Rational Angle

It's All Just History Repeating

2011-11-12T10:51:00.000-08:00

This is a repost of a blog entry from February 2009.

On Globalization

Ran across this during my reading:

Where one nation has got the start of another in trade, 'tis very difficult for the latter to regain the ground it has lost; because of the superior industry and skill of the former, and the greater stocks which its merchants are possest of, and which enable them to trade for so much smaller profits. But these advantages are compensated, in some measure, by the low prices of labour in every nation that has not an extensive commerce, and does not very much abound in gold and silver. Manufactures, therefore, gradually shift their places, leaving those countries and provinces, which they have already enriched, and flying to others, whither they are allured by the cheapness of provisions and labour, till they have enriched these also, and are again banished by the same causes. And in general we may observe, that the dearness of every thing, from plenty of money, is a disadvantage, that attends an established commerce, and sets bounds to it in every country, by enabling the poorer states to undersell the richer in all foreign markets.

-David Hume, Of Money- 1752

Vanity Fair: California and Bust

2011-10-10T12:24:00.000-07:00

The succession of financial bubbles, and the amassing of personal and public debt, Whybrow views as simply an expression of the lizard-brained way of life. A color-coded map of American personal indebtedness could be laid on top of the Centers for Disease Control’s color-coded map that illustrates the fantastic rise in rates of obesity across the United States since 1985 without disturbing the general pattern. The boom in trading activity in individual stock portfolios; the spread of legalized gambling; the rise of drug and alcohol addiction—it is all of a piece. Everywhere you turn you see Americans sacrifice their long-term interests for short-term rewards.

The entire Michael Lewis article - filled with comments from Arnold Schwarzenegger, Meredith Whitney, and more - can be found here.

Howard Marks: "What's Behind The Downturn"

2011-09-20T23:15:00.000-07:00

...Thus at Oaktree, we're making allowances for things that may go less well than they did in past periods. Cheapness provides a margin of safety, but only so much. We're moving forward, but catiously.

For the full memo, click here.

You Know To Sell When...

2011-08-18T00:08:00.000-07:00

....according to the average of more than 900 estimates compiled by Bloomberg. Industrial & Commercial Bank of China (601398) Ltd., China Construction Bank Corp. (939) and Bank of China Ltd. (3988) have 101 ratings equivalent to “buy” and zero “sell” recommendations, data compiled by Bloomberg show.

Bad Debt At China's Banks Growing: Jain

Market Summary For The Week Ended August 5, 2011

2011-08-06T12:51:00.000-07:00

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:

housing prices have quadrupled in some markets over the last four years
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.

Pictures Worth A Thousand Words

2011-07-15T15:15:00.000-07:00

Sources:
Report on asset securitization incentives
Forbes: the global debt bomb

"Monstrous Risks" in Emerging Markets

2011-06-12T22:51:00.000-07:00

From Reuters:

Brazil's and India's government yield curves are inverting, a condition in which short-term rates rise above longer yields. Historically, such an inversion almost invariably precedes a recession, as investors temporarily accept lower long rates in anticipation of the decline in yields that typically accompanies an economic downturn.
...
"If you look at inverted yield curves around the world, the most inverted yield curves are Greece, Ireland and Portugal, and then comes India and Brazil. There is your warning sign that no one is talking about," he said.

ECB Executive Lorenzo Bini Smaghi

2011-05-30T11:03:00.000-07:00

There's a terrific interview that came out this weekend in the FT. They talk with ECB board member Lorenzo B. Smaghi about the mess that Greece is currently in:

FT Why would it not be possible to organize a so-called “orderly” debt restructuring?
LBS It is a fairy tale because it tries to apply the Latin American experience of the 1980s to the current Greek situation, which is totally different, in many respects.
First, ...

He goes on to mention five real, compelling economic models that are well worth understanding.

Enjoy

This Time Is Different

2011-04-19T12:03:00.001-07:00

Two passages worth remembering, followed by its comparison to China.

From Carmen Reinhart & Kenneth Rogoff's "This Time Is Different : Eight Centuries of Financial Folly"

Banking Crises in Repressed Financial Systems

Our sample includes basically two kinds of banking crises. The first is common in poor developing countries in Africa and elsewhere, although it occasionally surfaces in richer emerging markets such as Argentina. These crises are really a form of domestic default that governments employ in countries where financial repression is a major form of taxation. Under financial repression, banks are vehicles that allow governments to squeeze more indirect tax revenue from citizens by monopolizing the entire savings and payments system, not simply currency. Governments force local residents to save in banks by giving them few, if any, other options. They then stuff debt into the banks via reserve requirements and other devices. This allows the government to finance a part of its debt at a very low interest rate; financial repression thus constitutes a form of taxation....

Governments frequently can and do make the financial repression tax even larger by maintaining interest rate caps while creating inflation. For example, this is precisely what India did in the early 1970's when it capped bank interest at 5 percent and engineered an increase in inflation of more than twenty percent...)

Inflation rate in China: 5.5%
Average rate on deposits: 1.4%
Average rate on Chinese bank assets: 3.7%

The Lessons of History

The lesson of history, then, is that even as institutions and policy makers improve, there will always be a temptation to stretch the limits. Just as an individual can go bankrupt no matter how rich she starts out, a financial system can collapse under the pressure of greed, politics, and profits no matter how well regulated it seems to be.
...
We have come full circle to the concept of financial fragility in economies with massive indebtedness. All too often, periods of heavy borrowings can take place in a bubble and last for a surprisingly long time. But highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked.

China's Fixed Asset Investment as a percent of GDP: 47 - 65% (depending on what figure you use)
That is a $3.5 trillion+ investment program.
According to a recent article, it now takes $4.3 of debt to create $1 of growth in Chinese GDP. The average for the US from 2001-2010 was about $4 to $1.

Buffett used to say, bubbles usually have their beginnings in something fundamental; public mania just takes the concept too far. China began its fabulous growth by becoming the world's exporter of choice. Yet gradually, an ever larger amount of GDP was composed of new fixed investment. And after the financial crisis, the Chinese government enforced a higher, unprecedented level of investment, taking its share of GDP from the mid 30's to where its at today.

Step back and think about that for a minute... through one of the biggest drops in demand ever... with Chinese wage pricing and currency levels rising... their level of new investment soared. It should be concerning.

As for commodities... Is this time really different?

Source: Macleans

Wells Fargo's CEO On Taking Market Share, Repurchase Risk

2011-01-23T19:59:00.000-08:00

It pays to listen to your quarterly conference calls. When Wells Fargo (NYSE: WFC) held its fourth-quarter presentation on Wednesday, CEO John Stumpf offered two golden pieces of news to his patient followers.
. . .

See the full article here

China's Risk To Your Portfolio in 2011

2011-01-23T19:57:00.000-08:00

China's scored plenty of obvious economic successes in the past few years. . . .

See the full article here

Insurance: Non-Life Business Now Enters Growth Phase

2010-10-26T10:39:00.000-07:00

http://economictimes.indiatimes.com/personal-finance/insurance/insurance-news/Insurance-Non-life-business-now-enters-growth-phase/articleshow/6745302.cms

MUMBAI: After playing second fiddle to the life insurance industry for several years, the non-life business has roared back into growth mode. In the first six months of the current fiscal, the industry has recorded 23% growth and there are signs that profitability has improved as well.

“In a stable price environment, the non-life industry should grow by 2-2 .5 times the rate of GDP growth. What we are now seeing is some stability in pricing coupled with opening up of hitherto untapped sectors because of government schemes like the Rashtriya Swastha Bima Yojana,” said ICICI managing director Bhargav Dasgupta .
The growth rate in the first half is almost twice the 13% growth recorded in the whole of 2009-10 .

....

For the first half of the current fiscal, private insurers have recorded total premium of . 9,204 crore against . 7,312 crore in FY10 — recording a growth of 25.9%. Stateowned insurers have collected total premium of . 14,500 crore in the first half of FY11 against . 11,184 crore in the previous year — resulting in a 21% growth.

....

Among companies, HDFC Ergo continues to be one of the most aggressive growing by 49%. ICICI Lombard General Insurance — leader among private companies — has grown 32%. Tata AIG General has also managed a 33% growth despite its foreign parent’s troubles internationally.

Chinese Housing Bubble

2010-10-20T09:59:00.001-07:00

http://www.time.com/time/photogallery/0,29307,1975397_2094492,00.html

Man's Search For Meaning

2010-10-19T21:46:00.000-07:00

Man's Search For Meaning (Rough Draft)

"He who was a why to live for can bear with almost any how" - Friedrich Nietzsche

For the people suffering life in concentration camps in the 1940's, it would seem hard to find much meaning in life. Prisoners were daily rationed a few ounces of bread, perhaps with a bowl of watery soup. They were worked past exhaustion each and every day. They slept by cramming eight people together on to a plank barely 5 feet wide. They suffered freezing weather with rags, and if they were lucky, a pair of shoes. Most were not lucky.

Once in a concentration camp, the chance of survival was put at 1 in 28 (computed after the fact). From inside the camp, it would seem easy to lose hope. Victor Frankl was one of the survivors of this tragedy. As he described in his book, "Man's Search for Meaning", one of the most depressing influences was that the prisoner could not know how long his term of imprisonment would be. He could not picture the future and he could not form goals. Victor watched as prisoner after prisoner succumbed to this depressing influence. The saddest thing for him was to watch a prisoner who refused to get up for the morning's work; who would not budge even after repeated beatings by the SS gaurds. It was a certainty where the guards would send him next.

Yet despite the bleakest of outlooks, Victor, and the other survivors, generally clung on to something. Victor wanted to reunite with the woman he loved. He wanted to finish his thesis work. He wanted to use his experience in the camps to describe, from a psychological standpoint, what he had learned. And in that respect, there was plenty.

For example, veteran prisoners learned quickly that two things gained him favor from the otherwise merciless guards: entertainment and applause. They learned that the human body, which believes itself to be so fragile, is actually capable of withstanding the harshest of punishments. Yet perhaps his biggest realizations came from studying the character of men.

Victor observed people anticipate the date they would be set free. Some people clung on to these predictions as a basis of hope. And when the day came around and passed, and freedom was not attained, they had set themselves up for a deep misery. It was common for people to cling to hopes of being home before the new year. And it is a well-documented fact that a majority of illnesses sprang up in the month of January (and this was not due to any weather related factors).

Others would set themselves intent on gaining freedom. They approached everyday with a mindset of how they would achieve their freedom. The problem was they were facing an insurmountable challenge. It is as if I decided I was going to chip my way through a mountain using only a small pick-axe. I would be faced every day with the grim realization that my progress was muted. One can only go so long before this evidence would prove disheartening.

Victor believed the greatest lesson he learned dealt with suffering, which he described as a fate that could not be changed. Those who accepted their grim situation generally maintained a healthy attitude to life. Those who anticipated freedom or intended to control the situation were soon disappointed by the grim and overwhelmingly powerful situation they were in.

Spinoza once said "emotion, which is suffering, ceases to be suffering as soon as we form a clear and precise picture of it." Victor returned home and championed a form of psychological help termed logotherapy. Logotherapy had the patient ask, "how will you approach the situations that life present's you?" "What was it that life expected of me?" Meanwhile, it strives to avoid the vicious cycles which led to the deepest rooted problems- things he labeled anticipatory anxiety and hyper-intention. His main conclusion was that many problems stem simply because people respond to suffering in every way other than accepting it. And when one does that, it is only a matter of time before reality catches up.

Demographics of the Worlds Leading Economies

2010-10-17T11:37:00.000-07:00

The following chart shows the old-age to working-age population ratio of the world's leading industrialized countries: US, Japan, UK, Germany, etc.

What I see is this: from 1990-2010, Japan's old-age to working-age population ratio shifted from .19 to .36. by 2030, it will be over .50.
The US from 2000 to 2010 went from .20 to .26, and by 2030 will be at .33. That is a drag on growth... but not nearly as bad as it was for Japan.

Where Are We With Market Valuations?

2010-10-10T16:52:00.000-07:00

great source:

Where Are We with Market Valuations?

10/10/2010:
The Stock Market is Fairly valued. Based on historical valuations, it is likely to return 6% a year from this level of valuation. This page is updated daily with the market.

Total Market Cap and US GDP

The Ratio of Total Market Cap to US GDP

The Predicted and the Actual Stock Market Returns

What returns can we expect from the stock market?

As of today, the Total Market Index is at $ 12196.2 billion, which is about 83.5% of the last reported GDP. The US stock market is positioned for an average annualized return of 6%, estimated from the historical valuations of the stock market. This includes the returns from the dividends, currently yielding at 2.1%.

As pointed by Warren Buffett, the percentage of total market cap (TMC) relative to the US GNP is “probably the best single measure of where valuations stand at any given moment.”

More at the source on:

1. Interest rates
2. Long Term Growth of Corporate Profitability
3. Market Valuations
Also....

As of 10/10/2010, the stock market is likely to return 6% a year in the next 8 years.

Note: If this stops updating, look here for Wilshire total market value. (I'd use full cap)

Today it is 95% TMV/ GDP

Is The S&P500 Overvalued? What Can You Expect . . .

2010-10-10T16:33:00.000-07:00

This article provides a range of values depending on the scenario chosen. The author believes that a fair value for the S&P 500 Index is within the range of 873 (for required expected return of 9%) to 1031 (for required expected return of 7%), with a mid-point estimate of 944 (for required expected return of 8%). Our assumption is that the S&P earnings will grow with GDP at about 4.5% per year and yield a 2.1% dividend yield and sell at a long-term P/E of 15 in ten years.

http://www.investorsfriend.com/S%20and%20P%20500%20index%20valuation.htm

Top Mortgage Servicers

2010-10-07T14:26:00.000-07:00

Expanding the Wells Fargo Moat:

Oct 7 (Reuters)

 Below are the largest U.S. mortgage servicers, which
collect mortgage payments and foreclose on delinquent loans, as
of June 30, 2010.

 Bank                           Total Loans         Market

                                Servicing now       Share

                                in $billions
1) Bank of America (BAC.N)       $2,135.30          19.9%
2) Wells Fargo (WFC.N)            $1,811.97          16.9%
3) JPMorgan Chase & Co (JPM.N)    $1,353.60          12.6%
4) Citigroup Inc (C.N)            $677.81             6.3%
5) GMAC/Ally Financial           $349.08             3.2%
6) US Bancorp (USB.N)             $189.85             1.8%
7) SunTrust Banks Inc (STI.N)     $175.93             1.6%
8) PHH Mortgage (PHH.N)           $155.97             1.4%
9) OneWest Bank, CA (IndyMac)     $155.00             1.4%
10)PNC Financial Services (PNC.N) $149.94             1.4%
Total residential mortgages outstanding             $10,640

 ($ billions, for 1-4 family homes)

 Source: Inside Mortgage Finance

Forest City Q2 2010 Conference Call Notes

2010-10-07T13:06:00.000-07:00

Intro
value not being reflected by the stock....
YTD net operating income up across all categories
See Supplemental for Geography.
Expect future growth from:

NOI
development pipeline

last 2 years, $800 million of our share of openings
expect 200 basis point spread over debt on these new openings
242 million cash at holdco, our share.
Working to joint venture of NY retail?
Over the past two years, they've done 2.5 billion in refinances, 100 million had to be put down.
Land & construction loans non-existent

Pipeline
East River Plaza opened. Costco!!
Presidio Landmark- 161 unit. Opened.

Beekmann- 904 units in Manhattan
(2% vacancies in the Manhattan market)
Ridge Hill- working hard to lease it up. Great demographics
Foundry Lofts- units at the DC yards.

From Q&A
Ridge Hill is an $800 million project
Rock Gaming Casino will:

lease 200,000 square feet from Tower City.
buy adjacent 16 acres
drive traffic to tower city
600 million casino investment plus 100 million phase 1 building

Steak N' Shake Annual Meeting Notes

2010-04-11T11:25:00.000-07:00

Going forward, the name will be changed to Biglari Holdings, symbol: BH .

Many company's have a fixed mindset to blindly reinvest in their business; We're going to examine the landscape and go where returns are the most attractive. Don't expect dividends. Looking at insurance.

Companies with low debt and strong balance sheets will acquire those with high costs and weak balance sheets. It's a competitive advantage we intend to keep.
Two advantageous aspects of the restaurant business: negative working capital requirements, and little required capital expenditures.
SNS Franchise Prototype
- current model: 4,200 sf, 97 seats, $2.2 million capital cost.
- New model: 3,200 sf, 94 seats, $1.5 million capital cost.
- 1 new franchisee expected in Rome, 1 in Richmond by the end of the year. 1 planned in Las Vegas, 1 of 5 planned in Denver.

Notes from Q&A:

On managing and incentivizing managers:

There are redundancies. For example, we have 81 stores in Florida. 1 district manager, several regional managers, and then each store has a general manager and then a manager.
Every district manager now goes through Sardar. "If all my money were in those 8 stores, would I want this guy running it?"

On Western Sizzlin:

cash flows are actually quiet strong.
we're making the franchise agreement stronger.
between Western Sizzlin and Steak N' Shake, we purchase a lot of beef. We expect improvements in cost from supply chain and procurement.
also puts the franchise experience from SNS to WS.
The merging of two very long legacies in the restaurant business. (50 & 75 years old)

On Store Prototype:

revenue to capital cost should be over 1.
I still see the potential for 1500 domestic units.
So far, our new franchisees have terrific resources. But we're trying to fix the economics so a small business owner can put up some equity and make it happen.
The new prototype brings the grill operations into the open, front and center, so customers can see the show. (In sight, it must be right!)

On running the business:

We're not trying to maximize the amount we charge the customer. This may be one of the worst lessons of business schools ever.
We're trying to maximize the value of the experience to customers.
Take our new Guacamole Steakburger. Rather than buy the guacomole several days old, we put the guacamole in from scratch. We bring the avocados, the cilantro, etc. That's good quality.

On investment management:

Possibly streamlining BH with the Lion Fund.
Hired someone to raise investment capital.
Mustang Capital has increased AUM to 66 million. (Up 18% since March 08)

Others:

Over the course of the new three years, we should see an international Steak N' Shake.
We'll put a company owned SNS on the San Antonio lot. It should happen within a year.
We plan to have 5 company owned in-line (strip mall) stores to test out the economics, the model.

Marketwatch: What AmEx's Ken Chenault Looks for in New Hires

2009-12-22T14:14:00.000-08:00

Jim Rogers Makes My Head Hurt, Too

2009-10-15T21:47:00.000-07:00

Every week there's a link from him promoting doom and oil. From Krugman:

“Well, capital has already been flowing into Asian economies, as you can see by the fact that they’re the world’s biggest creditors.” - Jim Rogers

...

Where Are The Reporters?

2009-07-24T11:10:00.000-07:00

Woe the decline of the newspapers.

Krugman: Deficits Saved The World

2009-07-16T12:38:00.000-07:00

From Krugman's Blog:

The private sector financial balance—defined as the difference between private saving and private
investment, or equivalently between private income and private spending—has risen from -3.6% of GDP in the 2006Q3 to +5.6% in 2009Q1. This 8.2% of GDP adjustment is already by far the biggest in postwar history and is in fact bigger than the increase seen in the early 1930s.
That’s an interesting way to think about what has happened — and it also suggests a startling conclusion: namely, government deficits, mainly the result of automatic stabilizers rather than discretionary policy, are the only thing that has saved us from a second Great Depression...

The Economist: Business in America

2009-05-30T10:50:00.000-07:00

The latest issue of The Economist has a special report on Business in America. You can view it here. Some passages which stuck out to me:

Second, one can look at America’s admirable record of dealing with turmoil. A study by the Ewing Marion Kauffman Foundation, a think-tank that studies entrepreneurialism, found that America’s high rate of economic “churning” boosts productivity and hence material well-being. Between 1977 and 2005 some 15% of all American jobs were destroyed each year as firms closed or cut back. Thanks to the expansion of successful firms and the entry of new ones, however, many more jobs were created than destroyed. Start-ups (ie, firms less than five years old) provided a third of the new jobs during this period.

...
But the central problem is that most Americans get their health insurance through their employers. This dates back to the era of post-war wage controls, when firms offered benefits instead of pay rises. Today’s tax code sets it in stone. Employers can buy health insurance with pre-tax dollars. Individuals cannot.

This creates an agency problem. When a typical patient goes to the doctor, he has no idea what anything costs. He pays only about 15% of the bill, so if the doctor recommends something he will probably say yes. The doctor gets paid for everything he does, so he has a powerful incentive to perform costly, unnecessary procedures. Besides, he may be socked for damages if he omits a test that a lawyer subsequently convinces a jury might have been useful. The costs are passed on to insurers, who pass them on to employers in the form of higher premiums, who then pass them on to workers in the form of lower pay.
...

…Managed care will return. This is the model whereby doctors work for the insurer, which pays them to keep people well. Instead of letting patients go straight to a specialist, managed-care firms like Kaiser Permanente make them see a primary-care doctor first, who will figure out whether the problem is serious. This is crucial. Specialists tend to recommend their own specialism—surgeons advocate surgery, and so on. The lack of a gatekeeper in traditional fee-for-service insurance leads to over-doctoring that is often harmful as well as costly, as that IBM executive discovered.

The Time Paradox

2009-05-25T23:27:00.000-07:00

hat tip to Miguel Barbosa at Simoleon Sense:

Let's Have Cap and No Trade

2009-05-20T09:44:00.000-07:00

A real good op-ed by David Sokol, CEO of Mid-American, regarding the cap and trade proposal:

...
The real hidden catch of the cap-and-trade system, though, is that it will require consumers to pay twice: first for emission allowances and then for the construction of new low- and zero-carbon power plants.
...

The solution? Keep the cap and remove trading from the equation: Mandate that the industry, over the same 40-year period, simply limit its emissions to the same levels proposed in the Waxman-Markey bill. This can be accomplished with a clear plan that gives states an option: Either they participate in a cap-and-trade program or they elect an alternative compliance mechanism to reach the same greenhouse gas emission goals by working with their utilities to develop a 40-year program of shutting down aging coal plants, retrofitting plants to capture carbon dioxide if the technology becomes available, and/or building zero-carbon energy plants. More important, the carbon dioxide reductions in this proposal can be achieved while providing adequate time to plan to minimize price shock and economic dislocation. It is the states, through their public utilities commissions -- not the federal government -- that have both the interest and obligation to manage citizens' costs while transitioning to a carbon-free future.

"The Wire": The Men Behind The Scenes

2009-05-01T21:08:00.000-07:00

Some argue it is the best TV series ever written- and I would be one of them. "The Wire" was an amazing HBO series dealing with the inner-workings of the Baltimore city. And for me, its writing and directing were in a class of its own. So, I got interested in learning about the leading men behind the scenes, David Simon and Ed Burns, and I loved what they had to say. Below are links to a good summary article as well as two interviews I quickly came across. There is surely plenty more.

The Angriest Man In Television

and then, the interviews...

*Update: PBS interview with David Simon (hat tip to comments)

Interview With David Simon

Slate: One thing that struck me about the show, from the get-go—and this may sound like base flattery: It reminded me of Shakespearean drama for the way that even the villains are humanized. No one is just a bad guy. Even Avon, whom I loathed at the opening of Season 1, I came to like.
Simon: It's funny you should say that, because the portrayals in Deadwood are in the Shakespearean model. On The Sopranos, there's an awful lot of Hamlet and Macbeth in Tony. But the guys we were stealing from in The Wire are the Greeks. In our heads we're writing a Greek tragedy, but instead of the gods being petulant and jealous Olympians hurling lightning bolts down at our protagonists, it's the Postmodern institutions that are the gods. And they are gods. And no one is bigger.

Interview With Ed Burns

HBO
So is there a message that you think people can take away from this year's arc?

BURNS
I think the idea we're trying to bring across is that kids are going to get educated. And that we're going to see where. It's not about kids making bad mistakes and becoming caught in the Criminal Justice system. They don't have an option of choice. We in society have the choices. So you might see a kid who clearly doesn't have a prayer and it will be very apparent why he doesn't have a prayer. It's not about blaming kids. They will survive. They will learn. It's just a question of where.

Growth in the 21st Century

2009-04-27T12:36:00.000-07:00

A rare dose of common sense:

The Paradox of Choice

2009-04-05T23:12:00.000-07:00

"The absence of alternatives clears the mind marvelously" - Henry Kissinger

You just bought a brand new pair of pants and bring them back home. You try it on again and this time notice that the waist is actually a little loose. Your satisfaction drops. You regret not having a better fit; in fact, you've already come to expect it. And you blame yourself for not making a better choice- because (or maybe even though) the options at the store were mind numbingly endless.

Sound familiar? Some particular variant of the story must ring true. That is the Paradox of Choice which has been created by our society, and it is something which has been studied closely by Barry Schwartz (who, with one look, you'll find has risen above this ).

Seriously though, how can we avoid this cycle of negative feeling? Well for one, I would acknowledge what you do have, instead of focusing on what you could. Keep things in perspective; it is one thing to err in a critical way, but chances are we are dealing within the realm of minor inconveniences. Finally, learn from the experience, and move on. There's no sense in getting riled up when what's done is done. Keep your focus on what lies ahead, and feel the weight of choices lift off your mind.

Coming Down To Earth?

2009-03-26T10:20:00.000-07:00

The Economist says Obama's Presidency is coming down to Earth, and they cite Buffett:

Mr Buffett has given voice to widespread worries about the administration’s failure to prioritize. “Job one is to win the war, the economic war. Job two is to win the economic war—and job three. And you can’t expect people to unite behind you if you’re trying to jam a whole bunch of things down their throat.”

Buffett is wrong to criticize. Obama and his team have done everything feasible and necessary to handle the financial crisis and restart growth. People will be surprised by how quickly things will change, and there's a glimmer of hope that it is already beginning. The major threat for America now lies in the structural problems it faces. And in this, Obama is right to be strong and efficient in trying to move us forward. He is sacrificing his own interests and tranquility for the benefits of our future. For this, he should be praised.

This Economist article, however, does the opposite, and in the process displays an all-too-familiar logical problem of keeping things in perspective. His faulty qualities, according to this article, are his optimism, hard-work and ambition (really?); his mistakes include mis-chosen cabinet members and 165 million in bonuses. These are very obviously minor in scale. Do I even need to list off the hundreds of real, serious, structural problems which were caused or left to us by the previous administration? And yet for some reason, the Economist was hesitant to rule Bush's presidency a disaster after 8 years, and it is already citing Obama's as potentially such.

Geithner: My Plan For Bad Bank Assets

2009-03-22T22:03:00.000-07:00

Posted on WSJ:

...
However, the financial system as a whole is still working against recovery. Many banks, still burdened by bad lending decisions, are holding back on providing credit. Market prices for many assets held by financial institutions -- so-called legacy assets -- are either uncertain or depressed. With these pressures at work on bank balance sheets, credit remains a scarce commodity, and credit that is available carries a high cost for borrowers.

Today, we are announcing another critical piece of our plan to increase the flow of credit and expand liquidity. Our new Public-Private Investment Program will set up funds to provide a market for the legacy loans and securities that currently burden the financial system.

The Public-Private Investment Program will purchase real-estate related loans from banks and securities from the broader markets. Banks will have the ability to sell pools of loans to dedicated funds, and investors will compete to have the ability to participate in those funds and take advantage of the financing provided by the government.

The funds established under this program will have three essential design features. First, they will use government resources in the form of capital from the Treasury, and financing from the FDIC and Federal Reserve, to mobilize capital from private investors. Second, the Public-Private Investment Program will ensure that private-sector participants share the risks alongside the taxpayer, and that the taxpayer shares in the profits from these investments. These funds will be open to investors of all types, such as pension funds, so that a broad range of Americans can participate.

Third, private-sector purchasers will establish the value of the loans and securities purchased under the program, which will protect the government from overpaying for these assets.

The new Public-Private Investment Program will initially provide financing for $500 billion with the potential to expand up to $1 trillion over time, which is a substantial share of real-estate related assets originated before the recession that are now clogging our financial system. Over time, by providing a market for these assets that does not now exist, this program will help improve asset values, increase lending capacity by banks, and reduce uncertainty about the scale of losses on bank balance sheets. The ability to sell assets to this fund will make it easier for banks to raise private capital, which will accelerate their ability to replace the capital investments provided by the Treasury.

This program to address legacy loans and securities is part of an overall strategy to resolve the crisis as quickly and effectively as possible at least cost to the taxpayer. The Public-Private Investment Program is better for the taxpayer than having the government alone directly purchase the assets from banks that are still operating and assume a larger share of the losses. Our approach shares risk with the private sector, efficiently leverages taxpayer dollars, and deploys private-sector competition to determine market prices for currently illiquid assets. Simply hoping for banks to work these assets off over time risks prolonging the crisis in a repeat of the Japanese experience.
...

I'm all for it.

March 7 Weekly Address

2009-03-07T12:14:00.000-08:00

Also, you can find some notes from a NYT interview with Obama here.

President's Weekly Address

2009-03-02T16:50:00.001-08:00

See it here.

Housing Correction

2009-02-28T11:32:00.000-08:00

According to Calculated Risk, total housing starts were 464 thousand annualized for the month of January. Now, I remember reading a government report stating that new household units of people were forming in the U.S. at a rate of 1.5 million a year. If so, any bubble in excess capacity over the last several years is quickly reversing itself (see chart). Assuming, of course, that people can still get jobs to afford shelter.

Attention Under Siege

2009-02-24T18:01:00.000-08:00

Thanks to Miguel for finding this article.

To avert a dark age, we must take several steps:

Question the values that undermine attention - Helped by influential tools that are seedbeds of societal change, we’ve built a culture over generations that prizes frenetic movement, fragmented work and instant answers. Recently, my morning paper carried a front-page story about efforts “in a new age of impatience” to create a quick-boot computer. Explained one tech executive, “It’s ridiculous to ask people to wait a couple of minutes” to start up their computer. The first hand up in the classroom, the hyper-businessman who can’t sit still, much less listen - these are markers of success in American society. Instead of venerating scattershot focus, rushed detachment, knowledge built on sound bites, we need to value whole focus, full awareness and the difficult work of knowledge creation.

Your Weekly Address

2009-02-22T17:55:00.001-08:00

Financial Innovation

2009-02-22T11:47:00.000-08:00

From Volcker's recent speech:

Volcker: When it comes to innovation, I'll raise a question to you, what is the most important financial innovation of the past 20 or 30 years for the average person? I think its the automatic teller machine. It's not any high class sophisticated financial operation, its a technical improvement which has sure changed banking. I have more connection with my automatic teller machine, as do many of you, than any other part of the financial markets.

Watching The Greats

2009-02-18T11:49:00.000-08:00

Berkshire Hathaway and Fairfax Financial are perhaps the two of the greatest asset allocating machines out there today. They both released their 13-F filing yesterday, listing their common stock holdings at the end of the December period. Paying particular attention to Fairfax, we see a lot of major positions:

(Value, in $)

102 mil Alcoa
99 mil Burlington Northern
271 mil Dell
162 mil Frontier Communications
195 mil GE
234 mil Intel
459 mil Johnson and Johnson
98 mil King Pharma
294 mil Kraft Foods
96 mil Level 3 Comm.
159 mil Magna Intl
318 mil Pfizer
104 mil Wells Fargo

*Note: Positions in bold are new.

Not surprisingly, there is a lot of overlap with Buffett, who holds major positions himself in Burlington Northern, Kraft, Wells Fargo, and Johnson and Johnson.

According to Nasdaq, the total value of U.S.-listed common stock holdings at Fairfax is now up to *$4.7 billion (this excludes any foriegn holdings). Just over two years ago, the total common stock portfolio was at about $1.8 billion, and that was significantly hedged with market short positions. Prem and co. are at last putting major money into work with stocks, indicating that they see significant returns ahead. If they're right, great things lie in store for shareholders of Fairfax.

Source:
http://holdings.nasdaq.com/asp/OwnerPortfolio.asp?FormType=OwnerPortfolio&CIK=0000915191&HolderName=FAIRFAX+FINANCIAL+HOLDINGS+LTD%2F+CAN

*Correction, 2/19/09: included in the Nasdaq portfolio was $2.2 billion in value of Odyssey Re shares which were not included under equities in their 2006 balance sheet. Because Fairfax reported earnings today however, we know that total common stocks is at $3.8 billion, with $2.3 billion added to investments in the quarter. So although not as large as the originally stated notional amount, there has been a considerable increase in their common stock exposure.

Disclosure: The author owns shares in Fairfax Financial, Odyysey Reinsurance, and Burlington Northern.

Buffett's Buy Metric

2009-02-15T20:57:00.000-08:00

...Fortune first ran a version of this chart in late 2001 (see "Warren Buffett on the stock market"). Stocks had by that time retreated sharply from the manic levels of the Internet bubble. But they were still very high, with stock values at 133% of GNP. That level certainly did not suggest to Buffett that it was time to buy stocks.
But he visualized a moment when purchases might make sense, saying, "If the percentage relationship falls to the 70% to 80% area, buying stocks is likely to work very well for you."...

See the complete article here.

On Globalization

2009-02-14T19:59:00.000-08:00

Ran across this during my reading:

Where one nation has got the start of another in trade, 'tis very difficult for the latter to regain the ground it has lost; because of the superior industry and skill of the former, and the greater stocks which its merchants are possest of, and which enable them to trade for so much smaller profits. But these advantages are compensated, in some measure, by the low prices of labour in every nation that has not an extensive commerce, and does not very much abound in gold and silver. Manufactures, therefore, gradually shift their places, leaving those countries and provinces, which they have already enriched, and flying to others, whither they are allured by the cheapness of provisions and labour, till they have enriched these also, and are again banished by the same causes. And in general we may observe, that the dearness of every thing, from plenty of money, is a disadvantage, that attends an established commerce, and sets bounds to it in every country, by enabling the poorer states to undersell the richer in all foreign markets.

-David Hume, Of Money- 1752

It's all just a little bit of history repeating!

Lessons From Animal Behavior

2009-02-14T13:32:00.000-08:00

A fascinating article from The Economist:

...
In a study reported in a special issue of the Philosophical Transactions of the Royal Society B, researchers led by Dr List looked at colonies of honeybees (Apis mellifera), which in late spring or early summer divide once they reach a certain size. The queen goes off with about two-thirds of the worker bees to live in a new home leaving a daughter queen in the nest with the remaining worker bees. Among the bees that depart are scouts that search for the new nest site and report back using a waggle dance to advertise suitable locations. The longer the dance, the better the site. After a while, other scouts start to visit the sites advertised by their compatriots and, on their return, also perform more waggle dances. The process eventually leads to a consensus on the best site and the swarm migrates. The decision is remarkably reliable, with the bees choosing the best site even when there are only small differences between two alternatives.

But exactly how do bees reach such a robust consensus? To find out, Dr List and his colleagues made a computer model of the decision-making process. By tinkering around with it they found that computerised bees that were very good at finding nesting sites but did not share their information dramatically slowed down the migration, leaving the swarm homeless and vulnerable. Conversely, computerised bees that blindly followed the waggle dances of others without first checking whether the site was, in fact, as advertised, led to a swift but mistaken decision. The researchers concluded that the ability of bees to identify quickly the best site depends on the interplay of bees’ interdependence in communicating the whereabouts of the best site and their independence in confirming this information.

This is something members of the European Parliament should think about. In the same journal, Simon Hix, also of the London School of Economics, and his colleagues examined their voting and concluded that, as might be expected, it was along party-political lines even though the incentives to do so were far less than at national parliaments. Dr Hix and his colleagues reckon that European parliamentarians share the collection of information but, unlike the honeybees, they do not necessarily progress to investigating the issues for themselves before taking a vote.

There is danger in blindly following the party line, a danger that the honeybees seem to avoid. Condorcet’s theory fails to consider whether there is an inbuilt bias among a group that comes together to consider a problem. This “groupthink” occurs when people copy one another. According to Dr List: “The swarm manages to block and prevent the kind of groupthink that can bedevil good decision making.” Dr List adds that people demonstrate this kind of bad decision-making when investors pile into a stock and others follow, creating a bubble for which there is no good reason.
...

Daily Tip For Improvement #2

2009-02-12T10:46:00.000-08:00

One secret recently put to words for me is that you should work hard first and foremost on yourself. To steal an example from the great motivational speaker Jim Rohn: A salesman putting in three extra hours a day at work may notice a slight increase in his sales. But that same salesman spending that three extra hours towards improving his skills and techniques, towards understanding what does and does not work, can notice a phenomenal change in his success. The slight change in focus means all the world.

So, I've been a harsh critic of myself recently, asking questions such as:
"Am I correctly communicating across my desired message?"
"Am I making the best use of my time?"
"How do my actions and habits match my long term goals?"

I end with a quote from Jim:

The only way things are going to change for you is when you change. What are you going to change that will in turn change your life? If you keep living the way you are right now, you will continue to produce the same life that you already have. That's the way it works.

Daily Tip For Improvement

2009-02-11T08:35:00.000-08:00

Fascinating things are being discovered in nueroscience. One concept that has particularly caught my attention is neuro-plasticity. It describes the ability of the brain to change and strengthen itself to better cope with its surroundings Even when specific brain regions have become damaged, scientists have found that the brain can re-wire so that new sections take over the lost function.

I've been reading a fascinating book on the subject titled "The Brain That Changes Itself" by Norman Doidge. In it, two points are repeatedly stressed. The first is the following:

Neurons that fire together, wire together. Neurons that fire apart, wire apart.

That is, neurons are the centerpiece of a lot of the activity within our brain. Whenever we act, several different neural pathways all fire simultaneously and invoke certain reactions in your brain. So for example, when you think of Chipotle, it might also trigger thoughts of their delicious burritos, their free student drinks, their distinctive brown paper bags, or images of your local Chipotle brand, or the general positive feelings you have towards the brand. And each time you think about it, these neurons are firing and you are reinforcing these images and connections in your brain.

My tip today is to become more aware of the actions you perform, and what other feelings or thoughts you associate with them. Think of ways you can improve, and learn to associate that with a relevant activity. As an example, I have been making it a point to stress both speed and penmanship while taking my notes in class. Every time I emphasize this, I am reinforcing both qualities in my general writing and noticeable improvement has already taken place.

Use positive reinforcement for those admirable things you do. Do the opposite for those bad habits you've been always wanting to kick. It's a process, but in time your brain will re-wire and you can change yourself for the better.

Disclosure: The author owns a position in Chipotle Mexican Grill.

Math, Meet Music

2009-02-10T12:56:00.001-08:00

This is interesting. Spotted first by Miguel at Simoleon Sense, a blog I highly recommend.

Ditch the Paper, Distribute E-Readers?

2009-02-10T12:38:00.000-08:00

A sense of things to come:

...
And then there's the math: From the NYT's financial report, production costs in terms of raw materials and wages/benefits tally around $844 million a year. Carlson has info suggesting the newsroom costs total around $200 million a year, meaning it costs some $644 million to print and distribute the physical newspaper.
The Times reportedly has 830,000 subscribers. A Kindle costs $359. Thus distributing a free Kindle to each subscriber would cost about $298 million.

If the times killed its paper print-run and followed the Kindle-only model, that would leave the newspaper with $346 million in its pocket. Okay, distributing the newspaper electronically in a secure way needs some electronic infrastructure...let's stick a figure of $10 million on that. That still leaves $336 million to spare--a figure not to be sniffed at.
...

Warren Buffett on President Obama

2009-02-07T12:59:00.000-08:00

I've got a conviction about him that I don't get very often... He has as much potential as anyone I've seen to have an important impact over his lifetime on the course that America takes.

From Warren Buffett Speaks by Janet Lowe

A Little Something About Investing

2009-01-13T22:03:00.000-08:00

From the General Theory of Employment, Interest, and Money, by John Maynard Keynes:

Decisions to invest in private business of the old-fashioned type were, however, decisions largely irrevocable, not only for the community as a whole, but also for the individual. With the separation between ownership and management which prevails to-day and with the development of organised investment markets, a new factor of great importance has entered in, which sometimes facilitates investment but sometimes adds greatly to the instability of the system. In the absence of security markets, there is no object in frequently attempting to revalue an investment to which we are committed. But the Stock Exchange revalues many investments every day and the revaluations give a frequent opportunity to the individual (though not to the community as a whole) to revise his commitments. It is as though a farmer, having tapped his barometer after breakfast, could decide to remove his capital from the farming business between 10 and 11 in the morning and reconsider whether he should return to it later in the week. But the daily revaluations of the Stock Exchange, though they are primarily made to facilitate transfers of old investments between one individual and another, inevitably exert a decisive influence on the rate of current investment. For there is no sense in building up a new enterprise at a cost greater than that at which a similar existing enterprise can be purchased; whilst there is an inducement to spend on a new project what may seem an extravagant sum, if it can be floated off on the Stock Exchange at an immediate profit. Thus certain classes of investment are governed by the average expectation of those who deal on the Stock Exchange as revealed in the price of shares, rather than by the genuine expectations of the professional entrepreneur. How then are these highly significant, daily, even hourly revaluations of existing investments carried out in practice?
...

Nevertheless the above conventional method of calculation [based on assuming that the existing state of affairs will continue indefinitely] will be compatible with a considerable measure of continuity and stability in our affairs, so long as we can rely on the maintenance of the convention.
For if there exist organised investment markets and if we can rely on the maintenance of the convention, an investor can legitimately encourage himself with the idea that the only risk he runs is that of a genuine change in the news over the near future, as to the likelihood of which he can attempt to form his own judgment, and which is unlikely to be very large. For, assuming that the convention holds good, it is only these changes which can affect the value of his investment, and he need not lose his sleep merely because he has not any notion what his investment will be worth ten years hence. Thus investment becomes reasonably “safe” for the individual investor over short periods, and hence over a succession of short periods however many, if he can fairly rely on there being no breakdown in the convention and on his therefore having an opportunity to revise his judgment and change his investment, before there has been time for much to happen. Investments which are “fixed” for the community are thus made “liquid” for the individual.

It has been, I am sure, on the basis of some such procedure as this that our leading investment markets have been developed. But it is not surprising that a convention, in an absolute view of things so arbitrary, should have its weak points. It is its precariousness which creates no small part of our contemporary problem of securing sufficient investment.

V

Some of the factors which accentuate this precariousness may be briefly mentioned.

(1) As a result of the gradual increase in the proportion of the equity in the community’s aggregate capital investment which is owned by persons who do not manage and have no special knowledge of the circumstances, either actual or prospective, of the business in question, the element of real knowledge in the valuation of investments by those who own them or contemplate purchasing them has seriously declined.

(2) Day-to-day fluctuations in the profits of existing investments, which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even an absurd, influence on the market. It is said, for example, that the shares of American companies which manufacture ice tend to sell at a higher price in summer when their profits are seasonally high than in winter when no one wants ice. The recurrence of a bank-holiday may raise the market valuation of the British railway system by several million pounds.

(3) A convetional valuation which is established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently as the result of a sudden fluctuation of opinion due to factors which do not really make much difference to the prospective yield; since there will be no strong roots of conviction to hold it steady. In abnormal times in particular, when the hypothesis of an indefinite continuance of the existing state of affairs is less plausible than usual even though there are no express grounds to anticipate a definite change, the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no solid basis exists for a reasonable calculation.

(4) But there is one feature in particular which deserves our attention. It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the convetional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it “for keeps”, but with what the market will value it at, under the influence of mass psychology, three months or a year hence. Moreover, this behaviour is not the outcome of a wrong-headed propensity. It is an inevitable result of an investment market organised along the lines described. For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.

Thus the professional investor is forced to concern himself with the anticipation of impending changes, in the news or in the atmosphere, of the kind by which experience shows that the mass psychology of the market is most influenced. This is the inevitable result of investment markets organised with a view to so-called “liquidity”. Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of “liquid” securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day is “to beat the gun”, as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.

This battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years, does not even require gulls amongst the public to feed the maws of the professional; — it can be played by professionals amongst themselves. Nor is it necessary that anyone should keep his simple faith in the conventional basis of valuation having any genuine long-term validity. For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs — a pastime in which he is victor who says Snap neither too soon nor too late, who passes the Old Maid to his neighbour before the game is over, who secures a chair for himself when the music stops. These games can be played with zest and enjoyment, though all the players know that it is the Old Maid which is circulating, or that when the music stops some of the players will find themselves unseated.

Or, to change the metaphor slightly, professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.

If the reader interjects that there must surely be large profits to be gained from the other players in the long run by a skilled individual who, unperturbed by the prevailing pastime, continues to purchase investments on the best genuine long-term expectations he can frame, he must be answered, first of all, that there are, indeed, such serious-minded individuals and that it makes a vast difference to an investment market whether or not they predominate in their influence over the game-players. But we must also add that there are several factors which jeopardise the predominance of such individuals in modern investment markets. Investment based on genuine long-term expectation is so difficult to-day as to be scarcely practicable. He who attempts it must surely lead much more laborious days and run greater risks than he who tries to guess better than the crowd how the crowd will behave; and, given equal intelligence, he may make more disastrous mistakes. There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable. It needs more intelligence to defeat the forces of time and our ignorance of the future than to beat the gun. Moreover, life is not long enough; — human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate. The game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll. Furthermore, an investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money — a further reason for the higher return from the pastime to a given stock of intelligence and resources. Finally it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks.^[4] For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.

(5) So far we have had chiefly in mind the state of confidence of the speculator or speculative investor himself and may have seemed to be tacitly assuming that, if he himself is satisfied with the prospects, he has unlimited command over money at the market rate of interest. This is, of course, not the case. Thus we must also take account of the other facet of the state of confidence, namely, the confidence of the lending institutions towards those who seek to borrow from them, sometimes described as the state of credit. A collapse in the price of equities, which has had disastrous reactions on the marginal efficiency of capital, may have been due to the weakening either of speculative confidence or of the state of credit. But whereas the weakening of either is enough to cause a collapse, recovery requires the revival of both. For whilst the weakening of credit is sufficient to bring about a collapse, its strengthening, though a necessary condition of recovery, is not a sufficient condition.

VI

These considerations should not lie beyond the purview of the economist. But they must be relegated to their right perspective. If I may be allowed to appropriate the term speculation for the activity of forecasting the psychology of the market, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life, it is by no means always the case that speculation predominates over enterprise. As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase. In one of the greatest investment markets in the world, namely, New York, the influence of speculation (in the above sense) is enormous. Even outside the field of finance, Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the stock market. It is rare, one is told, for an American to invest, as many Englishmen still do, “for income”; and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that, when he purchases an investment, the American is attaching his hopes, not so much to its prospective yield, as to a favourable change in the conventional basis of valuation, i.e. that he is, in the above sense, a speculator. Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism — which is not surprising, if I am right in thinking that the best brains of Wall Street have been in fact directed towards a different object.

These tendencies are a scarcely avoidable outcome of our having successfully organised “liquid” investment markets. It is usually agreed that casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of Stock Exchanges. That the sins of the London Stock Exchange are less than those of Wall Street may be due, not so much to differences in national character, as to the fact that to the average Englishman Throgmorton Street is, compared with Wall Street to the average American, inaccessible and very expensive. The jobber’s “turn”, the high brokerage charges and the heavy transfer tax payable to the Exchequer, which attend dealings on the London Stock Exchange, sufficiently diminish the liquidity of the market (although the practice of fortnightly accounts operates the other way) to rule out a large proportion of the transactions characteristic of Wall Street.^[5] The introduction of a substantial Government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise in the United States.

The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long-term prospects and to those only. But a little consideration of this expedient brings us up against a dilemma, and shows us how the liquidity of investment markets often facilitates, though it sometimes impedes, the course of new investment. For the fact that each individual investor flatters himself that his commitment is “liquid” (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk. If individual purchases of investments were rendered illiquid, this might seriously impede new investment, so long as alternative ways in which to hold his savings are available to the individual. This is the dilemma. So long as it is open to the individual to employ his wealth in hoarding or lending money, the alternative of purchasing actual capital assets cannot be rendered sufficiently attractive (especially to the man who does not manage the capital assets and knows very little about them), except by organising markets wherein these assets can be easily realised for money.

The only radical cure for the crises of confidence which afflict the economic life of the modern world would be to allow the individual no choice between consuming his income and ordering the production of the specific capital-asset which, even though it be on precarious evidence, impresses him as the most promising investment available to him. It might be that, at times when he was more than usually assailed by doubts concerning the future, he would turn in his perplexity towards more consumption and less new investment. But that would avoid the disastrous, cumulative and far-reaching repercussions of its being open to him, when thus assailed by doubts, to spend his income neither on the one nor on the other.

Those who have emphasised the social dangers of the hoarding of money have, of course, had something similar to the above in mind. But they have overlooked the possibility that the phenomenon can occur without any change, or at least any commensurate change, in the hoarding of money.

Weekend Reading

2009-01-09T20:53:00.001-08:00

1. Secrets of Greatness (hat tip to Joe)

The best people in any field are those who devote the most hours to what the researchers call "deliberate practice." It's activity that's explicitly intended to improve performance, that reaches for objectives just beyond one's level of competence, provides feedback on results and involves high levels of repetition.

2. Interview With Bruce Berkowitz (give your thanks once again to Joe)

I was extremely surprised that anyone would invest simply on a level of trust. I believe in “trust but verify.” [Editor's note: I like that phrase] Even businesses that might seem to operate simply on trust really employ a level of verification. For example, in the Diamond District in New York, millions of dollars may appear to change hands simply on the basis of a handshake. But, behind the scenes, there is a careful evaluation of the diamonds that were just sold. Those transactions take place at a single point in time and, if something goes wrong, the participants will never do another transaction. In Madoff’s case, investors continued to put money in over many years, without any verification.

3. " What Would Sir John Say?"

...
Now, with well over 100 independent nations on earth and rapid advances in communication, people with superior educational backgrounds are likely to progress more rapidly than others. These people with more advanced education are likely to be true innovators.

Comparisons show that prosperity flows toward those nations having the greatest freedom of competition. Especially, electronics and computers are likely to become helpful in all human activities, including even helping persons who have not yet learned to read.

Hopefully, many of you can help us to find published journals and websites and electronic search engines to help us benefit from accelerating research and discoveries.

Not yet have I found any better method to prosper during the future financial chaos, which is likely to last many years, than to keep your net worth in shares in those corporations, which have proven to have the widest profit margins and the most rapidly increasing profits. Earning power is likely to continue to be valuable, especially if diversified among many nations.

A Short Excerpt...

2008-12-26T16:21:00.001-08:00

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

2005 SEC Paper: "Madoff Securities is the World's Largest Ponzi Scheme"

2008-12-18T14:05:00.000-08:00

November 2005 Report to SEC about Madoff Being A Poniz Scheme

Publish at Scribd or explore others: Business madoff

This Is The End

2008-12-10T12:32:00.000-08:00

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.

Fairfax Removes Equity Hedges

2008-11-20T19:22:00.000-08:00

"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

I.O.U.S.A: The Thirty Minute Version

2008-11-09T11:05:00.000-08:00

Maslow's Heirarchy of Needs

2008-10-17T08:01:00.000-07:00

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.
....

Buy American. I Am.

2008-10-16T21:56:00.001-07:00

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.
Why?
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.

Also...

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.”

It Is Time to Buy Back Into Stocks

2008-10-11T10:50:00.000-07:00

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.

John Bogle: Keep Investing

2008-10-05T18:35:00.001-07:00

CNN Interview with Lee Kuan Yew

2008-09-30T21:40:00.000-07:00

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:

The Doctor's Bill

2008-09-25T17:55:00.000-07:00

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.

Economies Of Scales

2008-09-18T20:50:00.001-07:00

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.
...

Nassim Taleb On The Fourth Quadrant

2008-09-17T19:43:00.000-07:00

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)

Introduction

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

2008-09-17T18:48:00.000-07:00

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.

War, Part II: Strategy, Operations, and Tactics

2008-09-14T11:35:00.000-07:00

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.

The Fannie/Freddie Bailout, And Lessons To Be Learned

2008-09-08T23:41:00.000-07:00

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.

Lessons From War: Part I. Knights and Newspapers

2008-09-05T15:34:00.000-07:00

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.

Who Do You Want To Be?

2008-09-02T15:44:00.000-07:00

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:
Intelligent
Hard-working
Frugal
Just
Long term outlook
Honest
Incrementalist
Compassionate

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:

Irrational
Lazy
Excessive
Greedy
Unfair
Entity Mentality
Dishonest
Stagnant
Cold
Unsympathetic

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.

LBO's Gone Wild

2008-08-31T10:08:00.000-07:00

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.

No Shortage of Regulators

2008-08-24T11:20:00.000-07:00

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.

Quote Of The Day

2008-08-21T18:39:00.000-07:00

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"

2008-08-21T11:29:00.001-07:00

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.

Quote It

2008-08-19T18:11:00.000-07:00

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

Hypothetical Scenario For The Mortgage Nuts....

2008-08-19T15:09:00.001-07:00

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?

Josh Waitzkin @ Google

2008-08-15T23:55:00.000-07:00

"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

2008-08-15T14:34:00.000-07:00

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.

A Personal View of The Crisis

2008-08-07T21:09:00.000-07:00

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

2008-08-07T10:36:00.000-07:00

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.

Highlights:
- 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.

Black Box Insurers

2008-08-02T17:22:00.000-07:00

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.

Shaking Things Up At Steak N' Shake

2008-07-23T14:58:00.001-07:00

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.

Obituary: John Templeton

2008-07-19T14:18:00.000-07:00

....
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.
...

Direct Link

Value To Be Had In Europe

2008-07-17T15:12:00.000-07:00

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

Question: American Express Monthly Payment Rate?

2008-07-16T14:39:00.000-07:00

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?

2008-07-16T13:30:00.000-07:00

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.

Stock Market Capitalization to GNP Ratio

2008-07-11T12:47:00.000-07:00

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.

Interview with Wilbur Ross

2008-07-03T11:14:00.000-07:00

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.

Consumer Splurge Threatens UAE??

2008-06-29T20:00:00.000-07:00

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.

Some Helpful Advice from Dale Carnegie

2008-06-28T20:40:00.000-07:00

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.

The Economist: The Future of Energy

2008-06-20T20:25:00.001-07:00

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."

A Rare Perspective In Finance...

2008-06-18T13:36:00.000-07:00

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.

Stocks versus Bonds

2008-06-17T09:48:00.000-07:00

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.

The Case of Puerto Rican Housing

2008-06-15T17:23:00.000-07:00

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.

A Study of Transamerica

2008-06-09T13:11:00.000-07:00

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.

Who Says Big Ideas Are Rare?

2008-05-29T14:12:00.000-07:00

...
How useful is it to have a group of really smart people brainstorm for a day? When Myhrvold started out, his expectations were modest. Although he wanted insights like Alexander Graham Bell’s, Bell was clearly one in a million, a genius who went on to have ideas in an extraordinary number of areas—sound recording, flight, lasers, tetrahedral construction, and hydrofoil boats, to name a few. The telephone was his obsession. He approached it from a unique perspective, that of a speech therapist. He had put in years of preparation before that moment by the Grand River, and it was impossible to know what unconscious associations triggered his great insight. Invention has its own algorithm: genius, obsession, serendipity, and epiphany in some unknowable combination. How can you put that in a bottle?
But then, in August of 2003, I.V. held its first invention session, and it was a revelation. “Afterward, Nathan kept saying, ‘There are so many inventions,’ ” Wood recalled. “He thought if we came up with a half-dozen good ideas it would be great, and we came up with somewhere between fifty and a hundred. I said to him, ‘But you had eight people in that room who are seasoned inventors. Weren’t you expecting a multiplier effect?’ And he said, ‘Yeah, but it was more than multiplicity.’ Not even Nathan had any idea of what it was going to be like.”
The original expectation was that I.V. would file a hundred patents a year. Currently, it’s filing five hundred a year. It has a backlog of three thousand ideas...

Direct Link

Time Is Not Money

2008-05-25T07:27:00.000-07:00

While on vacation in the Caribbean, a buddy of mine brought up an interesting point last night: time is NOT money. The statement is a gross misconception. With money, you know how much you have. You have a multitude of options which are readily comparable through price tags. You can get more of it by doing work, and you can use it at your discretion. A man can hold off on a purchase and be fairly confident that the option to purchase that good will still be there tomorrow. His inaction will even be compensated.

People treat their time in a similar manner. They often try to forestall their their life and business, believing that these actions can always be done later. But time is not money. Every second, it is being used. Patience with it does not yield any rewards because every second is worth as much as the next. You do not know how much of it you have, but you do know it is always decreasing. And even the hardest working individual can not earn himself more time. All he can hope for is to make the best use of the time he is given.

In short, seize the day.

Wait... What?

2008-05-15T00:37:00.000-07:00

From Freddie Mac's 1st Quarter Earnings Release:

Fair Value of Net Assets
The company's attribution of changes in fair value relies on models, assumptions and other measurement techniques that evolve over time.
At March 31, 2008, the fair value of net assets was ($5.2) billion as compared to $12.6 billion at December 31, 2007, reflecting a net after-tax reduction of $17.8 billion. This change in fair value of net assets includes the payment of preferred and common stock dividends during the first quarter of 2008.
The change in fair value of net assets includes a pre-tax reduction in fair value of $28.8 billion as a result of net mortgage-to-debt OAS widening, partially offset by a pre-tax increase in fair value related to core spread income in the first quarter of 2008. In addition, the company estimates that the change in fair value of its credit guarantee activities resulted in a pre-tax reduction of $3.0 billion.

So using market prices as its determinant, Freddie Mac is now in negative equity. But rather then let that reflect into the income statements, the company has changed its accounting rules to more appropriately match its business expectations...

I'm reminded of what Buffett and Munger keep repeating about how two parties are entering into derivative contracts and then both sides are reporting gains. You know the person on the other side of Freddie's transactions aren't discounting their gains to conform with Freddie's models. Some time in the near future, one of them is going to find themselves much poorer than they think they are.

Justification-Deterioration Model?

2008-05-10T17:09:00.000-07:00

From Buffett's speech to the Tuck Investment Club:

Q: What is your view on the leverage in the economy?

A: We are currently an enormous debtor to the rest of the world. The danger is that our children and their children will not want to pay this debt, or said another way, will reject the costs that servicing this debt will impose on society. Let's say that during the Revolutionary War, the colonists were offered a choice: instead of fighting a bloody war that will cost thousands of lives, you can simply agree to pay King George 5% of total national income for perpetuity in exchange for full independence and political freedom. Now to the colonists this would have been a great deal, potentially having their lives spared and gaining freedom for only 5%/year. Decades later their children may not think it's as good a deal but will still have heard stories from their parents and will probably pay the fee. But eventually, three or four generations down the line, enough Americans will forget the original rationale for the deal and will in some way demand a change in terms - possibly go to war with England again to halt the payments. The danger today is that future generations of Americans will be unwilling to continue paying for today's spending and force political action with potentially negative consequences.

I think this example itself deserves its own mental model (although I'm having trouble giving it a proper name). But as I was reading this, I thought of another similar case. Let's say a foreign company offered to make a large factory investment in a developing country. Now at first, the country would praise the opportunity for bringing more production and job opportunities into their country. But as time goes on, children will start to wonder why some of the value of their labor is going to these companies abroad. Eventually, tensions build and the original rationale is lost, leading the people to demand nationalization of the factory.

I don't know what the call this tendency, but I experienced it for myself through my investment in Harvest. It appears destined to keep coming up in the future.

"To Strive Together"

2008-05-06T00:35:00.000-07:00

It's been a busy few days of school, and it has prevented me from posting in nearly a week. Rest assured that a lot has been learned in that time, and there is a heavy backlog of ideas to write upon. (One great lesson which I'll expand on later: have a clear vision of how shareholder's will get a hold of profits. No more majority owned firms with dicey managements. Sure, they are cheaper, but that is rightfully so. Most of those managers would never like you to see that cash. And with a large block of shares, they can make sure it stays that way.)

Yet for now, a friend of mine told me something interesting today. The Latin root for competition, when translated, means "to strive together". Competition existed as a means of improving their skills and themselves. That meaning seems to get lost sometimes today, overshadowed by a focus on the winners or losers. But to me, the older definition is in the right. The outcome is not necessarily as important as what you take away from the process.

Pulp News

2008-04-29T12:30:00.000-07:00

Two Pulp producers reported today- Canfor and Catalyst:

The announced price for April 2008 for Northern Europe is US$920 per tonne, an increase of $40 per tonne over the price in March. No price increases have been announced for the North American markets and prices are expected to remain steady at US$880 per tonne in the near term. Since there remains much supply uncertainty in the market, and demand is holding prices are expected to fluctuate in a narrow range over the balance of the year.

and...

"Fibre constraints required us to curtail 65,000 tonnes of pulp and paper at our Elk Falls mill during the quarter," said Richard Garneau, Catalyst president and chief executive officer. "As a result our manufacturing costs and sales volumes were unavoidably impacted. As we look to the balance of the year, we expect the Elk Falls No. 1 paper machine will remain idled with our pulp business also likely to be impacted by the continuing fibre shortage."
The Company's pulp business is expected to take the remainder
of any fibre related downtime in 2008. Approximately 150,000
tonnes of pulp and white top linerboard production is currently
anticipated to be curtailed through the balance of the year
between our Crofton and Elk Falls pulp operations.

2008-04-27T22:09:00.000-07:00

From Fairfax's 2007 AGM Slides:

For those conservatively positioned, industry losses from MBS and Corporate bonds could be a blessing which forces stronger pricing/underwriting profits.

Recently, I ran across a small-cap California insurer. It was trading for 53 million with shareholder's equity of 70 million. It also generated 80 million in float, and its investment portfolio was almost completely invested in US treasuries. To top it off, their operations were generating an underwriting profit while also heavily re-insuring their business. That to me was a bargain which beats holding cash any day.

For The Housing UberNerds...

2008-04-27T21:56:00.000-07:00

Here are some statistics from the New York Fed on Subprime and Alt-A loans in the country at December 2007. Some of the interesting US numbers (slightly rounded):

116 million total housing units
3.3 million sub-prime loans
300,000 non-owner occupied

3 million of owner occupied
1 million delinquent/foreclosure (of owner occupied)
(*32% delinquent or foreclosed on)

1.9 million variable rate loans
Resetting in: (keep in mind this was from Dec 07)

442,000 reset in 6-12 months
399,000 reset in 1-2 years
119,000 reset in 2 years++

682,000 + 306,000 Already reset + reset in 0-5 months