A Practical Look at Bond Insurers

A bond insurer provides credit protection by giving its guarantee to pay any unpaid principal and interest payments in a default. By giving its guarantee, a debt security can then be issued with a higher rating, usually AAA, and this lowers the interest cost of the debt. Now, I'd argue that if you take a close look at the competitive forces these companies face, you'll come to the conclusion that this is a mediocre business at best.

The most obvious competition is from other bond insurers and there really is no moat within this group. The AAA credit-rating is favorable because it lowers the cost of guaranteed securities to almost government treasury rates, but there are a few insurers who have this rating. Otherwise, the business is strictly based on how much capital you have and what price you are willing to pay. MBIA mentions in their annual report that it "also competes with other forms of credit enhancement, including senior-subordinated structures, credit derivatives, over-collateralization, letters of credit and guarantees."

But an even more significant competitor is "Mr. Market" himself. An issuer of debt likes bond insurance because it diminishes the investor's risk, and so it can potentially lower the issuer's interest costs. It all depends on cost of the insurance, and the spread between what the market will charge the issuer and what the market will charge its guaranteed security. If the cost of insurance is less than the spread, then the bond insurer gets new business and the issuer lowers his borrowing cost. But if the cost of insurance is more than the spread, then there is no transaction- the issuer would be better off selling the debt directly to the market. Thus, we see that credit insurers are competing against the market's perception of risk. Effectively, the bond insurer is saying that they have expertise and can profit by being better judges of a security's risk than the overall market.

Now that is plausible. But for one, these insurers are doing this with a large amount of money, making it more difficult to earn out-sized returns. And two, before the recent turmoil in the credit markets, spreads on risky securities were at unprecedentedly low levels.


So taking into account the competition, the large capital base, and the credit spread tightening, you would think that these companies would have been marginally profitable recently. But instead, these companies have been recording record profits with very healthy margins.

MBIA, 2002- 2006 ratios

Loss and LAE ratio

9.7 % 10.0 % 10.0 % 10.0 % 10.5 %

Underwriting expense ratio

26.6 24.7 21.5 22.2 22.9

Combined ratio

36.3 34.7 31.5 32.2 33.4

So that begs the question of how a credit insurer was able to underwrite so profitably(loss reserves at 10% of premiums) in an environment where "Mr. Market" was so willing to buy risky debt. And I guess you can say part of the answer lies in the fact that a bond insurer's loss reserves are very much up to judgment. In traditional property and casualty insurance, you typically have a very good sense of what your total losses will be by the second year. But in bond insurance, the time horizon is much longer. For example, we know that the average of MBIA's insured debt outstanding is over 10 years. That means that at anytime within those 10 years, a credit contraction could reveal that their reserves are drastically inadequate. This makes investing in a bond insurer sort of like a black-box, because you never really know what you are getting without knowing their loss assumptions.

Many bond insurers have lost 50 to 75 percent of their stock value in the last 6 months. (See MBI, ABK, AGO) Perhaps at these prices they are actual values, and maybe I am missing some factor that allows them to underwrite so effectively. All I know is based on these competing forces and the leeway available in their accounting, that it is very likely they have been under-provisioning for future losses, and that I can not tell you by how much. As I was writing this though I did come across this post on Calculated Risk- Egan Jones: Expect "Massive" Losses for Bond Insurers.

PetroChina Shares Triple in Shanghai Debut

This one caught my eye... (Link)

Shares in PetroChina, which raised $9 billion in the world's biggest initial public offer this year, nearly tripled in their market debut and far exceeded analysts' forecast, buoyed by the company's position in the world's second-biggest energy market.
...

The opening price gave PetroChina a total market value of $1.1 trillion, making it the world's largest listed company by market capitalisation, more than double the second biggest, Exxon Mobil, at $488 billion.

It'll be interesting to see whether the US-listed shares will follow their Chinese counterparts tomorrow morning. We know Buffett thought PetroChina was too expensive and recently sold his entire stake. So either Buffett was 300% off on his Intrinsic value estimate, or the Chinese are in a full-blown bubble.

The Importance of Loan Loss Reserves

Last post I said:

I'm going to have to make a post comparing this [Exchange Bank of Santa Rosa's] reserving with some of the companies Fairfax owns credit default swaps against. The allowance for loan losses doesn't even cover the 90+ day delinquencies for many of these companies, even after some very large loan loss provisions recently.

Well today, I made the comparison using two other household names in Fairfax's CDS portfolio: Countrywide Financial and Washington Mutual. Before going into that though, I want to comment that it was very difficult to find these numbers in their earnings report, and 30+ delinquency numbers could only be found by using FDIC Call Thrift Data. And for Countrywide and WaMu, getting a true understanding of their financial conditions is very complex.
(Numbers in 000's)

First to reiterate, is Exchange Bank of Santa Rosa's at the end of Q3:

Exchange Bank of Santa Rosa
(Numbers in 000's)

Gross loan portfolio: 1,173,194
Allowance for loan losses: 20,930
30-89 days delinquent: 1,327
90+ days delinquent: 7,890

30 day + delinquencies / gross loans = .78%
90 day + delinquencies / gross loans = .67%
Allowance for losses / gross loans = 1.78%


Now let's look at Countrywide Financial. First, a few things to note about Countrywide. One is that Countrywide is seperated into a mortgage originating and a banking operation. The originating business doesn't provision for losses, because they expect to sell their loans. For purposes of this exercise, we will only look at their banking operation because that involves the loans they plan on holding on their balance sheet. But it should also be remembered that Countrywide's originating business pumps out loans at very high multiples of equity. For example, in the latest quarter they produced 90 billion of loans. Annualize the rate and compare it to 15 billion in total equity, (traditional banking included) and you start to see what I am talking about. So at any given point, Countrywide is also holding a large amount of loans that it does not consider part of its portfolio and so doesn't reserve for. And because in the current credit turmoil, we saw them transfer 12 billion of loans to their banking portfolio this quarter in order to avoid selling them at current market prices. But anyways, I will be using only the banking operation numbers today.

Another thing to note is that since Countrywide does not provide 30 day delinquencies, I had to look them up using Call Thrift Data. For one, the most recently available report is from the 2nd Quarter, so the numbers are slightly lagging. Second, the numbers slightly differ between what the company reports, likely because of other subsidiaries. So do not accept these as precise, but very rough estimates. If anything though, it is underreporting delinquency numbers.

Countrywide Banking
(Numbers in millions)

Gross loan portfolio: 80,430
Allowance for loan losses: 1,127
90 days + delinquent at end Q3: 1,433
90 days+ delinquent at end Q2: 941

30-89 days delinquent at end Q2: 1,790

So we see that 90+ delinquencies shot up between the 2nd and 3rd quarter, which means 30-89 day delinquencies probably went up in Q3 too. But if we just assume the same 30-89 day numbers for Q3, we get:

30+ day delinquencies / gross loans = 4.00%
90+ day delinquencies / gross loans = 1.78%
Allowance for losses / gross loans = 1.40%

Now a few other things (I told you this was going to be complex). The gross loans number of 80.4 billion is inflated because Countrywide transferred 12 billion in loans over during the quarter from their originating business. But most of these loans were made recently, so they would either not be delinquent yet or they went delinquent during the third quarter, for which the figures aren't available (remember we had to use Q2). So these numbers are slightly inflated in that respect. Second, Countrywide holds 45 billion in Adjustable Rate Mortgages (ARMs), with many of those being Pay-Option ARMs. These are much more difficult to go delinquent on because any payment that can not be made is just added to the principal balance. But either way, we see that Countrywide's reserving is still inadequate.

With all that cleared up, it should be much easier to explain Washington Mutual. The same issues mentioned above apply here, with respect to originating vs banking business and the 3 month lag in some of the numbers.

Washington Mutual Banking
(Numbers in millions)

Gross loans = 227,348
Allowance for loan losses = 1,889
Non accrual loans at end of Q3= 4,577
Non accrual loans at end of Q2 = 3,443

90+ days delinquent and accruing at end of Q2 = 245
30-89 days delinquent at end of Q2 = 2,910

Using the same Q2 numbers going into Q3, we get:

30+ days delinquencies / gross loans = 4.58%
90+ days delinquencies / gross loans = 3.40%
Allowance for losses / gross loans = .83%

Again, Washington Mutual also has 138 billion in ARMs, with 56 billion of them Pay-Option ARMs, which do not normally go delinquent until much later on. Calculated Risk recently provided this chart with regards to recent deteriorating in ARM performance.
We see the recent trend has been much worse. So to summarize the point of this entire post, I'd say look at two percentage figures:
1. Allowance for loan losses to 30 day delinquencies, and
2. Allowance for loan losses to 90 day delinquencies.

Basically, the percentage which your allowances cover delinquent loans. The higher the better, and remember this is giving a lot of benefit to the doubt to CFC and WM. (lagging delinquencies, ARMs)

EXSR
1. 228%
2. 266%

CFC
1. 35%
2. 79%

WM
1. 18%
2. 24%

The significance of all this is that an under-reserved bank has no cushion for declining credit performance and will have to provision more for losses in the future, meaning their current earnings figures and equity are likely inflated and unreliable. Conversely, a well-reserved bank has a cushion for any adverse credit trends and the income figures are much more stable and protected.

Earnings Roundtable

Four of my companies released earnings today. Unfortunately I have not yet listened to the conference calls for any of these companies, so I will hopefully be able to expand on this commentary shortly. For now...

SFK Pulp Fund
First, the bad. SFK's earnings have and continued to get hit by the relentless rise in the Canadian dollar (see chart). This has the effect of lowering their revenues, which are based in terms of US dollars, while their costs remain the same. The thesis has basically been that 90% of NBSK pulp capacity is in Canada or Europe, so the entire industry is getting squeezed by the recent rise. And SFK represents a very low-cost competitor on the production curve, and worldwide demand should continue to grow into the future. So the timing has so far been off, but Pope and Talbot recently filed for creditor bankruptcy. Either the prices they charge will have to increase or their going to have to disband operations, because their EBITDA (Earnings before interest, taxes, depreciation and amortization) was negative 5 months ago before the Canadian dollar run-up. On that note, they did announce a $20 increase for this month as well. As for where the Canadian dollar is going from here, that is something I feel like looking into.

Harvest Natural Resources
There is not much to talk about in this one, especially without listening to the conference call. Since Chavez signed the contract after the third quarter ended, the company will not record the benefit and the results of the operations on their financials until the next quarter.

Exchange Bank of Santa Rosa
This report probably went by unnoticed because it is still not published on their site, but it is available on the FDIC Call Thrift Data. Overall, I continue to be impressed. Earnings per share for the quarter came out to $3.14, and $9.73 for the last 9 months. But more importantly, the loan underwriting and reserves continue to be phenomenal.

30 day + delinquencies / gross loans = .78%
90 day + delinquencies / gross loans = .67%
Allowance for losses / gross loans = 1.78%

I'm going to have to make a post comparing this reserving with some of the companies Fairfax owns credit default swaps against. The allowance for loan losses doesn't even cover the 90+ day delinquencies for many of these companies, even after some very large loan loss provisions recently.


Fairfax Financial
Fairfax reported exceptional earnings today. The insurance operations had an underwriting profit of $62 million for the quarter, the holding company now has $836 million in cash, and debt continues to fall. Simply put, the team at Fairfax has done a remarkable job to get Fairfax where it is today.

With respect to the credit default swaps, the portfolio had a fair value of 546 million at the end of September. If we compare the last two numbers of the table in this post, we can see that since quarter end these spreads have widened significantly more. The question on current value will almost certainly be brought up on the conference call tomorrow, but I'm not so certain they will answer that. Last quarter they mentioned the updated fair value of the CDS portfolio in their earnings release. It would seem uncharacteristic of them to release this number on a conference call, where some people will certainly hear it before others. The management at Fairfax will probably avoid giving any updates in order to avoid speculation in their own shares.

Milton Friedman on International Monetary Relations

Warren Buffett has mentioned frequently his concern about the twin deficits in the U.S.- the current account deficit and the budget deficit. The current account essentially refers to our balance of trade with other countries. The United States current account deficit has significantly increased lately, in both nominal terms and in terms of GDP. (See chart) The budget deficit refers to our government's income account, and the fact that it spends more than it receives through taxes.
On the current account, I came across this Milton Friedman analogy and discussion from his book, Capitalism and Freedom:

In discussing international monetary relations on a more general level, it is necessary to distinguish two rather different problems: the balance of payments, and the danger of a run on gold.(note:read dollar today) The difference between the problems can be illustrated most simply by considering the analogy of an ordinary commercial bank. The bank must so arrange its affairs that it takes in as service charges, interest on loans, and so on a large enough sum to enable it to pay its expenses- wages and salaries, interest on borrowed funds, cost of supplies, return to stockholders, and so on. It must strive, that is, for a healthy income account. But a bank which is in good shape on its income account may nonetheless experience serious trouble if for any reason its depositors should lose confidence in it and suddenly demand their deposits en masse. Many a sound bank was forced to close its doors because of such a run on it during the liquidity crises described in the preceding chapter.
These two problems are not of course unrelated. One important reason why a bank's depositors may lose confidence in it is because the bank is experiencing losses on income account. Yet the two problems are also very different. For one thing, problems on income account are generally slow to arise and considerable time is available to solve them. They seldom come as sudden surprises. A run, on the other hand, may arise suddenly and unpredictably out of thin air.
...
There are four, and only four ways, in which a country can adjust to such a disturbance and some combination of these ways must be used.

1. U.S. reserves of foriegn currencies can be drawn down or foreign reserves of U.S. currency built up...
2. Domestic prices within the U.S. can be forced down relative to foreign prices...
3. Exactly the same effects can be achieved by a change in exchange rates as by a change in domestic prices...
4... Instead, direct governmental controls or interferences with trade could be used to reduce attempted U.S. expenditures of dollars and expand U.S. receipts.

Warren has said that he expects 3 to happen, through a fall in the U.S. dollar exchange rate, and this is probably right. 1 has already happened on a large scale through foreign accumulation of U.S. dollars, and central banks have been weary about continuing to build up their reserves. 4 could happen through tariffs, such as the one trying to be brought up against China for their undervalued currency. Or there is 2, which is essentially deflation. Regardless of which combination is taken, it is clear that the effects of a persistent current account deficit are all troublesome.

Fairfax CDS Gains Demystified

Over the past few days, I have been posting about my expectations for huge gains in Fairfax's Credit Default Swap portfolio based on the terrible news the underlying companies have been reporting and the sharp drops in their stock prices. But the actual gains was still up for speculation because I could not find information on the actual credit default spreads for these companies. Well today, I received just that.
(Note: Current day refers to Oct. 26)

Spaced out by Oct'06- June'07- July'07- Sept'07- Current Day

Ambac 11- 47-152- 180-478

AIG 10- 13- 53- 32- 53

Countrywide 36- 67-136- 260-410

Freddie Mac 5- 9- 27- 17- 25

MBIA 22- 65-160- 132-302

MGIC 30- 70-206- 163-381

PMI 30- 45-106- 132-318

Radian 32- 72-216- 379-784

Washington Mutual 22- 41-82- 91- 154

The scale for the table and the chart use the last day of the month, and Fairfax's last CDS update was on July 31st. So if you compare the July '07 numbers with the current day numbers, you can get a sense for just how much some of these positions have appreciated.

Recent News Concerning Holdings

SFK Pulp Fund
Pope and Talbot announced $20 Increase in NBSK pulp effective immediately.

Harvest Natural Resources
Chavez has signed the new conversion agreement for Harvest, eliminating some of the political uncertainty over the stock.
Crude Oil rises to a record $92.40, adding more margin of safety to the Net Present Value calculations.

Fairfax Financial
Since my last update on Fairfax's CDS portfolio 10 days ago, some more bad news has popped up.

Countrywide Loses 1.2 Billion, Expects Turnaround. I'm not so optimistic.
MBIA posts a 3Q Loss.
MGIC slashes dividend 90% after 3rd quarter loss.
AIG may take a 9.8 billion dollar sub-prime mortgage hit. I was not sure when I saw AIG in their CDS portfolio if this position was meant as a hedge for recievables or as an investment. This seems to point to the latter.

Signs of a Bubble?

There are several names that are trading at very extreme valuations in today's market. The overall theme behind these companies is technology (again) and China. Some of these may have good growth prospects, but their moats seem relatively weak and at these prices the risk for shareholders is large.

Company Ticker / Price to Earnings / % gain in last 3 months (approx.)

ISRG / 107 / 130%
AMZN / 104 / 50%
APPL / 47 / 80%
CME / 47 / 25%
SPWR / 593 / 100%
JRJC / 587 / 600%
BIDU / 210 / 180%
CTRP / 95 / 57%
SINA / 73 / 57%
VMW / 224 / 100%
RIMM / 78 / 140%

John Bogle, "Black Monday and Black Swans"

This was posted on Reflections, but I liked it a lot so I'm repeating it here. It gives very in depth coverage on a variety of important issues.

I’ve taken you on this long trip through risk and uncertainty, not only because I find these ideas both important and intellectually stimulating, but because they set the stage for my discussion of the concerns I hold today regarding our financial system and our society. I recognize that some of these ideas are complex, so let’s summarize the ground we’ve covered so far:
1. Black Swans—extreme and unexpected outcomes—are part of investing, and can’t be predicted in advance.
2. As Karl Popper recognized, not only our market, but science itself, depends not on
observations confirmed by verification, but on wild conjectures sharpened by falsification (proof that the theory is wrong).
3. Frank Knight focused on a critical distinction between risk—which is subject to
measurement—and uncertainty—which is not.
4. Stock market returns, in the short-term, are not normally distributed, but are explained by the fractal patterns discovered by Mandelbrot. We can’t ignore the possibility—indeed, the virtual certainty—that such extreme patterns will persist, and we never know when.
5. Keynes’s insight was to separate stock returns into two elements, enterprise—subject to a reasoned financial analysis and speculation—the madness of crowds—which, he argued, would become increasingly dominant.
6. Bogle (if you will) applied numbers to Keynes’s insight, showing that future investment returns were subject to reasonable expectations, and that even speculative returns tended, over time, to move toward zero.
7. Minsky added a sobering note: the financial economy, focused on speculation, was not separate and distinct from the productive economy, focused on enterprise. Rather, the former would come to overwhelm the latter.

Direct Link

On Housing

It seems like a good idea to understand more about the housing market for many reasons. For one, it is a big source of consumer wealth, and some have estimated that we can see a four trillion decline in household real estate wealth by the time the current cycle is over. This would have secondary effects on all sorts of industries. But more importantly for investors, the 52 week low list is flooded with financial, real estate, and homebuilding names, so understanding this industry will be important in making informed investment decisions. Thanks to Calculated Risk for the charts and well, almost everything I've learned.

The housing boom from 2000-2006 saw huge gains in home prices, but it also saw a huge increase in sales activity. On that matter, it is important to understand there are two widely published metrics, new home sales and existing home sales. New home sales are houses being sold for the first time, while existing home are homes that are being re-sold. Both have had big increases during the current boom. (See charts below)


With Existing home sales, what is surprising is how much this sales activity has increased recently. You would naturally expect a certain level of existing home sales as people decide to move to new areas. But people are basically selling one home and moving to another. So, we can point to a few causes for the increase in sales activity. One cause is that the current environment made the housing market more flexible, with some people wanting to move up and others to move down. Easy credit made the first one possible, while taking profits on the current boom is probably the cause of the second one. A more likely cause is that there has been an increase in real estate speculators, who have been buying a house with the desire to flip it in a short period of time. We can see this in the recent HMDA Data Analysis , which I quote:

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.

We see that the share of mortgage originations being made by real estate investors has increased dramatically. But, and I think this is getting to the heart of the matter, every new house, whether owner-occupied or investment, requires someone to live in it. So ignoring second home purchases, which is a very small minority, this leaves the pool of non-homeowners to look towards. And the important thing to remember is the main thing stopping this group from owning a home is affordability. Every year, a certain amount of people rises into the affordability territory, and so we have new homes and new mortgages.(More on this below) But the recent boom expanded well beyond that into the group of people who could not afford their purchase. So the recent boom has on one hand, relied on increasing sales to the non-homeowner group which can not afford it; On the other hand, it has made it even harder for this group to afford the houses they want to buy. The fault for this lies in easy credit. In one situation, this allowed "sub-prime" borrowers to get a low adjustable rate with the hope of selling the house for a profit when the time for a reset came. The idea was never mentioned to them that if houses did appreciate during their low-interest period and they sold out for a profit before their reset, that any of their gains would just have to go towards paying for a new, now more expensive home. Similarly, we have the real estate "investor",(I use the term loosely) who pushes up the price of homes only to rent it out to someone who could not afford to purchase a home themself. In a way, the investor has financed the well-being of the rentor by paying the interest on the house and then renting it to someone for less.

So, the recent boom saw a huge increase in speculation and turnover, which to diverge again for a second, resulted in a huge increase in frictional costs. In the end, there are X number of homes that will provide shelter to Y number of people. A nationwide game of musical chairs with homes does nothing but make your real estate agent and your mortgage brokers rich. It is a similar situation to a stock market, where increased turnover isn't increasing the value of the businesses you are trading- it is just making your broker rich.

Besides the huge increase in turnover, but there was also some very wrong market signals being sent. We see this in new home sales. Historically, new home sales has always fluctuated within a range of 400,000 and 800,000 units. The reason being that over time there is an increase in the amount of people that can afford to purchase a home because of rises in standard of living and overall population increases, and this number of people has been relatively consistent throughout history. The recent boom went into unchartered territory:


There has been a large increase in new homes sales, but this was mostly achieved by appealing to people who could not afford it. The cycle was maintained as long as house prices went up, but it can only last so long. Lending to people who cannot afford their "true" interest or principal payments is unsustainable.

Where we stand today. There is a large supply of homes that will come on the market, and the market will need some time to absorb this recent boom and adjust to a more reasonable price. I do not know how much home prices will fall, but I would say 20% would not be unthinkable. That would be a 4 trillion decline in Household wealth. I would expect new home sales to have to considerably slow down even from today's levels if the excesses of this boom is to be absorbed. Until I see that, I would say it is too early to be investing in most of these homebuilders, real estate companies, and financial firms, given the uncertainty and the potential downside.

On a final note, here is a chart of an ABX index tracking AAA-rated mortgage backed securities. People should be very concerned that these are now trading at almost 85 cents on the dollar.

Coming soon, a look at Countrywide Financial and what must be some rose-tinted glasses they are wearing.

UPDATE* Stock Market Capitalization to GDP

While rummaging around for Buffett quotes, I ran into this 2002 interview with Buffett on the stock market. Besides an overall interesting perspective on the markets, one particular thing I noted:

On a macro basis, quantification doesn't have to be complicated at all. Below is a chart, starting almost 80 years ago and really quite fundamental in what it says. The chart shows the market value of all publicly traded securities as a percentage of the country's business--that is, as a percentage of GNP. The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment. And as you can see, nearly two years ago the ratio rose to an unprecedented level. That should have been a very strong warning signal.
For investors to gain wealth at a rate that exceeds the growth of U.S. business, the percentage relationship line on the chart must keep going up and up. If GNP is going to grow 5% a year and you want market values to go up 10%, then you need to have the line go straight off the top of the chart. That won't happen. For me, the message of that chart is this: If the percentage relationship falls to the 70% or 80% area,
buying stocks is likely to work very well for you. If the ratio approaches 200%--as it did in 1999 and a part of 2000 -- you are playing with fire.
As you can see, the ratio was recently 133%. Even so, that is a good -sized drop from when I was talking about the market in 1999. I ventured then that the American public should expect equity returns over the next decade or two (with dividends included and 2% inflation assumed) of perhaps 7%. That was a gross figure, not counting frictional costs, such as commissions and fees. Net, I thought returns might be 6%...

Now this isn't the first time we've seen someone make this argument. Prem Watsa has been making this case too:

The U.S. market capitalization is still at about 120% of GDP, down from over 170% in
2000 but way above its 80-year average of 58% and even higher than its 1929 high of 87%!!

This was from the 2005 Annual Shareholder Letter. Since then he has also made the point in several investor presentations, which I don't have readily available. Still two great investors like to look at this measure, so it is worth understanding what it means and the possible flaws.

---------------------------------------------------------------------------------------------------
*Update
Here is the original Warren Buffett on the Stock Market, 1999.

As you can see, corporate profits as a percentage of GDP peaked in 1929, and then they tanked. The left-hand side of the chart, in fact, is filled with aberrations: not only the Depression but also a wartime profits boom--sedated by the excess-profits tax--and another boom after the war. But from 1951 on, the percentage settled down pretty much to a 4% to 6.5% range.
...
Today, if an investor is to achieve juicy profits in the market over ten years or 17 or 20, one or more of three things must happen. I'll delay talking about the last of them for a bit, but here are the first two:

(1) Interest rates must fall further. If government interest rates, now at a level of about 6%, were to fall to 3%, that factor alone would come close to doubling the value of common stocks. Incidentally, if you think interest rates are going to do that--or fall to the 1% that Japan has experienced--you should head for where you can really make a bundle: bond options.

(2) Corporate profitability in relation to GDP must rise. You know, someone once told me that New York has more lawyers than people. I think that's the same fellow who thinks profits will become larger than GDP. When you begin to expect the growth of a component factor to forever outpace that of the aggregate, you get into certain mathematical problems. In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well. In addition, there's a public-policy point: If corporate investors, in aggregate, are going to eat an ever-growing portion of the American economic pie, some other group will have to settle for a smaller portion. That would justifiably raise political problems--and in my view a major re slicing of the pie just isn't going to happen.

He goes on to say also that besides these two factors, a stock should also appreciate at the rate of GDP. So between these two articles, we can get a good understanding of the factors Warren Buffett looks at when valuing the general market.

1) The relationship between current yields on government bonds and yields on common stocks. If the spread on these is large, you could expect to have long run performance gains from their convergence.
2) The future direction of interest rates
3) GDP growth
4) After-tax corporate profits as % GDP

And as for where we stand today:
1)
30 year bond yield- 4.69%
S&P500 earnings yield- 5%

2) Current yield is at 4.69%. Where we are going? (more below)
3) We appear heading for a period of either slower growth or recession at the moment.
4) After tax corporate profits are currently at 8.3%, which is the upper extreme of the historical range.

So using the Buffett approach, it is hard to make a case for large gains in the stock market. The yield difference between stocks and bonds is very minimal. If you assume interest rates remain constant, then you will need either GDP to grow or for corporate profits to take a larger portion of GDP, something which is Buffett discusses as very unlikely above. If we're optimistic and use the 5% GDP nominal growth over the next 10 years, then that appears to be what we can expect to earn. Unless, the future direction of interest rates goes down. Predicting future interest rates seems much more difficult, and Buffett does not give any insight into this. I'll have to look more into this.

Finally, below is an up to date stock market capitalization as % of GDP chart from Fairfax's 2007 Annual Shareholder's Meeting.

Why Buffett Sold Freddie Mac

Someone asked about this earlier. The article has been posted on Reflections.

Years before Freddie Mac was rocked by an accounting scandal, billionaire investor Warren Buffett got on the phone with Freddie Mac chairman Leland C. Brendsel and explained why he was selling shares of the giant mortgage funding company.

Brendsel had made pledges about earnings growth at Freddie Mac, and Buffett was apparently worried about where such promises might lead.

Warren Buffett warned in 2000 that institutions with "a primary goal of earnings growth get into trouble... All my history is that all institutions that have a primary goal of earnings growth get into trouble... If you put a gun to my head, I would produce the earnings..."

According to Brendsel's notes, as Buffett prepared to part ways with Freddie Mac, he told Brendsel he was "grateful for the money you made me" and offered some characteristically pointed homespun advice: "If you really want a marriage to last, you want to marry someone with low expectations..."

Canfor Pulp Third Quarter Earnings Report

Canfor reported overall solid results for the quarter. The average Canadian/US exchange rate for the quarter was .957, but the rate is currently at 1.03. As for the outlook:

We expect pulp prices to remain within a narrow range over the balance of 2007 and 2008. The escalating value of the Canadian dollar and the Euro, versus the US dollar, will motivate pulp producers in these countries to try to push prices higher. However, paper demand growth has weakened, and papermakers are struggling to remain profitable. Further, there is new hardwood pulp capacity entering the market from the southern hemisphere. This could cause some price slippage in hardwood pulp markets which could also put pressure on substitution of hardwood pulp for softwood pulp.

At the new exchange rate, SFK's yearly free cash flow would be closer to 20 million now. Meanwhile, a few high cost producers are still hanging on, despite operating at huge cash flow losses. I can see now why- these producers (Pope and Talbot, Tembec) have huge debt-burdens, and to just stop operations would mean a complete write off of these loans. So instead, the banks have been lending them money and asking them to continue their efforts to sell their assets. How long this will take, I do not know, but considering these assets were unprofitable at a .93 exchange rate, they must be bleeding money today. If I could share a lesson learned, supply and demand does really matter- but wait until the situation is clearly turning around and in your favor.

Fisher's 8 Investment Principles

1. Buy companies that have disciplined plans for achieving dramatic long range profit growth and have inherent qualities making it difficult for newcomers to share in that growth.
2. Buy companies when they are out of favor.
3. Hold a stock until either a) there has been a fundamental change in its nature (e.g. big management changes) or b) it has grown to a point where it no longer will be growing faster than the economy as a whole.
4. Deemphasize the importance of dividends.
5. Recognize that making some mistakes is an inherent cost of investment. Taking small profits in good investments and letting losses grow in bad ones is a sign of abominable investment judgment.
6. Accept the fact that only a relatively small number of companies are truly outstanding. Therefore, concentrate your funds in the most desirable opportunities. Any holding of twenty different stocks is a sign of financial incompetence.
7. Never accept blindly what may be the dominant current opinion in the financial community. Nor should you reject the prevailing view just for the sake of being contrary.
8. Understand that success greatly depends on a combination of hard work, intelligence, and honesty.

Bruce Lee and Warren Buffett

Recently, I posted up an article discussing the characteristics of successful people. Well, I wanted to take this Sunday night to give you some lighter reading by welcoming you to a recent obsession of mine, Bruce Lee. Bruce Lee was arguably the greatest martial artist. He took daily notes of everything he did, and it is clear he followed his training with a passion. But I did not make a write-up to talk to you about martial arts. Bruce Lee also loved philosophy, and he read about all the Western and Eastern beliefs. And he wrote a lot about his own philosophy which he had developed throughout his life. Now what is shocking is how much his philosophy coincides with that of Warren Buffett, who is arguably the best investor. And they both do share a lot of the characteristics of successful people. So below are some Bruce Lee quotes along with the Warren Buffett similarities. All the Bruce Lee quotes are from the book Striking Thoughts: Bruce Lee's Wisdom for Daily Living.

1. Bruce Lee says:

1. What does self-willed mean? Does it mean having a will of one's own? The human herd instinct demands adaptation and subordination, but for his highest honor man elects not the meek, the pusillanimous, the supine, but precisely the self-willed man, the heroes.
2. Evaluation by others is not a guide for me. Only the self-sufficient stand alone- most people follow the crowd and imitate.

Warren Buffett has said the problem with most money managers is they seek to do something in traditional fashion and be average. For example, they diversify into hundreds of stocks, they only buy names that people recognize or are fascinating, and they stick to companies that have an allure or have performed well. This way when they are wrong, they have an excuse- everyone else missed it. Buffett however disagrees with this philosophy. He looks where there is the most fear, and he has often said that there can not be group decisions in investing.


2. Bruce Lee says:

We should devote ourselves to being self-sufficient and we must not depend upon the external ratings by others for our happiness. So it is true that the more we value things, the less we value ourself. The more we depend on others for esteem, the less we are self-sufficient.

If there is anyone who fits this bill, I would think it is Warren Buffett. With over 40 billion dollars, he still chooses to live modestly, drive an old Lincoln town car, and he lives in the same house that he bought in 1955.

3. Bruce says:

Intelligence is sometimes defined as the capacity of the individual to adjust himself successfully to his environment, or to adjust his environment to his needs.

Charlie Munger had this to say about their recent investments in railroads:
"Railroads – now that’s an example of changing our minds. Warren and I have hated railroads our entire life. They’re capital-intensive, heavily unionized, with some make-work rules, heavily regulated, and long competed with a comparative disadvantage vs. the trucking industry, which has a very efficient method of propulsion (diesel engines) and uses free public roads. Railroads have long been a terrible business and have been lousy for investors.

We did finally change our minds and invested. We threw out our paradigms, but did it too late. We should have done it two years ago, but we were too stupid to do it at the most ideal time."

4. Bruce Lee says:

The important thing is that I am personally satisfied with my work. If it is a piece of junk, I will only regret it.

And Buffett:
"I get to do what I like to do every single day of the year," he says. "I get to do it with people I like, and I don't have to associate with anybody who causes my stomach to churn. I tap dance to work, and when I get there I think I'm supposed to lie on my back and paint the ceiling. It's tremendous fun."

5. Bruce Lee says:

Oh I know that we all admit that we are intelligent beings; yet, I wonder, how many of us have gone through some sort of self inquiries and/or self-examining of all these ready-made facts or truths that are crammed down our throats ever since we acquired the capacity and the sensibility to learn.

For this I'll turn to what Francis Chou had to say:
"If there is a secret to the Buffett/Munger success story, it is their willingness to be brutally honest and realistic in their analyses and assessments. They are highly introspective, always checking and rechecking their assumptions and premises against reality. Executives who sugarcoat business realities and embellish results, downplay issues and disguise potential problems to investors may well fool even themselves. They start believing in their own world of make-believe. Buffett/Munger’s formidable powers of analysis would be worth nothing if they looked at problems with rose colored glasses."

6. Bruce, what about emotions?:

1. In a time when everything is goes well, my mind is pampered with enjoyment, possessiveness, etc. Only in times of adversity, privation, or mishap, does my mind function and think properly of my state. This close examination of self strengthens my mind and leads me to understand and be understood.
2. There is intelligence when you are not afraid.

Buffett had this to say:
"Two diseases that are always present in the market are fear and greed. Benjamin Graham called this phenomenon "Mr. Market" and portrayed this character as a manic-depressive, constantly swinging from fear to greed and back to fear. However, you can contain Mr. Market with the right investment philosophy. Most of all, you need the right temperament..."

7. Bruce:

Concentration is a narrowing down of the mind- but we are concerned with the total process...

Warren Buffett has said a big factor in his success is because he is not bogged down in a particular industry. This allows him to look everywhere and find where the best investment returns are available.

8. Bruce says:

1."the height of cultivation runs to simplicity. Halfway cultivation runs to ornamentation."
2."The mark of genius is the capacity to see and to express what is simple, simply!"

Warren gets an A+ on that report card. He has an uncanny ability to say things in terms that even the least investment-literate person could understand.

9. Bruce, what do you like to do with your free time?:

But most of all, I like books. I read all types of books- fiction and non-fiction.

This is what Charlie Munger had to say about that:
"Half of all the time he [Warren Buffett] spends is just sitting on his ass and reading. And a big chunk of the rest of the time is spent talking one-on-one, either on the telephone or personally, with highly gifted people people whom he trusts and who trust him."


10. And finally, perhaps Bruce Lee's most important message to his students:

1.By an error repeated throughout the ages, truth, becoming a law or a faith, places obstacles in the way of knowledge. Method, which is in its very substance ignorance, encloses it within a vicious circle. We should break such circles not by seeking knowledge, but by discovering the cause of ignorance.
2. All fixed patterns are incapable of adaptability or pliability. The truth is outside of all fixed patterns.
3. I am no longer interested in systems of organization. Organized institutes tend to produce patternized prisoners of a systematized concept, and the instructors are often fixed in a routine. Of course what is worse is that by imposing the members to fit a lifeless pre-formation, their natural growth is blocked.

This is what first attracted me to Bruce Lee. Basically, he believed every moment and every instance should be treated as its own, and we should think instead of being bound by a pattern of doing things. I saw in this belief the counter to the idea brought up in The Black Swan, which stressed that systems cause us to get caught in a certain way of thinking and eventually leads to people getting blindsided. It is only through thinking and understanding that we grow. And when we make prejudices about something or accept a statement without understanding it, we are denying ourselves the truth.

Tectonic Shift, Part II

Sivaram Velauthapillai commented on Part I of Tectonic Shift saying:

Globalization, and basically free markets, will equalize the wages (same job will pay same wages within reason) and return on capital (capital can easily flow anywhere nowadays). Wages are downward rigid (due to a whole bunch of reasons) so they won't drop in developed countries. Instead, wages in developing countries will rise.

This idea that wages are downward rigid was best explained by John Maynard Keynes, who thought it was the source of a lot of our economic problems. He stated that individuals did not like to take a cut in their pay to help adjust during recessions. So employers would just fire them instead, and this would magnify the economic problem.

But the part I wanted to talk about was the last statement. It seems plausible that if the developed world would not accept pay cuts that their standard of living would be maintained, while the rest of the world would see a rise in their wages. But that forgets the idea of currency exchange rates. And the US dollar has been hitting record lows, which has a direct effect on our "real earnings". So tonight, I am going to try to show some basic understanding of a recent phenomenon.

It always surprised me that with the rapid increase in globalization, we in the US have not seen a consumer prices in the US decline. Basic economics says that if production costs are declining, competition should at least pass some if not most of this down to the consumer. And then, it has also surprised me that the US could drop interest rates to 1%, or that we could be "awash in liquidity", without seeing an increase in inflation.

Well it turns out the two have actually been balancing each other out. We can see this by looking at two money supply indicators, M1 and M2. M1 is the index tracking all physical currencies and the money in readily available bank accounts. M2 equals M1 plus savings accounts, money market accounts, and other time deposits. Since 2000, M1 has increased from 1123 to 1368. M2 has had a much more significant increase from 4665 to 7372. So there has been a big increase in the money supply, and this is probably what has been offsetting the deflationary forces. Greenspan recently commented that he is afraid of inflation going forward, because a lot of the deflationary benefits of of globalization have already been felt. So, the current pace of increase in the money supply can not continue like it has before. Below is a chart showing some of this historical data.
Now conclusions get rather tricky from here, so for now I'm just going to say that this huge increase in money supply puts a downward pressure on our exchange rate. So, it would be wrong to think our developed world wages and our standards of living are protected by this unwillingness to accept pay cuts. There is a method for real developed world wages to decline, through the much more subtle means of currency exchange rates.

The Crowd: A Study of the Popular Mind (Notes)

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.

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

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.
...

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.

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.


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.

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.

"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