Wednesday, August 27, 2008


I'm going away for a few days to enjoy some of the finest scenery that Canada has to offer.

I'll be back next week and rested up to look at the local real estate board reports.

Cheers - mohican.

Tuesday, August 26, 2008

Musings - Don't Panic!

Prayer -

'Lord, lord, lord, protect me from knowing what I don't need to know.
Protect me from even knowing that there are things to know that I don't know.
Protect me from knowing that I decided not to know about the things that I decided not to know about.

"There's another prayer that goes with it that's very important, so you'd better jot this down, too."

'Lord, lord, lord. Protect me from the consequences of the above prayer. Amen...'

And that's it. Most of the trouble people get into in life comes from missing out that last part.'

Courtesy of Douglas Adams via his book - The Hitchhiker's Guide to the Galaxy.

Friday, August 22, 2008

The Dimensions of Stock Returns

Abbreviated from here.
By Truman A. Clark

An ongoing objective of financial research is to explain the behavior of stock returns. Factors are sought that explain both differences among the returns of individual stocks in any given time period and the variation of stock returns through time. If a factor does both, it is said to explain the common variation of returns. In addition, if a factor is related to non-diversifiable risk and possesses explanatory power independent of other factors, the factor is considered a "dimension" of stock returns.

Fama and French (1992) found that two factors related to company size and book-to-market ratio (BtM) together explain much of the common variation of stock returns and that these factors are related to risk. Small cap stocks have higher average returns than large cap stocks, and high BtM (or "value") stocks have higher average returns than low BtM (or "growth") stocks. Based on Fama and French's findings, size and BtM are dimensions of stock returns.

Fama and French also investigated a market factor. A market factor is needed to distinguish stocks from fixed income securities, and it is important in explaining the variation of stock returns through time. But, among stocks in a given time period, differences in their sensitivities to the market factor are unrelated to differences in their average returns, so the market factor is not a dimension of stock returns.

The Fama/French results have important implications for domestic equity portfolio design. Large capitalization growth stocks constitute large portions of traditional "market-like portfolios" based on indexes such as the S&P 500, the Russell 3000 and the Wilshire 5000. Domestic equity portfolios with greater commitments to small cap stocks and value stocks offer higher average returns than conventional market-like portfolios.

Size and BtM also are dimensions of international and emerging markets stock returns. This confirms Fama and French's interpretation of size and BtM effects as rewards for bearing risk that cannot be eliminated by diversification.

Risk and Return
Controlling for differences in BtM by comparing large cap value to small cap value and comparing large cap growth to small cap growth, small cap stocks had higher average returns than large cap stocks. Controlling for differences in size by comparing large cap growth to large cap value and comparing small cap growth to small cap value, value stocks had higher average returns than growth stocks. The higher average returns of small cap and value stocks represent rewards for bearing risk.

If standard deviation were a complete measure of risk, average returns would increase as standard deviations increase. Controlling for differences in BtM, a direct relation between average returns and standard deviations is found when large cap stocks are compared to small cap stocks. But, controlling for differences in size, a discrepancy appears. Small growth stocks had a lower average return and a higher standard deviation than small value stocks. Since greater standard deviations are not consistently associated with higher average returns, standard deviation is not a reliable measure of risk.

Size, Book-to-Market and Earnings
Seeking a risk-based explanation for the relations of size and BtM to average returns, Fama and French (1995) investigated the behavior of the earnings of stocks grouped by size and BtM. Measuring profitability by the ratio of annual earnings to book value of equity, Figure 2 illustrates the evolution of profitability over long periods before and after stocks are classified by size and BtM. BtM is associated with persistent differences in profitability. On average, low BTM stocks are more profitable than high BtM stocks of similar size for at least five years before and after portfolio formation. Low BtM indicates sustained high earnings that are characteristic of firms that are growing and financially robust. High BtM indicates protracted low earnings that are typical of firms experiencing financial distress.

Expected Returns and the Cost of Capital
Financial markets channel funds from suppliers of capital to users of capital. Expected returns are the rewards investors anticipate for supplying capital. Investors require a higher rate of return (or risk premium) for bearing greater risk. Risk is something that investors collectively shun and that cannot be eliminated by diversification.

The cost of capital is the price users of capital must pay to obtain financing. Competition forces users of capital to bid higher prices to obtain funding for more risky ventures.

In equilibrium, the expected rate of return and the cost of capital are determined jointly as the price at which the demand for and supply of capital are equal. In financial markets that function efficiently, investors only receive risk premiums for bearing risk. As risk increases, the expected rate of return and the cost of capital increase.

High BtM and small size often indicate companies that are experiencing some degree of financial distress. On average, they have higher costs of capital because they tend to be riskier than companies with low BtM and large market capitalization. The higher average returns of small stocks and value stocks reflect compensation for exposure to non-diversifiable risk factors.

The Three-Factor Model
The findings of Fama and French suggest that much of the variation in stock returns is explained by three systematic risk factors.

· The market factor measured by the returns of stocks minus the returns of Treasury bills.
· The size factor measured by the returns of small stocks minus the returns of big stocks.
· The value factor measured by the returns of high-BtM stocks minus the returns of low-BtM stocks.

Portfolio Engineering
Many investors commit high proportions of their domestic equity holdings to portfolios resembling the S&P 500, Russell 3000 or other market-like proxies. Large cap growth stocks are the dominant holdings of the S&P 500 and the Russell 3000. As a result, market-like proxies are poor portfolio structures for investors seeking exposure to the size and/or value factors. Investors can get such exposure by increasing their relative holdings of small cap and/or value stocks.

The potential increases in expected returns due to these tilts can be estimated with the three-factor model. For purposes of illustration, it is assumed that the expected risk premiums are six percent per year for the market factor and three percent per year for both the size and value factors.

Words of Caution
Structured portfolios offer the prospect of higher long-term returns than market-like portfolios, but the expected risk premiums are not sure things. Factor premiums vary widely and randomly. For the 1927-2001 period, the standard deviations of the annual premiums were approximately 21% per year for the market factor, 14% for the size factor and 14% for the value factor. Owing to their high variability, it may take decades before rewards for bearing increased size and value risk are realized.

Cumulative premiums for each factor are computed by adding successive monthly premiums for the period January 1927 through December 2001. Although the cumulative premiums tend to rise over long periods of time, each moves erratically with lengthy episodes of downward drift. The market premium declined from December 1967 to July 1982—a period of more than 14 years. The size premium declined from December 1983 to December 2001—a period of 18 years (and still counting). The value premium declined from December 1987 to December 2000—a period of 13 years.

Structured portfolios are not appropriate for all investors. Structured portfolios have higher expected returns because they are riskier than market-like portfolios. Over periods of less than 20 years, structured portfolios often will have lower returns than market-like portfolios. It is only over periods of 20 years or more that it becomes more probable that structured portfolios will outperform market-like portfolios. Investors with short horizons or aversion to risk should stick with market-like portfolios. Structured portfolios only make sense for investors with long time horizons and sufficient tolerance for increased risk.

International and Emerging Markets Equities
Size and value effects are not confined to US equity markets. The MSCI EAFE Index represents a portfolio of international stocks from developed countries similar to the S&P 500. EAFE is composed predominantly of large cap growth stocks. During 1975-2001, international small cap stocks had a higher average return than EAFE indicating a size effect, and international large cap value stocks had a higher average return than EAFE indicating a value effect.Based on the limited amount of data available, size and value effects also appear in emerging markets. The IFC Investables Total Return Index represents a portfolio of tradable stocks in emerging markets countries that non-resident investors are permitted to own. During 1989-2001, emerging markets small cap stocks and value stocks had higher average returns than the IFC index.

The international findings are consistent with Fama and French's interpretation of the size and value effects as rewards for bearing non-diversifiable risk. If size and value effects were related to risk factors unique to the US, forming globally diversified portfolios could eliminate them. Instead, the existence of similar size and value effects in both domestic and international stock returns demonstrates that these effects are global phenomena reflecting exposures to ubiquitous sources of risk.

Implications for Global Equity Allocation
EAFE is the international equivalent of the S&P 500. EAFE returns, expressed in US dollars, are determined jointly by stock returns computed in local currencies and foreign-exchange gains or losses against the dollar. Because the two indexes contain stocks with similar size and value characteristics, it is reasonable to assume that the costs of capital of EAFE and the S&P 500 are approximately equal. If it is also assumed that currencies have zero expected returns, EAFE should have about the same expected gross rate of return as the S&P 500.

Concluding Comments
The identification of size and value factors by Fama and French has important implications for equity portfolio design. Relative to traditional market-like portfolios, portfolios with greater exposures to the size and value factors offer higher expected long-term rates of return.
Structured portfolios can be designed that provide targeted sensitivities to the size and value factors. International and emerging markets equity returns also exhibit size and value effects.
Structured portfolios only make sense for investors with long time horizons and sufficient tolerance for increased risk. For the right investors, structured portfolios are promising alternatives to old-fashioned market-like portfolios.

Tuesday, August 19, 2008

Mohican Buys House

Yes it is true and here is how it happened.

Me, Mrs Mohican, and Baby Mohican are expecting another addition to the family soon. We don't have enough space for the new baby in our current rental unit and we were considering our options. We were looking at renting a reasonable suite or townhouse as a first option since we don't like the prospect of spending more to own than rent and we especially don't like the value of our property dropping before we even move in.

The rents for the places that would be suitable ranged from $1400 to $1700 / month and the quality range was dramatic. Suffice to say that for me and the Mrs to be happy, we would need to spend $1600 / month to rent a suitable place for a family of four in the Fraser Valley. We would also have the prospect of moving again once we found a suitable place to purchase and we didn't really like the thought of moving with two small children.

The question then came up, what could we purchase for the same amount of money? Here is the formula which you may be familiar with by now:

Fair Value = 100/(5 Year Mortgage Rate) * (Annual Rent - Taxes - Strata - Maintenance)
Fair Value = 100/5.35 * (19,200 - 3,200)
Fair Value = $299,000

So the question became, can we find something to purchase that meets that criteria? The answer, as you've probably figured out by now, is yes we did. This would have been impossible even 3 months ago as we found a brand new unit available from a developer who was trying to unload the last unit in the complex at nearly 20% off the last sale price (May 2008) and more than 20% off current listings in the development. They had several offers fall through due to others being unable to remove subjects (sale of own home) and they were very willing to consider our lowball offer. We came to an agreement at well below the Mohican Fair Market Value and the deal was done.

We are comfortable with securing a residence which costs us less per month than renting an equivalent unit. We are also cognizant of the fact that our residence will likely fall in value over the next few years, a loss that is compensated for by not having to move again and the fact we are paying less than rent to own our new home. Some solace also comes from paying $50,000 less than my neighbour did for a similar unit only three months ago. Additionally, we have a 10 year mortgage payoff plan. The plan is quite realistic so although our Loan to Value ratio is low (60%) to begin with it will decline very quickly toward zero.

I still believe that prices will likely correct 30% to 50% from peak pricing and that some areas and housing types will correct more than others. I have never been tied to the idea of buying at the perfect 'bottom of the market' so I am free to rely on my cash flow / opportunity cost metrics instead or market timing. I am comfortable buying a home for personal use using the formula above but buying an investment property is another issue. We can examine that further at a later date.

Monday, August 18, 2008

The Undercover Economist

The Wisdom of Crowds?

A single economic forecast is usually wrong. But groups of economic forecasts are often just as mistaken. Why?

By Tim Harford
Posted Saturday, Aug. 9, 2008, at 6:44 AM ET

When people discover that I am an economist, they rarely ask me for my views on subjects that economists know a bit about—such as how to respond to climate change or pay less at a supermarket. Instead, they ask me what will happen to the economy.

Why is it that people won't take "I don't really know" for an answer? People often chuckle about the forecasting skills of economists, but after the snickers die down, they keep demanding more forecasts. Is there any reason to believe that economists can deliver?

One answer can be gleaned from previous forecasts. Back in 1995, economist and Financial Times columnist John Kay examined the record of 34 British forecasters from 1987 to 1994, and he concluded that they were birds of a feather. They tended to make similar forecasts, and then the economy disobligingly did something else, with economic growth usually falling outside the range of all 34 forecasters.

Perhaps forecasting technology has moved on since then, or the British economy is unusually unpredictable? To find out, I repeated John's exercise with forecasts for economic growth for the United Kingdom, United States, and Eurozone over the years 2002-08, diligently collected at the end of each previous year by Consensus Economics.

The results are an eerie echo of John Kay's: For 2004, for example, 20 out of 21 nongovernmental forecasts made in December 2003 were too pessimistic about economic growth in the United Kingdom. The Pollyannas of the U.K. treasury were more optimistic than almost any commercial forecaster and closer getting their forecast right. So, one might suspect that systematic pessimism is to blame.

But, no, in 2005, the economy grew more slowly than 19 out of 21 forecasters had expected at the end of the previous year. The Pollyannas of the U.K. treasury were yet again more optimistic than anyone and thus more wrong than anyone. A year later, all but one of the forecasters were too pessimistic again. Yet at the end of 2001, three-quarters of the forecasters were too optimistic about 2002.

2003 is an interesting anomaly: the one year for which the average U.K. forecast turned out to be close to reality but also the year where the spread between highest and lowest forecast was widest. The rare occasion that the forecasters couldn't agree happened to be the occasion on which they were (on average) right.

Recent U.S. forecasters have done a little better: The spread of forecasts is tighter, and the outcome sometimes falls within that spread. Still, five out of six were too pessimistic about 2003, almost everyone was too pessimistic about 2002, three-quarters were too optimistic about 2005, and nearly nine-tenths too optimistic about 2006. Perversely, the best quantitative end-of-year forecasts were made in December 2006, despite the fact that the credit crunch materialized eight months later to the surprise of almost everybody.

In the Eurozone, forecasting over the past few years has been so wayward that it is kindest to say no more.

The new data seem to confirm Kay's original finding that economic forecasters all tend to be wrong in the same way. Their incentives to flock together are obvious enough.

What is less clear is why the flight of the flock is so often thought to augur much—but then, some astrologers are also profitably employed.

The curious thing is that forecasters often have something useful to say, but it is rarely conveyed in the numerical forecast itself on which so much attention is lavished. For instance, in December 2006, forecasters were warning of the risks of an oil price spike, a sharp rise in the cost of credit, and a dollar crash. The quantitative forecasts are usually wrong and not terribly helpful when right, but forecasters do say things worth hearing, if only you can work out when to listen.Tim Harford is a columnist for the Financial Times. He is the author of The Undercover Economist, and his latest book is The Logic of Life.

Article URL:

Saturday, August 16, 2008

Vancouver Labour Market - VHB Guest Post

Vancouver's labour market is going through an unprecedented hot streak. Unemployment rates are the lowest since at least 1976. Employment rates (which measure employed age 15+ to population age 15+) are more than 2 points above the previous high.

But what is underlying this boom? Is it broadly based? The answer, as you'll see below is no. Definitely no. It is almost *entirely* a construction boom. All data available here.

Let's start with checking out the number of jobs. I've made an index set to Jan-2001 as 100 for construction, real estate-leasing, and total employment less construction and real-estate leasing.

Construction has boomed from 100 to 240 over the past 7 years. The rest of the economy? only from 100 to 118. The new Realtors out there don't account for a lot--only 36% growth.
But, there are raw employment counts. Maybe our population has grown enough to account for this? No. As VHB regulars know, population growth has been fairly moderate (even anemic) over the past 10 years.

Below is a graph of employment to population ratios for two specific industries, construction and real estate-leasing. Construction has gone from 3% of the population to over 6%. Real estate employment, perhaps surprisingly, hasn't moved much at all.

Ok. Now for the grande finale. Let's put this together. Let's imagine a scenario where the employment to population ratio in construction and real-estate leasing had stayed at its 2001 values instead of growing. In other words, we're looking at what would have happened if there had been no construction boom from 2001-2008. The analysis assumes that the new construction employment took people from being out of work and newly employed them, rather than just moving people from one industry to another. (If everyone employed in construction were previously employed somewhere else, then construction actually had no impact on total employment, right?) On the other hand, we are not accounting for the spillover boom into retail etc. caused by newly employed construction workers splurging on toys and joys.

Well, without the construction boom, employment to population would have stayed bouncing around between 58 and 61%. Instead, we see that it went over 64%. This is quite a difference.
Let's move on to the perhaps more familiar Unemployment rate. Unemployment rates take the number of people not working who are looking for work and divide that by the number of people who are employed or unemployed and looking. Again, the scenario we're imagining here assumes that all of the employment boom came out of the ranks of the unemployed; that if the boom ended tomorrow all of those construction guys would be unemployed and wouldn't find jobs elsewhere. Also, it assumes that there would be no spillover effects onto retail.

The results are pretty stunning. Without the construction boom, unemployment would have stayed bouncing around 8-10% instead of falling to under 4%, as it actually did.
Looking forward, what does this mean? Well, to sustain our employment rate, we need to sustain construction. If there is a drop off in housing starts, the labour market will get worse. If the government doesn't start building new big projects to replace the work finishing up on Olympic projects/canada line/etc. then the labour market will get worse.

-- Vancouver Housing Blog

Friday, August 15, 2008


Due to the pressure of falling commodity prices the TSX has fallen from 15,000 points only a couple months ago to around 13,000 points today.

Oil has fallen from nearly $150/bbl to $112/bbl today.
Gold has fallen from its lofty heights around $1000/oz to $780/oz today.
Most other commodity prices have fallen dramatically over the past two months.

For anyone unfamiliar with market volatility in a commodity based economy, you just got your first lesson. It's possible to make and / or lose a lot of money very quickly.

For any long term investment strategy, diversification is important, otherwise you need near perfect timing to avoid the dramatic ups and downs. Diversification doesn't mean holding 5 different energy trusts either, I mean truly non-correlated assets.

Wednesday, August 13, 2008

I'm Bored

Well, I'm not really bored generally speaking since work and life are very busy. I am bored of following our real estate market. It just seems so fatalistic at this stage of the process. We've seen this happen before in a myriad of places at many different times.
  • Inventory rises amidst general exuberance about real estate
  • Sales fall amidst claims of a 'seasonal' slow down
  • Prices stagnate with claims of a rebounding market in the fall/spring/summer whatever
  • Developers slash prices and introduce sales incentives with the general populace in denial
  • Prices fall modestly as some sellers who must sell come to the realization that price matters!
  • Inventory rises further and sales fall even more as the general public becomes aware that real estate does not always go up in value.
  • Prices fall dramatically.
  • Eventually people will avoid real estate investing and discussions like the plague.
The script has been written, auditions are complete, the set is ready, everyone is in place, quiet on the set and 'ACTION!'

Monday, August 11, 2008

Housing starts, prices show more signs of slowing

CBC News - Last Updated: Monday, August 11, 2008 9:08 AM ET

Canada's housing industry showed more signs of softening amid reports of easing summer construction starts and slowing price increases for new homes.

Canada Mortgage and Housing Corp. said Monday that the seasonally adjusted annual rate of housing starts in July was 186,500 units, down from 215,900 in June.

Starts of urban multiple units, such as condominiums, dropped 20.2 per cent to 91,600, while starts of urban single homes eased 6.6 per cent to 69,800 units.

"After a strong first half of the year, the volatile multiple segment is now readjusting itself," said Brent Weimer, a senior economist at CMHC's market analysis centre. "This brings activity since the start of the year closer in line with our 2008 forecast of more than 200,000 housing starts for the seventh consecutive year."

Meanwhile, Statistics Canada also reported Monday that new housing prices in June increased at their slowest pace in over six years. That continued a slowdown that started in September 2006, the federal government agency said.

The June decline reflected a softening housing market in Western Canada, Statistics Canada said.
Across the country, contractors' selling prices rose 3.5 per cent between June 2007 and June 2008. That was down from the 4.1 per cent year-over-year increase in May.

The June increase was the slowest rate of growth since March 2002 when year-over-year prices increased by 3.4 per cent.

Thursday, August 07, 2008

Down Payment Dillemna

In response to several of the comments on the previous thread I'm posting some thoughts on what to do with your downpayment if you are patiently waiting for housing prices to have some kind of resemblance to fundamental valuation before you purchase. Here are the essential steps in my humble opinion:

Step 1: Determine your time horizon - this is easier said than done.
Step 2: Determine your risk tolerance - is some level of value fluctuation acceptable and if so, how much? +/-5% in one year? +/-10%? more?


1) If your time horizon is uncertain and you need stability and flexibility then a money market fund, savings account or short term GIC offers your only real options. Your rate of return will be significantly hindered. The best rate on these short term deposits is approximately 3% right now.

2) If you are confident that you won't see fundamental value for at least one year then you can clearly lock in for a 'good' rate on a GIC for at least one year. This has the advantage of keeping you disciplined but is much less flexible in terms of access to your money. The best rate on a 1 year GIC today was 3.90%. A 2 year GIC was 4.15%.

3) If you don't mind some mild fluctuation in your investments then a low cost bond fund such as the TD eSeries bond index fund could provide you with a decent coupon yield plus some potential upside if you think interest rates are going to fall before you purchase. If you have enough money some higher yielding corporate bonds can be purchased through a brokerage account. A quick search turns up several decent short term bonds with yields over 4%. Bonds have the advantage of being liquid so if you need access to the funds you will likely be able to get your money.

4) Equities - whether we are discussing an exchange traded fund, mutual fund, or an individual stock, be prepared for volatility. Even if you think you are investing in so-called safe securities, don't be fooled, a stock is a stock and the price of that stock is dependent on the perceived value of the corporation's earnings as seen by the buyers on that day. Your values may fluctuate violently and when it comes time to pull your money out, you may have less than you counted on. For a simple lesson on volatility, please look at the standard deviation of an investment before you purchase it. Bond funds have a low standard deviation because they are less volatile than equity funds.

I am not recommending one of these options over any other option but I hope the explanation is helpful. I don't recommend any allocation to equities higher than 30% for any time horizon shorter than 3 years and I don't recommend any allocation to equities higher than 45% for time periods shorter than 5 years.

Tuesday, August 05, 2008

FVREB Sales Plummet, Listings at Record Levels, Prices Falling Like Rocks on the Sea to Sky Highway

The Fraser Valley Real Estate Board released their July 2008 statistics package and here is the info:

Active Listings were 56% higher than July last year at 12,299.
Sales were 35% lower than last July at 1284.
Months of Inventory now sits at 9.6 months to sell through the current inventory at the current sales pace.

House prices have had a long run up with tight supply and exhuberant demand. This situation has now reversed and prices are falling as supply has swelled and demand has been lacklustre so far this year.

It sure looks like we will have Year over Year price decreases in August or September. Annual appreciation of the Fraser Valley House Price Index clocked in at a measly 1.7%.

The correlation between Months of Inventory and price changes is holding up extremely well as the market has changed.

Median Prices in all categories of home fell during July. The Single Family Home median price fell -5.4% from June. The median fell from $527,500 to $499,000.

Well folks that is all she wrote. I am pretty excited that this is finally happening and that some semblance of fundamental value will hopefully be restored in our local real estate market.

REBGV Sales Tank, Inventory Balloons, and Prices Fall at an Annualized -17.91%

Well, this is it, the market is officially done like dinner.

The REBGV released their monthly price, sales, and inventory statistics for July 2008 and here it is on the down low.

Active Listings are at an unprecedented level.

Sales are at an abysmal level.

The number of months of inventory is sky high representing the inability of buyers and sellers to come to a quick agreement on the value of properties in the area.

Prices have fallen for two straight months now and are rapidly retreating to year ago levels as the few sellers who must sell drop their prices and buyers who have the means are agreeing to these lower price levels.

I was truly amazed at how quickly inventory levels have grown this year and I was wondering if the tight correlation between months of inventory and price changes would continue during a down market. It is continuing and seems to be an amazingly accurate representation of the effect of high MOI on price change.

Prices are Falling

The local real estate boards all released their statistics packages this afternoon and here they are for your perusal:

Greater Vancouver
Fraser Valley
Chilliwack and Area

Before I go over them in more detail I will summarize:

Greater Vancouver benchmark prices fell 1.1% from June.
Fraser Valley benchmark prices fell 1.6% from June. The average price of a detached home fell nearly 6%.
The average price of a home in Chilliwack fell 9% from June. Yowza!

Chilliwack area has now gone year over year negative for prices.
Fraser Valley will probably go negative in August since prices would only need to stay where they are.
REBGV will probably go negative later this year.

Shareholder Letter from Bill Miller

The following is a letter to shareholders of Legg Mason Value Trust: Second Quarter 2008

Dear Shareholder,

A group of us were standing around a few weeks ago when Warren Buffett wandered over. Chris Davis had dubbed us the Value Support Group, as we all adhered to that approach to investing. we were commiserating over how badly we had done in this market, how valuation appeared not to matter and had not for the past couple of years, how it was all about momentum and trend, and how we were all losing clients and assets over and above our losses in the market. It seemed like we needed a 12-step program to cure us of our addiction to buying beaten-up stocks trading at large discounts to our assessment of their intrinsic value.

Mason Hawkins said, "Warren, I'm an optimist. I think this whole thing can turn quickly, and surprise people. Are you an optimist?" "I'm a realist, Mason," the sage replied. Warren went on to say he was optimistic long term, and backed that up in a talk the next morning on the remarkable history of growth, innovation, and wealth creation the U.S. had produced over the past 200-plus years. He also offered a sober assessment of the current challenges we face, and said it would take some time to work through them.

He then made the perfectly sensible point that as we are all net savers, we should be happy if stock prices declined a lot more, so we could buy even better bargains. That is a point Charlie Ellis elaborated on in his fine book, Investment Policy, a few years back. As a matter of logic,
it is irrefragable. As a matter of psychology, I think most of us value investors think we have plenty enough bargains already, and may not be able to handle that many more. Or more accurately, our clients may not be able to. We are value investors because we are persuaded of the logic of buying shares of businesses when others want to sell them, and we understand that
lower prices today mean higher future rates of return, and high prices today mean lower future rates of return.

The best time to buy our funds or to open an account with us has always been when we've had dismal performance, and the worst time has always been after a long run of excess returns. Yet we (and everyone else) get the most inflows and the most interest AFTER we've done well, and the most redemptions and client terminations AFTER we've done poorly. It will always be so, because that is the way people behave.

John Rogers, the founder of Ariel Investments, came in to see us last week. John has been an outstanding investor for 25 years or so, but like almost all value types, is going through one of his toughest periods now. His assets are down, similar to the experience we've had. He said it was the most difficult market he'd seen, a judgment I would have given to the 1989-1990 market, up until the frenzy erupted over Fannie Mae and Freddie Mac, which sent financials to what looks like a capitulation low on July 15th. I am now in John's camp. A point he made that I have likewise noted to our staff is that this is the only market I have seen where you could just read the headlines in the papers, react to them, and make an excess return. I have used the mantra to our analysts that if it's in the papers, it's in the price -- which used to be correct. Indeed, it borders on cliche in the business that by the time something makes the cover of the major news or business publications, you can make money by doing the opposite. There is solid academic research to back this up. But in the past two years, you didn't need to know anything except to sell what the headlines were negative about (anything related to real estate, the consumer, or finance) and buy anything that was going up and that everybody liked (energy, materials, industrials).

I am reminded of what John Maynard Keynes, himself a great investor, said once about investing, "It is the one sphere of life and activity where victory, security, and success is always to the minority and never to the majority. When you find anyone agreeing with you, change your mind. When I can persuade the Board of my Insurance Company to buy a share, that, I am learning from experience, is when I should sell it." It has been explained to me that it was obvious we should not have owned homebuilders, or retailers or banks, and that I should have known better than to invest in such things. It was also obvious that growth in China and India and other developing countries would drive oil and other commodities to record levels and that related equities were the thing to own. "Don't you even read the papers?" was a common comment.

While I am quite aware of our mistakes, both of commission and omission, when I ask what is obvious NOW, there is little consensus. If there is something obvious to do that will earn excess returns, then we certainly want to do it. Is it obvious financials should be bought now, having reached the most oversold levels since the 1987 Crash, and the lowest valuations since the last great buying opportunity in 1990 and 1991? Or is it obvious they should be avoided, since the credit problems are in the papers every day and write-offs and provisioning will likely continue into 2009?

Is it obvious energy stocks should be bought on this correction in oil prices from $147 to $123, a correction that has wiped 25 points off the prices of companies like XTO Energy and Chesapeake Energy in just a few weeks? Or is it obvious that oil had reached bubble levels at $147, and that buying the stocks here, down 30% from their highs, is akin to buying homebuilders down 30% from their highs in 2005? If you had bought Tesoro Petroleum or Valero Petroleum when their prices broke late last fall -- remember the Golden Age of Refining story that took Tesoro from under $4 to over $60? -- you would be looking at losses in this year greater than if you had bought Citibank or Merrill Lynch. I do think some things are obvious: it is obvious the credit crisis will end, and it is obvious the housing crisis will end, and that credit markets will function satisfactorily and house prices will stop going down and then start moving higher. It is obvious that the American consumer will spend sufficiently to keep the economy moving forward long term. It is obvious that the U.S. economy, already the most productive in the world, will get even more productive and will adapt and grow. It is obvious stock prices will be higher in the future than they are now.

Sir John Templeton died a few weeks ago, full of riches and honors, as he so deserved to be. The legendary value investor got his grubstake by famously buying shares of companies selling for $1 a share or less when war began in 1939. He didn't know then that the war in Europe would spread to engulf the world, nor how long it would last, nor how low prices would ultimately go. He always said he tried to buy at the point of maximum pessimism, but he never knew when that was. He was, though, a long-term optimist, as is Mr. Buffett, as am I.

Bill Miller
July 27, 2008