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By Sandesh Trivedi, sandeshtrivedi@gmail.com

For value investors blindly shunning tech stocks they might want to read the book, Information Rules: A Strategic Guide to the Network Economy by Carl Shapiro and Hal Varian. Though the book might not help you catch the next Microsoft or Cisco or Amazon at a very early stage, it puts forth a very compelling argument that traditional economics still applies to the new economy. The book serves as a handbook to analyze the basic economics of tech businesses, and also whether they have any competitive advantages which might enable them to generate above average returns. The book might not make you an expert in the tech industry, but at least help you navigate successfully analyzing tech stocks. As the author mentioned in the beginning of this book, this book is seeking models, concepts, and analysis, which will provide reader with a deeper understanding of the fundamental principles in today’s high-tech industries.

According to the authors the traditional laws of economics are still very much applicable to the tech businesses. To drive home their point, they cite similarities between the evolution of railroads, telephone and tech industries. Essentially the authors try to convey that traditional concepts like economies of scale and network effects are hardly unique to information economy, and fundamental principles of economics are relevant in an information economy too. In fact many information goods businesses have huge fixed costs in such as high R&D, and infrastructure costs in the case of telecommunications systems. Information is costly to produce but inexpensive to reproduce because some tech businesses have high fixed cost and low marginal costs. If a company lays fiber optic cable, buys switches and puts on a telecommunications system which are all fixed costs, after that it costs next to nothing for signals to be sent. One of the properties peculiar to information technology businesses is that they are subject to large increasing returns to scale on both the supply and demand side. Market outcomes in these markets tend to be concentrated and require standardization.

Traditional manufacturing industries had supply side economies of scale but often it ran into natural limits on the supply side, whereas a business like Microsoft not only has supply side economies of scale but it maintains absolute dominance is because of the demand side economies of scale. Microsoft’s customers value its operating systems because they are widely used and are the de facto industry standard. Unlike the supply side economies of scale, demand side economies of scale don’t dissipate when the market gets large enough. In fact it becomes a winner-take-all market. For investors willing to evolve and learn more about the economics of tech business this is a must read book.

To purchase the book on Amazon.com click on the following link Information Rules: A Strategic Guide to the Network Economy

Nowadays, many people seem to be bullish on the BRICs( Brazil, Russia, India, China). The bulls expect these countries to experience rapid growth in the future and therefore argue that their equities should be purchased. But how much growth can we expect, and what is the macro picture like in these countries? Let us examine each country one by one.

Brazil: The country experienced a massive economic crisis only eleven years ago. Has so much changed then, and is this time different? Bulls will argue that Brazil is the eighth largest economy in the world, but it was also the eighth largest economy in 1999 when it devalued its currency.

There are also signs the economy is overheating. Brown Brothers Harriman’s Win Thin wrote recently:

Some of the numbers are deteriorating sharply for Brazil, including the external accounts, and should help limit BRL upside. Exports remain robust, but imports are going through the roof and leading to worsening trade and current account balances. June current account gap was reported at a much higher than expected -$5.2 bln, and pushed the 12-month total to -$40.9 bln or -2.1% of GDP, the highest since Oct. 2002. FDI flows have held up OK, but now only covers less than two thirds of the current account gap.

Russia: To state Russia has massive demographic problems would be an understatement. The population peaked in 1991 and has been declining ever since. The UN expects the population of Russia to decline as much as a third by 2050. In addition, Muslims are a growing percentage of the Russian population this will likely cause increasing social tensions. Russia is run by corrupt politicians and robber barons, and there are poor protections for investors rights. Russia also had its own economic crisis in 1998, when it defaulted on its debt. Now the Government is even more authoritarian and there is no way to predict if the Government would just default as it did in the past.

India:

To read the rest of the article on Guru Focus click here.

Warren Buffett

Big H/T to http://warrenbuffettresource.wordpress.com/the-man/books-recommended/ for putting together this fabulous, and lengthy list.

Over Warren Buffett’s lifetime, “The Oracle of Omaha” has suggested several books that he thinks is valuable to the investor.

Below is a list of Warren Buffett’s recommended reading list. While I have not read all these books, they do not need my endorsement as the Oracle himself recommends them. The list consists of economics, political, investing, history, and even baseball books.

(This post will be a permanent page under the book tab, on the top menu bar).

1989 — Essays In Persuasion by John Maynard Keynes

1992 — The Theory of Investment Value by John Burr Williams

1994 — The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel by Benjamin Graham

1994 — The General Theory of Employment, Interest and Money by John Maynard Keynes

1994 — The People v. Clarence Darrow: The Bribery Trial of America’s Greatest Lawyer by Geoffrey Cowan

1995 — A Piece of the Action: How the Middle Class Joined the Money Class by Joseph Nocera

1996 — The Money Masters by John Train

1996 — Paths to Wealth Through Common Stocks by Philip Fisher

1997 — Science of Hitting by Ted Williams

1997 — Only the Paranoid Survive: How to Exploit the Crisis Points That Challenge Every Company : How to Exploit the Crisis Points That Challenge Every Company by Andrew S. Grove (in OID)

1998 — The Expanded Quotable Einstein by Albert Einstein

2000 — The Farmer From Merna: by Karl Schriftgeisser

2000 — Common Stocks and Uncommon Profits and Other Writings by Philip Fisher

2000 — The Essays of Warren Buffett: Lessons for Corporate America Lessons for Corporate America by Lawrence A. Cunningham

2001 — The Warren Buffett CEO: Secrets from the Berkshire Hathaway Managers by Robert P Miles

2001 — Security Analysis by Ben Graham and Dave Dodd

2001 — Personal History by Katharine Graham

2002 — Take On the Street: What Wall Street and Corporate America Don’t Want You to Know by Arthur Levitt

2003 — First A Dream by Jim Clayton

2003 — Bull: A History of the Boom and Bust, 1982-2004 by Maggie Mahar

2003 — The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron by Bethany McLean and Peter Elkind

2003 — In an Uncertain World: Tough Choices from Wall Street to Washington by Bob Rubin

2003 — sam Walton: Made In America

2004 — Financial Times , Amercian Edition Newspaper

2004 — The General Theory of Employment, Interest and Money by John Maynard Keynes

2004 — A Short History of Nearly Everything by Bill Bryson

2004 — Poor Charlie’s Almanack: The Wit and Wisdom of Charles T. Munger by Charles T. Munger

2004 — Nuclear Terrorism: The Ultimate Preventable Catastrophe by Graham Allison

2005 —F.I.A.S.C.O.: Blood in the Water on Wall Street by Frank Partnoy

2005 — Travels with Barley: A Journey Through Beer Culture in America by Ken Wells

2006 — Seeking Wisdom: From Darwin to Munger by Peter Bevelin

2007 — Where Are the Customers’ Yachts: or A Good Hard Look at Wall Street by Fred Schwed, Jr

2007 — Supermoney by Adam Smith

2007 — The Audacity of Hope: Thoughts on Reclaiming the American Dream by Barack Obama

2007 — Warren Buffett: An Illustrated Biography of the World’s Most Successful Investorby Ayano Morio

2008 — Foods You Will Enjoy – The Story of Buffett’s Store , by Bill Buffett

2008 — Pleased But Not Satisfied by David Sokol (Note: Warren Buffett did not recommend this book, but he has written its foreword!)

More books recommended by Warren Buffett (Years Unkown):

• Benjamin Graham on Value Investing: Lessons from the Dean of Wall Street: Lessons from the Dean of Wall Street by Janet Lowe
• Do Business with People You Can Trust: Balancing Profits and Principles by L. J. Rittenhouse
• : John Bogle on Investing: The First 50 Years by John C. Bogle
• Common Sense on Mutual Funds by John C. Bogle
• The Real Warren Buffett: Managing Capital, Leading People by James O’Loughlin
• Of Permanent Value: The Story of Warren Buffett by Andrew Kilparrick
• Will America Grow up Before it Grows Old by Peter G. Peterson
• Father, Son & Co.: My Life at IBM and Beyond by Thomas, Jr. Watson
• Memos from the Chairman by Alan “Ace” C. Greenberg
• Jack Welch Speaks: Wisdom from the World’s Greatest Business Leader by Janet Lowe
• Quality Financial Reporting by Paul B. W. Miller & Paul R. Bahnson
• Jack: Straight from the Gutby Jack Welch
• Epidemic of Care: A Call for Safer, Better, and More Accountable Health Care by George C. Halvorson
• Running on Empty: How the Democratic and Republican Parties Are Bankrupting Our Future and What Americans Can Do About It” by Peter G. Peterson
• The Man Behind the Microchip: Robert Noyce and the Invention of Silicon Valleyby Leslie Berlin
• Speculative Contagion: An Antidote for Speculative Epidemics by Frank Martin
• The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns by John C. Bogle

Buffett gave Alice Schroeder access to him for her book The Snowball, which is a very in depth tale of Buffett’s life. One can assume Buffett would endorse the book.

Some other great books about Buffett include; The Warren Buffett Way by Robert Hagstrom, The Warren Buffett Way by Prem Jain, Buffettology by Mary Buffett, and Buffett: The Making of an American Capitalist by Roger Lowenstein.

By Rob Bennett

Please see Part One of this article for a background description of The Investment Strategy Tester and for a discussion of the first of the six tests examined.

Please don’t make the mistake of thinking that that rule [that high-stock-allocation portfolios offer higher returns at less risk than low-stock-allocation portfolios] applies at all price levels. Graphic Two shows what happens when we test the same strategies beginning with a starting-point valuation level of 32, an insanely high price level.

(You can click on all the images to increase size.)

The 20-percent-stocks portfolio still performs poorly on the upside. But the worst-case scenarios are far better for the 20-percent-stocks portfolio when starting from the high valuation level. Now there’s a trade off between return and risk for that portfolio.

Now it’s the 100-percent-stock portfolio that lacks a tradeoff. Look at the 10-year and 15-year and 20-year numbers. The 100-percent-stocks portfolio has worse worst-case scenario results. But it does not have better best-case scenario numbers. When stock prices are out of control, high stock allocations offer added risk with no potential for added return. Not too appealing a deal!

Different strategies make better sense at different starting-point valuation levels. That’s the takeaway point here.

Let’s take it in the other direction. Graphic #3 looks at what the possibilities are when starting from a super-low P/E10 level of 8 rather than a super-high P/E10 level of 32.

Here the rule is — More stocks means higher returns and reduced risk. Investor heaven!

Compare the results for 50 percent stocks with the results for 100 percent stocks at Year 30. The best-case result for 50 percent stocks barely beats the worst-case result for 100 percent stocks! Yowsa!

Now let’s throw a Valuation-Informed Indexing strategy into the mix. In the three following tests the four strategies examined are: (1) 20 percent stocks; (2) 50 percent stocks; (3) 80 percent stocks; and (4) a strategy in which the investor goes with 100 percent stocks up to a P/E10 level of 12, 80 percent stocks from a P/E10 level of 13 through a P/E10 level of 18; 50 percent stocks from a P/E10 level of 19 through a P/E10 level of 21, and 20 percent stocks for all higher P/E10 levels.

Graphic #4 shows what happens when the starting-point P/E10 level is 14 (fair value). Graphic #5 shows what happens when the starting-point P/E10 level is 32 (insanely high). And Graphic 6 shows what happens when the starting-point P/E10 level is 8 (insanely low).

Here’s Graphic #4:

The 20-percent-stocks and 50-percent-stocks portfolios cannot keep up. The contest is between the 80-percent-stocks portfolio and the Valuation-Informed Indexing portfolio. At Five Years, the 80-percent-stocks portfolio offers slightly more appealing probabilities. At 10 years, it’s a draw. At 15 years, the Valuation-Informed Indexing portfolio gains a tiny edge. At 20 years and 25 years, that edge grows. At Year 30, the Valuation-Informed Indexing portfolio offers higher returns at reduced risk. Nice!

Here’s Graphic #5:

Here the 20-percent-stocks portfolio makes some sense in the early years. At Year 10, it is competitive in the upside it offers while offering a far more appealing worst-case-scenario returns.

The Valuation-Informed-Indexing portfolio gains its edge over the 80-percent-stocks portfolio sooner and grows it larger over time. At every time-period, the 80-percent-stocks portfolio has a greater downside. Only at Year Five does it offer an enhanced upside. Sticking with a single stock allocation (Buy-and-Hold) imposes a double cost on investors at times of high valuations — lower returns, greater risk. That’s not supposed to happen according to the Efficient Market Theory!

Here’s Graphic #6:

You want to invest heavily in stocks when they are available at low prices. But you don’t want to stick with that high stock allocation when prices get out of hand (over the course of a 30-year return sequence beginning at a time of low prices there will of course be times when prices get out of hand). The 50-percent-stocks portfolio beats the 20-percent-stocks portfolio. The 80-percent-stocks portfolio beats the 50-percent-stocks portfolio. And the Valuation-Informed-Indexing portfolio beats the 80-percent-stocks portfolio.

Buy-and-Hold is rooted in a belief (the Efficient Market Theory) that investors always price stocks properly, that overvaluation and undervaluation are thus meaningless concepts and that investors may therefore feel free to stick with the same stock allocations at all price levels. It’s not so (at least not according to the historical stock-return data). Overvaluation and undervaluation are meaningful concepts. To invest heavily in stocks when they are selling at three times fair value (as they were in January 2000) makes about as much sense as paying $90,000 for a car with a fair market value of $30,000.

It’s true that the most important decision that an investor makes is his choice of a stock allocation. It is not true that an investor can afford to make this decision once and then stick with the allocation chosen forever. Stocks are riskier at high valuation levels and provide lower returns at high valuation levels. All investors should be changing their stock allocations in response to big valuation shifts. We need to move beyond the one-stock-allocation-fits-all-valuation-levels mentality of the Buy-and-Hold Era and begin teaching investors how to go about knowing when to change their stock allocations and how much to change them. This is the future of investing analysis, in my view.

Rob Bennett writes frequently on behavioral finance. He recently authored a Google Knol entitled Why Buy-and-Hold Investing Can Never Work.

By Rob Bennett

The most important factor affecting an investor’s results is his stock allocation. So argues the conventional investing wisdom of today, a wisdom popularized during the Buy-and-Hold Era.

I don’t subscribe to the Buy-and-Hold Model for understanding how stock investing works. I believe that this model, developed during a time when belief in the Efficient Market Theory was strong, is hopelessly flawed, and favor a model that I call “The Valuation-Informed Indexing Model.” The difference is that, while the Buy-and-Hold Model posits that there is no need for an investor to change his stock allocation in response to big changes in valuations, the Valuation-Informed Indexing Model posits that at least occasional allocation shifts are critical to long-term success. Investors who stick with the same stock allocation at all times are permitting their risk profiles to go wildly out of whack when stock prices go to levels far higher than the levels at which they determined that that stock allocation was appropriate.

A Valuation-Informed Indexer would agree that the most important decision an investor makes is the one he makes regarding his stock allocation. But a Valuation-Informed Indexer would add that it is impossible for any one stock allocation always to be right for any investor. The only way to choose your stock allocation effectively is to take into consideration the effect of valuations on long-term returns when making the choice and to make fresh choices as needed to keep your risk profile roughly constant. The best stock allocation is a stock allocation that varies with changes in stock valuations (heading downward when valuations rise and heading upward when valuations drop).

The Strategy Tester is an investment strategy calculator that permits users to create up to four strategies and compare how they perform in 1,000 30-year return sequences. The return sequences are generally random but not entirely so; statistical filters are applied to insure that they play out in a manner similar to how we have seen 30-year sequences play out throughout the historical record. That is, a Reversion to the Mean phenomenon works to pull valuations down when they get absurdly high and to pull valuations up when they get absurdly low.

The results of each strategy tested are reported in the form of color bars comprised of four colors: (1) green; (2) blue; (3) yellow; and (4) red. Each of the colors points to 25 percent of the results obtained from the 1,000 tests performed. Thus, the red color bar points to the worst possible results that could turn up for the indicated strategy, assuming that stocks perform in the future at least somewhat as they always have in the past. The green color bar, in contrast, points to the best results possible. The point at which the yellow color bar meets the blue color bar is the midpoint of all possible return sequences; the investor choosing that strategy knows at the outset of the 30-year time-period that there is a 50 percent chance that his real-world results will be better than the result shown at the midpoint and a 50 percent chance that his real-world result will be worse than the result shown at the midpoint. Results are shown at five years out, ten years out, fifteen years out, twenty years out, twenty-five years out and thirty years out.

The Strategy Tester shows that it is valuations that are the single most important factor bearing on long-term investing success. Investors willing to change their allocations in response to big price swings earn higher returns at less risk than do investors who insist on sticking with a single stock allocation at all valuation levels.

Graphic #1 shows that high stock allocations generally yield better results than low stock allocations. All of the results shown in Graphic #1 presume a starting-point P/E10 level of 14, the fair-value P/E10 level (P/E10 is the price of the S&P Index over the average of the last 10 years of its earnings). The four stock allocations examined are: (1) 20 percent stocks; (2) 50 percent stocks; (3) 80 percent stocks; and (4) 100 percent stocks.

(click on image to view a larger version)

The results for the 20 percent stock allocation are horrible. It’s not just that investors going with a low stock allocation give up the possibility of earning appealing returns by doing so. The low end of the red color bar reveals to investors the worst-case scenario for the strategy being tested. From Year 20 forward, the 20-percent stock allocation yields the lowest red color bar. The suggestion is that the risk associated with the 20-percent stocks portfolio is greater than the risk associated with the other portfolios. It’s not that the higher-stock-allocation portfolios may do better and may do worse. In the long run, there is no realistic scenario in which the higher-stock-allocation portfolios can generate results as poor as those that may well be generated by the 20-percent-stocks portfolio. Going with a low stock allocation is risky, according to The Investment Strategy Tester.

The other side of the story is that going with what would generally be viewed as an insanely high stock allocation does not appear to carry all that much risk. At 10 years out and at 15 years out, the 100-percent-stocks portfolio shows both higher possible returns and worse worst-case scenarios; that’s a finding consistent with the conventional thinking that higher stock allocations provide potentially higher returns at the cost of added risk. However, this is no longer the case from Year 20 forward. At Year 30, the 100-percent-stocks portfolio offers significantly greater upside combined with a worst-case-scenario no worse than that offered by any of the other portfolios and better than the 20-percent and 50-percent portfolios. Stocks are pretty darn appealing when selling at reasonable prices!

Five additional tests will be examined in Part Two of this article.

Rob Bennett often writes about safe investing strategies. He authors a weekly column entitledInvesting: The New Rules at the Death by 1,000 Papercuts site.