Friday, December 26, 2008

A Short Excerpt...

From a great book:

...As nature teaches the spectators to assume the circumstances of the person principally concerned, so she teaches this last in some measure to assume those of the spectators. As they are continually placing themselves in his situation, and thence conceiving emotions similar to what he feels; so he is as constantly placing himself in theirs, and thence conceiving some degree of that coolness about his own fortune, with which he is sensible that they will view it. As they are constantly considering what they themselves would feel, if they actually were the sufferers, so he is constantly led to imagine in what manner he would be affected if he was only one of the spectators of his own situation. As their sympathy makes them look at it in some measure with his eyes, so his sympathy makes him look at it, in some measure, with theirs, especially when in their presence, and acting under their observation: and, as the reflected passion which he thus conceives is much weaker than the original one, it necessarily abates the violence of what he felt before he came into their presence, before he began to recollect in what manner they would be affected by it, and to view his situation in this candid and impartial light.

The mind, therefore, is rarely so disturbed, but that the company of a friend will restore it to some degree of tranquility and sedateness. The breast is, in some measure, calmed and composed the moment we come into his presence. We are immediately put in mind of the light in which he will view our situation, and we begin to view it ourselves in the same light; for the effect of sympathy is instantaneous. We expect less sympathy from a common acquaintance than from a friend; we cannot open to the former all those little circumstances which we can unfold to the latter; we assume, therefore, more tranquility before him, and endeavour to fix our thoughts upon those general outlines of our situation which he is willing to consider. We expect still less sympathy from an assembly of strangers, and we assume, therefore, still more tranquility before them, and always endeavour to bring down our passion to that pitch, which the particular company we are in may be expected to go along with. Nor is this only an assumed appearance; for if we are at all masters of ourselves, the presence of a mere acquaintance will really compose us, still more than that of a friend; and that of an assembly of strangers, still more than that of an acquaintance.

Society and conversation, therefore, are the most powerful remedies for restoring the mind to its tranquility, if, at any time, it has unfortunately lost it; as well as the best preservatives of that equal and happy temper, which is so necessary to self-satisfaction and enjoyment. Men of retirement and speculation, who are apt to sit brooding at home over either grief or resentment, though they may often have more humanity, more generosity, and a nicer sense of honour, yet seldom possess that equality of temper which is so common among men of the world.

-Adam Smith, Theory of Moral Sentiments

Wednesday, December 10, 2008

This Is The End

No, not of the world economy. Many of you may have already assumed this was coming, but here it is- this is the end of any sort of consistent posting on this blog. It has been a great experience and I loved doing it, yet it is time to start attending to other matters. I thought I would finish with some brief closing thoughts.

The recession has now been going on for one year now, and people are worried. To some extent, there are valid reasons. In the short term, we are looking at an economy which has been built up on years of excess corporate greed and fundamental imbalances. A similar situation is faced around the world, and investment risk aversion is at extremes in the markets.

So be it. Prices today would have you believe that humanity can not settle its problems and move forward. It is predicting human ingenuity will all of a sudden ground to halt; that the world has plateaued, and in fact, will have to actually recede from levels experienced which must have been too high. I think such beliefs are ludicrous. The markets may be rattled, but citizens will get through this crisis with much less fear and panic thanks to a social system with security and safety nets. And more importantly, an amazing thing is happening today in the world. More people are being educated, exposed to ideas, and put to work, than ever dreamed of before. That is billions of people thinking creatively and progressively, wanting a better lifestyle. And I'd bet that their desire and perseverance will create a safer, and wealthier, system for themselves and humanity.

For investors in corporate America, that is terrific news. But prices today are caught up in the current fear. Not only do they not reflect this long term potential, but in fact they actually assume a doom-like future. The choice really comes down to one of opportunity cost- either you can put your excess money under the couch or in government bonds, where it will be sure to earn you nothing; or, you can put your money to work into business and likely make significant returns on the back of long term global prosperity. I'm strongly in favor of the latter.

Thursday, November 20, 2008

Fairfax Removes Equity Hedges

"Given the unprecedented decline of the equity markets during the past several months, we felt it was prudent to promptly inform our shareholders that we closed out our equity index total return swaps this week and effectively eliminated our equity portfolio hedge. While we believe the recession may be long and deep, we also believe that stock prices may have already discounted the worst of the economic decline. As value investors, we are finding an incredible number of investment opportunities across the world. That said, in the short term we recognize that stock markets can continue to fall significantly."
Why should you be interested? Because frankly, Fairfax has structured one of the most remarkable portfolios before this financial crisis, being heavily invested in cash, U.S. government bonds, equity index hedges, and credit protection against financial companies. But even they have made the change in stance. Buy at the sound of cannons in the streets, right?

Disclosure: I own shares of Fairfax Financial and Odyssey Re

Friday, October 17, 2008

Maslow's Heirarchy of Needs

The Economist has an article out on Maslow:

The hierarchy of needs is an idea associated with one man, Abraham Maslow (see article), the most influential anthropologist ever to have worked in industry. It is a theory about the way in which people are motivated. First presented in a paper (“A Theory of Human Motivation”) published in the Psychological Review in 1943, it postulated that human needs fall into five different categories. Needs in the lower categories have to be satisfied before needs in the higher ones can act as motivators. Thus a violinist who is starving cannot be motivated to play Mozart, and a shop worker without a lunch break is less productive in the afternoon than one who has had a break.

Thursday, October 16, 2008

Buy American. I Am.

Well it seems I'm not the only one advocating buying stocks. Warren Buffett had an op-ed contribution today in the New York Times entitled "Buy American. I Am" :

So ... I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.


A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.


Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: “I skate to where the puck is going to be, not to where it has been.”

Saturday, October 11, 2008

It Is Time to Buy Back Into Stocks

I have long advocated a cautious stance within the current investment universe. Stock prices did not properly reflect the existence of unsustainable practices and imbalances in the economy. But now, stocks are down sharply from their peaks, and the people who were touting stocks last year have been replaced by a new league of doomsayers. The fear is that companies and fixed assets will be useless after a systemic financial collapse, and stock prices now actually reflect this fear.
Well, I don't buy into the logic, and I am buying heavily into stocks instead. Simple economic knowledge will suffice. Economics is after all the study of labor. Every year, laborers work, build, and gather resources to create the national product.

Now every year in a closed system, it would be nearly impossible to consume more than you produce. Why? Because in order to do that, you would have to be able to liquidate capital (accumulated labor) in order to consume more today. And frankly, I can't think of many assets that can be liquidated and then turned into immediate consumption, and I don't think anyone can give an example of that happening on a large scale. You don't look at a factory from the potential to boil it down and consume its steel somewhere else. That is highly nonsensical for almost any kind of investment.

Rather, the general sense is that every year, you have a level of production. Most of that is consumed, and then some amount of labor goes to capital accumulation- building investments for the future. The general trend is that labor is accumulating in the world in the form of capital, meaning that every year people have more fixed assets to deal with and so can become more productive and consume more, as times goes on.

What could break this trend? I've identified three things.
-One I mentioned just previously- if the economy liquidated capital for present consumption. That is relatively hard to do for reasons explained.
-The second would be a temporary inefficient allocation of capital and labor. (Say for example, building a large call center and hiring a bunch of people to recklessly lend money. Or, massively over-investing in telecom and internet technology). These can not last too long because eventually reality hits and the bad investments cease to be profitable.
-Third would be imbalances between the units of the economy. For example, if the rich take too large a share of the value of production, then 1) workers won't have enough money to consume what is produced, and 2) the rich will have too much money and have nothing better to do with it then say... lend it recklessly for people to spend. Although this would be labeled investment, in reality is the finance of another's consumption. And that is a shaky investment proposition.

Both two and three have occurred, both in the global scene and the US. The rich have become to rich. And an entire infrastructure has subsequently been built around lending that money out recklessly. I find this chart to be no mere coincidence.

Yet it is important to keep these matters in perspective. There is potential for some loss of growth, but how much? I'll analyze the three risks from the standpoint of the US.

1) Consuming More than Production- unfortunately, the US is not a closed system. Every year, we import more than we export to the tune of 5% of GDP. Although it is not encouraging, it is tough to worry too much about it. After all, we are investing at the same time at over 20% of GDP. And total foreign debt amounts to 5 trillion, or maybe 250 billion in interest payments a year- That is definitely manageable in a 13 trillion annual economy.

2) Liquidating Inefficiencies- The financial sector was a bubble. An entire infrastructure was built around lending money recklessly and booking massive fake profits. At one point, financial profits made up 40% of S&P earnings. Yet still, this is also manageable. Finance as a whole employed 7 million people, or about 6% of the population. Some of that was wasteful, but many of those jobs are necessary. And most of the grossly reckless practices of the bubble days have now ceased to exist.
Meanwhile, it is hard to convince me that investments made in other sectors were bubbles as well. After all, the mere fact that people would choose to consume them given enough money is proof enough that given a little more income, these jobs and these investments would be profitable again. Rather, it points to the imbalance in the distribution of wealth, which embodies the next point.

3) System Imbalances- This touches at the heart of the problem, and it will also be the hardest to fix. There exists an imbalance between investment and consumption in the economy, with there being too much of the former. As you accumulate too much investment, the potential returns diminish; they can even be money losing propositions. Well, that appears to be exactly what is happening today, as large concentrations of wealth (what Keynes would call sink funds) have invested too much money, recklessly, in the financial sector (one of the easiest sectors to do that in). Think of economic actors such as China. Now, the correction must take effect. In a simpler world, the process would balance itself. They would invest recklessly, the returns on projects would be negative, they would lose wealth at the expense of their workers and their customers, and then things would return to a more correct level and the process would continue from there. Unfortunately, the real world is not so lucky. As this starts to happen, they panic. They throw all logic out the window and flee into anything that will protect their wealth- either cash or treasury bonds. Look at yields on short term treasuries today and they are barely half a percent annually. This has begun.

The good news is this is correctable. If the economy was producing at this level before, it can be maintained with a more equitable distribution of investment and consumption. What you need to do is let investors take losses, but also have government step in wherever it can to ensure confidence. Today, there are several things we must see. We need government to step in and invest in the financial sector, in return for equity participation in a brighter future. We need losses to be taken in stocks and bonds to correct imbalances, but we also need confidence restored for investing in the business. The government should take on debt to promote investment, taking advantage of the extremely low yields which they can now borrow at. Finally, it should tax the lower class less and tax the rich more to correct the current imbalances. Largely, this appears to me to be what the government has been doing.

So where does that leave you, the individual investor? Well today, stocks represent a huge discount to any type of scenario in which the world economy exists 5, 10 years from now. Yes, the rate of return on capital has been inflated, meaning recent profits are likely a bad representation of reality. But global growth will continue, and earnings will return one day. In the meantime, an investor today doesn't face much competition in terms of yield. For the first time in several decades, stock dividends now offer a higher yield than treasuries (whose yields have plummeted), and that is a major buying signal. Many companies are trading below any type of value based on replacement cost, or on earnings power in a normalized environment. An investor who can identify businesses which:
1) provide real value,
2) which will be around for the next 50 years,
3) have some forms of competitive advantages, and
4) are prudently financed

will find the prices on stocks today to be very attractive. Stock investors with long term time horizons will find significant bargains and returns in purchasing at today's stock levels.

Tuesday, September 30, 2008

CNN Interview with Lee Kuan Yew

CNN conducted a two part interview with Lee Kuan Yew, former Prime Minister of Singapore. I am currently reading his memoirs, which is a fascinating read about a fascinating individual. In approximately 30 years under his control, Singapore grew from $1000 GDP per capita to $22,000 (and even more today). The two part interview is embedded below:

Part I:

Part II:

Thursday, September 25, 2008

The Doctor's Bill

The Economist has a very good special report on the events leading up to the current bail-out plan, plus an analysis of where to go from here. You can find a direct link to the article here.

P.S. I've been fairly busy this week, but I hope to put up some original commentary in the next few days.

Thursday, September 18, 2008

Economies Of Scales

From The Economist:

Like most other fisheries in the world, Alaska’s halibut fishery was overexploited—despite the efforts of managers. Across the oceans, fishermen are caught up in a “race to fish” their quotas, a race that has had tragic, and environmentally disastrous, consequences over many decades. But in 1995 Alaska’s halibut fishermen decided to privatise their fishery by dividing up the annual quota into “catch shares” that were owned, in perpetuity, by each fisherman. It changed everything.

Wednesday, September 17, 2008

Nassim Taleb On The Fourth Quadrant

Nassim Taleb, author of The Black Swan, has submitted a wonderful essay to the Edge that is available for all of us to read. I HIGHLY recommend everyone click on the link and read the entire thing- it is filled with concepts that I think no one should live without. (Opening intro is pasted below)


When Nassim Taleb talks about the limits of statistics, he becomes outraged. "My outrage," he says, "is aimed at the scientist-charlatan putting society at risk using statistical methods. This is similar to iatrogenics, the study of the doctor putting the patient at risk." As a researcher in probability, he has some credibility. In 2006, using FNMA and bank risk managers as his prime perpetrators, he wrote the following:

The government-sponsored institution Fannie Mae, when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry: their large staff of scientists deemed these events "unlikely."

In the following Edge original essay, Taleb continues his examination of Black Swans, the highly improbable and unpredictable events that have massive impact. He claims that those who are putting society at risk are "no true statisticians", merely people using statistics either without understanding them, or in a self-serving manner. "The current subprime crisis did wonders to help me drill my point about the limits of statistically driven claims," he says.

Taleb, looking at the cataclysmic situation facing financial institutions today, points out that "the banking system, betting against Black Swans, has lost over 1 Trillion dollars (so far), more than was ever made in the history of banking".

But, as he points out, there is also good news.

We can identify where the danger zone is located, which I call "the fourth quadrant", and show it on a map with more or less clear boundaries. A map is a useful thing because you know where you are safe and where your knowledge is questionable. So I drew for the Edge readers a tableau showing the boundaries where statistics works well and where it is questionable or unreliable. Now once you identify where the danger zone is, where your knowledge is no longer valid, you can easily make some policy rules: how to conduct yourself in that fourth quadrant; what to avoid.

John Brockman

Stuck Holding the Bag

I posted a little while back about the silliness of this comment I heard on CNBC:
Pisani : …What fool would buy Fannie Mae now when everyone knows the equity is worthless? Here’s a fool who just bought Fannie Mae this morning. Now, what’s going on, why would you buy Fannie Mae right after the open, what price did you buy it at, what price did you get out at, and why?

Redler: Well as active traders we loFok for over-emotion. Everyone on TV was saying Fannie and Freddie are zeros. They might as well be zeros, but it doesn’t have to be a zero tomorrow…

Essentially, this trader was playing with fire. There was no actual value underlying the common shares- as far as I'm concerned, he might as well have been trading tulips. He was buying an asset he was willing to admit to be worthless, on the hope that he could sell it to someone else for more before the "jig was up", so to speak.

Well, Fannie and Freddie both rallied that day, to close at $4.85 and $3.16 per share, respectively, earning this trader a short segment on CNBC. Today, these stocks closed at $.43 and $.27 . Thats a loss of 91% for these stocks in a little under a month. What you will not see on CNBC though, are the millions of traders who tried to play the game and were stuck holding the bag.

Sunday, September 14, 2008

War, Part II: Strategy, Operations, and Tactics

In any war, the planning is broken down into three categories: tactics, operations, and strategy. Tactics refers to the plans within a battle; operations refer to the plan within a broader campaign; and strategy refers to the final military and political goals of the war. The history of warfare provides infinite examples of mistakes made in all three. And the same holds true in the battlefield of business. We can use the separation to great utility in investment research. Is the business we are looking at facing problems because of the recent direction it has taken with the company? Is it in dire straits because its method of fulfilling its consumer need is becoming ineffective? Or, is there really no need for their service in the first place?

I'll give you some examples which I think qualify. Back in 1963, American Express got caught within the "Salad Oil Scandal":

The scandal involved the company Allied Crude Vegetable Oil in New Jersey, led by Tino De Angelis, which discovered that it could obtain loans based upon the inventory of its salad oil.[2]

Ships apparently full of salad oil would arrive at the docks, and inspectors would confirm that the ships were indeed full of oil, allowing the company to obtain millions in loans. In reality, the ships were mostly filled with water, with a only a few feet of salad oil on top. Since the oil floated on top of the water, it appeared to inspectors that these ships were loaded with oil. The company even transferred oil between different tanks while entertaining the inspectors at lunch.[3]

The money was splurged and banks were stuck holding loans with worthless collateral. The scandal cost American Express over 58 million, and the stock dropped over 50%.

But what had really happened here? The problem was not that the company's services were poorly delivered and unnecessary. Rather, it was a one-time bad decision to loan money to characters with deceitful intent. The underlying business was in fact still very valuable, with several competitive advantages to protect its future profit stream. The stock subsequently rose significantly and became one of Warren Buffett's prized investments.

What about an operation problem- one where the fulfillment of a need proves inefficient? For example, consider classified advertising after the introduction of the internet. If you wanted to find or sell something in the old days, you really had only one product which would reach your local market, and that was the newspaper. Newspapers recognized this and made a killing by chaarging high rates for putting these into their papers. It's no wonder that newspaper execs often looked at classifieds as their "gold mines."

But the internet not only introduced competition to this field, it also slowly began to demonstrate a superior ability to fulfill the need for classifieds. The internet had several advantages: it could be posted for cheaper, it could reach a larger audience, and once it was posted it would remain up there for as long as the poster wanted. The internet also made it easier to search and find what their customers wanted. All this served to slowly make newspaper classifieds less and less effective, and their recent results reflect that.

Finally, a problem in strategy. Can businesses really exist and thrive for some period of time when they are reality adding no value to their customers. The answer is yes. I've mentioned one example before with the rise of the mortgage lenders. During the housing boom, the business of loaning money to people soared, and more importantly, people would pay a premium to loan value to buy these loans off you. This allowed several mortgage lenders to spring up and thrive by making loans and dishing them off to other lenders. But in principle, it was founded on an unsustainable practice. Economically, all these firms were doing was saving their customers the trip to their local bank (or providing them with exotic products that just really shouldn't have been made). Either way, competition would have eventually narrowed the gap and vastly eliminated this business.

So there you have it- examples of problems in strategy, operations, and tactics. As an investor, its important to recognize which type of problem you are dealing with and to include that information into any investment analysis.

Monday, September 08, 2008

The Fannie/Freddie Bailout, And Lessons To Be Learned

The government yesterday announced their plans for supporting the continued functioning of Fannie Mae and Freddie Mac(The "GSEs"). The specific details of the plan can be found here, but essentially it boils down to the government stepping in and backing GSE debt obligations with the full faith of the U.S. government, thus ensuring their full principal value. What does this mean, who gets affected, and why was this necessary? These are all questions I'll try to briefly answer.

The GSE's are massive organizations which were created with the intent of promoting homeownership and adding liquidity into the marketplace. The organizations were mostly involved in two lines of business. First, they operated as guarantors in the mortgage market. Banks could sell mortgage loans qualifying under certain criteria to the GSE's. They would then package them into securities, guarantee them, and take a portion of the interest payments as a fee in return for the guarantee. The second line of business involved issuing large amounts of debt (for cheap) and then using that money to purchase mortgage loans which gave a higher interest rate and had historically performed well.

But history is a bad measure, and the institutions were hit from multiple angles. They ended up under-pricing the risk of their mortgage guarantee business, and the mortgages they purchased with debt began to decline significantly in value. These combined to completely wipe out equity, at least if you were looking at their equity from a "fair value" basis. (The company for several quarters has insisted on using its own projections to value its assets/liabilities over the market's pricing, but they provided both figures.) That lead to the questioning of their viability, and the cost to issue debt for the institutions began to rise sharply. That began to add even more devastation to their second line of business, because they could no longer fund their mortgage assets with cheap debt. It would have only been a matter of time before the companies went into bankruptcy.

Now, the government has stepped in and essentially gauranteed full value for the debt issued by Fannie/Freddie, as well as their obligations for guaranteed mortgage securities. Those combine to total over 5 trillion. Those are backed by mortgage assets, and the first losses will accrue to common and preferred shareholders. Still, that is little comfort to me, as by fair value measures these institutions have been equity-negative, and I perceive things to continue to worsen for some time. Their will ultimately be big losses for government. That means taxpayers will be suffering for the benefit of the investors in mortgage assets.

That is a redistribution I would prefer without. And there is one more negative hazard to this deal as well, but these are completely over-shadowed by the systemic necessity of the deal. But first, that negative is that government has now taken over the judgment of future mortgage risk. It makes me shudder to think that we have offloaded the task of judging risk from hundreds of thousands of banks to one central institution (although we got into this mess because there was a complete lack of risk judging by banks, in the first place). Instead, everything will now dance to the tune of the GSE guidelines. The government has committed to wind down the GSE business over time and diminish its role in the mortgage market, but that will be a long time.

Unfortunately, the move was very, very necessary. If the GSE's were to announce bankruptcy, I believe you'd have a terrible hellish limbo (and please correct me in the comments if im wrong on this point). Unlike typical bankruptcies, nothing for the GSE's could function as usual. As I understand it, they could not pay off expiring debt, and they could not pay off guarantee obligations- simply, they couldn't do anything. That is because once in bankruptcy, their debt obligations would disregard time duration and instead put them on equal footing based on their class (senior, junior, etc). That means, a senior note expiring and scheduled to be paid back in 30 years would have the same value and rights as a senior note due tomorrow. That means the institution could not pay back anyone until it figured out what it could ultimately pay back. Well in the case of the GSE's, that could be ages. I mean, their assets are long duration mortgages to individuals which can't be redeemed, meaning you'd have to wait for them to slowly get paid back. And some of their guarantee liabilities extend for 10 years or more, and can change rapidly at any time depending on the mortgage market situation. Best case, you'd have to wait until the mortgage situation clears up and you find suitable buyers of its tremendous load of assets and guarantees. But considering the size of the liability, that is very unlikely for everyone except government.

And in the meantime, you have stagnation. The company would have to preserve all its capital and pay out nothing. That means that thousands of institutions around the world would be holding pieces of paper paying them no interest, with questionable ultimate value, and no idea of when any of that value may ultimately be able to be realized. Things would shutdown, people would be furious, and foreign lending to the US would cease. That could not happen, and sadly, that means the institutions could not be allowed to fail.

What can we learn from this saga? Well, the situation does not bode well for other mega-banks on shaky financial footing, especially those with long-duration credit default swaps. If one of these institutions were too fail, the same thing would happen here- everything would freeze up until ultimate liabilities can be determined, leaving a very large class of debt and CDS holders in stagnation for a long period of time. "Doomsday" would then ensue.

Friday, September 05, 2008

Lessons From War: Part I. Knights and Newspapers

I just so happen to be taking a class on War! this semester with a great professor on the subject, Ron Hassner. One week into it, I've already picked up many connections between the topic of war and the field of business.

Today's example looks at the introduction of the cannon into the field of warfare, which occurred in the early 14th century. At this time, armies were built around feudal knights, who were skilled with a lifetime of combative training. The introduction of guns and artillery changed everything though. A common man armed with a gun and a few weeks of training could now defeat a knight, meaning the knights had now lost their monopoly on force.

How did knights respond to this threat? "Stupidly" would be a fitting description. They decided to put on thicker and thicker armors, greatly sacrificing mobility for some safety. The strategy did little to help the knights, and their role soon diminished into nonexistence. But not before they suffered heavy casualties. Perhaps this inability to acknowledge reality is best seen at the Battle of Crecy, where a far outnumbered army of British longbow-men completely obliterate wave after wave of French knights and nobility. Afterwards people had no choice but to accept the new reality- after all, the knights of old had all just died.

To find a comparable example in business, we need an industry undergoing a dramatic shift in its business landscape. A good example is newspapers, and the introduction of the internet. The internet can do several things better than traditional newspapers. It is a more effective means of classified ads and it is a better source for information like weather, movies, etc. It has also introduced competition into a news field which had until then always been a local monopoly.

Newspaper companies, like the knights, were slow to react to this changing reality. By the time they realized the importance of the internet, their circulation was already in decline and they were too late to establish themselves as dominant internet firms. Some have tried to throw money at the problem, investing as much as they can now in internet projects to compensate for their past idleness. But I think the smarter ones will have to realize that the landscape has changed. A news company's only real asset is its staff of writers which collectively dominate the reporting of news happening in its locality. Whether that news will then best be transmitted on paper or on the internet, or whether it will be more subscription or advertising based, will have to be figured out. But there is still a place in the world for that company which aggregates and reports on local content- albeit, a smaller and more niche market with less attractive returns.

Tuesday, September 02, 2008

Who Do You Want To Be?

Warren Buffett often tells his audience to perform a simple exercise which runs like this: Imagine if you had to invest all your money today in a person, a friend. It would work similar to any investment, in that you would be getting a stake of his future income. Who would that person be? And more importantly, which of their qualities make you willing to put such faith in them? The point of the exercise is to get you thinking about qualities you admire, respect, and believe will lead to success.

I've run through this exercise countless times. I've found that the people I admire usually are:
Long term outlook

And no exercise would be complete without inverting the question.Which qualities do I dislike in others? That list of opposites would be something like:

Entity Mentality

Once I had this list, it became simply a matter of acting like the first list and avoiding the second. And although perfection is near unattainable, it helps immensely if you know what you are aiming for. Should you not uphold the qualities which you admire in others?

As you ask other people to perform this exercise, I think you will find the list of positives overlaps for many people; and you'd be hard-pressed to give approbation for any of the second list of qualities. The lesson has some bearing for the investors out there as well. It is difficult to find a truly great investment when you are entrusting your money in a crooked culture. So I recommend all of you to make your lists, study it closely, and start finding people and organizations which match your admirable ideals.

Sunday, August 31, 2008

LBO's Gone Wild

From The Economist:
To understand how private equity reached this position, consider the long-term prospects of leveraged buy-outs (LBOs), its core business. In 2006-07 the industry binged, buying companies with an enterprise value of $1.4 trillion. After adjusting for inflation, that is the equivalent to one-third of all the LBOs ever. Denial and rose-tinted accounting mean that losses on these investments have yet to be fully recognised. But the shares of listed buy-out funds are trading far below their book value and some clients, anticipating losses, are reportedly considering off-loading their interests in LBO funds.
Another corner of lending that I would be worried about, especially as profits begin to decline. Not to make it sound like a golden rule, but you should always be weary when activity surges in any financial corner. After all, remember that the final returns of all financial activity boils down to the underlying profits of American business. Market participants are constantly jockeying for a greater piece of the profit pie, and some do better than others. But we are dealing with 1.4 trillion dollars here. That means LBO firms found 1.4 trillion worth of securities that they thought that Wall Street was evaluating wrong-very wrong. Wrong enough where they could offer shareholders a 30% premium and still make out on top in the deal. I find it more likely that they were a little too optimistic in their projections.

Sunday, August 24, 2008

No Shortage of Regulators

From Three Hours With Warren- Live from Omaha:

QUICK: If you imagine where things will go with Fannie and Freddie, and you think about the regulators, where were the regulators for what was happening, and can something like this be prevented from happening again?

BUFFETT: Well, it's really an incredible case study in regulation because something called OFHEO was set up in 1992 by Congress, and the sole job of OFHEO was to watch over Fannie and Freddie, someone to watch over them. And they were there to evaluate the soundness and the accounting and all of that. Two companies were all they had to regulate. OFHEO has over 200 employees now. They have a budget now that's $65 million a year, and all they have to do is look at two companies. I mean, you know, I look at more than two companies.

QUICK: Mm-hmm.

BUFFETT: And they sat there, made reports to the Congress, you can get them on the Internet, every year. And, in fact, they reported to Sarbanes and Oxley every year. And they went--wrote 100 page reports, and they said, `We've looked at these people and their standards are fine and their directors are fine and everything was fine.' And then all of a sudden you had two of the greatest accounting misstatements in history. You had all kinds of management malfeasance, and it all came out. And, of course, the classic thing was that after it all came out, OFHEO wrote a 350--340 page report examining what went wrong, and they blamed the management, they blamed the directors, they blamed the audit committee. They didn't have a word in there about themselves, and they're the ones that 200 people were going to work every day with just two companies to think about. It just shows the problems of regulation.

Thursday, August 21, 2008

Quote Of The Day

A trader discusses his reason for purchasing Fannie Mae today on CNBC: (Video Link)

Pisani : …What fool would buy Fannie Mae now when everyone knows the equity is worthless? Here’s a fool who just bought Fannie Mae this morning. Now, what’s going on, why would you buy Fannie Mae right after the open, what price did you buy it at, what price did you get out at, and why?

Redler: Well as active traders we look for over-emotion. Everyone on TV was saying Fannie and Freddie are zeros. They might as well be zeros, but it doesn’t have to be a zero tomorrow…

It's kind of like musical chairs. As long as the music is playing, everyone can keep dancing around, and some will profit at other people's expense. But at some point reality will hit on the entire game and the music will stop for Fannie/Freddie Mac shares. And at that point, someone will be left holding the bag (or in this case, the worthless equity certificate).

Lessons from a "Lost Decade"

There's a great article in this week's The Economist drawing similarities between America's crisis and the Japan's experience with 10 years of stagnation.
By learning from Japan’s mistakes, America can avoid a dismal decade. However, it would be arrogant for those in Washington, DC, to assume that Japan’s troubles simply reflected its macroeconomic incompetence. Experience in other countries shows that serious asset-price busts often lead to economic downturns lasting several years. Only a wild optimist would believe that the worst is over in America.

Tuesday, August 19, 2008

Quote It

Charlie Rose: You can clearly say General Motors will not go bankrupt.
Wagoner, CEO of GM: Absolutely.

Hypothetical Scenario For The Mortgage Nuts....

Something has always bugged me about credit default swaps and mortgage/bond insurers. Imagine a community with one bank, and that bank has 10 million in loans. Now the usual rules dictate that the bank should have at least a 1 million in equity as a cushion because, face it, lending has a tendency to have its bad cycles. The other 9 million is financed by deposits.

Now let's say another party comes to the bank and offers to take the credit risk on all 10 million of the bank's loans, in what is essentially a blanket credit default swap on their loans. The bank now views its operation as essentially risk-free (ignoring liquidity risk), so their equity cushion doesn't matter. But shouldn't the new counter-party now be required to have a 1 million equity cushion in case things go bad, since they are supposed to be the first and only line of defense? I think the answer to that is yes.

The problem is I haven't seen that. Look at Fannie Mae. At September 30, 2007, they had 2.8 trillion in total mortgage assets and guarantees. But their balance sheet had total capital of only 49 billion, or 1.75% of total obligations. If it were looked at like a bank, that would be an asset-equity ratio of over 50-1. That doesn't leave much margin of safety at all.

Am I missing something?

Friday, August 15, 2008

Josh Waitzkin @ Google

"Chess champion Josh Waitzkin visits Google's Mountain View, CA headquarters to discuss his book "The Art of Learning: A Journey in the Pursuit of Excellence." This event took place on April 10, 2008, as part of the Authors@Google series.

Josh Waitzkin is an 8-time National Chess Champion, 13-time Tai Chi Chuan Push Hands National Champion, and Two-time Tai Chi Chuan Push Hands World Champion. In 1993 Paramount Pictures released the film Searching for Bobby Fischer, based on the highly acclaimed book of the same title written by Fred Waitzkin, documenting Josh's journey to winning his first National Championship."

Helpful Advice from Bruce Berkowitz

What is your strategy for the fund? If I was to build a stock screen like Bruce Berkowitz, what would it look like?

We start with this basis: The only thing you can spend is cash. We want companies that generate significant cash in most times. That is how we start. We don't care much about what they make, but we have to understand it. The balance sheet has to be strong; we want to make sure there are no tricks in the accounting. Then we try and kill the company. We think of all the ways the company can die, whether it's stupid management or overleveraged balance sheets. If we can't figure out a way to kill the company, and its generating good cash even in difficult times, then you have the beginning of a good investment.

The link to the full interview is here.

Thursday, August 07, 2008

A Personal View of The Crisis

They are called risk managers, and collectively, their job is to monitor their bank's transactions for signs of trouble. So where were they in the midst of the current tragedy that is among us? This week's The Economist gives a rare treat by allowing a risk manager at a large global bank to share his view of the current credit crisis. It unfortunately conveys the message that even in the banks, the heart of the financial system, serious misunderstandings exist about the nature of finance and their fiduciary duties.
IN JANUARY 2007 the world looked almost riskless. At the beginning of that year I gathered my team for an off-site meeting to identify our top five risks for the coming 12 months. We were paid to think about the downsides but it was hard to see where the problems would come from. Four years of falling credit spreads, low interest rates, virtually no defaults in our loan portfolio and historically low volatility levels: it was the most benign risk environment we had seen in 20 years
The possibility that liquidity could suddenly dry up was always a topic high on our list but we could only see more liquidity coming into the market—not going out of it. Institutional investors, hedge funds, private-equity firms and sovereign-wealth funds were all looking to invest in assets. This was why credit spreads were narrowing, especially in emerging markets, and debt-to-earnings ratios on private-equity financings were increasing. “Where is the liquidity crisis supposed to come from?” somebody asked in the meeting. No one could give a good answer.
Let me begin with an elementary lesson on financial bubbles. Let us imagine a perfect world where the future was clear and I could tell you all the future payments of an asset to an exact number- let us say $1 per year. And let us say I want my investment to give me 10% a year, and using that rate, I calculate that this asset is worth $10 to me. Now, Joe comes along and offers me $12, and I say sure. That $12 to me today is worth more than the $10 I calculated that asset to be worth. And whether Joe knows it or not, by paying $12 for that asset, he is now accepting a lower return for that asset- 8.3% to be exact. But Joe doesn't deal with things like that. Joe knows Bill will pay him 15 dollars for that, so he immediately flips it, books a very nice gain, and rids the asset to Bill. Bill, being the clueless investor he is, crosses his fingers and waits. And sure enough, Bob (whose financial understanding leaves room for improvement) says, "Look, this asset has already gone from $10 to $15, I'm sure I can dump it for $20." And you know what, maybe he is right.

Unfortunately, something is missed along this way. That is, that ultimately someone has to hold on to that asset, and the money they will get for it is that original income stream- that $1 per year. So "Johnny Ultimate Bagholder", who has seen this great run-up of this asset from $10 to $30 thinks the trend is his friend, and he can make big bucks by buying it today. Unfortunately, he is then stuck with a product making him only 3.3% a year. And although maybe that doesn't sound bad and Johnny can reconcile himself with that fact, the rest of the world can't- they still want their 10%. Reality comes crashing back in, and Johnny now sees a huge loss.

This sound far-fetched? Well, it has happened to us in the last ten years- twice. In 2000 when stocks were trading at 40x earnings (or worse), those stockholders were looking at returns near 2.5% a year on their asset- and that assumed the business would be around forever and competition didn't erode those earnings. And recently during the housing boom, investors flocked into the market on the belief that house prices could only go up. And people actually invested their money in an asset that was generating negative underlying returns, as the cost of interest was well above the money they could make renting the house out. And anyone with just a common understanding of the above financial concept could have seen how this was going to lead to disaster.

So let me return to the original quote:
...but it was hard to see where the problems would come from. Four years of falling credit spreads, low interest rates, virtually no defaults in our loan portfolio and historically low volatility levels: it was the most benign risk environment we had seen in 20 years.
The possibility that liquidity could suddenly dry up was always a topic high on our list...

My problem is these are not ways risk is supposed to be found. Every indicator he mentions there is actually more of a signal of a bubble than anything else, but I am not advocating contrarianism either. What these guys should of been doing was asking if these transactions made sense. Did it make sense for house prices to keep going up when the underlying payment (rent, or working income) could not afford it? Was any actual wealth created when the value attributed to nationwide homes was doubled? Did it make sense to let people subsequently draw money out of their homes to use to spend? The answer to all of these is no. And I regret to say that the harsh reality is that is the only way to do finance. You have to look at what makes sense and make reasonable expectations for the future. And unfortunately, it seems risk managers of banks worldwide have been clueless to that.

My gripe doesn't end there.
Our business and risk strategy was to buy pools of assets, mainly bonds; warehouse them on our own balance-sheet and structure them into CDOs; and finally distribute them to end investors. We were most eager to sell the non-investment-grade tranches, and our risk approvals were conditional on reducing these to zero. We would allow positions of the top-rated AAA and super-senior (even better than AAA) tranches to be held on our own balance-sheet as the default risk was deemed to be well protected by all the lower tranches, which would have to absorb any prior losses.
Let me rephrase it another way- "Our business was to pool assets, mainly bonds. We would then split them up into different groups, one which was safe and one which would take heavy losses. We made it a point to make sure our customers would buy the losses. We may not be too good at understanding risk, but you should see our customers. Boy, did we make money off of them!" Nowhere in that statement do I see any ideals of fiduciary duty, of doing whats mutually beneficial for both yourself and the customer. And I hate to break the news to you, but:
That mini-liquidity crisis was to be replayed on a very big scale in the summer of 2007. But we had failed to draw the correct conclusions. As risk managers we should have insisted that all structured tranches, not just the non-investment-grade ones, be sold.
THAT is not the right conclusion.

A Conversation with Peter Chernin

Charlie Rose recently conducted a conversation with Peter Chernin, Chief Operating Officer of News Corp. Investors looking to get some insight on the future of the media industry will find this very helpful.

- In today's media, you need to do something great. Why would you go to mediocre content in a world with infinite choices?
-Why is media undervalued by Wall Street? Wall Street likes predictability, and right now they are uncertain about the future of old media.

Myspace and the Internet
- Revenue sources on the internet are being found. MySpace reached 1 billion of sales in 5 years, faster than Google. It represents 10 - 12% of all page views on the internet.
- They are excited about hyper-target technology they are developing for the internet, and believe advertisers will begin to embrace the internet more.

- Over 2.5 billion mobile phones worldwide, representing a huge potential. News Corp is trying to be ahead of the curve on future mobile distribution market.

How has this change affected the creation of content?
- There have been resilient forms of content, such as movies, hour dramas, half hour comedies. People will begin to create very short forms of entertainment.
- You don't know what the world will want in a few years- but you do know what you like. You have to trust your own opinions.

What do you like most about Rupert Murdoch?
1, his curiosity and love of the world around him. Second his will, his phenomenal determination and dedication.

Saturday, August 02, 2008

Black Box Insurers

From The Economist:

AFTER watching bank shares drop by almost a third this year, most European investors probably consider the idea of buying insurance stocks a sick joke. Banks’ balance-sheets may be difficult to understand but insurers can be mind-bogglingly complex too.

The alternative is the industry’s home-grown accounting standard, which is called Embedded Value (EV). A life company’s EV represents its shareholders’ funds plus the value of future profits it expects to generate from its existing book of business, after adjusting for risk. This is a concept most investors can get their heads around. But individual companies can pick their own assumptions on things like investment returns. Furthermore, diversified firms often report EV only for their life divisions, making it harder still to compare companies on a consistent basis. The result is that many investors view EV as just another type of black-box reporting.

The good news is that the industry is taking note. In June, a forum of Europe’s biggest insurers agreed to implement new Market Consistent Embedded Value (MCEV) rules in 2009. These require companies to make uniform assumptions about investment returns and apply the reporting standard across the entire company. In addition it will no longer be possible to book at once the profit expected from holding risky assets. Mr Crean argues that MCEV standards make it easier to see how much cash is being generated by the “back book” of existing business and how much of this is being reinvested in new business, rather than being handed to shareholders as dividends.

This is something I've never looked into, but I know Fairfax holds credit-default positions against several European insurers- a bet signifying their belief in increased credit troubles for these companies. If these companies have been allowed to book immediate profits on risky assets, that could be a source of large write-downs in this current market turmoil.

Wednesday, July 23, 2008

Shaking Things Up At Steak N' Shake

I wrote this article in an application for the Motley Fool. Since that didn't work out, I figured I could now share it. Even though shares have soared over the last 3 days, I still.... well, read the article.

Investors in Steak N’ Shake have not had much to look forward to lately. The company reported a loss last quarter as expenses climbed and same store sales fell. And since the start of the year, shares have tanked roughly 35%. How did things get into such a mess? According to a recent activist group led by Sardar Biglari, the crumbling performance stems from the company’s “failed vision, failed strategy, failed execution, and failed board.” More specifically, management can be blamed for two faults: wasteful use of shareholder’s capital and poor expense management.

The motto of management lately has been “bigger, bigger, bigger”. Over the last six years, the company has spent $330 million building almost one-hundred new stores. Over that same period, operating profit has actually been reduced in half. Shareholder’s have nothing to show for management’s empire building, which has resulted in poorly performing new locations and unnecessary store improvements.

You want to talk expenses? They are up sharply, too. Since 2002, store operating costs (labor, utilities) per store has increased from an average of $638,000 to $775,000. General and administrative (corporate) expenses per store have increased from $95,000 to 133,000. Together they account for $76 million in incremental costs for the company. Yikes!

Indiana locals will be quick to confirm that store locations are excessive, and restaurants are packed with enough employees to put a Five-Star hotel to shame. These problems are unjustifiable and unacceptable. Sardar has put the blame squarely on the present board for spending lavishly and opening new locations without proper management controls in place.

Right People, Right Equipment, Right Mission… and Right Price

During World War II, Admiral Earnest J. King was asked whether he worried about the war’s final outcome. He replied, “I have supplied the best men with the best equipment we have and have given them what seems to be the wisest mission. This is all I can do.” Investors may find comfort in similar reasoning for Steak N’ Shake.

Activist shareholder Sardar Biglari has recently gained the position of Chairman of the Board. He has over 10% of the shares and has elected to take no pay, meaning if you aren't left stuffed, he'll be definitely left hungry. He's also a restaurant veteran and has experience in similar restaurant turnaround situations. He will have help from a nice collection of assets to work with. There is the “Steak N’ Shake” brand, a solid franchise with high value. It is a Midwest staple and customers can not imagine it going anywhere. There is also a large base of company owned land and real estate, which by itself is worth more than the stock price today. Perhaps most lucrative of all, he has a vision of what needs to be done to return the company to success: Cut expenses and allocate capital efficiently, while growing the company through franchises. Given the sloppy situation he is inheriting, the task seems more than achievable. The company has it all: right people, right equipment, and the right mission.

And the price? Over the last three years, the company has generated an average net income of $23 million. It also has $32 million in annual Depreciation expenses, which is much higher than the amount needed to maintain their stores and business. This is cash flow that can and will be thrown back to the shareholders under Biglari. And, if Sardar is successful in merely reversing half of the rise in “per-store expenses” over the last six years, he will add $38 million to the bottom-line. For a total price tag of $170 million, there seems to be many reasons for Steak N’ Shakers to think the price is right.

Bon appetite.

Disclosure: I own shares of SNS.

Also, I'm currently in South America and I won't be coming home for a week, so posts may be fairly scarce.

Saturday, July 19, 2008

Obituary: John Templeton

Sir John knew what he liked. Common stocks, like Dow Jones industrials, were unglamorous but usually dependable. Government bonds were steady, if you picked a country with no trade or fiscal deficits and a high savings rate. He disliked speculation, and any instrument over-geared to make money. But he was open-minded. Some moments were good for Treasuries, some for equities, some for blue-chip stocks. Late in life, he favoured market-neutral hedge funds. Diversity was important, in countries as well as instruments. A journey in 1936 round Europe and the Middle East, sleeping on open decks and chewing dry bread to save money, taught him that investment opportunities lay everywhere he looked.

But most of all Sir John went long on God. As a lifelong Presbyterian with a devout and curious mind, he reckoned that the market price of the creator of the universe was probably 1% of its actual value. The crowd might have lost interest in this underrated stock, so dully and unerringly recommended by theologians and priests down the centuries, but Sir John bought it up on the firm expectation of stellar future earnings. Indeed the divine, he once said, if approached in a humble spirit of inquiry, might turn out to be 3,000 times more than people imagined it was.

Thursday, July 17, 2008

Value To Be Had In Europe

From Buttonwood:

Another measure that could make shares attractive is a single-digit price/earnings ratio. Higher inflation tends to drive down p/es, because it leads to more volatile economic conditions. Investors may also be worried that profits are high, relative to GDP, and are thus due for a fall.

But single-digit p/es would compensate investors for those risks. Flip the ratio around and you have the earnings yield, the percentage of the share price that is represented by profits. If the p/e is in single digits, the earnings yield is above 10%. On the latest data, a number of European markets, including Belgium, France, Ireland, Italy, the Netherlands, Spain and Sweden fall into this category; with the DAX on a p/e of 10.6, Germany is not that far away. (Wall Street, by contrast, has still a fair amount to fall on this measure.)

There's value to be had in Europe, mates. Arrr

Wednesday, July 16, 2008

Question: American Express Monthly Payment Rate?

I was just trying to apply the "Wilbur Ross chart method" on American Express (I'll work on the name)

CNBC: I read that you have a chart system? How does that work?
WILBUR ROSS: We use charts, not stock trading charts but business charts, and the way they work is, when we're looking at an industry we try to put down in paper everything we can imagine that's wrong with the industry. Usually it's quite a long list. We then go over it, and over it, and over it, and over it till we're pretty well satisfied that we've identified everything that is wrong or is very likely to go wrong. Then we start work on a second chart, which is if we have control of this industry, what would we do to fix these problems. When the two charts get more or less similar in length, that's when we get serious about investing.

So, when looking at American Express, you have a business with several positive trends working in its favor:
1) Long term increased spending
2) Long term increased use of cards over cash
3) International growth potential
4) Increased retailer acceptance potential.

Now the main concern with American Express is their exposure to bad credit debt in this down-cycle. So:

Problem ...................... | Solution
-exposure to bad debt | -tighten standards, raise rates

(excuse the quick chart)
Remember, AmEx is not the typical card company. Most cards are issued by banks who make their money off of late charges and interest costs. AmEx earns a vast majority of its revenues from merchant fees. In fact, it has actually been losing money on its lending operations for some time.

Which led me to my next question: how fast can they reduce lending and change standards? To figure that out, I'm trying to find out the average loan length. I found this:

The first one is for consumer lending, while the second is for charges that go late. Am I reading it right then that consumer loans have an average life of about 5 months, and consumer charges are a little over 1 month? If so, it seems like guidelines can be tightened fairly quickly and without too much damage.

Disclosure: I own shares of American Express.

The Wrecking-Ball Response?

From The Economist:
TUMBLING house prices in America, rising foreclosures and a glut of unsold homes have produced a variety of unusual, even desperate, responses from policymakers. Of the 129m housing units in America, 18.6m stand empty. At 2.9%, the home-owner vacancy rate, which measures the share of vacant homes for sale, has reached its highest point since measurement began in 1956. At the end of the first quarter there were 2.3m empty homes on the market, an increase of more than 160,000 from the end of 2007. There is a vicious circle: the huge number of houses on the market pushes home prices down, and as prices decrease, mortgages become harder to refinance, leading to more foreclosures, vacancies and so on. The more homes are on the market, the less chance that prices will stabilise.
In prepared remarks for a speech earlier this year, Ben Bernanke, chairman of the Federal Reserve, praised programmes that seek to demolish the most ramshackle units in order to “mitigate safety hazards and reduce supply.” Unlike mortgage bail-outs, this policy does not encourage risky lending. However, it requires cities to spend money on demolition merely to lose money through reduced taxes...

I've just never felt that demolishing homes could really be the best possible social solution. Then again, maybe Puerto Rico's example teaches us that a demolished home is better than a decrepit one.

Friday, July 11, 2008

Stock Market Capitalization to GNP Ratio

This ratio was last brought up in October in a post using "Buffett's approach" to macroeconomics. He said:
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.
Below is an updated chart of the ratio from Fairfax's annual meeting slides:The post shows the ratio near levels of 110% at the beginning of 2008. Since then, GDP has remained essentially flat, while the S&P500 is down 11%. So, that puts the ratio at approximately 98% today.

Thursday, July 03, 2008

Interview with Wilbur Ross

Two particular comments I liked from a CNBC Interview with Wilbur Ross:

CNBC: Can you talk a little bit about your system?
WILBUR ROSS: When we're looking at an opportunity, first of all we look at it on an industry basis, because we've learned over the years that when companies go bad, they generally go bad as a whole industry. At one point it'll be all the airlines that are bad, another point all the steel companies, and another point the textiles. That's because what happens is you have industries that have been high users of leverage and then some catalytic event occurs, so the industry tends to have problems simultaneously. This creates two sets of opportunities, one is to fix the individual company, and second is the potential for changing the dynamics of the whole industry. If you can do both, then you get two big increments to value. So that's what we really try to shoot for.


CNBC: I read that you have a chart system? How does that work?
WILBUR ROSS: We use charts, not stock trading charts but business charts, and the way they work is, when we're looking at an industry we try to put down in paper everything we can imagine that's wrong with the industry. Usually it's quite a long list. We then go over it, and over it, and over it, and over it till we're pretty well satisfied that we've identified everything that is wrong or is very likely to go wrong. Then we start work on a second chart, which is if we have control of this industry, what would we do to fix these problems. When the two charts get more or less similar in length, that's when we get serious about investing.

Sunday, June 29, 2008

Consumer Splurge Threatens UAE??

From Reuters:
Rampant consumerism in the United Arab Emirates -- home to Dubai, the self-styled capital of conspicuous consumption -- could damage the economy and hinder the Gulf oil producer's efforts to become self-reliant, a government report said.

"The expansion of consumer spending at the expense of savings and investments has, and will continue to have, adverse effects on the local economy," the department said.

"This alarming consumption rate could, in the future, constitute a big hurdle in the face of any plans to transform the country from being a consuming to a producing nation."

In Abu Dhabi, the UAE capital, families spend about 60 percent of their monthly salaries, according to a survey conducted last year, the department said.

Should we be worried that the U.S. was not as vigilante in these matters? Consumer spending definitely blew well past 60% of income, that is certain.

Saturday, June 28, 2008

Some Helpful Advice from Dale Carnegie

I recently picked up Dale Carnegie's book How to Stop Worrying and Start Living for some light, summer reading. (hat tip to smazz for the suggestion) The entire book was very informative and inspiring, and I took the pleasure of jotting down a few of the approaches which I thought were particularly helpful.

Formula for Solving Worry Situations:
I. Analyze the situation fearlessly and honestly and figure out the worst thing that can happen as a result of failure.
II. After figuring out the worst case scenario, reconcile yourself to accepting that possibility (if necessary).
III. Calmly devote your time and energy to trying to improve from that worst case scenario.

When approaching problems, try this:
1. What is the problem?
2. What is the cause of the problem?
3. What are all possible solutions to the problem?
4. What would you suggest?

To be objective:
1. Pretend you are collecting the information for someone else. That helps to take a cold, impartial view of the evidence.
2. Try to get all the facts against yourself.
3. State both sides of the issue clearly.

Investors may also take a liking to this quote:
"I have supplied the best men with the best equipment we have and have given them what seems to be the wisest mission. This is all I can do." Admiral Earnest J. King
I sure did.

Friday, June 20, 2008

The Economist: The Future of Energy

So my understanding is, (and correct me if I'm wrong) The Economist is now free to read online. If so, I highly recommend this issue's special report entitled "The Future of Energy". Some fast highlights:

Costs of different sources: (kwh= kilowatt hour)
coal- 5 cents per kwh (ignoring carbon costs)
nuclear- 6.5 cents per kwh
wind- 8 cents per kwh
solar- 20 cents per kwh

"...American power companies are fearful that they will soon have to pay for one particular pollutant, carbon dioxide, as is starting to happen in other parts of the rich world. Having invested heavily in gas-fired stations, only to find themselves locked into an increasingly expensive fuel, they do not want to make another mistake.

That has opened up a capacity gap and an opportunity for wind and sunlight. The future price of these resources—zero—is known. That certainty has economic value as a hedge, even if the capital cost of wind and solar power stations is, at the moment, higher than that of coal-fired ones."

Wednesday, June 18, 2008

A Rare Perspective In Finance...

From an interview with John Stumpf, CEO of Wells Fargo.

On the sub-prime boom:

Stumpf: We never participated in some of the real exotic things that the industry and others participated in. For example: we never understood why it made sense to make someone a loan, a home mortgage with negative amortization. So you would owe more on the home later than what you started with. That didn't seem sensible to us. We don't do it in any other credit products, not in credit card, why would you do it on someone's home? Because you don't know what's going to happen in the future. You don't know what's going to happen to home values, so you owe more than what you start with some time later, or you underwrite somebody so they can pay a 'teaser rate' . . . part of the rate, and they can't afford the full rate. How can that possibly make sense? So as we saw, and we probably didn't see as early as we should have, but as you see 5-6 years of unprecedented appreciation, some time it is going to go down. So we started to trim back and thank goodness we didn't do a lot of those things, but here's the real secret . . . many companies not only did that for their portfolio, they also structured off balance sheet vehicles known as 'SIV's and CDO's and CLO's. I thought a SIV was a four-wheel drive; I had no idea what it was! And they put these products, and they leveraged their balance sheets with these off-balance sheets things, these vehicles that add NO value and now they're coming back on-balance sheet. And that's where the 380 billion dollars of losses have happened around the industry and we didn't participate in that.

On regrets about what is happening in finance:

Stumpf: I would say it this way. I feel badly anytime anyone from our industry does something that does not put the customer at the center of everything that they do. So it's for the benefit and for to help our customers. In fact, the first two lines in our vision is about helping customers succeed financially and earning all of their business. We feel what our customers feel. It helps us not at all to put a customer into a loan, into a product, into a home that they cannot afford. They lose, we lose. So when our customers grow and benefit and succeed, we grow and benefit and succeed. So if anybody that doesn't do that, have that as the primary motivation of their business model, I think is not serving our industry well and is not serving customers well.

And much more in the interview.

Tuesday, June 17, 2008

Stocks versus Bonds

Yesterday in my reading I ran across this from Bloomberg:
Standard & Poor's 500 Index shares yield 0.2 percentage point more in profits than the interest on 10-year notes, the smallest advantage since 2004, data compiled by Bloomberg show. The last time corporate earnings returned less than bonds, the index posted its biggest monthly decline in five years.
It reminded me of previous research done by Hoisington Investment Management comparing the performance of stocks versus bonds over 10-20 year periods. They looked at the best and worst periods for stocks and bonds and concluded that their relative performances are most affected by three considerations: the inflation rate; dividend yield of stocks versus treasuries; and the P/E ratio. The following chart shows the 4 best and worst periods for stocks and bonds:

Disregard the inflation factor for now (we will look at it again later). Notice though that the difference between the yields on stocks and bonds has been a fairly good indicator of their relative performance into the future. When dividend yields on stocks are much larger than treasuries yields, stocks have tended to outperform over the next decade(s). When the yields between the two converge, bonds have usually outperformed.

Interestingly, the dividend yield in both the best and the worst periods of Hoisington's research was still always higher than the treasury yield. The earnings yield was usually much higher (computed by the inverse of the P/E). According to Bloomberg, the earnings yield today on the S&P500 is just .2 percentage points above the yield of the treasuries. That strongly points in favor of treasuries over the coming decade.

Of course, the Hoisington study says itself that the most important factor of all is the inflation rate. Stock investors benefit from high inflation (relatively), while bond investors prefer benign inflation or even deflation. But predicting the inflation rate has always been a difficulty, and you can get arguments for both inflation and deflation. Yes, gas and food costs are soaring, which is inflationary. But at the same time, the rise in those costs is deterring consumer spending on more elastic goods, meaning less demand, i.e. deflationary.

There is only one thing investors can be sure of- that the relative yields of U.S. treasuries looks very attractive today when compared with the past.

Sunday, June 15, 2008

The Case of Puerto Rican Housing

If you build it, they will come... or so goes the saying. But while on vacation in Puerto Rico, I noticed a strange phenomenon- completely abandoned buildings. Many were severely decrepit. I even saw a tree growing through one building.

A typical site in Puerto Rico

I mean there was an abundance of them, and this was in the heart of the capital, San Juan. I even saw a beach-front hotel which was completely rundown. As I saw all this I couldn't help but wonder how so many good buildings could deteriorate into such a state.

It turns out, there was a very large property boom in the 50's and 60's which was followed by a very sharp drop in the 70's and 80's. I was hoping to research more details on the matter when I got home, but so far I've found limited information about it online. Still, the sight was a stark reminder that even real estate markets are held by reality- you need people to fill those buildings in order to add any real value. It seems Puerto Rico built way more than it needed, and they are reminded of their past excesses daily.

Is the U.S. in a similar situation? Unlikely, because I feel there is an abundance of people who would come and live here if the price is right (and immigration allows it). Also for those interested, you can find a 12 or so year history of housing units and vacancies here.

Monday, June 09, 2008

A Study of Transamerica

The Company
Last year, a friend of mine introduced me to a financial planning firm by the name of Transamerica. To take the description from their own webpage:
The companies of Transamerica offer a wide array of innovative financial services and products with a common purpose. Regardless of the distribution method, our mission is to help individuals, families, and businesses build, protect, and preserve their hard-earned assets. With more than a century of experience, we have built our reputation on solid management, sound decisions, and consumer confidence.

The Transamerica companies are members of the AEGON Group, a multinational insurance organization headquartered in The Hague, The Netherlands. AEGON is one of the world’s leading life insurance and financial services organizations.

As I spent more time on the job, I began to notice an interesting thing about their formula for success. (They are the fastest growing financial planning firm in the country)

Cialdini's Magic In Full Effect
I was luckily already well familiar with Cialdini's work by the time I began working there. For those who do not know, Robert Cialdini is a sociologist who has researched and wrote on psychological principles which can be used to influence a person's reaction. In his book Influence: The Psychology of Persuasion, he wrote about 5 particularly effective tools: liking, reciprocity, commitment, authority, and social proof. (For those who want to learn more about this, there are a few articles in my Online Archive "Cialdini, Robert.")

In my opinion, Transamerica's business formula had incorporated ALL of these methods. ( I'll disregard for now the many methods used to motivate the employees themselves within the company.) First, let me explain the process. As a new employee, my first "mission" was to make a list of one hundred friends and family members. I was then told to narrow down the list into two groups. The first, people who would potentially need financial advice. The second, people who would be interested in working for Transamerica themselves. After that, the calling began, and the goal was to set up a one or two hour meeting between the employee, the acquaintance, and a senior employee. During that time, senior employee would discuss the financial matters of the household and offer recommendations which could be helpful.

Now let me paint the picture of how I see Cialdini's principles in the process. It begins by using the "liking" which is already present between the employee and their friends. (Let's say Billy and John, respectively) Already, this inspires in John a sense of wanting to help his friend, and it makes him commit to something he would ordinarily refuse. That leads to the "commitment"- John has agreed to give up a few hours of time for this meeting. On the one hand, this means he will likely stick to the promise he has made to his friend. Even more importantly, after spending two hours on a meeting, John will likely feel the need to get something out of it.

Then, there is the presence of the boss. He represents "authority" because, face it, Billy's friends and family know Billy, and they've never known him for his financial expertise. But this senior employee is mysterious, and so John has no reason to doubt his financial accumen. As the boss is giving this speech to John, Billy is sitting complacently near by, making him feel comfortable about everything being said ("social proof"). After this long, personal meeting, John feels like he has just been done a huge favor by Billy and his boss. They have just given up their time trying to help him plan and save for his future. John feels the urge to want to "reciprocate" the favor, and implementing the recommendations seems like the least he can do. Besides, the recommendations will make him more money, so it is win-win, right?

To What End?
Cialdini mentioned in his book that these principles can be used on people for good or for bad. His goal was to reveal these principles to his readers so that they can spot these tactics and then decide for themselves. But as Charlie Munger pointed out, many sellers/advertisers picked up the book instead, and applied the principles in their business to the detriment of their customers.

Which side does Transamerica fall under? I am not going to say directly how I feel; rather, I will simply demonstrate an example in something I understand, mutual funds. Now as Transamerica makes clear:
Fund shareholders may incur two types of costs: (1) transaction costs, including sales charges (loads) on purchases, contingent deferred sales charges on redemptions and redemption fees; and (2) ongoing costs, including management fees, 12b-1 distribution and service fees, and other fund expenses.
So first, lets deal with transaction costs. You can find information for Transamerica's sales charges here. But as an example, if you were investing $50,000 in a Transamerica Equity Fund, it appears your sales charge as a percent of the amount invested would be 4.99%. To see how important that is, lets look at the value of that 50,000 invested for 10 years at 10%. With the charge, your final amount comes out to $123,216. Without it, it is $129,687. Some people might brush that off, but I surely don't, especially when there are an endless amount of funds out there which no longer charge upfront fees.

And then, there are the ongoing costs. Lets take the "TA IDEX Asset Allocation- Conservative Portfolio". In their financial report they state:
The average weighted annualized expense ratio of the underlying investment companies at April 30, 2007, was 0.83%.
That surprised me at first, because it is relatively low. And then I looked at the portfolio's composition: (Click on it below to get a closer look)

These are all affiliated funds, with their own expenses, which are not included. Essentially, you are getting charged .83% a year simply for them to put your money into multiple other TA IDEX funds.

It just so happens that I was writing this, news came out on Buffett's newest bet, which is completely relevant:
Will a collection of hedge funds, carefully selected by experts, return more to investors over the next 10 years than the S&P 500?

That question is now the subject of a bet between Warren Buffett, the CEO of Berkshire Hathaway, and Protégé Partners LLC, a New York City money management firm that runs funds of hedge funds - in other words, a firm whose existence rests on its ability to put its clients' money into the best hedge funds and keep it out of the underperformers.

You can guess which party is taking which side.

Protégé has placed its bet on five funds of hedge funds - specifically, the averaged returns that those vehicles deliver net of all fees, costs, and expenses.

On the other side, Buffett, who has long argued that the fees that such "helpers" as hedge funds and funds of funds command are onerous and to be avoided has bet that the returns from a low-cost S&P 500 index fund sold by Vanguard will beat the results delivered by the five funds that Protégé has selected...

Essentially, the issue boils down to a simple point which Buffett and John Bogle (founder of Vangaurd Funds) have long made. That is, the sum results of all participants in the stock market must average out to the stock market average. In any given year, some people will out-perform, some will under-perform, but their total can never average out to more than the returns of the market itself. Unfortunately, most people get hit with a variety of fees along the way- management fees, brokerage fees, trading fees, etc. Now, a piece of the market's total returns is going from investors to these third-parties, meaning that most people will actually end up under-performing the average return of the market itself. A passive investor's best hope is to minimize all of his fees and hope to achieve a return as close to the market average as possible.

Getting back to Transamerica's Conservative Portfolio, they are by my count investing in 36 other mutual funds. Each of those funds is probably invested in about a hundred stocks or bonds themselves, making it so diversified that it is hard to believe its results will be materially different than average. Yet, you are getting charged for two layers of fees and expenses along the way.

So let us now update our own example taking into account all of the fees. We're still investing $50,000 at 10% over 10 years. But in one situation, you are giving up 5% upfront and 1.5% (my guess) in total annual fees. That leaves you with a final amount of $107,408 in 10 years, compared with $129,687 with no fees. If you expand the time horizon to 25 years, the numbers are $365,160 versus $541,735. I'll let readers decide how much those differences mean to them.

P.S. If anyone sees any legal issues which may arise from this post, please do let me know so I can make any necessary changes. I really don't want to get sued.