End of year update

2016 was mostly a good year for me and my family. I am grateful and looking forward for the next year, which will likely bring changes to my personal life, hopefully good ones.

Investments

In 2015 GOOG(L) stock scored 40% gain, while BRK.B was ~15% down. In 2016, GOOG(L) has ~2% gain, while BRK.B went 23% up. My interpretation of market is that Ruth Porat's arrival was correctly anticipated to increase value of Google, and 2016 did not surprise markets as they saw it happening. On Berkshire, the level of undervaluation that existed throughout most of 2016 was borderline ridiculous for such a safe stock, and strong gains in late 2016 did only some part of catch up to the underlying value. Of course both stocks can drop in 2017, but I have hard time seeing how their intrinsic value could drop over next year.

Therefore, I continue to like the investment in both companies for the long term and don't mind that they ebb and flow. In 2016 I consolidated my investments on Interactive Brokers (IB) account. I also diversified - Alphabet + Berkshire went down from being 85% to 55% of my investments:

Since last update, I added (to) three positions: VRX, KORS and GILD. While I consider KORS and GILD as yet another regular value investments, Valeant is a different animal. I see a high chance of it doubling in a year or increasing five fold within next 5 years as it sells assets and reduces leverage. But there is also substantial chance of it dropping to zero or close to it, if some bad development gets amplified by their leverage. None of these two options apply to the other investments. As time permits, I will try to find more risky bets similar to VRX. I will try to keep my total exposure to such stocks modest (perhaps 20-30%), but spread out over more opportunities.

Leverage

Much has been said about using leverage in investing.

I would bucket them into three categories.

Safe, durable leverage

Famously, Berkshire has been built on using insurance float - effectively leveraging Company's investments. Because float is stable over time, even big drops in market prices of investments do not force asset sales. Similarly, real estate investments can be leveraged rather safely (assuming cash flows from these properties are safe themselves).

Unsafe leverage

Buying stocks or futures on margin is unsafe, in a sense that drop in instrument price can cause a margin call and selling at the bottom.

Hidden leverage

The less obvious is when the investment itself is leveraged (company with a lot of debt). Because of limited liability for stockholders, it can be perceived as inherent risk, rather than direct liability. Sometimes, though, I think it is instructive to think of it as investor's debt.

The flip side of the previous scenario is when company has material, positive net cash. I like to think of it as a my cash, even though I cannot force the company to distribute it. But when I have faith in company's management (including perceiving them as good capital allocators) I think it is a reasonable way of thinking.

To make it more concrete - Apple has enormous cash position (even after subtracting deferred tax liability) and consistently generates huge amounts of cash. In today's markets, with highly developed arbitrage, it is unimaginable for Apple stock to trade below it's net cash per share (in other words,  having negative Enterprise Value). It is even more so, for companies that are smaller and thus more susceptible to activist shareholders.

Putting everything together

When looking at my leverage, I prefer to think of all kinds of it.

Unfortunately, I do not really have as great source of safe leverage, as Berkshire. The one closest to it that I have, are 10 year employee stock options, which provide me with 'free capital' for ten years, as long as I keep this capital (and much more of it, actually, too) invested in Alphabet stock. For now I decided to do that, but within a few years this source will be gone.

Another concept that has some characteristics of the leverage is time-shifting of the investment. When I know for sure about an incoming cash flow, I can make and investment ahead of it using margin (unsafe) or options (safe, but costly).

Combined leverage

I do use margin when making stock investment. I do that, even though I have been bitten by using futures to go long Polish WIG20 around the 2007 highs. I thought I was being conservative then, but clearly I was not.

I strive to be careful in the amount of leverage I use. For example, when buying Berkshire not much higher than their buyback threshold of 1.2 of book value, I feel comfortable using relatively high leverage. But I also always want to be able to buy more and still not face a margin call if stock will go into what I would perceive as a bottom.

It is not an exact science, but I try to take into account all these pieces when deciding if and how much leverage to use. Another example is Valeant, where there are scenarios when it goes straight to zero, therefore no leverage can be used. And with standard RegT margin requirements (which I prefer), whenever security can drop by 50%, no leverage can really be applied anyway.

The picture could in theory be a bit more rosy for using leverage when considering diversified holdings, but that's a tricky path to follow.

To summarize, I keep the borrowed amount below my expected to-be-invested income from next 12 months. And also to such extent, that my planned buys when averaging down and unrealized losses will not cause a margin call in my "worst case" scenario.

Using some leverage "constantly" will prevent me from maximizing gains by buying more after severe declines, but will elevate returns at all other times.

Case against Tesla 2/2 - electric vehicles

[Disclaimer: I am an employee of Google, but have no connections or special knowledge about WayMo]

In addition to sources for part 1, Benedict Evans has excellent slides, also about cars (from # 61).

(Shared) (Self-Driving) (Electric) Vehicles.

Car Business

Manufacturing vehicles is generally not considered to be a great business. It is capital intensive, buyers are generally price-sensitive (as cars are big ticket items), but research and development costs are high while product cycles are relatively short and seemingly accelerating. On top of that, the business is highly-cyclical. All of this causes carmakers to generally trade at depressed valuations.

Premium and luxury carmakers can typically operate at higher margins, but this is a relatively small niche. I also think this niche will shrink with younger generations using car as a status symbol to a smaller extent and the advent of self-driving (more on this below).

Electric Vehicles

While EVs are expensive now, they are much simpler to develop and build. There will be little differentiation in electric motor performance, and batteries are and will continue to be a commodity, with price being the primary factor. There could be a break-through in battery storage technology and if some company will own the better technology, it can be a great competitive advantage, but it is unlikely that it will be an existing car company. Given Tesla's focus and investment in Li-Ion technology it will most likely suffer heavily from such a break-through.

Once EVs start to be competitive with ICE car on Total Cost of Ownership (TOC) basis (w/o subsidies and penalties for ICE), I foresee Chinese competitors going after the mass-market segment in developed countries. The barrier of entry caused by stringent emission regulations in Europe and US will no longer be a problem for them, and the low cost of materials, labor and battery will be a durable advantage.

Self-Driving

I was an enthusiast and optimist with regards to self-driving cars, for a few years already. It is great to see so much new entrants into the field, but I think it also clouds the picture as it is hard to distinguish hype from actual carmakers' capabilities.

SAE automation levels 2/3, marketed as partial self-driving, where driver in theory needs to be alert at all times are dangerous. It might still be safer than human driving, but I doubt it will withstand regulator's scrutiny when deployed and used widely. Inevitably, humans will stop to pay attention, crashes will start happening and public outcry will follow. 

I think full self-driving is an achievable, yet very hard problem, with intense R&D still needed.

Many relatively new entrants roll out tests or even on-demand services, but (thankfully) there is always a human fallback. I have not seen yet a convincing evidence that any one of them (incl. most recent Tesla video or Uber's claims to DMV that their cars are merely Tesla-like) is further down the self-driving path than WayMo (then Google) was in March 2012. Most likely they are less advanced now than WayMo was back then. But with the emergence of deep neural networks and better/cheaper computing and sensors the pace of advancement should accelerate for everyone.

I think that the sensors Tesla now puts into their cars will not be sufficient for full self-driving capabilities within foreseeable future. They are putting just a few more cameras than most automakers already are putting into their today driver-assist packages. And forward-facing radar and ultrasonic sensors were already present in my $20k 2015 Skoda Superb. Consequently, the "3.5 billion miles" driven mean relatively little, especially that they could not possibly transfer, store and process such amounts of data from cars into their data centers (of which there is no public information AFAIK).

There is one application where Tesla could possibly beat others to market. I have in mind SEA level 3/4 (i.e. when human needs to take over control, but with long advance warning and sufficient transition period, and with safe fallback strategy (e.g. pulling back car safely to the side of the road). In relatively safe and confined environments (e.g. long stretches of highways in US), the system can soon be good enough to be both useful and safe. The beginning and end of the journey will still be handled by a human. This could possibly be brought to market already, and automakers (including Tesla) are much better positioned to do that than outsiders (WayMo, Uber, nuTonomy, etc.). Quite obviously, driverless "ride-sharing" services will only be possible with Level 4/5 capabilities.

Selling such partially self-driving car can be good for Tesla financially, but I doubt it will materially help it to develop a fully self-driving car, given how different the needs are between unchanging highway stretches and dynamic urban environment. In the latter, I think there is no place for any level below 4. But I do not see how this can be a sustainable advantage for Tesla, with Mobileye and others perfecting their driver assist technology and enabling other automakers to roll out the same level 3/4 capabilities for highways.

On a cynical note, I see Tesla's boldness about their alleged full self-driving progress merely as a way to convince potential car buyers and stockholders that they are making a far-sighted, good investment by putting their money into Tesla.

Shared cars

Ride-sharing (which is mostly a misnomer) is an increasingly important phenomenon, but I wonder how big it would be without generous Silicon Valley investors. While taxis were always necessary, the cost of car depreciation and fuel tends to decrease compared to human labor over time. Therefore, in developed countries human-operated taxis (however called) are necessarily a niche market.

Therefore, the real and sustainable surge of car-sharing market can only be possible with the advent of self-driving cars. Once these capabilities are there, the transition of majority of users will be surprisingly fast, as using self-driving car sharing platform will be much cheaper and more convenient for most. There will be also other applications, such as trucking and package/food delivery that will reinforce the profitability of the business model.

With 1 billion cars to be eventually replaced with self-driving shared car network, there are a few ingredients necessary to succeed. The obvious one is technology, where I think WayMo has a lead, but others are getting closer by a minute. Another one is mapping technology, where WayMo, Apple and HERE are probably most advanced, but everyone will likely need to step up the level of mapping details to accommodate self-driving needs. Another one is existing ride-hailing network, with Uber, Lyft and Waze/Alphabet/WayMo having an advantage, in that order. Last but not least, the amount of capital necessary to deploy self-driving cars at scale will be huge.

Assuming Uber does 3 million rides a day (1B a year) nowadays, and that a self-driving car can make 20 of them a day (that's perhaps generous - 10h utilization at 30 minutes per ride) one would need 150k cars to achieve the current scale of Uber. At 30k a pop, it makes a minimum of $4.5B, quite quickly depreciating. Should we drop utilization to 10 rides a day and make the new car cost 100k, we suddenly look at $30B capex. On revenue side, Uber's gross bookings will probably in the ballpark of $20B this year. Given that's below human-operated cost, and that fuel (esp. electricity) will be a minor cost, the ROIC can be very good. Overall, the self-driving business model should work out very well, unlike the current one. To sanity-check these numbers for a single car, we can look at 10-20 rides a day, $20 each. This would make $300 a day or $100k per year - 2-3 times more than reportedly an Uber driver. To replace all 1B cars on a planet, we would perhaps need roughly 100M self-driving cars, which at $20k/car would work out to a mind-blowing $100 billion dollars of capex annually for 20 years, but still, that's only a fraction of the current ~$1'200B global car market.

Some of it can be financed, with cars and/or future revenue being the collateral, but with rapid technological progress, declining self-driving car prices and multiple competitors the leverage digestible by debt investors will be limited. Apple and Alphabet are best positioned from capital standpoint, but Uber, Lyft and Tesla can perhaps also raise equity capital for the network, if they are not obviously late to the game. 

To summarize, I think WayMo/Alphabet is uniquely positioned to deliver self-driving capabilities, but they need to act fast.

The Chinese exception

People's Republic of China is a unique market, ruled by different rules. Didi Chuxing, BYD or Baidu might well be the first ones to deploy self-driving at scale - it is hard for me to judge their capabilities. If they do, it will make it easier for them to expand into developed markets, as the branding/reputation will not matter as much for a service, compared to buying a car.

But I think that they will not be the first ones to deploy this at scale in the developed world.

Investment thesis

One of the takeaways for me is that Tesla has little chances of becoming the ride-hailing platform with self-driving cars (or Transportation as a Service - TaaS), where the real business potential is. In EVs, they might keep their niche, but it will be hard for them to profitably grow. I am inclined to short Tesla using long-dated options to limit my downside, but with relatively small amounts.

Writing all of this, makes me reconsider GM and F investments. I will perhaps want to redo my DCF assuming that rapidly growing TaaS enters service in 2017, with large chunk of consumers delaying or abandoning purchases of new cars in anticipation of using it.

Finally, I am as bullish as ever about Alphabet, but the sober realization that the moonshots outside the online services model were never really successful. Hopefully WayMo can disprove this.

But I accept the possibility that others (Uber? Chinese?) will succeed over WayMo on the TaaS market (I doubt these will be car companies, though). 

Case against Tesla 1/2 - solar panels and energy storage

[This and following post contain thoughts derived from multiple sources, including the great stratechery.com, many Seeking Alpha articles, WayMo self-driving car reports and other articles on the subject].

Disclaimer: I do not want Tesla to fail, nor I am against electric vehicles (EVs) nor solar energy or energy storage. I simply do not see Tesla as being in a good business and I see their stock as even less appealing investment.

I admire the boldness of Tesla in advancing EVs and making them cool. Likewise, I think the sooner we stop burning oil to move around cars the better, as we can save it for applications where it is much harder to be replaced, such as water and air transport, making useful chemicals, etc.

First principles

Famously, Elon Musk likes to refer to "first principles". It is from them, that I fail to see how current Tesla's energy storage strategy for stationary applications makes economical sense.

The most cost-efficient (see table 4) electrical energy storage is gravity, more precisely pumped-hydro or better yet operating dams when electricity is needed. Of course we do not have enough hydro capacity to shave off peak generation of the increasing amount of renewable energy sources.

Sodium-sulfur or compressed air are much more cost-effective today than Li-Ion, and in general it is unlikely that technology that is best suited for cars (high energy density) will also be the best one for stationary energy storage (where cost is the most important factor). Even if renewable energy was free to generate, Li-Ion storage cost amortized over its lifespan would be more expensive than the retail cost of grid energy for years to come.

I also don't see how Tesla could become the low-cost provider in this domain, given that "their" battery technology is owned by Panasonic and solar panels are a commodity mass-produced in China already.

Distributed vs. centralized energy generation and storage

Residential solar had some popularity in US and elsewhere, in large part thanks to subsidies and preferential net-metering which externalized costs such as energy storage for solar panel owners. But the solar and wind energy sources are becoming cheaper quickly and this trend will likely continue. They are likely to be the same kind of commodity that oil is. 

I see nuclear power as the perfect baseline and renewables as the ultimately 'free' energy. That leaves the energy storage the biggest obstacle for renewables to rule the energy generation.

Key element of the solution will be for sure an EV. Once (not if) this is the dominant transportation medium for humans and things, EVs can consume the surplus power from the grid, which will likely be generated mid-day, when traffic is limited. When economically sensible, they can give back energy to the grid during the off-peak times (especially in the evenings). Li-Ion or successor technology for car applications can be 'turned-on' instantly when the needs arise.

I see some potential in long-distance DC power lines time-shifting the energy consumption/production around the globe, but perhaps the human population is not distributed evenly enough for this to be practical.

Solar roofs

With solar panels becoming increasingly competitive with fossil energy sources (even w/o subsidies), the big question is - where they will be deployed?

Having them decentralized, on everyone's roof sounds very egalitarian and romantic, but I do not think it will be the most popular way, especially in the US. The deployment and maintenance costs of solar panels placed on roofs (or being the roof) will necessarily be higher than having the same panels deployed in a central location with safe, easy access. It also makes it easier to track sun movement to maximize utilization. As US has an abundance of land, central generation is much more economical and practical choice. In Europe, the landscape considerations might sometimes make for different trade-offs, though.

Elon Musk's concept of integrated solar roofs does not withstand common sense scrutiny. Why one would couple roof tiles and small solar panels and add deployment complexity on top of this? Also the recycling of such roof tiles will become much more complex than necessary. The most logical is to decouple the two. If, as Elon claims, these tiles are so beautiful to increase home value by 5% (really?), one can imagine that having glass tiles without integrated solar panels to have exactly the same effect, but being much cheaper.

Overall, I am an optimist with regards to humanity switching within a few decades to renewable energy sources for majority of energy consumption. But I do not see Tesla as being a significant part of this picture, given the lack of cost and technological advantages.

Portfolio Sizing

For a long time, I kept thinking what is the best strategy for deciding how to decide on the optimal size of allocation to a given stock.

Valuation and default allocation choices

I agree with Aswath Damodoran that valuation is part science and part art, which makes it a craft. I see how people can reasonably disagree over valuation of the same company and because we cannot know the future, it will never be an exact science. There will always be a necessity to use a judgement call (which is also why AI will not replace humans in high-level capital allocation, but might be a useful input if not too blackboxy). It is worth noting that I am a fan of concentrated portfolios - I usually have less then 20 stocks, excluding times when I "index" into some market.

The most straightforward choices I see are:

1. Equal-weight
2. Market-cap based

On one hand, equal weight sounds promising - if I feel good about owning a small set of companies on risk/reward basis, why not like them equally? But that makes it hard to make two kinds of bets - a rock-solid, well undervalued company where I feel good to "bet the farm" on it. Think Berkshire until recent run-up in price or Buffet's 40% bet on American Express. On the other hand, if I find high-risk, high-reward stock, I might prefer to limit the maximum loss in a concentrated portfolio.

But as a value investor, I have some valuation (or distribution of them) and perhaps some 'confidence' attached to it, right? It seems natural to use these to make decisions on buying/selling a certain number of shares at certain prices. This should be an easy task to do this in optimal way and it should enhance the returns, while reducing risks.

Alternative stock allocation and pricing buys and sells

To my surprise, I could not find much on the topic with casual Google search. Asset allocation is of course big, but irrelevant topic. Kelly criterion is often mentioned, but rarely in the context of multiple simultaneous allocations, let alone stock market. And I could not find anything based on assessment of intrinsic value. Perhaps this is a result of inherently individual way in which value investors assess intrinsic value and their confidence in it.

One more problem that I found little discussion of is how to price entering and exiting a stock. How to go beyond "buy once - sell once"? One could consider such decisions independently for each stock purchase/sale, but that's problematic given that these concern the same stock and therefore expected returns are highly connected, even with different buy/sale prices. I read some value managers buy half of a position initially, to allow buying more if it goes down. Or keep 30% of the stock even if it exceeds assessed intrinsic value, to make use of the momentum. These are all interesting ideas, but there is no 'science' to them.

Today, I mostly rely on my gut feeling and scale the investment with my confidence the value assessment. I also try to average down. The challenge with the latter is that when my recent Valeant purchase went down 15%, I have bought additional shares with too narrow steps and in total more than what I would normally consider a reasonable allocation for such a risky stock. In even more cases I undersized my position because market went away from my limit orders (recently: Fairfax, Gilead, Markel, Pershing Square Holdings, Alleghany, Valero). My top investment is roughly 50x the  bottom one. All of this seems to be a very suboptimal approach.

Long time ago, I read about progressive asset-allocation system called SIP (in Polish). It was quite novel and interesting, and while I outgrown many of the assumptions that this system makes (using futures to go long, expecting 20%+ yearly returns, stock-markets-always-rise, etc.). I think this is an interesting twist on dollar-cost-averaging and the idea of "expected price" can be easily swapped with intrinsic value.

Backtesting

I am not a big fan of backtesting complex algorithms on financial data. Markets and businesses change. There are various one-time events such as abandoning gold standard, PC/Internet revolutions, HFT, surge in index funds or stock-based compensation accounting changes that make various periods hardly comparable. And one cannot simply do an objective intrinsic valuation of a company from long time ago, as "future" will inevitably spill into their thinking.

But backtesting a stock allocation system might make sense, even with a few years worth of data and intrinsic valuations. Perhaps even analysts' price targets might be used in lieu of own intrinsic valuation, as I am only concerned about alpha provided by asset allocation, not the quality of price targets themselves.

I will try to come up with such a system, see how it would perform for my recent investments and maybe also do some backtesting.

Buybacks

"People are worried about stock buybacks" is a long-standing, tongue-in-cheek header on Money Stuff.

As an individual investor, striving to achieve some alpha, I am usually not worried at all.

On a micro level, as long as executed under intrinsic value, buybacks are obviously accretive to continuing shareholders. From famous Washington Post buyback up until most recent Apple, Google and Facebook ones, I believe quite often they makes perfect sense. I am not worried that the investments go down, because neither of the above-mentioned companies were constrained by capital resources. Another aspect is that often "R&D is the new CapEx" and therefore the regular measures of total investment are underestimating actual investments.

On a macro level, the capital returned to shareholders can be reinvested in new firms with more capital needs (and opportunity). I could simply stop here, but I will not, as I see another reassuring trend.

We are more and more moving to value being created based on intangible assets.
In the past, unless company had pricing power through brand or other moat, it could expect moderate but relatively reliable returns on investments. Therefore 100 companies (or even a single company for that matter) building one hundred $1M factories could expect, say, 10% ROI with relatively little variability. In the world of intangible assets driving increasing share of value creation and all-or-nothing successes, the picture is quite different. We can have one hundred startups with $1M "sunk" in each, with few of them being big successes and surfacing the created value by IPO, being acquired or "just" becoming an unicorn. The rest will simply disappear from the picture, with "investment" put into them not being as visible to the official statistica. Especially, that large portion of the 'lost' investment comes from capable employees foregoing steady salary to the (unrealized) equity upside.

Enough philosophy, though, back to buybacks.

Buybacks at elevated prices are of course not great for continuing shareholders and companies in general are not great market timers when doing buybacks. That's why I love Berkshire's approach of buying back below certain percentage of book value (120% currently, but perhaps will be slowly increased over time).

One reason I like Apple, Gilead, GM, Alleghany, Fairfax, etc. is that they apparently are striving to create shareholder value when executing buybacks.

I usually get my investment ideas from Seeking Alpha, but I played with Yahoo stock screener lately and after skimming through several unappealing ideas I noticed KORS. I don't know much about Michael Kors brand, but I am increasingly aware of the power of brands in general and noticed this brand worn even by people who I wouldn't assume are big on having branded clothes.

But it was a different thing that kept my attention to KORS. By looking at cash flows and balance sheet, it is quite apparent that this company since ~1.5 years ago is 'eating itself alive'. They are repurchasing ~$300M worth of stock every quarter, with <$8B market cap. This rate seems quite sustainable, given their earnings and cash flow. At such rate and with constant stock price, they would buy back themselves within less than 7 years. I will try to open a moderate position.

Gilead

I have run across Gilead as 'value' stock idea several times in the past, but only now took a deeper look.

It would be a daunting task to predict financial performance of each of the drugs in their portfolio or the new ones in the pipeline and perform a regular DCF.

Performance of Gilead's main products.

The revenue picture for the top products is not encouraging. But even after removing Harvoni, Sovaldi and Atripla, the Q3'16 revenue would still be at $3.9B, and quickly growing.

What I liked a lot is also a substantial share buyback program and increasing R&D budget. The debt (partially used for stock repurchases) seems to be reasonable.

I read a bit of commentary on Seeking Alpha and there is a usual mix of reasonable and unreasonable complaints (including wishes to stop buyback, increase dividends and do major acquisitions). The revenue decline will probably materialize, but with share buyback the effect on earnings should be muted, so at PE of 6.7 it seems to be a safe bet. I plan to initiate a small, 1% position and increase to moderate one (~5%), should price decline. My set of limit orders was fulfilled only in 1/10th today. I am hopeful for a decrease in price that will execute my remaining orders.

Portfolio Update

Since three weeks ago when I published my portfolio I made quite a few changes, for a self-identified long-term investor.

With price increasing and coming closer to my intrinsic valuation, I have sold:

• Almost 40% of my Berkshire holdings
• More than 90% of Wells Fargo
• All of Valero
• A little bit of Lucadia

It was motivated by profit-taking, and:

• For Wells Fargo, I became a little more worried about the long-term impact of the account-opening scandal, given the dropping account openings. I try not to sell during a panic, but in this situation I was comfortable taking the profits and reinvesting elsewhere.
• While Berkshire and it's stock portfolio clearly outperformed recently, I wouldn't be surprised if it goes down 10-20% from current highs and I would like to have ammunition to add to the position at lower prices.

I wouldn't be myself, if the proceeds would not go back into stocks. I bought:

• (Lots of) Valeant as it dropped to $15. It stills seems to me severely undervalued and latest Management's steps (i.e. not selling Salix cheaply and building sales force) are rather encouraging to me, actually.
• A little bit of Pershing Square Holdings, but less than I wanted, as price kept creeping up after my initial buy.
• A little bit of Fairfax, here again the market run away from me quickly.
• A little more of VEREIT, as it briefly touched $8.01

I think the new positions are much more likely to outperform than the old ones, even though Valeant is indeed quite risky proposition. But with BRKB, APPL and VER still being large holdings, I feel rather safe.

All positions:

All except top 5:

California

I just got back from a short business trip to Mountain View, California. While I liked the weather and being close to amazing places like Yosemite, I hardly would like to live there. I find the traffic and housing standard and costs truly terrible. I recognize that the critical mass of talent and VC money in the Valley is unbeatable and therefore large chunk of world's innovation will be driven from there. But I don't at all feel like participating in this personally.

I work on "Shopping" project, and during the trip I was much more exposed to the frontend aspects of it and heard some of our partners speaking. This brought to my attention how consumption-focused the American culture is and I think Poland or Switzerland are still significantly less so.

Having said all of that, I had a very nice trip to Point Reyes and did 21km hike there. Also the views around San Fransisco itself are great. I have fond memories of Rancho San Antonio, Stanford campus and hiking trail above it are very nice. RV trip around US National Parks is still a dream of mine.

Long time ago I used to admire US a lot and wanted to live there. I do not anymore, but I still think it is a land of opportunity, but not so much quality of life or equality, compared to Europe.

Index funds

Since John C. Bogle launched ‘index fund’ idea, it has been steadily gaining ground and for many people is now the primary or only way to invest. There is solid evidence it is generally good to investors. But there are also ‘index funds are worse than Marxism’ arguments, papers pinpointing issues with efficient tracking of indexes and the key question - which securities should (selected) index contain and how additions/removals/buybacks/issuances potentially make the index overweight “worse” securities. I think some of that criticism is legitimate, from both results and society point of view. On the other hand, with their scale, they can be very efficient and sophisticated.

But there are also other reasons I don’t just put money into an index fund. The first is that I believe I can beat the market (necessary arrogance of each active investor). The second is that if I understand the underlying value of what I bought, it should be easier for me to stick to it even when the market prices of it keep declining. Having the same confidence in buying more abstract thing like an index fund would be harder for me.

ETF tracking polish stocks (EPOL)

I had bad results in some individual Polish stocks, which at the core were caused by government’s intervention and poor management. Of course the blame of making these bad investment is still on me. My point is that I find it harder to assess Polish businesses, just because many are heavily influenced by government actions, which are rarely shareholder-friendly. And in aggregate, the mid-size, privately-owned businesses are not cheap and can get mismanaged too, with last example being Alma (I actually consider buying Alma, but was put off by the fact it had a controlling insider and some evidence on spending money *on* management).

I still want to have significant exposure to Poland as I will be spending money in PLN and prefer equity to cash/bond investments. So I decided to index into the market, with half of my current position initiated just after brexit and the other half very recently, after significant drop of PLN which caused EPOL to drop as well.

VEUR

I bought VEUR post-brexit as a contrarian move, additionally inclined by weak pound (in which it is denominated). The pound depreciated even further, but the index rose and I have not added to the position since.

I am considering buying VXUS just because of the strength of the dollar, which in my opinion is not sustainable. And I have too much exposure in USD already (almost 100%), which was beneficial until now, but I would prefer to significantly reduce it. But my limit orders are still waiting.

Apple (APPL)

Intrinsic Value (IV): 168$, Current price (CP): $113

I was for long time an Apple skeptic, mostly because I perceived Apple gadgets as expensive and vulnerable to low-cost competitors. I also am not a fan of walled gardens. But my thinking on Apple’s competitive advantage was greatly influenced by stratechery.com articles and observations made based on them.

Apple is cheap relative to both earnings and cash flow and has enormous amount of cash. I think market believes (as I used to) that iPhone’s high margins are not sustainable, but now I disagree. Seeing to what extent many people value their phones, I expect growing number of them willing to pay a premium for the best, hassle-free experience on a device they spend hours and hours every day. Brand and ‘cool’ factors are also durable competitive advantages, especially after Samsung’s recent failures with Note 7 and I don’t think any Chinese brand will be perceived as ‘premium’ in the West or in Japan for a long time.

Last but not least, I think Apple’s vertical integration and scale will enable it to come up with the next personal computer after smartphone, no matter if it will be a watch, smart glasses, other wearable or chip under our skin. I believe once the time is right, Apple will rollout out a gadget that everyone wants and it will perform better than the ones from competitors.

I bought a small position for $128 in 2015. I did not think it is very cheap, but I wanted to keep track of the company as I finally appreciated the competitive advantage. After poorly-received earnings, I added a lot in April and May 2016, dollar-averaging my cost basis to $97, as I did not see anything alarming in the results. I must say it was comforting to see Berkshire also buy a stake when they filed their 13F.

I expect the iPhone 7 results to be very strong and positively surprise the market. The iPhone 7 Plus has still 2-3 week shipping dates. And I think Apple manages their supply chain and predicts demand much better than Google.

Oil price

Both general economy and stock prices of many enterprises depend on the price of oil.

The 2014 drop in oil prices helped or harmed many stocks. But also, some stocks seemed to be under constant pressure of oil prices (being low or being expected to rise).

On one hand, extraction companies are lower, perhaps rightfully so. Many firms have a lot of debt and even with low valuations are a risky bet. There are also refiners and other companies that market perceives as dependent on oil price (e.g. CBI - construction company that does some projects for oil-related industries, but not that much and not all could be hurt by low oil price).

I think car producers, which have record profits thanks to SUVs and trucks are thought to lose a lot of profitability once gas prices rise and car-buying cycle reverses.

I think that the shale revolution will keep oil prices in check for a long time because the extraction methods and tools will become less and less expensive, but also, with advancing technology, more oil can be extracted from current and already shut-down oil/shale fields.

General Motors (GM) and Ford (F)

Intrinsic Value: $43.8, Current Price: $34.2

Both Ford and General Motors are very cheap. I think market discounts the cyclical nature of the auto market and fear that easy money from selling high-margin SUVs and trucks will go away with increased oil prices. I think that low oil prices are hear to stay, primarily because the shale oil extraction will jump everytime price goes above the cost of extraction. And shale extraction cost will get lower with increased efficiencies and new technologies.

As I understand both Ford and GM can keep profitability even with ~10M auto sales in US, down from current ~18M. And they generate nice cash-flow.

The other concern might be self-driving cars. I think that self-driving cars (as a service) will be quite popular in US 5 years from now, which will negatively impact total auto sales. Still, the impact will be gradual and I think that ease of use and reduced congestion will significantly increase demand for ‘mobility’ services, and will partially offset greatly increased utilization of each deployed self-driving car.

Valero (VLO)

While Valero’s results are very volatile, the normalized earnings looked attractive and I bought a small position close to 2016 low. The dividend yield seemed attractive and safe and the long-term prospects of the business do not depend much on price of oil. Now sitting on 30% unrealized, I contemplate locking these gains.

Valuing Valeant

Departing for a moment from discussing existing investments, this post focuses on a new one I just looked at.

Valeant (VRX)

Valuing Valeant is an interesting problem, that valuation guru Aswath Damodaran recently tackled. I read a few articles about Valeant, but did not consider investment until reading the aforementioned valuation post. With so steep declines from highs, my contrarian instincts got triggered and I looked more closely on Professor’s valuation, not to criticize it, but to see if I can understand the business enough and own it.

Just from naive, sum-of-the-parts point of view, the $5.6B market cap for company that owns household brand Bausch & Lomb (bought for $8B+ and unlikely to lose value in the meantime) and so many other assets, seems like a bargain. But the $30B+ debt is a big red flag. In his valuation, prof. Damodaran computes firm value and subtracts debt to arrive at equity value. He assigns 10% chance to failure and adjusts firm value, but before subtracting debt. Because in distress the equity will be wiped out, I think the 10% adjustment should come after subtracting debt from unadjusted assets. In other words, we should allow debt holders to carry part of the default burden in addition to equity being wiped out, instead of assuming entire default cost on equity. After all, this is what company pays for in increased interest rates. This is a minor point though, as 10% probability is arbitrary to begin with, and valuation does not change much (and for the upside, actually).

The big problem I see is with credit rating plummeting from Ba1 to B3. Presumably, most of the debt was obtained with former rating in place and B3 carries much higher spread, according to Professor’s table. Rising riskless rates don’t help. If we roughly calculate interest for current debt as 3.25% + 2% = 5.25% and future interest on rolled over debt as 7.5% + 2.5% = 10%, we look at almost doubling the interest expense. Eyeballing the “10. LONG-TERM DEBT” section in the latest 10Q I see ~6% rates at outstanding notes which would confirm it. Extrapolating last 9 months gives $1.8B annual interest expense today and $3B after refinancing. Valeant says: “We believe our existing cash and cash generated from operations will be sufficient to cover our debt maturities as they become due”. But judging from “Payments due by Period” in “Long-term debt obligations, including interest” in their 2016Q3 10Q, and the ~$3B of earnings before interest in Professor’s calculation, they could be short on cash as early as 2017 & 2018 when $7.7B of interest and principal is due and even more in 2019 & 2020 when the number raises to $12.7B. Of course if they pay down principal and stabilize business they can get upgraded and roll over debt at less than 10%. They could also divest some businesses - but a few subsidiaries guarantee debt and there may be other covenants I am not even aware of.

Finally, the assumption of flat revenues in first years might prove to be optimistic, as the reversal of previous price gouging can reduce it, maybe even substantially.

I recognize the potential for non-trivial upside, elevated by the optionality of positive surprises on the business side and successful divestitures. But the downside is also substantial, potentially 100% with hard-to-estimate probability.

But I can also see other another possibility. Famously, Bill Ackman’s Pershing Square bet heavily on Valeant and even doubled down. His fund trades at 22% discount to NAV, I think one of the highest to date. Buying into PSH gives me exposure to Valeant, with more diversification but also leverage (through NAV discount, PSH’s $1B debt, their long-short strategy and IIRC them holding not only Valeant’s stock but also deep out of money options).

Of course buying PSH also exposes me to high hedge fund fees, their bet against Herbalife (I think and hope HLF will fail, but I am wary about unlimited downside of shorting) and the risks that their leverage brings. But there are also additional upsides - if Ackman ‘wins’ Valeant or Herbalife the NAV discount may turn into premium and his overall performance/luck might also ‘revert to the mean’. I was actually considering QSR, MDLZ and CMG which were his other bets, as of Sept 30th. These seemed to be good businesses, but I didn’t spend enough time to value them. I am sure he did.

Lastly, as I understand PSH might currently have a headwind of performance fees for the successful 2014. I assume that poor performance of 2015 and 2016 will reduce the performance fees in the next couple of years, should the fund perform well.

I decided to pull the trigger and try to buy a ~4% position in PSH. I set limit orders for 13.9, 13.6, 13.3, 13.0 and 12.7. Should it go even lower, I will probably add above 4%. Early today, the first order got fulfilled, hopefully a few of the lower ones will as well.

Berkshire-inspired investments

IBM

I bought a modest chunk of IBM around $133, inspired by Berkshire holding it and encouraged by strong cash generation and the established position in IT departments. For non-tech companies, IBM can still be THE partner to handhold them into the world of (public, hybrid or private) cloud and machine learning. I sold it in two chunks, for approx. $155, primarily to free up funds for other investments (VEREIT and EPOL). I will surely consider buying IBM again after a dip or if business performs better than expected.

Wells Fargo (WFC)

Intrinsic Value: $81.5, Current Price: $52.8

This is another investment inspired by Berkshire’s holdings. While not cheap, the ROE is impressive and I was also convinced that downside is limited, given that interest rates will rather go up than down, and therefore business performance can mostly improve. Then the scandal with unauthorized account openings broke out. I increased my position, and I have decent post-Trump unrealized gains (cost basis %45.5), but far from what they would be, should I buy JPM/C/BAC or financial sector ETF instead. I still think by downside is more limited with the best-of-breed bank, and yield is still attractive. And I always have BAC exposure through BRK.B.

Kraft Heinz (KHC)

I was tracking Berkshire’s acquisition of Heinz and subsequent merger with Kraft and I was amazed how Buffett and 3G have turned ~$10B into ~$30B each in 3 years. I think this leveraged buyout indeed created lots of value by making the underlying business leaner and efficiently using the underlying cashflow to pay the acquisition debt. And the stable nature of the underlying business minimized the risk coming from leverage.

I recently bought a token position in KHC, primarily because of a large post-election drop in price as a contrarian, “impulsive” buy. The intrinsic value depends on achieving (or exceeding) the planned $1.5B of savings and I plan to track progress of this business.

VEREIT (previously known as ARCP)

Intrinsic Value: $11.38

Current Price: $8.40

I first learned about VEREIT (back then known as American Realty Capital Properties or ARCP) in 2014 from an article on Seeking Alpha. The very concept of REITs and reliable income is appealing, but usually also implies limited upside. ARCP was more reasonably priced than peers then. Still not cheap enough for me to buy.

In October 2014 the infamous accounting scandal broke out and stock dropped from $12 to $8. It suddenly started to look attractive and I initiated a relatively large position. I kept the stock since then, collecting dividends and sometimes doing small sells, realizing modest profits. After REITs got much cheaper, with increasing treasury rates after Trump’s election, I bought quite a lot, and currently I have cost basis of $8.3 and ~6.5% dividend yield on cost.

I have considered a few other reasonably-priced REITs in the meantime (SOHO, LXP, WPC), but when I looked at the first two, I was a bit worried about the debt levels. And WPC got more expensive than my orders. I still need to revisit them and maybe place an order.

Berkshire and Lookalikes

Berkshire Hathaway (BRK.B)

Intrinsic Value: $222, Current Price: $158.7

This is the company I read most about. Primarily from Warren Buffett's shareholder letters, but also financial filings and multitude of articles and a few books. In May 2015 I even made it into the famous shareholder meeting in Omaha.

The stability of earnings from various wholly-owned businesses, stock portfolio of strong companies and $20B of cash held at all times is fairly unique. Even more unique is the liabilities side of balance sheet: insurance float, deferred taxes on unrealized investment gains and depreciation of long-lived and intangible assets. Finally I strongly believe in the business and investment acumen of Buffet, Todd Combs, Ted Weschler and all the managers of operating businesses. I see them making smart decisions within their businesses and even more so in deployment of cash that they generate.

From the individual investor’s standpoint the stock repurchase plan with 1.2 book value limit provides almost a hard downside protection. I am convinced Buffett (or his successor) will buy back a lot of stock at significant discount to intrinsic value, or find even better ways to deploy capital elsewhere.

I am not certain why market undervalues Berkshire. Maybe it is because it is old and boring? Maybe they are worried about Berkshire after Buffett? Or maybe consistent selling from Bill and Melinda Gates foundation drives the price down. Neither thing worries me.

Leucadia (LUK)

I think of Leucadia mostly as ‘baby Berkshire’ with the same principles and source of funds (insurance float). Their wholly-owned businesses did not do great in last few years which caused them to be undervalued - I jumped in then and added on a dip. With price close to book value, I am confident in the long term prospects of this investment. Recently it tracked higher, perhaps partially because the businesses improved and because US-focused businesses overperformed after Trump election.

Markel (MKL)

Markel is another ‘baby Berkshire’, with a better track record and therefore with market capitalization at non-trivial premium over book value. Given its consistent performance I am happy to pay this premium. I was even happier to pick up more of Markel after the post-earnings dip. Unfortunately, only one of my orders got fulfilled, and then market run away.

Alleghany (Y)

Yet another example of baby-Berkshire. Another shareholder-friendly company, with value-investing principles and sensible capital allocation approach. Bought around book value and holding for the long term. I expect all baby-Berkshires to be consistent ‘compounding machines’ and having all of them provides some diversification for my otherwise very concentrated portfolio.

Fairfax (TSE:FFH)

The most recent addition to my portfolio - I bought a small position today after checking on performance of ‘discarded’ investments I wrote about yesterday.

Fairfax dropped heavily post US election and is now well within what I was ready to pay when I evaluated it the first time. The drop presumably comes from Fairfax hedging all (or even more than all) of their equity positions in expectation of market’s decline. They seem to be wrong for the time being, with post-election gains in the market. But I see this rather as an attractive entry point, given the proven record of management’s good judgement and the fact that company is diversified by having great insurance underwriting record and wholly-owned businesses. The potential losses from these hedges do not justify the drop, and current premium over last reported book value is in the order of only 10%.

My stock portfolio

I strongly believe in value investing principles, as defined by Ben Graham and all his successors. This approach not only has great track record, but most of all, simply makes sense. I try to focus on understanding the underlying business as much as I can, but being a small investor, I can only work with public data and the time I can spend on stock analysis is limited, no matter how interesting it is.

All of this causes me to hold a very concentrated portfolio (as of 2016-11-18):

Two largest, 'permanent' positions are vested Google equity and Berkshire Hathaway. I have high belief in both, and although they are not very cheap (and one might even argue that Google is expensive), I see bright future ahead of both, especially after adding Ruth Porat as a capital allocation expert at Google.

I have spent quite a bit of time studying APPL, VEREIT and most of the other positions. There might be a confirmation bias (I spend time studying companies I consider promising, and usually I can easily find evidence justifying an investment). But there were also some that I considered and rejected, such as RCAP, XOM, LXP, O, SOHO, PSX, C, FFH, etc. In hindsight, sometimes it was a good call, but in some cases I missed some gains. I think that's to be expected. But I felt comfortable with my choices and I still do. This will hopefully allow me to stick to them even through large market declines and even add to them.

In the following posts, I am going to shortly explain an investment thesis behind each investment.

Almost 8 years have passed since my last post here. A lot has happened in my personal life - we built a house, have two kids and recently moved to Zurich, after my company’s office in Krakow was closed. It was an exciting and busy time.

It is interesting to revisit my thoughts from such a long time ago. Not so much have changed in my thinking since then, but certainly time has corrected some of my predictions, such as that Nord Stream will never be operational or that we are close to the bottom of the stock market in January 2008 and then again on 13th of October 2008.

I am still interested in investing, perhaps even more so than before. I have had mixed results in the meantime, with some significant realized losses on WIG20 during the financial crisis, but also very nice gains on Google’s equity that I hold for the long term, with first small sales only in November 2014. And I am still holding most of my Google stock grants.

I have a bit of exposure to Polish stock market, but I mostly moved my investments to US, starting with Berkshire Hathaway (BRK.B) purchases in February 2014. Since then, I have been increasing this position, and also started diversifying into other stocks.

As one of my main motivations for writing this blog is to be able to reflect back on my thinking from the past, I will try to regularly post a list of stocks I own, with a short investment thesis and estimate of fair value.