In this issue:

Warren Makes a Bet

It's All About Values
Hedging Your Bet
Mean Reversion of National Wealth
New York, Las Vegas, and Sweden
The Sage of Omaha made a bet that was written up in a recent Fortune magazine article.
Basically, Warren Buffett bet that the S&P 500 would outperform a group of funds of hedge funds
over the next ten years. A million dollars to someone's favorite charity is on the line. This week we
will analyze the bet, using it as a springboard to learn about valuation and value investing. As we
will see, there are times that making a bet on the S&P 500 to outperform hedge funds (or bonds
or real estate or whatever asset class) makes sense and times when it doesn't.

But first, an apology is in order. I get to travel a lot with my daughter and business partner Tiffani
(actually, she runs the business) and meet new people. Over the years, she has become as
fascinated as I have with their individual stories. Everyone has a story to be told or a lesson to
teach. We have decided to write a book about those stories, looking at the differences in
perspective between old and young, retired and working, those who are wealthy and those who
aspire to wealth. What are the differences in attitudes, in work habits, in how you manage money,
in how you look at the future, and a score of other items? How do all of these things correlate?

We sent an email to some of you a few days ago, asking you to fill out a survey to help us gather
data, with the intention of sending it to everyone over time. After you complete this survey, I offer
an audio stream of a speech I recently made.

The survey software we're using had been stress tested to handle 50,000 surveys in a 24-hour
period. For whatever reason, though, the server on which the survey was hosted simply collapsed
under the number of people trying to complete the survey and listen to the speech.

I am sorry about the frustration some of you had not being able to get into the survey. We are
working on getting the problem fixed and will send an email out sometime next week with a
properly working link. I am really quite excited about this project, as we will all learn a lot, Tiffani
and I most of all. Thanks for your help, patience, and indulgence.

Warren Makes a Bet

The Motley Fool did a foolish thing and made me one of five nominees for Investor of the Year for
2007. Warren Buffett of course won, but I was surprised (as was The Motley Fool) that I came in
second. Buffett is the clear winner in investing, and his wisdom is followed by a large legion of
fans, among which I am one. So, let me get myself in trouble and disagree with him on a small
matter.

Carol Loomis (one of my favorite financial writers) writes in this week's Fortune about a bet that
Warren Buffett made with a hedge fund management company. You can read the fascinating
story at [Link]
Quoting:

"And to that there is a certain history, which began at Berkshire's May 2006
annual meeting. Expounding that weekend on the transaction and management
costs borne by investors, Buffett offered to bet any taker $1 million that over 10
years and after fees, the performance of an S&P index fund would beat 10 hedge
funds that any opponent might choose. Some time later he repeated the offer,
adding that since he hadn't been taken up on the bet, he must be right in his
thinking."

A New York firm, Protégé Partners, which manages $3.5 billion in a fund of hedge funds, decided
to accept that bet. Basically, Buffet and Protégé each put $320,000 into 10-year zero-coupon
Treasury bonds that will be worth $1 million in 10 years. The bet is straightforward. Protégé has
chosen five funds of hedge funds, and these funds must return more than the S&P 500 over the
10 years beginning January of 2008. (The list of funds is a secret.) The winner gets the $1 million
donated to their favorite charity.

Which way would you bet? If the online response at Fortune is any indication, 90% of you would
bet with Warren. As one enthusiastic responder wrote, "How can you bet against Buffett? I'd bet
my life savings on it ..." Well, Tom, you might want to hedge your bet. Even Warren said he thinks
his odds are only 60%.

The basic premise to Buffett's position is that the high fees simply eat up any potential for extra
profits, over those of a simple index fund. As Buffett writes:

"A number of smart people are involved in running hedge funds. But to a great
extent their efforts are self-neutralizing, and their IQ will not overcome the costs
they impose on investors. Investors, on average and over time, will do better with
a low-cost index fund than with a group of funds of funds."

And he is right about the fees. Hedge funds, and especially funds of funds, must do much better
than average to overcome their high fees. Loomis sums it up as follows:

"As for the fees that investors pay in the hedge fund world - and that, of course,
is the crux of Buffett's argument - they are both complicated and costly. A fund of
funds normally charges a 1% annual management fee. The hedge funds it puts
that money into charge an annual management fee of their own, which for funds
of funds is typically 1.5%. (The fees are paid quarterly by an investor and are
figured on the value of his account at the time.)

"So that's 2.5% of an investor's capital that continually goes for these fees,
regardless of the returns earned during a year. In contrast, Vanguard's S&P 500
index fund had an expense ratio last year of 15 basis points (0.15%) for ordinary
 shares and only seven basis points for Admiral shares, which are available to
large investors. Admiral shares are the ones ‘bought' by Buffett in the bet.

"On top of the management fee, the hedge funds typically collect 20% of any
gains they make. That leaves 80% for the investors. The fund of funds takes 5%
(or more) of that 80% as its share of the gains. The upshot is that only 76% (at
most) of the annual return made on an investor's money accrues to him, with the
rest going to the ‘helpers' that Buffett has written about. Meanwhile, the investor
is paying his inexorable management fee of 2.5% on capital.

"The summation is pretty obvious. For Protégé to win this bet, the five funds of
funds it has picked must do much, much better than the S&P."

True. But the growth of hedge funds and fund of funds suggests that some think there is value
there that is worth the fees. But let's set aside that argument for now, and look at the prospects
for the bet between Protégé and Buffett.

It's All About Values

As I wrote in Bull's Eye Investing ([Link]) and occasionally stress in my writing, the long-
term returns you get from index fund investing are very highly correlated with the P/E (price to
earnings) ratio at the time you make your initial investment. The P/E is price divided by earnings.
If the ratio is 10, then earnings are about 10% of the stock price. If the ratio is 20, they are about
5% of the stock price. The higher the price, the less earnings you get for your invested dollar.
However, a rising P/E ratio can be a major boost to stock market returns.

If you make your investment when valuations are low, you return is going to be much higher over
time than if you make your investment when valuations are high. Look at this graph from South
African partner Prieur du Plessis of Plexus:
Prieur divided the S&P 500 into five groups based on the initial P/E ratio and then calculated what
the returns would be for the next 10 years, after inflation. He also used a 10-year average of the
P/E ratio, to take out the fluctuations caused by one-off events, recessions, etc.

As you can see, and long-time readers should expect, if you invest when stocks are at their
cheapest, you can make a remarkable 11% on average for the next 10 years after inflation. As
stocks get more expensive in terms of their P/E, returns begin to fall. Real returns for the last
group are only 3.2% on average.

We are currently in the range of the highest valuations. If you make the generous assumption that
inflation will be 3% over the next decade, you are talking about a 6% total return, based on
historical averages. Not bad, but not what a lot of investors are hoping for. Remember that 6%
number, as we will revisit it in a moment.

One of my basic premises is that we need to look at markets in terms of valuation and not just
price. Markets go from high valuations to low valuations and back to high. The round trip can take
the better part of 30-40 years. These are long-term secular markets, and they are mean-reverting.
By that I mean that markets will go both well above and well below the long-term mean average
over time.

To see how well correlated long-term returns and P/E ratios are, you can go to
[Link] and click on the link where it says "get the stock market graphs here"
on the upper right-hand side. You can see what your returns would have been in any period of
time since 1900. Then check at the top to see what the P/E ratio was at that time. If the return
numbers are white, then P/E ratios were falling and returns were either negative or low. When the
numbers are black, that means P/E ratios were rising, and returns are also likely to be good.

Look at the following charts from Vitaliy Katsenelson (author of the most excellent book Active
Value Investing, and one I recommend to anyone interested in value investing. [Link])

Again, these are 10-year trailing P/E ratios. Notice how the P/Es always go back below the
average? And we are a long way from the average now. There are two ways that we can get back
to low P/Es. Either the stock market can go down or earnings can go up faster than prices (or
some combination thereof). The stock market bottomed in 1974 in terms of price, but in terms of
valuation the market took another eight years to get to its low. Then in 1982, with valuations
below 10, the stock market was a coiled spring ready to explode.

Let's look at one more chart from Vitaliy. This chart shows the one-year trailing P/Es. Today, if you
go to the S&P 500 tables at Standard and Poor's, you find the current P/E ratio is a heady 22,
with the long-term one-year average being 15.2. There is a long way to go before we get to
anything we can call mean reversion.
Hedging Your Bet

Now, let's look at how Warren's bet would have done in the bull market years of 1990-99. We will
compare how a fund of hedge funds index from [Link] did between 1990 and 1999, to
the S&P 500.

(Note: these hedge fund indexes are representative of funds of funds in general, but you cannot
invest in them. They have problems like survivor bias; they don't have all the fund of funds, just
the ones that report, etc. Past performance is not indicative of future results. Further, the hedge
fund climate is much different today than in 1990. But the indexes are the best proxy we can find
if we want to do a comparison.)

The S&P 500 rather handily beat the hedge funds. The S&P 500 went from 353 to 1469 in those
10 years, for an average total return (including dividends) of 433%, or an average 18.2% a year.
The hedge fund index returned 14% a year for a total return of 271%, net of fees. The standard
deviation for the S&P 500 was 13.38% and for the hedge funds was a lower 7.87%, so the hedge
funds were a lot less volatile. Still, buy-and-hold index investors were rewarded for the risk. The
chart below shows how $1,000 invested might have grown over the 10 years.
Now, let's look at the last 10 years, from May 1998 to May 2008. Here we use a fund of funds
index from [Link]. Now, we find a different story. The market returned 4.21% on
average, or a total of 51%, with a standard deviation of 14.7%. The hedge fund index returned
7.7%, with a standard deviation of 5.1%. So, you got a lot less return with a lot more volatility, if
you stayed with the S&P 500.
Of course, there was a nasty bear market in 2000-2002, and a roaring bull market in the 1990s.
But let me make one observation. In 1990 the P/E ratio was 15 and had been below 12 just a few
quarters earlier. In 1998 the P/E ratio was 27.8, almost double what it was eight years earlier. A
lot of the difference came from the starting point of stock market valuations.

Where are we today? The P/E ratio is 23.2. Earnings are dropping as we work our way through a
very tough economy. As I have written elsewhere, I think the recovery, such as it is, will take at
least two years before we can get back to 3% growth, because the twin bubbles of the housing
market and the credit crisis will take at least two years to work themselves out. 1-2% growth in
GDP for the next two years is not an environment for significant earnings growth. It is also not an
environment in which stock markets are likely to thrive.

Roughly 20% of the S&P is financial stocks. Do you think they are likely as a group to start
reporting robust earnings growth over the next two years? They are deleveraging, which will not
help earnings growth. There are more write-offs to come. A significant portion of the S&P is tied to
US consumers, who are pulling back. On the other hand, there are some very large multinational
corporations that are benefitting from a weak dollar, as both their exports rise and their foreign
subsidiaries profit.

But the climate is not favorable to robust earnings growth for the next few years. That will make it
tougher for the stock market to keep up with the funds of hedge funds.

Mean Reversion of National Wealth

One more thought pointed out to me by Woody Brock: National wealth is a mean-reversion
machine. That is a fundamental basic truth in economics. Over very long periods of time (multiple
decades), growth in national wealth will equal growth in nominal GDP. And by national wealth, I
am referring to our homes, stocks, bonds, real estate, etc.

Now, nominal GDP has been running about 5.5% for a long time. But between 1981 and 2006,
US national wealth grew at an astounding 7.2%, from $10 trillion to $57 trillion. Mean reversion,
or getting back to the average, means that national wealth must dip below 5.5% for an extended
period of time. Woody thinks that from 2009 to the end of the next decade, we could see national
wealth grow between 2.5-3%, well below our recent experience. National wealth is likely to fall
this year and maybe next as housing values drop. This drop in wealth and slower growth means
that consumers are not likely to return to their previous "shop till we drop" mode. And that is a
serious pressure on earnings.

Graham taught us that in the short run the stock market is a voting machine, but in the long run it
is a weighing machine. And what it weighs are earnings.

I have little doubt that earnings will rise at 6-8% on average over the next 10 years. The 1990s
saw earnings more than double over 10 years, and the back of my napkin says that is around 8%
annualized growth, although earnings dropped by 50% over the next three years. Over the very
long run, earnings are going to grow at the level of nominal GDP, or around 5.5-6%.

For the stock market to do more than 6%, P/E levels would have to rise to even loftier levels than
at present. Can it happen? Sure, it did in the late '90s; but we saw how that ended.

Let's go back to the graphs from Katsenelson. If P/E ratios continue the process of mean
reversion and continue to fall, that will be a serious headwind for stock market growth. And we
have no example in history where valuations did not revert to the mean. That doesn't mean that
this time it couldn't be different. But that is not usually the way to bet.

If it was 1990 and a lower P/E, or 2002 and low P/Es (on a normalized basis), when the stock
market outperformed the hedge funds, then I would not want to bet against Warren. But with
today's valuations, a Muddle Through Economy staring us in the face for the next two years, a
potential and serious tax increase in 2010 that would prolong any recovery and be even more
problematical for earnings and stocks, I think the absolute-return funds will win this time.

In the end, it will depend on how good the funds of funds are that Protégé picked, but these are
savvy managers. They want to win, and I bet they picked the best they could find. We will find out
each year at the annual Berkshire meeting how the bet is coming along. Right now, the market is
down 10% and the hedge funds are down about 2%, but this is a long race. The first five months
mean very little.

But the real winners will be the charities they have picked. And that is a good thing, not matter
who wins the bet.

Now, if Buffett bet that Berkshire will do better than the funds of funds, I would not take that bet.
But that is another story.

New York, Las Vegas, and Sweden

I will go to New York and Philadelphia to meet with managers and partners in a whirlwind two
days, and I am scheduled to do Larry Kudlow's show on July 1. Then I will be in Las Vegas July
10-12 for the annual Freedom Fest Conference, where I will speak several times; and the line-up
of speakers is as strong as for any conference I have ever been to: Denish D'Souza will debate
Christopher Hitchens; and Steve Forbes, Ron Paul, Stephen Moore (Wall Street Journal),
Charles Murray, George Gilder, John Goodman, and about 100 other speakers, each impressive
in their own right, will be there, as will 1,500 freedom-loving attendees. You can go to
[Link] and click on the list of speakers to see more and to
register. Hope to see you there.

Last October I agreed to go to Sweden , so it looks like I will be going to Europe and am going to
try and go to the Middle East as well. It looks like I will get to check off a few more countries on
my list. I am not certain what I will do in August. I try to leave the heat of Texas for cooler climes,
but am not sure the schedule will let me take off all that long.

The wedding shower for Tiffani last Saturday was fun. I got to see a lot of old friends I had not
seen for years. Where does the time go? And it was good to have the kids under one roof again,
if only for a few days.

This weekend I am going to relax and catch up on some fun reading, and play with my new Apple
MacBook Air. It is so light. I think I am really going to enjoy it.

Have a great week.

Your not believing he would bet against Warren analyst,

John Mauldin
John@[Link]

Copyright 2008 John Mauldin. All Rights Reserved

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