Tobin's Q and Capital Cycle theory

From Edward Chancellor's Capital Account (Marathon Asset Management letters)

p50
"In fact, the overvaluation of assets by the stock market is probably one of the key drivers of the capitalist process. After all, companies should convert cash into assets only if they believe they can add value.
Thus, when Tobin's q ratio is in excess of one, there is a strong incentive for firms to increase capacity. All too often, this encourages undisciplined expansion, which in turn leads to excess capacity and falling profitability, causing share price to tumble. This process of regression to the mean is always at work in the stock market. In the US, however, the stock market does not appear to revert to the mean except in the very long run. For a period of more than 15 years to the mid-1980s, share sold for well below replacement value as measured by Tobin's q. This suggests that the current phase of full (or over) valuation could also last for an extended period."

I agree with the thesis to a point. But do corporate managers think "Wow, I can generate $2 in market value by investing $1 into my asset?" I don't think so. They are mostly looking at profitability and pro-forma ROIC statements. I don't think anyone is that naiive to think that P/B ratio will hold when they increase investment. That's like Phil Fisher's comment on how high P/E ratio stocks have more torque per dollar in earnings increased because it will add that much market value to the shares.

I think the real reason behind overinvestment is that the managers tend to be extremely optimistic when the market is. They overestimate their ROIC, just as the market overestimates future profitability of the firms.

Still, one important tool that can be used when evaluating possibility in oversupply can be gathered - you can look at not only the competition entering the industry but what the industry aggregate CAPEX is doing. Could be interesting, especially when you have oligopolistic industry structure such as the Canadian Telecoms.

Why Money Makes Us More Unhappy

"Experience stretching - when we have money, we are more bound to splurge, giving ourselves a taste of "a better life." Once the splurging is over, our expectations for experiences are hiked up and we can no longer enjoy mundane things in life to the same degree. "

Same thing as my philosophy of "never trade up unless you can afford it for rest of your life" - trading up will make you temporarily happy but over long term you will definitely adjust due to the hedonic treadmill. On the other hand, trading down will produce unhappiness.

Dan Ariely on Simoleon Sense

"People just don't get second opinions or shop around - most people who are diagnosed with Prostate cancer decide to get it treated within the same hour (without getting a second opinion)."

Most likely because we assume that professionals and experts are all the same - we need to recognize and accept that for whatever field it is, everyone's skill level is on a normal curve. ALWAYS get a second opinion.

T2 on MSFT and Investment horizon

From T2 fund letter - July

"Our investment horizon is quite a bit shorter for any technology company.... We can't accurately predict where MSFT's business will be in 5-10 years but you don't have to in order to own the stock today."

Is this true? MSFT's current multiple is at least 10x. If you owned the business today you are relying on greater fools who have much more confidence in you to value the company 10-15 years out. Without those people, you wouldn't be making the purchase if you thought above was true.

At the end of the day, if you don't have some confidence in where the business will be in 10 years, you are relying on greater fools.

Paragraphs of wisdom

The second and more important development relates to the shift of investment emphasis from values established by the past record to values to be achieved solely by future growth. This would be an entirely logical proceeding if security analysts and investors could be sure that their predictions of future earnings changes are reasonably reliable. An accurate forecast of the long-term future is infinitely more valuable than the most elaborate dissection of the past. But we are skeptical of the ability of all but the most gifted analysts to chart with precision the growth rate of a given company for many years ahead. A large part of the market's valuation of our most popular common stocks is closely tied in with prophecies as to their future rate of growth; were the earnings actually to increase much more slowly than anticipated or not at all, the value justified by the past rate of earnings alone would be only a minor fraction of the price the "investor" pays.


- Benjamin Graham, Security Analysis

Buffett's Rule

One rule that is often sited is "Invest within your circle of competence."

I think I've  been taking the wrong approach to this, trying to figure out what I'm really good at.

I think the inverted approach to the problem, trying to figure out what type of stuff I'm NOT good at, would be a better idea in many sense.   

TARP

Apparently TARP's been making money.. (WSJ)

Now I'm wondering... how will they retire this fund? Especially for equity investments? Will they force companies to buy the shares back?

It might sound easier for the debt but that's still a huge chunk of payment for companies down the road. In the meantime, they have to generate enough cashflow. Is that realistic in this type of environment?