Market Summary For The Week Ended August 5, 2011

When Warren Buffett made his open call for a Chief Investment Officer, he stated:

"Over time, markets will do extraordinary, even bizarre, things. A single, big mistake could wipe out a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions."

That was March 2007.

I still remember the application I wrote to Buffett regarding the position. I went into lengthy detail about Hyman Minsky, his theory of ponzi finance, and how we may be imminently approaching such a moment (This was all before Minsky went mainstream). After explaining the concept, I dug into specifics and I think I came up with seven- Government spending & Social Security, the housing and mortgage sectors, the private equity bubble. I think oil was on that list too, on the premise that traders holding oil add no value. The rest unfortunately are lost. That is to say, the desktop holding the original file is kaput.

Enter today- markets are down over ten percent from their highs, and there are lessons to be learned. I believe successful investment today requires more than just an ability to identify and hold cheap stocks. I think a critical lesson (one that I have failed to apply this time around) is to not only hold cash as markets become frothy, but also to adjust your margin of safety requirements on equities as market levels go up and economic stability comes into question.

I'm still concerned about the overall macro economy. The richest world' nations continue to run government deficits at nearly 10% of their GDP, and there are compelling reasons to believe in a Chinese slowdown. Top amongst them:

1. housing prices have quadrupled in some markets over the last four years
2. fixed investment is near 50% of GDP, and there is evidence that a large amount of this is resulting in empty offices and homes
   

I would want some pretty outrageous buys to entice me to buy right now. As today's Wall Street Journal points out, 10 year P/E's on the S&P500 are still at over 20, and as some people have been pointing out, the real economic earnings of S&P500 companies is considerably lower than what is reported. That being said, here's what I found in my research yesterday:

• A low-cost producer with a very depressed 16% free cash flow yield, where the rest of the industry is actually losing money. Arguably, it could fairly easily see a rise to 33%.
• Another company where one segment operates under contracts with very strong credit customers and high switching costs. Yield to value on just that one segment is 20%. Then, you get another segment which is the #2 market player, sells internationally, and at its prime made an additional 16% yield on today's EV.

No, I will give no specifics. These are probably buys now. So long as the business risk on these companies is as minimal as I see it (especially in times of economic hardship), then the market cannot ignore these earnings yield when they compare so favorably to your 3% ten year treasury. Opportunities today exist, but investors must be careful. I can give no greater warning than this: Team Hamblin Watsa at Fairfax Financial implemented their stock market hedges when the S&P and Russell Index were still 10% lower than this. And their long-term record is near the best.