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.