

    Unfortunately, patience is in rare supply. According to the well respected newsletter Grant’s Interest Rate Observer, the average holding period of the average equity has declined from 4 years after World War II, to 8 months in 2000, to 2 months in 2008 and an even shorter period today (although current data is not available). We view this trend towards more active trading favorably, as it makes long-term buy and hold strategy a less crowded and competitive industry and should, therefore, make it easier to find attractive long-term investment opportunities.

  4. Be contrarian.

    Well known John Maynard Keynes said that “The central principle of investment is to go contrary to the general opinion on the grounds that if everyone agreed about its merit, the investment in question is inevitably too dear and therefore unattractive.”

    We humans, being social animals, are wired so that we are prone to herd mentality. We feel the pain of social exclusion sometimes much more than real physical pain. Being contrarian is a little bit like taking a beating on a regular basis and is therefore not easy to do. Thankfully, value investing tends to lead us to be contrarian naturally, as we will be searching for opportunities only when prices are down and assets are cheap thanks to the selling pressure of others.

  5. Risk is the permanent loss of capital, not volatility.

    Regrettably, academics and media alike have convinced the average investor that market risk (i.e. daily fluctuations) is the most important risk of all. The former are obsessed in quantifying this risk and the latter makes it its main focus on a daily basis.

    To us, the biggest risk we are trying to avoid is the permanent impairment of capital. It can be broken down into 3 components: 1) Valuation risk – meaning we pay too much for an asset; 2) Fundamental risk – i.e. something is wrong in our analysis; and 3) Financing risk – leverage.

    By concentrating on these components of risk, we believe investors would have a better chance of avoiding a permanent loss of capital.

  6. Be leery of leverage.

    Leverage is very dangerous. It cannot turn a bad investment good but it can turn a good investment bad. By limiting your staying power during volatile periods, it can transform a temporary impairment (i.e. price volatility) into a permanent loss of capital (i.e. margin call).

    While on the subject of leverage, most financial crises have their origin in leverage. Witness 1990 Savings and Loan disaster, 1998 Long-Term Capital Management debacle and the 2008 subprime loan driven Bears Stearns and Lehman Brothers bankruptcies followed by the US banking crisis and the most recent sovereign debt driven Euro zone banking crisis.

  7. Be skeptical of complex investment concepts and products.

    If something seems too good to be true, it probably is. The financial industry (we are including here all banks, investment brokers and insurance companies) have perfected the art of turning the simple into the complex and in so doing managed to extract enormous fees for themselves. Structured products, income plus funds with guarantee, hedge funds and funds of funds are among the ones we see on a daily basis in the market place. We suggest that investors be leery of any product where one cannot see through the investment concept and get to the heart of the process. In general, the more complex the product is, the more layers of intermediaries there are, the more fees it will contain and therefore the less likely it will be a good investment.

We wish all of you a prosperous year for 2012 full of joy and good health.

The Claret Team