This book is a study of the characteristics of crowds as well as the tremendous impact they can have. In terms of investing, I picked up a lot of similarities between his "crowds" and the mob-like behavior of Mr. Market. But beyond that, this work made me think a lot about how much this psychology of crowds has come up in my past experiences and in everyday life. The full text is available here for those interesting in reading the book. Otherwise, I took very comprehensive notes below- sorry for the length. Note this book was written in 1896.
Foreward
"The substitution of the unconscious action of crowds for the conscious activity of the individual is one of the principal characteristics of our time."
"Crowds, doubtless, are always unconscious, but this very unconsciousness is perhaps one of the secrets of their strength."
Intro
"Today, it is the traditions which used to obtain in politics, and the indvidual tendencies and rivalries of rulers which do not count; while on the contrary, the voice of the asses has become preponderant."
"When the structure of civilization is rotten, it is always the masses that bring about it's downfall."
Mind of Crowds
-Disappearance of conscious personality and the turning of feelings and thoughts in a definite direction.
-Characteristics common to crowds
1. People in a crowd act different than they would in isolation. Why? The greater part of our daily actions are the result of hidden motives which escape our observation.
2. People resemble each other most in their unconscious elements. It is the conscious element- education, hereditary conditions, etc- that they differ.
3. It is precisely these general qualities of character, governed by forces of which are unconscious, and possessed by the majority, that in crowds become common property. Individuality is weakened, and the heterogeneous is swamped by the homogeneous.
4. Because crowds possess common ordinary qualities, they can never accomplish acts demanding a high degree of intelligence.
-How are the characteristics formed in crowds?
1. People in crowds feel greater power due to numerical standpoint.
2. There is less responsibility when in a crowd.
3. Acts in a crowd are contagious, to such a degree that an individual will even sacrifice personal interests for the crowd.
4. Individual is no longer conscious of his acts. (They mention something similar to the Zimbardo experiment, where people kept shocking and harming other people as long as the person conducting the experiment kept nudging them foreward)
5. "Suggestions will be followed like a hypnotized person, only stronger due to reciprocity o crowd." They "immediately transform the suggested ideas into acts."
-Isolated, a person can be a cultivated individual. In a crowd, he is a barbarian, a creature acting on instinct.
Conclusion: Crowd is always intellectually inferior to the isolated indivudal, but from the point of view of feelings and acts they provoke, it can be better or worse than the individual. (ex: is the crowd performing criminal or heroic acts?)
Sentiments and Morality of Crowds
- Individual's brain shows him the inadvisability of yielding to reflex reactions. Not so in a crowd.
- Impossibility disappears for the individual in a crowd.
- Events witnessed by a crowd are easily transformed; due to contagion effect it is all perverted similarly.
- In a study by a psychologist, it became clear that witnesses in numbers may give circumstantial relations which are completely erroneous, but whose result is that, if their descriptions are accepted as exact, the phenomena they describe are inexplicable by trickery. (Basically saying, a crowd is just as likely to see an event incorrectly, but because they have so many people supporting the view it becomes impossible to deny their claim)
- People no longer see the object itself, but the image-evoked in his mind.
- Conclusion: the collective observations are unreliable.
Exaggeration and Ingeniousness of Sentiments of Crowds
- A crowd is only impressed by excessive sentiments.
- An orator wishing to move a crowd must make an abusive use of violent affirmations. To exaggerate, to affirm, to resort to repitions, and never to attemp to prove anything by reasoning are methods of argument well known to speakers at public meetings.
- Intellectually, a crowd can only go down. Sentiment can go up or down.
Intolerance, Dictatorialness and Conservatism of Crowds
- Dissent is not tolerated in crowds.
- Crowds respect force, slightly impressed by kindness.
- Crowds are in fact, conservative. They show incessant mobility only on superficial matters- they want to keep traditions and status quo.
- "Had democracies possessed the power they wield today at the time of the invention of the mechanical loom or the introduction of steam power and of railways, the realizations of these inventions would have been impossible, or would have been achieved at the cost of revolutions and repeated massacres." (I disagree, but in general we do see a lot of resistance to change)
The Morality of Crowds
- Crowds are too impulsive and mobile to be moral, but certain qualities such as abnegation, self-sacrifice, disinterestedness, devotion, equity may be exhibited.
- Individual knows he cannot gratify instincts; in a irresponsible crowd, he can. But appeals to glory, honor and patriotism are particularly likely to appeal to moral side of a crowd.
- And, if people had always satisfied their immediate interests, it is possible that no civilization would have grown up on our planet and humanity would have had no history.
The Ideas of Crowds
1. Ideas of the moment- infatuations.
2. Fundamental ideas- religious beliefs or democratic ideals.
- Ideas may be modified in order to lower them to level of intelligence of crowds. Usually in the direction of simplification.
Reasoning Power of Crowds
- Arguments of crowds are inferior in terms of reasoning.
- Associate dissimilar things possessing a merely apparent connection.
- Judgments accepted by a crowd are the ones enforced on them, not the one adopted by themselves after the discussion.
Imagination of Crowds
- "All great statesmen of every age and every country, including the most absolute despots, have regarded the popular imagination as the basis of their power, and they have never attempted to govern in opposition to it."
- To capture the imagination of crowds, don't use intelligence or reasoning. Rather, cunning rhetoric, something clear and marvelous/mysterious.
Conviction of Crowds
- Convictions of a crowd take on a sort of religious sentiment.
- At the heart of the matter is the soul of the masses
Opinions and Beliefs of Crowds
- Remote factors set up the groundwork, such as the work of philosophers, scientific thought, etc.
- Immediate factors of the moment such as speeches, resistance, etc, spark the crowd.
- Some important remote factors: race, traditions, time, institutions, education.
Race
- By far the most important remote factor.
Education
- Education does not necessarily make a man more moral or happier. Maybe more professional.
- Primary danger of the system of education is that it is based on the idea that intelligence is developed by the learning by heart of text-books. The endeavor has been made to enforce a knowledge of as many books as possible. A man does nothing but acquire books by heart without judgment of personal initiative ever being called int play.
- The conditions of success in life are the possession of judgment, experience, initiative, and character- qualities which are not bestowed by books. Books are dictionaries, useful to consult, but of which it is perfectly useless to have lengthy portion's in one's head. (my emphasis)
-Crowds are swayed by images, words, and formulas.
- As soon as living beings are gathered together, they place themselves under a chief.
- Leaders are typically men of action rather than thinkers.
- The multitude is always ready to listen to the strong willed man.
- It is the need not of liberty but of servitude that is always predominant in the soul of crowds.
- To imbue the mind of a crowd with ideas and beliefs, the leaders must use affirmation, repetition and contagion.
- Affirmation, free of reasoning, is one of the surest means to enter mind of crowd.
- Affirmation has no real influence unless it is constantly repeated.
- Napoleon: only one figure in rhetoric of serious important, namely, repetition.
(This section reminded me of the use of propaganda in Nazi Germany)
- After affirmation and opinion, a current of opinion is formed and it is contagious. Imitation is in reality an effect of contagion.
- The precise moment at which a great belief is doomed is easily recognizable; it is the moment when its value begins to be called in question. Every general belief being little else than fiction, it can only survive on the condition that it not be subjected to examination.
- The opinions of crowd tends to become the supreme guiding principles in politics.
- The idea of prestige is very important in leading crowds.
- On societies- the inevitable decline is always marked by the weakening of the ideal that was the mainstay of the race.
Friday, October 19, 2007
Thursday, October 18, 2007
Update on Fairfax's CDS Portfolio
Fairfax Financial owns a large portfolio of Credit Default Swaps (CDS) on several mortgage and financial companies. These contracts protect the principal value of the debt of these financial companies in case they default. But Fairfax does not own the debt of any of these companies, so it is not being used as a hedge. Rather, the CDS portfolio is a large (18 billion notional amount) bet that these companies will face credit difficulties. Back in August, I gave a list of the companies in their portfolio. Below is an update on what has been happening to some of the companies since then.
1. Countrywide Financial
Stock Since August (1st): -39%
Countrywide to Book Restructuring Charge
2. PMI Group
Stock Since August: -32%
PMI Group to Swing to Loss in 3Q
3. Washington Mutual
Stock Since August: -19%
WaMu profit sinks 72%, sees more housing slump
From Calculated Risk:
4. MGIC Investment
Stock Since August: -30%
MGIC Investment Swings to 3Q Loss
Stock Since August: -7%
Ambac Expects 3Q Loss
1. Countrywide Financial
Stock Since August (1st): -39%
Countrywide to Book Restructuring Charge
Struggling mortgage lender Countrywide Financial Corp. expects to book a pretax charge ranging from $125 million to $150 million related to its plan to slash thousands of jobs amid rising defaults and foreclosures.Note that this charge doesn't even deal with provisions or loan write-downs. This is just for severance expenses. I'm looking forward to the 3rd Quarter report on October 26th.
...Last week, Countrywide disclosed its mortgage fundings for September fell 44 percent from the same period a year ago.
Countrywide also reported a higher percentage of delinquencies between August and September in its loan servicing portfolio, which accounts for nearly 14 percent of all mortgage debt in the U.S., along with a higher number of loans in foreclosure.
2. PMI Group
Stock Since August: -32%
PMI Group to Swing to Loss in 3Q
Mortgage insurer PMI Group Inc. said Thursday it expects to report a net loss of $1.05 per share for the third quarter due its weakening mortgage insurance business and writedowns on derivatives.
3. Washington Mutual
Stock Since August: -19%
WaMu profit sinks 72%, sees more housing slump
From Calculated Risk:
"This is perhaps the most challenging cycle for housing that we've seen in many decades," WaMu Chief Executive Kerry Killinger said in an interview. He and other WaMu executives said they don't see any improvement in the near term.
"I have never seen housing credit conditions change so significantly over such a short period of time, nor can I remember a period when there was less clarity about near-term housing and credit trends," [Chief Financial Officer Tom] Casey said
4. MGIC Investment
Stock Since August: -30%
MGIC Investment Swings to 3Q Loss
Without a decline in loss severity or improved cure rate in the coming months and because of expected paid losses, MGIC projects it will not post net income in the fourth quarter or for the full year in 2008.5. Ambac Financial
Stock Since August: -7%
Ambac Expects 3Q Loss
Ambac Financial Group Inc., an insurer of corporate and public bonds, said Wednesday it expects to post a third-quarter loss of up to $3.50 per share, as a result of a "mark-to-market" adjustment for its credit derivative portfolio.
Tuesday, October 16, 2007
A Tectonic Shift?
I mentioned in my notes on "Mosaic" that there was something I wanted to talk more about:
There is currently a broad tectonic shift going on- businesses are profiting while jobs are being outsourced, but white- and blue-collar wages are eroding.
The effects of globalization is something that has been on my mind recently. This is the abstract concept I have come up with so far:
The chart below shows the annual incomes of everyone around the world. The graph is highly skewed to the right, because capital is heavily accumulated in a small proportion of people, and this disproportionately affects their income. In general though, most people rely solely on wages.
Before going on, there are two things which I think people should recognize:
1. People working in areas with more investment have higher productivity and so can be paid higher wages.
2. Even when it comes to businesses such as services which do not need capital investment, people in wealthy areas still have higher incomes because the opportunity cost of time in the region is higher- so saving the time of the people around them is more valuable. To better see this, think of a dry cleaner working in the US and in China. The dry cleaner in the US is saving more time for a wealthier population, which has higher time opportunity costs, and so this dry cleaner is paid a much higher wage than the dry cleaner in China. This is all despite the fact that dry cleaning itself does not require much capital as a business to run and both of them are essentially doing the same amount of work.
Now, what is globalization doing? Pabrai said so far it has increased profits of capital, and it is eroding the value of labor. Long term, I disagree with the first point. The increased profits from capital seem to be a temporary boost, and economic law would suggest that competition would eventually bring these back to normal levels. But globalization and technology is dramatically increasing the supply of labor, and hence competition. As a result, there is overall downward pressure on wages. But it is also balancing, because the demand for the cheapest labor is increasing while demand for rich world labor is decreasing.
All this so far has been pretty well understood in the financial community. But what I haven't heard discussed frequently is what a synchronization of (lower) wages is doing.
1. It doesn't seem unreasonable to think that this synchronization will lead to an increased demand in basic necessities, such as food, oil, energy, water, etc, as more people are able to afford these goods. In fact, this is maybe what we are already seeing here. But, increased demand shouldn't be necessarily confused with higher prices. Many of these commodities have already increased significantly from their lows. What is important besides increased demand is at what price that demand can be fulfilled. For most agricultural goods, that price is low. For oil and some other commodities, it is debatable. (Or rather, I just haven't looked into much specific data and the media never provides good answers to these questions)
2. People in first world countries seem to have maintained our standard of living by mostly saving less and borrowing against our assets. I base this mostly based on what I've seen in the United States and the United Kingdom. This is unsustainable, and eventually we will start seeing declines in our purchasing power due to the pressure on our high wages. Again, we might already be seeing that through the declining US dollar rather than direct wage decreases. This pressure would also affect the gap between service sector jobs in different countries. (think the US/China dry cleaner example again, only now the wealth of both populations are slowly converging, and so are their wages)
3. There might be a decrease in more conspicuous types of consumption, as the average first-world wages which supported this demand would be under pressure. This would also affect business profit margins, and hence investment returns.
This is all mostly abstract so far, but I think these broad trends seem fairly credible. Please do comment if you have any thoughts on the matter. I do plan on looking more into this myself. As to how this will effect investing: well, for myself personally, that would mean increased demand for both oil and pulp, two things I would consider basic necessities. But in general, I would be also worried about the deflationary pressures that this globalization can cause.
There is currently a broad tectonic shift going on- businesses are profiting while jobs are being outsourced, but white- and blue-collar wages are eroding.
The effects of globalization is something that has been on my mind recently. This is the abstract concept I have come up with so far:
The chart below shows the annual incomes of everyone around the world. The graph is highly skewed to the right, because capital is heavily accumulated in a small proportion of people, and this disproportionately affects their income. In general though, most people rely solely on wages.
Before going on, there are two things which I think people should recognize:
1. People working in areas with more investment have higher productivity and so can be paid higher wages.
2. Even when it comes to businesses such as services which do not need capital investment, people in wealthy areas still have higher incomes because the opportunity cost of time in the region is higher- so saving the time of the people around them is more valuable. To better see this, think of a dry cleaner working in the US and in China. The dry cleaner in the US is saving more time for a wealthier population, which has higher time opportunity costs, and so this dry cleaner is paid a much higher wage than the dry cleaner in China. This is all despite the fact that dry cleaning itself does not require much capital as a business to run and both of them are essentially doing the same amount of work.
Now, what is globalization doing? Pabrai said so far it has increased profits of capital, and it is eroding the value of labor. Long term, I disagree with the first point. The increased profits from capital seem to be a temporary boost, and economic law would suggest that competition would eventually bring these back to normal levels. But globalization and technology is dramatically increasing the supply of labor, and hence competition. As a result, there is overall downward pressure on wages. But it is also balancing, because the demand for the cheapest labor is increasing while demand for rich world labor is decreasing.
All this so far has been pretty well understood in the financial community. But what I haven't heard discussed frequently is what a synchronization of (lower) wages is doing.
1. It doesn't seem unreasonable to think that this synchronization will lead to an increased demand in basic necessities, such as food, oil, energy, water, etc, as more people are able to afford these goods. In fact, this is maybe what we are already seeing here. But, increased demand shouldn't be necessarily confused with higher prices. Many of these commodities have already increased significantly from their lows. What is important besides increased demand is at what price that demand can be fulfilled. For most agricultural goods, that price is low. For oil and some other commodities, it is debatable. (Or rather, I just haven't looked into much specific data and the media never provides good answers to these questions)
2. People in first world countries seem to have maintained our standard of living by mostly saving less and borrowing against our assets. I base this mostly based on what I've seen in the United States and the United Kingdom. This is unsustainable, and eventually we will start seeing declines in our purchasing power due to the pressure on our high wages. Again, we might already be seeing that through the declining US dollar rather than direct wage decreases. This pressure would also affect the gap between service sector jobs in different countries. (think the US/China dry cleaner example again, only now the wealth of both populations are slowly converging, and so are their wages)
3. There might be a decrease in more conspicuous types of consumption, as the average first-world wages which supported this demand would be under pressure. This would also affect business profit margins, and hence investment returns.
This is all mostly abstract so far, but I think these broad trends seem fairly credible. Please do comment if you have any thoughts on the matter. I do plan on looking more into this myself. As to how this will effect investing: well, for myself personally, that would mean increased demand for both oil and pulp, two things I would consider basic necessities. But in general, I would be also worried about the deflationary pressures that this globalization can cause.
Monday, October 15, 2007
"Mosaic" by Mohnish Pabrai. (Notes)
I finally got my hands on a copy of Mosaic, and I read through it in one sitting. As Pabrai mentions in the introduction,
my perspective on writing is simple:
1. Only write about subjects one is passionate about.
2. Avoid fluff at all costs.
3. Have no set periodicity for writing
Overall, this makes the entire book a very great read. Unfortunately, it also is out of print and currently goes for $388 on Amazon. So below are the notes I took. The material from the book is in italics, and is still mostly in Pabrai's original words; sentences in brackets are my additional commentary.
The future of a business is never assured. There are always the super-low probability events. Attribute a small probability to cover for this. (ie: fraudulent accounting, meteor-strike, etc)
Avoid shorting- going against the 8 to 10% long run return of the market. More importantly, an overvalued company can naturally boost its own intrinsic value by issuing inflated stock, and you are always vulnerable to a short squeeze.
[There is usually also an additional charge from brokers for shorting, usually at about 3% per year. Overall, shorting is usually a bad proposition]
There is currently a broad tectonic shift going on- businesses are profiting while jobs are being outsourced, but white- and blue-collar wages are eroding.
[I think understanding this is very important, and I'm going to write another post about this]
Investment managers are introverted, skeptical, and very analytical
CEOs are extroverts, optimists, and leaders.
You must have a comfortable understanding of both perspectives- know the uncertainties of running a business and the importance of capital allocation and Return on Equity.
Retailing is an arbitrage between what customers want and how it can be provided to them. In general it is a terrible business because there are no trade secrets and it is difficult to assess "need". The less dependent the retailer is on fashion trends, the better.
[This third point will also be brought up in another post soon]
Problems Microsoft is facing:
1. Highly dependent on two products, Windows and Office, for all of their operating profit.
2. They face competition from themselves- their products are not getting much better.
[I feel there is probably a lot of situations where one of these problems would apply for a company]
Look at the "DNA" of your companies- a culture is hard to change. If you cant understand the financial statements, management probably does not want you to.
Some quotes from Warren Buffett on investment management:
"We don't get paid for activity, we get paid for being right. As to how long we'll wait, we'll wait indefinitely!"
"The way people extrapolate the future is stupid. Not just slightly stupid, but massively stupid."
"The best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results delivered by the great majority of investment professionals."
On avoiding fraud:
1. Avoid obtuse financial statements
2. Look out for "managed" earnings
3. Take into account when "restructuring" becomes the norm
4. Be wary of earnings guidance
5. Look at related party transactions, compensation, options
6. Try to find integrity in management
[If you want to see some of these, look at the financial industry today. They have very unclear financial statements, managed earnings, lots of "restructuring" charges, and earnings guidance which keeps being completely off]
Things to look for in management:
-lack of an ego
-speak the truth
-love for the company
-capable and energetic
In summary, look for situations where high uncertainty about the business leads to a very attractive risk proposition for shareholders.
Finally, he also recommends two books:
The Innovator's Dilemma by Clayton Christensen
The Origin and Evolution of New Businesses by Amar Bhide
my perspective on writing is simple:
1. Only write about subjects one is passionate about.
2. Avoid fluff at all costs.
3. Have no set periodicity for writing
Overall, this makes the entire book a very great read. Unfortunately, it also is out of print and currently goes for $388 on Amazon. So below are the notes I took. The material from the book is in italics, and is still mostly in Pabrai's original words; sentences in brackets are my additional commentary.
The future of a business is never assured. There are always the super-low probability events. Attribute a small probability to cover for this. (ie: fraudulent accounting, meteor-strike, etc)
Avoid shorting- going against the 8 to 10% long run return of the market. More importantly, an overvalued company can naturally boost its own intrinsic value by issuing inflated stock, and you are always vulnerable to a short squeeze.
[There is usually also an additional charge from brokers for shorting, usually at about 3% per year. Overall, shorting is usually a bad proposition]
There is currently a broad tectonic shift going on- businesses are profiting while jobs are being outsourced, but white- and blue-collar wages are eroding.
[I think understanding this is very important, and I'm going to write another post about this]
Investment managers are introverted, skeptical, and very analytical
CEOs are extroverts, optimists, and leaders.
You must have a comfortable understanding of both perspectives- know the uncertainties of running a business and the importance of capital allocation and Return on Equity.
Retailing is an arbitrage between what customers want and how it can be provided to them. In general it is a terrible business because there are no trade secrets and it is difficult to assess "need". The less dependent the retailer is on fashion trends, the better.
[This third point will also be brought up in another post soon]
Problems Microsoft is facing:
1. Highly dependent on two products, Windows and Office, for all of their operating profit.
2. They face competition from themselves- their products are not getting much better.
[I feel there is probably a lot of situations where one of these problems would apply for a company]
Look at the "DNA" of your companies- a culture is hard to change. If you cant understand the financial statements, management probably does not want you to.
Some quotes from Warren Buffett on investment management:
"We don't get paid for activity, we get paid for being right. As to how long we'll wait, we'll wait indefinitely!"
"The way people extrapolate the future is stupid. Not just slightly stupid, but massively stupid."
"The best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results delivered by the great majority of investment professionals."
On avoiding fraud:
1. Avoid obtuse financial statements
2. Look out for "managed" earnings
3. Take into account when "restructuring" becomes the norm
4. Be wary of earnings guidance
5. Look at related party transactions, compensation, options
6. Try to find integrity in management
[If you want to see some of these, look at the financial industry today. They have very unclear financial statements, managed earnings, lots of "restructuring" charges, and earnings guidance which keeps being completely off]
Things to look for in management:
-lack of an ego
-speak the truth
-love for the company
-capable and energetic
In summary, look for situations where high uncertainty about the business leads to a very attractive risk proposition for shareholders.
Finally, he also recommends two books:
The Innovator's Dilemma by Clayton Christensen
The Origin and Evolution of New Businesses by Amar Bhide
Sunday, October 14, 2007
What's On My Mind
Calculated Risk has been my favorite blog to read recently, but it has also been a new source of inspiration. I find the site fascinating because it covers all things finance and economics-related and appeals to a broad audience. Someone can come to the site and read some current financial or economic news along with some great insight. Or, a more interested individual can devour through the entire site, and end up with knowledge oozing out of them.
Well, this got me thinking about my own blog. This site is focused on investing, but mostly for those who are excited about the field. The average Joe passing by would probably quickly feel this site has nothing for him, and that is a shame because there are things I can teach them about, such as: 1) the impact of high management fees, 2) how heavy trading is probably only making your broker rich, and 3) the use of debt. So, I will try to also publish some important investment knowledge for a general audience in the near future. The goal is to get this across while still providing the same content for the more passionate readers.
Well, this got me thinking about my own blog. This site is focused on investing, but mostly for those who are excited about the field. The average Joe passing by would probably quickly feel this site has nothing for him, and that is a shame because there are things I can teach them about, such as: 1) the impact of high management fees, 2) how heavy trading is probably only making your broker rich, and 3) the use of debt. So, I will try to also publish some important investment knowledge for a general audience in the near future. The goal is to get this across while still providing the same content for the more passionate readers.
Friday, October 12, 2007
Respone to Harvest Question
In my last update on Harvest, I said the following:
Now I'm going to conclude by throwing out one question that has been bothering me: In the reserve estimates in the valuation report, Ryder Scott attributes zero reserves for probable and possible for the original SMU fields. But if you look at the production and reserve numbers in the chart I provided here, you can see that Harvest has clearly been successful at expanding their proved reserves at their traditional SMU oil fields. So my question is, why is there no probable or possible reserves for the SMU oil fields?
The response from the company was:
In the opinion of Ryder Scott, all of the remaining reserves in the SMU fields are proved due to the extensive amount of information available regarding well control in these three fields.
So that is that. Meanwhile, some other questions that have popped into my mind:
1. Do other oil companies publish the NPV of their oil assets, and if so where do their stocks trade in relation to those numbers?
2. Venezuela's currency has a special problem- from a Bloomberg article:
Now I'm going to conclude by throwing out one question that has been bothering me: In the reserve estimates in the valuation report, Ryder Scott attributes zero reserves for probable and possible for the original SMU fields. But if you look at the production and reserve numbers in the chart I provided here, you can see that Harvest has clearly been successful at expanding their proved reserves at their traditional SMU oil fields. So my question is, why is there no probable or possible reserves for the SMU oil fields?
The response from the company was:
In the opinion of Ryder Scott, all of the remaining reserves in the SMU fields are proved due to the extensive amount of information available regarding well control in these three fields.
So that is that. Meanwhile, some other questions that have popped into my mind:
1. Do other oil companies publish the NPV of their oil assets, and if so where do their stocks trade in relation to those numbers?
2. Venezuela's currency has a special problem- from a Bloomberg article:
The bolivar fell 0.9 percent to 5,350 bolivars per U.S. dollar in unregulated currency trading today from 5,300 yesterday, traders said. The bolivar has fallen 36 percent this year.
Venezuela pegs the bolivar at the official exchange rate of 2,150 bolivars under restrictions imposed in February 2003. People turn to unregulated markets when they can't get approval from the government's Foreign Exchange Administration Commission to buy dollars at the official exchange rate.
How is this taken into account in the Ryder Scott NPVs and should we adjust the numbers for this?
I hope the key thing readers take away from these recent posts on Harvest is that you should never just accept the number someone gives you as the value of a company (Not from the company, and not even mine!). You need to look at the assumptions yourself and challenge them, until you come up with your own number that you 1) are comfortable with, and 2) feel is fairly conservative. Keep asking questions!
Wednesday, October 10, 2007
Characteristics of Successful People
(hat tip to David Lau for finding this)
What makes a person successful? What makes them motivated, prosperous, a great leader?
What makes a person successful? What makes them motivated, prosperous, a great leader?
These questions fired the writing of each book covered in 50 Success Classics, and it is possible to draw out some common threads as answers. The following is only a brief and partial list, but may whet your appetite to discover for yourself some of the principles of success.
Optimism
Optimism is power. This is a secret discovered by all who succeed against great odds. Nelson Mandela, Ernest Shackleton, Eleanor Roosevelt - each admitted that what got them through tough times was an ability to focus on the positives. They understood what Claude Bristol called 'the magic of believing'. Yet great leaders also have an unusual ability to face up to stark reality, so creating a single powerful attribute: 'tough-minded optimism'.
Optimistic people tend to succeed not simply because they believe all will turn out right, but because the expectation of success makes them work harder. If you expect little, you will not be motivated to even try.
Definite aim, purpose or vision
Success requires concentration of effort. Most people disperse their energies over too many things and so fail to be outstanding in anything. In the words of Orison Swett Marden, "The world does not demand that you be a lawyer, minister, doctor, farmer, scientist, or merchant; it does not dictate what you shall do, but it does require that you be a master in whatever you undertake."
Have higher aims and goals and doggedly pursue their realisation. As the Bible says, "Where there is no vision, the people perish".
Willingness to labor
Successful people are willing to engage in drudgery in the cause of something marvellous. The greater part of 'genius' is the years of effort to solve a problem or find the perfect expression of an idea. With hard work you acquire knowledge about yourself which idleness never reveals.
A law of success is that, once first achieved, it can create a momentum that makes it easier to sustain. As Talleyrand put it, "Nothing succeeds like success".
Discipline
Enduring success is built on discipline, an appreciation that you must give yourself orders and obey them. Like compound interest, this subject may be boring, but its results in the long term can be spectacular.
The great achiever knows that while the universe is built by atoms, success is built by minutes; he or she is a master when it comes to their use of time.
Integrated mind
Successful people have a good relationship with their unconscious or subconscious minds. They trust their intuition, and because intuitions are usually right, they seem to enjoy more luck than others. They have discovered one of the great success secrets: that the non-rational mind infallibly solves problems and creates solutions when trusted to do so.
Prolific reading
Look into the habits of the successful, and you will find that they are usually great readers. Many of the leaders and authors covered in this book attribute the turning point in their lives to picking up a certain book. If you can read about the accomplishments of those you admire, you cannot help but lift your own sights. Anthony Robbins remarked that 'success leaves clues', and reading is one of the best means of absorbing such clues. Curiosity and the capacity to learn are vital for achievement, thus the saying "Leaders are readers". The person who seeks growth, Dale Carnegie said, "must soak and tan his mind constantly in the vats of literature."
Risk-taking
The greater the risk, the greater the potential success. Nothing ventured, nothing gained. Have a bias for action.
The power of expectation
Successful people expect the best, and they generally get it, because expectations have a way of attracting to us their material equivalent.
Since our lives correspond pretty much to the expectations we have of it, the achiever will argue, why not think big instead of small?
Mastery
The advanced being can turn any situation to their advantage. They are 'masters of their souls, captains of their fate.'
When other parties are involved, they will seek solutions in which gains are maximised for all. In the words of Catherine Ponder, "You do not have to compromise in life, if you are willing to let go of the idea of compromise."
Well-roundedness
Achievements mean little if we are not a success as a person. The capacities to love, listen and learn are vital for our own well-being, and without them it is difficult to have the fulfilling relationships that we need to both renew us and inspire achievement.
Tuesday, October 09, 2007
Appreciating Fannie and Freddie
Reflections on Value Investing recently put up "An Interview with Richard Pzena" conducted in 2006. In it, he shares some great insight into the Government Sponsored Entities(GSEs), Fannie Mae and Freddie Mac:
Take Fannie Mae and Freddie Mac: nobody would touch
This is a very great advantage. In fact, almost all the problems in the banking industry come from the mismatch of short term borrowing and long term lending. Add to that the GSEs special status which makes investors feel it is essentially backed by the US government. This allows them to borrow at the rate of the US government, plus about 10 to 15 basis points. These two benefits give a huge moat around the company. But perhaps the most interesting statement is this:
"And the stock gets killed. So where does it go? It actually trades below the liquidation of their portfolio. Forget accounting, I could stop the business and earn a profit. And people are saying, “Oh my god, the business is going to stop. I don’t want to own the stock.” But it’s already selling for below what it’s worth if the business stops. And if doesn’t stop, you’re making a fortune."
Since this interview, the share prices of both companies have gone essentially nowhere, while the businesses have continued to operate, so I can only assume the discount has increased. If so, this might still be a great opportunity to get into a wide moat company at a very cheap price.Sunday, October 07, 2007
Learning From Mistakes
This week's Economist had this article about Meg Whitman, CEO of Ebay, and also her purchase of Skype:
Among the many lessons that Margaret (“Meg”) Whitman has picked up during her three decades as a businesswoman, three stand out, she told an audience at Stanford's business school last year...
The first lesson, which she learned in 1979, was that attention to detail is all important. At the time, she was fresh out of Harvard Business School and just starting her first job at Procter & Gamble. She was charged with figuring out whether the nozzle on shampoo bottles should be half or three-eighths of an inch wide. Despite the tediousness of the task, “I decided I was going to do the very best job that had ever been done at the Procter & Gamble company”
Well, this lesson is not necessarily bad. Attention to detail is usually very good, although I would argue it is much better to focus your attention on things that add or affect value, and not on whether a nozzle should be an eight of an inch different.
The second lesson occurred in 2002. As boss of eBay, she had noticed that a lot of the sellers and buyers on its site were using an online-payment service called PayPal as a sort of virtual wallet, so she decided to buy it. She negotiated for a year, during which the price kept rising. She concluded that in the internet industry one bids early, boldly and pre-emptively high.
Again, which part of that philosophy focuses on the value of what you are getting? Her statement seems to best resemble that of someone who is victim to the wild mood swings of Mr. Market. Just because you see prices rising does not mean you should be jumping in.
The third lesson was that in such a fast-moving realm “the price of inaction is far greater than the cost of a mistake.” In any case, mistakes can always be corrected. In other words, it did not matter that the “synergies” between a telephone service and an online flea-market seemed few and far between. In her view, eBay was right to buy first and look for the answers to such concerns later.
Well this one has its own Buffett counter-quote which I happen to like a lot:
"In investments, there's no such thing as a called strike. You can stand there at the plate and the pitcher can throw a ball right down the middle; and if it's General Motors at 47 and you don't know enough to decide on General Motors at 47, you let it go right on by and no one's going to call a strike. The only way you can have a strike is to swing and miss."
I think somewhere along the way Meg Whitman learned the wrong set of investing rules. She bought first and asked questions later, and she completely ignored the intrinsic value of the companies she was purchasing. The outcome:
Collectively, these three lessons have led to disaster. On October 1st eBay conceded, in the language of book-keepers, that the purchase of Skype was just that. It had paid $2.6 billion up front, and agreed to cough up yet more if Skype met certain targets. It did not. This week eBay said that it would take a $1.4 billion charge in relation to the purchase.
A 55% loss. Swing and a miss, Strike!
Among the many lessons that Margaret (“Meg”) Whitman has picked up during her three decades as a businesswoman, three stand out, she told an audience at Stanford's business school last year...
The first lesson, which she learned in 1979, was that attention to detail is all important. At the time, she was fresh out of Harvard Business School and just starting her first job at Procter & Gamble. She was charged with figuring out whether the nozzle on shampoo bottles should be half or three-eighths of an inch wide. Despite the tediousness of the task, “I decided I was going to do the very best job that had ever been done at the Procter & Gamble company”
Well, this lesson is not necessarily bad. Attention to detail is usually very good, although I would argue it is much better to focus your attention on things that add or affect value, and not on whether a nozzle should be an eight of an inch different.
The second lesson occurred in 2002. As boss of eBay, she had noticed that a lot of the sellers and buyers on its site were using an online-payment service called PayPal as a sort of virtual wallet, so she decided to buy it. She negotiated for a year, during which the price kept rising. She concluded that in the internet industry one bids early, boldly and pre-emptively high.
Again, which part of that philosophy focuses on the value of what you are getting? Her statement seems to best resemble that of someone who is victim to the wild mood swings of Mr. Market. Just because you see prices rising does not mean you should be jumping in.
The third lesson was that in such a fast-moving realm “the price of inaction is far greater than the cost of a mistake.” In any case, mistakes can always be corrected. In other words, it did not matter that the “synergies” between a telephone service and an online flea-market seemed few and far between. In her view, eBay was right to buy first and look for the answers to such concerns later.
Well this one has its own Buffett counter-quote which I happen to like a lot:
"In investments, there's no such thing as a called strike. You can stand there at the plate and the pitcher can throw a ball right down the middle; and if it's General Motors at 47 and you don't know enough to decide on General Motors at 47, you let it go right on by and no one's going to call a strike. The only way you can have a strike is to swing and miss."
I think somewhere along the way Meg Whitman learned the wrong set of investing rules. She bought first and asked questions later, and she completely ignored the intrinsic value of the companies she was purchasing. The outcome:
Collectively, these three lessons have led to disaster. On October 1st eBay conceded, in the language of book-keepers, that the purchase of Skype was just that. It had paid $2.6 billion up front, and agreed to cough up yet more if Skype met certain targets. It did not. This week eBay said that it would take a $1.4 billion charge in relation to the purchase.
A 55% loss. Swing and a miss, Strike!
Saturday, October 06, 2007
Utility Industry Q&A
With Prem Watsa continuing to buy more shares in International Coal Group, ICO, I've taken an interest in hoarding more general information about coal and energy in general. So, I decided to interview a real expert in the utility field- my dad. He is a top manager at the Los Angeles Department of Water and Power, and his example reminds me everyday that I can be working harder. Anyways, these are some key notes I took based off what I remember asking him.
Which is cheaper to run, a coal or natural gas plant?
A coal plant is much, much cheaper to operate. Coal costs about $30 per (?)*, while natural gas costs about $70. This is significant because fuel accounts for 95% of the costs in the industry. (*Note: I forgot the unit of measurement, but the numbers are correct)
What about capital investment costs?
Traditional coal and natural gas plants are fairly similar. But now, there is a lot more difficulty in building a coal plant because of pollution and the idea of clean energy. In fact, many of the new plants that will soon be online are natural gas plants. But, the ratio of the cost of building a very clean coal plant to a natural gas plant is about 1.5: 1.
So based on investment merit alone, which is the more logical choice?
Coal by far, even after taking into account higher capital investment costs. The main reason that you do not see more coal plants coming online though is because environmental concerns play a big part though in the process; for example, California has no coal plants and it's practically impossible to build one there.
Any other difference between coal versus natural gas plants?
Natural gas plant is much easier, and cheaper, to adjust the capacity at a plant, whereas a coal plant takes some time to get started and costs more for shutdowns/ start-ups. It is much more practical to leave a coal plant going, but then there is the problem that energy can not be stored- it must be used that instant it is created.
That seems very important?
Very. In fact most people don't understand that about the industry, and the hardest part is balancing reducing waste while also generating enough power for everyone. And that is why small recessions are actually a good thing, because we can easily reduce our highest cost capacity.
What about ideas being brought up more making coal more eco-friendly, and efficient? (I think I mentioned specifically the idea mentioned in the Economist about the use of photosynthesis)
The technology for coal to become eco-friendly is mostly there, a lot of it is just stigma, or just that power generating companies who can avoid making the additional investment would rather not make it. As for the photosynthesis idea, that has been brought to them, the problem is it is still in research phase and the research companies are trying to get them to finance the further research.
Regarding natural gas, I remember reading that energy output of natural gas to crude oil barrel is about 1 to 6. If so, why is there such a huge divergence between the two right now and will that correct?
Though it doesn't work out exactly, energy is still energy. So yes, in the long run the two should converge.
Have any insight into the production costs in the natural gas industry?
Well for over 50 years, natural gas always hovered at about $2 to $2.50. Then all of a sudden we saw a spike to $8, and now its back to about $6. I think a lot of it is just speculative money coming into it. The production costs for natural gas are still low and there is plenty more capacity.
That's the most important parts I can remember. Except also, he mentioned that in order to secure coal production his company made an investment in ICO after the mining collapse. I thought that was a great coincidence, and he could probably help me a lot if I decided to pursue the idea further. Prem keeps buying more, so I probably should look more into it.
Thursday, October 04, 2007
More Info on Harvest Natural Resources
As I mentioned in my original posting a few days ago, there was going to be more research into Harvest Natural Resources. Here is some more analysis and some key notes.
First, to briefly go over the contract details:
1. Ownership of the corporate entity went from 80% to a net 32%.
2. There is now a 33.3% royalty on production.
3.Tax Rate increased from 34% to 50%.
4. Price realized increased from 47% of WTI to 70% of WTI.
5. They kept their original oil fields, and also received 3 new fields.
Now, if you look from the viewpoint of the Venezuelan government, before this change foreign companies(in general, not just Harvest) were receiving 66% of the profits from Venezuelan oil profits, while the government took only its 34% in taxes. Now, after the new royalty, foreign ownership restrictions, and tax rate, the ratio is about 13% to 87%. So the incentive to impose even stiffer terms seems to have become significantly reduced.
Second thing I wanted to mention regards the reimbursement fee. Unfortunately, most of it should not be included in our intrinsic value calculations. The reimbursement fee is supposed to make up for Harvest's costs and profits from April 1st, 2006 to the date the contract is signed. But, the NPV calculations we have been using for analyzing the oil assets are also based off of April 1st, 2006. So, this would be double counting the profits in our value calculation. We can still include the operating cost portion of the fee to Harvest though, which I estimated at approximately 25 million. Also, since it is now October 2007, there was been some increase in time value in the NPV of the oil assets, but I'm choosing to ignore that. So it is nice that we will be getting a hefty reimbursement soon, but the appropriate net cash number to use seems to be 140 million.
Now, Oil Assets. One thing I found interesting was that the Ryder Scott valuation report said it conformed to SPE/WPC reserve definitions for proved, probable, and possible. So, I looked that up and found this link. Basically, the summary of the definitions are:
Proved: "If probabilistic methods are used, there should be at least a 90% probability that the actual quantities recovered will equal or exceed the estimate."
Probable: "In this context, when probabilistic methods are used, there should be at least a 50% probability that the quantities recovered will equal or exceed the proved reserves plus the probable reserves."
Possible: "In this context, when probabilistic methods are used, there should be at least a 10% probability that the actual quantities recovered equal or exceed the proved plus probable plus possible reserves estimates."
Now this is interesting because we can use this to come up with an average based on strict interpretation of the definitions. The calculation is as follows:
(Note: I used 100% for proved instead of 90% to simplify, and just because I think that's fair)
(.50)(308) + (.40)(466) + (.10)(862) = 427 million
So interpreting those definitions strictly comes up with an average value of 427 million. Note also that in this and all the other NPV calculations mentioned, the net price used was $45.81, while the price today would be about 53.24, a 17% increase.
Now, using the net cash of 140 million plus this 427 million calculation gives us 567 million, compared to a purchase price of 460 million. And, there is a 17% safety margin in the oil price not taken into account. And this is not taking into account what appears to be management's sincere beliefs that they can recognize a lot of the probable and possible reserves, based on what they have done historically with their three fields.
Now I'm going to conclude by throwing out one question that has been bothering me: In the reserve estimates in the valuation report, Ryder Scott attributes zero reserves for probable and possible for the original SMU fields. But if you look at the production and reserve numbers in the chart I provided here, you can see that Harvest has clearly been successful at expanding their proved reserves at their traditional SMU oil fields. So my question is, why is there no probable or possible reserves for the SMU oil fields?
First, to briefly go over the contract details:
1. Ownership of the corporate entity went from 80% to a net 32%.
2. There is now a 33.3% royalty on production.
3.Tax Rate increased from 34% to 50%.
4. Price realized increased from 47% of WTI to 70% of WTI.
5. They kept their original oil fields, and also received 3 new fields.
Now, if you look from the viewpoint of the Venezuelan government, before this change foreign companies(in general, not just Harvest) were receiving 66% of the profits from Venezuelan oil profits, while the government took only its 34% in taxes. Now, after the new royalty, foreign ownership restrictions, and tax rate, the ratio is about 13% to 87%. So the incentive to impose even stiffer terms seems to have become significantly reduced.
Second thing I wanted to mention regards the reimbursement fee. Unfortunately, most of it should not be included in our intrinsic value calculations. The reimbursement fee is supposed to make up for Harvest's costs and profits from April 1st, 2006 to the date the contract is signed. But, the NPV calculations we have been using for analyzing the oil assets are also based off of April 1st, 2006. So, this would be double counting the profits in our value calculation. We can still include the operating cost portion of the fee to Harvest though, which I estimated at approximately 25 million. Also, since it is now October 2007, there was been some increase in time value in the NPV of the oil assets, but I'm choosing to ignore that. So it is nice that we will be getting a hefty reimbursement soon, but the appropriate net cash number to use seems to be 140 million.
Now, Oil Assets. One thing I found interesting was that the Ryder Scott valuation report said it conformed to SPE/WPC reserve definitions for proved, probable, and possible. So, I looked that up and found this link. Basically, the summary of the definitions are:
Proved: "If probabilistic methods are used, there should be at least a 90% probability that the actual quantities recovered will equal or exceed the estimate."
Probable: "In this context, when probabilistic methods are used, there should be at least a 50% probability that the quantities recovered will equal or exceed the proved reserves plus the probable reserves."
Possible: "In this context, when probabilistic methods are used, there should be at least a 10% probability that the actual quantities recovered equal or exceed the proved plus probable plus possible reserves estimates."
Now this is interesting because we can use this to come up with an average based on strict interpretation of the definitions. The calculation is as follows:
(Note: I used 100% for proved instead of 90% to simplify, and just because I think that's fair)
(.50)(308) + (.40)(466) + (.10)(862) = 427 million
So interpreting those definitions strictly comes up with an average value of 427 million. Note also that in this and all the other NPV calculations mentioned, the net price used was $45.81, while the price today would be about 53.24, a 17% increase.
Now, using the net cash of 140 million plus this 427 million calculation gives us 567 million, compared to a purchase price of 460 million. And, there is a 17% safety margin in the oil price not taken into account. And this is not taking into account what appears to be management's sincere beliefs that they can recognize a lot of the probable and possible reserves, based on what they have done historically with their three fields.
Now I'm going to conclude by throwing out one question that has been bothering me: In the reserve estimates in the valuation report, Ryder Scott attributes zero reserves for probable and possible for the original SMU fields. But if you look at the production and reserve numbers in the chart I provided here, you can see that Harvest has clearly been successful at expanding their proved reserves at their traditional SMU oil fields. So my question is, why is there no probable or possible reserves for the SMU oil fields?
Wednesday, October 03, 2007
Harvest Natural Resources Historical Data
Here is a chart I made of some historical information on Harvest going back to 1994. Click to expand. No interpretations yet.
Tuesday, October 02, 2007
Shiller, Robert J. Testimony at Congress on Housing.
The
Note from Figure 1 that neither the rise of home prices to 2006 nor the fall thereafter can
The futures market for single family homes at the Chicago Mercantile Exchange that I
Sunday, September 30, 2007
New Position: Harvest Natural Resources
I'm going to keep this write-up short because frankly, I still have only a basic understanding of the company and I have many more questions that I hope to uncover as time goes on. But based on the numbers and the story, it seems clear that Harvest represents a compelling valuation at current prices.
Harvest Natural Resources is an American company with oil production in Venezuela. Over the past few years, the stock price has been hit because of fears over the possibility of nationalization. Today however, the revised contract is very near implementation on the terms that the Venezuelan government has wanted. The terms were very stiff: 33% royalties, reduced ownership in the properties to 40%, and 50% tax rate. But if we accept this as final, then the risk reward situation as follows:
Price: 12.21
Market Cap: 460 million
At end of 2nd Quarter, 115 million in net cash.
Reimbursement payment: 60 million cash(*)
= approximately 175 million adjusted net cash.
The company also provides you with a discounted valuation of their reserves, after-tax and at 10%, as follows:
Proved reserves: 308 million
Probable reserves: 158 million
Possible Reserves: 396 million
Play around with the scenarios and you can see the range of values can be exciting, at 175 million - 1037 million. A few things to note:
*First, with regards to the reimbursement payment- this is the money the company is supposed to get reimbursed for operating their oil wells during the past year and a half without a contract. I believe the number I came up with is approximately right based on the terms in the new contract, although I will be double checking my methodology some more. See the comments below for further discussion.
Second, with regards to the valuation of the properties. These NPV's were done using a recovery rate(the amount of oil you recover out of the total in the field) of 13% on their reserves. The company showed how they have historically done much better than this, and they see their new fields having the same characteristics as their past successes. So, if you assume their 13% recovery rate is conservative, that means you would value the properties all the way to 3P (Possible), because that would be 13% recovery. Every subsequent 1% improvement in rate adds about 100-125 million in value to HNR, implying another huge upside in the stock based on exploration potential.
With regards to the fears over Venezuela, it seems like Venezuela has already "done its worst", so to speak. They have gotten the terms they have wanted, and to ask for anything stiffer would send the companies packing. Harvest and the other companies have shown how they can add plenty of value by exploring and operating these oil assets, so Venezuela doesn't want to see them go. So I think it might be fair for now to consider these terms as final.
I do have plenty of questions; (for example, what is the price of oil used in the NPV calculations?) Plus, I have also always been sort of an oil bear, thinking that most the rise in oil prices has been due to speculation rather than fundamentals. But add up the numbers for Harvest and you have a stock price backed by a lot of cash, along with a high quality oil asset with very low operating costs (Currently about $5-6 per barrel of oil). It was enough for me to buy a position today. Look forward to more on this in the future.
Update on 10/4/07
Harvest Natural Resources is an American company with oil production in Venezuela. Over the past few years, the stock price has been hit because of fears over the possibility of nationalization. Today however, the revised contract is very near implementation on the terms that the Venezuelan government has wanted. The terms were very stiff: 33% royalties, reduced ownership in the properties to 40%, and 50% tax rate. But if we accept this as final, then the risk reward situation as follows:
Price: 12.21
Market Cap: 460 million
At end of 2nd Quarter, 115 million in net cash.
Reimbursement payment: 60 million cash(*)
= approximately 175 million adjusted net cash.
The company also provides you with a discounted valuation of their reserves, after-tax and at 10%, as follows:
Proved reserves: 308 million
Probable reserves: 158 million
Possible Reserves: 396 million
Play around with the scenarios and you can see the range of values can be exciting, at 175 million - 1037 million. A few things to note:
*First, with regards to the reimbursement payment- this is the money the company is supposed to get reimbursed for operating their oil wells during the past year and a half without a contract. I believe the number I came up with is approximately right based on the terms in the new contract, although I will be double checking my methodology some more. See the comments below for further discussion.
Second, with regards to the valuation of the properties. These NPV's were done using a recovery rate(the amount of oil you recover out of the total in the field) of 13% on their reserves. The company showed how they have historically done much better than this, and they see their new fields having the same characteristics as their past successes. So, if you assume their 13% recovery rate is conservative, that means you would value the properties all the way to 3P (Possible), because that would be 13% recovery. Every subsequent 1% improvement in rate adds about 100-125 million in value to HNR, implying another huge upside in the stock based on exploration potential.
With regards to the fears over Venezuela, it seems like Venezuela has already "done its worst", so to speak. They have gotten the terms they have wanted, and to ask for anything stiffer would send the companies packing. Harvest and the other companies have shown how they can add plenty of value by exploring and operating these oil assets, so Venezuela doesn't want to see them go. So I think it might be fair for now to consider these terms as final.
I do have plenty of questions; (for example, what is the price of oil used in the NPV calculations?) Plus, I have also always been sort of an oil bear, thinking that most the rise in oil prices has been due to speculation rather than fundamentals. But add up the numbers for Harvest and you have a stock price backed by a lot of cash, along with a high quality oil asset with very low operating costs (Currently about $5-6 per barrel of oil). It was enough for me to buy a position today. Look forward to more on this in the future.
Update on 10/4/07
Friday, September 28, 2007
"Estimating the Stock/Bond Risk Premium" (My Notes)
The folks at Hoisington Investment Management did some great research into the performances of stocks versus risk-free treasuries. Unfortunately I can not post a direct link, but below are my notes on their report, published in the 2002 Journal of Portfolio Management.
"This study sheds new light on the risk premium of stocks over US Treasury bonds, which indicates most research overstates the advantages of stocks over bonds. Our research also indicates long periods when bonds actually outperformed stocks and the conditions that produce these results."
With regard to the first point with the comparison of returns of stocks against bonds, the report goes all the way back to the creation of the S&P500 in 1871. From 1871 to 2001, stocks returned 9.3%,versus bond returns of 5.0%, much lower than most calculations on the matter.
More important for us is the second point- the scenarios under which bonds or stocks outperform. They concluded that the 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 10 and 20 year periods for stocks and bonds:
The overriding factor has been price change, with deflation good for bonds and inflation good for stocks. But in periods where dividend yields have been excessively more than treasuries, stocks have tended to outperform. And in periods where treasury yields are higher than dividend yields, bonds tend to outperform. Also, a third factor has been the P/E yield. The report goes on to mention the implications of these findings in 2002's environment, and how they expected bonds to outperform .
And, they have been right so far. One problem I do have though is that in the examples they give, dividend yields are exceeding treasury yields. This is something that hasn't happened since the 1960's. But anyways, looking at these factors in today's environment:
1. Inflation rate:
This is the most important factor, and also the hardest for most people to predict. My opinion has been we have too much capacity if anything, because we have been requiring debt and assets to pay for our spending, rather than just income. And it's hard to see people spending considerably more from their already highly indebted levels. But these things are notoriously hard to predict, and who knows whether I'll be right or not.
2. Relative yields
Currently, the yield on a 10-year treasury is 4.57%. Meanwhile, the dividend yield of the S&P500 for 2006 was 1.77%, leaving a spread of 2.80% in favor of treasuries. As I mentioned before though, the dividend yield has not exceeded the treasury yield since the 1960's. It is difficult to say what to make of the fact that the dividend yield has been so low for so long. The common response is companies are reinvesting capital at favorable returns, or they have also been buying back shares. But dividends are money in the pocket today for investors, whereas the benefits of capital expenditures will only show over the long term and have usually been marginal at best.
3. P/E Ratio
The ratio for the S&P500 in 2006 was 17.3, above average but not by much. Still, it is nowhere near the low levels seen before the greatest stock advances.
The report concludes with the following:
We know that over very long terms stocks must outperform bonds, because investors must be rewarded for riskier assets, and we will experience again in the future conditions that warrant higher prospective returns. First, the baseline conditions must change, a process that may result in an extended period when bond returns will equal, or even exceed, returns on stocks.
"This study sheds new light on the risk premium of stocks over US Treasury bonds, which indicates most research overstates the advantages of stocks over bonds. Our research also indicates long periods when bonds actually outperformed stocks and the conditions that produce these results."
With regard to the first point with the comparison of returns of stocks against bonds, the report goes all the way back to the creation of the S&P500 in 1871. From 1871 to 2001, stocks returned 9.3%,versus bond returns of 5.0%, much lower than most calculations on the matter.
More important for us is the second point- the scenarios under which bonds or stocks outperform. They concluded that the 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 10 and 20 year periods for stocks and bonds:
The overriding factor has been price change, with deflation good for bonds and inflation good for stocks. But in periods where dividend yields have been excessively more than treasuries, stocks have tended to outperform. And in periods where treasury yields are higher than dividend yields, bonds tend to outperform. Also, a third factor has been the P/E yield. The report goes on to mention the implications of these findings in 2002's environment, and how they expected bonds to outperform .
And, they have been right so far. One problem I do have though is that in the examples they give, dividend yields are exceeding treasury yields. This is something that hasn't happened since the 1960's. But anyways, looking at these factors in today's environment:
1. Inflation rate:
This is the most important factor, and also the hardest for most people to predict. My opinion has been we have too much capacity if anything, because we have been requiring debt and assets to pay for our spending, rather than just income. And it's hard to see people spending considerably more from their already highly indebted levels. But these things are notoriously hard to predict, and who knows whether I'll be right or not.
2. Relative yields
Currently, the yield on a 10-year treasury is 4.57%. Meanwhile, the dividend yield of the S&P500 for 2006 was 1.77%, leaving a spread of 2.80% in favor of treasuries. As I mentioned before though, the dividend yield has not exceeded the treasury yield since the 1960's. It is difficult to say what to make of the fact that the dividend yield has been so low for so long. The common response is companies are reinvesting capital at favorable returns, or they have also been buying back shares. But dividends are money in the pocket today for investors, whereas the benefits of capital expenditures will only show over the long term and have usually been marginal at best.
3. P/E Ratio
The ratio for the S&P500 in 2006 was 17.3, above average but not by much. Still, it is nowhere near the low levels seen before the greatest stock advances.
The report concludes with the following:
We know that over very long terms stocks must outperform bonds, because investors must be rewarded for riskier assets, and we will experience again in the future conditions that warrant higher prospective returns. First, the baseline conditions must change, a process that may result in an extended period when bond returns will equal, or even exceed, returns on stocks.
Wednesday, September 26, 2007
Rubin, Robert. Commencement Speech at Harvard, 2001.
Added to Online Library.
"I doubt if Kant or Spinoza viewed themselves as offering the best and more important preparation for risk arbitrage or for intervention in the dollar/yen foreign exchange market or for the many other activities of a finance minister. But, in my view, they did. Looking back on all my years in the private and public sectors, in the most important issues, certainties were almost always illusory and misleading, as were the simple answers or opinions that often were the response to the complicated issues in both political discourse and the private sector. Reality is complex, and recognizing complexity and engaging with complexity was the path to best decision-making."
...
"An important corollary to recognizing that decisions are about probabilities is that decisions should not be judged by outcomes but by the quality of the decision-making, though outcomes are certainly one useful input in that evaluation.. Any individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better overall results, and more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome. In managing trading rooms, I always focused on evaluating and promoting traders not on their results alone, but also and very importantly, on the thinking that underlay their decisions. Unfortunately, this approach is not widely taken, much to the detriment of decision-making in both the private and public sectors."
"I doubt if Kant or Spinoza viewed themselves as offering the best and more important preparation for risk arbitrage or for intervention in the dollar/yen foreign exchange market or for the many other activities of a finance minister. But, in my view, they did. Looking back on all my years in the private and public sectors, in the most important issues, certainties were almost always illusory and misleading, as were the simple answers or opinions that often were the response to the complicated issues in both political discourse and the private sector. Reality is complex, and recognizing complexity and engaging with complexity was the path to best decision-making."
...
"An important corollary to recognizing that decisions are about probabilities is that decisions should not be judged by outcomes but by the quality of the decision-making, though outcomes are certainly one useful input in that evaluation.. Any individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better overall results, and more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome. In managing trading rooms, I always focused on evaluating and promoting traders not on their results alone, but also and very importantly, on the thinking that underlay their decisions. Unfortunately, this approach is not widely taken, much to the detriment of decision-making in both the private and public sectors."
Railroads: Following Buffett's Latest Move
The Texas Hedge Report has come out with a new letter discussing the railroad industry, and what has changed, in some detail. Thanks to Lincoln Minor for bringing it to my attention.
Monday, September 24, 2007
Keynes on Cyclical Bottoms
While reading "Essays in Persuasion" by John Maynard Keynes, I came across this:
"The time which elapses before production ceases and unemployment reaches its maximum is, for several reasons, much longer in the case of the primary products than in the case of manufacture. (Note: by primary products, he means commodities) In most cases the productive units are smaller and less well organized amongst themselves for enforcing a process of orderly contraction; the length of the production period, especially in agriculture, is longer; the costs of a temporary shut-down are greater; men are often their own employers are so submit more readily to a contraction of the income for which they are willing to work; the social problems of throwing men out of employment are greater in more primitive communities; ..."
So when looking for cyclical bottoms, these are some additional factors that can help determine how long until an industry rationalizes. For the pulp industry and my investment in SFK Pulp Fund, the main problems which seem to apply are:
A. many small productive units that are not well organized
B. the costs of a temporary shut-down are great
C. the social problems of throwing men out of employment in primitive communities
I would also add my own problem: High leverage. Many pulp companies have taken on significant debt, which makes stopping operations and "giving up" not a viable option.
"The time which elapses before production ceases and unemployment reaches its maximum is, for several reasons, much longer in the case of the primary products than in the case of manufacture. (Note: by primary products, he means commodities) In most cases the productive units are smaller and less well organized amongst themselves for enforcing a process of orderly contraction; the length of the production period, especially in agriculture, is longer; the costs of a temporary shut-down are greater; men are often their own employers are so submit more readily to a contraction of the income for which they are willing to work; the social problems of throwing men out of employment are greater in more primitive communities; ..."
So when looking for cyclical bottoms, these are some additional factors that can help determine how long until an industry rationalizes. For the pulp industry and my investment in SFK Pulp Fund, the main problems which seem to apply are:
A. many small productive units that are not well organized
B. the costs of a temporary shut-down are great
C. the social problems of throwing men out of employment in primitive communities
I would also add my own problem: High leverage. Many pulp companies have taken on significant debt, which makes stopping operations and "giving up" not a viable option.
Sunday, September 23, 2007
Just Some Economic Charts: Part 2
Kudos to Prudent Bear for these. Click to expand.
And for those who continue to think of housing as a solid investment...
Here's the link to Just Some Economic Charts, Part 1.
And for those who continue to think of housing as a solid investment...
Here's the link to Just Some Economic Charts, Part 1.
Saturday, September 22, 2007
Warren Buffett Speaks- And I Expand
I recently got the opportunity to read a complementary copy of "Warren Buffett Speaks: Wit and Wisdom from the World's Greatest Investor" by Janet Lowe. It is essentially a compilation of Warren Buffett quotes, categorized into an easy to read format. Overall, I really enjoyed reading it as a sort of refresher course in Buffett wisdom. And for someone who is new to investing or trying to understand who Warren really is, I think this is a great place to start. But I did want to share a few quotes that in particular struck out at me:
"We like stocks that generate high returns on invested capital where there is a strong likelihood that it will continue to do so. For example, the last time we bought Coca-Cola, it was selling at about 23 times earnings. Using our purchase price and today's earnings, that makes it about 5 times earnings. It's really the interaction of capital employed, the return on that capital, and future capital generated versus the purchase price today." (My emphasis added)
Well here is a quote that maybe I should put right smack there at the top of my blog because it's a point you hear and you think you understand only to disregard it the next time you're analyzing a business. Ben Graham built an entire investing philosophy based on looking at capital employed, albeit focusing only at that which could quickly be turned to cash. The reason being that it was A, simple, and B, there were plenty of these opportunities to exploit available. Unfortunately, B is no longer the case. Still, it is easy for many investors to want to summarize investing decisions based on something as easy as a Price to Book ratio- after all, if the company spent X million to build this business, it should be worth around X million. That philosophy gives too much credit to businessmen. Here's another way to look at it. Assets have costs - think shareholder equity, and they have market values- think of this as the price you are paying for a common stock investment. But using either as a indicator of true worth is faulty. When you get really down to it, the main determinant of value will always be future earnings, discounted of course.
Another thing regarding capital employed. I used to always just look at this as fairly straight forward- it is the amount the company has invested in its business. A look at a company's balance sheet can easily come to this figure. But then I got to thinking, what about future capital? If a company is going to continually invest all its earnings into the business just to stay competitive, doesn't that mean the real number will approach infinity? Inversely, if a company doesn't have to make any more investments into its business, well then the number would really be about the traditional figure.
And this is where moat comes along. Because if a company doesn't have to re-invest in its business, but it also has no moat, then competitors will quickly erode that return on capital, no matter how low that capital is. (Think, the staffing industry) And if a company has to constantly re-invest all its earnings into its business, then earnings might keep growing, but your return on total capital is always going to be meager. The sweet spot is obviously a company that doesn't have to worry much about putting in new capital, and can still keep growing earnings. Runner up would be a company that can keep growing by investing new capital at very nice rates of return. And also, a moat makes determining future cash flow much easier. So it's easy to see why Buffett has put so much emphasis on them.
"An irony of inflation-induced financial requirements is that the highly profitable companies- generally the best credits- require relatively little debt capital. But the laggards in profitability never can get enough. Lenders understand this problem much better than they did a decade ago- and are correspondingly less willing to let capital-hungry, low profitability enterprises leverage themselves to the sky."
Here is something we've seen happen a lot in two categories. One being mortgage lenders, who have skipped the traditional bank model and came up with a new one that is leveraged to the sky. And the second group is investors as a whole. The bitter truth seems to be that future returns are going down. Again, the response by investors has been to jack up the leverage- examples include: private equity funds loading up buy-outs with debt; hedge funds using significant multiples of leverage; the universe of derivatives.
"The way I see it is that my money represents an enormous number of claim checks on society. It's like I have these little pieces of paper that I can turn into consumption. If I wanted to, I could hire 10,000 people to do nothing but paint my picture every day for the rest of my life. And then GNP would go up. But the utility of the product would be zilch, and I would be keeping those 10,000 people from doing AIDS research, or teaching, or nursing."
...
"In essence, one who spends less than he earns is accumulating 'claim checks' for future use. At some later date, he may reverse the procedure and consume more than he earns by cashing some of the accumulated claim checks. Or he may pass them on to others..."
The question today is are we the United States using up some of our 'claim checks' from the past wealth we built, or are we now going into 'claim debt'. It stands to reason that those accumulating 'claim debt' are spending more than they earn, and at some later date, may have to reverse the procedure and save more later. That is something to look deeper into.
"We like stocks that generate high returns on invested capital where there is a strong likelihood that it will continue to do so. For example, the last time we bought Coca-Cola, it was selling at about 23 times earnings. Using our purchase price and today's earnings, that makes it about 5 times earnings. It's really the interaction of capital employed, the return on that capital, and future capital generated versus the purchase price today." (My emphasis added)
Well here is a quote that maybe I should put right smack there at the top of my blog because it's a point you hear and you think you understand only to disregard it the next time you're analyzing a business. Ben Graham built an entire investing philosophy based on looking at capital employed, albeit focusing only at that which could quickly be turned to cash. The reason being that it was A, simple, and B, there were plenty of these opportunities to exploit available. Unfortunately, B is no longer the case. Still, it is easy for many investors to want to summarize investing decisions based on something as easy as a Price to Book ratio- after all, if the company spent X million to build this business, it should be worth around X million. That philosophy gives too much credit to businessmen. Here's another way to look at it. Assets have costs - think shareholder equity, and they have market values- think of this as the price you are paying for a common stock investment. But using either as a indicator of true worth is faulty. When you get really down to it, the main determinant of value will always be future earnings, discounted of course.
Another thing regarding capital employed. I used to always just look at this as fairly straight forward- it is the amount the company has invested in its business. A look at a company's balance sheet can easily come to this figure. But then I got to thinking, what about future capital? If a company is going to continually invest all its earnings into the business just to stay competitive, doesn't that mean the real number will approach infinity? Inversely, if a company doesn't have to make any more investments into its business, well then the number would really be about the traditional figure.
And this is where moat comes along. Because if a company doesn't have to re-invest in its business, but it also has no moat, then competitors will quickly erode that return on capital, no matter how low that capital is. (Think, the staffing industry) And if a company has to constantly re-invest all its earnings into its business, then earnings might keep growing, but your return on total capital is always going to be meager. The sweet spot is obviously a company that doesn't have to worry much about putting in new capital, and can still keep growing earnings. Runner up would be a company that can keep growing by investing new capital at very nice rates of return. And also, a moat makes determining future cash flow much easier. So it's easy to see why Buffett has put so much emphasis on them.
"An irony of inflation-induced financial requirements is that the highly profitable companies- generally the best credits- require relatively little debt capital. But the laggards in profitability never can get enough. Lenders understand this problem much better than they did a decade ago- and are correspondingly less willing to let capital-hungry, low profitability enterprises leverage themselves to the sky."
Here is something we've seen happen a lot in two categories. One being mortgage lenders, who have skipped the traditional bank model and came up with a new one that is leveraged to the sky. And the second group is investors as a whole. The bitter truth seems to be that future returns are going down. Again, the response by investors has been to jack up the leverage- examples include: private equity funds loading up buy-outs with debt; hedge funds using significant multiples of leverage; the universe of derivatives.
"The way I see it is that my money represents an enormous number of claim checks on society. It's like I have these little pieces of paper that I can turn into consumption. If I wanted to, I could hire 10,000 people to do nothing but paint my picture every day for the rest of my life. And then GNP would go up. But the utility of the product would be zilch, and I would be keeping those 10,000 people from doing AIDS research, or teaching, or nursing."
...
"In essence, one who spends less than he earns is accumulating 'claim checks' for future use. At some later date, he may reverse the procedure and consume more than he earns by cashing some of the accumulated claim checks. Or he may pass them on to others..."
The question today is are we the United States using up some of our 'claim checks' from the past wealth we built, or are we now going into 'claim debt'. It stands to reason that those accumulating 'claim debt' are spending more than they earn, and at some later date, may have to reverse the procedure and save more later. That is something to look deeper into.
Thursday, September 20, 2007
Paul Volcker at Stanford. Feb. 11, 2005
Notes from the video:
- Past few years, most Anglo-Saxon economies have been growing fast
- China and India, with 40% of the world population, have been growing extraordinarily and lifting their people out of poverty.
-But underneath that, there are huge imbalances and risks; they seem as dangerous as I can remember, and I can remember a lot.
- The world is even more dependent on the United States as an engine of growth.
- With the free flow of capital there has emerged new benefits and risks.
- US and Europe have more room to maneuver than ever before, due to strong tradition of monetary stability. And there has been a vast accumulation of wealth- real, paper, housing.
- What's not to like? Let me suggest a few things:
- Boomers are spending like there is no tomorrow. Personal savings in the US have practically disappeared.
- True, businesses have started to rebuild their reserves, but at the same time federal deficit has come to offset this source of national savings.
- We're buying a lot of homes at rising prices, but homeownership is becoming a vehicle for borrowing and leveraging as much as a source for financial security.
- Businesses, particularly manufacturing, aren't investing much.
- At the heart of the problem, as a nation we are consuming and investing, that is to say spending, about 6% more than we are producing. What holds it all together- high consumption, high leverage, government deficits- is a really massive and growing flow of capital from abroad, at about 2 billion a day.
- The lesson I draw: there's a high premium to doing what we can to minimize the risks. We need a willingness to act even when everything on the surface seems placid. It boils down to the oldest lesson of financial policy... a strong sense of monetary and fiscal discipline.
- Past few years, most Anglo-Saxon economies have been growing fast
- China and India, with 40% of the world population, have been growing extraordinarily and lifting their people out of poverty.
-But underneath that, there are huge imbalances and risks; they seem as dangerous as I can remember, and I can remember a lot.
- The world is even more dependent on the United States as an engine of growth.
- With the free flow of capital there has emerged new benefits and risks.
- US and Europe have more room to maneuver than ever before, due to strong tradition of monetary stability. And there has been a vast accumulation of wealth- real, paper, housing.
- What's not to like? Let me suggest a few things:
- Boomers are spending like there is no tomorrow. Personal savings in the US have practically disappeared.
- True, businesses have started to rebuild their reserves, but at the same time federal deficit has come to offset this source of national savings.
- We're buying a lot of homes at rising prices, but homeownership is becoming a vehicle for borrowing and leveraging as much as a source for financial security.
- Businesses, particularly manufacturing, aren't investing much.
- At the heart of the problem, as a nation we are consuming and investing, that is to say spending, about 6% more than we are producing. What holds it all together- high consumption, high leverage, government deficits- is a really massive and growing flow of capital from abroad, at about 2 billion a day.
- The lesson I draw: there's a high premium to doing what we can to minimize the risks. We need a willingness to act even when everything on the surface seems placid. It boils down to the oldest lesson of financial policy... a strong sense of monetary and fiscal discipline.
Wednesday, September 19, 2007
Le Bon, Gustave. "The Crowd: A Study of the Popular Mind"
Added to Online Library. Here is a book I was about to buy, until I found the entire text for free online. To copy Amazon's description:
One of the greatest and most influential books of social psychology ever written, brilliantly instructive on the general characteristics and mental unity of a crowd, its sentiments and morality, ideas, reasoning power, imagination, opinions and much more. A must-read volume for students of history, sociology, law and psychology.
It is about 200 pages. I haven't had the chance to read it yet, but it seems like a worthwhile book.
One of the greatest and most influential books of social psychology ever written, brilliantly instructive on the general characteristics and mental unity of a crowd, its sentiments and morality, ideas, reasoning power, imagination, opinions and much more. A must-read volume for students of history, sociology, law and psychology.
It is about 200 pages. I haven't had the chance to read it yet, but it seems like a worthwhile book.
Tuesday, September 18, 2007
SFK Cuts Its Dividend
SFK Pulp Fund announced today a cut in its dividend to 2 cents per share from the previous 5 cents. In my 2nd Quarter Recap, i mentioned that at prevailing conditions, it seemed that a distribution cut was likely, and since then things got worse: the Canadian dollar continued to rise by another 3%. The fact still remains that 90% of NBSK pulp production is in Canada and Europe, so the fall in the US dollar is affecting everyone in the industry. In the short run, these currency changes can be devastating, but in the long term I have to believe economic forces will work themselves out. A friend of mine recently told me that things like these can take years to play out- for example, the refining industry was in turmoil for almost 20 years before finally correcting with a huge cyclical upswing. I am starting to understand what he means. But, I've always been long-term focused. My barometer for change relies on looking on 3 public competitors- Tembec, Catalyst Paper, and Pope & Talbot, who control, approximately 16% of the NBSK market. These companies have been generating negative EBITDA's (Earnings Before Interest, Tax, Depreciation & Amortization) for some time now, and I can only hope that the recent fall in the US dollar will be the nail in the coffin leading to industry rationalization. But I've been too optimistic in the past, and it could be some time before economic forces play out.
Sunday, September 16, 2007
Pabrai Funds Meeting
I had the pleasure of attending the Pabrai Funds Meeting yesterday, which was simply just amazing in terms of the type of people that were all gathered in one place. I also took notes of Pabrai's presentation and wanted to share a few of the things from the Q&A section. The words in italics are my own.
Q: On Ipsco, why were the analysts so wrong?
A: With Ipsco, it is difficult to forecast the cashflow going far out in a cyclical business like steel, and no one likes to deal with uncertainty. But we were able to take advantage of that.
For reference, Pabrai's thesis on Ipsco was simple. It was trading at a market cap of 2.5 billion. It had 900 million in excess capital, and was projected to earn 650 million in free cash flow over the next two years, meaning 2.2 billion in cash by the end of that period. Though steel is highly cyclical, one can relatively easily forecast an industry 2 years out just by researching new supply projects and usual demand trends. Afterwards a gray area exists, but at that point it was a true Dhando situation- heads you win, tails you don't lose much.
Q: Why were you in and out of RailCar America so quickly?
A: There was a lot to like about the business. Though it is very cyclical, odds were pretty good this would be fairly profitable. We sold because it was very narrow, with its only product being rail cars carrying coal. Second, there was environmental and union issues. Finally, there was a chance that the expected replacement for coal cars wouldn't come around for several years. Probably a mistake to sell- we will see.
Q: How do you assess political risk in your framework?
A: Sometimes there is inefficient markets in how to deal with political risk. An example is with our Embraer in Brazil. The company was very cheap based on concerns about the currency, but that was just noise. Underneath you had a business that was the best at what they do and in a duopoly. They were the icon of Brazil, so the talent of the country wanted to go there, giving them a competitive edge. Also, Brazil wouldn't want to screw up an export champion.
There are several things I took from this. First was the idea of talent attraction as a competitive advantage. It's something that I never really factored in but has a lot of merit. Most likely, the best in an industry will attract those that are most passionate about that sector. One obvious example is Google. A second example- me! I was recently telling my family that if I could work right now, I'd jump at the opportunity to work with Exchange Bank of Santa Rosa because they're the best at what they do. And I'd like to think I'd be worth the cost.
The other thing I took from this is very important for any international investor. A unconventional test I like to put on any investment is the value-added. Well, with a company like Embraer, who is the best at what they do, there is definitely a lot of value added. There is also only one other competitor, and they sell their products all around the world. In such a situation, currency risk is really "noise". Any rise or fall in currency can easily work through the business to conserve profitability. Alternatively, I was recently looking at another wide-moat Brazilian company, but they sold only to customers in Brazil. In such a situation, currency risk is much more present- a decline in their currency wouldn't be offset by higher profitability on exports for a US investor like me.
Third, I'm guessing this original question was being asked with reference to Harvest Natural Resources, an American oil company with production in Venezuela. Again, currency risk seems to be less of a worry here, because they have a global product (as long as the government allows them to export that production). They're producing barrels of oils- and the value being created by that is practically the same whether its coming from Venezuela or somewhere else. This is something I'll be looking into.
Finally, I see the same thing with SFK. The product is sold mostly in North America, Europe, Asia. The fall of the US dollar seems bad, until you recognize that 90% of NBSK production is from either Canada or Europe. And there is also offsetting forces because I am a US investor putting money to work in Canadian dollars.
I hope some of these concepts were helpful.
Q: On Ipsco, why were the analysts so wrong?
A: With Ipsco, it is difficult to forecast the cashflow going far out in a cyclical business like steel, and no one likes to deal with uncertainty. But we were able to take advantage of that.
For reference, Pabrai's thesis on Ipsco was simple. It was trading at a market cap of 2.5 billion. It had 900 million in excess capital, and was projected to earn 650 million in free cash flow over the next two years, meaning 2.2 billion in cash by the end of that period. Though steel is highly cyclical, one can relatively easily forecast an industry 2 years out just by researching new supply projects and usual demand trends. Afterwards a gray area exists, but at that point it was a true Dhando situation- heads you win, tails you don't lose much.
Q: Why were you in and out of RailCar America so quickly?
A: There was a lot to like about the business. Though it is very cyclical, odds were pretty good this would be fairly profitable. We sold because it was very narrow, with its only product being rail cars carrying coal. Second, there was environmental and union issues. Finally, there was a chance that the expected replacement for coal cars wouldn't come around for several years. Probably a mistake to sell- we will see.
Q: How do you assess political risk in your framework?
A: Sometimes there is inefficient markets in how to deal with political risk. An example is with our Embraer in Brazil. The company was very cheap based on concerns about the currency, but that was just noise. Underneath you had a business that was the best at what they do and in a duopoly. They were the icon of Brazil, so the talent of the country wanted to go there, giving them a competitive edge. Also, Brazil wouldn't want to screw up an export champion.
There are several things I took from this. First was the idea of talent attraction as a competitive advantage. It's something that I never really factored in but has a lot of merit. Most likely, the best in an industry will attract those that are most passionate about that sector. One obvious example is Google. A second example- me! I was recently telling my family that if I could work right now, I'd jump at the opportunity to work with Exchange Bank of Santa Rosa because they're the best at what they do. And I'd like to think I'd be worth the cost.
The other thing I took from this is very important for any international investor. A unconventional test I like to put on any investment is the value-added. Well, with a company like Embraer, who is the best at what they do, there is definitely a lot of value added. There is also only one other competitor, and they sell their products all around the world. In such a situation, currency risk is really "noise". Any rise or fall in currency can easily work through the business to conserve profitability. Alternatively, I was recently looking at another wide-moat Brazilian company, but they sold only to customers in Brazil. In such a situation, currency risk is much more present- a decline in their currency wouldn't be offset by higher profitability on exports for a US investor like me.
Third, I'm guessing this original question was being asked with reference to Harvest Natural Resources, an American oil company with production in Venezuela. Again, currency risk seems to be less of a worry here, because they have a global product (as long as the government allows them to export that production). They're producing barrels of oils- and the value being created by that is practically the same whether its coming from Venezuela or somewhere else. This is something I'll be looking into.
Finally, I see the same thing with SFK. The product is sold mostly in North America, Europe, Asia. The fall of the US dollar seems bad, until you recognize that 90% of NBSK production is from either Canada or Europe. And there is also offsetting forces because I am a US investor putting money to work in Canadian dollars.
I hope some of these concepts were helpful.
Calculated Risk: HMDA Data Analysis
Calculated Risk published a post which I nearly missed and I think has some very important facts for investors. To take some quotes from their summary which I thought were very important:
Although mortgage companies represented only 22 percent of the reporting institutions, they submitted information on more than 60 percent of all the reported loans and applications.
The most active lenders (those providing information on 5,000 or more loans or applications) accounted for about 5 percent of the reporting institutions and nearly 90 percent of all the reported loans and applications.
For 2006, lenders covered by HMDA reported information on 27.5 million applications for home loans. Almost all the applications were for loans to be secured by one- to four-family (so-called single-family) houses, as follows: 10.9 million applications to purchase a home, 2.5 million to make home improvements, and 14.0 million to refinance an existing home loan.
After declining in the early 1990s, the share of non-owner-occupant lending among first-lien loans to purchase one- to four-family site-built homes began rising in 1994, and it has risen in every year between 1996 (when it was 6.4 percent) and 2005, when it reached 17.3 percent (table 8). For 2006, the share fell somewhat, to 16.5 percent.
Although mortgage companies represented only 22 percent of the reporting institutions, they submitted information on more than 60 percent of all the reported loans and applications.
The most active lenders (those providing information on 5,000 or more loans or applications) accounted for about 5 percent of the reporting institutions and nearly 90 percent of all the reported loans and applications.
For 2006, lenders covered by HMDA reported information on 27.5 million applications for home loans. Almost all the applications were for loans to be secured by one- to four-family (so-called single-family) houses, as follows: 10.9 million applications to purchase a home, 2.5 million to make home improvements, and 14.0 million to refinance an existing home loan.
After declining in the early 1990s, the share of non-owner-occupant lending among first-lien loans to purchase one- to four-family site-built homes began rising in 1994, and it has risen in every year between 1996 (when it was 6.4 percent) and 2005, when it reached 17.3 percent (table 8). For 2006, the share fell somewhat, to 16.5 percent.
Saturday, September 15, 2007
A Few Tangents on Fairfax
Last night I went looking into a few things that I thought might affect Fairfax's value. The results are below.
1. Effect of a strengthening Canadian dollar
From the standpoint of a US investor, the overall strengthening of the Canadian dollar is a positive for US investors, in that it increases the value of Northbridge, their Canadian subsidiary. This is partially offset by an increase in corporate costs from the Toronto headquarters. Overall, the effect is pretty insignificant. Judging based on the market value of Northbridge, a 5% rise would add 88 million in value. If looking at earnings, a 5% rise would add approximately 9 million in operating income. (before tax) These are based off the table on pg. 53 which breaks down the overall business in terms of region.
2. Very Long-Tail Float from Run-off?
Under "Contractual Obligations", insurers include their loss reserves as well as a time-span for when they expect those to be paid out. I was hoping that perhaps Fairfax possessed a lot of super long-tail business from run-off which are reserved for today, but will not have to be paid until much, much later.
At the end of 2006, Fairfax had:
3-5 years 1.686 billion
5++ years 2.162 billion
Total reserves 10.658 billion
3 year++ reserves/ total reserves : 36.1%
5 years ++ reserves/ total reserves: 20%
Now in comparison, Allstate's property and casualty business had:
3 year++ reserves/ total reserves: 25.78%
5 years++ reserves/ total reserves: 14.23%
Which seems encouraging, but then I looked at Berkshire Hathaway, which only provides 3 years ++ numbers, and they were at 36.3%. So overall, I'd have to say that perhaps they have a slight edge in this respect, but not by much.
Also, some people have asked whether Fairfax's long term bond portfolio perhaps was a way to match assets with expected liabilities. Fairfax had over 6.7 billion in treasuries with a maturity greater than 5 years, far more in excess of the 2.1 billion they have reserved for. So the answer to that appears to be "No".
1. Effect of a strengthening Canadian dollar
From the standpoint of a US investor, the overall strengthening of the Canadian dollar is a positive for US investors, in that it increases the value of Northbridge, their Canadian subsidiary. This is partially offset by an increase in corporate costs from the Toronto headquarters. Overall, the effect is pretty insignificant. Judging based on the market value of Northbridge, a 5% rise would add 88 million in value. If looking at earnings, a 5% rise would add approximately 9 million in operating income. (before tax) These are based off the table on pg. 53 which breaks down the overall business in terms of region.
2. Very Long-Tail Float from Run-off?
Under "Contractual Obligations", insurers include their loss reserves as well as a time-span for when they expect those to be paid out. I was hoping that perhaps Fairfax possessed a lot of super long-tail business from run-off which are reserved for today, but will not have to be paid until much, much later.
At the end of 2006, Fairfax had:
3-5 years 1.686 billion
5++ years 2.162 billion
Total reserves 10.658 billion
3 year++ reserves/ total reserves : 36.1%
5 years ++ reserves/ total reserves: 20%
Now in comparison, Allstate's property and casualty business had:
3 year++ reserves/ total reserves: 25.78%
5 years++ reserves/ total reserves: 14.23%
Which seems encouraging, but then I looked at Berkshire Hathaway, which only provides 3 years ++ numbers, and they were at 36.3%. So overall, I'd have to say that perhaps they have a slight edge in this respect, but not by much.
Also, some people have asked whether Fairfax's long term bond portfolio perhaps was a way to match assets with expected liabilities. Fairfax had over 6.7 billion in treasuries with a maturity greater than 5 years, far more in excess of the 2.1 billion they have reserved for. So the answer to that appears to be "No".
Wednesday, September 12, 2007
Prem Watsa Presentation at Scotia Capital- Notes
Fairfax Today
- At end of march 2007, 700 millionUS
- Consolidated, about 4.8 billion premiums written, 60% orh and 60% northbridge
- Mostly, commercial line company
- 5 Yr Growth in book value adjusted for dividends
Northbridge (?)
Odyssey 18.7%
Crum forster 17.9%
- At end of march 2007, 700 million
- Consolidated, about 4.8 billion premiums written, 60% orh and 60% northbridge
- Mostly, commercial line company
- 5 Yr Growth in book value adjusted for dividends
Northbridge (?)
Odyssey 18.7%
Crum forster 17.9%
-
- 25% net debt to capital, soonest payment is 245 million due in 2012.
- We think property and casualty industry is on a downswing.
- Prices have come down in first half, we think it will continue to come down.
- Investment Side of business; 22% cash reserves, 55% in bonds, small corporate bond position. Went from 50% to 80% of equity portfolio hedged, plus 18 billion notional CDS portfolio.
- Conservatively structured for potential risks we see, not what we’ve seen over the last 6 months but worse, so we’re keeping our portfolio structure.
Why we’re concerned about the
- The 13 or 14 years from Nikkei peak in 1890, it went down. 40,000 to 7,500.
- even though interest rates fell from 8.00% to .50%, the stock market still fell down significantly.
- we like treasuries, 10 yr and above- if you look at it from a very long perspective, it is still a very high rate, 4.60%.
- High yield spread has been much higher, went down, going up again now.
- CDS for countrywide was about 150 basis when we bought, went to 50 basis points , now significantly higher.
- Q: whether you would sell CDS'? (Question doesn’t come up on call, my guess based on the answer given below)
Our view is it’s our judgment, and if we get sufficient spread we will take it. Some we think have a higher chance of having credit problems, but fair to say given an appropriate price we would sell it.
Counter-parties are Citibank, Duetsche bank, and Barclays, so major institutions, along with pledged collateral. People think Fed Reserve will drop rates and we will be back in business, we think that might not be the case, so we’re keeping treasuries and CDS portfolio.
Long, long term holding. Right now 6 billion premiums of
We focus on increasing book value by 15%, earnings may be volatile depending on when they realize capital gains, and we don’t give guidance. $1.50 book value in 1985 to $165 today.
No, still the case, we’re looking at approximately break even.
-Q: Long-tail claims of Runoff still stable?
There could be bumps, but we’re happy with reserves we have set.
I'll post Archive Link and Slides here as soon as available.
Tuesday, September 11, 2007
Mercer Investment Presentation
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