Pulp News

Two Pulp producers reported today- Canfor and Catalyst:

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

and...

"Fibre constraints required us to curtail 65,000 tonnes of pulp and paper at our Elk Falls mill during the quarter," said Richard Garneau, Catalyst president and chief executive officer. "As a result our manufacturing costs and sales volumes were unavoidably impacted. As we look to the balance of the year, we expect the Elk Falls No. 1 paper machine will remain idled with our pulp business also likely to be impacted by the continuing fibre shortage."

The Company's pulp business is expected to take the remainder
of any fibre related downtime in 2008. Approximately 150,000
tonnes of pulp and white top linerboard production is currently
anticipated to be curtailed through the balance of the year
between our Crofton and Elk Falls pulp operations.

From Fairfax's 2007 AGM Slides:


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

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

For The Housing UberNerds...

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

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

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


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

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

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

21st Century Economics

The best way I can explain the global economy today is from the perspective of the following equation:

Value of Production = Labor + Knowledge + Materials + Investment + Power

Now, remember the value is allocated across these factors based on the basic rules of competition. In that sense, the United States (and the developed world) has long had an advantage in three factors: Knowledge, Investment, and Power (think global brands or other forms of market power). And this advantage allowed them to bring relatively more value and wealth to their countries. Company X could invest in developing country Y. They could pay there employees next to nothing, and then send both the goods and the profits back to the home country. This wealth would then be dispersed throughout the population.

Everyone knows that globalization has greatly increased the working population, driving down the value of pure labor. (Supply goes up, returns go down) But other factors have also come into play. These workers have seen the developed world's living standards, and they see all the goods which they are producing, and they decide that they want these things too. And more importantly, they are acquiring the ability to do so without the developed world. First, they have developed modern financial systems, so they have the ability to raise capital and finance large investments on their own. Second, they are rapidly acquiring expertise and knowledge from us. Finally, their power over in the global economy is rising. As the competitive advantages start to deteriorate, then more competition takes place- and production can go up.

This sounds great for long term growth because the rest of the world is raising their living standards. The problem is there is now a new bottleneck. Demand for production has increased significantly, but the supply of materials remains static. So now there is a new advantage from the control over scarce materials. This is why we are seeing such large increases in basic goods- food, energy, raw materials, etc. In the short term, things seem surely to become more difficult and costly. But long-term optimists can take comfort that the solutions to these problems are going to have to come from scientific and technological progress (Or war... see post). And in that sense, the developed world still has a very large advantage in terms of the possession and acquisition of knowledge.


Feel free to critique.

Brookfield Asset Management's 8 Investing Principles

Taken from Bruce Flatt's speech for the Whitman Day Keynote Address.

8. Buy great assets- pay more for great assets at great location with great fundamental characteristics. Rarely buy where land is cheap because it is easily replaceable.

7. Generally invest for the long term. Assume you will own it forever. Properly leveraged quality assets inherently appreciate faster than inflation. It also compounds your dollars tax-free.

6. Prudently finance your assets. Mis-financing the portfolio can lead to disaster. You might not be able to realize the full value of your assets if you can’t make it through a down market, liquidity crisis, etc. Even the best assets are absolutely worthless if you cannot hold them to see another day.

5. Never become too positive or too negative in the markets. In the longer term, assume asset appreciate will always revert to the mean.

4. Invest against the common trend. Significant opportunities arise when things are negative. This is where great value investments can be made. 99% of business transactions occur inside some band of reasonable valuation. 1% of business transactions occur outside of that band, and that's what you should be looking for. In the 99% area, just try to avoid the mistakes.

3. Build with quality people. Business and life are about doing things you enjoy. If you don’t enjoy them, you likely won’t become successful. Finding good people, who are competent and willing to work in a team, is one of the most important organizational factors. Very important during the turbulent times.

2. Execution. Strategy is important, but without execution it is worthless.

1. Never deviate from the first 7 principles. It is very seductive to invest when everyone is making money. It is easier to buy low quality assets because they look like they are better starting off. But higher risk more than offsets it in the end.

Johnson & Johnson Overview

Let's begin with a ten year operation history for Johnson & Johnson:


The company has a long history of double digit growth, with sales growing annually over the last 10 years at 10.5%, and operating income at an even faster 11.95%. It generates tons of free cash flow that is really "free". It has a great position in the worldwide health market, meaning it can benefit from the falling US dollar. Finally, it is a 4 trillion dollar per year industry which is bound to keep growing.

But can we show it is cheap? I think you can if you look at the breakdown of their businesses:
(*these are operating incomes)

There are three segments: Consumer, Medical Devices, and Pharmaceutical. The first two are solid businesses with great brands. For example, the Consumer brands include Band-Aid, Listerine, Neutrogena, Aveeno, and Nicorette. And 80% of the Medical Division's products are number 1 or 2 in their markets. These are also stable and consistently growing businesses:

Then you have the Pharmaceutical business, with 2007 Operating Income of $6.5 billion. My understanding is this industry has been heavily discounted because analysts have become nervous about expiring patents and the limited possibilities for new breakthrough drugs. Now, I don't claim to have any insight or expertise with regards to their actual drug pipeline. But I do know that of the company's 2007 Research & Development expenses of $7.7 billion, $5.3 billion was for the Pharmaceuticals segment. So, if you applied a rich multiple to the company's Consumer and Medical divisions, and then assume that the Pharmaceutical business stopped research and was simply "ran-off", then you can likely justify Johnson and Johnson's current price. ( 185 billion) And their Pharmaceutical business, with its large resources and the abundance of human capital in its employees, is likely worth much more than a "run-off" type scenario.

What Warren Thinks...

...

How does the current turmoil stack up against past crises?

Well, that's hard to say. Every one has so many variables in it. But there's no question that this time there's extreme leveraging and in some cases the extreme prices of residential housing or buyouts. You've got $20 trillion of residential real estate and you've got $11 trillion of mortgages, and a lot of that does not have a problem, but a lot of it does. In 2006 you had $330 billion of cash taken out in mortgage refinancings in the United States. That's a hell of a lot - I mean, we talk about having $150 billion of stimulus now, but that was $330 billion of stimulus. And that's just from prime mortgages. That's not from subprime mortgages. So leveraging up was one hell of a stimulus for the economy.

If that was one hell of a stimulus, do you think the $150 billion government stimulus plan will make an impact?

Well, it's $150 billion more than we'd have otherwise. But it's not like we haven't had stimulus. And then the simultaneous, more or less, LBO boom, which was called private equity this time. The abuses keep coming back - and the terms got terrible and all that. You've got a banking system that's hung up with lots of that. You've got a mortgage industry that's deleveraging, and it's going to be painful.

The scenario you're describing suggests we're a long way from turning a corner.

I think so. I mean, it seems everybody says it'll be short and shallow, but it looks like it's just the opposite. You know, deleveraging by its nature takes a lot of time, a lot of pain. And the consequences kind of roll through in different ways. Now, I don't invest a dime based on macro forecasts, so I don't think people should sell stocks because of that. I also don't think they should buy stocks because of that.

...

Direct Link

Joseph LeDoux: Putting Emotions Back into the Brain

(hat tip to Arpit)

Twenty years ago no one cared about emotions and the brain, but it seems in the last couple of years there's been a flurry of activity. One reason for this may be that the topic was ignored for so long, and the vacuum is being filled. Another, though, is that there have been some successes in approaching the problem, and these have changed peoples' minds about the feasibility of studying emotions in the brain...

I've come to think that emotions are products of different systems, each of which evolved to take care of problems of survival, like defending against danger, finding mates and food, and so forth. These systems solve behavioral problems of survival. Detecting and responding to danger requires different kinds of sensory and cognitive processes, and different kinds of motor outputs, different kinds of feedback networks, and so on, than finding a mate or finding food. Because of these unique requirements, I think different systems of the brain are going to be involved in the different kinds of emotions…

Emotional reactions that occur in this quick and dirty way are really reactions that are important in survival situations. The advantage is that by allowing evolution to do the thinking for you at first, you basically buy the time that you need to think about the situation and do the most reasonable thing. For example, freezing is often the first thing people and other animals do when sudden danger appears. Predators respond to movement, so freezing is overall probably the best single thing to do first, at least it was for our distant ancestors. If they had to think about what to do first, they'd have been so caught up in the thought process they'd probably fidget around and then get eaten.

Direct Link

How International Is This Housing Bust?

Some anecdotal evidence to show that it wasn't just the US that got out of hand. From the New Zealand Herald:

Mr Bowie, 30, and his fiancee Charlene McFarlane, 29, have just taken out a mortgage for 100 per cent of the cost of their modest home in Birkdale, Auckland, which cost them $397,000.
...
The couple are among a growing number of first home buyers who are willingly taking on huge financial burdens by borrowing 100 per cent of the cost of their homes.

"Going back three or four years, 100 per cent mortgages were only available through non-conforming type entities and second-tier lenders," says Mortgage Brokers Association chairman Geoff Bawden.

"Now you have a situation where most, if not all, of the mainstream bank players are able to offer 100 per cent funding on reasonable terms."

Most brokers put 100 per cent loans at around 5 to 10 per cent of all new mortgages...

Easier financing has helped to push up house prices. Although brokers say they aim for mortgage payments of no more than 30 to 35 per cent of household incomes, the Reserve Bank says the average is now nudging 50 per cent (see graph)...

"We are not good savers," says Ms McFarlane.

And in England...

A collective shudder ran down the spines of British homeowners on Tuesday April 8th when Halifax, a part of HBOS and the country’s biggest mortgage lender, revealed that house prices fell in March by 2.5%. The monthly decline recorded by the Halifax house-price index was the biggest since September 1992, when the housing market was enduring an agonisingly prolonged bust.
...
Mortgage lenders are reluctant to talk down the market, so it says something that both the Halifax and Nationwide are predicting “modest” declines in house prices this year. Forward-looking indicators suggest a gloomier picture. The number of mortgages approved for house purchase was almost 40% lower in February than a year before. According to the Royal Institution of Chartered Surveyors, estate agents have been grappling with the worst conditions—measured by the ratio of completed sales to unsold stock—since September 1996.
...
Last week a study by the International Monetary Fund found that Britain’s housing market was the third most over-valued of 17 developed economies, narrowly behind Ireland and the Netherlands. House prices were almost 30% higher than could be explained by fundamental factors such as disposable income, interest rates and working-age population.

These findings are not shocking given the extraordinary house-price boom of the past decade. Between the first quarter of 1997 and the first quarter of 2007, house prices rose by 214%. This was the third highest among 20 countries covered by The Economist. It contrasts with a rise of 135% in America up to its peak in 2006.

The housing bubble seems to have been a global occurrence.

Update*- Great article from the comments.

As Mr Greenspan pointed out in his response to his critics in the Financial Times on Monday, the housing bubble was not unique to the US. On the contrary, as the background chapter on housing in the International Monetary Fund’s latest World Economic Outlook shows, US experience was far from exceptional. On the contrary, the biggest apparent overvaluations occurred in Ireland, the Netherlands and the UK.

The chart shows the proportionate increase in house prices between 1997 and 2007 that cannot be explained by the fundamental drivers: affordability (the lagged ratio of house prices to disposable incomes); growth in disposable incomes per head; interest rates (short- and long-term); credit growth; changes in equity prices; and changes in working-age population. Thus, the rises reveal the extent to which a country has experienced what seems to be a bubble. The US is in the middle ranks.

"Permenently High Home Prices?"

Paul Krugman comments:

Brad Delong is of the belief that home prices won’t fall back to pre-bubble levels, because “America is filling up” and “we will wind up with higher prices for scarce positional goods–chief among which is location, location, location.”

The trouble with this argument is that it’s an argument for rising rents as well as rising prices — and if you believe the BLS data, that just hasn’t happened nationally. Below are the Case-Shiller home price index and the BLS index of “rent of primary residence”, both adjusted for overall CPI and expressed as indexes with Jan. 1987=100. Bottom line: rents have hardly risen at all in real terms.

Now, maybe the BLS is wrong. But for what it’s worth, the data say that essentially all the rise in real home prices came from a rise in the price-rent ratio, which suggests that things will go right back to where they were.

I would add one other thing: that real risk-free yields have also fallen over that period, and that should also be accounted for.

Poetry Corner

THERE was a time when meadow, grove, and stream,
The earth, and every common sight,
To me did seem
Apparell'd in celestial light,
The glory and the freshness of a dream.	5
It is not now as it hath been of yore;—
Turn wheresoe'er I may,
By night or day,
The things which I have seen I now can see no more.
The rainbow comes and goes,	10
And lovely is the rose;
The moon doth with delight
Look round her when the heavens are bare;
Waters on a starry night
Are beautiful and fair;	15
The sunshine is a glorious birth;
But yet I know, where'er I go,
That there hath pass'd away a glory from the earth. ...

From Ode: Intimations of Immortality by William Wordsworth

Wordsworth basically says: remember back when the smallest things gave you such joy? You can remind yourself about it just by spending some time watching children and seeing how easily they amuse themselves. But the now mature Wordsworth asks where has that feeling gone?

Now, the first time you read this poem, the prognosis looks pretty bleak. He seems to say that this childhood delight and freedom is gone, and that we have to settle for just our memories and "find strength in what remains behind" (180). He uses a metaphor to of a vast sea and land to sum up this point. We start off in birth in the ocean. As we age, we make it to shore and then further move inland. Once there, we are left only with what we remember of that vast immortal sea.

Yet starting from stanza nine, you can make an entirely different interpretation as well. For he says he has found "perpetual benediction" not in "delight and liberty, the simple creed of childhood." Rather, he finds it in his "obstinate questionings of outward things," or the innate curiosity within him. Why? Well if you think about it, curiosity may be directly linked with our childhood delight and liberty. After all, life begins with an empty conception of the world. So much of the world remains inexperienced in the eyes of the child, and nearly every moment leads to some new experience. All of a sudden, the reader has come across an explanation for “those first affections, those shadowy recollections” of our childhood joy. Why did everything once raise such great feelings of interest and joy within us, yet now seem ordinary and boring? The great affections we felt for these things arose because we were experiencing them for the first time. Yet as these things were “the fountain light of all our day, … [and] of all our seeing,” they have become habitual experiences and cease to amaze us. (151)

Now I'll leave it to you to decide whether you want to see how this interpretation is carried into the rest of the poem. But the argument itself is an interesting one that you don't often think of. In the end, the reader learns that there is nothing so enviable about childhood. Our peaceful attitude is simply the result of a life filled with experiences in a complex world. And although maturity takes us far inland in Wordsworth's analogy, we would not choose to give up our "calm weather" and stability for the vast unknown of the sea.

Of course, the second part of this argument is that it is the satisfaction of our curiosity which leads to happiness. So break out of the routine and keep asking questions: the world is big enough to always learn or experience more, if you take the time to notice it.

P.S. Reader's of The Black Swan may also enjoy thinking about how that argument relates with this.

Clearing Up Some Housing Uncertainty

There is risk, and then there is uncertainty. The distinction was first made by Frank Knight in his popular work Risk, Uncertainty, and Profit. Risk exists when a probability can be attached and an expected value can be derived. Uncertainty exists when there is no objective way to place a probability on an event and so an approximate outcome can not be made. The word 'uncertainty' seems to characterize the state of the housing market today. The predictions for how bad it will end up being seem to be all over the charts because no one is quite sure about the extent of the problem.

Well today, the New York Fed posted up a new dynamic mapping and data tool which gives some valuable information towards clearing the uncertainty. The site provides many statistics on sub-prime and Alt-A mortgages, including:

• Loans per 1,000 housing units
• Loans in foreclosure per 1,000 housing units
• Loans real estate owned (REO) per 1,000 housing units
• Share of loans that are adjustable rate mortgages (ARMs)
• Share of loans for which payments are current
• Share of loans that are 90-plus days delinquent
• Share of loans in foreclosure
• Median combined loan-to-value ratio (LTV) at origination
• Share of loans with low credit score (FICO) and high LTV at origination
• Share of loans with low- or no documentation
• Share of ARMs with initial reset in the next 12 months
• Share of loans with a late payment in the past 12 months

The one I found most interesting though is the first one: "Loans per 1,000 housing units". If I'm understanding this correctly, this gives us the percentage of homes in a market which are backed by subprime or Alt-A mortgages. So let's take a look at two states which are supposed to be the worst housing market offenders: Florida and California.

Florida
Subprime loans per 1000 units: 39.40
Alt-A loans per 1000 units: 20.40
Total = 5.98%

California
Subprime loans per 1000 units: 38.60
Alt-A loans per 1000 units: 48.60
Total = 8.72%

These numbers are far from great; they also do not include many poorly underwritten home equity loans. Still, the risk of housing causing a doomsday type scenario seems pretty small to me if the share of houses with shaky loans is not even in the double digits. Some new problem will have to step up if the doomsayers are going to be proved right.

Mental Models From Guns, Germs, And Steel

I was flipping through Guns, Germs, and Steel by Jared Diamond today. As luck would have it, the first page I flipped to reminded me of not one, but two mental models from other subjects. Maybe these just happened to stand out because I have been reading so much on Charlie Munger lately. Regardless, I kept reading and kept making more and more connections from a variety of disciplines. Here was what I came up with it.

1.

All other things being equal, people seek to maximize their return of calories, protein, or other specific food categories by foraging in a way that yields the most return with the greatest certainty in the least time for the least effort. Simultaneously, they seek to minimize their risk of starving: moderate but reliable returns are preferable to a fluctuating lifestyle with a high time-averaged rate of return but a substantial likelihood of starving to death. One suggested function of the first gardens nearly 11,000 years ago was to provide a reliable reserve larder as insurance in case wild food supplies failed.

The first part of this involves the opportunity cost concept from economics. Here, it is being used in a narrowed sense to describe the satisfaction of hunger. Even more interesting is the idea that people prefer "moderate but reliable returns" of food compared to higher risk and higher returns. You often hear Warren Buffett and Prem Watsa take the opposite statement on investing- that they prefer lumpy but out-sized returns over reliability. On closer analysis, this difference makes sense. In investing, we have a much longer time horizon and so a short-term slump can be handled without severe consequences. But with food, the consequence of a slump is starvation and death- a much less manageable risk.

2.

As we already noted, the first farmers on each continent could not have chosen farming consciously, because there were no other nearby farmers for them to observe. However, once food production had arisen in one part of a continent, neighboring hunter-gatherers could see the result and make conscious decisions. In some cases the hunter-gatherers adpoted the neighboring system of food production virtually as a complete package; in others they chose only certain elements of it; and in still others they rejected food production entirely and remained hunter-gatherers.

This reminded me of my philosophy class on Descartes. He argued that all of our ideas came from a combination of other ideas we have experienced in the past, and no idea could exist in us unless it had some truth in the outside world. The same concept is being used here regarding agriculture. Its mass implementation occurred only after someone stumbled upon farming's great benefits and other people witnessed it.

3.

A fourth factor was the two-way link between the rise in human population density and the rise in food production. In all parts of the world where adequate evidence is available, archaeologists find evidence of rising densities associated with the appearance of food production. Which was the cause and which the result? This is a long-debated chicken-or-egg problem: did a rise in human population density force people to turn to food production, or did food production permit a rise in human population density?

The old Chicken-or-egg dilemma. Just because you have found a correlation between two variables doesn't mean you've also answered which one has caused the other. These are usually two different problems.

4.

That is, the adoption of food production exemplifies what is termed an autocatalytic process- one that catalyzes itself in a positive feedback cycle, going faster and faster once it has started.

We saw another example of an autocatalytic process with the housing bubble. As lenders began to loosen their standards, less people defaulted because they had more access to refinancing. This made the lender's business look great, and caused them to loosen their standards even more.


5.

Instead of being enclosed in a poppable pod, wild wheat and barley seeds grow at the top of a stalk that spontaneously shatters, dropping the seeds to the ground where they can germinate. A single-gene mutation prevents the stalks from shattering. In the wild that mutation would be lethal to the plant, since the seeds would remain suspended in the air, unable to germinate and take root. But those mutant seeds would have been the ones waiting conveniently on the stalk to be harvested and brought home by humans. When humans then planted those harvested mutant seeds, any mutant seeds among the progeny again became available to the farmers to harvest and sow, while normal seeds among the progeny fell to the ground and became unavailable. Thus, human farmers reversed the direction of natural selection by 180 degrees: the formerly successful gene suddenly became lethal, and the lethal mutant became successful.

This is just to remind us of the inherent randomness of the world. Sometimes, you can have every conceivable thing in your favor, and then one black-swan type event comes in and completely changes everything. Long Term Capital Management thought they had a sure thing, and then one "six sigma event" came along and completely wiped them out, endangering the entire financial system in the process.


6.

The second type of change was even less visible to ancient hikers. For annual plants growing in an area with a very unpredictable climate, it could be lethal if all the seeds sprouted quickly and simultaneously. Were that to happen, the seedlings might all be killed by a single drought or frost, leaving no seeds to propagate the species. Hence, many annual plants have evolved to hedge their bets by means of germination inhibitors, which make seeds initially dormant and spread out their germination over several years. In that way, even if most seedlings are killed by a bout of bad weather, some seeds will be left to germinate later.

Instead of seedlings being all killed by a single frost, think of an entire investment portfolio getting wiped out by the loss of a single holding. So what do you do? You hedge your bets. The plants spread out their germination over several years so some seeds will still be left. Similarly, people diversify their portfolio so no single event can wipe them completely out.

I came across all of this within 13 pages, and I've learned two things. One, these big concepts can be applied in a lot of instances if you really look for it. Two, Jared Diamond has a brilliant multi-disciplined mind and I need to really finish his book.

P.S. Many of you might also find this post comparing Bruce Lee's philosophy with Warren Buffett interesting.

Commercial Honor, Equitable Principles, Fair Dealings

John Bogle, chairman of Vangaurd, recently gave a speech to the Financial Industry Regulatory Authority about the declining ethics in the mutual fund industry.

This morning, I’ll focus on investor protection in the mutual fund industry, discussing what can be done to assure that fund investors get a fair shake, or, as I wrote in my senior thesis at Princeton University almost 57 years ago, that “mutual funds must be operated in the most efficient, economical, and honest way possible.” It was that thesis that opened the door to my first job in this industry, and I’ve been with the same firm ever since, although it has changed greatly.¹ That was a pretty good characterization of how the industry worked in 1951. But it is with regret that I report to you that the ethos of today’s mutual fund industry—with some, but not nearly enough, exceptions—has moved away from those principles. I am a tough critic of today’s fund industry, but acknowledge that my views are not widely shared by my industry colleagues. Indeed, one veteran industry leader has stated that “Mr. Bogle’s view of ethics may be somewhat outside the mainstream.” He was, of course, quite right.

To set the stage for my remarks, I’ve chosen as my title the three central standards of the NASD Rules of Fair Practice: “a member, in the conduct of its business, shall observe high standards of commercial honor and just and equitable principles of trade,” and shall engage in “fair dealing with investors.” With these principles in mind, let me discuss how they relate to the mutual fund industry, which has changed in so many fundamental ways.

• A new mission. We’ve moved our central mission from stewardship to salesmanship, and our core value from managing assets to gathering assets. We have become far less of a management industry and far more of a marketing industry, engaging in a furious orgy of “product proliferation” that has ill-served our investors. Once an industry that “sold what we made,” our new motto has become “if we can sell it, we will make it.” For example, right at the peak of the late, great bull market, we created 494 new “aggressive growth” funds, investing largely in technology and telecommunication stocks. The consequences for our investors were devastating.
• Our funds, once broadly diversified, became largely specialized. In 1951, almost 80 percent of all stock funds (60 of 75) were broadly diversified among investment-grade “blue-chip” stocks, pretty much tracking the movements of the stock market itself, and lagging its returns only by the amount of their then-modest operating costs. Today, our total of 512 “large-cap blend funds” account for only 11 percent of all stock funds. These “market beta” funds are now vastly outnumbered by 4200 more specialized funds—3,100 U.S. equity funds diversified in other styles; 400 funds narrowly-diversified in various market sectors; and 700 funds investing in international equities, some broadly diversified, some investing in specific countries. The challenge in picking funds, dare I say, has become roughly akin to the challenge in picking individual stocks. I don’t regard that change as progress
• The wisdom of long-term investing has given way to the folly of short-term speculation. In 1951, a mutual fund held the average stock in its portfolio for about six years—investing. Today, the average holding period for a stock in an equity fund portfolio is just over one year—speculation. Neither is that change progress.
• We’ve discouraged long-term investors. With the substantial differences in short-term returns that inevitably occur among these different fund styles, investors have come to chase past performance. In 1951, most fund investors just picked funds and held them—on average, for about 16 years. Today, investors trade their funds, now holding the typical fund in their portfolios for a period of only about four years. A negative reversal with unfortunate consequences for our clients.
• The ethos of fund managers has changed. Once dominated entirely by small, privately-owned firms and operated by professional investors, the industry is now dominated by giant, publicly-owned firms, largely operated by businessmen bereft of investment experience. Today, 41 of the 50 largest fund managers are publicly-held, including 35 owned by giant U.S. and international financial conglomerates. Small wonder that these firms are all too eager to focus on maximizing the return on their own capital invested in the fund management companies they own, rather than focusing on maximizing the return on the capital they are investing for fund shareholders. Another compelling negative for our clients.

….

Together, this disgraceful conduct represents a sorry chapter in this industry history. But I know of no easy way to regulate or legislate a return to our industry’s traditional values. Competition, in fact, is driving us in quite the opposite direction. As long as our industry participants—our fund managers and marketers, our brokerage firm account executives, and our financial advisers—have more information at hand than their clients possibly could—the economists call this information asymmetry—a largely unaware investment public will be inadequately informed. Regulations calling for more complete disclosure would be a huge help in protecting investors from their own naiveté and lack of information.

Also interesting:

One of the great unexplained curiosities of the mutual fund industry is its unwillingness to call attention to the vital role of investment income in shaping the returns on equities. Theory tells us, and experience confirms, that dividend yields play a crucial role in shaping stock market returns. In fact, the dividend yield on stocks has accounted for almost one-half of their total long-term return. Of the 9.6 percent nominal total return earned by stocks over the past century, fully 9½ percent has been contributed by investment return—4 ½ percent by dividend yields and 5 percent from earnings growth. (The remaining 0.1 percent resulted from an 80 percent increase in the price-earnings ratio, from 10 at the start of the century to 18 at the end, amortized over the long period. I describe changes in the P-E ratio as speculative return.)

Prescriptions for Sure Misery

I'm on spring break now, which means I have some extra time for my leisure reading. So, I finished the first book on my list, which was Poor Charlie's Almanack. It was a terrific book which offers you ages of experience and knowledge. For this Easter holiday, I wanted to share with you the message from one of my favorite speeches, which discusses the prescriptions for sure misery. This idea originated from Johnny Carson, who offered the first three rules:

1. Ingesting chemicals in an effort to alter mood or perception,
2. Envy
3. Resentment

To these, Charlie adds:

4. Be unreliable,
5. Learn only from your own experience
6. Go down and stay down
7. Minimize objectivity

As many of you may know, Charlie is always very big on the process of inversion. So instead of telling you how to be very successful in life, he discusses the surefire ways to be miserable. And if you can just manage to avoid these terrible pitfalls in life, you should turn out fairly happy and successful.

Happy Easter

A discussion about the economy with Paul Volcker

Charlie Rose interviews Paul Volcker, Chairman of the Fed from 1979 to 1987, about the state of the economy today.

Characteristics of Equity and Debt

I thought that in the wake of the current financial mess, it would be a good time to go over an important difference between equity and debt investing.

Every company faces the choice to finance their business/ expansion plans with equity capital or debt capital. First, let us start with equity investing. There is a clear and pretty well accepted definition for the value of issued shares to investors- it is the discounted future cash flow of your share in the business. It is much more difficult in practice, and most people's guesses are as good as anybodies. For the company however, all that matters is that initial issuance price. Regardless of what the true value of their issued shares are, the amount of money the company raises is equal to the initial share price multiplied by the number of shares issued. These shares can never be "put back" to the company.

Afterwards, investors deal only amongst themselves. If I, as an investor, am able to perfectly calculate the value of a company's share and purchase it for less than that price, I would be value investing. In the short term, their value is reliant on what "Mr. Market" is willing to offer me on that day. But the good thing about stock investing is that I have no deadline on which I am forced to sell my shares. So if I had no time restraints, I could just hold on to those shares and watch as the company generates the cash flow (which I had perfectly predicted). At some point, the market will either recognize this or investors will demand the company dividend this money to them, allowing me to recognize fair value for my shares.

But when dealing with debt investing, the situation is usually very different. The reason is because debt matures and principal must be paid back. Let us say that once again, I can perfectly predict the future cash flow of a certain business. This time though, the business is financed with debt which initially matures in five years. For the first five years, everything goes as planned. The company pays its interest, and even uses its excess cash flow to start repaying its debt. Still, at the end of five years, the company has a large portion of its principal remaining unpaid.

The company now has no choice- it needs to refinance to pay back its existing debtholders, and its ability to do so relies completely on the market's risk perception at the time. With stocks, this wasn't the case: an investor could just hold on to his shares into the future, and the share price would eventually represent its fair value. But as a holder of debt, an investor is now exposed to the danger that the market might not want to refinance the company's debt at a fair cost, if at all. And although I know the company's future cash flow justifies refinancing, I, in all likelihood, can not afford to refinance all the debt myself. The business can now be forced into bankruptcy, and a perfectly viable business can be forced into liquidation. The only way a debt investor can completely avoid this risk exposure is to make sure that the business' income can cover both its interest and its principal payments as they come due, but this type of conservatism is rarely seen.

To make matters worse, the great business rarely even bothers with debt. The Coca Cola's of the world have the most predictable and stable businesses, and the lenders feel the most comfortable lending to them. Yet, these companies also never need to leverage themselves because they have strong competitive advantages and are already earning great returns on their investment. It is usually the bad businesses which resort to debt in order to boost their profitability. And the worst businesses need to leverage themselves to the moon just to earn a decent return. The current financial crisis is fraught with just those types of situations. What happened to Carlye Capital, which collapsed earlier this month? (link)

In a short news release issued early Friday, the fund, which is managed by a unit of Washington, D.C., private-equity firm Carlyle Group, said it received "substantial additional margin calls and additional default notices from its lenders" and that "these additional margin calls and increased collateral requirements could quickly deplete its liquidity and impair its capital."
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Carlyle Capital managed only $670 million in client money, but used borrowing to boost its portfolio of bonds to $21.7 billion, meaning it was about 32 times leveraged.

What Carlyle did was borrow at X% and invest in securities making (X+.50)%. The only way to make the returns on investment in that semi-attractive was, well... 32 times leverage. And what happened? The market got nervous and they decided not to refinance. The same thing is causing problems for SIV's, hedge funds, and financial institutions in general. Some of these companies may have done all of their work correctly (unlikely), but making the market confident of that is not so easy. After all, if a company like Carlyle was only 3% off, its entire equity would be wiped out and losses would start accruing to its debtholders. These financial firms are starting to realize that when dealing with debt, it is not just what you think that counts. And a 3%, 5%, or even 10% margin of safety is not very reassuring to investors after the housing bubble we have just witnessed.

Hypothetical Question

If you were put in charge with the goal of making a better society, would you want the cost of purchasing a house to go up or down?

I'm not saying we should be happy that home prices are now falling. But as we were celebrating our increased home wealth over the last several years, not many people stopped to think how these illusionary gains were really making us any better off.

Updated Info on Fairfax's CDS Portfolio

At the end of 2007, Fairfax's CDS portfolio held the following names:

Munich Re
Ace Ina Holdings
Allianz Finance
Societe Generale
Aegon NV
Zurich Financial
Deutsche Bank
Swiss Re America
Ambac Inc
AIG
Bank of America
Barclays
Capital One Bank/Financial
Citigroup
Countrywide
Freddie Mac
Fannie Mae
Genworth Financial
Goldman Sachs
Hanover Re
JP Morgan
MBIA
MGIC
PMI Group
Radian Group
Washington Mutual
XL Capital

Of these, the ones in bold were initiated/added to during the year.

Last year, I wondered why so many property and casualty insurers were included in their CDS portfolio. The reason appears more clear now, as insurer investment losses are set to overtake those of Hurricane Katrina. These has caused the credit protection costs of many of these insurers to soar:

Canwest Global

After running through the numbers and business for Canwest, an investment in their stock definetely looks interesting. Canwest has an Enterprise Value of 2.8 billion (2.1 billion debt + 100 million cash + 800 million market capitalization).

Of that, their publicly-traded 56% stake in Network 10 is worth 1.2 billion. This is before any capital gains taxes, but effectively you are paying 1.6 billion for the rest of their business.

For that 1.6 billion, you get 28% of the Canadian newspaper publication, 11.3% of total TV audience, and a 250 million equity stake in CW Media(more on this later). In 2007, the publishing business had revenues of 1.3 billion and pre-tax profit of 260 million. The Television business had 670 million in revenues and 70 million in pre-tax profits.

Why is it so cheap? One reason is because of balance sheet confusion, which makes Canwest look more indebted than it really is. If you subtract Network 10's debt (because it is a seperate publicly traded co.) and CW Media's debt (non-recourse), the debt level is much more manageable.

A more likely reason though is because the terms of the CW Media deal is very confusing. Currently, Canwest owns 35% of the subsidiary, yet it is consolidated because it has majority voting power. The deal was levered up with almost 800 million in debt, and in three years the company will merge with Canwest's Canadian Television business. Their ultimate stake will depend on how profitable the business is at that time, making this entire mess difficult to value.

Still, it is difficult not to assign some at least some positive value for the Canadian TV segment. And you can likely justify the price you are paying for Canwest off the newspaper alone; It currently trades at 1.23x sales, while most of its American peers are trading at around 1.3x sales. Throw in the fact that this is business has minimal capital expenditures and the cash flow is really "free", and it seems like a great deal.