Milton Friedman on International Monetary Relations

Warren Buffett has mentioned frequently his concern about the twin deficits in the U.S.- the current account deficit and the budget deficit. The current account essentially refers to our balance of trade with other countries. The United States current account deficit has significantly increased lately, in both nominal terms and in terms of GDP. (See chart) The budget deficit refers to our government's income account, and the fact that it spends more than it receives through taxes.
On the current account, I came across this Milton Friedman analogy and discussion from his book, Capitalism and Freedom:

In discussing international monetary relations on a more general level, it is necessary to distinguish two rather different problems: the balance of payments, and the danger of a run on gold.(note:read dollar today) The difference between the problems can be illustrated most simply by considering the analogy of an ordinary commercial bank. The bank must so arrange its affairs that it takes in as service charges, interest on loans, and so on a large enough sum to enable it to pay its expenses- wages and salaries, interest on borrowed funds, cost of supplies, return to stockholders, and so on. It must strive, that is, for a healthy income account. But a bank which is in good shape on its income account may nonetheless experience serious trouble if for any reason its depositors should lose confidence in it and suddenly demand their deposits en masse. Many a sound bank was forced to close its doors because of such a run on it during the liquidity crises described in the preceding chapter.
These two problems are not of course unrelated. One important reason why a bank's depositors may lose confidence in it is because the bank is experiencing losses on income account. Yet the two problems are also very different. For one thing, problems on income account are generally slow to arise and considerable time is available to solve them. They seldom come as sudden surprises. A run, on the other hand, may arise suddenly and unpredictably out of thin air.
...
There are four, and only four ways, in which a country can adjust to such a disturbance and some combination of these ways must be used.

1. U.S. reserves of foriegn currencies can be drawn down or foreign reserves of U.S. currency built up...
2. Domestic prices within the U.S. can be forced down relative to foreign prices...
3. Exactly the same effects can be achieved by a change in exchange rates as by a change in domestic prices...
4... Instead, direct governmental controls or interferences with trade could be used to reduce attempted U.S. expenditures of dollars and expand U.S. receipts.

Warren has said that he expects 3 to happen, through a fall in the U.S. dollar exchange rate, and this is probably right. 1 has already happened on a large scale through foreign accumulation of U.S. dollars, and central banks have been weary about continuing to build up their reserves. 4 could happen through tariffs, such as the one trying to be brought up against China for their undervalued currency. Or there is 2, which is essentially deflation. Regardless of which combination is taken, it is clear that the effects of a persistent current account deficit are all troublesome.

Fairfax CDS Gains Demystified

Over the past few days, I have been posting about my expectations for huge gains in Fairfax's Credit Default Swap portfolio based on the terrible news the underlying companies have been reporting and the sharp drops in their stock prices. But the actual gains was still up for speculation because I could not find information on the actual credit default spreads for these companies. Well today, I received just that.
(Note: Current day refers to Oct. 26)

Spaced out by Oct'06- June'07- July'07- Sept'07- Current Day

Ambac 11- 47-152- 180-478

AIG 10- 13- 53- 32- 53

Countrywide 36- 67-136- 260-410

Freddie Mac 5- 9- 27- 17- 25

MBIA 22- 65-160- 132-302

MGIC 30- 70-206- 163-381

PMI 30- 45-106- 132-318

Radian 32- 72-216- 379-784

Washington Mutual 22- 41-82- 91- 154

The scale for the table and the chart use the last day of the month, and Fairfax's last CDS update was on July 31st. So if you compare the July '07 numbers with the current day numbers, you can get a sense for just how much some of these positions have appreciated.

Recent News Concerning Holdings

SFK Pulp Fund
Pope and Talbot announced $20 Increase in NBSK pulp effective immediately.

Harvest Natural Resources
Chavez has signed the new conversion agreement for Harvest, eliminating some of the political uncertainty over the stock.
Crude Oil rises to a record $92.40, adding more margin of safety to the Net Present Value calculations.

Fairfax Financial
Since my last update on Fairfax's CDS portfolio 10 days ago, some more bad news has popped up.

Countrywide Loses 1.2 Billion, Expects Turnaround. I'm not so optimistic.
MBIA posts a 3Q Loss.
MGIC slashes dividend 90% after 3rd quarter loss.
AIG may take a 9.8 billion dollar sub-prime mortgage hit. I was not sure when I saw AIG in their CDS portfolio if this position was meant as a hedge for recievables or as an investment. This seems to point to the latter.

Signs of a Bubble?

There are several names that are trading at very extreme valuations in today's market. The overall theme behind these companies is technology (again) and China. Some of these may have good growth prospects, but their moats seem relatively weak and at these prices the risk for shareholders is large.

Company Ticker / Price to Earnings / % gain in last 3 months (approx.)

ISRG / 107 / 130%
AMZN / 104 / 50%
APPL / 47 / 80%
CME / 47 / 25%
SPWR / 593 / 100%
JRJC / 587 / 600%
BIDU / 210 / 180%
CTRP / 95 / 57%
SINA / 73 / 57%
VMW / 224 / 100%
RIMM / 78 / 140%

John Bogle, "Black Monday and Black Swans"

This was posted on Reflections, but I liked it a lot so I'm repeating it here. It gives very in depth coverage on a variety of important issues.

I’ve taken you on this long trip through risk and uncertainty, not only because I find these ideas both important and intellectually stimulating, but because they set the stage for my discussion of the concerns I hold today regarding our financial system and our society. I recognize that some of these ideas are complex, so let’s summarize the ground we’ve covered so far:
1. Black Swans—extreme and unexpected outcomes—are part of investing, and can’t be predicted in advance.
2. As Karl Popper recognized, not only our market, but science itself, depends not on
observations confirmed by verification, but on wild conjectures sharpened by falsification (proof that the theory is wrong).
3. Frank Knight focused on a critical distinction between risk—which is subject to
measurement—and uncertainty—which is not.
4. Stock market returns, in the short-term, are not normally distributed, but are explained by the fractal patterns discovered by Mandelbrot. We can’t ignore the possibility—indeed, the virtual certainty—that such extreme patterns will persist, and we never know when.
5. Keynes’s insight was to separate stock returns into two elements, enterprise—subject to a reasoned financial analysis and speculation—the madness of crowds—which, he argued, would become increasingly dominant.
6. Bogle (if you will) applied numbers to Keynes’s insight, showing that future investment returns were subject to reasonable expectations, and that even speculative returns tended, over time, to move toward zero.
7. Minsky added a sobering note: the financial economy, focused on speculation, was not separate and distinct from the productive economy, focused on enterprise. Rather, the former would come to overwhelm the latter.

Direct Link

On Housing

It seems like a good idea to understand more about the housing market for many reasons. For one, it is a big source of consumer wealth, and some have estimated that we can see a four trillion decline in household real estate wealth by the time the current cycle is over. This would have secondary effects on all sorts of industries. But more importantly for investors, the 52 week low list is flooded with financial, real estate, and homebuilding names, so understanding this industry will be important in making informed investment decisions. Thanks to Calculated Risk for the charts and well, almost everything I've learned.

The housing boom from 2000-2006 saw huge gains in home prices, but it also saw a huge increase in sales activity. On that matter, it is important to understand there are two widely published metrics, new home sales and existing home sales. New home sales are houses being sold for the first time, while existing home are homes that are being re-sold. Both have had big increases during the current boom. (See charts below)


With Existing home sales, what is surprising is how much this sales activity has increased recently. You would naturally expect a certain level of existing home sales as people decide to move to new areas. But people are basically selling one home and moving to another. So, we can point to a few causes for the increase in sales activity. One cause is that the current environment made the housing market more flexible, with some people wanting to move up and others to move down. Easy credit made the first one possible, while taking profits on the current boom is probably the cause of the second one. A more likely cause is that there has been an increase in real estate speculators, who have been buying a house with the desire to flip it in a short period of time. We can see this in the recent HMDA Data Analysis , which I quote:

After declining in the early 1990s, the share of non-owner-occupant lending among first-lien loans to purchase one- to four-family site-built homes began rising in 1994, and it has risen in every year between 1996 (when it was 6.4 percent) and 2005, when it reached 17.3 percent (table 8). For 2006, the share fell somewhat, to 16.5 percent.

We see that the share of mortgage originations being made by real estate investors has increased dramatically. But, and I think this is getting to the heart of the matter, every new house, whether owner-occupied or investment, requires someone to live in it. So ignoring second home purchases, which is a very small minority, this leaves the pool of non-homeowners to look towards. And the important thing to remember is the main thing stopping this group from owning a home is affordability. Every year, a certain amount of people rises into the affordability territory, and so we have new homes and new mortgages.(More on this below) But the recent boom expanded well beyond that into the group of people who could not afford their purchase. So the recent boom has on one hand, relied on increasing sales to the non-homeowner group which can not afford it; On the other hand, it has made it even harder for this group to afford the houses they want to buy. The fault for this lies in easy credit. In one situation, this allowed "sub-prime" borrowers to get a low adjustable rate with the hope of selling the house for a profit when the time for a reset came. The idea was never mentioned to them that if houses did appreciate during their low-interest period and they sold out for a profit before their reset, that any of their gains would just have to go towards paying for a new, now more expensive home. Similarly, we have the real estate "investor",(I use the term loosely) who pushes up the price of homes only to rent it out to someone who could not afford to purchase a home themself. In a way, the investor has financed the well-being of the rentor by paying the interest on the house and then renting it to someone for less.

So, the recent boom saw a huge increase in speculation and turnover, which to diverge again for a second, resulted in a huge increase in frictional costs. In the end, there are X number of homes that will provide shelter to Y number of people. A nationwide game of musical chairs with homes does nothing but make your real estate agent and your mortgage brokers rich. It is a similar situation to a stock market, where increased turnover isn't increasing the value of the businesses you are trading- it is just making your broker rich.

Besides the huge increase in turnover, but there was also some very wrong market signals being sent. We see this in new home sales. Historically, new home sales has always fluctuated within a range of 400,000 and 800,000 units. The reason being that over time there is an increase in the amount of people that can afford to purchase a home because of rises in standard of living and overall population increases, and this number of people has been relatively consistent throughout history. The recent boom went into unchartered territory:


There has been a large increase in new homes sales, but this was mostly achieved by appealing to people who could not afford it. The cycle was maintained as long as house prices went up, but it can only last so long. Lending to people who cannot afford their "true" interest or principal payments is unsustainable.

Where we stand today. There is a large supply of homes that will come on the market, and the market will need some time to absorb this recent boom and adjust to a more reasonable price. I do not know how much home prices will fall, but I would say 20% would not be unthinkable. That would be a 4 trillion decline in Household wealth. I would expect new home sales to have to considerably slow down even from today's levels if the excesses of this boom is to be absorbed. Until I see that, I would say it is too early to be investing in most of these homebuilders, real estate companies, and financial firms, given the uncertainty and the potential downside.

On a final note, here is a chart of an ABX index tracking AAA-rated mortgage backed securities. People should be very concerned that these are now trading at almost 85 cents on the dollar.

Coming soon, a look at Countrywide Financial and what must be some rose-tinted glasses they are wearing.

UPDATE* Stock Market Capitalization to GDP

While rummaging around for Buffett quotes, I ran into this 2002 interview with Buffett on the stock market. Besides an overall interesting perspective on the markets, one particular thing I noted:

On a macro basis, quantification doesn't have to be complicated at all. Below is a chart, starting almost 80 years ago and really quite fundamental in what it says. The chart shows the market value of all publicly traded securities as a percentage of the country's business--that is, as a percentage of GNP. The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment. And as you can see, nearly two years ago the ratio rose to an unprecedented level. That should have been a very strong warning signal.
For investors to gain wealth at a rate that exceeds the growth of U.S. business, the percentage relationship line on the chart must keep going up and up. If GNP is going to grow 5% a year and you want market values to go up 10%, then you need to have the line go straight off the top of the chart. That won't happen. For me, the message of that chart is this: If the percentage relationship falls to the 70% or 80% area,
buying stocks is likely to work very well for you. If the ratio approaches 200%--as it did in 1999 and a part of 2000 -- you are playing with fire.
As you can see, the ratio was recently 133%. Even so, that is a good -sized drop from when I was talking about the market in 1999. I ventured then that the American public should expect equity returns over the next decade or two (with dividends included and 2% inflation assumed) of perhaps 7%. That was a gross figure, not counting frictional costs, such as commissions and fees. Net, I thought returns might be 6%...

Now this isn't the first time we've seen someone make this argument. Prem Watsa has been making this case too:

The U.S. market capitalization is still at about 120% of GDP, down from over 170% in
2000 but way above its 80-year average of 58% and even higher than its 1929 high of 87%!!

This was from the 2005 Annual Shareholder Letter. Since then he has also made the point in several investor presentations, which I don't have readily available. Still two great investors like to look at this measure, so it is worth understanding what it means and the possible flaws.

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*Update
Here is the original Warren Buffett on the Stock Market, 1999.

As you can see, corporate profits as a percentage of GDP peaked in 1929, and then they tanked. The left-hand side of the chart, in fact, is filled with aberrations: not only the Depression but also a wartime profits boom--sedated by the excess-profits tax--and another boom after the war. But from 1951 on, the percentage settled down pretty much to a 4% to 6.5% range.
...
Today, if an investor is to achieve juicy profits in the market over ten years or 17 or 20, one or more of three things must happen. I'll delay talking about the last of them for a bit, but here are the first two:

(1) Interest rates must fall further. If government interest rates, now at a level of about 6%, were to fall to 3%, that factor alone would come close to doubling the value of common stocks. Incidentally, if you think interest rates are going to do that--or fall to the 1% that Japan has experienced--you should head for where you can really make a bundle: bond options.

(2) Corporate profitability in relation to GDP must rise. You know, someone once told me that New York has more lawyers than people. I think that's the same fellow who thinks profits will become larger than GDP. When you begin to expect the growth of a component factor to forever outpace that of the aggregate, you get into certain mathematical problems. In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well. In addition, there's a public-policy point: If corporate investors, in aggregate, are going to eat an ever-growing portion of the American economic pie, some other group will have to settle for a smaller portion. That would justifiably raise political problems--and in my view a major re slicing of the pie just isn't going to happen.

He goes on to say also that besides these two factors, a stock should also appreciate at the rate of GDP. So between these two articles, we can get a good understanding of the factors Warren Buffett looks at when valuing the general market.

1) The relationship between current yields on government bonds and yields on common stocks. If the spread on these is large, you could expect to have long run performance gains from their convergence.
2) The future direction of interest rates
3) GDP growth
4) After-tax corporate profits as % GDP

And as for where we stand today:
1)
30 year bond yield- 4.69%
S&P500 earnings yield- 5%

2) Current yield is at 4.69%. Where we are going? (more below)
3) We appear heading for a period of either slower growth or recession at the moment.
4) After tax corporate profits are currently at 8.3%, which is the upper extreme of the historical range.

So using the Buffett approach, it is hard to make a case for large gains in the stock market. The yield difference between stocks and bonds is very minimal. If you assume interest rates remain constant, then you will need either GDP to grow or for corporate profits to take a larger portion of GDP, something which is Buffett discusses as very unlikely above. If we're optimistic and use the 5% GDP nominal growth over the next 10 years, then that appears to be what we can expect to earn. Unless, the future direction of interest rates goes down. Predicting future interest rates seems much more difficult, and Buffett does not give any insight into this. I'll have to look more into this.

Finally, below is an up to date stock market capitalization as % of GDP chart from Fairfax's 2007 Annual Shareholder's Meeting.

Why Buffett Sold Freddie Mac

Someone asked about this earlier. The article has been posted on Reflections.

Years before Freddie Mac was rocked by an accounting scandal, billionaire investor Warren Buffett got on the phone with Freddie Mac chairman Leland C. Brendsel and explained why he was selling shares of the giant mortgage funding company.

Brendsel had made pledges about earnings growth at Freddie Mac, and Buffett was apparently worried about where such promises might lead.

Warren Buffett warned in 2000 that institutions with "a primary goal of earnings growth get into trouble... All my history is that all institutions that have a primary goal of earnings growth get into trouble... If you put a gun to my head, I would produce the earnings..."

According to Brendsel's notes, as Buffett prepared to part ways with Freddie Mac, he told Brendsel he was "grateful for the money you made me" and offered some characteristically pointed homespun advice: "If you really want a marriage to last, you want to marry someone with low expectations..."

Canfor Pulp Third Quarter Earnings Report

Canfor reported overall solid results for the quarter. The average Canadian/US exchange rate for the quarter was .957, but the rate is currently at 1.03. As for the outlook:

We expect pulp prices to remain within a narrow range over the balance of 2007 and 2008. The escalating value of the Canadian dollar and the Euro, versus the US dollar, will motivate pulp producers in these countries to try to push prices higher. However, paper demand growth has weakened, and papermakers are struggling to remain profitable. Further, there is new hardwood pulp capacity entering the market from the southern hemisphere. This could cause some price slippage in hardwood pulp markets which could also put pressure on substitution of hardwood pulp for softwood pulp.

At the new exchange rate, SFK's yearly free cash flow would be closer to 20 million now. Meanwhile, a few high cost producers are still hanging on, despite operating at huge cash flow losses. I can see now why- these producers (Pope and Talbot, Tembec) have huge debt-burdens, and to just stop operations would mean a complete write off of these loans. So instead, the banks have been lending them money and asking them to continue their efforts to sell their assets. How long this will take, I do not know, but considering these assets were unprofitable at a .93 exchange rate, they must be bleeding money today. If I could share a lesson learned, supply and demand does really matter- but wait until the situation is clearly turning around and in your favor.

Fisher's 8 Investment Principles

1. Buy companies that have disciplined plans for achieving dramatic long range profit growth and have inherent qualities making it difficult for newcomers to share in that growth.
2. Buy companies when they are out of favor.
3. Hold a stock until either a) there has been a fundamental change in its nature (e.g. big management changes) or b) it has grown to a point where it no longer will be growing faster than the economy as a whole.
4. Deemphasize the importance of dividends.
5. Recognize that making some mistakes is an inherent cost of investment. Taking small profits in good investments and letting losses grow in bad ones is a sign of abominable investment judgment.
6. Accept the fact that only a relatively small number of companies are truly outstanding. Therefore, concentrate your funds in the most desirable opportunities. Any holding of twenty different stocks is a sign of financial incompetence.
7. Never accept blindly what may be the dominant current opinion in the financial community. Nor should you reject the prevailing view just for the sake of being contrary.
8. Understand that success greatly depends on a combination of hard work, intelligence, and honesty.

Bruce Lee and Warren Buffett

Recently, I posted up an article discussing the characteristics of successful people. Well, I wanted to take this Sunday night to give you some lighter reading by welcoming you to a recent obsession of mine, Bruce Lee. Bruce Lee was arguably the greatest martial artist. He took daily notes of everything he did, and it is clear he followed his training with a passion. But I did not make a write-up to talk to you about martial arts. Bruce Lee also loved philosophy, and he read about all the Western and Eastern beliefs. And he wrote a lot about his own philosophy which he had developed throughout his life. Now what is shocking is how much his philosophy coincides with that of Warren Buffett, who is arguably the best investor. And they both do share a lot of the characteristics of successful people. So below are some Bruce Lee quotes along with the Warren Buffett similarities. All the Bruce Lee quotes are from the book Striking Thoughts: Bruce Lee's Wisdom for Daily Living.

1. Bruce Lee says:

1. What does self-willed mean? Does it mean having a will of one's own? The human herd instinct demands adaptation and subordination, but for his highest honor man elects not the meek, the pusillanimous, the supine, but precisely the self-willed man, the heroes.
2. Evaluation by others is not a guide for me. Only the self-sufficient stand alone- most people follow the crowd and imitate.

Warren Buffett has said the problem with most money managers is they seek to do something in traditional fashion and be average. For example, they diversify into hundreds of stocks, they only buy names that people recognize or are fascinating, and they stick to companies that have an allure or have performed well. This way when they are wrong, they have an excuse- everyone else missed it. Buffett however disagrees with this philosophy. He looks where there is the most fear, and he has often said that there can not be group decisions in investing.


2. Bruce Lee says:

We should devote ourselves to being self-sufficient and we must not depend upon the external ratings by others for our happiness. So it is true that the more we value things, the less we value ourself. The more we depend on others for esteem, the less we are self-sufficient.

If there is anyone who fits this bill, I would think it is Warren Buffett. With over 40 billion dollars, he still chooses to live modestly, drive an old Lincoln town car, and he lives in the same house that he bought in 1955.

3. Bruce says:

Intelligence is sometimes defined as the capacity of the individual to adjust himself successfully to his environment, or to adjust his environment to his needs.

Charlie Munger had this to say about their recent investments in railroads:
"Railroads – now that’s an example of changing our minds. Warren and I have hated railroads our entire life. They’re capital-intensive, heavily unionized, with some make-work rules, heavily regulated, and long competed with a comparative disadvantage vs. the trucking industry, which has a very efficient method of propulsion (diesel engines) and uses free public roads. Railroads have long been a terrible business and have been lousy for investors.

We did finally change our minds and invested. We threw out our paradigms, but did it too late. We should have done it two years ago, but we were too stupid to do it at the most ideal time."

4. Bruce Lee says:

The important thing is that I am personally satisfied with my work. If it is a piece of junk, I will only regret it.

And Buffett:
"I get to do what I like to do every single day of the year," he says. "I get to do it with people I like, and I don't have to associate with anybody who causes my stomach to churn. I tap dance to work, and when I get there I think I'm supposed to lie on my back and paint the ceiling. It's tremendous fun."

5. Bruce Lee says:

Oh I know that we all admit that we are intelligent beings; yet, I wonder, how many of us have gone through some sort of self inquiries and/or self-examining of all these ready-made facts or truths that are crammed down our throats ever since we acquired the capacity and the sensibility to learn.

For this I'll turn to what Francis Chou had to say:
"If there is a secret to the Buffett/Munger success story, it is their willingness to be brutally honest and realistic in their analyses and assessments. They are highly introspective, always checking and rechecking their assumptions and premises against reality. Executives who sugarcoat business realities and embellish results, downplay issues and disguise potential problems to investors may well fool even themselves. They start believing in their own world of make-believe. Buffett/Munger’s formidable powers of analysis would be worth nothing if they looked at problems with rose colored glasses."

6. Bruce, what about emotions?:

1. In a time when everything is goes well, my mind is pampered with enjoyment, possessiveness, etc. Only in times of adversity, privation, or mishap, does my mind function and think properly of my state. This close examination of self strengthens my mind and leads me to understand and be understood.
2. There is intelligence when you are not afraid.

Buffett had this to say:
"Two diseases that are always present in the market are fear and greed. Benjamin Graham called this phenomenon "Mr. Market" and portrayed this character as a manic-depressive, constantly swinging from fear to greed and back to fear. However, you can contain Mr. Market with the right investment philosophy. Most of all, you need the right temperament..."

7. Bruce:

Concentration is a narrowing down of the mind- but we are concerned with the total process...

Warren Buffett has said a big factor in his success is because he is not bogged down in a particular industry. This allows him to look everywhere and find where the best investment returns are available.

8. Bruce says:

1."the height of cultivation runs to simplicity. Halfway cultivation runs to ornamentation."
2."The mark of genius is the capacity to see and to express what is simple, simply!"

Warren gets an A+ on that report card. He has an uncanny ability to say things in terms that even the least investment-literate person could understand.

9. Bruce, what do you like to do with your free time?:

But most of all, I like books. I read all types of books- fiction and non-fiction.

This is what Charlie Munger had to say about that:
"Half of all the time he [Warren Buffett] spends is just sitting on his ass and reading. And a big chunk of the rest of the time is spent talking one-on-one, either on the telephone or personally, with highly gifted people people whom he trusts and who trust him."


10. And finally, perhaps Bruce Lee's most important message to his students:

1.By an error repeated throughout the ages, truth, becoming a law or a faith, places obstacles in the way of knowledge. Method, which is in its very substance ignorance, encloses it within a vicious circle. We should break such circles not by seeking knowledge, but by discovering the cause of ignorance.
2. All fixed patterns are incapable of adaptability or pliability. The truth is outside of all fixed patterns.
3. I am no longer interested in systems of organization. Organized institutes tend to produce patternized prisoners of a systematized concept, and the instructors are often fixed in a routine. Of course what is worse is that by imposing the members to fit a lifeless pre-formation, their natural growth is blocked.

This is what first attracted me to Bruce Lee. Basically, he believed every moment and every instance should be treated as its own, and we should think instead of being bound by a pattern of doing things. I saw in this belief the counter to the idea brought up in The Black Swan, which stressed that systems cause us to get caught in a certain way of thinking and eventually leads to people getting blindsided. It is only through thinking and understanding that we grow. And when we make prejudices about something or accept a statement without understanding it, we are denying ourselves the truth.

Tectonic Shift, Part II

Sivaram Velauthapillai commented on Part I of Tectonic Shift saying:

Globalization, and basically free markets, will equalize the wages (same job will pay same wages within reason) and return on capital (capital can easily flow anywhere nowadays). Wages are downward rigid (due to a whole bunch of reasons) so they won't drop in developed countries. Instead, wages in developing countries will rise.

This idea that wages are downward rigid was best explained by John Maynard Keynes, who thought it was the source of a lot of our economic problems. He stated that individuals did not like to take a cut in their pay to help adjust during recessions. So employers would just fire them instead, and this would magnify the economic problem.

But the part I wanted to talk about was the last statement. It seems plausible that if the developed world would not accept pay cuts that their standard of living would be maintained, while the rest of the world would see a rise in their wages. But that forgets the idea of currency exchange rates. And the US dollar has been hitting record lows, which has a direct effect on our "real earnings". So tonight, I am going to try to show some basic understanding of a recent phenomenon.

It always surprised me that with the rapid increase in globalization, we in the US have not seen a consumer prices in the US decline. Basic economics says that if production costs are declining, competition should at least pass some if not most of this down to the consumer. And then, it has also surprised me that the US could drop interest rates to 1%, or that we could be "awash in liquidity", without seeing an increase in inflation.

Well it turns out the two have actually been balancing each other out. We can see this by looking at two money supply indicators, M1 and M2. M1 is the index tracking all physical currencies and the money in readily available bank accounts. M2 equals M1 plus savings accounts, money market accounts, and other time deposits. Since 2000, M1 has increased from 1123 to 1368. M2 has had a much more significant increase from 4665 to 7372. So there has been a big increase in the money supply, and this is probably what has been offsetting the deflationary forces. Greenspan recently commented that he is afraid of inflation going forward, because a lot of the deflationary benefits of of globalization have already been felt. So, the current pace of increase in the money supply can not continue like it has before. Below is a chart showing some of this historical data.
Now conclusions get rather tricky from here, so for now I'm just going to say that this huge increase in money supply puts a downward pressure on our exchange rate. So, it would be wrong to think our developed world wages and our standards of living are protected by this unwillingness to accept pay cuts. There is a method for real developed world wages to decline, through the much more subtle means of currency exchange rates.

The Crowd: A Study of the Popular Mind (Notes)

This book is a study of the characteristics of crowds as well as the tremendous impact they can have. In terms of investing, I picked up a lot of similarities between his "crowds" and the mob-like behavior of Mr. Market. But beyond that, this work made me think a lot about how much this psychology of crowds has come up in my past experiences and in everyday life. The full text is available here for those interesting in reading the book. Otherwise, I took very comprehensive notes below- sorry for the length. Note this book was written in 1896.

Foreward
"The substitution of the unconscious action of crowds for the conscious activity of the individual is one of the principal characteristics of our time."
"Crowds, doubtless, are always unconscious, but this very unconsciousness is perhaps one of the secrets of their strength."

Intro
"Today, it is the traditions which used to obtain in politics, and the indvidual tendencies and rivalries of rulers which do not count; while on the contrary, the voice of the asses has become preponderant."
"When the structure of civilization is rotten, it is always the masses that bring about it's downfall."

Mind of Crowds
-Disappearance of conscious personality and the turning of feelings and thoughts in a definite direction.
-Characteristics common to crowds
1. People in a crowd act different than they would in isolation. Why? The greater part of our daily actions are the result of hidden motives which escape our observation.
2. People resemble each other most in their unconscious elements. It is the conscious element- education, hereditary conditions, etc- that they differ.
3. It is precisely these general qualities of character, governed by forces of which are unconscious, and possessed by the majority, that in crowds become common property. Individuality is weakened, and the heterogeneous is swamped by the homogeneous.
4. Because crowds possess common ordinary qualities, they can never accomplish acts demanding a high degree of intelligence.

-How are the characteristics formed in crowds?
1. People in crowds feel greater power due to numerical standpoint.
2. There is less responsibility when in a crowd.
3. Acts in a crowd are contagious, to such a degree that an individual will even sacrifice personal interests for the crowd.
4. Individual is no longer conscious of his acts. (They mention something similar to the Zimbardo experiment, where people kept shocking and harming other people as long as the person conducting the experiment kept nudging them foreward)
5. "Suggestions will be followed like a hypnotized person, only stronger due to reciprocity o crowd." They "immediately transform the suggested ideas into acts."

-Isolated, a person can be a cultivated individual. In a crowd, he is a barbarian, a creature acting on instinct.

Conclusion: Crowd is always intellectually inferior to the isolated indivudal, but from the point of view of feelings and acts they provoke, it can be better or worse than the individual. (ex: is the crowd performing criminal or heroic acts?)

Sentiments and Morality of Crowds
- Individual's brain shows him the inadvisability of yielding to reflex reactions. Not so in a crowd.
- Impossibility disappears for the individual in a crowd.
- Events witnessed by a crowd are easily transformed; due to contagion effect it is all perverted similarly.
- In a study by a psychologist, it became clear that witnesses in numbers may give circumstantial relations which are completely erroneous, but whose result is that, if their descriptions are accepted as exact, the phenomena they describe are inexplicable by trickery. (Basically saying, a crowd is just as likely to see an event incorrectly, but because they have so many people supporting the view it becomes impossible to deny their claim)
- People no longer see the object itself, but the image-evoked in his mind.
- Conclusion: the collective observations are unreliable.

Exaggeration and Ingeniousness of Sentiments of Crowds
- A crowd is only impressed by excessive sentiments.
- An orator wishing to move a crowd must make an abusive use of violent affirmations. To exaggerate, to affirm, to resort to repitions, and never to attemp to prove anything by reasoning are methods of argument well known to speakers at public meetings.
- Intellectually, a crowd can only go down. Sentiment can go up or down.

Intolerance, Dictatorialness and Conservatism of Crowds
- Dissent is not tolerated in crowds.
- Crowds respect force, slightly impressed by kindness.
- Crowds are in fact, conservative. They show incessant mobility only on superficial matters- they want to keep traditions and status quo.
- "Had democracies possessed the power they wield today at the time of the invention of the mechanical loom or the introduction of steam power and of railways, the realizations of these inventions would have been impossible, or would have been achieved at the cost of revolutions and repeated massacres." (I disagree, but in general we do see a lot of resistance to change)

The Morality of Crowds
- Crowds are too impulsive and mobile to be moral, but certain qualities such as abnegation, self-sacrifice, disinterestedness, devotion, equity may be exhibited.
- Individual knows he cannot gratify instincts; in a irresponsible crowd, he can. But appeals to glory, honor and patriotism are particularly likely to appeal to moral side of a crowd.
- And, if people had always satisfied their immediate interests, it is possible that no civilization would have grown up on our planet and humanity would have had no history.

The Ideas of Crowds
1. Ideas of the moment- infatuations.
2. Fundamental ideas- religious beliefs or democratic ideals.
- Ideas may be modified in order to lower them to level of intelligence of crowds. Usually in the direction of simplification.

Reasoning Power of Crowds
- Arguments of crowds are inferior in terms of reasoning.
- Associate dissimilar things possessing a merely apparent connection.
- Judgments accepted by a crowd are the ones enforced on them, not the one adopted by themselves after the discussion.

Imagination of Crowds
- "All great statesmen of every age and every country, including the most absolute despots, have regarded the popular imagination as the basis of their power, and they have never attempted to govern in opposition to it."
- To capture the imagination of crowds, don't use intelligence or reasoning. Rather, cunning rhetoric, something clear and marvelous/mysterious.

Conviction of Crowds
- Convictions of a crowd take on a sort of religious sentiment.
- At the heart of the matter is the soul of the masses

Opinions and Beliefs of Crowds
- Remote factors set up the groundwork, such as the work of philosophers, scientific thought, etc.
- Immediate factors of the moment such as speeches, resistance, etc, spark the crowd.
- Some important remote factors: race, traditions, time, institutions, education.

Race
- By far the most important remote factor.

Education
- Education does not necessarily make a man more moral or happier. Maybe more professional.
- Primary danger of the system of education is that it is based on the idea that intelligence is developed by the learning by heart of text-books. The endeavor has been made to enforce a knowledge of as many books as possible. A man does nothing but acquire books by heart without judgment of personal initiative ever being called int play.
- The conditions of success in life are the possession of judgment, experience, initiative, and character- qualities which are not bestowed by books. Books are dictionaries, useful to consult, but of which it is perfectly useless to have lengthy portion's in one's head. (my emphasis)


-Crowds are swayed by images, words, and formulas.
- As soon as living beings are gathered together, they place themselves under a chief.
- Leaders are typically men of action rather than thinkers.
- The multitude is always ready to listen to the strong willed man.
- It is the need not of liberty but of servitude that is always predominant in the soul of crowds.
- To imbue the mind of a crowd with ideas and beliefs, the leaders must use affirmation, repetition and contagion.
- Affirmation, free of reasoning, is one of the surest means to enter mind of crowd.
- Affirmation has no real influence unless it is constantly repeated.
- Napoleon: only one figure in rhetoric of serious important, namely, repetition.
(This section reminded me of the use of propaganda in Nazi Germany)
- After affirmation and opinion, a current of opinion is formed and it is contagious. Imitation is in reality an effect of contagion.

- The precise moment at which a great belief is doomed is easily recognizable; it is the moment when its value begins to be called in question. Every general belief being little else than fiction, it can only survive on the condition that it not be subjected to examination.
- The opinions of crowd tends to become the supreme guiding principles in politics.
- The idea of prestige is very important in leading crowds.
- On societies- the inevitable decline is always marked by the weakening of the ideal that was the mainstay of the race.

Update on Fairfax's CDS Portfolio

Fairfax Financial owns a large portfolio of Credit Default Swaps (CDS) on several mortgage and financial companies. These contracts protect the principal value of the debt of these financial companies in case they default. But Fairfax does not own the debt of any of these companies, so it is not being used as a hedge. Rather, the CDS portfolio is a large (18 billion notional amount) bet that these companies will face credit difficulties. Back in August, I gave a list of the companies in their portfolio. Below is an update on what has been happening to some of the companies since then.

1. Countrywide Financial
Stock Since August (1st): -39%
Countrywide to Book Restructuring Charge

Struggling mortgage lender Countrywide Financial Corp. expects to book a pretax charge ranging from $125 million to $150 million related to its plan to slash thousands of jobs amid rising defaults and foreclosures.
...

Last week, Countrywide disclosed its mortgage fundings for September fell 44 percent from the same period a year ago.

Countrywide also reported a higher percentage of delinquencies between August and September in its loan servicing portfolio, which accounts for nearly 14 percent of all mortgage debt in the U.S., along with a higher number of loans in foreclosure.

Note that this charge doesn't even deal with provisions or loan write-downs. This is just for severance expenses. I'm looking forward to the 3rd Quarter report on October 26th.


2. PMI Group
Stock Since August: -32%
PMI Group to Swing to Loss in 3Q

Mortgage insurer PMI Group Inc. said Thursday it expects to report a net loss of $1.05 per share for the third quarter due its weakening mortgage insurance business and writedowns on derivatives.

3. Washington Mutual
Stock Since August: -19%
WaMu profit sinks 72%, sees more housing slump
From Calculated Risk:

"This is perhaps the most challenging cycle for housing that we've seen in many decades," WaMu Chief Executive Kerry Killinger said in an interview. He and other WaMu executives said they don't see any improvement in the near term.

"I have never seen housing credit conditions change so significantly over such a short period of time, nor can I remember a period when there was less clarity about near-term housing and credit trends," [Chief Financial Officer Tom] Casey said

4. MGIC Investment
Stock Since August: -30%
MGIC Investment Swings to 3Q Loss

Without a decline in loss severity or improved cure rate in the coming months and because of expected paid losses, MGIC projects it will not post net income in the fourth quarter or for the full year in 2008.

5. Ambac Financial
Stock Since August: -7%
Ambac Expects 3Q Loss

Ambac Financial Group Inc., an insurer of corporate and public bonds, said Wednesday it expects to post a third-quarter loss of up to $3.50 per share, as a result of a "mark-to-market" adjustment for its credit derivative portfolio.

A Tectonic Shift?

I mentioned in my notes on "Mosaic" that there was something I wanted to talk more about:

There is currently a broad tectonic shift going on- businesses are profiting while jobs are being outsourced, but white- and blue-collar wages are eroding.

The effects of globalization is something that has been on my mind recently. This is the abstract concept I have come up with so far:

The chart below shows the annual incomes of everyone around the world. The graph is highly skewed to the right, because capital is heavily accumulated in a small proportion of people, and this disproportionately affects their income. In general though, most people rely solely on wages.


Before going on, there are two things which I think people should recognize:
1. People working in areas with more investment have higher productivity and so can be paid higher wages.
2. Even when it comes to businesses such as services which do not need capital investment, people in wealthy areas still have higher incomes because the opportunity cost of time in the region is higher- so saving the time of the people around them is more valuable. To better see this, think of a dry cleaner working in the US and in China. The dry cleaner in the US is saving more time for a wealthier population, which has higher time opportunity costs, and so this dry cleaner is paid a much higher wage than the dry cleaner in China. This is all despite the fact that dry cleaning itself does not require much capital as a business to run and both of them are essentially doing the same amount of work.

Now, what is globalization doing? Pabrai said so far it has increased profits of capital, and it is eroding the value of labor. Long term, I disagree with the first point. The increased profits from capital seem to be a temporary boost, and economic law would suggest that competition would eventually bring these back to normal levels. But globalization and technology is dramatically increasing the supply of labor, and hence competition. As a result, there is overall downward pressure on wages. But it is also balancing, because the demand for the cheapest labor is increasing while demand for rich world labor is decreasing.

All this so far has been pretty well understood in the financial community. But what I haven't heard discussed frequently is what a synchronization of (lower) wages is doing.

1. It doesn't seem unreasonable to think that this synchronization will lead to an increased demand in basic necessities, such as food, oil, energy, water, etc, as more people are able to afford these goods. In fact, this is maybe what we are already seeing here. But, increased demand shouldn't be necessarily confused with higher prices. Many of these commodities have already increased significantly from their lows. What is important besides increased demand is at what price that demand can be fulfilled. For most agricultural goods, that price is low. For oil and some other commodities, it is debatable. (Or rather, I just haven't looked into much specific data and the media never provides good answers to these questions)

2. People in first world countries seem to have maintained our standard of living by mostly saving less and borrowing against our assets. I base this mostly based on what I've seen in the United States and the United Kingdom. This is unsustainable, and eventually we will start seeing declines in our purchasing power due to the pressure on our high wages. Again, we might already be seeing that through the declining US dollar rather than direct wage decreases. This pressure would also affect the gap between service sector jobs in different countries. (think the US/China dry cleaner example again, only now the wealth of both populations are slowly converging, and so are their wages)

3. There might be a decrease in more conspicuous types of consumption, as the average first-world wages which supported this demand would be under pressure. This would also affect business profit margins, and hence investment returns.

This is all mostly abstract so far, but I think these broad trends seem fairly credible. Please do comment if you have any thoughts on the matter. I do plan on looking more into this myself. As to how this will effect investing: well, for myself personally, that would mean increased demand for both oil and pulp, two things I would consider basic necessities. But in general, I would be also worried about the deflationary pressures that this globalization can cause.

"Mosaic" by Mohnish Pabrai. (Notes)

I finally got my hands on a copy of Mosaic, and I read through it in one sitting. As Pabrai mentions in the introduction,
my perspective on writing is simple:
1. Only write about subjects one is passionate about.
2. Avoid fluff at all costs.
3. Have no set periodicity for writing

Overall, this makes the entire book a very great read. Unfortunately, it also is out of print and currently goes for $388 on Amazon. So below are the notes I took. The material from the book is in italics, and is still mostly in Pabrai's original words; sentences in brackets are my additional commentary.


The future of a business is never assured. There are always the super-low probability events. Attribute a small probability to cover for this. (ie: fraudulent accounting, meteor-strike, etc)

Avoid shorting- going against the 8 to 10% long run return of the market. More importantly, an overvalued company can naturally boost its own intrinsic value by issuing inflated stock, and you are always vulnerable to a short squeeze.
[There is usually also an additional charge from brokers for shorting, usually at about 3% per year. Overall, shorting is usually a bad proposition]

There is currently a broad tectonic shift going on- businesses are profiting while jobs are being outsourced, but white- and blue-collar wages are eroding.
[I think understanding this is very important, and I'm going to write another post about this]

Investment managers are introverted, skeptical, and very analytical
CEOs are extroverts, optimists, and leaders.
You must have a comfortable understanding of both perspectives- know the uncertainties of running a business and the importance of capital allocation and Return on Equity.

Retailing is an arbitrage between what customers want and how it can be provided to them. In general it is a terrible business because there are no trade secrets and it is difficult to assess "need". The less dependent the retailer is on fashion trends, the better.
[This third point will also be brought up in another post soon]

Problems Microsoft is facing:
1. Highly dependent on two products, Windows and Office, for all of their operating profit.
2. They face competition from themselves- their products are not getting much better.
[I feel there is probably a lot of situations where one of these problems would apply for a company]

Look at the "DNA" of your companies- a culture is hard to change. If you cant understand the financial statements, management probably does not want you to.

Some quotes from Warren Buffett on investment management:
"We don't get paid for activity, we get paid for being right. As to how long we'll wait, we'll wait indefinitely!"

"The way people extrapolate the future is stupid. Not just slightly stupid, but massively stupid."

"The best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results delivered by the great majority of investment professionals."

On avoiding fraud:
1. Avoid obtuse financial statements
2. Look out for "managed" earnings
3. Take into account when "restructuring" becomes the norm
4. Be wary of earnings guidance
5. Look at related party transactions, compensation, options
6. Try to find integrity in management
[If you want to see some of these, look at the financial industry today. They have very unclear financial statements, managed earnings, lots of "restructuring" charges, and earnings guidance which keeps being completely off]

Things to look for in management:
-lack of an ego
-speak the truth
-love for the company
-capable and energetic

In summary, look for situations where high uncertainty about the business leads to a very attractive risk proposition for shareholders.


Finally, he also recommends two books:
The Innovator's Dilemma by Clayton Christensen
The Origin and Evolution of New Businesses by Amar Bhide

What's On My Mind

Calculated Risk has been my favorite blog to read recently, but it has also been a new source of inspiration. I find the site fascinating because it covers all things finance and economics-related and appeals to a broad audience. Someone can come to the site and read some current financial or economic news along with some great insight. Or, a more interested individual can devour through the entire site, and end up with knowledge oozing out of them.

Well, this got me thinking about my own blog. This site is focused on investing, but mostly for those who are excited about the field. The average Joe passing by would probably quickly feel this site has nothing for him, and that is a shame because there are things I can teach them about, such as: 1) the impact of high management fees, 2) how heavy trading is probably only making your broker rich, and 3) the use of debt. So, I will try to also publish some important investment knowledge for a general audience in the near future. The goal is to get this across while still providing the same content for the more passionate readers.

Respone to Harvest Question

In my last update on Harvest, I said the following:

Now I'm going to conclude by throwing out one question that has been bothering me: In the reserve estimates in the valuation report, Ryder Scott attributes zero reserves for probable and possible for the original SMU fields. But if you look at the production and reserve numbers in the chart I provided here, you can see that Harvest has clearly been successful at expanding their proved reserves at their traditional SMU oil fields. So my question is, why is there no probable or possible reserves for the SMU oil fields?

The response from the company was:
In the opinion of Ryder Scott, all of the remaining reserves in the SMU fields are proved due to the extensive amount of information available regarding well control in these three fields.

So that is that. Meanwhile, some other questions that have popped into my mind:

1. Do other oil companies publish the NPV of their oil assets, and if so where do their stocks trade in relation to those numbers?

2. Venezuela's currency has a special problem- from a Bloomberg article:

The bolivar fell 0.9 percent to 5,350 bolivars per U.S. dollar in unregulated currency trading today from 5,300 yesterday, traders said. The bolivar has fallen 36 percent this year.

Venezuela pegs the bolivar at the official exchange rate of 2,150 bolivars under restrictions imposed in February 2003. People turn to unregulated markets when they can't get approval from the government's Foreign Exchange Administration Commission to buy dollars at the official exchange rate.

How is this taken into account in the Ryder Scott NPVs and should we adjust the numbers for this?

I hope the key thing readers take away from these recent posts on Harvest is that you should never just accept the number someone gives you as the value of a company (Not from the company, and not even mine!). You need to look at the assumptions yourself and challenge them, until you come up with your own number that you 1) are comfortable with, and 2) feel is fairly conservative. Keep asking questions!

Characteristics of Successful People

(hat tip to David Lau for finding this)

What makes a person successful? What makes them motivated, prosperous, a great leader?

These questions fired the writing of each book covered in 50 Success Classics, and it is possible to draw out some common threads as answers. The following is only a brief and partial list, but may whet your appetite to discover for yourself some of the principles of success.

Optimism

Optimism is power. This is a secret discovered by all who succeed against great odds. Nelson Mandela, Ernest Shackleton, Eleanor Roosevelt - each admitted that what got them through tough times was an ability to focus on the positives. They understood what Claude Bristol called 'the magic of believing'. Yet great leaders also have an unusual ability to face up to stark reality, so creating a single powerful attribute: 'tough-minded optimism'.

Optimistic people tend to succeed not simply because they believe all will turn out right, but because the expectation of success makes them work harder. If you expect little, you will not be motivated to even try.

Definite aim, purpose or vision

Success requires concentration of effort. Most people disperse their energies over too many things and so fail to be outstanding in anything. In the words of Orison Swett Marden, "The world does not demand that you be a lawyer, minister, doctor, farmer, scientist, or merchant; it does not dictate what you shall do, but it does require that you be a master in whatever you undertake."

Have higher aims and goals and doggedly pursue their realisation. As the Bible says, "Where there is no vision, the people perish".

Willingness to labor

Successful people are willing to engage in drudgery in the cause of something marvellous. The greater part of 'genius' is the years of effort to solve a problem or find the perfect expression of an idea. With hard work you acquire knowledge about yourself which idleness never reveals.

A law of success is that, once first achieved, it can create a momentum that makes it easier to sustain. As Talleyrand put it, "Nothing succeeds like success".

Discipline

Enduring success is built on discipline, an appreciation that you must give yourself orders and obey them. Like compound interest, this subject may be boring, but its results in the long term can be spectacular.

The great achiever knows that while the universe is built by atoms, success is built by minutes; he or she is a master when it comes to their use of time.

Integrated mind

Successful people have a good relationship with their unconscious or subconscious minds. They trust their intuition, and because intuitions are usually right, they seem to enjoy more luck than others. They have discovered one of the great success secrets: that the non-rational mind infallibly solves problems and creates solutions when trusted to do so.

Prolific reading

Look into the habits of the successful, and you will find that they are usually great readers. Many of the leaders and authors covered in this book attribute the turning point in their lives to picking up a certain book. If you can read about the accomplishments of those you admire, you cannot help but lift your own sights. Anthony Robbins remarked that 'success leaves clues', and reading is one of the best means of absorbing such clues. Curiosity and the capacity to learn are vital for achievement, thus the saying "Leaders are readers". The person who seeks growth, Dale Carnegie said, "must soak and tan his mind constantly in the vats of literature."

Risk-taking

The greater the risk, the greater the potential success. Nothing ventured, nothing gained. Have a bias for action.

The power of expectation

Successful people expect the best, and they generally get it, because expectations have a way of attracting to us their material equivalent.

Since our lives correspond pretty much to the expectations we have of it, the achiever will argue, why not think big instead of small?

Mastery

The advanced being can turn any situation to their advantage. They are 'masters of their souls, captains of their fate.'

When other parties are involved, they will seek solutions in which gains are maximised for all. In the words of Catherine Ponder, "You do not have to compromise in life, if you are willing to let go of the idea of compromise."

Well-roundedness

Achievements mean little if we are not a success as a person. The capacities to love, listen and learn are vital for our own well-being, and without them it is difficult to have the fulfilling relationships that we need to both renew us and inspire achievement.

Appreciating Fannie and Freddie

Reflections on Value Investing recently put up "An Interview with Richard Pzena" conducted in 2006. In it, he shares some great insight into the Government Sponsored Entities(GSEs), Fannie Mae and Freddie Mac:

Take Fannie Mae and Freddie Mac: nobody would touch these stocks. Why? There was potentially bad accounting, and the government could have pulled the plug because of the bad accounting. Did anybody ever sit there and say, “Does the accounting matter in this business.” I mean how many people looked at this and said, “You can’t use generally accepted accounting principles for this business.”

You can’t. The fact that anybody is even looking at GAAP earnings is ludicrous, including it’s a hedge fund. What are Fannie and Freddie? They’re a small number of people sitting in Washington DC who buy mortgages and fund them with debt. And the reason they make more money than anybody else doing this is because their status allows them to borrow long-term, and no financial institution can borrow long-term. Not even Citibank. If you look at Citibank’s balance sheet there’s not a lot of long-term debt on it. Fannie and Freddie’s long-term debt is callable debt, so they can pretty much match the duration of the asset and the liability side and take very little interest rate risk. Nobody else can do that so they make a spread. The regulators understand that nobody else can do that so they have a low capital requirement and earn a high return on equity. So if you invested in that fund, let’s say it was a fund instead of a stock, if you invested in that fund it would have returned 20-25% per year after-tax for the last 20 years. Pretty good business.

This is a very great advantage. In fact, almost all the problems in the banking industry come from the mismatch of short term borrowing and long term lending. Add to that the GSEs special status which makes investors feel it is essentially backed by the US government. This allows them to borrow at the rate of the US government, plus about 10 to 15 basis points. These two benefits give a huge moat around the company. But perhaps the most interesting statement is this:

"And the stock gets killed. So where does it go? It actually trades below the liquidation of their portfolio. Forget accounting, I could stop the business and earn a profit. And people are saying, “Oh my god, the business is going to stop. I don’t want to own the stock.” But it’s already selling for below what it’s worth if the business stops. And if doesn’t stop, you’re making a fortune."

Since this interview, the share prices of both companies have gone essentially nowhere, while the businesses have continued to operate, so I can only assume the discount has increased. If so, this might still be a great opportunity to get into a wide moat company at a very cheap price.

Learning From Mistakes

This week's Economist had this article about Meg Whitman, CEO of Ebay, and also her purchase of Skype:

Among the many lessons that Margaret (“Meg”) Whitman has picked up during her three decades as a businesswoman, three stand out, she told an audience at Stanford's business school last year...

The first lesson, which she learned in 1979, was that attention to detail is all important. At the time, she was fresh out of Harvard Business School and just starting her first job at Procter & Gamble. She was charged with figuring out whether the nozzle on shampoo bottles should be half or three-eighths of an inch wide. Despite the tediousness of the task, “I decided I was going to do the very best job that had ever been done at the Procter & Gamble company”

Well, this lesson is not necessarily bad. Attention to detail is usually very good, although I would argue it is much better to focus your attention on things that add or affect value, and not on whether a nozzle should be an eight of an inch different.

The second lesson occurred in 2002. As boss of eBay, she had noticed that a lot of the sellers and buyers on its site were using an online-payment service called PayPal as a sort of virtual wallet, so she decided to buy it. She negotiated for a year, during which the price kept rising. She concluded that in the internet industry one bids early, boldly and pre-emptively high.

Again, which part of that philosophy focuses on the value of what you are getting? Her statement seems to best resemble that of someone who is victim to the wild mood swings of Mr. Market. Just because you see prices rising does not mean you should be jumping in.

The third lesson was that in such a fast-moving realm “the price of inaction is far greater than the cost of a mistake.” In any case, mistakes can always be corrected. In other words, it did not matter that the “synergies” between a telephone service and an online flea-market seemed few and far between. In her view, eBay was right to buy first and look for the answers to such concerns later.

Well this one has its own Buffett counter-quote which I happen to like a lot:

"In investments, there's no such thing as a called strike. You can stand there at the plate and the pitcher can throw a ball right down the middle; and if it's General Motors at 47 and you don't know enough to decide on General Motors at 47, you let it go right on by and no one's going to call a strike. The only way you can have a strike is to swing and miss."

I think somewhere along the way Meg Whitman learned the wrong set of investing rules. She bought first and asked questions later, and she completely ignored the intrinsic value of the companies she was purchasing. The outcome:

Collectively, these three lessons have led to disaster. On October 1st eBay conceded, in the language of book-keepers, that the purchase of Skype was just that. It had paid $2.6 billion up front, and agreed to cough up yet more if Skype met certain targets. It did not. This week eBay said that it would take a $1.4 billion charge in relation to the purchase.

A 55% loss. Swing and a miss, Strike!

Utility Industry Q&A

With Prem Watsa continuing to buy more shares in International Coal Group, ICO, I've taken an interest in hoarding more general information about coal and energy in general. So, I decided to interview a real expert in the utility field- my dad. He is a top manager at the Los Angeles Department of Water and Power, and his example reminds me everyday that I can be working harder. Anyways, these are some key notes I took based off what I remember asking him.

Which is cheaper to run, a coal or natural gas plant?
A coal plant is much, much cheaper to operate. Coal costs about $30 per (?)*, while natural gas costs about $70. This is significant because fuel accounts for 95% of the costs in the industry. (*Note: I forgot the unit of measurement, but the numbers are correct)

What about capital investment costs?
Traditional coal and natural gas plants are fairly similar. But now, there is a lot more difficulty in building a coal plant because of pollution and the idea of clean energy. In fact, many of the new plants that will soon be online are natural gas plants. But, the ratio of the cost of building a very clean coal plant to a natural gas plant is about 1.5: 1.

So based on investment merit alone, which is the more logical choice?
Coal by far, even after taking into account higher capital investment costs. The main reason that you do not see more coal plants coming online though is because environmental concerns play a big part though in the process; for example, California has no coal plants and it's practically impossible to build one there.

Any other difference between coal versus natural gas plants?
Natural gas plant is much easier, and cheaper, to adjust the capacity at a plant, whereas a coal plant takes some time to get started and costs more for shutdowns/ start-ups. It is much more practical to leave a coal plant going, but then there is the problem that energy can not be stored- it must be used that instant it is created.

That seems very important?
Very. In fact most people don't understand that about the industry, and the hardest part is balancing reducing waste while also generating enough power for everyone. And that is why small recessions are actually a good thing, because we can easily reduce our highest cost capacity.

What about ideas being brought up more making coal more eco-friendly, and efficient? (I think I mentioned specifically the idea mentioned in the Economist about the use of photosynthesis)
The technology for coal to become eco-friendly is mostly there, a lot of it is just stigma, or just that power generating companies who can avoid making the additional investment would rather not make it. As for the photosynthesis idea, that has been brought to them, the problem is it is still in research phase and the research companies are trying to get them to finance the further research.

Regarding natural gas, I remember reading that energy output of natural gas to crude oil barrel is about 1 to 6. If so, why is there such a huge divergence between the two right now and will that correct?
Though it doesn't work out exactly, energy is still energy. So yes, in the long run the two should converge.

Have any insight into the production costs in the natural gas industry?
Well for over 50 years, natural gas always hovered at about $2 to $2.50. Then all of a sudden we saw a spike to $8, and now its back to about $6. I think a lot of it is just speculative money coming into it. The production costs for natural gas are still low and there is plenty more capacity.

That's the most important parts I can remember. Except also, he mentioned that in order to secure coal production his company made an investment in ICO after the mining collapse. I thought that was a great coincidence, and he could probably help me a lot if I decided to pursue the idea further. Prem keeps buying more, so I probably should look more into it.

More Info on Harvest Natural Resources

As I mentioned in my original posting a few days ago, there was going to be more research into Harvest Natural Resources. Here is some more analysis and some key notes.

First, to briefly go over the contract details:
1. Ownership of the corporate entity went from 80% to a net 32%.
2. There is now a 33.3% royalty on production.
3.Tax Rate increased from 34% to 50%.
4. Price realized increased from 47% of WTI to 70% of WTI.
5. They kept their original oil fields, and also received 3 new fields.

Now, if you look from the viewpoint of the Venezuelan government, before this change foreign companies(in general, not just Harvest) were receiving 66% of the profits from Venezuelan oil profits, while the government took only its 34% in taxes. Now, after the new royalty, foreign ownership restrictions, and tax rate, the ratio is about 13% to 87%. So the incentive to impose even stiffer terms seems to have become significantly reduced.

Second thing I wanted to mention regards the reimbursement fee. Unfortunately, most of it should not be included in our intrinsic value calculations. The reimbursement fee is supposed to make up for Harvest's costs and profits from April 1st, 2006 to the date the contract is signed. But, the NPV calculations we have been using for analyzing the oil assets are also based off of April 1st, 2006. So, this would be double counting the profits in our value calculation. We can still include the operating cost portion of the fee to Harvest though, which I estimated at approximately 25 million. Also, since it is now October 2007, there was been some increase in time value in the NPV of the oil assets, but I'm choosing to ignore that. So it is nice that we will be getting a hefty reimbursement soon, but the appropriate net cash number to use seems to be 140 million.

Now, Oil Assets. One thing I found interesting was that the Ryder Scott valuation report said it conformed to SPE/WPC reserve definitions for proved, probable, and possible. So, I looked that up and found this link. Basically, the summary of the definitions are:

Proved: "If probabilistic methods are used, there should be at least a 90% probability that the actual quantities recovered will equal or exceed the estimate."
Probable: "In this context, when probabilistic methods are used, there should be at least a 50% probability that the quantities recovered will equal or exceed the proved reserves plus the probable reserves."
Possible: "In this context, when probabilistic methods are used, there should be at least a 10% probability that the actual quantities recovered equal or exceed the proved plus probable plus possible reserves estimates."

Now this is interesting because we can use this to come up with an average based on strict interpretation of the definitions. The calculation is as follows:
(Note: I used 100% for proved instead of 90% to simplify, and just because I think that's fair)
(.50)(308) + (.40)(466) + (.10)(862) = 427 million

So interpreting those definitions strictly comes up with an average value of 427 million. Note also that in this and all the other NPV calculations mentioned, the net price used was $45.81, while the price today would be about 53.24, a 17% increase.

Now, using the net cash of 140 million plus this 427 million calculation gives us 567 million, compared to a purchase price of 460 million. And, there is a 17% safety margin in the oil price not taken into account. And this is not taking into account what appears to be management's sincere beliefs that they can recognize a lot of the probable and possible reserves, based on what they have done historically with their three fields.

Now I'm going to conclude by throwing out one question that has been bothering me: In the reserve estimates in the valuation report, Ryder Scott attributes zero reserves for probable and possible for the original SMU fields. But if you look at the production and reserve numbers in the chart I provided here, you can see that Harvest has clearly been successful at expanding their proved reserves at their traditional SMU oil fields. So my question is, why is there no probable or possible reserves for the SMU oil fields?