Some investing wisdom

I haven't had much time to write lately, so I figured I would share some investing wisdom I have come across recently.


Matt Schifrin over at Forbes has written a great synopsis of the investing habits of some extraordianrily successful individual investors.

Jason Trennart raises and interesting argument that successful investing may require less of the technical tools taught in busineses schools and more of the social sciences contextual approach to problems, with the ability to synthesize data of various (and often qualitative) sorts.  Personally,  I believe this is true.  As an historian (undergrad) with an MBA, I can say that while financial skills are important (value is a financial concept), evaluating the risks around the estimate of value often require imprecise contextual thinking.  This is most true in evaluating the managers who hold investors assets in their hands.

Aelph suggests that buy and hold investing is neither dead nor a bad idea.  Admittedly, returns on equity do fall for most businesses over time as it gets harder to redeploy cash generated by the business in initiatives with the ROI of previous investments, but this is an argument for dividends, not an argument against buy and hold.

And a two-for-one: Aelph also has eight rules of investing.  I generally agree with them, though I think he puts too much emphasis on relative valuation, which is a strategy for long-only mutual funds and investment "professionals" who cannot afford to appear to be too passive (especially if the market is rising).  Personally, I believe a real advantage of the individual investor is the luxury of looking at absolute valuation, and mitigating risk by NOT INVESTING when there aren't attractive risk/return opportunities (e.g. US equities in 1999 and 2000).

Finally, I have to give Aelph huge credit for the diligence with which he posts.  I aspire to have that much to contribute.

Good Advice

If I have a weakness, it is procrastination.

This is in part because I am something of a perfectionist - I like to believe that I can produce the Platonic Form of whatever it is I am doing.  This has cost me in the past, in investing, and in other things.

This article from CNBC talks about habits of economically successful people.  I strive every day to be more like this, though I find the going hard.

Of course, deciding NOT to do something, for the right reasons, is also a good thing.

Warren Buffett's Letter

Warren Buffett had his worst year ever in 2008. This is not surprising, since it was the worst year for the stock market in Buffett's investing life. Personally, I found the letter thinner on content than usual. There were not pithy observations on accounting rules, nor a simple explanation of the credit markets nor the currency markets. Even his discussion of Berkshire's businesses seemed a bid weak. Only in his explanation of his derivates book did his explanation of his thinking on how to price assets really shine. Nevertheless, I take four points from his letter.

1. Even investing geniuses are still human. Buffett acknowledges many mistakes this year, some are sins of commission and some of omission. As James B. Stewart of Smart Money observes, even Buffett can get caught up in the euphoria. I also made two sins of omission in 2008: not selling Bank of America stock when they acquired Merrill Lynch and not selling Bassett furniture immediately when it became clear that my outlook for the economy (that it would be dismal and that consumer durables would be particularly hard hit) was correct.

In the first case, I liked the strength of the commercial and retail banking franchise of BoA, and assumed that they had an idea of how to integrate Merrill Lynch retail broking and wealth management into their branches, which would be both cost saving and revenue raising at the same time. They may yet execute such a plan, but I suspect that the real hope was to vertically integrate along the asset backed security value chain: originating mortgages, bundling and selling Mortgage Backed Securities (MBS) all in house. That this will be difficult, if not impossible in the short term, is obvious, to say nothing of the credit quality of the combined balance sheet.

In the second case, I was simply blinded by my own assessment that BSET trades for far less than the value of its assets. Indeed, at this point, BSET may be more valuable dead than alive. The real problem was a conditional liability that I missed in the financial statements. Bassett has largely guaranteed their franchisees' leases, and this is a very large number. If, as the market clearly believes likely, many franchisees default, Bassett will be left to find a new tenant, or take over (loss-making) operations directly. Since retail storefronts are now a dime-a-dozen, the probability is quite high, that the company will be left holding the bag for a large amount of non-performing real estate. Ouch. Still, the new store format to which they are migrating does indeed seem to be helping sales, and with a strengthening dollar, the imported furniture that they sell may enable them to maintain margins and supported by cash flows from their investment portfolio, they may get through the next 24 months and recover. One can only hope.

So, sins of omission, but perhaps I shouldn't take it too hard.

2. Buy and hold of passive investments doesn't really work, even for great investors. Buffett has suffered huge declines on his public investments, including American Express, Coca-Cola, Burlington Northern and others. Many are treasured firms whose stock he has owned for years. It begs the question: if the best investor of all time cannot make money "buying and holding" then what should the rest of us do?

In my own portfolio, I have one "permanent" holding, and it is Colgate-Palmolive. This is a stock whose forward dividend yield is now at almost 3%, which continues to raise its dividend by 10% or more per year, which continues to repurchase stock in huge quantities and whose investor-friendly activities are backstopped by rising earnings that I project to be over $4.20 per share in 2009 (providing a dividend coverage ratio of 2.38). Plus, the stock is in a recession-proof business and has avoided making big acquistions. In short, it is the perfect investment.

But I have also watched the value of that investment decline from $80 a share to $56 (I purchased in the low $40s, so I have still had decent returns). Admittedly, at $80 a share in early 2008, it was a bit pricey at 20x forward earnings. Plus, it trades at 10x book (but earns about 90% on book). Why didn't I sell?

The truth is, Buffett has a good reason to have "permanent" holdings. In most cases, his ownership stake is so large and his portfolio so carefully monitored that he would have difficulty disposing of his positions. If Buffett is selling, after all, how exceptional can the value be? Retail investors, myself included, lack this rationale. Even if we hold a few blocks, and few of us do, our transactions are unlike to affect the markets, unless the stocks involved are very thinly traded. So, I conclude that the focus on "permanent" holdings, indeed the very idea of "buy and hold" is mostly the result of a desire for reassurance. Psychologically, we want to believe that we are "right" and that means keeping that which we own.

At these prices though, I am looking to add to my CL holdings, not reduce them. I still believe this is a $100 stock in 24 months, unless equity valuations completely implode, which is possible, but then, it will simply mean that I will have a rising annuity with higher yields than most bonds and insurance products. Not too shabby. More on this in another post.

3. Management counts. The secret of Buffett's success has always been in his ability to recruit the right people. As a investor, he has sought in most cases to have them in situ. He does mention that he has developed a few of his best managers, though obviously they were already natural talents.

As a passive investor, I pay a huge amount of money to professional managers who run my businesses for me. How they do it is probably the single biggest determinant of success or failure. But here, I think point one still applies. Even great managers make mistakes. Ken Lewis is a natural deal-maker - it is how he built BoA into the powerhouse that it is. He made a mistake buying Merrill, and sadly, this was a mistake that was driven by ego.

Lewis always wanted to show the New York crowd that a hick from North Carolina was at least as good as they were. They always looked down on him for building a commercial and retail bank, since everyone in banking knows that the "big swinging dicks" of banking are all "investment" bankers. Acquiring Merrill was Lewis' way to do it. But Lewis' careful and steady build-up of a leading commercial/retail bank was stupendously profitable. Even the disaster with Countrywide was manageable given the strength of the cashflows from the retail network. It remains to be seen if a universal bank can truly be made to function - the economics and compensation may simply be too far apart. For the forseeable future, though, Lewis will be out of dealmaking and will instead have to focus on operations. Is he the right manager for that?

4. Panic and fear are my friends. In spite of my losses on a few securities, I managed to liquidate most of my holdings in April of 2007, when the Dow was at 12,500. I missed the October top, but I have not regretted sitting in cash, where my interest earned actually afforded my a mild gain in 2008. Now, I sit confidently and wait for values to keep coming my way, confident in the meantime that I can suffer no major permanent impairment to capital. Low interest rates now make solid dividend yielding stocks the ideal area to look, though this does expose one to at least temporary capital loss.

In January, I did reenter the market, buying HELE aggressively, only to suffer another loss. However, the stock trades at a clear discount to intrinsic value and I may very well purchase more soon. The problem is, there are even more attractive values now than there were in January.

So, while I believe that the economic bottom will be reached at the earliest sometime in 2010, I continue to watch for individual values, knowing that the market is likely to continue downward movement due to panic selling of index funds by retail investors. I look forward to having a chance to make some significant gains in the next few years.

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.

Why I'm Focused on Capital Preservation

Almost exactly one year ago, I wrote an article predicting that the CDOs on many banks balance sheets (and off of them in SIVs and other conduits) were about to implode and this was going to make for some very tough time for financial companies. Essentially, I argued that banks would find that their balance sheets were overleveraged and be forced to liquidate assets (in many cases at bargain prices) in order to meet

My suggestion at the time was to keep the powder dry, since values were bound to begin popping up, eventually and in extremely unstable markets capital preservation and liquidity were the keys to success. He who has ready cash to deploy when everyone else is running for the hills can purchase terrific assets on the cheap.

A few days ago, I read an article that basically said that my thesis (which is shared by many) is an example of the usual nattering nabobs of negativity predicting the end of the world. The article, entitled How Banks Work, by Nathan Lewis of New World Economics, basically argued that the relative strength or weakness of banks balance sheets is not the major source of financial crises; it is borrowers’ willingness and ability to borrow which matters. Moreover he selected as his example Japan 1989-2003, my favourite example of monetary deflation because it happened with a modern central bank and all of the government statistical analysis available now that was not available in 1929-1933. This had me thinking – do I have it all wrong? Is the market far more resilient than I believe (in which case, I need to rethink my tactics)?

Let’s take a more in depth look at his claims. First, the issue that banks do not stop lending because they lack lending facilities (that is, banks don’t run out of money to lend). He states:

Typically, when banks have capital impairment (losses), there is much hue and cry that lending will shrink as a result, leading to recession. This is based on a very simple multiplication: banks typically have about 10:1 leverage. Their assets (mostly loans) are typically about 10x their capital base. So, this simple line of thinking goes, if capital shrinks by 20%, then loans must also shrink by 20% to keep the ratio in line. And indeed, the BIS capital ratio requirements mandate that large banks not get too far out of line regarding these ratios.

This was essentially my argument. But he counters:

But banks don't really work like that. This is a subset of a broader group of theories, that an economy can be managed by a sort of mechanical top-down monetarist approach. … They are all based on the idea that there is some amount of "money" (or capital), and everyone jumps up and down like puppets depending on this one quantity variable. Thus, if banks have capital, then they create loans according to some sort of inevitable mechanical multiplication function, and if they don't have capital then loans shrink by the same inevitable mechanical multiplication function.

The fact of the matter is that banks have indeed been forced to reduce their balance sheets. In fact, what we discovered in this process was that banks’ balance sheets were far weaker than we had been led to believe due to large off-balance sheet obligations. That the FASB and the SEC continue to allow this is amazing. Banks have been struggling to find means of raising liquidity so that they can continue to meet obligations and make new loans. They are struggling because other banks no longer trust the value of their collateral. So, bank balance sheet weakness does indeed lead to financial instability. It leads to higher rates and tighter credit conditions, under which borrowers may no longer find it attractive to borrow.

He goes on to argue that banks have a variety of ways to raise capital, which means that they will always have adequate funding for attractive investment opportunities. He says:

[W]hat if there were lots of wonderful loan opportunities, but banks today are unable to take advantage of them because of impaired capital? Well, they could then raise some more capital, which is exactly what they are doing. "We need capital to take advantage of this wonderful situation. If you buy an equity stake in our bank, we are sure you will enjoy a wonderful return on equity." … This is also an argument behind the sovereign wealth funds' recent investments in big US banks. "Well, they're having a hard time now, but they have fantastic franchises and have proven to be very profitable in the past. We'll bet on a winning horse, and when the situation turns around and there are more lending opportunities, the bank will make good money again."

This is true, so far as it goes. I for one believe that many large banks will probably be on sale (though smaller banks that rely more heavily on specific kinds of lending will continue to suffer). But the idea that there is plenty of capital outside of the US is belied by the fact that so many global banks are suffering in this crisis. Capital is being wiped out all over the world. (IKB a small German bank that focuses on real estate lending in Germany – IKB stands for Immobilien Kredit Bank, German for Real Estate Credit Bank) has become insolvent due to its exposure.

Of course, capital can always be raised on some terms. The question is, are those terms attractive? Thus when he concludes

[L]ending is not driven by capital, rather capital is driven by opportunities in the lending business

He elides over the fact that “attractive” opportunities are partially defined by the terms upon which one can obtain financing. A project that returns 15% might be attractive, but surely it is not if financing cannot be had for less than 20%.

The point he wants to make is that it is the absence of attractive opportunities that lead to a collapse of borrowing. Without borrowing banks lose out on two major income streams: interest margins and origination fees. He details how this happened in Japan. A collapse in asset prices led to a lack of interest in borrowing and indeed to a general monetary deflation in which aggregate demand failed to match the existing supply capacity in the economy.

Since monetary deflation makes borrowed money extremely expensive and since capacity was already sufficient to meet demand, there was no incentive to borrow. (Actually, operating cash flow is the normal source of investment income under monetary deflation, which is on reason why IT firms tend to hoard cash and not borrow. This is the world they face every day). Even interest rates near zero were insufficient. But this BEGS the question he doesn’t ask: how are banks approaching lending opportunities today?

The answer is not reassuring.

Banks are calling in and reducing all sorts of outstanding financing arrangements, particularly if those arrangements are linked to real estate. There are several examples. This means that many borrowers who have been using home equity as a crutch to maintain spending levels and lifestyle will find fewer options to do so. This suggests that aggregate demand will drop and as that happens, many firms will find that investing is simply unnecessary. Instead the focus will actually be on reducing financial and operating leverage so that supply can be matched to demand. Doing so takes time, so in the short run output is likely to exceed demand and prices will have to fall to clear the market. Monetary deflation is likely to result. Yes, I know that central banks and governments are falling all over themselves to create inflation, but I return to the BoJ and its experience in Japan. Low rates do not guarantee attractive terms.

Why will banks do this? Contrary to Mr Lewis’ thesis, banks do not like to float new capital, even if they can. They much prefer increasing the balance sheet through retained earnings. Having to tap the general markets or strategic investors like sovereign wealth funds, is expensive. Those investors are in a position to demand high returns on their capital. It is the benefit of having capital to offer when no one else does. Beggars cannot be choosers.

This is why my approach has been, and continues to be, to keep cash on hand and scour the markets for attractive opportunities. They need not be stocks. I am myself looking at a few possibilities in common stocks (more on this in anther post). Because of some decisions that I made in 2006, I am not looking at real estate right now, but I will be before long. I see this market as a real buying opportunity – but only for selective purchases.

Mr Lewis is making an argument against a massive federal bank bailout. I support his thesis: banks and investors cannot go to the casino and then only keep the winning bets. They pocketed the fees and got the dividends and the buybacks. Why should taxpayers share the burden (unless the financial system becomes so ossified that the payment system breaks down. This is not impossible. In such a case, taxpayers should be glad to pay the price to prevent the complete implosion of credit markets). But he supposes that the markets and the pundits are being too pessimistic (and that the banks, looking for the losing bet insurance, are the source). Credit markets are indeed becoming much tighter, however, and this means that it is wrong to assume that investors aren’t being rational in their perception of heightened risk.

This credit cycle is going to produce a great deal of pain. No one knows exactly how it will turn out. We have never had so many alternative financial products with various risk profiles as we have today. The models aren’t working, so irrationality is coming to the fore. I continue to maintain large cash balances – and believe me it is no fun earning peanuts on those balances. But I am willing to be patient and selective and purchase from Mr Market those assets about which he is unnecessarily pessimistic.

Lowest existing home sales in years

Yahoo! Finance is reporting that existing home sales have fallen to a nine year low. This means that sales have returned to the level of 1999. Seasonally adjusted sales remained below 5 million for the first time this decade. You can get the data from the National Association of realtors as a PDF here and as an MS Excel sheet here. One way to look at this is that, after now reaching multi-year lows, housing must be do to reach a bottom soon. The other view is to view 1999 as a pretty good year in the housing market (it was) and to argue that even with the long fall, housing has only just returned to long-term trend sales figures. This view holds that while we may have returned to “normal” conditions, we have not yet begun to work off the excesses of the boom. Thus, housing is likely to continue to head lower and underperform other assets, likely for years with yet lower prices required to clear the market.

Naturally, the irrepressible Lawrence Yun and the National Association of Realtors take the first (more optimistic) view. They have chosen to spin the numbers and call yet another bottom to the housing market. They do this by simultaneously focusing on the (un-annualized) month over month decline, which is less than ½ of 1 percent and simultaneously talking up phantom demand that is simply waiting for a “catalyst” – in this case the increase in the ceiling of conforming mortgages, which will enable homeowners with mortgages larger that $417.000 to obtain a mortgage backed by Fannie Mae or Freddic Mac.


In fact, if anything this report confirms that housing will continue to decline for the foreseeable future. The 0.4% decline over December represents a pretty steep decline year over year. And, in the datasheets provided, it becomes clear that housing is now much slower than last January: the year-over-year comparison (the only one which matters) shows a 23% decline in the number of homes sold and a 4.6% decline in median home prices (with a smaller decline in average home prices).

What the data say in clear terms is that even significant price discounts (a 5% fall is huge: final prices exclude other incentives like closing costs paid by the seller or upgrades to kitchens, bathrooms and the like) buyers are simply unwilling to do deals. Inventory remains extremely high. After dropping over the holidays, units on the market have increased and inventory again surged above 10 months supply. More houses are likely to come on the market in the next few months as the foreclosures mount. More inventory and more sales by banks rather than homeowners, suggest that prices will continue to fall and sales will continue to decline.

Buyers will naturally be reluctant to purchase for the same reason that they were so desperate to purchase during the boom: the effect of leverage. If one is able to put down 10% on a home and experience 5% appreciation per year, the leverage provides the buyer with a 50% gain. During the boom, prices regularly increased by 11-15% per year providing an annual gain of 100% or more. With even an even lower or no down payment returns became magnified to even greater extent.

But let us return to that same buyer today. A buyer who can qualify for a conforming mortgage, and who has 20% down is staring at a first year loss of 25%. If the trend continues for two years that same buyer is out 9.75% of the purchase price and has succeeded in wiping out nearly half his capital. Better to keep renting and hold onto the principal. A buyer with 10% or less to put down would have his entire equity wiped out in the first year. The NAR is hoping that buyers who already own homes and who are looking to trade up to a substantial home, $500k or more, will return to the market and generate more sales at the high end. If this were to happen the owner would likely list his current home, which means that no inventory would be removed. The problem remains without first time homebuyers there is no one to clear the inventory and right now there are no first time buyers.

Going inside of the numbers

Let’s move beyond theory and see what the numbers suggest.

This chart (created by the Center for Economic Policy Research using data from the US Census Bureau) shows the vacancy rate for home (both rentals and owned homes) is a clear indication of the source and magnitude of the current problem: there are too many residences and not enough families to occupy them. With a sharp reduction of interest rates in 2001-2003, rental vacancies soared.


The vacancy rate, which had remained fairly stable between 7.5 and 8% decade, leaped to 11% in two years. The decline was both so strong and so sudden that rents actually declined (lower rents suggested deflation in the CPI calculation, which reinforced the argument to keep rates low!). At the same time, home vacancies remained quite stable, virtually a flat line. With many renters shifting to being homeowners, we might expect home vacancies to be falling. That this did not happen shows how rapidly new home construction was running. By 2004, the rush was on to condo convert every apartment building in America. This finally brought rental vacancies down (by eliminating rental stock from the market - not by finding new renters) and the rise in vacant homes began. Many of these units were purchased in anticipation of future price increases and, as we can now see, nearly 3% of owned homes are vacant. But selling or renting these homes will not fix the basic problem: the surplus of residences. We may see arbitrage back and forth between rental units and owned units (condo conversions or rental of purchased condos). It doesn't matter because vacancy rates in both rented and owned homes are much higher than in 2000. This problem will not be resolved until positive absorption can be restored. Even then, the process will take years.

So how low can housing go?

This is the big question. Let's see if we can get inside some of the numbers to make a sensible projection. Before we do, I want to point out that housing corrections are slow to unfold and resolve. The negative impact of leverge and the stress that the losses put on the banking system require years to resolve and sometimes decades. Japan has yet to recover from the property boom of the 1980s.

I take as a principle that housing sales is a mean reverting series with a bias toward a long term rise. Population and household creation in the US are growing, albeit slowly, which leads to a rise in the need for homes (and generally, though not necessarily, owned homes). If the series is mean reverting however, we should expect that a series that experiences a spike outside of the normal range to experience an offsetting dip. So, where is the market now? That depends on how far back you look.

There are two basic series of housing data. The first is existing home sales. (These are the numbers reported by the NAR above). Unfortunately, the NAR charges for data beyond 12 months. (If anyone has the data series going back a ways and is willing to share, please contact me). The second series is the New Home Sales, which is available from the US Census Bureau. I used the publicly available dataseries from Economagic. The publicly available information is excellent and there are some free chart generators (gif and pdf) There is also a premium subscription available which allows for more data series and more customization of the charts and a direct export of the data series to MS Excel for analysis.

Back to the data. If I were the realtors, I would want to use this chart. Yes, it paints an extremely grim picture of new home sales since the middle of 2006. However, the chart suggests that we have returned to the level of home construction prevalent before the housing bull market started around 1995. Furthermore, new home sales are well below the long germ trend presented here. Given the weakness of new home building in the early 1990s, it could be reasoned that we are now sopping up excess demand and are poised to make a comeback.


The problem with this chart is that the long-term trend is broken, but there is no comparable data series to use to estimate how far this knife is going to fall. Let's take a longer term view with a goal of establishing a) how long housing markets stay down and b) how much of a decline in sales activity we tend to experience and how much of a decline in prices we tend to experience. With that, let us see if we can figure out where we are in the housing cycle.

The data series are available back as far as 1964. If you import the data to Excel and run an Ordinary Least Squares (OLS) regression, you find that the best fit is a polynomial (i.e. not a linear) trendline. Excel proposes this graph:

I find this graph amazing because it shows two things. First, that the housing boom of the 1980s, which peaks in 1987, only represented a return to trend (the peak falls right on the trend line). The impact of the financing crisis that resulted from the aftermath the rapid surge in sales (an increase of about 62%) led to a 10 year period where sales failed to re-attain the volumes at the peak. The trendline also suggests that we have only just returned to the trend line. To put it another way, the decline from 2005 to late 2007 was only the return to long-term trend activity. As a mean-reverting series, it can be seen that we are only at the beginning of the backing and filling necessary to work off the excess.

In fact this peak seems to show more similarity to the 1970s boom, which was driven primarily by the massive growth in household expansion from the Baby Boomers. There has been some discussion of the potential for new sales from the “Echo Boom”, but as noted above, first time buyers have no incentive to enter the market.

One further point, this trend line is quite distorted because the data series is short. If we had more historical data, we would likely see a flatter and more linear curve. This would serve to reduce the amount that sales in the 1970s were “above trend” but would also INCREASE the amount that recent sales are above trend. It is possible that we have YET to return to trend, though I think we are probably close. That chart would look more like this:

So how long are we likely to wait?

I believe that sales are likely to continue to decline over the next 18-24 months. Prices will likewise continue to decline, but that by 2010-2011 we are likely to reach bottom. Most of the earlier peaks and troughs are 4-5 years apart. This would put the bottom somewhere in 2009-2010. This boom is larger than the previous ones, so the down-cycle could be longer. However, the data seem to suggest that the decline is likely to be much sharper. In other words, the fall will be much greater, but will occur over the same time period so the curve will be much steeper.

What can we expect on prices?

Here the news is even more sobering than on volumes. Home prices soared very, very far about the long-term trend. Ironically, one of the usual appeals of real estate investing is that price levels tend to increase at very consistent rates, about in line with wages (which are the big limiter on the amount people can borrow). Even the surge in prices of the 1980s is a comparable mild and look at how long prices remained below trend thereafter. After 1997, however prices began accelerating.

This chart suggests that prices must continue to decline, at least another 5% just to return to trend, but that prices are unlikely to begin rising again once the trend is reached. In fact, it is quite likely that prices will undershoot similarly to overshooting. If that were to happen, prices would have to fall 20-25% below trend and remain below trend until 2012-2013 at a minimum. From here, then, we should expect a 25%-30% decline from here. This means that unless you can get a deal, or have more than 25% to put down, or you can be quite sure that you will not need to move in the next 6-7 years, or you have the ability to ensure adequate cash flow (including a cushion should rents begin falling again) investing in real estate is a losing proposition.

If you already own, but have adequate cash flow and don’t mind just collecting rent checks, you don’t need to sell. If you need to sell, it might be better to do it now rather than risk braving the market 12-24 months from now.

I know many people think the market will come back soon. I still believe that the only true analog to this housing phenomenon is Japan from 1989-2004. After a similarly foolish bubble in asset prices, asset prices declined for 15 years. It probably won’t be that bad: regulators in Japan were painfully slow to force banks to clean up their balance sheets and most banks in the US seem to be moving with reasonable speed. But it is worth noting that every quarter involves yet another massive charge from UBS, Citi, JP Morgan and now Credit Suisse.

If you have cash and credit, you can start looking, but you MUST focus on cash flow. Capital appreciation will not happen for years. A 10-year IRR calculation should assume NEGATIVE capital gain. Thus, cash flow returns must be quite adequate. This is also necessary to ensure that you will not be forced to sell the property in the event of a decline in rental prices (which may happen if many other investors follow similar bottom-feeding strategies). Finally, consider if you have the resources to upgrade and remodel in the event that you find your neighborhood becomes competitive.

Book Review: The Intelligent Investor

Synopsis: This book is a true investment classic. It relates in simple, plain English the key concepts behind investing. Graham artfully distinguishes between investing and speculating (the presence of a “margin of safety” against loss) and explains the essence of “intrinsic value” and shares his famous depiction of “Mr Market”. While not a “reference” book or a textbook (for that, one needs to read his other seminal work, Security Analysis, written with David Dodd in 1934), it is a book to which one can return many times, as there are always new nuggets and perspective to consider. This book is simply a must read for anyone who intends to make money investing.

My take on Graham is that he believes that investing is about knowing what one is looking for: this, I think is the true sense of “businesslike investing”. Different investors, facing different circumstances with different strengths and weaknesses must think about how they want to approach the market. The key is to understand clearly what one is looking for and then seek to exploit the opportunities the market offers, when it offers them. This is very much like a firm must approach the market for its goods and services. The firm must be selective and targeted. So must the investor. Picking a good target is important, but then the investor must train his ability to see and to be patient if that which he seeks is not readily available. What many (un)intelligent investors choose to do is change their strategy to fit the market, making them slaves to Mr Market and his whims.

Full version: When Warren Buffett was 19 he read a book published by Columbia University professor and money-manager Benjamin Graham. Buffett was so impressed, he decided to attend business school at Columbia and subsequently to work for Professor Graham at his hedge fund, the Graham-Newman Company. Buffett, of course, was no ordinary student. In fact, Graham later remarked that Buffett was the best student he ever had. Certainly, he is the most successful. The book is titled “The Intelligent Investor” and it has recently been republished with commentary by Jason Zweig and an introduction by none other than Graham’s famous student.

Graham’s views of investing were heavily informed by his experience in the Great Depression. Graham had been a successful speculator in the late 1920’s boom, before losing his entire fortune. That experience was an eye-opener, though. He came to realize that his purchase decisions had been driven by entirely the wrong set of measures. He resolved to revise his principles and make investing based only on the “fundamental” value of a business. This was a fortuitous decision for two reasons: a major change in the information available to investors in securities and an extremely inexpensive market. Just at the time that he resolved to make decisions based on the financial condition of a company, the US government was passing landmark securities legislation, the Securities Act of 1933 and Securities Exchange Act of 1934. These two laws dramatically increased the amount and quality of information that public companies were forced to share with outsiders and investors. At the same time, stocks were trading at multi-decade lows. Many stocks were not only trading at significant discounts to book value but were actually trading below liquidation value.

Graham seized this opportunity to begin purchasing stocks at bargain basement prices. Together with his textbook, which was the first systematic approach to using the newly standardized financial statements required by the SEC, his professorship at Columbia and his success as an investor led to the creation of his hedge fund.

By the early 1950s Graham was again a wealthy man and was something of a legend. He decided to write a book that would encapsulate his investing philosophy. Graham’s philosophy is often distilled into two basic concepts: Margin of Safety and the irrationality of the Market in short term price decisions. In spite of the efficient market hypothesis and its heralds (many of whom are professors at my alma mater on the shores of Lake Michigan), the Intelligent Investor takes both of these factors into consideration in order to maximize his returns.

In my opinion, his system can be boiled down to two factors: know your strategy and exploit market conditions to when they are favourable to your strategy (either in the purchasing or selling). This would be good enough advice (it is often not followed), but he broke down the elements of these two investing rules into more practical factors

• Know what you are looking for. “Value” does not inhere exclusively in an investment. Aninvestment’s value is also based on the objectives and skills of the investor

• ·Leave room for error. Investing is too uncertain to haggle over small differentials. The amount of time some firms spend determining (and arguing) about small changes in discount rates never fails to amaze me. Technical wizardry often trumps common sense, with disastrous results (think LTCM). Better to be approximately correct than precisely wrong, as Buffett says.
  

• Use market error in your favour. If you know what you are looking for, and you can distinguish value from irrational swings, you can have the confidence necessary to make significant capital allocation (or significant reduction of capital allocation) and achieve fantastic returns.

In short, this is one of my favourite books on the topic. It is readable, enjoyable, sensible and practical, which is more than one has a right to expect from most books on finance. It is available for $9.99 from Amazon.

Bill Gross on the Alpha/Beta Challenge

Well, I have just returned from beautiful and warm Thailand. Thai must mean "snacks" in Thai, because the country is literally full of them. I have to say, it was pretty interesting having 78 degrees (Fahrenheit, that's 24 degrees Celsius) on Christmas Day. I'm now in Munich again, where it's sunny (if only for a few hours a day), but -3 (Celsius, which is 26 degrees Fahrenheit. It is an adjustment).

Any event, with my return to broadband, I am also catching up on my back reading, which has been severely curtailed by vacation travelling and sightseeing, moving countries, leaving my former employer and gearing up for a year at the University of St Gallen in Switzerland, where we compress a 22 month degree (the MBA) into 12 months.

But to the topic of this article, Gualberto Diaz has written a post about the current arguments between bulls and bears. I just read a great assessment by Bill Gross, the Managing Director at Pacific Investment Management (PIMCO) about the dilemma that we as investors are facing, which also sheds some light on the issue of what sort of markets to expect going forward. He describes it as the Alpha/Beta anemia. It's implications are far-reaching for investing strategy.

Start with a basic (and correct) assumption. Since GDP measures the overall income from domestic sources (domestic assets), over long periods, returns on assets are likely to rise in lock-step with growth in (nominal) GDP. Many investors still long for the "good old days" when double digit investing returns were common. This was due to the fact that from 1970-1985, nominal GDP increased in double digit amounts. (In the 1970s, asset price returns - which can diverge sharply from the growth of the underlying business income - lagged overall GDP growth, setting the stage for asset price growth stronger than GDP growth in later years to restore the correlation), and the period after 1993, when real GDP grew at 4-5% per year for most of a decade. While nominal GDP increased around 8%, any selectivity in investment choices meant that returns above 8% were easily obtained (and were easily magnified by using financial leverage, i.e. buying on margin).

Unfortunately, from one perspective, those days are over, at least, it would appear so. Economic growth (GDP by another name), is averaging much closer to 2.5%, with inflation matching that figure for a nominal GDP rate of 5% or so per year. Assets should return, therefore, something like that figure. Applying financial leverage (debt) might enable investors to push that up by 1 or 2%. Since asset price levels (in the very long term) reflect earning power of the underlying assets, asset prices (investor returns) are likely to be in this range. Incidentally Warren Buffett wrote an article in Fortune a few years back, and said about the same thing - he expected 6% returns going forward.

Are you still with me? In short, what Gross is saying is, asset income growth should be between five and six percent in the future, with the opportunity to use debt to improve returns on equity to six to seven percent per year. This figure, also called "beta" which describes how much of an investment's price movements can be correlated to market price movements (a basket of stocks with perfect market correlation has a beta of 1.0) is simply too anemic for most investors.

Faced with these returns, however, investors are essentially saying, "that's fine for other people, but I need at least nine or 10 percent". There are several reasons for this, Gross mentions only one, which is the fact that six or seven percent returns will not be adequate to fund future liabilities. He does not specify which liabilities he means but my sense is that he means healthcare and retirement expenses. This blog has said as much many times over (see retirment crisis).

As a result, investors are instead seeking out riskier investments, those that tend to have higher "alpha" which is the additional "reward" that riskier investments should offer. But with that effort to find higher return investments (like small-cap stocks, a favorite of "foolish" investors, particulalry right now), the ususal price discounts that these investments offer in return for their high risk (the risk premium) has diminished. In fact, small cap stocks, far from trading at a discount to large issues, trade at a substantial price premium (which, to some degree may be mitigated by the potential for faster growth, but this is what these alpha-seeking investors are all assuming).

You know what happens when people are lining up to buy something, particularly something that is sold at an auction (which is the case with stocks!), buyers overpay.

In short, what has happened is that the price of risk, the risk premium, has declined substantially. The implications are significant. First, periods of significant stability can actually create risk, because over long periods investors become accustomed to being rewarded for making ever riskier bets, until, unfortunately, they aren't. When the tide turns, many investors will find they have been "swimming naked" in the words of Buffett.

Worse, systemmic underpricing of risk means that index-weighted portfolios (which are weighted in large part based on price levels) will always over-invest in over-priced assets, and under-invest in (risk-adjusted) underpriced assets, as the overpriced assets have higher market capitalization relative to earning potential, and underpriced assets, by definition, have low capitalization relalitve to earning potential. Indexers, in other words, far from being protected by "diversification" will discover that diversification has them overinvesting in today's high priced assets. While their losses might not be as spectactular as those of an investor who was 100% invested in "optical networking" stocks in 2000-2001, losses of 30-50% in diversified porfolios will be little comfort.

Gross suggests, I believe rightly, that the only thing an investor can do is seek to concentrate his money in the single few best investments he can find. Those that offer opportunities to earn superior (and here he means 7%) returns with comparably little risk.

He does not believe that assuming addtional financial leverage is a smart move at this point. Basically, there are two options, the first is that the Fed will renew vigilance with respect to inflation and again raise interest rates. This will reduce financial leverage in the system, which _should_ make things safer, but might also lead to a collapse in certain overvalued asset prices, thereby provoking the crisis that the Fed hopes to prevent. Or, the Fed can allow higher inflation, which, while it will prevent (at least in the short term) a credit crisis, inflation also generally leads to lower asset prices as the twin effects of taxes and higher discount rates reduce present values of assets thereby leading to price declines or stagnation (like the 1970s).

Finally, unmentioned by Bill Gross, but mentioned by Gualberto, most businesses are at peak earning cycles. corporate profits' share of GDP is at all time highs (which is one way that asset prices have outstripped GDP growth over the past three years). The trend of business income increasing faster than overall income cannot continue indefinately. Tax levels linger near post-war lows as (unrecognized) government liabilities pile up on balance sheets, which foretells of greater tax burdens in the future; corporate income, already at high levels, is a natural target for revenue raising.

Finally, we have the issue of those other pesky liabilities for which assets earning six or seven percent - the ones I call the Boomer-Lifestyle Liabilities. These are the costs associated with retiring in the style the Boomers imagine themselves living. Let me make this clear, Boomers, as a group, will live a retirment lifestyle well below that which they are living now. There are various ways that they can help to reduce the gap - they can continue to work in retirement (or not retire), they can pick really great investments (but not all of them can) and they can win the lottery (again, not all can do this either), which means that Boomer consumption will begin declining.

Lower consumption (and higher savings) means more money chasing assets of declining quality (less consumption means lower business income). I don't have to tell you where that leads.

What does this all mean? Most of the bull arguments I have seen are really trader/herder mentality. It amounts to "ride the wave", with a focus on recent economic reports and stock market price level movements as a reason to invest. I will not tell anyone not to ride the wave. But I will ask, what happens when the tide turns, as it will, maybe next year, maybe 2009. Are your assets good enough to survive a major change? Even good enough to survive a tsunami? As Thais can tell you, bad things can happen even when the weather seems perfect at the beach.

Commodity Prices, what do they Suggest

Well, I am already on record as paying relatively little attention to commodities, but I do pay attention to prices levels of some commodities, particularly gold, because of what it suggests about the purchasing power of the dollar. The news here is not good. The dollar is hitting 20 month lows against the Euro. Worse, the price of gold has quietly crept up to near $640 and it might go higher.

One cornerstone of any successful investing strategy is maintaining (at a minimum) purchasing power in spite of a dollar that loses its value on a regular basis (inflation).

Now I have perhaps taken both sides of this argument in the past, which is to say, I have purchased (and continue to hold) a position in CL becuase of its ability to have strong earnings regardless of the relative strength or weakness of the dollar. At the same time, I have argued that commodity prices should fall with the next US recession, which will, in my opinion, be deep.

Ironically, I see the very rise in commodity prices as a major factor in provoking the recession. The Fed has finally admitted that its monetary policy was far too loose in 2003-2004. As a result prices have begun rising significantly, because there is too much money sloshing around the system, and not enough goods for them to chase.

While this is not bad, what makes this situation a disaster is the resulting credit bubble. Credit bubbles are very, very bad. When there seems like there is little consequence of borrowing (like low interest rates), people borrow more than is prudent. They take advantage of the lower rates possible, by using variable interest rates on their debt. In short, they set themselves up for a credit crunch when money gets tighter (as it inevitably does). The Fed would like to end the credit bubble without bringing economic activity to a standstill. This is an admirable objective, but as price levels are again demonstrating, it is not a probable result.

I felt that the Fed erred in stopping further interest rate rises, which, after a monetary orgy, the likes of which we have not seen in decades, only aggresive policy was likely to really curb the bubble. Instead, the Fed has just slowed down the expansion of credit, rather than rein it in. Therefore, prices are bound to keep rising. But the Fed cannot continue to allow these higher prices. They will be forced not to trim rates, but rather to raise them. In the 1990s, we watched central banks go on competitive devaluations and cut rates. Now, we will watch them go on competitive "protection" positions - each raising in part because it wants to defend the value of its currency. The alternative is to watch commodity prices, in local currency terms, rise to highly inflationary levels.

As banks keep tightening credit, those who borrowed imprudently when money was cheap will begin to have difficulty making payments. You know the story from there. Imagine the impact on housing if the Fed finds itself raising rates to 5.75% or 6% next year! Brutal.

But, with rates headed higher, it still pays to keep savings in short term vehicles. They are already paying higher rates, are protected against principal loss (which will happen if long rates rise to reflect inflation) and offer liquidity for making opportunistic purchases.

Developments

Nathan Mayer Rothschild, the oldest of the five Rothschild brothers who established the venerable commercial bank in the late eighteenth and early nineteenth centuries, is said to have remarked, "I never buy at the bottom and I always sell too soon." This sentiment is echoed by the American financier (I believe it was JP Morgan), who, when presented with an investment offering 100% returns, remarked, "Well, you can have the first 30% and the last 30% and I will just take the nice safe 40% in the middle." In other words, he wasn´t interested in buying before he was certain that the return would be positive.

I have recently read that the essence of investing is not managing returns, it´s managing risk. First you want to be reasonably sure of a positive return (capital preservation), only then do you want to consider the potential magnitude of the returns. Too many people look at the magnitude of returns first, and only then consider the probability of achieving these returns. This is why the lottery is so popular - it offers a huge return, for essentially nothing. Of course, most purchasers are simply incapable of appreciating the remoteness of the probability that their return will be positive. So they lose 100% every week, occasionally winning a minor pot of $5 or $10 to desensitize them to the dififculty of the odds they face.

This post isn´t about the lottery, however, it´s about TRLG. I mentioned in a prior post that I had left the temple of True Religion. Actually, I left a few weeks too early. I sold at $22.60 on a day when the high price for the day was §22.80. A few weeks later, the stock actually made new all-time highs in the $24.65 range. I lost out on an extra $800 by "selling too soon". But as my calculations from my DCF model suggested, the stock was near its highs at $22.60, and the probability of further gains were remote. Earnings would have to rise even faster than the 50% I projected for this year (35% for next), or operating margins would have to increase. While the first event was possible, I held out no expectations of the latter.

I work for a manufacturer. Like all companies with independent distribution, we regularly consider whether we wouldn´t be better off if we could capture more downstream revenue. Since pricing is usually based on cost-plus margining, capturing retail sales would significantly increase revenue, without actually capturing market share (we would benefit from selling at the retail price, which , for spare parts, is usually 65-100% greater than the wholesale price). The problem is that in order to do this, we would also have to absorb retail inventory, which would significantly increase working capital. We would also have to pay the expenses at retail that the distributors bear, personnel, rent and overhead. Worse, as a manufacturer, we would only really have one product line, whereas most distributors can amortize expenses over a wider product assortment available to them (since they can sell products from many manufacturers). This is essentially the difference between a specialty retailer and a department store. The department store also finds it easier to attract new customers, since it can easily cross-sell shoppers in the store for other promotions or products.

In fact, what we have begun to see from True Religion is that sales outside of the US are flagging, or at least, not increasing. Sales in the US are increasing, but primarily due to growth in the retail segment (i.e. the company is capturing that downstream revenue). However, this means that revenue is increasing faster than product volume, which raises serious questions about the acceptance of the brand on a broader scope. Worse, they are seeing increasing overhead, which management insists is required for future product introductions, but managing a retail chain is difficult. The company has brought in experience for this. The current management team has demonstrated success with retail, but what we are seeing is collapsing operating margins. For a company whose primary value is in future earnings, lower operating margins have to terrify investors.

In fact, while I was in Mexico on a business trip (I was in the buffett line at lunch actually), two other attendees started talking about the collapse of the stock price of TRLG, which has since declined to the mid $15 range. At this price, you might very well be able to round-trip the stock back up to $20, if management can find the new revenues to justify the ramp-up in expenses. But for the first time, management has failed to deliver the goods and so their ability to win converts on the street will come much harder.

At this point, I am sitting on lots and lots of cash. Buffett notes that this is no fun, and I concur, but at the same time, its better to sit on cash than watch your positions collapse. I am still looking for another investment that I find as attractive as TRLG. Right now, the only investment I consider worthwhile is BAC. I am even beginning to doubt the CL. Since I purchased in October 0f 2004, I have watched the stock price rise 50%, from $44 to $66, at the same time, I have earned nice dividends, which have been hiked twice, from 24 cents to 32 cents a share (for a 33%) increase over the same period. My shareholdings have increased by nearly four percent, giving me a total return of over 56% for the period (If you are wondering why my return isn´t 54%, the sum of the two, the reason is that the shares purchased from dividend reinvestment have also benefitted from rising prices, so my total return exceeds the price increase plus dividend payments).

Generally speaking, your return should reflect the dividend yield plus the rate of increase of dividends. (I have another post explaining why this is so, but essentially, with dividend paying stocks, prices tend to increase at the same rate as dividend increases). With CL price increases have outstripped dividend increases, so the dividend yield has fallen. This suggests lower returns going forward. Indeed, to return to the dividend rate of Oct 2004, when I purchased, dividends would have to increase about 17% or 5 cents per share, from here with no increase in the stock price. This would then offer a return of about 2.6% (the dividend yield at 37 cents per share, per quarter). Such a dividend increase is actually quite probable. The company tends to maintain a dividend payout ratio of around 50% of earnings, with much of the remaining money going to repurchase stock, both preferred and common. In the latest quarter the company earned $0.73 per share. With forward earnings expected to run about $0.80 per share per quarter the company could raise to 38-39 cents per share per quarter. Organic growth, plus benefits from the company´s restructuring make these very reasonable projections. But even with this strong dividend increase rate, the stock should have only moderate price appreciation. Of course, as I have suggested many times, I own the stock because it offers a reasonable return with a high degree of safety, but even stocks like KO can take big dives (granted, at its all-time high Coke was trading at a ridiculous 45 times earnings).

The real kicker with CL is that it trades at 27 times earnings, but that is before the stock is fully diluted. There are 39 million options on the stock. While repurchases are easily oustripping option issuance, redemptions and forfeits are reducing the overall stock of ourstanding options, but with all options exercised, the stock trades at over 30 times earnings. There have to be better options. Unfortunately I haven´t had the time to find them.