Thursday, December 04, 2008

Blodget says bubbles are rational

Henry Blodgett, a man whose greatest accomplishment was making a trend call on Amazon in 1998, has done it again. He substitutes narrative for analysis and now explains to us that the bubble was rational.

After constructing a list of possible culprits for bubble-mania (a list which includes mortgage brokers, real estate agents, Wall Street bankers, the SEC, and Alan Greenspan), he then lays the blame on the public - in his word "us". He excuses all of his straw-men with the following:
Everyone else on that list above bears some responsibility too. But in the case
I have described, it would be hard to say that any of them acted criminally. Or
irrationally. Or even irresponsibly. In fact, almost everyone on that list acted
just the way you would expect them to act under the circumstances.
He argues that every individual participant in the market had a specific aim, and that participating was a means to that end (and was therefore rational). He points out that buyers wanted houses (though in many cases so they could sell them to some other fool who would pay even more), agents wanted commissions, brokers wanted fees, and so on and so on. Playing the game was "rational" - and only the buyer had a real interest in predicting the future of the housing market (since he was the one who would have to pay for the asset, albeit over 30 years).

But what he overlooks, largely because his article is an act of narrative, not one of analysis, is the investor PURCHASING the loan in the form of a bond. What was irrational, ultimately, was that Mortgage Backed Securities (MBS) would always offer the same default risk as a government bond for substantially higher yield. This was idiotic. The price of the asset against which the security was secured (the house) in relation to the intrinsic value of the asset (the potential rental income of ownership) was already becoming strained in 2003-2004 in most markets. To believe that liquidation at anything approaching par would be possible, or that borrowers would really follow historical trends when it was obvious that an orgy of buying was pushing prices higher, was simply not rational.

True, the rating agencies wanted to rate bonds (because they wanted fees), but relying on the recommendation of a third party to do your homework for you - for free - now that is what I call irrational.

Wednesday, July 09, 2008

Eight Years of Agony

Hard to believe that eight years after the highs of the markets in 2000, we are again below those levels on all three indices. True, the DOW remains near its 2000 peak of 11722, while the S&P500 is about 20% below that level and the NASDAQ, well, the less said the better. Eight years on the index remains at less than half of the 5000 level it achieved in March of 2000.

How can this be? Earnings, which are supposed to drive valuations, have increased meaningfully since that time. Moreover, many companies have much stronger balance sheets than they did before. I would point to four factors - financials, changes in index components, fear about the economy and inflation.

Over the past 10 years or so, financial stocks have represented about 20% of the S&P500s capitalization. As industrial firms and manufacturing, the old staples of the index, declined in market value banks and financial firms came to dominate the index. Financial stocks have been crushed. It is therefore no surprise that the indices have also been punished.

The financial crisis continues to rage with an evolving sense that the whole system is rotten.
What first seemed an isolated problem in a few narrow classes of assets - CDOs and other structured finance products - have metasised throughout the sector. The reality is that while the owners of structured finance might have appeared to be narrow, hedge funds, pension funds wealthy investors - all of them seeking income yield unlike most individual investors - structured products were sold backed by all manner of securities, which drove the prices of those assets above reasonable levels (Greenspan's "conundrum") and encouraged massive leveraging, which, sadly, was rewarded not by the lower prices that increased risk should have produced, but by higher prices as people piled in to ride the wave of asset price appreciation. More on this in a moment.

The second factor is the way the indices have changed. This is most evident in the NASDAQ and is a major reason why the price levels there have not rebounded with profitability. Stop to consider that when one of the profit measures of an index is performed it considers the profitability of all the components - this is logical. But if many of your components were money losing companies and they go bust, your index sees a profit improvement, even though the remaining companies may not really be more profitable than they were before. Sadly, this is exactly what has happened in the information technology sector. The composite index has seen strong profit growth mostly through an "addition by subtraction [of a negative]". The remaining companies, however, have not demonstrated strong profit growth and their prices therefore linger. Think MSFT, a company that is struggling to change from being a fast growth company into one that basically operates a franchise with modest growth potential.

The third factor is of course fear about the economy. If overall economic activity declines, future profitability will likely be lower. Marginal companies, in particular will find the going difficult. And many traditional policy supports such as lower taxes and easier money seem more foolish than helpful given the massive red ink of the US Federal Government and the surge in global prices. Thus, the economy seems set for a cycle of lower growth - possibly below the rate of productivity growth - which leads to unemployment (or fear thereof) and therefore lower consumption and lower economic activity and so on - the classic downward spiral. The only upside in this is that lower spending likely means lower prices for consumers, since output capacity that exceeds demand may lead to lower prices to clear the market (though it may also lead to reductions in capacity and massive write-offs: think Ford and GM). The other upside is that employed people may have the chance to save and repair household balance sheets, if falling asset prices don't overwhelm saving efforts.

Falling asset prices are of course, the biggest concern of policy makers. Sadly, these same people never worry about asset prices increasing too much. People throughout the world have been able to rely on higher asset prices and the high internal rates of return on savings to consume. As I write this, I realize how illogical it is - high rates of return should encourage investment and low rates consumption, but the reverse has happened. There must be a Ph.D. in this somewhere.

The fourth factor is inflation. This is showing up in specific commodities and affecting consumers spending patterns. There is significant substitution toward fuel, heating oil, natural gas and electric expenditure. That money has to come from somewhere and it appears that it is coming from other consumer purchases, particularly in durable goods where outlays can often be deferred for years. Of course, higher inflation also discourages savings and the higher costs of living, unless offset with higher wages, may also be accomodated by lower savinsg, so as to keep consumption consistent.

Inflation, apart from its "real" economic effects, also has another affect on asset prices. Hint: it is not good. High inflation leads to demand for high earnings yields and that means low P/Es for stocks. Note: stocks are usually sold as an inflation hedge, since companies can raise prices and therefore increase earnings. But the problem is, when inflation increases, the value of a dollar of future earnings decreases and it is a struggle to keep earnings growing fast enough to offset the higher discount rate demanded by investors.

To keep it simple - remember that the value of a growing perpetuity is

Dividend/(Discount rate - Growth Rate)

this is the famed "Gordon Growth Model". In theory if the discount rate and the growth rate increase the same amount the value of the perpituity remains the same. However, when inflation is rising, r tends to increase faster than g, so the value of the perpetuity declines.

Recent history offers a compelling example - in 1964 the Dow stood at 766. After 18 years and strong absolute earnings growth - in 1982, the Dow stood at 781. This was because P/Es had collapsed due to inflation. It didn't hurt that earnings took a beating during the nasty 1982 recession.

So - eight years into this cycle, could we be stuck at this level for another decade? Well, let's not forget that the index cycled up and down around this level, hitting 500 and 1000 many times in between. But doesn't this feel like a similar situation to where we are today?

So what to do. Well, one option is to purchase true inflation-fighting investments. Stocks don't do that well against inflation because CapEx expense increases at least as fast as earnings. Returns on Book can plummet. But investments like real estate (I know, real estate? am I crazy!) and commodities are proven inflation fighters. My problem with commodities is that they don't offer current income, so it is pure speculation on price movements. I have to claim ignorance here.

That leaves stocks and bonds. Bonds, unfortunately, get killed in high inflation cycles. Long Treasuries were trading at 15 - 15! - in 1981. Short maturities don't offer yield high enough to prevent the decay of price power. For me, that leaves equities.

But - this is the key - what kind. We must look for current yield, as yield appears to be the only return available to us. We must therefore look for companies with solid yields and a high probability of an increase in dividends goign forward.

These are boring companies, mostly, but their prices will exhibit less volatility and their yields provide a good floor against sudden price drops. Price decreases, actually, are opportunities to dollar cost average your dividends into the stock. A good example is CL.

Also look for stocks that trade a low ratios to book value. Book value is often a good indicator of intrinsic value. Because assets are held on the balance sheet at the lower of cost or market, companies that trade near book are likely to have large phantom equity that you as the shareholder can obtain. Rather than purchase an income stream whose value is questioned by the market, you get real assets that are available now. Good examples here are BSET and HELE.

On the more speculative side, I believe that there are some values in the financial sector, but it will be difficult to determine which banks are relatively safe. The insane leverage of the investment banks makes them all suspect, but the money center banks (excepting Citi, which is a basket case) have been pummelled. Personally, I still believe that BAC is the strongest of the large banks. It continues to make money even after the writedowns (though it has not earned its dividend and may need to reduce it). In a world where finding creditworthy borrowers is the problem, banks will have to offer services and other values to attract those borrowers.

BAC is uniquely positioned to offer the help of a local branch and a local agent who can help people shopping for a mortgage, real estate investors and other small and medium sized business owners looking for financing. Investment banks will be pummeled because large businesses will not have the financing needs they had before. Why float new issues when you don't need new capacity? Easier to finance low CapEx from cashflow. Competition for deals will be amazing and fees will likely be reduced. Commerical banking will be the most profitable part of the industry and here the BoA footprint is a real advantage.

That is how I see it going forward and now you know what I am looking for: firms with solid balance sheets that trade near book value (and will be less immune to multiple contraction) that pay dividends that are reliable and likely to be increased.

Wednesday, April 09, 2008

The End of the Euro?

Jim from The Depression of 2006 has started a very interesting conversation on the return of the Deutsche Mark. I have been arguing that the Euro is here to stay and that it has benefitted Europe in many ways, not least, through higher efficiency and by making cross border consolidation of industries easier, since currency arbitrage is no longer necessary, at least within Europe.

But this article is another piece of "evidence" that there is dissastifaction with the project. So I wanted to address it.

Jim and others have taken the view that the Euro is a real drag on competitiveness, particularly for Germany, a country that is heavily dependendent on exports. Germans often complain about prices under the Euro, calling it der Teuro, which is a pun on the German word for expensive, which is teuer (pronouced toi´-er). The German pronunciation of Euro is Oi´-ro, so it rhymes.

I countered that the actual influence of the higher Euro on finished goods prices was not that large, because a stronger Euro was making raw materials relatively less expensive. Raw materials are a major factor in the price of automobiles and other high-end export products. The higher Euro primarily creates a price disadvantage in labor costs - this is not nothing, but a 50% increase in the value of the Euro does not translate into a 50% cost change, more like 15-20%.

This, of course, is still an issue, but there are other positives that offset some of this decline. First, Europeans are experiencing higher purchasing power - energy costs, food costs and other basic materials, not to mention imports of equipment like computers and software from the US have become less expensive. The higher purchasing power allows Europeans to increase aggregate consumption, meaning that more economic growth can be driven by the home market. Overall, I argue (and most economists and business leaders would agree) that the Euro has been a net positive.

Politics, of course, is something else. Focused on Germany, I largely neglected the other side of the coin - the Mediterranean economies, Italy, France, Spain, Portugal and Greece. An article in Forbes argues that they desire to pull out of the Euro, because they are prevented from using their traditional strategy for restoring economic balance: currency devaluation.

Andre Sapir, a major insider at the EU, has published a paper on the European Social Models, which argues that there are really four different economic models offered in Europe. Each model offers certain strengths and weaknesses, though some more strengths and some more weaknesses. A key factor is that the Mediterraneans have traditionally resorted to devaluation to escape structural problems in their economies, such as demands for high wages from relatively unproductive union workers. Because it enforces a consistent monetary policy (and one that reflects the desires of the "Continentals" - Germany, Belgium, Luxembourg as well as Austria and France) it essentially runs counter to the political situation in Spain, Italy and Greece, and that they may chose to leave. (Note that the Nordics and Anglo-Saxons largely avoided joining the Euro altogether).

The argument in Forbes essentially says that if they were to leave (certainly if France were to pull out) the Euro as a currency would collapse, and Jim would be right, we would have a new Deutsche Mark. (Though, were this to happen, I believe the Germans would still engage in policies such as fiscal displine an a positive balance of payments that would ensure the Mark would be strong, not weak).

I still think this outcome unlikely, in spite of the glacial progress of European integration. More and more, that integration is leading to substantial gains. Moreover, many of the countries, particularly Germany and Austria and to a much lesser extent France, have made real strides in improving the productivity of their economies. A collapse of the Euro would invite many other changes which are generally well received in Europe. It would ask whether the common market should really be maintained, or whether the Schengen system (which allows for free movement of people, i.e. the ability to work outside of one's home country) should be continued and on what scale. All of which would lead to reduced, not enhanced, opportunity for Europeans.

Economic nationalism is rearing its ugly head in many places, the US presidential election, particularly in places like Pennsylvania, which has seen a decline in manufacturing employment (much of which has moved South, not offshore, or simply been automated out of existence).

Globalization is not an inexorable trend. Largely global markets in the late 19th century, which coincided with massive gains in labor productivity and also purchasing power, were undone in the period 1915-1935, especially 1930-1935, when international trade declined by over 30%. The outcome was predictable. With the loss of global markets, local surpluses of goods, services and commodities could not reach needed customers and prices, employment and investment fell precipitiously. At the same time, consumers could no longer tap global sources of supply, so local shortages resulted in higher prices and lower consumption.

I remain optimistic that Europeans will keep the Euro. I find it much better than changing currencies all the time (how many Austrian shillings to the dollar again?) and it creates a sense of a broader European market, rather than a series of small national ones - a sense which is slowly becoming a reality. I am even getting used to the 1 and 2 Euro coins, though, as an American, I still believe change should be for amounts smaller than a basic currency unit.

The article has some advice on what to do if you want to speculate on a disintegration of the Eurozone. I have no better suggestions, but I will point out that the devaluation that is anticipated would be bad for commodity prices (in US dollar terms). But it is a bit early to go short on commodities over anticipation of the demise of the Euro.

Posting Delay

Sorry all, I have been unable to post due to some technical difficulties.

But I have found an interim solution, so I will return to normal posting now.

Tuesday, April 01, 2008

Housing Analysis: You read it here first

I relgiously read two of John Mauldin's weekly newsletters, Thoughts from the Frontline and the Outside the Box E-Letter. Last Friday, in FrontLine, he mentioned two deep analyses of the housing market, both Powerpoint presentations. Based on his recommendation I read them both. One slide, from John Burns Real Estate Consulting made me particularly proud, because of this chart:

A few weeks ago, in my own reading of the housing tea leaves I produced and published this chart:

When I published this analysis, readers of this blog were quick to comment on my view that it is necessary to see a significant overshoot to the downside in order to offset the long and excessive overshoot to the upside. This follows from the very definition of a trend line. A trend line is defined using a statistical process known as ordinary least squares (OLS). What this does is draw a line through the data set such that minimizes the total distance between the square of the actual data (the Y-value) and the trend line, for every X-value in the data set. Squares are used to eliminate negative values. In other words, we try to find the line that has the least “error” – that one which does the best job of estimating what the Y -should be for any X-value.

In a good data series with a strong trend, we can often “free-hand draw” a trend line through a data series because visually we see that the line must be roughly “in the middle” that is – that error of underestimation (where the actual data is above the trend line) must roughly equal the amount of overestimation (where the actual data fall below the trend line). That is, the point at which there is the least “error” in estimation.

Drawing a trend line through a data set is easy (actually, we can draw multiple trend “lines” as many trends are better described by curves, such as compound interest projections). The question is – does the trend line matter: that is, is the relationship a significant one.

In the case of home sales and their growth over time, the answer is yes. Home sales volume, over the long term, is driven by household formation which itself is remarkably stable, though it certainly has gone through periods of faster and slower expansion, thus residential real estate sales growth over time is remarkably stable (note that the growth rate is the slope of the trend line). Home sales growth is a geometric series with respect to time, however, so there should be a curve sloping upwards, the problem is, the growth rate itself is so small (At less than 1% per year) that even over long periods of time the series may appear to be linear.

Nevertheless, not to get carried away, what is important to realize is in order for housing to bottom, sales must remain below trend for some time. This is not what policymakers are suggesting. Rather, they are trying to find ways to support bubble-era prices in a post-bubble environment.

One suggestion has been for the Federal Government to purchase and demolish undesired homes so as to reduce inventory. Incidentally, this policy is not without precedent in major cities that have fallen on hard times. Philly and Buffalo both have crews who perform demolitions, though sadly, there are so many homes that the crews have multi-year backlogs.

While I think this to be a good idea in cities that clearly have far too many homes to support the population that actually wants to live there, I think it should be done at the local level, since it was local planning boards who approved the building of the homes in the first place. Local taxpayers will suffer the demolition costs, but they are also the ones who will benefit from the presumably higher prices that derive from having fewer homes for sale (and fewer abandoned homes in the neighbourhood). I see no reason to make residents of Omaha pay for demolition to support home prices in Las Vegas.

But attempts to manage inventory is trying to fix the wrong problem. The issue with sales (and ultimately prices) is that there are relatively few buyers. Very few people have anything like an incentive to purchase a home, given that buying a home represents a huge premium to renting. Moreover, very few people can come up with a substantial down payment required to purchase a home in the absence of home price appreciation. But reducing inventory will likely make the problem worse.

Reducing inventory is an attempt to maintain artificially high prices – but who would or could pay those prices? Even the people who “purchased” the homes, using questionable financing let us not forget, could not afford those homes. At best we will exacerbate the problem of poor affordability at worst we could reignite bubble lending and more building.

Do you see, as our politicians do not, that keeping prices high means that the only option for purchasing is to continue to rely on low-down payment financing and hope for future appreciation (i.e. bubble thinking)? The higher prices remain, the larger the down payment required to obtain a conventional mortgage. Why do we want to make it harder for people to purchase a home?

The best option is to see a reduction in prices. Only a revaluation of owned real estate with respect to rented real estate can encourage buyers to make the switch from renting to owning or to purchase an additional property with the intent of renting it. This could, begin to help us lift that trend line.


Housing sales will be down for years. The fundamentals are against home purchase, though there is some potential in trade up now, if you can sell your own home. First time buyers are still priced out of the market and will be discouraged by falling prices to risk hard-saved equity. Moreover, lenders will be insistent on having lower LTV so as to ensure adequate protection for their own loans. The lack of buyers cannot be materially improved by policy moves, though it can be materially impaired by them.

I also recommend that you sign up for John Mauldin’s newsletters here and that you read the presentations here and here.

Just remember, you read it at the Strategic Investor first.

Monday, March 31, 2008

End of Month Review

It has been a week since I last posted, for which I apologize. I want to cover a few topics with this post, which is technically a violation of the rules of good blogging, but it just doesn’t make sense to have a bunch of really short posts.

First, I would like to thank all of you who have been visiting. March 2008 is, by my standards, the most successful month in the history of this blog. Daily traffic has been rising along with inbound links and this blog now ranks in the upper half of finance blogs in TopBlogSites, an improvement of about 100 positions inside of a month. Even more satisfying to me, the frequency of comments has increased as well. My goal is continously to improve the quality and value of the content here. More on how I plan to do this in a following post.

Second, I want to criticize a few points in my most recent Bear Stearns post. Given the willingness of JPM to quintuple its bid to $10 per share, one can only conclude that, indeed, the $2 bid was too low. If I were being obstinate, I might argue that the need to increase the bid so dramatically was the result of a negotiating mistake. JPM agreed to guarantee the debt of Bear (beyond the guarantees of the Fed) without being certain that they would consummate the deal. Thus, JPM apparently faced the possibility of guaranteeing the debt while Bear was free to find other suitors. The new arrangement involves issuance of new equity to JPM, which means that it gets to vote on its own deal – just wait until the lawyers get a hold of this one. Still, there was clearly enough “margin of safety” in the deal to add $8 per share, about $900 million based on 113 million shares outstanding. So I was wrong.

Third, the results of our first poll are in. The question was who was most likely to succeed Warren Buffett as the chief investment manager of Berkshire Hathaway, since increasingly this seems to be the focus of the Board. Several candidates were proposed, all of whom have money management experience. It’s a tie. There were only two votes, one for Eddie Lampert and one for J Christopher Flowers. Since it’s a tie, I guess I will have to break it. I think they are both candidates, but Lampert’s investing style and breadth of investment focus better suit Berkshire’s portfolio. Flowers, a brilliant investor, is too focused on the financial sector. His focus is what makes him successful. He might be an ideal manager of the insurance business, but Berkshire already has that talent available in house. I vote for Lampert.

Finally, I want to discuss my posting schedule. It is my objective to publish something every day the markets are open, but it is difficult to do meaningful analytical writing at that pace. For the month of April, I will endeavor to publish four days of the week - Monday through Thursday, though some weekend posting is also likely.

Again, thanks for reading and responding, it makes this blog much, much better

Sunday, March 23, 2008

The Credit Crisis in Song

This is hillarious and well done.

I will start off by saying that I did not write this and am claiming no credit for it. A friend sent it to me (she didn't write it either).

I have added a link to a YouTube version of the song, in case you want to get the various melodies and changes into your head.

.. sing along to the tune of Bohemian Rhapsody

Is this the real price?
Is this just fantasy?
Financial landslide
No escape from reality

Open your eyes
And look at your buys and see.
I'm now a poor boy
High-yielding casualty
Because I bought it high, watched it blow
Rating high, value low
Any way the Fed goes
Doesn't really matter to me, to me
Mama - just killed my fund
Quoted CDO's instead
Pulled the trigger, now it's dead
Mama - I had just begun
These CDO's have blown it all away
Mama - oooh
I still wanna buy
I sometimes wish I'd never left Goldman at all.
I see a little silhouette of a Fed
Bernanke! Bernanke! Can you save the whole market?
Monolines and munis - very very frightening me!
Super senior, super senior
Super senior CDO - magnifico
I'm long of subprime, nobody loves me
He's long of subprime CDO fantasy
Spare the margin call you monstrous PB!
Easy come easy go, will you let me go?
Peloton! No - we will not let you go - let him go
Peloton! We will not let you go - let him go
Peloton! We will not let you go - let me go
Will not let you go - let me go (never)
Never let you go - let me go
Never let me go - ooo
No, no, no, no, no, no, no, -
Oh mama mia, mama mia, mama mia let me go
S&P had the devil put aside for me
For me, for me, for me

So you think you can fund me and spit in my eye?
And then margin call me and leave me to die
Oh PB - can't do this to me PB
Just gotta get out - just gotta get right outta here

Ooh yeah, ooh yeah
No price really matters
No liquidity
Nothing really matters - no price really matters to me

Any way the Fed goes..

Monday, March 17, 2008

Did JPM get a good deal with Bear Stearns?

On the surface, it seems like JPM walked off with a great deal. As of the last reported period, ended November 30, 2007, Bear had $11.4bn in Equity and an asset base of $395bn. With 113mn shares outstanding (184 issued less 71 mn treasury shares) the company had almost exactly $100 book value per share and $349 in assets per share.

If we throw in an extra billion for the actual value of the Manhattan HQ, which was (probably generously) estimated at $8 per share, the company had $108 in equity/share. JPM must have stolen the company, right?

JPM was able to by the company for less than 2% of tangible book as of Nov 30. Not only that, they were able to get the Fed to pretty much guarantee the balance sheet, so there should be few write-downs, right? Couldn't the Fed have allowed Bear to work off its balance sheet problems and have allowed the company to go on, rather than let JP Morgan make a vulture killing?

I think we shall see that JPM got a decent price for the company but this might not be as good a as ideal t first appears. It is worth noting that several other players, including J. C. Flowers, who has made himself a billionaire by purchasing distressed banks, took a look and decided to walk. Perhaps they could not have gotten the Fed's guarantee. It is also worth noting that the folks who decided to sell were among the firm's largest shareholders and were among those who will feel the loss most personally as their equity and their options are essentially wiped out.

Bear was carrying massive leverage under which small losses would wipe out shareholder equity. Furthermore, its operating businesses were experiencing massive reductions in volumes and coupled with the growth of the balance sheet and the interest associated with it, Bear was going to find itself having difficulty meeting its fixed charges. This is a pernicious problem with banks - once under distress it becomes virtually impossible to do the additional business required to earn the money to repay the obligations. JPM itself wanted to make sure that it would have no goodwill writedowns that would raise speculation that its own balance sheet would become impaired. Thus, doing a business at a hefty discount to an uncertain book value was the only way to get this deal done.

We need to go deeper into the financials to understand why Bear could no longer continue as a going concern. Against a bankruptcy, $2/share doesn't seem so bad, actually. I believe there is every reason to believe that the actual book value of Bear is much lower than the annual report suggests.

First, let's look at the balance sheet. Like all banks, Bear uses generous amounts of leverage. Investment banks, in particular, use high leverage because they hold assets for very short periods of time - they underwrite securities, they do not hold them as investments.

High leverage is what enables banks to make good profits on small margins. For instance, if your assets are earning 1.1% (on total asset value), after interest payments, but you only own 10% of the assets with equity, you get to keep the full earnings, turning a 1.1% return into an 11% return.

But on the downside what it means is that you can be wiped out with a small loss.

Bear had this to say about Leverage in its own 2007 Annual Report (pg 52). You can find the entire report at the or get it here from Yahoo! Finance.

Balance sheet leverage measures are one approach to assessing the capital adequacy of a securities firm, such as the Company. Gross leverage equals total assets divided by stockholders' equity, inclusive of preferred and trust preferred equity. The Company views its trust preferred equity as a component of its equity capital base given the equity-like characteristics of the securities. The Company also receives rating agency equity credit for these securities. Net adjusted leverage equals net adjusted assets divided by tangible equity capital, which excludes goodwill and intangible assets from both the numerator and the denominator, as equity used to support goodwill and intangible assets is not available to support the balance of the Company's net assets. With respect to a comparative measure of financial risk and capital adequacy, the Company believes that the low-risk, collateralized nature of the items excluded in deriving net adjusted assets (see table) renders net adjusted leverage as the more relevant measure.

Bear argues that comparing the gross balance sheet to shareholder's equity (what I would consider normal) unfairly reflects the position of several assets that are cash or equivalent and which *could* be used to reduce borrowings. A fair point is that preferred stock, particularly in distress, should be considered equity capital because dividends can be suspended and because in this case the preferred is not redeemable at the option of the holder (thus Bear has no obligation to actually pay this debt. For our convenince Bear makes the adjustments to the balance sheet and summarized them in the follwing table.

As we can see, Bear's leverage rates increased from 25x, a not uncommon figure, to 33x. Even if we add the additional value of the real estate, we only bring the leverage down a bit. Adjusted, of course, this number becomes lower at around 19x. This was not simple misfortune on the part of this bank. Moreover, there is also this "nugget", also from pg 52 of the 2007 Annual Report:

Given the nature of the Company's market-making and customer-financing activity, the overall size of the balance sheet fluctuates from time to time. The Company's total assets at each quarter end are typically lower than would be observed on an average basis. ... At November 30, 2007, total assets of $395.4 billion were approximately 12.2% lower than the average of the month-end balances observed over the trailing 12-month period, while total assets at November 30, 2006 were approximately 0.5% higher than the average of month-end balances over the trailing 12-months prior.

So the actual leverage ratio during the year was even higher than is here represented.

It may be yet worse - another gem from the section on Off Balance Sheet Arrangements, on pg 61- "[the] Company reflects the fair value of its interests in QSPEs on its balance sheet but does not recognize the assets or liabilities of QSPEs". QSPEs are Special Purpose Entities which hold various mortgage backed paper. While the company may not have to repurchase the paper, (thus avoiding the need to consolidate the entity) we have no idea how much risk the company is really taking - what is the actual exposure here? Fine that the balance sheet reflects earnings or losses through 30 November, but what happened in December, January and Feburary as housing and the mortgage market continued to decline and foreclosures set post-war records?

Even without this exposure the high leverage ratios from on-balance sheet positions mean that a loss of somewhere bewteen 3-5% would be enough to wipe out the equity on the balance sheet. Considered under those terms, even JPM might not be buying much above actual value. Another way of saying that is that 3% of $400bn is a $12bn loss, against which Bear has equity of $11.4bn.

It was a systematic mismangement of the balance sheet. As recently as 2003 the balance sheet was half the size at $212bn. Not only did they allow asset volume to explode (while it was obvious that asset quality was declining), they failed to ensure that equity would even keep pace, because during the extremely difficult 2007 they still found cash to pay $172m in dividends AND repurchase $1.6bn in stock ! Had that money remained on the balance sheet, the company would have at least maintained its already high 25x leverage ratio affording it some extra cushion. Given the fact that the company was still buying back stock in October and November well after the crisis began in August, rather than shoring up the balance sheet it becomes clear that the company was simply out of control.

This might have been salvagable, were Bear capable of continuing to book high fees and unload some of the paper. But then we look at what is happening to revenue.

Fee income is suffering because of writedowns in the fixed income underwriting category. Revenue declined by 36% from over $9bn to under $6bn. Substantially all of that decline came from reversals in the fixed income segment, but as we entered 2008 it was clear that revenue from other key sources - serving as a prime broker to hedge funds, securities underwriting, merchant banking and the like were likely to decline further. Moreover, further writedowns in fixed income were a near certainty.

Income did even worse - declining by nearly 94% to a paltry $193mn. This meant that income before operations (including interest income) just covered fixed charges. Since this year is sure to result in worse top line development, it will no longer be possible to meet fixed charges. This could alone be a $2bn or 20% hit to equity with no prospect of "riding out the storm".

JPM, with its stronger balance sheet has a better chance of doing so. But in the end, there might not be much value left for JPM to acquire.

What I was trying to say

In my last post was that the meltdown of Bear Stearns threatens the entire financial system. This was the reason that the Fed had to intervene to arrange the sale of Bear.

The reason that any element can bring down the system now is the interdependence of the players. The rise of structured finance, which enables risk to be sliced into various pieces and traded between banks, funds, insurance firms, investors, the government, corporations, farmers, travellers - in short, everyone - means that the failure of any large player inevitably weakens everyone else.

Derivatives essentially function like insurance - enabling the buyer to receive protection from specific risks (like having one's house burn down or having to make payments in currencies other than those in which a firm earns its revenue) at a cost - an insurance premium. Likewise, the seller function as an insurer, taking on that risk in return for consideration (the premium paid). If the seller decides to lay off some or all of that risk, they seek reinsurance, by assigning the contract (selling it) or by purchasing an offsetting position. This can be done for all or part of a position.

The problem is that as the risk becomes dispersed throughout the financial system, those at teh center, the investment banks and their large clients - hedge funds and insurance firms, and some corporations - find themselves counterparties to everyone. If one fails, the insurance that they have offered becomes worthless, forcing the insured to recognize a loss from an exposure they had believed to be hedged. Once that loss appears, equity of the counterparties can be quickly wiped out and more selling and liquidation ensues.

In a very real sense, what structured finance has done is not only spread the risk widely, it has meant that when any sector has a major problem the effects are impossible to isolate, because, at the end of the day, through the banks, everyone becomes a counterparty to everyone else, and failure at one bank is enough to bring down the system.

I point out that this is not news, though many seem to be surprised by it. In 1998, LTCM, having suffered a $5 billion loss, nearly had its equity wiped out and it stood to default on over $100bn in trades. The effect of the write-downs on the markets would have been huge.

Why does this happen? Well, insurance is based on estimates of what is likely to happen. Most of the time, it's a good bet for the insurance company. They reliably collect premiums that are more than adequate to offset small losses on in the position taken. However, sometimes really big events happen and when they do there is a surprising amount of correlation among assets, particularly financial assets and particularly among assets of similar classes. This means that if you regularly issue insurance against a specific type of default - all of your claims are likely to come at the same time. This would be OK, were it the case that the insurer had the assets in place and that those assets were sufficiently liquid to ensure that conversion to cash to pay claims didn't lead to greater imbalance and higher losses.

Virtually no firm, and certainly no investment bank, which operate with massive leverage, has the balance sheet necessary. It requires huge stores of cash - and cash is not a big earner. High returns on equity and the big bonuses that come with them aren't earned with cash. If you own 1/3rd of the company and live in a nice house in Omaha, you might not care that much about holding cash (especially if you operate with an underwriting profit, in which case the cash is free), but if you work in NYC and are competing to have your kids get in the most prestigious pre-school and you rely on annual performance bonsuses to pay for your lifestyle then you don't want lots of cash sitting around. You need to keep dealing and generating fees.

This is not to knock the investment banks. Generating fees is a very good idea, since those profits can be used to offset the loses (if you can continue operations).

But what I want to caution against is the belief that the risk models used to predict the insurance payoffs are good. Even Alan Greenspan, a fan of structured finance - and asset bubbles - admits that overreliance on models is a problem. This is because of the Rumsfeldian "unknown unknowns" which are impossible to model, no matter how good we get at modeling "known unknowns". Worse, the moments that the models will be most useless will be precisely those moments when insurance is most needed, that is during crises when traditional risk measures, such as Value-at-Risk (VaR) that depend on predicting the correlations among a series of risks, will break down.

I posted the first, unedited, and considerably less clear explanation, because I wanted to share my thoughts at the time. There has been evidence that my thinking on this was pretty good - the bank is selling for much less than its close on Friday (even I didn't think it would essentially go for liquidation value) and because I predicted more problems. The WSJ already hinted at problems at Lehman (though, thus far, it's speculation - on my part as well).

The Times of London is also insinuating that several leveraged hedge funds are near to collapse. This would also not surprise me. Leverage, so great on the way up is even more deadly on the way down. Long periods of being rewarded for taking increasing risks and getting paid less and less (but still getting paid) to take them inevitably leave one naked. And the tide is rushing out.

As an investor, I remain patiently on the sidelines. Right now, there is panic selling, knives are coming out and I'm not real interested in trying to catch it - never was that coordinated. The deleveraging that is underway will dramatically change the investing climate that we have come to know. It will truly be unlike anything we have seen in my lifetime.

Most of the old rules will be out of the window. I think there is still a great deal of reason to expect deflation and not inflation. As an investor, preparing oneself to thrive regardless of which scenario occurs is very tricky, but as always - the first rule is Hippocrates: "do no harm".

Has anyone else noticed

That the Nikkei has lost 1/3rd of its value since July?

I was checking market response to the news about Bear and I saw that the Nikkei had not only shed 450 points, but that it was trading below the Dow's Friday close. That got me thinking - hadn't the Nikkei been above the Dow recently. So I checked the chart and courtesy of Yahoo! Finance, I saw this.

I guess there is a great deal of concern about Japanese exporters and the US dollar. Or maybe just concern about Japanese exporters and the US economy in general. But is it really this bad? And if it is this bad, why is the US not showing similar declines? After all, Japan increasingly trades with East Asia so it's US leverage should be muted.


Why the Fed had to intervene to prop-up Bear Sterns

I wrote the article below yesterday afternoon and then decided to leave it for awhile so I could edit it. I didn't get a chance to get back online yesterday, and after waking up this morning discovered that the Fed had taken further action and that JPM had agreed to purchase BSC for $2 per share.

I have decided to post the unedited article - you will see that it takes something of a detour in paragraph 3, discussing derivates and counterparty risk - the driving force behind the Fed's unusual action to keep Bear afloat until it could be sold.


Quick quiz – what is the biggest risk that an insured takes after purchasing insurance? Answer - That the insurer won’t be able to meet the obligation in the event of a major loss. When the insured is himself an insurer of other risks the potential for reverberations to lead to systematic failure are too large to ignore. The Fed saw the need to prevent the fifth largest investment bank from failing specifically because it saw that the failure of Bear would lead to a collapse of the structured finance market, a catastrophe that had to be averted at all costs. One can argue that the Fed managed to get a pretty good deal.

Bear Stearns had to be prevented from failure because it served as both a source of liquidity and lending to several dozen large hedge funds (in the form of a prime broker) and also found itself as the counterparty of several transactions (many with the same hedge funds). Had it gone under, its hedge funds would have found it difficult to process transactions and also to obtain adequate financing. Furthermore, many hedge fund positions – though winners – would have been effective losers, since the insurer (the counterparty) couldn’t actually make good on the contract. If this were to happen, these hedge funds, who are themselves counterparties to thousands of transactions would themselves no longer be viable counterparties and the contract failures would resound throughout the system, potentially rendering the entire structured finance/derivative markets inoperative.

To understand things a bit more clearly, let’s first review the primary uses for derivatives. Over the next days and weeks we will likely hear several pundits cry, either shrilly or smugly, that rampant speculation is the cause of the problem. Perhaps. Derivates, however, are at least as often used for hedging as for speculation. Derivates, such as forwards, futures, and swaps allow one party to “lock in” a price or an interest rate which allows them to focus on their business and not currency markets. Options, though more often discussed, function quite differently from most other derivatives. Exporters regularly use currency forwards to ensure that their transfer prices remain stable (avoiding the problems with either prices or margins jerking up and down in response to currency fluctuations). Farmers and ranchers use futures to ensure that at least some of their crops or herds will be sold at a price known in advance, protecting them from the influence of weather. In any of these cases it is possible that one would have made more money with an un-hedged position. (E.g. the farmer who agrees to sell soybeans at $3.00 a bushel may find that when he actually comes to deliver that the market would have paid $4. But he accepts this because it ensures that he doesn’t find himself trying to sell for $2, which might lead to bankruptcy).

In principle, the counterparty to the transaction is usually also be seeking to hedge. A meat producer or Ag firm also locks in a price and can therefore contract with its suppliers and be certain of a profit. In actual fact, however, the counterparty may simply be trying to make money as an insurer – either by exploiting price differentials in the market (hoping that the prices really is $4 and that they can purchase at $3 and sell for a profit) or by generating sufficient premium income from writing the contract to cover a small loss.

Generally these products work well. In fact, it can be argued that they reduce risk, since they provide for price negotiation over a long period. (Contrast that to the daily fluctuations possible in these markets – small increases or reductions of supply or demand can cause dramatic price changes – Marc Rich can tell you all about how to do it).

The problem is, derivatives often lead to small losses or small gains, punctuated by rare, but often extraordinary, gains or losses. Such risks are indeed popular with hedge funds and traders, since they can usually exploit small price “errors” and make stable and reliable profits. The problem is when things break down. Naturally, when one side experiences an extraordinary gain (which might be offsetting a large currency loss for instance), the counterparty is experiencing the large loss. If he hasn’t ensured adequate liquidity to write that check, he can often find himself illiquid, or even insolvent.

Regardless of the technical correctness of the models used by the “insuring” party, it is easy to see that many people who had purchased insurance might find themselves uninsured after all. This would lead to yet more chaos and likely more insurance failures (or more extraordinary events) putting yet more strain on the system and moving from the financial sector to the real economy as the breakdown began to affect the movement of commodities and other products.

Against such a dire outcome, the Federal Reserve has essentially left itself open to taking a small loss on Bear’s collateral. In return, it is able to charge JP Morgan the discount rate for the cash. Seems like a good deal –IF and it is a capital IF – this holds the line.

I am less certain that it will. There are many other companies who have been engaging in the same practices and the markets are likely to remain stressed. We have no idea what price BSC will actually fetch when the negotiations for sale are completed. The stock closed around $30, but if the company is in this bad shape it is unlikely that it will go for this price in a distressed sale. Given the poor management (decisions like trying to bail out its own funds stripping equity from the balance sheet) and high leverage there may be few tangible assets at all. Intangible assets may also have little value. The name Bear Stearns will be erased as it is now tainted. And who can say how long the bankers will be allowed to stay? Customer lists are worth something. In any event I suspect that we will hear something quite soon.

There will likely be more hedge fund failures and possibly another investment bank will find itself overextended. It is more likely to be one of the exclusive I-Banks (like Lehman Brothers) and not a money center bank, but Citi is having its problems, so who knows?

One thing is for certain, claims by those like Larry Kudlow that this credit crisis is near over are simply untrue.

Friday, March 14, 2008

Bear Stearns Bankruptcy?

Bear Stearns announced today that it would receive temporary (28 days) secured financing on an as needed basis for JP Morgan Chase and (indirectly) from the Federal Reserve.

The plan was announced as a response to a major liquidity crisis that has been ongoing since two hedge funds imploded in August. Bear remarked that

Bear Stearns has been the subject of a multitude of market rumors regarding our liquidity. We have tried to confront and dispel these rumors and parse fact from fiction. Nevertheless, amidst this market chatter, our liquidity position in the last 24 hours had significantly deteriorated.

Furthermore, they announced that they are in talks with JPM regarding "permanent financing or other alternatives."

This unusual financing structure will see that:

Through its Discount Window, the Fed will provide non-recourse, back-to-back financing to JPMorgan Chase

Read both statements here.

This essentially turns JP Morgan into conduit. The collateral for the loans will come from Bear Stearns. Should Bear default and the collateral fail to satisfy the outstanding loan to JP Morgan the Fed will take the loss. The loan is "non-recourse" which means that the Fed cannot pursue assets of JP Morgan to satisfy the debt.

This unusual step has been taken because, as an investment bank Bear Stearns is not eligible to borrow from the Fed, whereas JP Morgan, a commercial bank, is a member of the Federal Reserve System and does have that right.

The problem is transforming from one of liquidity to one of solvency. Investment banks tend to have extremely high leverage, much higher than that of commercial banks, because I-Banks rarely hold investment assets for long periods. They underwrite and need keep assets on the books only until they have sold them to clients or other syndicate members. Commercial and retail banks, by comparison, tend to hold loan portfolios as investments and so use more "modest" 9:1 leverage (I-Banks are often 25:1).

Obviously, with such high leverage rates even small declines in asset prices can wipe out equity on thinly capitalized balance sheets. Merging Bear out of existence would reduce the leverage of the portfolio, by combining it with the much healthier balance sheet of JPM.

Temporary revolving credit such as the Fed is extending can solve liquidity problems, but it cannot solve a solvency crisis. Nor can it resolve the bigger problem for stand alone I-Banks that they need to be able to sell their paper to someone, at a premium, not simply trade it for cash.

Thursday, March 13, 2008

Economists agree: US is in a Recession

The Wall Street Journal is reporting that several prominent economists now agree that the US is in recession. In a recent survey the vote was 70% / 30% that the US has entered a recession. The turning point was apparently the payrolls decline from last week.

This is an interview with the WSJ's Phil Izzo, who wrote the story.

So far as I know, there is still no official word from the National Bureau of Economic Research, the "official" declarer of recessions.

A recession and job loss and a major increase in unemployment is certain to put further strain on the housing market in the US. All of the bricks are now falling into place for the worst economic catastrophe since the 1930s.

As usual, the Federal Reserve is largely to blame. It helped to bring about both the real estate booms of the 1920s and 2000s and the subsequent crashes.

As an investor, I continue to keep money in cash, because major economic downturns tend to produce deflation and not inflation (though inflatinary recessions are possible as the 1970s have taught us) and invest only in securities with firms who will do well regardless of economic cycles and monetary expansion or contraction (think consumer staples).

I believe that the housing market will be indicative of the investing climate going forward, liquidity will pay dividends - bargains will be available for investors who can "write the check". But there is no need to be hasty - scavenging cheap assets in 1932 was lots of fun, and profitable, if you had any money. We'll be saying the same things in 2025 about the investing opportunities of 2009-2011.

Wednesday, March 12, 2008

Eliot Spitzer's Demise: Some good news in Mortgage Insurance

There was some reason to rejoice on Wall Street and in the bond insurance business as well. First, AMBAC was able to raise an additional $1.5bn last week and together with MBIA, they have now recapitalized to the tune of $4bn. This is a drop in the bucket compared with the face value of the outstanding guarantees, but the companies need only pay the defaulted interest until the bonds principal is due. Since the principal on many of these mortgages will not even begin to come due for years yet (or will only come due in small amounts even then) it buys time to avoid default and to use premiums earned to offset default losses over time.

Better news, yet, however is the fact that Eliot Spitzer has resigned as NY Governor. Spitzer has been no friend to investors or the markets over the years, regularly using his position as the Attorney General of NY State to threaten firms with indictment (a corporate death sentence, just ask Arther Anderson) if they failed to meet his demands. See Spitzer's hit list.

It is pretty amazing just how unpopular this guy managed to be. He was elected in a major landslide promising an end to sleazy NY politics (which is exceeded only by that of neighboring New Jersey - my home state - and Massachucetts, 'nuff ced). A guy who uses the "wife of Caesar" standard (that one must be above reproach) this was indefensible behavior. It's even more amazing to consider the fact that Spitzer was ensnared by the very tactics that he, as prosecutor, had used.

But the good news is, it also means that he cannot pursue his crazy plan to restructure the bond market by separating the mortgage bond insurance business from the muni bond insurance business. Such a separation, while it might have preserved slightly lower rates for municipal bond issuers (like the State of NY, ahem) would have ensured default on the mortgage bond business. The best hope for preserving insurance and normal operations in both markets it to continue to allow the insurers to use the premiums earned on muni bonds (which are quite unlikely to default) to offset losses on the mortgage bonds (that are already in default and getting worse).

Tuesday, March 11, 2008

Sub-Prime Humor

Well, it's not exactly true - many of these mortgages were made to less dodgy buyers than they suggest in this clip, but the basic response of the markets is the same.

The bailout is coming because there are simply too many people who are going to suffer large losses. The sad thing is, the people who didn't get caught up in the frenzy will wind up paying the taxes to those who did.

And that is no joke.

Friday, March 07, 2008

Can you feel the recession coming on?

Together with a dismal housing report came further news that the Federal Reserve's study of household wealth saw American households becoming poorer in the final quarter of 2007, for the first time since the 2002 bear market.

Now, household wealth recovered from that first bear market, in part because of strong gains in housing and then a recovery of stock prices from post-bubble lows. But this report shows that American households are suffering from declines in both stocks and real estate.

Further declines in real estate are a certainty. I have recently read an article which studied the impact of a decline in real estate values on foreclosure rates It noted that the declines in real estate in the most hard hit markets of the 1988-1991 downturn took years to recover. In fact, foreclosures did not return to pre-crash levels until 1995 or so, nearly 10 years after the boom ended. This bust will likely be no different. If it is, it will be in the magnitude of the decline and potentially the length of it.

I also expect equity prices to stagnate and even fall, especially if inflation expectations continue to be raised. This is because of the impact that inflation has in the perceived earning power of assets. Basically, a higher inflation rate reduces the present value of an investment by reducing the present value of the first cash flows. This is true even when higher inflation leads to higher nominal earnings growth. I will save a more detailed explanation for another post.

The result of the twin fall is a negative wealth effect. Falling value of leveraged assets will lead to a desire to deleverage or to sell. The first will lead to less borrowing and less activity. At a minimum the opportunity to use home equity to consume or "reinvest" in the property itself (remodelling, new furniture, etc). The consumer-led recession, which everyone had been looking for between 2002-2004 will finally be upon us. When that happens, unemployment will begin rising which will then make it all the more difficult to meet high payments.

The same report showed that real estate in America is the most highly leveraged it has been since the end of WWII. (It is not clear if it was higher in 1945 or if there was simply no data).

This is definately a buyers market, but if you are looking to purchase cash flow real estate, prices may yet have to fall in many areas to ensure that an investor can maintain positive cash flow and charge reasonable rents.

Stop waiting for the Housing Recovery

I wrote a post not long ago that housing prices have to overshoot to the downside before the fall in prices can stop. Today, Reuters caught on.

Quoting Mark Zandi of, Reuters said:
Home buyers are not going to catch that falling knife and that's going to weigh very heavily on the housing market through this year and next.
Homebuyers have no incentive to purchase a home right now, as by waiting another month or six or 12, they can often find a comparable home (indeed, perhaps the same home) at a lower price, so why rush? But it is not only that: buyers have a huge disincentive to purchase - a leveraged asset whose price is falling will quickly wipe out any equity invested, unless one can purchase for cash.

The only way buyers can be enticed back into the market when buying represents a real advantage to renting. Thus, prices must overshoot below intrinsic value to the point where it becomes a "no brainer" to purchase, irrespective of the potential loss of equity.

This occurs when:

1. The (after tax) carrying costs of the real estate are lower than rents, or
2. Rental availability in specific segments (e.g. 4 bedroom residences) is too thin
3. The emotional value of owning a home becomes overwhelming

This process will take a long time because the costs of owning became extremely high. I admit that if my personal circumstances were different, though, I would be out shopping for foreclosures, REOs and desparate sellers, though looking for rental property and not a home.

Wednesday, March 05, 2008

Take Our Poll !

I'm introducing a new feature here: The Strategic Investor poll.

Our first question asks - who among the notable people on the right is THE strategic investor sought by Berkshire Hathaway to succeed Warren E. Buffett as portfolio manager?

They are all young (under 60), successful, investors in their own right, and rich.

A brief review of the candidates:

Stanley Druckenmiller
is the former partner of George Soros at the Quantum Fund

Abigail Johnson
is the scion of Edward Johnson, founder of Fidelity. She runs the empire now, so she has experience taking over existing shops and improving them and Berkshire would give her a chance to get out from her father's shadow (though she is a successful investor in her own right).

Eddie Lampert
is considered by many to be the Warren Buffett of his own generation. Interned with Robert Rubin at Goldman Sachs, founded his own fund at 28. Made fortune with AutoZone and AutoNation, then made big play for bonds of bankrupt Kmart. Later merged with Sears. Knows how to hire and manage managers

Bill Miller
is the manager of the Legg Mason Value Trust and a legendary value investor. He is one of the few actively managed funds to regularly outperform the S&P 500, having done so for 15 consecutive years before being edged in 2006.

Tony Nicely
is the CEO of Geico and regularly featured by Buffett for his management of the company. Nicely has on more than one occasion been known to have higher investment returns than his boss.

Kenneth Fisher
is the son of legendary Philip Fisher and has built an asset management empire of his own. He is the longest-running columnist in the history of Forbes magazine. His quarterly stock market reports are notoriously bullish but always interesting.

J Christopher Flowers is a former M&A star from Goldman Sachs. Specializes in buying and reorganizing banks and financial institutions.

Warren Buffett’s Letter To Shareholders Berkshire Hathaway Annual Report,

One of the financial world’s most anticipated events is the Berkshire Hathaway Annual Report full of commentary from Warren Buffett, Chairman of the Board and the world’s most famous investor.

What I liked about this report –

There were many things to like about this years’ letter from the Oracle of Omaha. He turned his attention once again to a few basic themes of great importance to investors, particularly those interested in investment strategy. First and foremost, his letter included a review of the four conditions for which he and Charlie Munger look when making an investment. Knowing what to look for is the most important and most difficult discipline in investing, and in my opinion is the factor that separates successful investors from unsuccessful ones. Added to that, he provided an example of a great investment (and subtly contrasted it with the sorts of investments offered by CNBC). He also covered a few of his errors and went on to talk about important issues of accounting and how they affect financial statements. This year, having finally won expensing of stock options, he chose to focus on an even more important topic – pension accounting. Here’s to hoping that he treats deferred tax assets and liabilities next year.

I present seven key insights for investors that I gleaned from Buffett’s letter, together with my own thoughts on each one.

Key insight #1: Control affects investment returns. While he has done well in purchasing publicly traded stocks, Buffett’s outsized returns more often came from businesses over which he acquired control.

I have often argued that Buffett’s single greatest investment was his purchase of 15% of the Washington Post in 1973 for the bargain price of US$11mn. Today this investment is worth $1.6bn and generates more dividend income every year than his initial investment. No wonder it was among the first listed stocks to attain the status as a “permanent” holding of BH. In spite of this investment, Buffett's returns on the publicly traded investment portfolio have not significantly outpaced the market. In fact, were it not for WaPo, he might be about average, at least in recent years. The investments that have really driven BH stock are the operating businesses.

See’s Candies is a successful chain of chocolate shops primarily doing business in the Western US. Buffett was able to purchase this business for $25mn in 1972. At the time the business was generating $30mn in revenue, and earning $5mn on book of $8mn, for an RoE of 62.5%. Buffett actually managed to acquire this business for 5x earnings (the See’s family was looking for 6x). If you find something like this, please tell me.

Over time, the capital of See’s has had to grow as new stores were added and new capital expenditures were made. Nevertheless, 40 years later, the company still has book value of only $40mn, meaning that (after depreciation) the company has only required a subsequent investment of $32mn in capital. In return, it has produced $1.35bn in free cash for BH to go on and make acquisitions.

See's has been able to take this slow, but highly profitable growth track (growing volume about 2% per year) because Buffett has controlled the asset. A public company would have been under far more pressure to generate faster return growth and to expand into many markets and/or segments, or risk being acquired and becoming a boutique of Hershey or Cadbury Schwepps. Buffett's control over the capital expenditure has ensured steady growth with very small but incremental market share gains.

Of course, having control has also meant that Buffett has had to make those decisions himself. He is a very good manager (which explains much of his outsized peformance -not his security selection).

Key Insight #2: Growth is gravy. Great investments are those that require little if any additional capital investment (i.e. are those from which all future CapEx can be financed out of cash flows from the asset).

Buffett’s point is this – Great investments are almost always those where the cash flows cannot be reinvested at similarly high internal rates of return. That is not to say that it isn’t desirable to do so, but rather that a truly great investment, like See’s, generates so much cash it would simply be impossible to reinvest it all in the business. There aren’t enough good opportunities.

In contrast, there are a great many “solid” investments that can grow earnings every year, often by double digits. But in order to do so, many require huge capital expenditure and working capital increases to support the higher volume. This often leads to lower returns on capital employed: the law of diminishing returns require more and more capital to be invested in order to get progressively less and less out of the system. Worse yet are those investments that require so much cash that the actual cash from operations are insufficient to support the required CapEx. These businesses promise that in the future CapEx will decline with growth and the firm will turn cash flow positive, but an investor always has to worry about a cash flow chart that starts out deep in the hole.

Future cash flows are notoriously dangerous to predict, particularly in fast growing businesses. Worse, because the company may have earnings (or not) but is experiencing rapid top line growth, the market seems to think that the stock should trade at a significant premium, reflecting the present value of the massive and hoped for cash flows. It is much more likely that the hoped for flows will not materialize and that expectations will not be met. Buffett eschews such businesses almost entirely (he is working with one manager to build a new insurance business and has paid up for anticipated future earnings, but this is a rarity).

Even if there isn’t huge investment in long-term assets, often working capital requirements eat a business alive. As revenue increases, inventory and receivables increase proportionally. If a firm sustains its high share price by maintaining high revenue growth, often working capital increases even faster than sales, because sales are often extended to customers with shaky credit or ability to pay in order to book the sale.

Key insight #3: Know what you are looking for

So what does Buffett look for? Four things –

  1. Management – honest and shareholder friendly
  2. Simple and understandable business
  3. Reliably profitable, with a solid moat to protect it and ensure earnings in good times and bad
  4. A good price

Because Buffett knows what he is looking for, he can rapidly eliminate from among his investment possibilities those investments that don’t meet his criteria. Think about it, there are some 8000 publicly listed stocks in America and orders of magnitude more closely held businesses. If we expand our universe to global firms we multiply orders of magnitude again, and if we move beyond businesses to also include bonds, commodities, currencies, real estate and other products, not to mention the derivative investments from these, the investment universe becomes impossible to cover effectively.

One must have a system by which one can eliminate the vast majority of uninteresting investments in order to devote time to those that offer the most promise. I had the opportunity to meet a successful technology entrepreneur during my MBA. He had developed a framework which he titled the “Technology Bridge”. The purpose of the bridge was to eliminate technologies weak, for his purpose, commercializing them. Using such as system meant picking the things that would disqualify the most technologies the fastest. Surprisingly, the first thing on the list wasn’t the technology – it was ownership.

Incidentally, there is no “right” formula here. Just because Buffett avoids tech doesn’t mean someone else should. This is part of developing one’s unique investing strategy (which, Professor Porter would remind us involves UNIQUE activities, since advantage comes from doing something different than others).

Key Insight #4 – People are the key

Buffett’s success as a CEO is driven by the fact that he hires great CEOs. Since BH is really a holding company it is vital that the people who control the physical assets, the businesses, treat those assets in a way consistent with shareholder value. The tendency of management to use corporate assets in ways that are more in line with their own interests than those of shareholders (corporate jets, one-way stock options, etc) is known as the “agency problem” and is difficult to control. Buffett’s solution is to simply hire great managers.

Buffett achieves his objective primarily by offering a unique place for owners of businesses to park their business when it is time to diversify. He offers the potential to sell the business but retain control of operations and remain invested in the business (retain a minority stake).

Small investors can follow Buffett’s principles, either by purchasing investments where it is possible to obtain control (real estate, a franchise, small business) or in making retail investments, look first at management and its behaviour.

Key Insight #5 – “Forever” is not Buffett’s only holding period

Buffett has often stated that his (and Charlie Munger’s) favourite holding period for an investment is “forever”. Usually this is linked to his discussion of the “permanent” holdings of BH, such as the Washington Post and Coca-Cola. This is usually taken to mean that the ideal holding period for any security, once purchased, is as long as possible. Based on Buffett’s own actions and comments from both himself and Munger, however, I think we can conclude that “forever” is a holding period that is only appropriate for certain investments.

This statement has been regularly borrowed by the asset management industry as a justification for a buy and hold strategy for investing in securities. Ironically, many of the securities being sold with this justification are actively managed mutual funds with high turnover rates – thus the “buy and hold” investor is actually exposed to rapid portfolio churn. Less ironic and more sobering is the realization that asset managers have a real incentive to advocate such a strategy, since their own compensation is driven by assets-under-management (AuM). Convincing investors to park their money results in an annuity income stream with rising payments over time (as the asset base is increased through regular contributions and, hopefully, investment gains). Such annuity streams of income command high multiples in the event of a sale of the asset management business. (Gains which, it can be assumed, fall disproportionately into the pockets of the managers and only incidentally into the pockets of the investors).

Buffett has done little to clarify or disabuse the public of this understanding. He regularly rails against efforts at active management – noting, rightly, that in the aggregate investors in common stocks cannot beat the market, but they can lag it due to fees, from which we deduce that Buffett favors a “forever” holding strategy in passive index funds.

This year, Buffett discussed the decision of BH to sell a large position in PetroChina. He described his estimate of fair value during the purchase in 2002-2003 and noted that BH has had a huge gain, as intrinsic value has increased along with energy prices and the market has simultaneously increased its understanding of that value. Thus his financial returns have outpaced growth in intrinsic value and he has decided to sell. But how does this square with a “forever” holding period?

One possibility is that he expects energy prices to moderate and for intrinsic value to actually decline in the future. Another is that he does not trust management to continue to generate outsized growth in intrinsic value. But if these are reasons to sell PetroChina, aren’t they actually good reasons to sell other investments as well? Munger echoes this in an earlier post of mine. Investment opportunities are relative. It is true that there is a transaction cost and so there should be a bias toward holding, but if that cost can reasonably be overcome because of more attractive investments or increased risk related to the asset itself, this is still a good idea.

So what should we make of the “forever” as favourite holding period? I take it more attitudinally. There is simply nothing better than an investment that can be held permanently that more or less permanently generates high returns on capital employed, requires little or no additional capital investment and generates massive free cash flow (e.g See’s). Naturally, we would all like to have such investments and then our holding period would be forever. But there is no reason to assume that forever represents a superior investment strategy, in and of itself. Sometimes, selling makes sense.

I equate it to eating dinner. My favourite dinner is steak (filet mignon, rare, please). Given a choice to have anything I want, that is what I would choose. But that doesn’t mean that it is all I have for dinner. Circumstances (like the need for a balanced diet) mean that my “favourite” is not necessarily the best option in all cases.

Key Insight #6 – Long term assets often predict the future

In accounting parlance, an asset is a future benefit (and liabilities future obligations). Therefore, long term assets and liabilities more than current ones, can indicate the future condition of the company. As a good example, we can cite GM, which was forced to write down some $38bn of deferred tax assets. These were estimated cash value of the tax loss carry-forwards that the company could use to offset tax payments on future earnings. By writing them off, GM essentially said that, based on the estimates of management, the company would not generate enough profit to actually take advantage of the carry forwards. Management ought to know, since they are the ones with the 10 and 15 year product, revenue and profit plans. The carry forwards aren’t gone - if the company makes a miraculous recovery, it can still use them, but management does not expect to be able to use them before they expire (over the next 20 years).

Buffett chose my other favourite long-term asset and a friend of any management that wants to manipulate earnings: their pension accounts. I will not go into pension accounting mechanics here (its another post unto itself). But suffice it to say that this line item can be very large and is almost entirely up to management’s opinion about the future. If the estimates seem too rosy, they probably are and the company’s obligations are larger than anticipated. The increase in liability which is sure to be booked in the future will be a major drag on future earnings.

Key Insight #7 – Read the footnotes

This is the crappy part of stock investing. The footnotes to the financial statements are often tortuous, repetitive and almost always boring. But without them an investor cannot really understand the financial statements. The key ones that I always read first, because they help me discard possible investments are the statement of significant accounting principles, equity compensation (stock options), pension rules (estimated rates of return) and goodwill and other impairments (which business units and why).

If these haven’t ruled out the investment then it is then time to read the statements, risk assessment and review of operations and all of the footnotes taken together.